FundInvestor PMS 185 U

Transcription

Cover_0807.qxp
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8:36 PM
Page 1
StockInvestor
August 15, 2007
Volume
Number
7
2
Buying core holdings at a discount
Options for Long-Term
Investors
Although stock options are viewed by many as the
realm of traders and speculators, there are ways they
can be used by rational investors with a long-term
view. We are expanding our options coverage here at
Morningstar, and I plan on periodically sharing ideas
from the options realm for companies in the Tortoise
and Hare. This month, I thought I would introduce
stock options for those who are unfamiliar, as well as
explain some of the basic strategies available.
Our focus on businesses and intrinsic value gives
us an edge in this space. As I will explain in a moment,
the vast majority of options traders are focused
on two things we should not care about—short-term
stock prices and volatility. By focusing on intrinsic
business value and using options to exploit this
perspective-based advantage we have, we should be
able to increase our returns.
An Introduction
There are two types of stock options that can be
bought and sold—the call and the put. A call option
gives its owner the option (but not the obligation)
to buy a stock at a specific price, known as the strike
price, up to a given point in time, called the expiration
date. A put provides the owner of the option the
right to sell a stock at a specific price up to a given
point in time. Options are contracts, and one
can either buy a contract or sell to create a contract.
Options are traded in units called contracts. Each
contract covers 100 shares, though option prices
are quoted in per-share terms. An example should make
things clearer. If I were to buy five contracts priced
at $10 to buy eBay EBAY with a $30 strike price and a
January 2010 expiration, I would hand over $5,000
(5 contracts x $10 x 100 shares per contract) plus
commission. I’d then have the right to buy 500 shares
of eBay at $30 between now and January 2010.
If a call option has a strike price below the market
price, it is “in the money,” as is a put option that has
a strike price above the market price. In the money
options have intrinsic value if exercised today, which
is the case in our eBay example above. Options
“out of the money” would not have value if exercised,
but still have some value because of the potential
to become in the money in the future.
There are several key factors that influence option
values. First, the level of volatility in the underlying
stock plays a key role in an option’s price. The higher
the volatility of the underlying security, the greater
the value of the option. If the underlying stock is more
volatile, it means the option has a greater chance of
trading in the money before the option expires. Second,
the amount of time left until the option expires
influences the option’s value. The more time left until
expiration, the greater the value of the option.
Again, the longer until expiration, the more time for
an option to trade or finish in the money. Finally,
the direction in which the underlying stock is trading
will affect the value of the option. If a stock appreciates, it will positively affect call options and
negatively affect put options. If a stock falls, it will
have the opposite effects.
Pros and Cons
Options certainly can have their place in a long-term
investor’s portfolio, but some very important caveats
Continued on Page 30
Paul Larson
Equities Strategist and Editor
The Tortoise Portfolio
2
Our favorite conservative
picks, including Bank of America
and Novartis
The Hare Portfolio
Our favorite aggressive picks,
including eBay and CarMax
4
Tortoise and Hare Focus
6
Washington Mutual and Expedia
Bellwether Watchlist
8
Ratings and comments on more
than 150 wide-moat companies
InternationalInvestor
Russia: The Bear Roars
17
Company Spotlights
Q&A with our Corporate
Executive Board and Amgen
analysts
22
Company Focus
Nike, Discover Financial
Services, Hershey, and
Lowe’s
26
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2
The Tortoise Portfolio
blend funds since inception, but it has outperformed
only 10.5% of these funds over the past 12 months.
Morningstar Stock Portfolios | Paul Larson
From its inception on June 18, 2001, through July 31,
2007, the Tortoise Portfolio has returned 90.6%
compared with a total return of 33.2% for the S&P 500
Index and 37.3% for the average large-cap blend
mutual fund. Year to date, this portfolio has risen 1.4%
versus a 3.6% total return for the S&P 500. The
Tortoise has outperformed 97.9% of U.S. large-cap
The Tortoise
Portfolio
Portfolio Holdings
Performance
and Transaction
Summary
Stock Name
Å 5 Shares added
Í 5 Shares sold
Bank of America BAC
C 5 New holding
UR 5 Under Review
Berkshire Hathaway BRK.B
Star
Rating
Business
Risk
QQQQQ
QQQQQ
QQQQQ
QQQQ
QQQ
-Avg
Fair
Value ($)
Current
Price ($)
Consider
Buying
Consider
Selling
4700.00 3604.00 4004.90 6170.60
Size of
Moat
Dividend
Yield (%)
Wide
0.0
œ
Stewardship
61.00
46.29
47.00
76.40
Narrow
1.7
∑
70.00
47.42
54.00
87.70
Wide
4.7
∑
-Avg
60.00
52.11
51.10
78.80
Wide
2.5
¥
-Avg
71.00
66.00
60.50
93.20
Wide
2.1
∑
QQQQQ
QQQ
QQQQ
QQQQQ
QQQQQ
-Avg
73.00
53.95
62.20
95.80
Wide
2.0
—
-Avg
61.00
57.68
52.00
80.10
Wide
1.9
¥
-Avg
53.00
46.42
45.20
69.60
Wide
1.9
∑
-Avg
80.00
60.50
68.20
105.00
Wide
1.9
∑
-Avg
70.00
58.54
59.60
91.90
Wide
1.0
œ
QQQQ
QQQQQ
QQQQQ
QQQQQ
QQQ
-Avg
57.00
48.77
48.60
74.80
Wide
2.4
œ
-Avg
47.00
36.56
40.00
61.70
Wide
1.1
œ
-Avg
60.00
45.95
51.10
78.80
Wide
1.7
∑
-Avg
63.00
44.01
48.60
78.90
Wide
3.2
œ
-Avg
79.00
78.56
60.90
99.00
Wide
1.3
œ
QQQQQ
QQQQ
QQQ
QQQ
QQQQ
-Avg
44.00
37.17
37.50
57.80
Wide
2.2
¥
-Avg
700.00
549.50
539.80
877.00
None
1.5
œ
-Avg
35.00
36.20
29.80
46.00
Narrow
3.2
œ
-Avg
55.00
49.90
46.90
72.20
Wide
6.7
œ
-Avg
76.00
65.62
64.80
99.80
Wide
1.9
∑
58.00
37.53
44.70
72.70
Narrow
5.8
∑
31.00
23.51
23.90
38.80
Wide
4.5
¥
Moody’s MCO
QQQQQ -Avg
QQQQQ -Avg
QQQQQ -Avg
65.00
53.80
55.40
85.30
Wide
0.6
∑
Broadridge Fin Solutions BR
Not Rated
NA
NA
17.59
NA
NA
NA
0.3
—
Coca-Cola KO
Colgate-Palmolive CL
Novartis AG NVS
Wrigley Wm Jr WWY
Automatic Data Prcsng ADP
Johnson & Johnson JNJ
American Express AXP
Anheuser-Busch Co BUD
What is the goal of
the Tortoise Portfolio?
The Tortoise Portfolio has two
goals: to outperform the S&P
500 Index and to generate positive returns regardless of
the broad market environment.
Companies in this portfolio
tend to be large, moderate to
low risk, and slow growing.
We aim for all the companies
here to have an economic moat.
Morningstar Ratings & Fundamentals
-Avg
Spec 5 Speculative
Avg 5 Average
The Tortoise had yet another bad month in terms of
performance. Not only did it lose more value, but
it also lost ground to the S&P 500. Leading the way on
the downside again was Moody’s MCO, falling
13.5% in July. Look no further than the tumult in the
-Avg
First American FAF
1Avg 5 Above Average
2Avg 5 Below Average
There were no trades in the Tortoise in July. But with
the recent market volatility creating numerous
buying opportunities (the “Consider Buying” list on
page 14 is at record length), I would not be
surprised to find myself making some trades shortly.
Cintas CTAS
Wal-Mart Stores WMT
J.P. Morgan Chase & Co. JPM
General Dynamics GD
Home Depot HD
White Mountains Ins WTM
TransCanada TRP
Kinder Morgan Mngmt KMR
PepsiCo PEP
Washington Mutual WM
Pfizer PFE
Cash Holdings
Tortoise Portfolio Total
2.5
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Page 3
Morningstar StockInvestor
Median Price/Fair-Value Ratio
Subgroup
Med. P/FV Ratio
All Stocks
Wide Moat
Narrow Moat
No Moat
Below Avg. Risk
Average Risk
Above Avg. Risk
NYSE
NASDAQ
0.96
0.91
0.94
1.00
0.91
0.96
0.99
0.96
0.96
Data through July 31, 2007.
credit markets for a reason for Moody’s decline. I
am kicking myself for not selling all of the portfolio’s
stake in Moody’s when I trimmed the position in
February. Only two fair value changes to note—a $2
per share decrease at Pfizer PFE reflecting higher
Lipitor competition, and a $4 increase at General
Dynamics GD mirroring accrued cash flows.
Ticker
Paul Larson personally owns shares of the following Tortoise stocks:
BAC, BRK.B, BUD, CTAS, FAF, GD, HD, JNJ, JPM, KMR, KO, NVS, PFE,
TRP, +WM, WMT, and WWY.
1 5 Paul has bought the stock in the past month.
2 5 Paul has sold the stock in the past month.
© 2007 Morningstar, Inc. All rights reserved. Any opinions, recommendations,
or information contained herein: (i) is for educational purposes only; (ii) is not
guaranteed to be accurate, complete, or timely; (iii) has not been tailored to suit
any particular person’s portfolio or holdings; and (iv) should not be construed
as investment advice of any kind. Neither Morningstar nor any of its agents shall
have any liability with respect to such opinions, recommendations, or information.
Morningstar has not given its consent to be deemed an “expert” under the
federal Securities Act of 1933. Past performance is no guarantee of future results.
Before making any investment, consult with your financial advisor. Morningstar
employees may have holdings in the stocks recommended.
Portfolio Performance Breakdown
Portfolio Value
Date of First # of Shares
Purchase
+/– Change Total
Cost Basis/
2
Share ($)
Total
2
Cost ($)
Current
Value ($)
8613.00
14416.00
67.4
% Gain / % of
Loss
This
Month
12 Month
Since5
Inception
—
-3.2
12.4
11.1
S&P 500 Index
1455.3
-3.1
16.1
4.8
NASDAQ Composite
2546.3
-2.1
22.7
4.2
Trailing Return (%)
Index
Level
8.0
Tortoise Portfolio
Portfolio
BRK.B 06-18-01
0
4
2153.25
FAF
03-17-04
0
300
28.70
8610.99
13887.00
61.3
7.7
BAC
04-25-07
0
270
50.43
13615.67
12803.40
-6.0
7.1
KO
10-01-04
0
200
40.63
8125.72
10422.00
28.3
5.8
CL
06-26-02
0
150
45.54
6831.23
9900.00
44.9
5.5
% Total Return
NVS
02-09-07
0
170
57.05
9697.79
9171.50
-5.4
5.1
•Tortoise Portfolio • S&P 500 Index
WWY 04-18-06
0
150
45.97
6895.59
8652.00
25.5
4.8
70
ADP
06-14-02
0
175
27.84
4872.72
8123.50
66.7
4.5
JNJ
12-06-05
0
130
59.51
7736.38
7865.00
1.7
4.4
AXP
07-18-01
0
125
29.46
3682.50
7317.50
98.7
4.1
BUD
10-20-03
0
150
48.70
7304.36
7315.50
0.2
4.1
CTAS
05-16-07
0
200
37.61
7522.00
7312.00
-2.8
4.0
WMT 07-19-02
0
150
47.43
7114.28
6892.50
-3.1
3.8
07-23-02
0
150
30.49
4574.16
6601.50
44.3
3.7
JPM
3
Contact Paul Larson at [email protected]
One correction to mention. Last issue, Broadridge
Financial BR (the spin-off received from Automatic
Data Processing ADP earlier this year) did not appear
in the portfolio table. I did not sell it just yet, and
Broadridge should have appeared. All the other portfolio data was correct. My apologies for the error. œ
Portfolio Transactions
August 2007
35
0
06-01
06-02
06-03
06-04
Top Five Sectors (%)
a Financial Srvcs
s Consumer Goods
37.6
22
33
26
Lrg
11
7
0
Med
0
0
0
Sm
0
80
25.31
2025.06
6284.80
210.4
3.5
09-24-01
0
150
21.85
3277.50
5575.50
70.1
3.1
i Healthcare
p Business Srvcs
11.7
HD
WTM 11-05-01
0
10
355.30
3553.00
5495.00
54.7
3.0
o Consumer Srvcs
7.1
TRP
01-23-04
0
150
21.21
3181.88
5430.00
70.7
3.0
KMR
03-08-06
0
105
38.33
4024.13
5239.50
30.2
2.9
75
35.92
2694.25
4921.50
82.7
2.7
WM
12-05-01
0
125
31.05
3881.75
4691.25
20.9
2.6
PFE
09-24-01
0
150
35.21
5281.01
3526.50
-33.2
2.0
MCO
12-16-02
0
50
20.80
1039.75
2690.00
158.7
1.5
BR
06-14-02
0
43
11.92
512.56
756.37
47.6
0.4
5554.423
4
180844.24
3.1
100.0
10.3
p50 –100
p25 – 50
p10 – 25
p0 – 10
Morningstar ratings and fundamentals as of 07-31-07. Portfolio inception date: 6-18-01.
1
0
06-07
Value Blend Growth
23.5
03-12-03
07-19-02
06-06
Style Breakdown (%)
GD
PEP
06-05
Master limited partnership units have
different tax characteristics than common
stocks and may not be suitable for taxdeferred accounts such as IRAs. Please
consult your tax advisor before buying.
2
Cost basis includes commissions.
Includes interest and dividends.
4
Includes capital gains.
5
Returns since inception are annualized
and include dividends.
3
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Page 4
4
The Hare Portfolio
Though the Hare lost value, July was good for the
portfolio on a relative-performance basis versus both
the S&P and the Tortoise. The S&P had its worst
month since July 2004, yet seven of the Hare’s holdings bucked the trend and rose in value.
Morningstar Stock Portfolios | Paul Larson
From its inception on June 18, 2001, through July 31,
2007, the Hare Portfolio has returned 62.7% compared
with a total return of 33.2% for the S&P 500 Index
and 19.7% for the average large-cap growth mutual
fund. Year to date, this portfolio has returned
5.2% versus a 3.6% total return for the S&P 500 Index.
The Hare has outperformed 97.3% of U.S. largecap growth funds since inception and 98.8% of these
funds in the past 12 months.
The Hare
Portfolio
Performance
and Transaction
Summary
Å 5 Shares added
Í 5 Shares sold
C 5 New holding
UR 5 Under Review
Spec 5 Speculative
1Avg 5 Above Average
2Avg 5 Below Average
Avg 5 Average
Portfolio Holdings
I made several trades this past month. On July 10, I
sold the portfolio’s entire stake in Nokia NOK
at $28.88, raising $11,541.83. I’ve never been a fan of
companies with very rapid product cycles, and
Nokia selling at a premium to our fair value estimate
proved a juicy chance to reallocate capital to some
of the other opportunities available.
I then used the funds to buy one new position—
Corporate Executive Board EXBD—and added to
existing holdings Enterprise GP Holdings EPE
Morningstar Ratings & Fundamentals
Star
Rating
Business
Risk
-Avg
32.00
23.93
-Avg
167.00
160.80
-Avg
40.00
32.84
30.80
50.10
eBay EBAY
QQQQQ
QQQ
QQQQ
QQQ
QQQQQ
Paychex PAYX
QQQQ
Stock Name
CarMax KMX
MasterCard MA
Compass Minerals Intl CMP
Biogen Idec BIIB
Fair
Value ($)
Current
Price ($)
Consider
Buying
Consider
Selling
Size of
Moat
Dividend
Yield (%)
24.70
40.10
Narrow
0.0
128.80
209.20
Wide
0.3
¥
Narrow
3.8
∑
Stewardship
∑
-Avg
58.00
56.54
44.70
72.70
Wide
0.0
∑
-Avg
49.00
32.40
41.80
64.30
Wide
0.0
∑
œ
-Avg
46.00
41.38
39.20
60.40
Wide
2.3
QQQQQ -Avg
Å Fastenal FAST
Enterprise
GP
Holdings
LP
EPE
QQQQQ -Avg
Å
63.00
45.07
53.70
82.70
Wide
0.9
œ
54.00
40.45
41.60
67.70
Wide
3.5
∑
QQQQ -Avg
QQQQQ -Avg
34.00
28.99
29.00
44.60
Wide
1.4
œ
38.00
31.88
32.40
49.90
Wide
2.3
∑
QQQ
QQQQQ
QQQQQ
QQQQQ
QQQQ
-Avg
65.00
59.11
50.10
81.40
Wide
0.0
¥
-Avg
32.00
19.95
27.30
42.00
Wide
0.1
¥
-Avg
63.00
47.89
48.60
78.90
Wide
0.2
¥
-Avg
47.00
35.32
36.20
58.90
Wide
1.5
∑
-Avg
34.00
27.97
26.20
42.60
Wide
0.0
†
QQQQQ -Avg
QQQQ -Avg
QQQQ -Avg
93.00
67.42
71.70
116.50
Wide
2.1
¥
41.00
32.34
31.60
51.40
Narrow
2.3
—
69.00
53.74
53.20
86.50
Wide
0.0
¥
Microsoft MSFT
Sysco SYY
Apollo Group APOL
What is the goal of
Western Union WU
the Hare Portfolio?
International Speedway ISCA
The Hare Portfolio has two
International Game Tech IGT
goals: to outperform the S&P
Dell DELL
500 Index and to generate positive returns regardless of the
C Corporate Executive Brd EXBD
broad market environment.ComCemex SAB de CV CX
panies in this portfolio tend to
Amgen AMGN
either be small or fast growing,
or have a high risk/return
IAC/InterActiveCorp IACI
proposition. All companies here
Expedia EXPE
have an economic moat.
Boston Scientific BSX
Í Nokia NOK
-Avg
UR
28.74
UR
UR
Narrow
0.0
¥
QQQQQ -Avg
38.00
26.61
29.30
47.60
Narrow
0.0
¥
QQQQQ -Avg
QQQ
Avg
21.00
13.15
16.20
26.30
Wide
0.0
¥
27.00
28.57
20.80
33.80
Narrow
2.1
œ
UR
Cash Holdings
Hare Portfolio Total
1.7
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Page 5
and Fastenal FAST. There is much more on Corporate
Executive on page 22, while Enterprise was spotlighted in the June issue, and the interview with our
Fastenal analyst was in the March issue.
AMGN, APOL, BIIB, CMP, CX, DELL, +EBAY, EPE, +EXBD, EXPE, FAST,
IACI, IGT, ISCA, KMX, MA, MSFT, PAYX, SYY, and WU.
© 2007 Morningstar, Inc. All rights reserved. Any opinions, recommendations,
or information contained herein: (i) is for educational purposes only; (ii) is not
guaranteed to be accurate, complete, or timely; (iii) has not been tailored to suit
any particular person’s portfolio or holdings; and (iv) should not be construed
as investment advice of any kind. Neither Morningstar nor any of its agents shall
have any liability with respect to such opinions, recommendations, or information.
Morningstar has not given its consent to be deemed an “expert” under the
federal Securities Act of 1933. Past performance is no guarantee of future results.
Before making any investment, consult with your financial advisor. Morningstar
employees may have holdings in the stocks recommended.
Sign up for free Portfolio E-Mail Alerts
Want to find out about changes to our portfolios? Sign up for e-mail
alerts at http://msi.morningstar.com. We’ll let you know what
stock(s) we traded, and why, within 24 hours of any transaction.
Portfolio Performance Breakdown
Portfolio Value
Ticker
Date of First # of Shares
+/– Change Total
Purchase
KMX
01-20-04
0
1100
14.71
16181.44
26323.00
62.7
14.8
MA
05-30-06
0
100
44.00
4399.98
16080.00
265.5
9.0
CMP
08-18-05
0
350
24.26
8490.48
11494.00
35.4
6.5
BIIB
12-12-02
0
200
32.58
6516.00
11308.00
73.5
6.4
EBAY 04-20-06
0
330
33.08
10917.98
10692.00
-2.1
6.0
% Total Return
PAYX
06-24-02
0
250
28.55
7138.50
10345.00
44.9
5.8
•Hare Portfolio • S&P 500 Index
FAST
01-29-07
+95
220
38.56
8482.65
9915.40
16.9
5.6
80
EPE
05-29-07
+65
235
37.74
8867.87
9505.75
7.2
5.3
MSFT 08-22-05
0
300
26.30
7891.26
8697.00
10.2
4.9
10-09-03
0
250
31.98
7996.00
7970.00
-0.3
4.5
APOL 08-02-04
0
125
66.81
8351.73
7388.75
-11.5
4.2
WU
10-02-06
0
365
17.74
6474.63
7281.75
12.5
4.1
ISCA
01-06-06
0
150
48.44
7266.11
7183.50
-1.1
4.0
IGT
06-27-05
0
200
28.35
5669.00
7064.00
24.6
4.0
DELL
09-21-01
0
200
20.39
4078.00
5594.00
37.2
3.1
EXBD 07-10-07
+80
80
67.76
5421.14
5393.60
-0.5
3.0
12-11-06
0
128
31.52
4034.10
4139.52
2.6
2.3
AMGN 06-11-02
0
75
38.80
2910.25
4030.50
38.5
2.3
01-11-05
0
100
28.39
2838.87
2874.00
1.2
1.6
SYY
CX
IACI
Cost Basis/
2
Share ($)
Total
2
Cost ($)
Current
Value ($)
% Gain / % of
Loss
Portfolio
01-11-05
0
100
BSX
NOK
22.73
2273.12
2661.00
17.1
06-18-01
0
06-18-01
-400
160
8.60
1376.00
2104.00
52.9
1.2
0
12.48
4991.00
0.00
0.0
0.0
137.993
1.5
0.1
4
178182.76
100.0
This
Month
12 Month
Since5
Inception
—
-2.4
31.8
8.3
S&P 500 Index
1455.3
-3.1
16.1
4.8
NASDAQ Composite
2546.3
-2.1
22.7
4.2
Trailing Return (%)
Index
Level
Hare Portfolio
40
0
06-01
06-02
06-03
06-04
Top Five Sectors (%)
o Consumer Srvcs
p Business Srvcs
06-05
06-06
06-07
Style Breakdown (%)
36.5
Value Blend Growth
27.5
0
14
39
Lrg
i Healthcare
d Ind Mtrls.
9.8
0
12
28
Med
6
0
0
Sm
g Utilities
5.3
8.8
p50 –100
p25 – 50
p10 – 25
p0 – 10
Morningstar ratings and fundamentals as of 07-31-07. Portfolio inception date: 6-18-01.
1
EXPE
5
Paul Larson personally owns shares of the following Hare stocks:
Many portfolio companies have reported second
quarter earnings in recent weeks. We had IAC/InterActive IACI “under review” at publication after the
firm reported disappointing results, but nearly all the
other earnings reports looked solid. We knocked a
dollar off our Compass Minerals CMP fair value, and
also reduced our Expedia EXPE fair value after the
proposed share buyback was reduced in size. On the
other side of the coin, we modestly increased our fair
values for Paychex PAYX and Biogen Idec BIIB. œ
Portfolio Transactions
August 2007
Master limited partnership units have
different tax characteristics than common
stocks and may not be suitable for taxdeferred accounts such as IRAs. Please
consult your tax advisor before buying.
2
Cost basis includes commissions.
Includes interest and dividends.
4
Includes capital gains.
5
Returns since inception are annualized
and include dividends.
3
Focus_0807.qxp
8/2/07
8:22 PM
Page 6
6
Washington Mutual WM
Paul’s Position
Though subprime woes certainly represent a headwind, we have it incorporated into our cashflow models, and banks as a group look cheap.
Tortoise Stock Focus | Erin Swanson, CFA
Morningstar’s Take
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$46.38/37.50
$58.00
$37.53
$44.70
$72.70
Size of Moat
Business Risk
Market Cap
Dividend Yield Revenues
Narrow
-Avg
$33.3 bil
5.8%
$14.4 bil
Stewardship
∑
• Washington Mutual
% Change in Price
• S&P 500 Index
100
75
Washington Mutual is a major player in the U.S.
mortgage industry, a thorn in the bank’s side of late.
Although we don’t believe the challenges facing
this market will abate soon, we contend that management is making the best of a challenging situation
and that strong retail banking operations and
diversification efforts will help WaMu weather the
current storm.
50
25
20
-25
97
1998
1999
2000
2001
2002
2003
2004
2005
2006
07
Profile
From its humble beginnings in 1889, Washington Mutual has grown
into the largest thrift in the U.S., with nearly $350 billion in assets.
The Seattle-based firm operates four primary business segments—
retail banking, card services, commercial, and home loans—serving
more than 19 million households. WaMu is focused on the mass
middle market through approximately 2,225 retail banking stores, 465
lending centers, and 3,925 ATMs.
Management and
Stewardship
For the last 15 years, Kerry Killinger has guided WaMu with a focus
on enhancing shareholder value. For example, WaMu is scheduled
to sell nearly $18 billion in low-margin loans in 2007, with the
intention of using its excess capital to repurchase shares. Other areas
of corporate governance that we like include the required level
of stock ownership for executives and directors as well as the recent
decision to elect directors annually. At 56, Killinger should remain
at the helm for the foreseeable future—good news for shareholders.
However, we’d feel better if he had more skin in the game.
Killinger’s ownership of less than 1% of WaMu’s stock—valued at
just below $280 million—could be increased.
Valuation
We think WaMu is worth $58. We aren’t blind to the view that
the mortgage business will drag on results. We believe net chargeoffs to loans will increase to 0.7% in 2007, up from 0.22% in
2006. We expect charge-offs will moderate to 0.43% on average
through 2011 as the credit environment normalizes. Because the
mortgage market is consolidating, we believe WaMu stands to gain
share, driving loan growth. We expect loan balances will grow
5% annually during the next five years. In addition, we believe the
firm will realize some leverage, with operating expenses falling
to 57% of revenue by 2011 from 61% in 2006. We expect net
interest margins will improve to 2.8% by 2011 from 2.6% in 2006.
Retail banking is WaMu’s crown jewel. We believe the
firm’s hassle-free approach to banking and its open,
personal banking environment—a sharp contrast to a
traditional bank—have been cheered by customers.
In 2006, WaMu opened a record 1.23 million net new
checking accounts, even though it opened only
144 new stores. The benefits don’t stop there, in our
opinion. WaMu is leveraging its strong retail platform
and customer relationships to diversify its revenue
stream. In 2005, it acquired Providian, a leading credit
card issuer to the middle market. We believe this
business is a great fit for WaMu, as it allows the firm
to cross-sell its existing customers additional products.
We are further encouraged that WaMu focuses on
creating new products to meet the changing needs of
its customer base, helping it stay at the top of the
competitive landscape. For instance, WaMu was the
first bank to offer free checking to its customers. In
the second quarter of 2006, WaMu launched another
industry first: Customers can now open a checking
account online, without any paperwork, which has the
potential to boost deposit base growth.
All is not smooth sailing for WaMu, however. Mortgage banking is softening after years of robust
growth. We think WaMu’s management team anticipated this slowdown and began taking steps to
position its balance sheet for tougher times. During
2006, WaMu sold nearly all of its subprime mortgage originations, tightened its underwriting standards,
and reduced its subprime portfolio by $2.4 billion. œ
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8:22 PM
Page 7
Expedia EXPE
August 2007
7
Paul’s Position
The share buyback, even though it was reduced, still
adds value.
Hare Stock Focus | Sumit Desai, CFA
Expedia has set itself apart in the cutthroat online
travel market, and we think it will remain on top.
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$29.85/12.87
$38.00
$26.61
$29.30
$47.60
Size of Moat
Business Risk
Market Cap
Narrow
-Avg
$8.1 bil
NA%
$2.3 bil
Stewardship
¥
• Expedia
% Change in Price
• S&P 500 Index
30
15
0
Online travel agents (OTAs) negotiate wholesale rates
with travel suppliers (airlines and hotels) and sell
at a markup, pocketing the difference. Initially, travel
suppliers were eager to use OTAs to help sell inventory. In recent years, however, hotels and airlines—
boosted by an improved economy and improving occupancy rates—have begun selling inventory through
their own Web sites and reducing allocations to OTAs.
-15
-30
-45
97
1998
1999
2000
2001
2002
2003
2004
2005
2006
07
Profile
Expedia is the world’s largest online travel agency, with more than
$16.8 billion in gross bookings during 2006. The firm’s brands
include Expedia.com, Hotels.com, Hotwire, and TripAdvisor. In 2006,
Expedia generated almost 28% of sales from its international
operations. Expedia was spun off from IAC/InterActiveCorp in 2005.
Management and
Stewardship
Dara Khosrowshahi was appointed CEO of Expedia after the spin off.
Prior to his current role, Khosrowshahi served in various executive
positions within IAC. Barry Diller remains chairman of Expedia, in
addition to his role as CEO and chairman of IAC. We’re not fans
of Expedia’s dual-class ownership structure, as each B-class share
gives its owner 10 votes compared with only one vote per common
share. Liberty Media LINTA owns 100% of these B shares, however
Diller controls the voting power over these shares. This structure
gives Diller majority voting power over the company, leaving minority
shareholders with little say in the strategy and business proceedings
of Expedia. That said, we have no reason to expect any wrongdoings and admire management’s willingness to sacrifice short-term
results to create value over the long haul.
Valuation
We lowered our fair value estimate to $38 from $42 to account
for the company’s revised tender offer. We now assume a 25 million
share buyback at $30 per share. We project compound annual
revenue growth of 11% for the next five years. This revenue-growth
forecast assumes that Expedia continues to lose market share
over the next five years, and that this loss is offset by an increasing
number of travel transactions moving online. As Expedia expands
its top line, we think the company can spread its fixed costs over a
larger base of transactions and drive significant margin expansion.
We’ve forecast operating margins improving to about 25% in
five years, compared with 18% in 2006 (excluding charges).
Expedia has separated itself from the pack, however,
with several competitive advantages. Expedia is
almost twice as big as its closest competitor, with a
near-35% market share of the U.S. OTA market.
The company uses its size to negotiate lower wholesale
prices from suppliers, and, because Expedia is
the largest OTA, more suppliers are likely to distribute
through the firm. The lower costs lead to higher
margins than competitors, and the diverse inventory
attracts even more customers to Expedia’s sites,
leading to favorable network economics and an uphill
battle for competing OTAs.
Expedia is focusing on differentiating its product
offerings. For example, the company is focusing
on offering higher-margin vacation packages, which
are difficult for suppliers and meta-search firms to
duplicate. Expedia also benefits from the vast amount
of user reviews on its various Web sites. User reviews
are often the last feature viewed on Expedia’s site
before a purchase is made, demonstrating the importance consumers often place on this feature.
We also have high hopes for Expedia’s international
expansion. Online travel penetration has yet to
reach the levels seen in the U.S. In Europe and Asia,
only 17% of travel was booked online during 2006,
compared with almost 47% in the U.S. As Expedia and
other OTAs increase their marketing in Europe, we
expect online travel bookings to increase rapidly. œ
Bell_0807.qxp
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8:19 PM
Page 8
8
All the companies on this watchlist have wide economic
moats. Go to http://msi.morningstar.com to track changes
throughout the month.
Bellwether Watchlist
Company Name
Star
Rating
3M Company MMM
QQQQ
-Avg 103.00
88.92
87.80 135.20 X 2.1 15.5
Innovation and manufacturing skills cornerstone of moat.
Featured May 2007. Raised fair value in June.
Abbott Laboratories ABT
QQQQ
-Avg
56.00
50.69
47.70
73.50 X 2.5 51.8
Debated in May 2006 “Bulls vs. Bears” feature. Recently
purchased Kos Pharmaceuticals.
Adobe Systems ADBE
QQQ
Avg
38.00
40.29
29.30
47.60 C 0.0 42.4
Network effect and switching costs create a superwide
moat. Featured July 2006.
Aflac AFL
QQQ
Avg
54.00
52.12
41.60
67.70 X 1.3 17.1
Wide-moat life insurers are very rare. Last featured in the
May 2006 issue.
Alcon ACL
QQ
-Avg 112.00
136.50
Allergan AGN
QQQ
Avg
57.00
58.13
44.00
71.40 C 0.3 43.1
Specialty pharmaceutical company that derives more than
one third of its revenue from Botox.
Q
Avg
63.00
83.92
48.60
78.90 C 5.0 19.2
Robust growth from rising international equity markets
already priced into shares of this asset manager.
+Avg
78.00
66.47
49.70
94.10 C 4.9 12.1
Litigation environment stabilizing. Kraft spin-off
completed in April.
[ Alliancebernstein Hldg LP AB
Altria Group MO
QQQQ
Bus.
Risk
Fair
Current Consider Consider
Yield
Value ($)* Price ($) Buying ($) Selling ($) Stew. (%) P/E
95.40 147.00 C 1.5 31.3
Portfolio
Comment
Ophthalmic leader currently benefiting from Bausch &
Lomb’s problems. Raised fair value estimate in July.
[ Amazon.com AMZN
Q
Avg
40.00
78.54
30.80
50.10 Z 0.0 107.5
Head and shoulders above the competition in online
retailing. Featured Jan. 2007.
] American Express AXP
QQQQQ -Avg
70.00
58.54
59.60
91.90 Z 1.0 18.4
Potential legal windfall from competitors. One of our
favorite business models. Featured May 2006.
Amgen AMGN
QQQQ
Avg
69.00
53.74
53.20
86.50 C 0.0 20.7
Top-shelf biotech firm, but recent clinical trial disappointments prompt fair value decline. Spotlighted this issue.
Anheuser-Busch BUD
QQQQ
-Avg
57.00
48.77
48.60
74.80 Z 2.4 19.1
Controls more than 50% of domestic beer market. New
Busch-family CEO in 2006. Debated in March 2006 issue.
Apollo Group APOL
QQQ
Avg
65.00
59.11
50.10
81.40 C 0.0 27.1
Largest for-profit education firm, with over 300,000
students. Featured in Sept. 2006, debated in Feb. 2007.
Applied Materials AMAT
QQQ
Avg
20.00
22.04
15.40
25.10 C 1.0 18.4
Semiconductor equipment standard-bearer. Technological
lead and broad product portfolio provide moat.
Autodesk ADSK
QQQ
Avg
45.00
42.37
34.70
56.40 C 0.0 31.9
AutoCAD software has high switching costs. Upped fair
value, reduced Stewardship Grade. Featured Oct. 2006.
Automatic Data Prcssng ADP
QQQQ
-Avg
53.00
46.42
45.20
69.60 X 1.9 21.8
Client turnover very low. Spun off Broadridge Financial in
April. Featured March 2006.
Avon Products AVP
QQQQ
Avg
44.00
36.01
33.90
55.10 X 2.0 28.2
Brands and direct-sales model lead to high and consistent
returns on capital. Debated in Sept. “Bulls vs. Bears.”
QQQQQ Avg
70.00
47.42
54.00
87.70 X 4.7 10.1
A retail-banking juggernaut. Bought in Tortoise in April
and June. Spotlighted in July.
50.00
42.55
38.60
62.60 X 2.1 21.0
Getting out of retail banking to focus on securities
servicing. Mellon acquisition closed in July.
] Bank of America BAC
Bank of New York Company BK QQQQ
] Berkshire Hathaway BRK.B
Avg
QQQQQ -Avg 4700.00 3604.00 4004.90 6170.60 Z 0.0 14.8
Buffett still going strong. Firm continues to create copious
amounts of value. Raised fair value in May.
Biogen Idec BIIB
QQQ
Avg
58.00
56.54
44.70
72.70 X 0.0 33.4
Tysabri is back, and growth appears to be reaccelerating.
In Hare Portfolio. Raised fair value in July.
Biomet BMET
QQQ
-Avg
46.00
45.52
39.20
60.40 C 0.0 33.2
Growing senior population provides strong secular tailwinds. After recent tender, likely to go private soon.
Blackrock BLK
QQQ
Avg 155.00
159.50
Merged with Merrill Lynch’s asset management business.
Featured April 2006. Raised fair value again in July.
-Avg
38.00
36.25
32.40
49.90 C 4.5 19.3
Natural-gas pipeline company that is well-positioned for
growth. Structured as a master limited partnership.
QQQQQ Avg
21.00
13.15
16.20
26.30 C 0.0
Recently hit by recalls and safety concerns.
New fair value in May. Featured March 2006.
Boardwalk Pipeline Prtnrs BWP QQQ
] Boston Scientific BSX
119.50 194.20 C 1.4 37.2
NA
*Fair value based on Morningstar analyst estimates. Data through July 31, 2007. UR 5 Under Review –Avg 5 Below Average +Avg 5 Above Average ] 5 Stocks to consider buying [ 5 Stocks to consider selling
Bell_0807.qxp
8/2/07
8:19 PM
Page 9
9
Company Name
Star
Rating
Bus.
Risk
Fair
Yield
Bristol-Myers Squibb BMY
QQQ
Avg
29.00
28.41
22.40
36.30 C 3.9 35.5
Pharmaceutical firm experienced several management
miscues in recent years. Recently reduced risk rating.
Brown & Brown BRO
QQQQ
Avg
30.00
25.70
23.10
37.60 Z 0.9 20.1
Stout returns on capital created by innovative incentive
structure and disciplined acquisitions.
Buckeye GP Holdings BGH
QQQ
-Avg
33.00
35.90
28.10
43.30 C 1.9 80.0
Owns general partner of Buckeye Partners LP. General
partner’s returns are leveraged. Raised fair value in July.
Buckeye Partners LP BPL
QQQ
-Avg
54.00
53.87
46.00
70.90 C 5.8 18.5
Pipeline firms tend to have moats due to their geographic
advantage, and Buckeye is among our favorites.
Calamos CLMS
QQQ
Avg
26.00
24.70
20.00
32.60 V 1.6 17.8
Asset management can be a fantastic business, as
evidenced by its 50% operating margins.
Campbell Soup CPB
QQQQ
-Avg
42.00
36.83
35.80
55.10 C 1.6 17.3
Strong brands and market share in excess of 70%. Perfect
potential Tortoise stock.
QQQQQ Avg 115.00
70.76
88.70 144.10 X 0.2 11.1
Strategy provides an advantage in customer targeting and
pricing risk appropriately.
QQQ
Avg
73.00
78.80
56.30
91.50 X 1.6 15.2
Sensitive to economic cycles, so near-term results may be
bumpy. A well-run firm nevertheless. Featured June 2006.
CH Robinson Worldwide CHRW QQQ
Avg
45.00
48.65
34.70
56.40 X 1.4 30.0
Leading truck brokerage with an interesting business
model. Benefits from scale advantages.
QQQQQ Avg
53.00
36.84
40.90
66.40 V 0.0 26.9
Leader in electronic bill payment and processing. Strong
secular tailwinds. Featured Oct. 2006.
Avg 630.00
552.50
] Capital One Financial COF
Caterpillar CAT
] Checkfree CKFR
Chicago Mercantile Exchan CME QQQQ
Portfolio
August 2007
485.80 789.30 X 0.5 43.5
Comment
Hall of Fame member of Hare. Enjoys network effect,
leading to huge profit growth. In bidding war for CBOT.
QQQQQ -Avg
47.00
36.56
40.00
61.70 Z 1.1 17.5
Economies of scale story. Reduced risk rating in Feb.
Purchased in Tortoise. Spotlighted in June issue.
QQQ
Avg
30.00
28.91
23.10
37.60 X 0.0 26.0
Still 800-pound gorilla of networking industry. Retaking
significant market share. Featured Dec. 2006.
QQQQQ Avg
64.00
46.57
49.40
80.20 X 4.4 11.2
Its businesses collectively have core earnings power of
more than $20 billion per year, by our estimate.
Coca-Cola KO
QQQQ
-Avg
60.00
52.11
51.10
78.80 C 2.5 23.2
Perhaps one of the longest-lived moats around thanks to
its brands and business model. Featured July 2006.
Colgate-Palmolive CL
QQQ
-Avg
71.00
66.00
60.50
93.20 X 2.1 21.9
Worldwide leading toothpaste brand. In Tortoise Portfolio.
Featured April 2006, raised fair value in March.
Comcast CMCSA
QQQ
Avg
27.00
26.27
20.80
33.80 C 0.0 29.5
Unmatched ability to offer multiple services over one
connection. Featured Jan. 2006.
] Corporate Executive Board EXBD QQQQQ Avg
93.00
67.42
71.70 116.50 C 2.1 33.3
] Cintas CTAS
Cisco Systems CSCO
] Citigroup C
Collects and sells best-practices intelligence. Bought in
Hare in July. Spotlighted in July issue.
Dell DELL
QQQQ
Avg
34.00
27.97
26.20
42.60 V 0.0 19.7
Facing competitive pressures and accounting issues, but
Michael Dell back in charge. Featured June 2006.
DeVry DV
QQQ
Avg
35.00
32.40
27.00
43.90 C 0.3 31.8
For-profit education companies tend to be very profitable,
and DeVry is no different. Featured March 2007.
Dow Jones & Company DJ
UR
Avg
UR
57.38
UR
UR V 1.7 41.3
Dun & Bradstreet DNB
QQ
-Avg
87.00
97.76
74.10 114.20 C 0.5 25.6
Eaton Vance EV
QQQ
Avg
40.00
41.86
30.80
50.10 X 1.2 52.4
Money management firm with below-average customer
turnover. Raised fair value in March. Featured Jan. 2006.
QQQQQ -Avg
49.00
32.40
41.80
64.30 X 0.0 32.7
In Hare Portfolio. Excellent example of network effect.
Featured Aug. 2006 and Feb. 2007.
Electronic Arts ERTS
QQQQ
Avg
61.00
48.64
47.00
76.40 X 0.0 204.1
Profits ebb and flow with video game console cycle, but
strong long-term growth expected.
Eli Lilly & Company LLY
QQQ
Avg
61.00
54.09
47.00
76.40 X 3.1 25.2
Leading maker of mental-health drugs. Enjoys fastgrowing portfolio of new branded drugs.
] eBay EBAY
Stew. 5 Morningstar Stewardship Grade C 5 New Addition
5 Potential Tortoise Portfolio Holding
5 Potential Hare Portfolio Holding
The newspaper business model is under attack on
multiple fronts. To be purchased by News Corp.
Database model characterized by high barriers to entry
and low incremental costs.
Bell_0807.qxp
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8:19 PM
Page 10
10
Company Name
Star
Rating
Bus.
Risk
Fair
Yield
Portfolio
Comment
QQQQQ Avg
54.00
40.45
41.60
67.70 X 3.5 34.8
Owns general partners of TEPPCO and Energy Transfer.
Purchased in Hare Portfolio. Spotlighted in June issue.
Equifax EFX
QQQ
Avg
42.00
40.46
32.40
52.60 C 0.4 18.6
Credit bureaus operate in an oligopoly. Like other database firms, enjoys high entry barriers. Featured Oct. 2005.
Expeditors Intl of WA EXPD
UR
-Avg
UR
44.68
UR
UR Z 0.6 41.0
ExxonMobil XOM
QQQ
-Avg
84.00
85.13
Fannie Mae FNM
Not Rated
+Avg
NA
59.84
NA
NA V 2.6 10.0
Firm “not rated” due to lack of reliable financial statements. Justice Dept. investigation recently dropped.
] Fastenal FAST
QQQQQ -Avg
63.00
45.07
53.70
82.70 Z 0.9 33.1
Interesting distributor focused on the fastener market.
Spotlighted March 2007. In Hare portfolio.
] Federated Investors FII
QQQQQ Avg
48.00
36.01
37.00
60.10 C 2.1 19.3
Major player in the money management industry.
Featured Dec. 2006.
First Data FDC
QQQ
Avg
33.00
31.79
25.40
41.30 V 0.5 30.6
Raised fair value after $34 cash buyout offer received.
Featured Nov. 2006.
Fiserv FISV
QQQQ
Avg
59.00
49.42
45.50
73.90 C 0.0 19.6
Easily the nation’s largest bank processing firm. Enjoys
significant customer switching costs. Featured Jan. 2006.
Fortress Investment Group FIG
QQQ
+Avg
17.00
18.97
10.80
20.50 V 1.8
New addition to the watchlist. Runs large hedge fund and
private equity shop. Featured July 2007.
Forward Air FWRD
UR
Avg
UR
34.07
UR
Franklin Resources BEN
QQ
Avg 110.00
127.37
Freddie Mac FRE
Not Rated
Gamco Investors GBL
] Enterprise GP Holdings LP EPE
71.60 110.30 X 1.5 12.4
NA
UR X 0.8 22.0
Freight consolidation business model benefits from
network effect, scale advantages. Featured Jan. 2006.
Largest, most efficient oil company on the planet.
We discussed oil in June 2006 “Bulls vs. Bears.”
Has no rival with the same scale and service quality.
84.80 137.80 Z 0.5 20.2
Owns some of the best-established brand names in the
mutual fund industry. Raised fair value in July.
Like sister Fannie, we have Freddie “not rated” because
of a lack of reliable financial statements.
+Avg
NA
57.27
NA
NA V 3.4 20.2
QQ
Avg
44.00
51.94
33.90
55.10 V 0.2 21.3
Genentech DNA
QQQQ
Avg
89.00
74.38
68.60 111.50 X 0.0 33.2
General Dynamics GD
QQQ
Avg
79.00
78.56
60.90
99.00 Z 1.3 18.2
Focused on cash generation and allocates capital with
admirable discipline. In Tortoise Portfolio.
General Electric GE
QQQQ
Avg
45.00
38.76
34.70
56.40 X 2.8 19.3
Leader in large number of industries. Featured Feb. 2007.
Raised fair value estimate significantly in July.
Genzyme GENZ
QQQ
Avg
71.00
63.07
54.70
89.00 X 0.0 454.6
New addition to the watchlist. Upgraded to “wide” moat
in Oct. 2006 due to improving operating efficiency.
QQQQQ Avg
66.00
44.93
50.90
82.70 C 0.0 21.0
Has dominant market position in images and significant
operating leverage. Featured May and Oct. 2006.
188.34
] Getty Images GYI
151.10 245.60 X 0.7
Mario Gabelli’s name is excellent advertising for Gamco’s
products, though he is facing legal issues today.
One of our favorite biotech companies with strong
research amd development capabilities.
Goldman Sachs Group GS
QQQ
Avg 196.00
Graco GGG
QQQQ
Avg
50.00
41.04
38.60
62.60 X 1.6 18.5
Standout among industrial firms, dominant in several
niche markets. Spotlighted in May issue.
QQQQQ Avg
27.00
19.95
20.80
33.80 C 2.7 17.4
Tax prep leader currently playing a game of chicken with
N.Y. attorney general over IRA fees. Featured Feb. 2006.
QQQ
Avg
64.00
57.32
49.40
80.20 X 1.5 15.0
One of the strongest and most profitable brands on the
planet. Featured Feb. 2007.
] Hershey Company HSY
QQQQQ -Avg
58.00
46.10
49.40
76.10 C 2.3 20.6
Largest candymaker in the U.S., with a 30% share. Wide
portfolio of consumer brands. Featured this issue.
] Home Depot HD
QQQQQ -Avg
44.00
37.17
37.50
57.80 C 2.2 14.2
One of only a handful of wide-moat retailers. Debated in
Aug. 2006 “Bulls vs Bears” feature.
-Avg 105.00
110.65
] H & R Block HRB
Harley-Davidson HOG
IBM IBM
QQQ
8.8
89.50 137.90 X 1.2 17.9
Simply the gold standard among investment banks.
Featured June 2006.
Bread and butter is servicing rat’s nest of IT infrastructure
at core of most firms. Featured Feb. 2006.
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11
Company Name
Star
Rating
Bus.
Risk
Fair
Yield
IMS Health RX
QQQQ
Avg
35.00
28.13
27.00
43.90 C 0.4 20.1
Moat comes from hard-to-replicate database of global
pharmaceutical sales.
Intel INTC
QQQ
Avg
25.00
23.62
19.30
31.30 X 1.8 26.0
Facing competitive pressure from AMD, but still wide
moat. Featured May 2006. Raised fair value in April.
] International Game Tech IGT
QQQQQ Avg
47.00
35.32
36.20
58.90 X 1.5 25.6
Slot machine manufacturer with approximately 70%
share. In Hare Portfolio. Featured April 2007.
] International Speedway ISCA
QQQQQ Avg
63.00
47.89
48.60
78.90 C 0.2 26.3
Strong relationship with NASCAR sanctioning body. Abandoning NYC and WA efforts. Featured Feb. and May 2006.
Intuit INTU
QQQQ
Avg
33.00
28.64
25.40
41.30 X 0.0 23.3
Dominates small-business accounting, tax prep, and
personal finance software. Featured Dec. 2005.
Iron Mountain IRM
QQQQ
-Avg
31.00
26.79
26.40
40.70 Z 0.0 40.0
Document storage provides high switching costs and
recurring revenue stream. Featured Sept. 2006.
QQQQQ Avg
63.00
44.01
48.60
78.90 Z 3.2 10.2
Banking behemoth led by former winner of Morningstar
CEO of the Year award. In Tortoise. Featured April 2007.
-Avg
25.00
24.02
21.30
32.80 X 1.0 22.0
Bank processing firm focused on smaller banks. Enjoys
high customer switching costs. Featured Sept. 2005.
-Avg
47.00
42.29
40.00
61.70 X 1.0 24.8
Book publisher enjoys high returns on capital. Featured
Dec. 2005.
QQQQQ -Avg
80.00
60.50
68.20 105.00 X 1.9 17.2
] J.P. Morgan Chase & Co. JPM
Jack Henry & Associates JKHY QQQ
John Wiley & Sons JW.A
] Johnson & Johnson JNJ
QQQQ
Portfolio
August 2007
Comment
Health-care giant recently completed purchase of Pfizer’s
consumer business. Featured in June issue.
Kinder Morgan Energy Ptnr KMP QQQ
-Avg
55.00
52.98
46.90
72.20 Z 6.3 28.8
Largest master limited partnership focused on energy
transport and storage. Pipelines tend to have moats.
Kinder Morgan Mngmt KMR
QQQ
-Avg
55.00
49.90
46.90
72.20 Z 6.7 42.7
Different share class of KMP without MLP tax complexity.
Pays in shares instead of cash. Featured Feb. 2007.
KLA-Tencor KLAC
QQ
Avg
48.00
56.79
37.00
60.10 C 0.9 22.6
One of several entangled in stock option backdating mess.
Still dominates certain niches of semiconductor industry.
QQQQQ Avg 119.00
90.00
91.80 149.10 C 1.0 20.1
Now among the largest asset managers on the planet.
Featured Dec. 2006.
Linear Technology LLTC
QQQQ
Avg
42.00
35.65
32.40
52.60 X 1.9 25.5
Among semiconductor companies, lower risk. Featured
Oct. 2006. Reduced fair value estimate in July.
Lockheed Martin LMT
QQQ
Avg
97.00
98.48
74.80 121.50 X 1.4 15.1
QQQQQ -Avg
39.00
28.01
33.20
51.20 X 0.8 14.4
Not many retailers have wide moats, but Lowe’s does.
Featured this issue.
] Legg Mason LM
] Lowe’s Companies LOW
Improved efficiency and being sole provider of many key
defense items prompt recent moat upgrade.
Magellan Midstream Hldgs MGG QQQ
-Avg
31.00
30.43
26.40
40.70 C 3.2 47.6
General partner of pipeline firm MMP. Higher growth but
slightly higher risk than MMP. Raised fair value in June.
Magellan Midstream Part MMP QQQ
-Avg
46.00
45.31
39.20
60.40 C 5.3 20.2
Long-haul oil pipelines and energy storage assets. Advantage period several decades.
QQQQQ Avg
45.00
27.55
34.70
56.40 X 2.7 18.4
Regulatory woes appear to be mostly in the rearview
mirror. Featured March 2007.
Avg 167.00
160.80
] Marsh & McLennan Cos MMC
MasterCard MA
QQQ
128.80 209.20 C 0.3 161.3
One of three major global card systems. In Hare Portfolio.
Raised fair value again in June. Featured Jan. 2007.
QQQQQ Avg
46.00
31.70
35.50
57.60 X 2.0 23.2
Analog semiconductor expertise in short supply. Featured
Nov. 2006. Reduced fair value in July.
McCormick MKC
QQQ
-Avg
37.00
34.16
31.50
48.60 X 2.3 21.6
More than two times larger than its next competitor in
spices and seasonings. Featured Jan. 2007.
McDonald’s MCD
QQQ
-Avg
49.00
47.87
41.80
64.30 Z 2.1 19.4
Recent watchlist addition. Brand and scale make “Golden
Arches” unique. Spotlighted in May issue.
McGraw-Hill Companies MHP
QQQ
-Avg
63.00
60.50
53.70
82.70 X 0.9 21.7
Book publisher and parent company of S&P has very wide
moat. Featured March 2006.
QQQQQ -Avg
64.00
50.67
54.50
84.00 X 0.9 21.0
Largest medical-equipment maker with wide product portfolio and technological lead. Featured July 2007.
] Maxim Integrated Prod MXIM
] Medtronic MDT
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12
Company Name
Star
Rating
Merck MRK
UR
Merrill Lynch & Company MER
Bus.
Risk
Fair
Yield
UR X 3.1 23.4
Comment
+Avg
UR
49.65
QQQ
Avg
83.00
74.20
64.00 104.00 X 1.6
] Microsoft MSFT
QQQQ
-Avg
34.00
28.99
29.00
44.60 Z 1.4 20.9
Gates to step down from day-to-day role to run charity.
New Vista software selling now. Featured Dec. 2006.
] Moody’s MCO
QQQQQ -Avg
65.00
53.80
55.40
85.30 X 0.6 19.8
Credit markets prefer fewer voices to many. In the
Tortoise Portfolio. Featured Jan. 2006.
Morgan Stanley MS
QQQQ
Avg
80.00
63.87
61.70 100.20 C 1.7
News Corporation NWS
QQQ
-Avg
25.00
22.66
21.30
32.80 V 0.4 21.0
Improved capital allocation and returns prompt moat
upgrade for the media titan. Featured in May issue.
Nike NKE
QQQQ
Avg
65.00
56.45
50.10
81.40 X 1.6 19.3
Strong brands translate to high returns. Featured this
issue.
Northern Trust NTRS
QQQ
Avg
59.00
62.46
45.50
73.90 X 1.6 20.2
Focused on large institutions and the wealthy.
Sold from Tortoise in June.
Nuveen Investments JNC
QQQ
-Avg
65.00
61.14
55.40
85.30 X 1.6 26.0
Leader in closed-end fixed-income funds as well as munibond products. Announced deal to go private in June.
ONEOK Partners LP OKS
QQQ
-Avg
68.00
67.56
57.90
89.30 C 5.8 12.7
Pipeline firm changed name from Northern Border Partners. Like most pipelines, very long advantage duration.
Oracle ORCL
QQQQ
Avg
22.00
19.12
17.00
27.60 X
While wide moat is being tested, maintains enviable position in the database market.
Paychex PAYX
QQQQ
-Avg
46.00
41.38
39.20
60.40 Z 2.3 30.7
Payroll processor focused on small businesses that are
uneconomical for rivals to steal. Featured Aug. 2006.
PepsiCo PEP
QQQQ
-Avg
76.00
65.62
64.80
99.80 X 1.9 18.4
Dominant salty-snacks company. Boasts 16 brands with
over $1 billion in sales. New CEO. Featured March 2006.
QQQQQ Avg
31.00
23.51
23.90
38.80 C 4.5 16.2
Lipitor facing significant competition from generics.
Featured Feb. 2007. In Tortoise portfolio.
QQQ
-Avg
46.00
46.10
39.20
60.40 X 2.8 18.0
Long and dominant history in the postage meter industry,
but facing challenges from alternatives to direct mail.
] Procter & Gamble PG
QQQQQ -Avg
77.00
61.86
65.60 101.10 X 2.1 21.3
] Progressive PGR
QQQQQ Avg
28.00
20.98
21.60
35.10 Z 0.1 10.3
Can apply greater underwriting insight more finely and
much faster than competitors.
Qualcomm QCOM
QQQ
Avg
46.00
41.65
35.50
57.60 Z 1.2 25.4
Intellectual property powerhouse in wireless industry.
Patents provide very high-margin revenue stream.
Renaissance Re Holdings RNR
QQQQ
+Avg
77.00
57.50
49.10
92.90 X 1.5
Highly technical underwriting skills. Benign hurricane
season in 2006 benefitted all insurers.
Schering-Plough SGP
QQQ
+Avg
31.00
28.54
19.80
37.40 C 0.8 28.3
Not nearly as attractive a business as other pharmaceutical companies, but still possesses a wide moat.
SEI Investments SEIC
QQQ
-Avg
25.00
27.26
21.30
32.80 X 0.5 22.6
Strong technology platform to offer investmentprocessing services to private-banking and trust clients
SLM SLM
QQQ
Avg
51.00
49.17
39.30
63.90 Z 1.5 19.3
$60 buyout appears in jeopardy from changes in government policy. Sold from Tortoise in April.
] St. Joe JOE
QQQQQ Avg
56.00
40.54
43.20
70.20 X 1.6 52.6
Recent addition to the watchlist. Owns huge amounts of
undeveloped land in Flordia. Featured in July issue.
] Starbucks SBUX
QQQQQ Avg
36.00
26.68
27.80
45.10 C 0.0 33.8
Strong brand creates large barrier to success in industry.
Spotlighted in the July issue.
State Street STT
QQ
Avg
57.00
67.03
44.00
71.40 X 1.3 20.0
Majority of revenue and profits come from the bank’s feebased businesses.
Stericycle SRCL
UR
Avg
UR
47.94
UR
UR X 0.0 38.9
] Pfizer PFE
Pitney Bowes PBI
UR
Portfolio
7.9
7.3
UR 23.6
5.4
Vioxx mess explains above-average risk. Sold completely
from Tortoise in Oct. Featured Sept. 2006.
Has a top-tier advisory and brokerage as well as an
investment banking business.
Diversified investment bank, recently freed from conservative management.
Has 22 brands that generate more than $1 billion in
sales annually. Featured in June issue.
Medical waste is a noncyclical business, and Stericycle
has a dominant share.
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Star
Rating
Bus.
Risk
Strayer Education STRA
QQ
Avg 127.00
Stryker SYK
QQ
-Avg
55.00
62.43
46.90
72.20 C 0.4 29.4
Demographics are on its side. Government looking into
competitive behavior of industry. Raised fair value in Feb.
Synovus Financial SNV
QQQQ
Avg
35.00
27.96
27.00
43.90 X 2.9 14.6
Owns a bank as well as 81% of Bellwether firm Total
System Services.
QQQQQ -Avg
38.00
31.88
32.40
49.90 X 2.3 21.0
Wide-moat distributors are rare, but this one dominates.
In Hare. Featured April 2006.
T Rowe Price Group TROW
QQ
Avg
43.00
52.13
33.20
53.90 Z 1.3 25.1
Asset manager with excellent fund lineup and ethical
reputation. Raised fair value in Dec.
TEPPCO Partners TPP
QQQ
-Avg
43.00
43.57
36.60
56.50 X 6.2 16.6
Pipeline company enjoys significant barriers to entry and
very stable cash flows. Featured Aug. 2006.
QQQQQ -Avg
25.00
19.26
21.30
32.80 C 1.1 15.4
Like Disney and News Corp., improved capital allocation
and returns prompt moat upgrade. Featured May 2007.
Total System Services TSS
QQQ
Avg
29.00
28.13
22.40
36.30 C 1.0 21.8
Handles applications, billing, collections, and customer
service for credit card issuers. Featured April 2006.
United Parcel Service UPS
QQQQ
-Avg
88.00
75.72
75.00 115.50 X 2.1 20.2
One of the more attractive Bellwethers, with a very strong
balance sheet. Featured July 2006.
United Technologies UTX
QQQ
-Avg
78.00
72.97
66.50 102.40 Z 1.5 19.0
Diversified company operating efficiently in several industrial markets. Featured Feb. 2007.
QQQQQ -Avg
41.00
29.95
34.90
53.80 Z 5.1 11.5
Strong competitive position in terms of geographic reach
and earnings growth prospects.
UST UST
QQQ
Avg
48.00
53.55
37.00
60.10 C 4.4 17.5
Strong brands, owns 90% share of market for premium
smokeless tobacco. Featured Sept. 2006.
W.P. Stewart & Company WPL
QQQQ
Avg
13.00
10.85
10.00
16.30 B 7.0 13.2
Reduced fair value in April after more bleeding and dividend cut. Featured July 2006 and in Sept. cover story.
QQQQQ -Avg
60.00
45.95
51.10
78.80 X 1.7 15.5
Retailing goliath enjoys enormous cost advantages.
Debated in March 2006 and featured in Oct. 2006.
QQQQ
Avg
56.00
44.18
43.20
70.20 X 0.7 21.7
Impressive and consistent growth. Wal-Mart generic-drug
threat caused increased risk rating. Featured Feb. 2007.
QQQQQ -Avg
40.00
33.00
34.10
52.50 X 0.9 15.4
Owns outstanding brands and extensive media library.
Featured March 2007.
] Time Warner TWX
] US Bancorp USB
] Wal-Mart Stores WMT
Walgreen WAG
] Walt Disney DIS
151.53
Portfolio
13
Company Name
] Sysco SYY
Fair
Yield
August 2007
97.90 159.10 X 0.8 37.5
Comment
Very profitable for-profit education company. Featured
Aug. 2006.
Washington Post Co WPO
UR
-Avg
UR
790.75
UR
UR X 1.0 24.4
Waters WAT
QQQ
-Avg
58.00
58.26
49.40
76.10 X 0.0 25.9
Large share in analytical instruments important in drug
discovery, research, manufacturing. Featured Oct. 2006.
Weight Watchers Intl WTW
QQQ
Avg
54.00
48.52
41.60
67.70 X 1.4 22.3
Worldwide leader of weight-loss services, with a highly
recognizable and respected brand. Featured Oct. 2005.
Wells Fargo WFC
QQQQ
Avg
39.00
33.77
30.10
48.90 X 3.3 13.3
Boasts top-three deposit market share in 15 of its 23
states. Attractive lending spreads.
QQQQQ -Avg
32.00
19.95
27.30
42.00 C 0.1 17.4
The Hare received shares in spin-off from First Data, then
we bought more in Oct. Featured extensively Nov. 2006.
Wrigley Wm Jr WWY
QQQ
-Avg
61.00
57.68
52.00
80.10 C 1.9 28.6
Dominant gum company around the globe, in Tortoise
Portfolio. Raised fair value. Featured May and June 2006.
Wyeth WYE
QQQ
Avg
52.00
48.52
40.10
65.20 C 2.1 15.3
Excellent growth-oriented drug portfolio complemented by
consumer-products and animal-health businesses.
Zimmer Holdings ZMH
QQQQ
-Avg
89.00
77.76
75.80 116.80 X 0.0 21.8
] Western Union WU
Talented management guiding namesake newspaper and
Kaplan. Featured Oct. 2005. Reduced fair value in Dec.
Government looking into competitive behavior of orthopedic industry. Featured July 2006. Raised fair value.
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14
Morningstar Bellwether Watchlist Recommendations
Stocks to Consider Buying
Allied Irish Banks AIB*
Bank of America BAC
Berkshire Hathaway BRK.B
Boston Scientific BSX
Cadbury Schweppes CSG*
Capital One Financial COF
Checkfree CKFR
Cintas CTAS
Citigroup C
Corporate Exec Board EXBD
eBay, EBAY
Enterprise GP Holdings LP EPE
Fastenal FAST
Federated Investors FII
Getty Images GYI
H & R Block HRB
Hershey HSY
Home Depot HD
International Game Tech. IGT
J.P. Morgan Chase JPM
Legg Mason LM
Lowe's Companies LOW
Marsh & McLennan MMC
Maxim Integrated MXIM
Amazon.com AMZN
Comp. Vale Do Rio Doc RIO*
Medtronic MDT
Microsoft MSFT
Moody's MCO
Novartis NVS*
Pfizer PFE
Procter & Gamble PG
Progressive PGR
St. Joe JOE
Starbucks SBUX
Sysco SYY
Time Warner TWX
US Bancorp USB
Wal-Mart Stores WMT
Walt Disney DIS
Western Union WU
Stocks to Consider Selling
Alliancebernstein Hold. LP AB
Above are all the firms trading below their “Consider Buying” price as well as those trading above their “Consider Selling” price.*Stocks from the International Stalwarts list. See Page 18 for more.
Cost Advantage: Companies that
thrive on being the low-cost
provider in a commodity industry
can offer lower prices to
customers and still make a profit.
These companies create difficulty
for higher-cost competitors.
Types of Economic Moats
What separates a bad company
from a good one, in large part,
is the size of the “economic moat,”
or competitive barrier, a firm builds
around itself. Here are four main
types of economic moats along with
explanations of how they work:
High Customer-Switching
Costs: If a company sells products
that customers can’t get elsewhere—at least not easily—it
has high customer-switching costs.
This creates a situation in which
customers are willing to pay higher
prices for products because
of convenience.
Bellwether
Watchlist Review
American Express continued to produce solid results in
the second quarter, with earnings up 12% from last
year and return on equity reaching an astounding 38%.
All the operating metrics show that the credit card
business, which generates the bulk of the earnings, is
firing on all cylinders. Card-billed business and
cards in force grew in the second quarter by 15% and
10%, respectively, from last year. The average
discount rate remained at 2.57%, and average
spending per card member rose by 8% from last year.
Star Rating
QQQQQ
Business Risk
-Avg
70.00
Fair Value ($)
58.54
Current Price ($)
Market Cap ($bil)
69.6
1.0
Dividend Yield (%)
Wide
Size of Moat
Consider Buying ($)
59.60
Consider Selling ($)
91.90
1-Yr Hi/Low ($) 65.89/51.19
Stewardship
P/E
œ
18.4
The only negative in the quarter was a 36% jump in
provisions. Nevertheless, we don’t think credit
quality is a concern because last year’s provisions
were unusually low and net charge-offs to average
loans remained unchanged from the first quarter.
In addition, we have modeled normalized provisions
for the next five years. At this point, our fair
value estimate remains unchanged.
Analyst: Michael Kon, CFA
Intangible Assets: Some
companies have an advantage over
competitors because of unique
nonphysical assets such as intellectual property rights (patents,
trademarks, and copyrights),
government approvals, brand
names, a unique company culture,
or a geographic advantage.
The Network Effect: A common
trait among companies that
exploit the network effect is
that they are the first, or one of
the first, to create a standard
in an emerging industry. These
companies can sometimes
create monopolies.
Bank of America BAC
Bank of America reported first-half earnings that
largely met our estimates. We are holding our
fair value estimate steady. The bank’s spread business
as well as several fee-income businesses actually
experienced negative growth from the prior-year period.
Compressed spreads were behind the declining
net interest income, while rising credit costs took their
toll on the credit card business. While the bank
managed to expand its loan book an impressive 14%,
deposit growth was anemic at just over 3%, as
the bank let some of the higher-price deposits run off.
There were some bright spots. Investment banking
income improved 27% in the first half from the prioryear period as the huge impetus from private-equity
deals and demand for leveraged loans drove B of
A’s syndicated lending business. Client assets in the
wealth-management businesses grew 11%, to $808
billion, boosting profits of that division. Increased
mortgage originations to existing checking account
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Page 15
Bank of America BAC
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
70.00
Current Price ($)
47.42
Market Cap ($bil)
210.4
Dividend Yield (%)
4.7
Size of Moat
Wide
Consider Buying ($)
54.00
87.70
1-Yr Hi/Low ($) 55.08/46.90
Stewardship
∑
P/E
10.1
eBay EBAY
Star Rating
QQQQQ
Business Risk
-Avg
Fair Value ($)
49.00
Current Price ($)
32.40
Market Cap ($bil)
44.0
Dividend Yield (%)
—
Size of Moat
Wide
Consider Buying ($)
41.80
64.30
1-Yr Hi/Low ($) 35.41/22.83
∑
Stewardship
P/E
32.7
Fastenal FAST
Star Rating
QQQQQ
Business Risk
-Avg
Fair Value ($)
63.00
Current Price ($)
45.07
Market Cap ($bil)
6.8
Dividend Yield (%)
0.9
Size of Moat
Wide
Consider Buying ($)
53.70
82.70
1-Yr Hi/Low ($) 48.93/33.05
Stewardship
œ
P/E
33.1
customers boosted profits by 60% in that business.
Mortgages still represent a large opportunity for B of
A, as only 10% of its checking customers have mortgages through the bank.
We are thrilled with Bank of America’s proposed
purchase of LaSalle bank. We believe LaSalle will
be worth a lot more under the B of A umbrella than its
$21 billion purchase price. B of A expects to close
the acquisition in the fourth quarter, and we estimate
it will take as long as a year for the bank to bring
LaSalle’s sky-high expense ratio in line with its own.
Nonetheless, we are confident that B of A will accomplish that goal, now that it is a veteran integrator of
large acquisitions. We believe the market is offering a
tremendous discount for the shares of this giant.
Analyst: Ganesh Rathnam
eBay EBAY
After reviewing eBay’s second-quarter results, we are
maintaining our fair value estimate. Revenue, operating profits, and free cash flow grew by 30%, 47%,
and 45%, respectively. These solid fundamental
results, combined with the repurchase of $344 million
of outstanding shares, led to impressive 59%
growth in diluted earnings per share.
The company’s U.S. and international marketplaces
generated $1.3 billion in revenue, a 26% increase
from the prior-year quarter and an acceleration from
the 23% growth rate in the first quarter. Higher
average selling prices and stronger conversion rates
more than made up for the 6% decline in new
listings. Although declining listings isn’t a good sign,
eBay has undertaken several initiatives to address
the issue. In addition, eBay has proved that it can still
generate growth in gross merchandise volume and
revenue without growth in listings.
PayPal generated $454 million in revenue, an increase
of 34% from the prior-year quarter. Total payment
volume from the online payment service grew a
respectable 18% on the eBay platform and a remarkable 57% off the platform. Skype also performed
well, with revenue reaching $90 million, an increase
of 103% from a year ago. Despite Skype’s impressive
growth and second quarter of profitability,
August 2007
15
management said the business has not performed
as expected.
Overall, eBay had another strong quarter. Therefore,
the company yet again raised its forecast for 2007.
It now calls for 2007 revenue to increase 22%-25%, to
$7.30-$7.45 billion (up from its previous forecast of
$7.20-$7.45 billion), and for earnings per share to rise
37%-42%, to $1.08-$1.12 (versus its prior estimate
of $1.05 -$1.09).
Analyst: Larry Witt, CFA
Fastenal FAST
Fastenal posted impressive second-quarter results,
with sales and earnings up 13.3% and 17%, respectively.
While the firm did a fine job of controlling support
expenses versus last year, its gains on the gross margin
line are even more notable. Excluding a one-time
inventory charge uncovered alongside an IT system
upgrade, product margins improved by a full
percentage point over last year. With encouragement
from management, store-level employees have
been pushing up prices on less-profitable transactions.
At the same time, cost reductions have resulted
from increased direct sourcing from Asia and lower
freight costs as more products are transported
with company assets—which can be leveraged alongside growth—rather than by third-party shipping.
Fastenal’s recent strategy shift is also beginning to
show up in the financials. While higher sales growth
from new salespeople might take a while to develop,
lower capital-reinvestment requirements are already
on display. Inventory growth has slowed and capital
expenditures are running substantially below last
year. As a result, the company bumped up its dividend
and has been buying back more shares, which we
think is a great use of shareholder capital at recent
prices. We’re maintaining our fair value estimate.
Analyst: Matthew Warren
International Game Technology IGT
International Game Technology announced fiscal
third-quarter results that showed year-over-year and
sequential improvement. We are maintaining our
fair value estimate and continue to believe the future
looks promising for this wide-moat firm.
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8:19 PM
16
Page 16
Bellwether Watchlist Review
Continued from Page 15
Intl Game Tech IGT
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
47.00
Current Price ($)
35.32
Market Cap ($bil)
11.7
Dividend Yield (%)
1.5
Size of Moat
Wide
Consider Buying ($)
36.20
58.90
1-Yr Hi/Low ($) 48.79/35.18
Stewardship
∑
P/E
25.6
Intl Speedway ISCA
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
63.00
Current Price ($)
47.89
Market Cap ($bil)
2.5
Dividend Yield (%)
0.2
Size of Moat
Wide
Consider Buying ($)
48.60
78.90
1-Yr Hi/Low ($) 54.78/44.56
Stewardship
¥
P/E
26.3
Star Rating
QQQQQ
Business Risk
-Avg
Fair Value ($)
80.00
Current Price ($)
60.50
Market Cap ($bil)
175.2
Dividend Yield (%)
1.9
Size of Moat
Wide
Consider Buying ($)
68.20
105.00
1-Yr Hi/Low ($) 69.41/59.72
Stewardship
∑
P/E
17.2
Sales for the quarter increased 15.4% compared with
last year, driven by a 22.5% jump in product sales
and 8.6% increase in the gaming operations segment.
Product sales were especially strong due to the
sale of almost 15,000 units in Japan (proving that
weakness in Japan during the second quarter was a
temporary issue). Revenue growth in the product
sales segment will continue to be lumpy, given the lull
in the domestic replacement cycle. The gaming operations segment was boosted by increased placements
in Mexico and New York. IGT’s operating margin
increased to 30.6% in the quarter as a result of gross
margin expansion (due to improved product mix and
better pricing) and general operating leverage. During
the quarter, IGT bought back 6.4 million shares for
a total cost of about $249 million, and the company has
bought back about $611 million of shares year to date.
We continue to be impressed with the firm’s willingness to return cash to shareholders in this manner,
especially given that the shares currently trade at a
discount to our fair value estimate.
Analyst: Sumit Desai, CFA
International Speedway Corporation reported secondquarter results that left much to be desired. However,
after sorting through a litany of charges and other
short-term challenges, the long-term attractiveness of
International Speedway remains. We’re keeping
our fair value estimate intact.
Starting with the bad news, the first half of the year has
been riddled with arguably nonrecurring expenses.
Issues to blame for these extra costs include the failed
attempts to develop racetracks in Washington and
New York; the Kentucky antitrust litigation; and losses
at ISC’s joint venture, Motorsports Authentics, due
to the departure of Dale Earnhardt Jr. from Dale Earnhardt Inc. In addition, inclement weather weighed
on the results of certain races hosted by International
Speedway tracks. These adverse developments led
to a dismal 19% operating margin, compared with
30% a year ago.
Looking past these items, we can still see a great
underlying business. Revenue increased 5%—no
small feat, given that the new television contract
(with its lower annual revenue) is creating tough
year-over-year comparisons. The transition of
Chicagoland Speedway from an equity investment to
a wholly owned track provided some of this boost.
Other motorsports-related revenue also contributed,
increasing by an impressive 19%. This business
is driven by corporate advertising at ISC events, which
remains this firm’s fastest-growing revenue stream.
The 10-year comprehensive sponsorship deal signed
with Coca-Cola is solid evidence of this trend.
Analyst: Joel Bloomer
Johnson & Johnson’s second-quarter results were in
line with our expectations, and we don’t expect
any material changes to our fair value estimate. Sales
increased 13.2% in the second quarter, with 2.4%
of that growth coming from currency benefits. Overall
growth was boosted significantly by the addition
of Pfizer’s PFE consumer product business, which J&J
acquired late last year.
Growth in the pharmaceutical division came from a
couple of key products, including J&J’s schizophrenia
franchise and Topamax for epilepsy and migraines.
Strength in these products was offset by continued
challenges for anemia treatment Procrit and
generic competition in some markets. Challenges in
the medical device segment continued, with sales
advancing just 2.8% from the same period last year
(excluding currency benefits), as sales declines
continued in the Cordis division. Cypher, J&J’s drugcoated stent, continued to suffer from price
declines and weakness in demand for drug-coated
stents in general, particularly in the U.S.
Despite some sales declines for Procrit and Cypher, as
well as generic competition with some products,
J&J did an admirable job preserving profitability.
Earnings before tax increased almost as fast as sales,
as the firm controlled growth in research spending.
While we expect J&J to continue to spend heavily on
research and development, we expect this cost
will decline as a percentage of sales as the firm’s sales
become more heavily weighted toward less
research-intensive businesses. œ
Analyst: Heather Brilliant, CFA
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8:17 PM
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Special InternationalInvestor Insert
InternationalInvestor | Allan Nichols, CFA
Allan Nichols, CFA
International Equities
Strategist
Rostelecom ROS
Star Rating
Q
Business Risk
Spec.
Fair Value ($)
31.00
Current Price ($)
57.00
Market Cap ($bil)
7.2
Dividend Yield (%)
0.6
Size of Moat
None
Consider Buying ($)
16.10
38.10
1-Yr Hi/Low ($) 60.33/27.42
Stewardship
—
NA
P/E
Golden Telecom GLDN
Star Rating
QQQ
Business Risk
Spec.
Fair Value ($)
56.00
Current Price ($)
64.65
Market Cap ($bil)
2.4
Dividend Yield (%)
0.3
Size of Moat
None
Consider Buying ($)
29.10
68.80
1-Yr Hi/Low ($) 70.48/23.19
Stewardship
¥
P/E
29.2
According to the results of an annual survey released
in June, Mercer Human Resource Consulting declared
Moscow the most expensive city in the world for
expatriates. I was in Moscow in June and can vouch
for its high-priced services. I’ve stayed at the Waldorf
Astoria in New York for less per night than it cost
me to stay at a Holiday Inn five miles from the Kremlin.
Food was also expensive, as were electronics.
I was surprised by the number of cranes I saw and new
buildings under construction. It reminded me of
when I was in Asia in March 1997; Bangkok, Jakarta,
and Kuala Lumpur were all undergoing major
construction booms. However, just more than three
months later, the Asian crisis began with Thailand
devaluing the baht, and goodbye boom. Historically,
buildings in Russia have been fairly short because
of the abundance of land. It’s a different story today,
and tall skyscrapers are actively going up. There
are no zoning laws in Russia, and while most of the
tall buildings are being built outside the center of
Moscow, some are going up near the Kremlin and will
block the views from other buildings. I think zoning
regulations will likely become a hot political issue.
Despite Russia’s similarities to Asia, I don’t think its
current boom will end soon. There are significant
differences between Russia today and Asia in 1997.
The Asian governments were running large current
account deficits—similar to the U.S. today—but with
their currencies fixed to the U.S. dollar. The two
situations were incompatible but were being propped
up by hot money from foreign investors wanting
access to the Asian Tigers. As more people began to
talk of the unstable situation, locals began moving
money offshore or converting to hard-currency-based
accounts. As investors began to flee, the countries’
reserves fell, creating a vicious cycle that ended in
devaluation and spread throughout Asia. (Hot money
is once again flowing into emerging markets, but
most countries are running current account surpluses.)
Whereas, the Asian governments of 1997 were running
current account deficits, Russia is running a current
account surplus as well as a fiscal surplus. With oil
hitting all-time nominal highs, Russia has paid off its
debts and is hoarding cash. It now sits on $406 billion
in reserves, trailing only China and Japan. This is a
far cry from its position in 1998, when the Asian crises
caused a global recession that sent oil to $10 per
barrel. This in turn led to the Russian crises, with the
country devaluing its currency and defaulting on its
debt—something that the Soviet Union, through more
than 70 years of existence, had never done.
With the rise of the price of oil, president Vladimir Putin
has been able to once again exhibit Russia’s global
power. Twice he has cut off natural-gas flows to
Western Europe, reminding the countries there how
dependent they have become on Russian natural
gas. The Soviet Union was long referred to as “the
Bear.” I spent four summers as a river guide and
spent a lot of time outdoors. In the wild, there aren’t
many situations more dangerous than getting
between a large female bear and her cubs. Unfortunately, the West has gotten between Russia and
her former satellite states—her cubs—and Russia
has become angry, powerful, and dangerous.
It’s no wonder that with newfound strength, Russia is
once again flexing its muscles. Russia has been
reconsolidating its natural-resource assets, which it
considers strategic and which Putin thinks were
sold at ridiculously cheap prices. We might not agree
with his tactics, such as claiming back taxes on
Yukos for issues that were standard practice and not
enforced elsewhere, or claiming environmental
problems with Sakhalin II that disappeared once International Stalwart Shell RDS.A turned control of the
project over to state-controlled Gazprom. However, it
is understandable why Russia has done what it
has. In the telecom industry, the government has used
Gazprom’s pension funds to buy back Rostelecom ROS.
Continued on Page 20
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8:17 PM
Page 18
A watchlist of our 50 favorite international stocks with
moats. Go to http://msi.morningstar.com to track changes
throughout the month.
International Stalwarts
Star
Rating
Fair
Current Consider Consider Size of
Value ($)* Price ($) Buying ($) Selling ($) Moat
Div.
Yield (%) P/E
QQQQQ Avg
71.00
52.23
54.70
3.7
8.3
Continues to benefit from Ireland’s robust economy.
Strength in U.K. and Poland as well. Featured this issue.
America Mobile SAB AMX
QQQQ
+Avg
83.00
59.88
52.90 100.10 Narrow 0.6
26.8
137 million wireless customers, largest in Latin America.
Fair value increased 88%. Highlighted Jan. 2007.
Arcelor Mittal MT
QQQ
Avg
56.00
61.02
43.20
11.6
Largest steel producer in the world. Leading industry
consolidation and improved economics.
ARM Holdings PL ARMHY
QQ
+Avg
7.50
8.90
4.80
9.00 Wide
0.6
43.5
Sells chip designs to the semiconductor industry that are
used in electronics, mobile phones, and autos.
AstraZeneca PL AZN
QQQ
Avg
51.00
51.83
39.30
63.90 Wide
3.3
13.5
Firm is No. 1 in gastrointestinal (ulcer) drugs. Closed
MedImmune acquisition. Will further enhance pipeline.
Bank of Montreal BMO
QQQQ
Avg
75.00
62.51
57.80
94.00 Wide
3.6
12.9
Wide-moat Canadian bank. Agreed to acquire two
Wisconsin banks. Featured Oct. 2006.
Bank of Nova Scotia BNS
QQQ
Avg
46.00
46.52
35.50
57.60 Wide
3.2
14.0
25% of earnings from international operations, especially
Latin America. Highlighted Nov. 2006.
Barclays PL BCS
QQQQ
Avg
64.00
55.99
49.40
80.20 Wide
4.4
10.0
Good first-half results. Increased bid for ABN Amro Bank.
Still below RBS offer. Highlighted July 2006.
BP PL BP
QQQ
Avg
72.00
69.40
55.50
90.20 Narrow 3.5
10.5
Despite safety problems, still one of the world’s best oil
firms. CEO stepped down early. Featured Feb. 2007.
British Amer Tbco PL BTI
QQQ
+Avg
64.00
65.09
40.80
77.20 Wide
3.3
19.3
Successfully taking cigarettes into emerging markets.
Cash cow.
British Sky Brdcsting BSY
UR
—
UR
53.81
UR
UR UR
1.9
23.8
Dominant pay television provider in the U.K. and Ireland.
More than twice as many customers as cable competitor.
Avg
32.00
35.14
24.70
40.10 Narrow 1.3
18.5
Owns and manages offices, residential develpments, and
hydro plants. Split stock 3 for 2 recently.
QQQQQ -Avg
60.00
49.73
51.10
78.80 Wide
2.2
24.6
Announced split between confectioneries and beverages.
Highlighted April 2007.
Canadian Imp Bk Of Cmrc CM
QQQ
Avg
82.00
87.02
63.20 102.70 Wide
3.0
12.5
Fair value raised $3. Despite Enron-related woes,
it boasts an excellent retail bank.
Canon CAJ
QQQ
Avg
50.00
53.08
38.60
62.60 Narrow 1.6
19.1
Leading consumer electronics firm, with specialties in
photography and printing.
Cemex SAB de CV CX
QQQQ
Avg
41.00
32.34
31.60
51.40 Narrow 2.3
10.1
World’s best cement company. Global diversification
offsetting weak U.S. In Hare Portfolio.
China Mobile CHL
QQQ
+Avg
52.00
57.39
33.10
62.70 Narrow 1.5
26.6
Wireless phone company with more than 300 million
subscribers. Fair value increased $7. Featured April 2007.
Companhia de Bebidas ABV
QQQ
+Avg
75.00
68.50
47.80
90.50 Wide
2.0
30.1
Dominates Brazil beer market; strong in other markets and
soft drinks. Highlighted June 2006. Fair value raised 23%.
Q
+Avg
21.00
49.01
13.40
25.30 Narrow 1.2
18.2
Largest exporter of iron ore—key to steel production.
Sizable position in nickel and other metals.
Company Name
] Allied Irish Banks AIB
Brookfield Asset Mngmnt BAM QQQ
] Cadbury Schweppes PLC CSG
[ Companhia Vale Do Rio Doc RIO
Bus.
Risk
89.00 Wide
70.20 Narrow 1.5
Comment
Dassault Systemes SA DASTY
QQQ
Avg
62.00
60.16
47.80
77.70 Wide
0.7
29.4
French product life management and 3D design software
firm. Featured Jan. 2007.
Diageo PL DEO
QQQQ
-Avg
92.00
81.68
78.40 120.80 Wide
3.0
15.1
Largest spirits producer in the world. Exclusive distribution competitors can’t match. .
E.ON AG EON
QQQ
Avg
59.00
52.33
45.50
73.90 Narrow 2.9
15.5
Large electric utility in Germany. Pulled out of bidding war
for Endesa. Large cash war chest. Featured June 2007.
Enel Spa EN
UR
Avg
UR
51.45
UR
UR Narrow 6.3
15.2
Large electric utility in Italy. Appears to have won bidding
war for Endesa of Spain. Large cash war chest.
Fomento Econ Mex SAB FMX
QQQQ
Avg
46.00
37.02
35.50
57.60 Narrow 1.1
73.0
Top producer/distributor of beer and Coke in Mexico.
Featured May 2007.
GlaxoSmithKline PL GSK
QQQQ
Avg
63.00
51.08
48.60
78.90 Wide
13.5
Strong drug portfolio despite recent negative safety data
on Avandia. Featured March 2007.
3.7
siii_0807.qxp
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8:17 PM
Page 19
Company Name
Star
Rating
Bus.
Risk
Fair
Current Consider Consider Size of
Value ($)* Price ($) Buying ($) Selling ($) Moat
Grupo Danone GDNNY
QQQ
Avg
17.00
14.60
13.10
21.30 Narrow 1.8
19.0
Top global producer of yogurt. Selling biscuits. Buying
Numico. Fair value lowered $1. Featured Nov. 2006.
Grupo Aero del Norte OMAB
QQQ
+Avg
26.00
26.70
16.60
31.40 Wide
0.7
31.6
Wide-moat firm with airport monopoly in
northern Mexico.
Grupo Aero Pacifico PAC
QQQ
Avg
47.00
48.62
36.20
58.90 Wide
2.8
33.0
Airport monopoly in west-central Mexico, including
Guadalajara. Fair value raised $4. Highlighted Dec. 2006.
Grupo Aero Sureste ASR
QQQQ
+Avg
61.00
52.57
38.90
73.60 Wide
1.3
32.4
Completed third terminal at Cancun airport. Increased fair
value 24%. Highlighted Sept. 2006.
HSB HBC
QQQ
Avg
97.00
93.16
74.80 121.50 Wide
4.5
13.4
2006 results hurt by subprime mortgage lending. Fair
value raised $6. Highlighted March 2007.
Imperial Tbco Grp PL ITY
QQQ
+Avg
93.00
87.66
59.30 112.20 Wide
2.8
18.0
Appears to have won bidding for Spanish-French cigarette
firm Altadis. Fair value increased 26%. Cash cow.
Infosys Technologies INFY
QQQ
Avg
54.00
49.60
41.60
67.70 Narrow 0.5
33.1
Largest offshore IT outsourcer. Growing rapidly with
clients worldwide. Highlighted June 2007.
Lloyds TSB Group PL LYG
QQQQ
Avg
53.00
45.24
40.90
66.40 Wide
5.9
11.4
Shareholder friendly. Increased already large dividend
5%. Featured July 2006. Selling Abbey Life.
Luxottica Group LUX
QQQ
Avg
34.00
36.04
26.20
42.60 Narrow 1.6
28.3
World’s largest manufacturer and retailer of prescription
eye glasses. Acquiring sports eyeglass brand Oakley.
Nokia NOK
QQQ
Avg
27.00
28.64
20.80
33.80 Narrow 2.0
20.2
Market leader. Best profits in industry. Recently sold from
the Hare Portfolio. Highlighted March 2007.
QQQQQ -Avg
73.00
53.95
62.20
95.80 Wide
2.0
18.2
Recent addition to Tortoise Portfolio. Strong 1Q. Robust
drug pipeline. Highlighted Jan. 2007.
Novo Nordisk NVO
QQ
Avg
88.00
104.91
67.90 110.30 Wide
1.2
28.9
Leader in diabetes treatments. Rivals also attracted to
growing diabetes market.
Reed Elsevier PL RUK
QQQ
Avg
44.00
49.37
33.90
55.10 Narrow 2.5
24.3
Leading publisher & information provider, esp. in science
and technology. Selling rest of U.S. education business.
Royal Bank of Canada RY
QQQ
Avg
46.00
51.04
35.50
57.60 Wide
3.0
15.1
Largest bank in Canada by assets. Dominates many
product categories.
Royal Dutch Shell PLC RDS.A
QQQ
-Avg
74.00
77.59
63.10
97.20 Narrow 3.4
9.8
One of the three largest integrated oil companies. Largest
retail distribution network. Strong chemical results in 1Q.
SABMiller PL SBMRY
UR
—
UR
25.70
UR
UR Wide
1.8
24.6
Leading wide moat international brewer that is also a top
producer of Coke and other soft drinks.
Sanofi-Aventis SNY
QQQQ
Avg
48.00
41.75
37.00
60.10 Wide
2.8
20.9
FDA panel rejected new drug rimonabant. Plavix patent
upheld. Still strong pipeline. Featured July 2007.
SAP AG SAP
QQQ
Avg
56.00
53.92
43.20
70.20 Narrow 1.2
26.2
German software firm dominates enterprise resource
planning market. Fair value raised $8.
Taiwan Semiconductor TSM
QQQ
+Avg
11.00
10.15
7.00
13.30 Narrow 4.4
13.6
Largest independent semiconductor foundry. Roughly 50%
market share.
Teva Pharmceuticl Ind TEVA
QQQ
Avg
43.00
42.02
33.20
53.90 Narrow 0.7
61.0
Fair value raised another $5. World’s largest generic drug
firm. Competition from big pharma is a looming threat.
Toronto-Dominion Bank TD
QQQ
Avg
64.00
64.12
49.40
80.20 Wide
2.9
10.8
Wide-moat Canadian bank. High return on equity in
Canada, expanding into U.S.
Toyota Motor TM
QQQ
Avg 135.00
120.63
104.10 169.10 Narrow 0.7
14.5
World’s largest automaker in 1Q. Seems above industry’s
struggles. FV increased 25%. Highlighted Nov. 2006.
TransCanada TRP
QQQ
-Avg
35.00
36.20
29.80
46.00 Narrow 3.2
18.0
Dominant Canadian natural-gas pipeline firm that is in
the Tortoise Portfolio.
UBS AG UBS
QQQ
Avg
60.00
55.07
46.30
75.20 Wide
3.3
0.0
Struggled recently. Ousted CEO Peter Wuffli. World’s
largest asset manager. Strong I-bank.
Vodafone Group PL VOD
QQQ
Avg
30.00
30.35
23.10
37.60 Narrow 4.5
0.0
Largest wireless telephone carrier by revenues. Most
geographically diversified. Closed Indian acquisition.
] Novartis AG NVS
Div.
Yield (%) P/E
Comment
siii_0807.qxp
8/2/07
8:17 PM
Page 20
Mobile TeleSystems MBT
Star Rating
QQQ
Business Risk
Spec.
Fair Value ($)
68.00
Current Price ($)
63.95
Market Cap ($bil)
25.4
Dividend Yield (%)
—
Size of Moat
Narrow
Consider Buying ($)
35.40
83.60
1-Yr Hi/Low ($) 70.39/31.30
Stewardship
—
P/E
23.7
Vimpel-Com VIP
Star Rating
Business Risk
Fair Value ($)
Current Price ($)
Market Cap ($bil)
Dividend Yield (%)
Size of Moat
QQQ
Spec.
113.00
105.90
21.7
1.5
Narrow
Consider Buying ($)
58.80
138.90
1-Yr Hi/Low ($) 118.55/46.86
—
Stewardship
P/E
26.5
Price/Fair-Value Ratio **
All International Stocks
Emerging Mkt Stocks
Developed Mkt Stocks
U.S. Stocks
1.04
1.10
1.03
0.95
**Median price to fair value ratios
among Morningstar’s coverage
universe. Data as of July 31, 2007
Russian Telecom Firms
On my visit, I met with representatives of Rostelecom,
Golden Telecom GLDN, Mobile TeleSystems
MBT (otherwise known as MTS), Sistema, and Comstar.
I was also scheduled to meet with people from
VimpelCom VIP, but they stood me up.
In other countries where the long-distance telephone
market was deregulated, the incumbent has lost
significant market share, but that hasn’t happened in
Russia. Because of Russia’s unique tariff structure,
the majority of the cost of a long-distance call is paid
to Svyazinvest, the local operator outside of Moscow
or MGTS, the operator in Moscow. This precludes
other operators from cutting prices significantly to take
market share.
Golden Telecom has become the largest provider of
telephone services to businesses in Moscow, where it
holds a 42% market share, and the firm is growing
rapidly as its clients move from Moscow to St. Petersburg and beyond. A major reason for Golden’s success
in the corporate market is the poor state of Svyazinvest’s and MGTS’ networks. Both are private companies, but Comstar owns stakes in both. Comstar
confirms Golden’s claims that the incumbent’s networks
aren’t up to snuff. This is leading large corporations,
especially global ones, to use Golden or other
alternative carriers.
On the wireless front, growth in Russia has been
phenomenal, going from 1.4 million subscribers, or less
than 1% penetration of the population, in 1999 to
152 million subscribers, or 105% penetration, by the
end of 2006. The two biggest beneficiaries of this
growth have been MTS and VimpelCom. Both have
shown tremendous growth in subscriber base,
revenue, and profits over the past seven years. With
penetration rates of more than 100%, one might
think that the market is quite saturated. However,
Russia counts this number by SIM cards rather
than by the number of phones, as most Western countries do, and many people have SIM cards from
more than one operator. Because of the difference in
accounting for penetration, I think there is still
growth left in the Russian market.
Both MTS and VimpelCom have also been expanding
into other countries of the former Soviet Union, where
MTS has a first-mover advantage over VimpelCom.
The other countries have smaller populations, but also
have lower penetration levels, which will add
additional growth opportunities for both firms.
Two other things I learned. I’ve been concerned about
what would happen to all these new wireless
subscribers if the price of oil dropped. Sistema, a large
conglomerate, owns a bank and makes short-term
loans for people to buy $500 wireless handsets, which
are not subsidized in Russia. People will pay them
off, and after a year’s use, take out a new loan for a
new phone to always be on the cutting edge.
People will likely stop buying new $500 phones if oil
prices drop, but I don’t think they’ll stop using
the phones, as the average bill is only $10 per month.
The other issue I’ve had is this: Why won’t the government take control like with Yukos? Managers
think because they started companies from scratch
rather than buying them cheap from the government
that the government will let them be. After all,
the government has been a big beneficiary of the
improved networks that it couldn’t afford to build.
Unfortunately, none of the Russian stocks Morningstar
covers are cheap currently, but with the historical
volatility of the country’s stock market, I think opportunities could present themselves in the future. And
as I’ve said before, it is important to be familiar with
investments before an opportunity hits.
One final humorous story. Because of the quantity of
land in Russia, Moscow doesn’t have a central
business district. Companies are headquartered all over
the city, which is built in concentric circles moving
out from the Kremlin. Left turns are not allowed at
major intersections, causing drivers to overshoot their
destination and either do a series of right turns or
find a small street where a left or U turn is allowed.
The left turn issues, and Putin’s increased power,
has led to the political saying that “at least they can’t
turn left.” œ
Contact Allan Nichols at [email protected]
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Allied Irish Banks AIB
Allan’s Position
Ireland’s growth has been impressive and looks
sustainable. Allied Irish continues to benefit from this.
International Stock Focus | Erin Davis
Allied Irish is a solid, conservatively run bank riding
the wave of favorable economic trends in Ireland.
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$64.38/48.03
$71.00
$52.23
$54.70
$89.00
Size of Moat
Business Risk
Market Cap
Wide
-Avg
$24.0 bil
3.7%
$4.3 bil
Stewardship
—
• Allied Irish Banks
% Change in Price
• S&P 500 Index
350
280
210
140
70
0
97
1998
1999
2000
2001
2002
2003
2004
2005
2006
07
Profile
Management and
Stewardship
Valuation
Allied Irish Banks is one of the top two banks in Ireland and has
sizable investments in financial services firms in other countries:
About half of its profits are generated abroad. The firm operates a
specialty bank in Great Britain focused on midsize firms and highnet-worth individuals, and an international capital markets group.
We applaud Allied Irish for its solid corporate-governance practices.
The company requires the roles of chairman and CEO to be split and
a substantial majority of the board to be independent. CEO
Eugene Sheehy, 51, was appointed in 2005 after a series of scandals
rocked the bank. He was seen as both an insider and an outsider
because, while he has worked for Allied Irish since 1971, he spent
three years in the U.S. as the CEO of AIB USA, overseeing the
takeover of Allfirst by M&T MTB. Since his appointment as CEO, he
has tightened up risk-management systems and brokered an agreement with the finance union to link employee compensation more
closely to performance.
We recently raised our fair value estimate for Allied Irish to $71 per
share from $66 to account for cash flows accrued in 2006. We
expect net income growth to average 6% annually through 2011,
down from average growth of 30% since 2001, as Ireland’s
economy cools. The most important factors affecting net income
will be asset growth, net interest margins, and operating costs. We
anticipate that asset growth will be 15% in 2007 and will slow to
7% by 2011, a tad above Ireland’s projected nominal GDP growth of
6%. We project net interest margins to be 2.25% in 2007, gradually
increasing to 2.3% by 2011. We expect charge-offs will remain low
by industry standards. We apply a 19% tax rate and charge Allied
Irish an 11% cost of capital. Adjusting for the 2 for 1 ADR ratio and
using an exchange rate of $1.34 we reach our fair value estimate.
Ireland is one of the most attractive banking markets
in the world, and Allied Irish’s position as the
country’s largest bank has afforded it a wide economic
moat. The Irish banking market is extremely consolidated; Allied Irish and its largest competitor, Bank of
Ireland, are estimated to control more than 70% of
the market for personal current accounts. This makes
it unlikely that any new competitors will emerge
to pose a serious threat to Allied Irish’s market share.
Ireland also enjoys highly favorable economic
conditions; in 2006, it benefited from 6% GDP growth
and 5% job growth. Allied Irish has translated
these ideal economic conditions into good returns on
invested capital, averaging 16% since 2002.
In Ireland, Allied Irish is a plain-vanilla bank that takes
deposits, makes loans, and earns a moderate interest
spread. We appreciate the bank’s conservative
underwriting, which should limit write-offs in the event
of a downturn. The bank’s loan and deposit growth,
propelled by Ireland’s economic expansion, has averaged 19% and 11%, respectively, since 2001.
We believe Allied Irish will be insulated from any
slowdown in Ireland by its operations abroad, which
generated about 40% of its income in 2006. The
largest of these is its bank in Great Britain. It focuses
on providing a high level of service to business
customers in selected sectors, such as legal services
and private education.
Allied Irish’s goal is to continually expand profitability
by increasing income 3% faster than costs. For the
past three years, the bank has comfortably exceeded
this goal. Allied Irish has brought its efficiency
ratio, a common measure used to compare operating
expenses with net revenue, down to about 45%.
This is in line with our expectations for an exceptionally well-run bank. œ
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22
Corporate Executive Board EXBD
Company Spotlight | Paul Larson and Brett Horn
Brett Horn
Stock Analyst
Corporate Exec Board EXBD
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
93.00
Current Price ($)
67.42
Market Cap ($bil)
2.5
Dividend Yield (%)
2.1
Size of Moat
Q: Let’s get everyone up to speed. Can you explain
what Corporate Executive does and how the firm
makes money?
Wide
Consider Buying ($)
1-Yr Hi/Low ($)
Stewardship
P/E
In early July, I bought three stocks for the Hare Portfolio, including new holding Corporate Executive
Board. Although the company was in the previous issue,
I thought I’d have our analyst Brett Horn back to
share even greater detail about this opportunity. Brett
has been with Morningstar for about one year, and
he also covers portfolio holding Western Union WU.
71.70
116.50
97.10/58.54
¥
33.3
A: Corporate Executive Board provides best-practices
research. The company currently offers 43 separate
programs covering topics specific to common functional
areas (such as human resources and legal) and is
used primarily by upper management. Member companies pay, on average, $34,000 per program per year to
get access to the research and peer networking events.
One important thing to understand is that the research
is mainly generated from member companies’
experiences. Corporate Executive Board utilizes its
members to investigate what important issues
companies are facing and how different companies
have tackled the problem. With approximately
3,700 member companies, Corporate Executive Board’s
research teams have access to a large pool of information, which they use to determine which approaches
are best, and, perhaps just as importantly, which
common approaches are not effective.
Q: How does this differ from what consultants
typically offer? What is the value proposition for their
clients, and how is it better than the substitutes?
A: Consultants could be considered indirect competition for Corporate Executive Board, but the two
could be just as accurately described as complements
to each other. The main differences are that consul-
tants are generally used for specific projects, and hiring
a group of consultants is an expensive proposition.
Meanwhile, membership in Corporate Executive Board
programs is ongoing and relatively cheap. But it’s
not a one-or-the-other proposition. Let’s say a human
resources director is thinking about making some
changes. A member of Corporate Executive Board will
probably turn first to its research to look for ideas.
If, based on that, a major reorganization needs to take
place, some consultants will probably be called in.
But even in this case, membership has probably saved
some time and money. Using the research, the consultants can be brought in with a specific agenda and
shorten the time they spend in the office and the bill.
You could draw an analogy to investors’ options of
subscribing to Morningstar or hiring a financial
advisor to manage their portfolios. Individual investors
might choose one or the other, or both. Investors
might use Morningstar’s research to help make their
own stock selections or use the research to surface
ideas to discuss with their financial advisor. But being
a Morningstar subscriber and hiring a financial
advisor aren’t mutually exclusive choices.
Q: Beyond the fantastic financial characteristics of
this business, what other pieces of evidence make
you think this company has a wide moat?
A: I would first point out that Corporate Executive
Board has consistently maintained client-renewal
rates of 90% and above, even during the last recession in 2001. This is a strong indication that its clients
see value in being members, and those relationships
are quite sticky. It seems unlikely that high-level executives would give up access to research that helps
them perform their duties, even if just at the margins,
to save a relatively small amount of money.
Also, the company benefits from a network effect.
Having a large membership base means it has more
empirical data on best practices and a stronger peer
network. This improves the quality of the company’s
programs, which in turn attracts more clients, and so
on. Based on this, the company’s competitive
advantage should only widen in the coming years as it
increases its membership base.
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Q: Is there anything preventing anyone from cloning
this business model? What are the barriers to entry?
A: At first glance, the barriers to entry would seem
to be low, as it wouldn’t be terribly difficult for
others to create and distribute best-practices research.
But there are a couple of reasons why the firm
should be able to hold off any potential competitors.
First, the company has built a large base of research
and staff that would be very difficult for any new
entrant to match quickly. Also, there is something of a
natural monopoly for this business, in my opinion.
I can’t imagine that time-pressed executives would feel
the need to subscribe to two sets of best-practices
research. And, if they are going to choose only one, I
think it’s a good bet they will go with the company
that has more than 80% of the Fortune 500 as clients,
as opposed to any new upstart.
Q: I think the financial statements from this firm are
stunning. Care to share the more salient statistics?
A: During the last five years the company has grown
at a 29% compound annual growth rate as it has added
new clients and expanded its programs. On top of
this, the company has been able to expand operating
margins during the same period from 24% to 28%,
if you exclude the effects of stock option expenses.
The most impressive aspect of Corporate Executive
Board’s statements is its ability to generate free cash
flow. Clients pay their annual dues up front, but
accounting rules require waiting to recognize the
revenue over the course of the year. Operating
cash flow is therefore consistently much higher than
net income. Also, the business requires very little
in the way of hard assets, which keeps capital spending
down. In short, the company’s investment rate is
negative, and growth actually creates more cash. These
factors lead to an astounding amount of free cash
flow, which averaged 32% of sales in the last three
years, excluding the effect of deferred taxes. Returns
on invested capital are essentially infinite because
there is no invested capital at the moment.
Q: What are the primary cash-flow assumptions
standing behind your $93 fair value estimate?
August 2007
23
A: We project revenue to grow at a 17% compound
annual growth rate during the next five years.
That’s a healthy growth rate, but much less than the
company has achieved historically. On the margin
side, we expect operating margins to increase from
23% in 2006 to 25% by 2011. There is a natural
uplift to the company’s margins as it grows, as it is
essentially taking the same pool of research and
selling it to a bigger group of customers. As I mentioned,
because the company has negative working capital,
its operating cash flow is consistently much higher than
its net income. Our model takes this into account
and basically assumes the relationship between net
income and operating cash flow stays steady.
Q: If I am going to lose money with this stock, how
might it happen? In other words, what are the risks?
A: One risk is cyclicality. When the economy falters
and corporate budgets get tight, the company has
a much harder time sighing up new clients. Corporate
Executive Board is seeing some of this tightness
right now, which is part of the reason its growth has
slowed in recent quarters. For the long-term investor,
though, these cycles should even out in the end.
The biggest risk is that the company’s growth hits a
wall at some point in the near future. It has a fairly
well-defined potential customer base, and at some
point penetration may start to stall. However, I think
the company has plenty of growth opportunities.
First, the company has about 25% penetration into its
potential customer base. While Corporate Executive
has almost fully penetrated the top tier of companies,
it’s really just starting to move into smaller firms.
Based on the fact that the company has achieved more
than 80% penetration into the Fortune 500, I don’t
think doubling the overall penetration to 50% is
a stretch. Secondly, the company can grow by crossselling more programs to existing clients. Currently,
clients on average participate in about four programs,
but clients who have been members over three
years participate in an average of seven programs, and
this average has been moving up steadily. To sum up,
doubling the client base and the number of programs
per client would quadruple the revenue base. œ
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24
Amgen AMGN
Company Spotlight | Paul Larson and Karen Andersen
Karen Andersen
Stock Analyst
Amgen AMGN
Star Rating
QQQQ
Business Risk
Avg
Fair Value ($)
69.00
Current Price ($)
53.74
Market Cap ($bil)
62.3
Dividend Yield (%)
—
Size of Moat
Wide
Consider Buying ($)
53.20
86.50
1-Yr Hi/Low ($)
Stewardship
P/E
77.00/52.36
¥
20.7
It‘s been a very difficult year for long-time Hare Portfolio holding Amgen, with several pieces of bad news
negatively affecting the intrinsic value of its business.
Here to talk about the issues is Karen Andersen, who
has covered the firm the last two years.
Q: What are the primary sources of Amgen’s
revenue and profit today?
A: Unlike its large pharma cousins, Amgen has
a relatively small portfolio of drugs on the market—
but most are highly profitable. In fact, Amgen has
five drugs that are considered blockbusters, each with
annual sales north of $1 billion. All of these drugs
are true “biotech” drugs, variations of proteins that
are manufactured by living cells.
Amgen focuses on treating patients with kidney
disease, cancer, or inflammatory diseases like arthritis
and psoriasis. Last year, 46% of revenue—or roughly
$7 billion—came from two similar drugs, Epogen and
Aranesp, which treat anemia that can occur in
dialysis patients as well as in cancer patients on
chemotherapy. Although Amgen doesn’t release profit
margins for individual drugs, I think it’s a safe bet
that these two drugs, known as erythropoiesis stimulating agents (ESAs), have historically been on
the more profitable end of the spectrum, based on a
combination of ease of manufacturing and economies
of scale. However, with 85% overall gross margins,
the other products are hardly a drag on profitability.
Q: We started the year with a fair value estimate of
$91 for the company, and now we think the stock
is only worth $69. Can you explain what happened?
A: It’s safe to say this has been one of Amgen’s
roughest years. We had anticipated some of the challenges, such as Roche’s efforts to introduce a drug
that would compete with Amgen’s ESAs, or the polit-
ical pressure to cut drug costs and create a pathway
for the approval of generic versions of biologic
drugs, or biosimilars. However, what we did not project
was Amgen being hit with alarming safety data
from multiple trials of its ESAs, pertaining to both dialysis and cancer patients. The Food and Drug
Administration slapped a black-box warning on labels
on the entire class of drugs in March, at which point
I lowered my fair value estimate to $83 to account for
the new label’s emphasis on using the lowest
possible doses of these drugs that would be effective
in preventing the need for a transfusion.
Then in May, an FDA advisory committee assembled
to discuss the use of ESAs in cancer patients,
and from Amgen’s perspective, the meeting was a
disaster. Not only were several committee members
frustrated by the piles of clinical data that leave
safety concerns unanswered, representatives from
the FDA berated Amgen for failing to complete
several promised clinical trials. In the end, the panel
voted that Amgen should be required to perform
additional clinical trials for these drugs and that the
FDA should further restrict their usage—and perhaps
even revoke approval for particular types of cancer
treatments. This negative sentiment pushed my sales
assumptions even lower, and I lowered my fair
value estimate to $69. This meeting was followed a few
days later with a proposal from Medicare to drastically reduce reimbursed ESA use in cancer patients.
Q: How have you incorporated the larger required
warnings and reduced reimbursements in your
projections for Epogen and Aranesp? Why do you
think these drugs will sell in the future at all?
A: The warnings and reimbursement changes have
so far had the biggest impact on my assumptions
for Aranesp—I now see 2007 sales of the drug dropping by 14% from the roughly $4 billion in sales
recorded last year, as off-label (unapproved) uses of
the drug will all but disappear, and physicians will
use more conservative dosing when treating patients
for approved indications. This is a dramatic reversal
for what had been one of the highest growth drugs at
Amgen; 2006 sales growth for Aranesp in the U.S.
was a whopping 33%.
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I still believe ESAs have an indisputable role in the
treatment of anemia in dialysis patients as well
as cancer patients on chemotherapy. The chief safety
concerns have revolved around a group of clinical
trials that tested off-label uses of the drugs. Based on
a compilation of data from trials involving more
than 9,000 patients, these drugs don’t have an adverse
effect on survival when used for approved indications.
In addition, there is no good alternative; without
drugs like Aranesp and Epogen, patients have a higher
risk of requiring blood transfusions—lengthy, costly
procedures that put the patient at risk of infection and
further strain the already taxed blood supply.
Q: Do you think Amgen still has a wide moat?
A: In a word, yes. Although it’s true that Amgen’s
cash-generating capabilities have their roots in
the success of Epogen and Aranesp, we’d already been
expecting that the firm would be forced to wean
itself from these products in the future. Despite safety
concerns, we think the lack of alternative treatments
gives Amgen’s anemia franchise a solid foundation to
rely on. With three other blockbusters and a growing
pipeline, I think Amgen has amassed enough industry
talent and drug development experience to allow it to
continue generating returns above its cost of capital.
Q: Let’s assume a worst-case scenario for Amgen’s
anemia drugs. What would your fair value
estimate look like?
A: The Centers for Medicare & Medicaid Services
(CMS) recently announced their final decision
regarding government reimbursement of Aranesp for
cancer patients, which actually turned out to be
much less severe than the initial proposal. While
investors are concerned that similar restrictions could
be slapped on Epogen for dialysis patients, CMS’
proposed reimbursement changes in this category are
pretty minor. Moreover, if I completely remove
Aranesp and Epogen from my valuation model as of the
start of 2008, the fair value estimate drops by
about $14 per share. Although this is highly unlikely, it
does serve to show that the firm is not solely
dependent on these two drugs.
August 2007
25
Q: Does Amgen have anything going for it today?
A: Amgen has broad-based experience with various
avenues of drug development—monoclonal antibody
Vectibix was approved last year to treat colorectal
cancer, and Amgen has several novel small molecule
drugs in development, which is traditionally the
territory of large pharma. Amgen’s portfolio of approved
drugs is getting a strong boost from dialysis patient
drug Sensipar, which we think has blockbuster potential. The next drug likely to gain approval—perhaps
early next year—is AMG 531, which has been shown
very effective at boosting platelet count in patients
with a rare bleeding disorder. We think AMG 531
could eventually be approved to treat a broader range
of patients and that sales could reach $1 billion
within five years of its launch. The star of the pipeline
today is denosumab, an antibody with multibilliondollar potential that is in late-stage development for
osteoporosis and bone cancer.
Q: What are the other main projections in your
discounted cash-flow model?
A: During the next 10 years, I see average sales and
earnings growth in the midsingle digits. Although
generic biologic competition and reimbursement pressures should prevent operating margins from widening
further, the firm should be able to maintain them.
I’ve included competition from biosimilars in Europe
starting at the end of this year, and though a pathway
is still in the works in the U.S., we’ve assumed the
first generic biologics will enter this market in 2010.
Q: Any final words of wisdom?
A: Anyone invested in Amgen today is already wellaware that biotech investing is not for the faint of
heart. Amgen could suffer another blow before shares
begin to recover in earnest. That said, Amgen is
one of the world’s premier biotechs, and I think the
market’s fears have made the shares a value today.
Investors should be somewhat encouraged by Amgen’s
view of the value in its shares. Buybacks are continuing at a frenzied pace; another $5 billion in buybacks
was just approved by the board of directors. œ
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26
Nike NKE
Paul’s Position
We hiked Nike’s moat rating to “wide” in late June.
Tortoise Stock Focus | Brady Lemos
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQ
$60.35/37.76
$65.00
$56.45
$50.10
$81.40
Size of Moat
Business Risk
Market Cap
Wide
-Avg
$28.3 bil
1.6%
$16.3 bil
Stewardship
∑
• Nike
% Change in Price
• S&P 500 Index
200
Promising growth opportunities, global scale advantages, and a history of product innovation position
Nike to maintain market dominance in athletic apparel
and footwear. We believe Nike’s iconic image, in
addition to its diversified product portfolio and global
presence, is a major competitive advantage. This
brand prestige allows Nike to charge premium prices,
which should help the firm earn returns on invested
capital well in excess of its cost of capital.
160
120
80
40
0
97
1998
1999
2000
2001
2002
2003
2004
2005
2006
07
Profile
Nike is the world’s largest athletic footwear and apparel brand.
International sales to more than 160 countries account for more
than half of the company’s total revenue. Primarily a wholesaler,
Nike also operates about 400 retail stores domestically and abroad.
Nike owns several footwear and accessory brands, including Cole
Haan, Jordan, Converse, Starter, Bauer, and Hurley.
Management and
Stewardship
Mark Parker was named CEO in 2006 following the resignation of
William Perez, who clashed with founder and chairman Phil Knight.
We think Nike is in good hands with Parker at the helm. A Nike
employee for nearly 30 years, most recently serving as copresident
with Charlie Denson, Parker brings plenty of industry experience.
Perhaps just as crucially, he arrives fully wired into Nike’s unique
company culture, an obstacle that outsider Perez could not overcome. We are confident Parker and Knight are capable of leading
Nike through its latest growth cycle and maintaining its market
dominance. Knight has sold some of his Nike stock since stepping
down as CEO, yet still owns about 40% of the company with his
Class A and B shares. Even though Knight is entitled to elect the
majority of the directors, we believe the board is sufficiently independent; nine of the 11 directors are outsiders.
Valuation
Our fair value estimate is $65. We assume Nike’s sales growth,
excluding the impact of exchange rates, will average 8% annually
during the next five years. This is consistent with the average
growth rate during the last five years. International growth, particularly in China, should offset any slowdown in the U.S. market. We
anticipate that Nike will broaden its golf, pro apparel, and women’s
footwear offerings and extend its Starter business within the mass
channel. Our valuation model assumes that operating margins
average just more than 13% during the next five years, up slightly
from the average return during the last five years.
Vital to the firm’s growth strategy is international
expansion, and World Cup 2006 provided the ideal stage
to showcase the Nike brand to an estimated 1 billion
viewers around the globe. Sales of replica jerseys and
boots helped expand Nike’s soccer division into a $1.5
billion business, more than double its size following
World Cup 2002. We expect Nike to deepen its
penetration of the massive soccer markets in Europe
and South America through athlete endorsements
and club licensing deals.The exploding popularity of
basketball in Asia provides another avenue for
growth in China, where Nike is already the top-selling
brand and business has more than doubled the
last two years. The Beijing 2008 Olympics should spark
sales even higher. Domestically, Nike entered the
low-price sneaker business in 2005 by introducing
Starter footwear into Wal-Mart WMT. This foray into
the mass channel offers significant growth potential
without diluting the premium Nike brand.
Even the best-run apparel companies are susceptible
to unfavorable industry trends, however. In 2006,
for example, the firm struggled in Europe, where fads
favoring low-profile shoes hurt demand for Nike’s
higher-price sneakers. Fortunately for Nike, expansion
in other regions like China and South America
more than offset weak performance in softer markets.
Furthermore, Nike’s new low-profile footwear collection has been well-received by consumers. Although
certain risks are largely unavoidable, Nike has demonstrated that its diverse product offering and global
reach can provide a mitigating buffer unequaled in
the industry. œ
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Discover Financial Services DFS
August 2007
27
Paul’s Position
Despite only a “narrow” moat, this one is quite cheap.
Tortoise Stock Focus | Michael Kon, CFA
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$32.17/22.38
$35.00
$23.05
$27.00
$43.90
Size of Moat
Business Risk
Market Cap
Narrow
-Avg
$11.0 bil
NA%
• Discover Financial Services
% Change in Price
$4.9 bil
Stewardship
—
• S&P 500 Index
0
Discover Financial Services might appear to be an ugly
duckling at first glance, but a closer look reveals
a decent business with heaps of potential. Discover
operates one of the two national closed-loop
credit card networks in the U.S.; American Express
AXP operates the other. Discover issues proprietary
cards, extends card loans to cardholders, and acquires
transactions from merchants whenever a cardholder
pays with a Discover card.
-4
-8
-12
-16
-20
07-07
08-07
Profile
Discover Financial Services issues credit cards and acquires transactions. It operates a closed-loop credit card network and also uses
third parties to issue its cards. Discover extends card loans (receivables) to cardholders who wish to borrow through their credit
cards. It also operates a PIN-based (online) debit card network
(Pulse) in the U.S. and has a credit card-issuing business in the U.K.
and credit card-acceptance agreements with JCB (a Japanese card
firm) and China UnionPay (a Chinese card firm).
Management and
Stewardship
CEO David Nelms has been at the helm of Discover since 2004.
Nelms is an experienced executive and is surrounded by industry
veterans. However, we think management still has to prove that it
can successfully lead Discover as an independent firm, especially in
light of the inferiority of its network. In the past, a great chunk of
executive compensation was tied to the performance of the parent
company. With the spin-off from Morgan Stanley MS, Discover will
have to craft a new incentive plan that will place top executives in
the same boat with shareholders. However, the firm hasn't
disclosed enough information to conclude whether future compensation practices will achieve such goals.
Valuation
We think Discover is worth $35. We expect funding costs to rise
after the spin-off because Discover will cease to benefit from
Morgan's cheap funding programs. However, we think the spin-off
will have a positive effect on overall performance because it will
free Discover from any impediments that come with being owned
by a big bank. After the spin-off, Discover should be better-positioned to pursue strategic alliances, especially with other banks.
We expect card volume and the number of transactions to accelerate over the next five years, to a high-single-digit growth rate.
We think this will enable noninterest income to increase by 7% and
net interest income by 9% annually during the next five years.
Discover’s network is inferior to peers’. Its cards are the
least-accepted among the four major networks.
Cardholders often view Discover as a second-choice
card, leading to many inactive accounts (more
than half of total accounts) and low spending levels
per account. Discover also has fewer cards
outstanding, and card volume—the total dollar amount
cardholders spend—grows much slower than that
of the other large networks. During the last three years,
Discover card volume grew less than 5% annually,
while other networks registered double-digit rates. The
biggest weakness, in our opinion, is the firm’s
revenue mix. Unlike Amex, which earns a boatload of
discount fees (60% of revenue), the bulk of Discover’s
revenue (about 60%) comes from the spread on
card receivables. This suggests that Discover fails to
fully monetize the operating leverage embedded in
its network and has to rely on the performance of its
receivables to fill its coffers.
Discover still has a solid brand name and a network
that, despite all the disadvantages, would be hard to
duplicate. The firm also boasts low attrition compared
with other issuers, because cardholders tend to
keep using their cards once they get used to paying
with them at certain merchant locations. In addition,
the Pulse network makes Discover a large force in
the debit card market, which is growing much faster
than the credit card market. We also like the strategy
of teaming up with third-party issuers and expect
more partnerships of this sort. In the long run, these
relationships will boost the number of cardholders
and improve the acceptance of Discover cards. œ
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28
Hershey HSY
Paul’s Position
Hershey is getting pinched by higher input costs, but
the stock market reaction looks overdone.
Tortoise Stock Focus | Mitchell Corwin, CFA, CPA
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$56.75/45.37
$58.00
$46.10
$49.40
$76.10
Size of Moat
Business Risk
Market Cap
Wide
-Avg
$10.5 bil
2.3%
$5.0 bil
Stewardship
¥
• Hershey
% Change in Price
• S&P 500 Index
120
90
60
30
0
-30
97
Hershey’s supply-chain transformation should result in
needed manufacturing flexibility and a lower-cost
structure, expanding margins while supporting higher
marketing costs. We believe that the firm is positioning itself well to drive sustainable moderate topline growth, though we continue to believe that it
will remain challenged internationally.
1998
1999
2000
2001
2002
2003
2004
2005
2006
07
Profile
The Hershey Company is the largest North American manufacturer
of chocolate and nonchocolate confectionery products. The company markets brands, including Hershey’s, Reese’s, Hershey’s
Kisses, Kit Kat, Almond Joy, Mounds, York, Jolly Rancher, Twizzlers,
Ice Breakers, and Bubble Yum. The company derives about 10%
of its sales internationally.
Management and
Stewardship
Hershey is ultimately controlled by the Milton Hershey Trust, which
owns Class B 10-to-1 supervoting shares that, when combined with
its 7% ownership of common stock shares, give the trust nearly
80% voting power and 32% ownership. We don’t like these types of
dual share classes that limit the rights of minority shareholders. In
addition, the company and the trust have butted heads in the past.
Without the support of the trust, an acquirer can’t seriously
approach Hershey. The company has a stockholder protection rights
agreement, which gives older shareholders a preferred stock dividend should an outside party attempt to acquire more than 15% of
the shares. CEO Rick Lenny earned a reasonable $1.1 million of
salary in 2006, and we were pleased that no bonuses were paid out
to executives in light of a disappointing year, and salaries were
frozen into 2007 for Lenny and two other executives. Directors are
elected annually, but only two are elected by common shareholders.
Valuation
We think Hershey is worth $58. The company’s top line should
rebound a bit from increased marketing support and improving performance of core brands in the United States, but we are cautious
regarding the long-term success of the new platforms. Some
of that will be offset by higher marketing costs, but gross margins
should also improve as the company’s product mix shifts toward
more premium items and higher-margin, single-serve products. We
assume that operating margins will increase to nearly 23% in five
years from a restructuring-adjusted 20.4% last year.
Transitioning away from limited editions and into new
platforms, such as premium chocolate and refreshments, should give Hershey more sustainable top-line
growth. However, growth will come at a higher cost.
The limited-edition products not only provided incremental sales but also increased consumer awareness
around the company’s core brands. Absent that sort
of halo effect, the firm is substantially increasing its
marketing spending to reinvigorate growth in its core
Hershey, Reese’s, and Kisses franchises. Plus, more
incremental advertising dollars will be necessary
to introduce products under Hershey’s new platforms.
To support higher average marketing expenditures and
specialized products and packaging, Hershey is
embarking on a $500 million supply-chain transformation project. We think the economics of the project are
compelling, with the company expecting to save $180
million annually by 2010. It is important to note that
the number doesn’t take into account the offset from
annual increases in marketing costs. The cost
savings and increased advertising support give us more
comfort that Hershey will be able to improve margins
while continuing to strengthen its foothold in the
domestic confectionery market, where it holds about
30% market share, and 45% in chocolate. The company’s free cash-flow margins and returns on invested
capital remain at the high end among consumerproducts firms, justifying its wide moat. We are less
confident about Hershey’s global efforts, though.
Despite some recently announced joint ventures, the
firm has its work cut out for it competing in China
and India against more well-established players, such
as Mars and Cadbury Schweppes CSG. œ
Co_Focus_0807.qxp
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Page 29
Lowe’s LOW
August 2007
29
Paul’s Position
Both Home Depot and Lowe’s look inexpensive today.
Tortoise Stock Focus | Brady Lemos
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$35.74/26.15
$39.00
$28.01
$33.20
$51.20
Size of Moat
Business Risk
Market Cap
Wide
-Avg
$42.2 bil
0.8%
$47.2 bil
Stewardship
∑
• Lowe’s
% Change in Price
• S&P 500 Index
425
340
255
170
85
0
97
1998
1999
2000
2001
2002
2003
2004
2005
2006
07
Profile
While housing market worries could pressure sales
over the next few quarters, we like Lowe’s long-term
prospects and expect the retailer to continue to gain
share of the fragmented home-improvement market.
We believe it can leverage industry-leading customer
service, shopper-friendly stores, and a proven business
model to profitably expand domestically and abroad.
Lowe’s Companies is the second-largest home-improvement retailer
in the world and operates approximately 1,400 warehouseformat stores throughout the United States. The company’s stores
offer products and services for home decorating, maintenance,
repair, and remodeling. Lowe’s targets retail do-it-yourself and doit-for-me customers, as well as commercial business clients.
Management and
Stewardship
Robert Niblock, who previously served as president of Lowe’s,
became CEO and chairman in 2005 after his predecessor retired. In
2006, Niblock was paid approximately $2 million in salary and
incentive compensation and was given about $4.5 million worth of
stock and option awards. Overall, we believe that executive
compensation is reasonable, given the company’s impressive track
record. While senior managers are relatively young (no one on the
executive team is over 60), they do average several years of experience with the company. We believe that the board of directors is
sufficiently independent, yet we think staggered three-year terms
for directors limit the influence of outside investors. Executive officers and directors own less than 1% of Lowe’s common stock.
Valuation
Our fair value estimate is $39. We assume the U.S. housing market
remains soft over the next few quarters and that same-store sales
growth is flat in 2007. We estimate that same-store sales growth
will improve slightly over the next five years as the housing market
rebounds. In 2007, we expect Lowe’s to open about 150 stores
in the United States and five stores in Canada. We believe Lowe’s
can maintain its rapid-growth strategy over the next several years
by expanding within the United States and Canada and entering
Mexico. Based largely on new store expansion, revenue growth
should average about 10% annually over the next five years. Weak
same-store sales growth should reduce operating margins to
roughly 10% in 2007, but we expect a rebound thereafter.
In order for Lowe’s to succeed, it must offer consumers
a compelling reason to shop its stores rather than
Home Depot’s HD (the primary competitor in virtually
every market), and we think it does. Given that
the two firms’ pricing and merchandise selection are
largely comparable, the key differentiating characteristics become customer service and shopping
convenience. We believe Lowe’s has excelled in these
areas by keeping stores well staffed and designing
intuitive store layouts, among other customer-focused
initiatives. Not surprisingly, Lowe’s routinely outperforms Home Depot in customer satisfaction studies.
We’re also encouraged that Lowe’s is sticking to its
core retail strategy of aggressively opening new
stores in the United States and Canada, as well as
Mexico beginning in 2009. With just a 7% share of the
U.S. home-improvement market, Lowe’s still has
plenty of room to expand, particularly in the quickly
growing installation-services segment. Furthermore,
Lowe’s stores’ superior shopping experience allows
them to prosper even in locations where they overlap
with other home-improvement retailers. Lowe’s
has seized on Home Depot’s stumbles to steal share.
Home Depot’s renewed focus on retail could lead to
increased competition, but we’re convinced the North
American market can support this emerging duopoly.
Despite Lowe’s runner-up position to Home Depot,
Lowe’s is the 11th largest retailer in the world and can
capitalize on its scale advantages. Thanks to substantial buying power and efficient store operations,
Lowe’s consistently earns returns on invested capital
well in excess of its cost of capital, and we expect
that trend to continue in the future. œ
Cover_0807.qxp
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8:36 PM
30
Page 30
Options for Long-Term Investors
Continued from Front Cover
eBay EBAY
Star Rating
QQQQQ
Business Risk
-Avg
Fair Value ($)
49.00
Current Price ($)
32.40
Market Cap ($bil)
44.0
Dividend Yield (%)
—
Size of Moat
Wide
Consider Buying ($)
41.80
64.30
1-Yr Hi/Low ($) 35.41/22.83
Stewardship
∑
P/E
32.7
Coca-Cola KO
Star Rating
Business Risk
Fair Value ($)
Current Price ($)
Market Cap ($bil)
Dividend Yield (%)
Size of Moat
QQQQ
-Avg
60.00
52.11
120.6
2.5
Wide
Consider Buying ($)
51.10
78.80
1-Yr Hi/Low ($) 54.49/43.48
¥
Stewardship
P/E
23.2
apply. The largest in my mind is the fact that options
insert a level of complexity. Namely, when trading
options, one not only has to get the direction a stock
is going to move correct (a difficult enough an
endeavor), one also has to worry more about magnitudes while also considering timing. Someone
buying and holding a solid business for the long haul
need not worry about short-term timing and the
magnitude of stock price movements. After all, common
stocks have no expiration date. But with options,
timing and magnitude are huge factors to consider.
The upside is that options can be used in a myriad of
ways to create income, increase returns via leverage,
and lower risk by providing “insurance.” While
Warren Buffett once famously called derivatives,
“financial weapons of mass destruction,” stock options
can be a positive force if used wisely and in moderation.
Below are some of the more basic options strategies.
In this article, I will not go into the more complex
and exotic strategies—spreads, straddles, strangles,
ladders, and so forth. It’s an understatement to say
I am just scratching the surface here, but we will have
much more to say about options in the future.
Buying Calls
Perhaps the easiest way to juice potential returns on
the really fat pitches the market is offering is to
simply buy call options. Think of call options as putting
TNT into your bat. In general, the amount of leverage
involved is correlated to how far “in the money”
an option is. Buying calls far out of the money is one
of the most leveraged bets one can make, while
buying options far in the money is a comparable risk
to using margin.
Examples, again, are probably the best teachers.
Remember the $30 strike, January 2009 eBay calls
priced at $8? If the stock closes near our current $49
fair value estimate for eBay before expiration,
these options would be worth $19 apiece ($49 - $30
strike). If I bought these options, I would have a return
of more than double my initial investment, versus
“only” a 50% or so return if I had just held the stock.
Don’t forget that leverage can cut both ways. If the
market doesn’t come to its senses about eBay before
expiration and the stock was at $30 in 30 months,
I’d lose all of my investment in this call option. But if I
only held the shares, I’d only have a nominal paper
loss and still actually own the shares.
When buying call options to create leverage, it makes
sense to me to buy options with as long an expiration
as possible. I’ll gladly pay more for longer-dated
options if it means minimizing the chance I will get
my timing wrong. My edge as an investor comes
largely from my focus on intrinsic value, not from being
able to guess short-term stock movements better.
Buying long-dated options plays to my strength while
minimizing an area in which I have no edge.
Covered Calls
When one embarks on a covered call strategy, usually
the goal is to create additional income and return
from positions already held in a portfolio. A covered
call strategy involves taking something already in a
portfolio and selling out of the money call options at a
price one would indeed be willing to sell.
For instance, let’s say I wanted to do a covered call
strategy in the Tortoise. There are 200 shares of
Coca-Cola KO in the portfolio, and I could sell (write)
two call contracts on those shares. Our fair value
estimate for Coke is $60. At this writing, I could sell
options with a $60 strike and a January 2008 expiration
for $0.70, taking in $140 (2 contracts x $0.70 x 100
shares), minus commission (let’s assume $10). If Coke’s
stock sticks around the low $50s over the next five
months, I still collect the $0.34- per- share quarterly
dividend from the underlying shares in addition to the
$130 I collected from selling the option, essentially
doubling my income for Coke. If Coke appreciates to
our $60 fair value estimate, I’m happy with the capital
appreciation on my shares, and still collect the
$130. Only if Coke’s stock appreciates past $60.65
before expiration do I start to forfeit the upside.
The key danger with a covered call strategy is that I am
still taking a risk with the underlying shares. If
Coke’s business were really only worth $30 tomorrow
and the stock closed the gap to this theoretical
Cover_0807.qxp
8/2/07
8:36 PM
Page 31
near-doomsday intrinsic value, the $4,800 paper loss I
would incur on my 200 underlying shares would greatly
overshadow the $130 in extra income I produced.
You might say that it is not worth losing a dollar in
underlying capital to gain a dime in income. This
is why I would limit doing a covered call strategy to
very solid companies in which one has a lot of
faith in the durability of the business, such as those
companies contained in the Tortoise.
August 2007
31
juice returns in times when one is flush with cash
and the market is offering few bargains to put that cash
to work in stocks. After all, there will always be
attractive wide-moat companies out there, and there
will always be a price at which I’d be willing to
buy those companies. With this strategy, I can keep
my powder dry in times of overvaluation, while
also generating income. You might say it is like getting
paid to patiently wait for the fat pitches.
Options Summary
Call
Put
Long
Short
Right to Buy
Right to Sell
Obligation to Sell
Obligation to Buy
Selling Baby Puts
“Baby puts” refer to put options that are far out of the
money and therefore trade cheaply. Investors will
sell these baby puts on stocks that they are comfortable purchasing at a specific price, which will be
the strike price of the put they are selling. Typically,
this is the price that builds in a margin of safety
to their estimate of the stock’s fair value.
Let’s use Coke as an example again. Our “Consider
Buying” price on Coke is $51.10, and I would be very
happy to purchase Coca-Cola for $45 per share.
I could sell two put contracts with a $45 strike and a
January 2009 expiration for $1.50, netting me
$290 after $10 commission (2 x $1.50 x 100, minus $10
commission). If Coke falls below $45 between
now and January 2009, I might be required to buy 200
shares at $45, something I would probably be doing
anyway. If Coke never goes below $45 again, I pocket
the $290 as well as any interest from the cash I
have set aside to secure this trade.
This strategy is not without risk. If one does not have
enough cash in their account to purchase the stock,
margin calls could result. As such, it’s advisable to have
plenty of cash on hand with this strategy. Also, a
fresh piece of news could surface between the time
one sells the put and expiration, and this news
might change our opinion of the fair value of the stock.
By selling put options, I would be giving up the
flexibility to incorporate new information into our fair
value estimate for a certain period of time.
All that said, selling baby puts is a great strategy to
Index Puts
One way I’ve seen investors use options is by buying
put options on the major market indexes. You might
call this strategy “buying insurance” on the portfolio in case of a major market correction. It’s also a
way to minimize short-term systemic risk (noncompany-specific risk) of the market.
For instance, I can buy S&P 500 index puts with a 1,300
strike and December 2007 expiration for about
$13 today, or $1,300 for one contract. If the market goes
into the tank between now and the end of the
year, closing at 1,200 (about where the market was in
late 2005), these options would be worth $100
each, or about $10,000. Of course, I would likely have
some meaningful declines in the market value of my
core stocks portfolio were the market to fall this far, but
an index put would offset some of that decline.
On the other side of the coin, if the market continues
to go up, this “insurance” I bought will go unused,
but the value of my core portfolio would be higher.
Puts Versus Shorting
Though we don’t focus on shorting companies here at
StockInvestor, I still occasionally make bearish
bets on individual stocks in my personal accounts. I’ve
come to the conclusion that buying put options is
a much more attractive way to make these bets than
shorting. After all, my potential loss when shorting
a stock is infinite. I don’t like having potentially infinite
losses, because nothing (and I mean nothing!) in the
market is a sure bet. By buying puts to make a bearish
bet, the most I can lose is what I paid for the contract.
If you have any questions about options, don’t be afraid
to contact me ([email protected]) or
Continued on Back Cover
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8/2/07
8:36 PM
Page 32
Options for Long-Term Investors
Volume 7, Number 2
Equities Strategist and Editor
Paul Larson
Phil Guziec ([email protected]). Phil is a
long-time Morningstar analyst who has become
our in-house options guru. Again, expect to see much
more on options in the near future.
About Tender Offers
I often get questions about what to do with tender
offers received in the mail. Right now, two portfolio
companies—Expedia EXPE and Home Depot HD—
have tenders currently outstanding, while other
companies in the portfolios including Biogen Idec
BIIB and Microsoft MSFT have made offers in
the recent past to repurchase shares from owners.
this strategy work in practice. The market is just too
efficient, and the market price and actual company
repurchase price will tend to converge at expiration.
Of course, one could try to game the system and tender
their shares at a higher price than the stock market
is offering with the intention of buying those shares
back at the (hopefully still) lower market price
when the tender expires. For instance, I could tender
my Home Depot shares today at, say, $43 with the
intention of buying them back at the current market
price near $38. The problem is that only rarely does
I might seriously consider a tender offer under only one
circumstance—if the tender offer was made at prices
above fair value and above what I could get in the
open market. This hasn’t been the case recently, nor
do I expect it to be the case often in the future.
The bottom line: I am putting the offers from Expedia
and Home Depot into the proverbial circular file. I’m
also hoping the firms buy back a boatload of shares at
prices below our fair value estimates. œ
225 West Wacker Drive
Chicago, Illinois 60606
Director of Stock Analysis
Pat Dorsey
Karen Andersen, Mitchell Corwin,
Erin Davis, Sumit Desai,
Brett Horn, Michael Kon,
Brady Lemos, Erin Swanson
Copy Editors
Kevin O’Shaughnessy,
Ryun Patterson
Designer
Christopher Cantore
Design Intern
Meghan Tweedie
Data Team
Desiree Deleoz, Jeff Manczko,
Neelm Pradhan
Programmers
Eider Deleoz, Christine Tan
Publisher
Paul Larson owns the following companies mentioned in this
article: BIIB, +EBAY, EXPE, HD, KO, MSFT
Maureen Dahlen
Product Manager
Sara Mersinger
Chief of Securities Analysis
Haywood Kelly
Performance (%): Morningstar StockInvestor Portfolios vs. S&P 500
President, Securities Research
Catherine Gillis Odelbo
Period
Tortoise
Hare
Combined
2001*
2002
2003
2004
2005
2006
Trailing 12 Months
Since Inception**
Since Inception***
9.1
-1.6
26.2
13.1
8.0
13.7
12.4
90.6
11.1
0.7
-23.9
26.3
26.9
3.2
22.0
31.8
62.7
8.3
4.9
-12.3
26.2
18.8
5.8
17.3
20.6
76.7
9.7
S&P 500
-4.8
-22.1
28.7
10.9
4.9
15.8
16.1
33.2
4.8
Data as of July 31, 2007. Returns include interest and dividends.
*Since Inception 6-18-01 **Total Cumulative Returns ***Annualized Returns
© 2007 Morningstar, Inc.
All rights reserved. Reproduction by
any means is prohibited. While data
contained in this report are gathered
from reliable sources, accuracy
and completeness cannot be guaranteed. The publisher does not give
investment advice or act as an investment advisor. All data, information,
and opinions are subject to change
without notice.
Reprints of articles and information
appearing in Morningstar StockInvestor
are available in quantity. 312-696-6100.
For inquiries regarding your subscription, contact:
[email protected].
Please address all correspondence
to Maureen Dahlen, Morningstar, Inc.,
225 W. Wacker Dr., Chicago, IL 60606.
Subscribers Download Morningstar StockInvestor Early
Want to get next month’s StockInvestor even earlier? Go to
http://msi.morningstar.com and log in to get a free electronic
copy of the September issue. This electronic copy will be available
on or after September 7. We are providing this electronic copy free
Allan Nichols
Stock Analysts
My thinking concerning what to do with these offers is
pretty simple. If the company is offering to buy my
shares below fair value, I generally ignore the offer (and
hope that legions of other shareholders take the
offer and accrete value to the remaining shares). This
has been the case with all the tender offers from
portfolio companies in recent years. The way I view it,
if I would not sell my shares on the open market at
a given price, why would I be any more interested in
selling them to the company itself at that same price?
International Strategist
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