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About the Editor
David Harrell is the editor of the Morningstar StockInvestor, a monthly newsletter that focuses on a wide-moat stock investing strategy. For illustration purposes, issues highlight activities pertaining to Morningstar, Inc. portfolios invested in accordance with a strategy that seeks to focus on companies with stable or growing competitive advantages. David served in several senior research and product development roles and was part of the editorial team that created and launched He was the co-inventor of Morningstar's first investment advice software.

David joined Morningstar in 1994. He holds a bachelor's degree in biology from Skidmore College and a master's degree in biology from the University of Illinois at Springfield.

Our Portfolio Managers

Matthew Coffina, CFA, is the portfolio manager for Morningstar Investment Management LLC’s Hare strategy. Matt was previously a senior healthcare analyst, covering managed care and pharmaceutical services companies. Matt also developed the discounted cash flow model used by Morningstar analysts to assign fair value estimates to most of the companies in its global coverage universe.

Matt joined Morningstar in 2007. He holds a bachelor's degree in economics from Oberlin College and also holds the Chartered Financial Analyst (CFA) designation.

Michael Corty, CFA, is the portfolio manager for Morningstar Investment Management LLC’s Tortoise strategy. Before focusing his attention on the Tortoise, Michael co-managed five equity strategies offered by Morningstar Investment Management LLC and Morningstar Investment Services LLC since December 2013. Michael was previously a senior equity analyst on Morningstar Inc.’s equity research team covering companies in the media, business services, and consumer industries. Michael also spent several years on Morningstar’s moat committee, which assigns economic moat and moat trend ratings to their global coverage.

Prior to joining Morningstar in 2004, Michael worked at a public accounting firm and in the business lending arm of a major commercial bank. He has an undergraduate accounting degree from Loyola Marymount University, an MBA from Cornell University and is a CFA charterholder.

Feb 19, 2018
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About the Editor David Photo
David Harrell
Editor, Morningstar StockInvestor
David Harrell is the editor of the Morningstar StockInvestor, a monthly newsletter that focuses on a wide-moat stock investing strategy. For illustration purposes, issues highlight activities pertaining to Morningstar, Inc. portfolios
Featured Posts
Roundup 2/16/2018 -- Amgen and More

StockInvestorSM focuses on the activities of portfolios of Morningstar, Inc. that are invested in accordance with the Tortoise and Hare strategies. These portfolios are managed by Morningstar Investment Management LLC, a registered investment adviser, which manages other client portfolios using these strategies.

A quick note about the Amgen AMGN tender offer: While we cannot provide specific buy/sell advice to newsletter subscribers who own Amgen, Tortoise portfolio manager Michael Corty does not plan to participate in the current tender offer/auction. That said, we cannot make any predictions about how long he will hold Amgen (or any other portfolio holding), as he could decide to sell the stock for other reasons. See the Feb. 2 document on the Amgen investor relations website for details about the offer.

Please see new analyst notes from Morningstar Research Services below for AmerisourceBergen ABC, Baidu BIDU, Berkshire Hathaway BRK.B, Compass Minerals CMP, Enbridge ENB, General Dynamics GD, IQvia IQV, Omnicom OMC, and PepsiCo PEP. Magellan Midstream Partners MMP and Enbridge were tagged in a general note about MLPs and lower tax rates, which is also included below.

Best wishes,

David Harrell,
Editor, Morningstar StockInvestor

Rumor Has It: Walgreens Wants to Follow Familiar Buyout Playbook, but Amerisource May Not Go Along
by Vishnu Lekraj | Morningstar Research Services LLC | 02-13-18

On Feb. 12, The Wall Street Journal reported that Walgreens recently approached AmerisourceBergen about acquiring the drug distributor's remaining equity that Walgreens does not already own. This transaction would vertically integrate the drug distribution and retail pharmacy spaces within the U.S. and falls in line with the strategy that Walgreens' current management team has executed in Europe as it built its Alliance Boots business. While this news is still a press report, we believe the rumor has some substantiation. Over the past few years, Walgreens has partnered and integrated a significant portion of its operating assets and equity with Amerisource. Thus, a total merger seems like the next logical step for the retail pharmacy, particularly given the desire of the firm's leadership to vertically integrate its business in the U.S. However, we believe Amerisource may not share this sentiment. We have assigned Amerisource a wide moat rating, while we assign Walgreens a no-moat rating, and we believe a vertical integration would benefit Walgreens more than Amerisource. Accordingly, we anticipate Amerisource would demand a significant premium above our $106 fair value estimate. We are leaving our moat ratings and fair value estimates in place, given that there has been no official announcement from either firm regarding a potential merger.

Baidu's Improved Revenue Outlook Should Offset the Impact of Margin Pressure in the Near Term
by Chelsey Tam | Morningstar Research Services LLC | 02-14-18

We are planning to maintain our fair value estimate of $217 per share for wide-moat Baidu. While we think operating margin will decline in the near term, we are now more confident in increasing revenue growth, driven by feed revenue and a recovery in the search ad business. Management guided sequential increase of 20% for feed revenue in the second through the fourth quarter of 2018. Baidu's fourth quarter revenue met our estimate but beat the group's guidance, driven by feed revenue and strong search traffic, particularly from e-commerce companies. Fourth-quarter operating profit and non-GAAP operating profit beat our estimates by 2% and 3%, respectively.

We think 2018 operating margin is likely to decrease, owing to increased traffic acquisition costs in the market, 70% content costs year over year, growth in research and development spending growth above 2017's 27% level, and sales and marketing expenses reverting to year-over-year growth. To support the development of the flagship Baidu app and other new apps, management believes in the importance of investing to acquire traffic and promote these apps. While peers like Sohu are reducing content costs, video content market leader Baidu will invest heavily in both self-produced content and licensed content for iQiyi, which will help sustain its leading position, in our view.

Announced Sale of Phillips 66 Shares Adds to the Changes Seen in Berkshire's Equity Portfolio in 4Q
by Greggory Warren, CFA | Morningstar Research Services LLC | 02-14-18

Wide-moat Berkshire Hathaway's fourth-quarter 13-F filing provides insight into changes in the insurer's common stock holdings in the previous quarter. By our estimates, the insurer sold off $6.0 billion in stock holdings and put $6.4 billion to work during the period, primarily in names the firm already held. The biggest moves were basically a swap of 35 million shares of narrow-moat IBM (worth around $5.2 billion) for 31.2 million shares of wide-moat Apple (at a cost of around $5.1 billion). This lifted the latter to Berkshire's largest stock holding, with Apple accounting for 14.6% of the insurer's $191.2 billion portfolio at the end of 2017, and whittled down the company's stake in IBM to 2 million shares, which we do not expect to remain in the portfolio for long.

Other purchases during the quarter included 10.6 million shares of Bank of New York Mellon and 2 million shares of US Bancorp for an estimated $566 million and $107 million, respectively. This looked to be financed in part by an expected trimming of 6 million shares of Wells Fargo for an estimated $347 million, which is tied more to the insurer's ownership threshold in that bank than the company's fundamentals. Berkshire also picked up another 2.8 million shares in Monsanto for an estimated $335 million and put new money to work in Teva Pharmaceutical, acquiring 18.9 million shares for around $345 million.

As for the remaining sales, the company sold off one sixth of its stake in General Motors for an estimated $407 million, as well as relatively small trimmings of holdings in American Airlines and Sanofi-Aventis. The bigger news on the sales front involved Berkshire's announcement earlier on Feb. 14 that Phillips 66 is buying back 35 million shares from the insurer for $3.3 billion in a private transaction. This deal reduces Phillips 66 outstanding share count by around 7%, while still leaving Berkshire with close to 45.7 million shares.

Trimming Our Compass Minerals FVE to $82 as Goderich Geology Concerns Chill Cost Savings
by Seth Goldstein, CFA | Morningstar Research Services LLC | 02-14-18

Compass Minerals reported fourth-quarter results roughly in line with our expectations as the company wrapped up a challenging 2017 that saw salt profits decline due to mild winter weather. Although the 2017-18 winter weather has begun with an above average number of snow days, we're lowering our fair value estimate to $82 per share from $84 on lower near-term profits than we previously anticipated.

At the Goderich mine, the salt that Compass is currently extracting has an increased level of impurities. In order to meet product quality specifications, Compass will have to install new refining equipment. Because the vast majority of salt that Compass sells is a lower quality product used for deicing, we think the increased refining costs will only partially offset the firm's cost savings measures from the implementation of continuous miners. While we had projected the total company's unit production costs to fall roughly 15% from 2015 levels (in real terms), we now expect only a 10% reduction. As we still see an overall unit cost reduction, our wide-moat rating based on Compass' cost advantage moat source is unchanged.

We note that the winter of 2017-18 has continued to bode well for Compass' near-term deicing salt sales. Through January, the number of snow days in Compass' Midwest and Great Lakes footprint was around 10% higher than what we would expect in an average winter. While the two previous winters saw an unusually light amount of snowfall, this winter's solid start is likely to significantly increase near-term demand for deicing salt as municipalities and consumers will likely need to replenish inventories. As such, we forecast Compass' total salt sales will grow to 12.4 million tons in 2018, versus 10.6 million in 2017.

Best Idea Enbridge: Record Mainline Throughput and an Impressive Quarter
by Joe Gemino, CPA | 02-16-18

Wide-moat Enbridge reported fourth-quarter adjusted EBITDA of CAD 3 billion, which was not materially different from our expectations. Adjusted EBITDA was up significantly from the prior year of CAD 1.8 billion. The increase in performance was attributable to the positive impact from the new assets as part of the Spectra Energy Merger coupled with record-high throughput levels on the Canadian Mainline and Lakehead systems. We anticipated high utilization of the Mainline and Lakehead system due to our recent bullish forecast in Canadian crude growth. However, the Mainline and Lakehead averaged 2,531 barrels of oil per day and 2,677 bbl/d, respectively, both ahead of our expectations. Additionally, Distributable Cash Flow, or DCF, almost doubled from the year-ago period to CAD 1.7 billion on the same factors as adjusted EBITDA and was in line with our expectations.

We intend to incorporate these financial and operating results shortly, but for now our $50 (CAD 64) fair value estimate and wide moat rating are unchanged.

In Contrarian Move, General Dynamics Acquires CSRA
by Chris Higgins | Morningstar Research Services LLC | 02-12-18

Wide-moat General Dynamics announced it will acquire CSRA, a U.S. government IT services company, for $9.6 billion ($6.8 billion plus $2.8 billion of assumed debt). The deal should close during the first half of 2018. We're surprised by the deal because it invests in GD's slowest-growing business line. On the other hand, if GD is going to keep its $4.5 billion GD-IT business line (currently housed in the information systems and technology segment), the company needs to scale up to compete in a consolidating industry. GD is now the second-largest IT services provider for the U.S. federal government, nipping at the heels of Leidos. We're maintaining our $200 fair value estimate and wide moat rating for GD for now but plan to revisit our valuation as we analyzing the deal further. Although we think GD-IT and CSRA are narrow-moat businesses, their combined size in GD's portfolio will stand at only 25% of revenue.

We would have appreciated a divestment of the GD-IT business more than an acquisition adding to the company's footprint in this market. Nonetheless, hardware targets large enough to move GD's needle in the defense world are few and far between, which meant that if management wanted to acquire, services was the most target-rich environment. GD is bucking industry trends with this deal, doubling down on a business area that Lockheed Martin, L3, and other hardware players have exited over the past several years because of pricing pressures and conflicts of interest.

Management's thesis is that pricing pressures are fading after a disastrous experiment with lowest price technically acceptable contracting and that CSRA's technical advice to the Department of Defense doesn't create conflicts of interest with GD's hardware business. We think pricing on contracts is improving but consolidation will continue to put a lid on services margins for CSRA and other players, as competitors take overhead costs out of their business.

Momentum Continues for IQvia With 4Q Results; Increasing FVE to $105
by Kelsey Tsai, CFA | Morningstar Research Services LLC | 02-16-18

We are updating our fair value estimate for IQVIA, formerly QuintilesIMS, slightly to $105 per share from $100 following the company’s fourth-quarter results. The gain is largely attributable to the time value of money, as quarterly results and 2018 outlook prompted no major changes to our estimates. With its amassed scale and intangible assets, IQVIA is in a plum position in the late-stage contract research industry and healthcare technology space, which underlies our wide moat rating.

Although we anticipated a bump in fourth-quarter sales from the firm’s commercial solutions segment thanks to the seasonal spending pattern for technology, growth was even stronger than we expected (up 8% year over year in constant currency). Given the pressure on top-line growth from the legacy Quintiles Encore business is now fully behind the company, as well as the growing traction seen in the firm's real-world insight solutions business (high teens growth), we anticipate strong high-single-digit growth in 2018.

However, softer fourth-quarter revenue from R&D Solutions, IQVIA's contract research arm, partially shadowed this outperformance (up 5% year over year in constant currency). Weaker bookings from a year prior fed into the fourth quarter's marginal weakness, but the impressive momentum in net new business throughout 2017 led by IQVIA's next-generation CRO offering is expected to support robust 2018 growth. Emerging biotechs have led adoption of IQVIA's next-generation solution for complex clinical trials, but we anticipate contributions from larger biopharma firms, which typically have longer decision-making processes, will further expand demand next year. As a result, the company's twelve-month trailing book-to-bill ratio swelled to 1.24 times and should support our 2018 mid-single digit growth expectations for the segment, which is artificially weighed by the adoption of new accounting standards that require revenue to be recognized on a percentage of completion basis.

Integrated engagement solutions, which largely consists of IQVIA's contract sales organization, remained a sore spot for the firm in the quarter (down 5% year over year in constant currency). The company is investing minimally to stabilize the business as it tries to find a buyer. We have little expectation for the segment, which is a minor contributor to the bottom line. In our view, the company's focus on its most moatworthy contract research and technology segments is a smart strategy. We expect better product mix and operational leverage from top-line growth to be the biggest drivers of modest margin improvement over the long term.

Omnicom Ended 2017 With Mixed 4Q but Expects Solid Organic Growth in 2018; Plan to Maintain $85 FVE
by Ali Mogharabi | Morningstar Research Services LLC | 02-15-18

Omnicom reported mixed fourth-quarter results as the firm missed our expectation and consensus on revenue but slightly beat on the bottom line. While organic growth was strong during the quarter, there were indications of some weakness in a couple of developed regions mainly due to tough comps from the prior year. Management guided for solid organic growth in 2018 but currently does not expect margin expansion, in line with our assumption. We do not expect to make any material changes to our model and plan to maintain our $85 fair value estimate for Omnicom. Due to the revenue miss, the stock is down 6% but remains in the 3-star territory, which it entered recently after climbing more than 26% from its lows in November of last year.  We are now recommending a wider margin of safety before investing in narrow-moat Omnicom. We do note that at current levels, Omnicom's dividend yield stands at over 3%

Pepsi's Brand Investments Should Restore Top-Line Gains in Beverage Portfolio; Shares Fairly Valued
by Sonia Vora | Morningstar Research Services LLC | 02-13-18

While wide-moat PepsiCo's annual results came in slightly shy of our expectations, with sales of $63.5 billion and operating margin of 16.5% falling below our outlook of nearly $64 billion and operating margin around 17%, we contend that the firm's sustained investments in its brands will accelerate top-line growth over the long run. Further, we were pleased to see product and packaging innovation drive a 2% improvement in net pricing. This supports our view that the firm's brand strength has remained intact despite near-term volume challenges, which we've largely seen across the nonalcoholic beverage space, as domestic carbonated soft drink consumption continues to be sluggish and competition from niche players remains heightened. We plan to maintain our forecast for mid-single-digit operating income growth, driven by further gains in the higher-margin snack business and modest net pricing increases. As such, we don't anticipate material changes our $118 fair value estimate, outside of adjustments for the time value of money, and think shares look fairly valued.

While the North American beverages segment (33% of sales) posted volume declines for the second quarter in a row, we think Pepsi's investments in advertising and marketing will help the firm capture consumers' attention at points of sale and drive volumes of its higher-velocity core brands, restoring growth to the low-single-digit range seen over the last two years. We think Pepsi's product innovation among its ancillary brands has remained solid (for example, the launch of Bubly should help it tap into the sparkling water category), but larger brands like Gatorade and Mountain still contribute the majority of the firm's beverage volumes and require sufficient investment. We contend that a return to growth in Pepsi's North American beverage portfolio will ultimately depend on turnover among these brands, which an uptick in promotional spending should support.

Tax Impact on Pipelines Likely Overblown; Time to Consider Undervalued Midstream
by Stephen Ellis | Morningstar Research Services LLC | 02-12-18

A Feb. 8 Wall Street Journal article suggested that all regulated pipelines would be negatively affected by lower tax rates, as regulators would force pipeline operators to cut rates and pass the savings on to customers. We think fears over the issues raised in the article are generally overstated, and we would be looking to purchase quality midstream firms at a discount, including Enbridge, Spectra Energy Partners, Enterprise Products Partners, and Plains All American Pipeline. We do not plan to adjust our fair value estimates or moat ratings for the industry.

The issue at hand is that for pipelines operating under a cost-of-service pricing model, rates are tied to operational costs, which include taxes. With lower tax rates, the Federal Energy Regulatory Commission has asked 13 pipeline operators to review their rates. We think it is important to understand that the cost-of-service pricing model is not the dominant rate model, as FERC also allows market-based or negotiated rate setting, as well as index-based rate setting. The latter two approaches are the most common rate-setting models in the industry and would not be affected by changes in tax rates. For example, Enterprise Products Partners has most of its pipelines on market-based rates. Further, FERC only regulated interstate pipelines, meaning intrastate assets, including Energy Transfer Partners' large Texas system, would not be affected. Energy Transfer has been able to negotiate rates for its Texas assets without regulatory hearings. Other pipeline operators such as Spectra Energy Partners have not filed a rate case in more than a decade, and unless they do so, they are unlikely to be affected.


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David Harrell may own stocks from the Tortoise and Hare Portfolios in his personal accounts.

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