W E E K L Y S T A F F R E P O R T

September 30, 2019

Vol. 86, No. 140

Investors Hoping for Usual 4Q Rally IN THIS ISSUE
A year ago, in late September 2018, the S&P 500 reached what was then a record SECTION 1
close at 2,930.75. It didn’t last, and by 12/24/18 the index hit bottom at 2,351.10. The Economic & Market Commentary
S&P 500 has done well since then, rising about 20% thus far in 2019. But because of that Technical Trends Commentary

late 2018 selloff, the stock market as of 9/20/19 was only about 2% higher than it was on SECTION 2
the same date in 2018. Focus Stocks
Stocks have typically enjoyed their best three-month performance in the fourth quarter. Changes in Ratings
Even after a 20% year-to-date gain, investors are greedy for another surge into year-end, Growth & Value Stocks
at least partly because the market has not moved much in the past 12 months. UtilityScope
To get there, investors must be reconciled to a future that may not include a trade Stocks to Avoid
deal, at least in the near term. The economy also needs to avoid further signs of slowing,
SECTION 3
particularly in the industrial sector. And the third-quarter earnings season, which gets Economic Calendar
underway in mid-October, cannot disappoint what are currently low expectations. All or Special Situations & Screens
most of those factors, in our view, are required to drive at least an average rally in 4Q19 Master List Changes
– and to avoid the mistakes of 4Q18. Rcent Argus BUY Upgrades

Last Year’s Lessons

The trade war goes on, with nothing resolved after two years. The stock market cannot break its habit of rising on upbeat ru-
mors, only to sell off on dashed hopes. Investors have become accustomed to picking over small details. After rising on news
that a Chinese delegation was visiting major agricultural states, the market gave back when the delegation cancelled its visit.
Entering the fourth quarter, investors need to care about trade, because trade contributed to the 4Q18 selloff even if it was
not exclusively responsible. The change in economic sentiment, and in Fed policy, was a key driver. Entering 4Q18, investors’
chief concern was that the economy might overheat and inflation might shoot past the Fed’s comfort level. The 10-year Treasury
yield hit a peak 3.25% early in October 2018.
Seeking to address what it still saw as an overheating economy, the Federal Reserve raised interest rates at the end of
September 2018. The central bank was simultaneously de-leveraging its balance sheet. Fed Chairman Jerome Powell famously
roiled markets when he said this quantitative tightening program was on “autopilot,” even as cracks were appearing in the
economic advance.
Higher yields pushed up mortgage rates, slowing the housing market and refinancing activity. The capital spending boom
fueled by the Tax Cuts and Jobs Act ran out of gas. November retail sales were soft, and jobless claims began to rise into year-
end. The Fed’s hike on 12/20/18, which in retrospect seems particularly ill-timed, sent Treasury yields lower and tanked the
stock market, which hit bottom on Christmas Eve.
(continued on next page)

A R G U S R E S E A R C H C O M P A N Y • 6 1 B R O A D W A Y • N E W Y O R K, N.Y. 1 0 0 0 6
 ECONOMIC & MARKET COMMENTARY (CONT.)

By January, a chastened Fed chairman was walking

MAJOR INDEX
back his “autopilot” commentary. Economic data appears DATA AS OF SEPTEMBER 20, 2019
to have stabilized. The one factor that remains outside of
investors’ control is the trade war. The president recently Year-To-Date Return
entertained the notion that the trade war with China might
not be resolved before the 2020 election. Nasdaq Composite 23.3%

S&P 500 21.1%

Promising Signs for the Economy
In theory, continued low interest rates should be aiding the Growth Stocks (Wilshire Large Growth) 19.3%
housing economy. While refinancing activity has generally
been brisk in 2019, housing sales have not always benefited. DJIA 17.7%

Investors were cheered in mid-September by news that U.S.

Russell 2000 16.7%
homebuilding surged to a 12-year high. Housing starts for
August jumped 12.3% from July, reaching a seasonally Value Stocks (Wilshire Large Value) 15.8%
adjusted annual rate (SAAR) of 1.364 million units. July
starts were also revised upward, to a 1.215 million SAAR Lehman US Aggregate Bond Index 8.0%

from the originally reported 1.191 million. 0% 10% 20% 30%

In addition to the monthly surge, housing starts rose
6.6% from August 2018, suggesting that lower rates are
making a difference. Building permits also rose a sharp SECTOR PERFORMANCE
7.7%; economists like to see these two metrics move
together. These positive numbers were consistent with Year-To-Date Performance
the homebuilder sentiment data released two days earlier. Technology 31.4%
According to the National Association of Homebuilders/ Real Estate 29.3%
Wells Fargo housing market index, builder sentiment rose Utilities 23.8%
one point in September, to 68 – its highest level in 2019. Communication Services 23.7%
Builder sentiment hit a low of 56 in December 2018. While Consumer Discretionary 22.9%
builders are generally upbeat as lower mortgage rates drive Industrials 22.6%
increased activity, they remain concerned about a shortage
Consumer Staples 21.5%
of building lots and skilled labor.
Financials 20.1%
Existing home sales did not show quite the same vigor
Materials 17.2%
as starts, but rose in August for a second consecutive month.
9.8%
August existing home sales rose 1.3% from July to a 5.49 Energy

7.2%
million SAAR. Existing home sales were also up 2.6% from Health Care

August 2018. The median price for existing homes sold in 0% 10% 20% 30% 40%

August 2019 was $278,200, up 4.7% from the prior year.

This metric has risen for 90 straight months. Millennials
INTERNATIONAL EQUITY
cite price as one of the key inhibiting factors in purchasing
MARKET PERFORMANCE
a home. Year-To-Date Return
The Conference Board’s Leading Economic Index
33.8%
(LEI) was 112.1 in August, unchanged from the July Russia

level — which marked a 2019 high in the series. Positive Euro Zone 21.7%

contributors to LEI included building permits, the leading S&P 500 21.1%

credit index, and manufacturing hours. The positives were Canada 20.3%

offset by weakness in manufacturing components and in Brazil 19.1%

the yield spread. On a trailing six-month basis, the LEI DJ World Index 15.8%
increased 0.5%, or at about a 1.1% annual rate – slower UK 12.9%
than the economy overall, but positive. Japan 11.9%
Markets were knocked for a loop on 9/3/19 when the China 10.4%
Institute for Supply Management (ISM) reported that its India 9.5%
purchasing managers’ index had fallen to 49.1; a reading
Mexico 6.8%
below 50 in this diffusion index signals contraction. The
0% 10% 20% 30% 40%

(continued on next page) Source: Dow Jones, Argus Research

- Section 1 -
 ECONOMIC & MARKET COMMENTARY
IHS Markit survey is usually a bit more downbeat than
ISM’s survey. But Markit reported that the manufacturing
PMI rebounded to 51.0 in September from 50.3 in August.
Markit’s services PMI also moved higher, to 50.9 in Sep-
tember from 50.7 in August.
However, the Markit commentary around the release
was far from reassuring. While noting that the index rose
slightly from August lows, September readings remained
“among the weakest since 2016.” Markit also reported that
the Eurozone manufacturing PMI fell to 45.6 in September,
the worst reading in nearly seven years. With monetary
policy looking toothless, the European Central Bank has
now asked Eurozone nations to use fiscal measures to spur
economic growth.
3Q19 EPS Outlook
Economic activity, inflation and interest rates all matter to
stock performance. But perhaps the most important stock
market driver is earnings, and specifically S&P 500 earn-
ings from continuing operations.
One reason that the S&P 500 in September 2019
trades just a few percentage points above prior-year lev-
els is that earnings growth has slowed markedly. Aided
by a strong global economy and a lift from the federal
tax cut, total 2018 earnings from continuing operations
rose 22.7%, according to historical data compiled by
Bloomberg. That set up tough EPS comparisons for 2019,
a year characterized by uncertainty surrounding interest
rates and trade policy.
Against expectations for slightly negative compari-
sons, earnings for 1Q19 and 2Q19 exceeded expectations.
The 1Q19 data inched up less than a percentage point, and
2Q19 earnings rose just under 3%.
Companies and the analysts that cover them have had
to keep pushing out the date of a trade resolution. As such,
analysts have reduced 3Q19 EPS estimates by about two
percentage points, to $41.63, for S&P 500 earnings from
continuing operations. Even at that reduced level, EPS
would be up about 3.2% from an actual $40.36 in 3Q18.
The aggregate estimate reflects some analysis and a
lot of company guidance. The CFOs responsible for EPS
guidance have an interest in underguiding against their
own expectations in order to avoid a miss against guidance.
While a miss can happen to one or a few companies, it won’t
happen to 500. Former Argus Chief Investment Strategist
Peter Canelo performed his own analysis, which led him to
(CONT.)
repeatedly and correctly assume that consensus estimates
were a few points too low.
With his passing, Argus continues to use Peter’s
models, which point to a slightly better outcome in 3Q19
earnings. We are modeling 3Q19 EPS from continuing
operations in the $43.50-$44.50 range, which would imply
mid- to high single-digit EPS growth.
Altogether, 3Q19 EPS won’t be great, particularly
coming against a very tough and tax-cut-fueled comp from
3Q18. But earnings should be sufficiently solid to reassure
investors that the economy is not rolling over. Further,
even if earnings are not growing rapidly, they remain at
sufficiently high levels to support the market at current
valuations.
Conclusion
With about a week’s worth of trading days remaining in
September, the S&P 500 is up in the high teens for the
nine months to date. That is usually a good sign for a bet-
ter-than-average fourth quarter.
For all fourth quarters on the S&P 500 since 1980,
capital appreciation has averaged 4.6% -- almost two per-
centage points better than any other quarter. For those years
in which the S&P 500 is up in the double digits at the nine-
month mark, average fourth-quarter capital appreciation is
5.9% (this excludes the outlier year of 1984, when stocks
fell 31% in the fourth quarter).
Since the millennial turn, 4Q’s following double-digit
nine-month periods have averaged a gain of 7.4%; and
during the bull market since 2009, 4Q’s following dou-
ble-digit nine-month periods have averaged a gain of 6.0%.
The caveat: these numbers exclude the outlier year of 2018,
which brings us back to our opening paragraphs.
While we cannot predict the next step in the trade war
or in the course of interest rates, we can read a stock chart.
The S&P 500 as of mid-September 2019 is only a few
percentage points above where it was in September 2018.
Meanwhile, corporate earnings have continued to grow,
and our normalized (five-year & centered) EPS calculation
used for market valuation has also moved higher.
Based on normalized earnings and the current index
level, the S&P 500 at mid-September 2019 was trading a
few percentage points below fair value, which we peg at
3,030. Our 12-month target price for the S&P 500 is 3,200,
representing a 5% premium to fair value and a 7% premium
to the S&P 500 as of 9/23/19.
Jim Kelleher, CFA,
Director of Research
 TECHNICAL TRENDS COMMENTARY
August underperformed its historical trend. Now it
looks as though September will outperform its sorry track
record.
Between 1980 and 2018, August averaged a decline of
0.08% on the S&P 500, just a rounding error away from a
flat performance. In August 2019, however, the S&P 500
recorded a 1.8% decline. It could have been much worse;
at one point near mid-month, the index was down 5.7%.
The August month-end rally provided momentum that
carried into early September, sending the S&P 500 to a
recent peak close above 3,009 on 9/12/19. Although some
of that momentum has wavered of late, the index is still
holding a 2.5% gain as of the close of trading on 9/20/19.
The latest trade rumor (a bad one) sent stocks lower on
9/20/19, ensuring that stocks would post a losing week.
- Section 1 -
Still, September 2019 to date is much better than
average. For all Septembers from 1980 to 2018, the S&P
500 has averaged a decline of 0.67%
Thanks to a decent July and a solid September brack-
eting the down August, the S&P 500 is up 2.0% so far in
3Q19. The third quarter is the only quarter that has two
months averaging a negative return on the S&P 500 be-
tween 1980 and 2018. It’s no surprise, then, that the third
quarter is the weakest of the four quarters on the index
over that span. The best quarter for stocks, no surprise, is
4Q, averaging a 4.6% gain on S&P since 1980. The first
and second quarters clock in with 2.6% and 2.7% gains,
respectively. Through 2018, 3Q has averaged 0.3%. As
such, stocks in 3Q19 are playing with “house money.”
Jim Kelleher, CFA,
Director of Research
 FOCUS LIST
Focus List Stocks Focus List Stocks in this Report
PRICE
AS OF PRICE
TICKER AS OF
9/25/19 TICKER 9/25/19

Basic Materials Adobe Inc ADBE $272.47

Packaging Corp of America PKG $103.30

Communication Services Adobe Inc (ADBE)

Walt Disney Company DIS 131.97
Current Rating: BUY Publication Date: 9/19/19
HIGHLIGHTS
Consumer Discretionary
*ADBE: Reaffirming $320 target after 3Q results
MGM Resorts International MGM 28.40 *While Adobe again posted strong results in fiscal 3Q19,
TJX Companies, Inc. TJX 55.30 with both solid revenue growth and margin expansion, it also
Ulta Beauty Inc ULTA 239.48
reported some sales execution weakness.
Yum Brands Inc. YUM 112.24
*We think that Adobe has positioned itself at the center of
Consumer Staples the exploding market for digital video content and advertising
Colgate-Palmolive Co. CL 72.49 creation and management.
Pepsico Inc. PEP 135.36 *We are trimming our non-GAAP FY19 EPS estimate by
Walmart Inc WMT 118.40 a penny to $7.84 and our FY20 forecast to $9.73 from $9.77.
*Our target price of $320 implies a multiple of 33-times
Energy our FY20 EPS estimate.
Baker Hughes a GE company BHGE 23.65
Oneok Inc. OKE 74.14 ANALYSIS
Financial INVESTMENT THESIS
We are maintaining our BUY rating on Focus List
KKR & Co. Inc. KKR 29.26
Nasdaq Inc NDAQ 101.37
selection Adobe Systems Inc. (NGS: ADBE) to a target price
Raymond James Financial, Inc. RJF 83.81 of $320. We think that Adobe has positioned itself at the
center of the exploding market for digital video content and
Healthcare advertising creation and management. The company has an
AstraZeneca PLC AZN 45.17 admirable track record of innovation in enabling digital
Boston Scientific Corp. BSX 42.33 content creation. It also has a unique collection of software
Charles River Laboratories Int CRL 136.99 assets centered on its Creative Cloud digital content creation
Pfizer Inc. PFE 36.01 tools, which enable both professional and amateur users to
create and manage digital content. With its Experience Cloud,
Industrials
Adobe has expanded from the initial analytics suite acquired
L3Harris Technologies Inc LHX 211.91 through the Omniture merger into digital video advertising
Norfolk Southern Corp. NSC 182.91 marketing and management. Adobe continues to accelerate
Northrop Grumman Corp. NOC 369.51
organic product refreshes and new rollouts. It is also making
Roper Technologies Inc ROP 356.59
both large and small acquisitions to bolster its software service
Real Estate offerings, and partnering with a host of industry leaders, from
Equity Residential Properties EQR 85.47 Microsoft to Accenture to SAP and ServiceNow, to drive
further growth. We think that Adobe's overall consistently
Technology strong revenue growth, margin expansion, and earnings
Adobe Inc ADBE 272.47 momentum is a strong positive. We also note that management
Marvell Technology Group Ltd MRVL 24.31 has typically underpromised and overdelivered.
Microsoft Corporation MSFT 137.38
Square Inc SQ 57.50 Our target price of $320 implies a multiple of 33-times
Western Digital Corp. WDC 59.58 our FY20 EPS estimate.
Utility RECENT DEVELOPMENTS
American Water Works Co. Inc. AWK 124.87 Adobe reported results for fiscal 3Q19 (ended August 30)
Centerpoint Energy Inc. CNP 30.45 after the close on September 17. EPS topped management's
own guidance and the consensus estimate by $0.08. However,

Section 2.1
 FOCUS LIST
4Q19 guidance came in lighter than expected, with EPS $0.05
below the consensus estimate. On the 3Q call, management
also pointed out that subscription bookings growth for the
recent Marketo acquisition did not meet its expectations. There
were also Analytics cloud bookings delays, with related
shortfalls in consulting services bookings and revenue
surrounding the launch of the new Adobe Experience
Platform. ADBE shares fell 2% intraday on September 18.
Revenue rose 24% year-over-year to $2.83 billion in
3Q19, beating management's own guidance by $34 million and
the consensus by $25 million. Foreign exchange movements
had a net $44.3 million negative impact on 2Q revenue. In
2Q19, Creative Cloud annual recurring revenue growth, a key
performance indicator, rose 21% year-over-year and 4%
sequentially to $6.87 billion, in line sequentially though
slowing from 31% year-over-year growth in 3Q18.
Non-GAAP operating income rose 25% year-over-year to
$1.15 billion and the non-GAAP operating margin expanded
by 30 basis points to 41%. Non-GAAP net income rose 17%
to $1 billion. However, non-GAAP EPS increased 18.5% to
$2.05. Share repurchases over the last year boosted
non-GAAP EPS growth relative to net income growth.
The company will hold its annual Adobe MAX user
conference beginning on November 4. During the conference,
Adobe typically announces new products. Management
promises 'significant new Creative Cloud innovations' at this
year's Adobe MAX.
EARNINGS & GROWTH ANALYSIS
We are lowering our non-GAAP FY19 EPS estimate by a
penny to $7.84 and our FY20 forecast to $9.73 from $9.77.
Our FY19 estimate remains above management's guidance of
$7.80; however, Adobe typically outperforms both its own
guidance and consensus. Our estimates imply an average of
20% EPS growth over the next two years. Our long-term
earnings growth rate forecast is 11%.
The company's adoption of a cloud SaaS model has
enabled it to execute a faster product refresh cycle and rapidly
introduce new and adjacent product offerings, raising the value
of its products for existing customers. It has also increased the
company's ability to attract and retain users through new
offerings and enabled it to segment products to appeal to new
classes of users. The company launched the Adobe Experience
Platform in March. The platform brings together customer data
from across the enterprise, creating real-time customer profiles
to enable the activation and delivery of hyper-personalized
customer experiences. The company also launched Adobe
Sign for Small Business in July, which provides a cloud-based
electronic signature solution for small and medium-sized
businesses. Adobe also introduced Adobe Fresco in 3Q, which
extends digital drawing and painting applications to mobile
devices and tablets, with availability for iPad coming in the
Section 2.2
fall.
Revenue in the Digital Media segment, the company's key
revenue growth driver, continued to slow in 3Q19, though
growth was still quite robust at 22% (revenue rose 27% in
3Q18). Management pointed to an exhaustive list of revenue
growth drivers, including new user growth driven by targeted
campaigns and promotions promoting desktop and mobile
applications. The company is also expanding into adjacent
creative categories while increasing the adoption of single
application offerings like Adobe Premiere Pro for video and
Adobe Illustrator for artwork. The company also sees growth
internationally, including more than 40% growth in key
emerging markets.
The company is seeking to attract new customers by
expanding its current market and by pursuing adjacent markets
through product segmentation, as in the case of its Photoshop
offering for photography enthusiasts. The company is also
adding new services that add value to a customer subscription,
such as Adobe Stock, introduced in 2015. These added
services may justify price increases over time as subscribers
perceive more value. In addition to its basic growth strategies,
Adobe believes that its transition to the cloud-based
subscription model supports international expansion, the
diminution of piracy, and increased penetration of the
education market.
Management expects the company's total addressable
market (TAM) to increase 29% to $83 billion in 2020 and an
additional 30% to $108 billion in 2021. Adobe has three
business lines: Creative Cloud, i.e., digital content creation
tools; Document Cloud (Acrobat PDF); and Experience Cloud,
consisting of the Marketing, Analytics, Advertising Clouds,
and the most recent addition, Commerce Cloud.
Management expects the TAM for Creative Cloud to grow
to $24.2 billion in 2020 and 29.2 billion in 2021. Digital
Media's underlying growth drivers fall into three categories:
core, market expansion, and value expansion. Core business
growth is expected to come from:
-- The continued migration of Creative Suite and Acrobat
customers to subscriptions from the old perpetual license
model;
-- New user growth from product additions, including
nascent offerings to address emerging technologies like 3D,
augmented reality (AR) and virtual reality (VR);
-- Upselling to existing customers;
-- Pricing optimization designed to attract new users.
Management expects market expansion to come from
photo hobbyist growth, new paid mobile users, a premium
 FOCUS LIST
photo service, and new creative offerings. The third category,
value expansion, is expected to come from Adobe Stock and
training content and services, as well as from document
protection and digital document market expansion.
The Experience Cloud TAM is expected to grow 33% to
$53.2 billion in 2020 and a further 34% to $71.2 billion in
2021. Management is working to increase the sales 'velocity' of
the Experience Cloud business to capture the rapidly
expanding market opportunity. It believes that the integrated
content and data platform under the company's machine
learning platform, called Sensei, provides significant
differentiation and a competitive advantage. The recent
acquisitions of Marketo and Magento Commerce should also
boost this segment's reach.
Adobe is enlisting partners that can leverage its digital
media and marketing technologies, and has entered into a
series of strategic partnerships. The company has integrated
Marketing Cloud into Microsoft Dynamics CRM, Microsoft's
enterprise customer relationship management software and
Azure cloud service platform. The companies are jointly
pursuing the Marketing Analytics/CRM market. Recent
alliances include ones with ServiceNow and Software AG,
enabling the integration of Adobe's Experience Platform with
these services to enhance Adobe's real-time customer profiles
with rich customer data, and a partnership with Amazon to
enable small and medium-sized businesses to access Adobe's
Magento Commerce offering. Adobe had previously agreed to
partner with IBM Interactive Experience and has also
expanded an alliance with Accenture Interactive. IBM and
Adobe offer enterprises a digital platform that integrates
customer experience management, including idea generation,
transactions, loyalty programs, special promotions, and
customer relationship history. Accenture and Adobe offer a
cloud-based managed service for the development, execution,
and measurement of digital marketing. In 2014, Adobe
brought on advertising agency Publicis Group, Indian IT
outsourcing company Wipro, and enterprise software company
SAP as strategic partners. Adobe also partnered with Samsung
on the launch of Samsung's Galaxy Note 9 phablet
smartphone, introducing Adobe Scan for Bixby Vision,
Galaxy's intelligent assistant system. The Adobe Scan
application has almost 14 million downloads.
Adobe completed the acquisition of Marketo, a B-to-B
marketing engagement platform, for $4.75 billion in cash on
October 31, 2018. This is Adobe's biggest acquisition ever.
Marketo offers a cloud-native solution for B-to-B marketing
planning, engagement, and attribution and will be integrated
into Adobe's Digital Experience business. The company
expects to leverage Marketo, using its global scale, into new
geographic regions, industry verticals, and across its large
enterprise customer base. Marketo CEO Steve Lucas has
joined the Adobe leadership team and will continue to manage
Marketo.
Section 2.3
Adobe completed its acquisition of Magento Commerce
for $1.68 billion in cash on June 19, 2018. Magento is an
e-commerce platform that combines digital commerce, order
management, and predictive intelligence to enable companies
to scale their customers' digital shopping experiences.
Magento has built an ecosystem of 300,000 developers, 800
technology partners, and 350 system integration partners.
Adobe is also integrating Magento into the Adobe Experience
Cloud, bolstering its e-commerce capabilities. Adobe sees an
opportunity to expand Magento's addressable market by
leveraging it across its global distribution channels. Magento
Commerce Cloud will continue to be available as a standalone
offering within Adobe Experience Cloud. CEO Mark Lavalle
continues to lead the Magento team.
FINANCIAL STRENGTH
Our financial strength ranking for ADBE is High. The
credit agencies give Adobe ratings in the low A's, comfortably
within investment grade, and outlooks are stable. Adobe's
share repurchase program has resulted in a modestly declining
share count over the last few years.
RISKS
Adobe's technology software market is intensely
competitive. The company must continually update older
products and launch new products for which customer demand
is uncertain. In addition, Apple's importance as a trend-setter
in new markets like mobile data gives it an impact greater than
its actual market share.
Adobe is shifting from a traditional software
perpetual-license model to a cloud-based software-as-a-service
subscription model. Execution risk surrounding these shifts are
high, and we have seen some revenue headwinds as the
company made the transition.
It is critical for Adobe to defend its intellectual property
from other claimants and potential infringers. In addition,
security is always a concern with software, and the company's
reputation could be damaged by software-enabled security
breaches.
Because Adobe is a successful growth company, its shares
tend to trade at relatively high multiples of revenue, earnings
and cash flow. Expectations are high, and if the company's
financial results fall short, investors could experience a
significant and abrupt decline in market value. Other risks
include unexpected pullbacks in software investment spending
and the potentially adverse impact of foreign exchange
movements.
COMPANY DESCRIPTION
Based in San Jose, California, Adobe Inc. provides
software for creative professionals, consumers and enterprises.
Its products are organized into three segments. Digital Media
Solutions products, including Creative Cloud and Creative
 FOCUS LIST
Suite, Acrobat, Photoshop and Flash Player; the Digital
Marketing Solutions segment, including LiveCycle and the
legacy Omniture web analytics businesses; and the Publishing
segment. The company acquired Omniture in October 2009.
Adobe derives more than 40% of its revenue from overseas
markets.
VALUATION
ADBE shares have risen 24% year-to-date, above the 20%
capital gain for the S&P but below the 31% gain for the S&P
Information Technology index. ADBE shares rebounded
robustly in the early 2019 market rally after participating in the
late 2018 tech sector selloff; however, they are now trending
down from their July 2019 highs.

Adobe's forward enterprise value/EBITDA multiple of

23.3 is currently 24% below the peer average, slightly worse
than the two-year historical average discount of 21%. We are
maintaining our BUY rating on Adobe to a target price of
$320. Our target implies a multiple of 33-times our FY20 EPS
estimate.
On September 18, BUY-rated ADBE closed at $279.72,
down $4.97. (Joseph Bonner, CFA, 9/18/19)

Section 2.4
 CHANGE IN RATING / INITIATION OF COVERAGE
Change in Rating / Initiation of
Coverage in this Report
PRICE
AS OF
TICKER 9/25/19
AECOM ACM $37.21
AECOM (ACM)
Current Rating: BUY Publication Date: 9/20/19
HIGHLIGHTS
*ACM: Upgrading to BUY with a $44 target price
*ACM is switching to a professional services business
model. It has reduced G&A by $225 million by pulling out of
risky, noncore markets, reducing debt, and spinning off its
management services division as a government services
business.
*We expect growing demand for road and water projects
to provide the company's Design & Consulting Service unit a
stable source of revenue, even in a slowing economy.
*We are raising our FY19 and FY20 estimates to $3.04
and $3.34, respectively, up from a prior $3.02 and $3.32. Both
our estimates are above consensus.
*As ACM continues to execute its strategic initiatives, we
expect the shares to go higher. Our long-term rating remains
BUY.
ANALYSIS
INVESTMENT THESIS
We are upgrading AECOM (NYSE: ACM) to HOLD
from BUY and setting a price target of $44. ACM is switching
to a professional services business model. It has reduced G&A
by $225 million by pulling out of risky, noncore markets,
reducing debt, and spinning off its management services
division as a government services business. We view favorably
these initiatives and expect them to enable ACM to become
more of an infrastructure firm going forward.
We expect growing demand for road and water projects to
provide the company's Design & Consulting Service unit a
stable source of revenue, even in a slowing economy.
As ACM continues to execute its strategic initiatives, we
expect the shares to go higher. Our long-term rating remains
BUY.
RECENT DEVELOPMENTS
Year-to-date, shares of AECOM are up 43%, versus just
under 21% for the S&P 500.
As discussed in a previous note, on August 6, AECOM
reported fiscal 3Q19 results. Revenue declined 3% from the
prior year to $5.0 billion, below the consensus of $5.23 billion,
and income from operations rose 20% to $161 million.
Section 2.5
Adjusted EPS came to $0.72, up from $0.62 a year earlier but
$0.02 below consensus.
On June 17, AECOM announced a plan to spin off its
management services division into a government services
company.
AECOM reiterated its FY19 EPS guidance of $2.60-$2.90
and its EBITDA estimate of $920-$960 million after removing
two gas power plant projects from the backlog. It also
reiterated its effective tax rate forecast of 25%.
In FY18, revenue rose 11% to $18.2 billion, while
adjusted EPS fell to $2.69 from $2.94.
EARNINGS & GROWTH ANALYSIS
ACM reports results in three business segments: Design
and Consultancy Services, which includes the URS
infrastructure and environment business as well as ACM's
global design business; Construction Services, which includes
URS's engineering and construction and oil and gas divisions,
as well as ACM's building construction business; and
Management Services, which includes national government
businesses.
Fiscal 3Q results and segment outlooks are summarized
below.
In Design and Consultancy Services, revenue decreased
by 2% to $2.1 billion, driven by flat organic growth and the
negative impact of having to rebuild following a storm in the
U.S. Virgin Islands. The consensus estimate had called for
revenue of $2.18 billion.
In Construction Services, revenue decreased 10% to $1.9
billion, with a 9% decrease in organic revenue. The results
reflected the company's decision to exit the fixed-price
combined cycle gas power market, which negatively impacted
the Power business. The consensus estimate had called for
revenue of approximately $2.1 billion.
In Management Services, revenue rose 10% to $1.0
billion, with organic revenue up 10% from the prior year. The
increase reflected conversion of a record backlog and strong
funding for the U.S. Department of Defense and Energy.
ACM ended the quarter with a backlog of $59 billion, up
10% from the prior year. Backlog in all segments remain near
record levels.
We are raising our FY19 and FY20 estimates to $3.04 and
$3.34, respectively, up from a prior $3.02 and $3.32. Both our
estimates are above consensus.
Our long-term EPS growth rate forecast remains 10%, in
line with management's five-year target, but down from 12%
 CHANGE IN RATING / INITIATION OF COVERAGE
previously. We expect demand for AECOM's expertise and
services to benefit from several secular trends, including
accelerating urbanization in developing countries, the steady
increase in the share of global GDP represented by these
countries, the need to replace aging infrastructure in developed
economies, and rising energy consumption.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on AECOM is Medium. The
company receives average marks on our three primary
financial strength criteria: debt levels, fixed-cost coverage, and
profitability.
The company had $887 million in cash and equivalents at
the end of 3Q19. Total debt was $3.7 billion at the end of the
quarter, down from nearly $3.9 billion at the end of FY18.
AECOM does not pay a dividend and does not plan to
implement one in the near term.
MANAGEMENT & RISKS
Michael Burke is the company's chairman and CEO. John
Dionisio, the former CEO, is now the executive chairman.
Stephen Kadenacy is the current president and chief operating
officer. He was previously the company's CFO and has also
held executive positions at KPMG. Troy Rudd, who has been
with AECOM since 2009, is the CFO.
Management met with investors in December 2016 and
outlined goals for the next five years including:
-- 5% annual organic revenue growth
-- 10% annual adjusted EPS growth
-- Cumulative free cash flow of $3.5 billion
There are risks to owning ACM shares.
AECOM depends on long-term government contracts,
some of which are funded on an annual basis. As a result, the
company's results may suffer if government agencies terminate
contracts ahead of schedule or if appropriations for multiyear
contracts are not renewed. The company's quarterly results
may also fluctuate significantly due to the spending cycles of
public sector clients. In addition, AECOM is exposed to risk
from fixed-price contracts, as well as from its participation in
joint ventures.
AECOM is an intellectual-capital driven company, so
recruitment and retention is a very important part of its
business. The global market for skilled labor remains
extremely tight, and the resulting upward pressure on wages
and benefits could hurt the company's profit margins. In
addition, AECOM's contracts often require government
clearances for employees, which can be difficult to obtain.
Section 2.6
AECOM conducts business in more than 150 countries,
and is thus subject to numerous legal, political, economic and
currency risks. For example, AECOM has projects in both Iraq
and Afghanistan, and has halted its business in Libya
indefinitely due to civil unrest. In addition, although AECOM
has a record of successful acquisitions in emerging markets,
future difficulties in these regions could dampen growth.
AECOM's results are typically linked to global economic
trends. Worldwide, a strong dollar and slumping commodity
prices have lowered expectations for growth, particularly in
emerging markets. However, we expect the global GDP
picture to brighten slightly this year.
AECOM is also sensitive to trends in the dollar. The
recent decline in the dollar has been a positive development
for Industrial sector companies, including AECOM.
COMPANY DESCRIPTION
Based in Los Angeles, AECOM is a global provider of
planning, consulting, architectural and engineering design, and
construction management services for a broad range of
infrastructure projects, including highways, airports, bridges,
buildings and mass transit systems.
INDUSTRY
Our rating on the Industrial sector is Market-Weight.
Although Industrial stocks followed a difficult 2018 with a
solid first quarter, they have been hurt by company-specific
issues among leadership stocks (BA and MMM). Sector
fundamentals, meanwhile, are under pressure from weak
Eurozone demand, diminishing prospects for a U.S.-China
trade deal, and now the potential for reduced trade with
Mexico. Expected moderation in dollar strength has not
materialized as overseas economies are softer than the U.S.,
suggesting that Industrial stocks could remain out of favor.
The Industrial sector accounts for 9.3% of S&P 500
market capitalization. Over the past five years, the weighting
has ranged from 9% to 12%. We think that investors should
allocate 8%-10% of their diversified portfolios to the group.
The sector includes industries such as transportation,
aerospace & defense, heavy machinery and electrical
equipment.
The sector is outperforming the market thus far in 2019,
with a gain of 20.9%. It underperformed in 2018, with a loss
of 15.0%, and in 2017, with a gain of 18.5%.
By our calculations, the 2020 P/E ratio is 15.3, below the
market multiple of 16.5. Earnings are now expected to rise
15.5% in 2020 and to be flat in 2019 after rising 23.6% in
2018. The sector's debt/cap ratio of 50% is above the market
average. The yield of 1.3% is below the market average.
VALUATION
We think that ACM shares are undervalued at current
 CHANGE IN RATING / INITIATION OF COVERAGE
prices just below $38, near the top of their 52-week range of
$26-$41. To value the stock on a fundamental basis, we use
peer and historical multiple comparisons. ACM shares are
trading at 12.5-times our revised FY19 estimate, at the
midpoint of the historical range of 7-17. On a price/sales basis,
they are trading at the midpoint of the five-year range.
Compared to the peer group, ACM's multiples point to
undervaluation. As such, our rating is now BUY.
On September 19, BUY-rated ACM closed at $37.87,
down $0.44. (John Staszak, CFA, 9/19/19)

Section 2.7
 GROWTH / VALUE STOCKS
August 2017. Although Brighthouse has the opportunity to
Growth / Value Stocks in this Report reshape its operations over the next several years, we believe
that it has limited near-term growth prospects given declining
PRICE demand for annuity plans in the U.S. and the recent reduction
AS OF in its roster of policies. In particular, the company has
TICKER 9/25/19 discontinued new sales of whole life and certain term-life
Brighthouse Financial Inc $39.97 policies. We also expect margins to face pressure due to
BHF
post-spinoff expenses, including the costs of transition service
Cracker Barrel Old Country Sto CBRL 164.74
agreements with MetLife, and interest costs on $3.0 billion of
Darden Restaurants, Inc. DRI 117.82 recently issued debt.
Emergent BioSolutions Inc EBS 51.61
Fedex Corp FDX 143.25 The company does not pay a dividend and does not expect
Hartford Finl Servs Grp Inc HIG 60.55 to in the near term. However, Brighthouse has announced a
Illumina Inc ILMN 295.28 $400 million share repurchase program and recently bought
back $179 million of its stock on this authorization. The
Jabil Inc JBL 32.85
authorization represents a relatively small portion of BHF's
KLA Corp KLAC 156.50
$4.5 billion market cap.
Mondelez International Inc. MDLZ 55.05
Netflix Inc NFLX 254.59 On valuation, BHF shares are trading at 4.3-times our
New Relic Inc NEWR 64.00 forward four-quarter EPS estimate, below the peer average of
Qualcomm, Inc. QCOM 75.23 6.0, and at a price/book multiple of 0.3, below the peer
Regency Centers Corporation 67.62
average of 0.7. We believe that these discounts are appropriate
REG
given the company's relatively weak near-term outlook. We
State Auto Financial Corp. STFC 31.80
would consider an upgrade on signs of a sustainable upturn in
Texas Instruments Inc. TXN 125.81 revenue and earnings or the initiation of a dividend.
Xilinx, Inc. XLNX 96.12
RECENT DEVELOPMENTS
BHF shares have outperformed the broad market over the
Brighthouse Financial Inc (BHF) last three months, rising 7%, compared to a gain of 1% for the
Current Rating: HOLD Publication Date: 9/24/19 S&P Midcap 400 index. The shares have underperformed over
HIGHLIGHTS the past year, however, declining 12%, compared to a loss of
*BHF: Challenging outlook for MetLife spinoff 4% for the index. The beta on BHF is 1.33, above the peer
*Although Brighthouse has the opportunity to reshape its average of 1.17.
operations over the next several years, we believe that it has
limited near-term growth prospects given declining demand for On August 5, BHF reported 2Q19 adjusted earnings of
annuity plans in the U.S. and the recent reduction in its roster $2.19 per share, up from $1.27 in 2Q18 but below our estimate
of policies. of $2.25 and the consensus forecast of $2.28. Second-quarter
*On a positive note, the company repurchased $136 adjusted earnings rose to $254 million from $153 million in
million of its common stock in the second quarter and $43 2Q18 due to higher investment income. Revenue before
million in July. investment and derivative gains and losses rose 3% to $2.2
*On August 5, BHF reported 2Q19 adjusted earnings of billion, reflecting higher investment income. Including
$2.19 per share, up from $1.27 in 2Q18, due to higher adjustments, total revenue also rose 3% to $2.1 billion, due to
investment income. The result was below our estimate of derivative gains, and was above both our estimate and the
$2.25 and the consensus forecast of $2.28. consensus forecast of $2.0 billion. Life insurance sales fell
*We are lowering our 2019 adjusted EPS forecast to 50% to $1 million as Brighthouse discontinued sales of whole
$8.78 from $8.90 based on lower 2Q results than we had life and certain term life products. The company expects life
expected. We are also lowering our 2020 estimate to $10.22 insurance sales to remain at similar levels over the next 12-18
from $10.28. We expect adjusted revenue to fall 2% to $8.1 months as it restructures this business. On a GAAP basis, the
billion in 2019, and to rise 2% to $8.3 billion in 2020. Our company reported net income of $377 million or $3.27 per
five-year earnings growth rate forecast is 4%. share, compared to a loss of $239 million or $2.01 per share in
2Q18. Net investment income rose 17% from the prior year to
ANALYSIS $942 million.
INVESTMENT THESIS
We are maintaining our HOLD rating on Brighthouse Management projects mid- to high single-digit annual EPS
Financial Inc. (NGF: BHF), a provider of life insurance and growth going forward. However, we question the company's
annuity products. The company was spun off from MetLife in ability to meet even the low end of this guidance given past

Section 2.8
 GROWTH / VALUE STOCKS
performance.
BHF is a large variable annuity company and must hold
sufficient assets to satisfy contracts in the event of severe
market losses. In particular, it must have 98% confidence that
the assets held will be sufficient to meet its annuity obligations
in a worst-case scenario - what the industry terms a
'conditional tail expectation 98' (CTE98).
In 2Q, BHF had variable annuity assets of $1.5 billion in
excess of CTE98, reflecting favorable market conditions.
Brighthouse plans to boost its operating results by
focusing on particular market segments, including 'secure
seniors' (retirees or near retirees ages 55-70 with at least
$500,000 in investable assets), 'middle-aged strivers' (active
workers focused on paying bills, reducing debt and protecting
family wealth), and 'diverse and protected,' (active purchasers
of insurance products despite lower income and investible
assets than the other two segments). It also plans to lower
costs, simplify its product offerings, and shift to an
independent distribution network from a captive sales force.
Management would like to boost cash flow to
shareholders to 50%-70% of adjusted earnings by 2020. It is
also targeting mid- to high single-digit annual growth in
adjusted EPS, and an 11% ROE by 2021. These targets are
based on Brighthouse's baseline business scenario, which
assumes annual separate account returns of 6.5% and an
increase in the 10-year U.S. Treasury yield to 4.25% over a
10-year period.
EARNINGS & GROWTH ANALYSIS
The company has three reporting segments. Its annuities
business (57% of 2018 revenue) offers variable, fixed,
index-linked and income annuities. Its life insurance division
(16% of revenue) had 2.5 million policies in force; however,
this division accounts for a very small percentage of earnings,
and is now focused entirely on term life and universal life
policies without secondary guarantees. The company also has
a run-off division (25% of revenue), comprised of products
that are no longer actively sold, including company-owned life
insurance, bank-owned life insurance, and funding agreements.
In addition, Brighthouse has a 'corporate and other' segment
(2% of revenue), which contains excess capital not allocated to
the other segments.
Over the next two years, we expect revenue to be hurt by
the company's decision to discontinue sales of whole life and
certain term life policies, and by declining demand for
annuities. We also expect margin pressure from
post-separation expenses, including costs related to transition
service agreements with MetLife, and high interest costs
related to the issuance of $3 billion of debt in 2017. On the
positive side, we look for results to benefit from cost-cutting
measures, such as the sale of the company's retail advisor force
Section 2.9
in July 2016.
We are lowering our 2019 adjusted EPS forecast to $8.78
from $8.90 based on lower 2Q results than we had expected.
We are also lowering our 2020 estimate of to $10.22 from
$10.28. We expect adjusted revenue to decline 2% to $8.1
billion in 2019, and to rise 2% to $8.3 billion in 2020. Our
five-year earnings growth rate forecast is 4%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Brighthouse is
Medium-Low, the second-lowest rank on our five-point scale.
Brighthouse is targeting a return on equity of 11% by 2021, in
line with the current insurance industry average. The company
plans to eventually return 50%-70% (or more) of adjusted
earnings to shareholders, toward the middle of the range
targeted by peers.
Total debt was $4.4 billion at the end of 2Q19, compared
to $4.6 billion at the end of 2018. Debt/capital stood at 34%,
above the peer average of 23%. BHF's debt is rated investment
grade, with a Baa3/stable rating from Moody's and a
BBB+/negative rating from S&P. Second-quarter operating
income covered interest expense by a factor of 10.8, compared
to 8.7 for peers. The company's adjusted net profit margin in
2Q19 was 7.2%, below the peer average of 12.8%.
Brighthouse has not made any cash dividend payments
since becoming a publicly traded company in August 2017,
and does not intend to make any over at least the next couple
of years. We do not expect the company to pay a dividend in
2019 or 2020.
In 2Q, the company repurchased $136 million of its
common stock. It also bought back $43 million of its stock in
July. The company has a $400 million repurchase
authorization.
MANAGEMENT & RISKS
Eric Steigerwalt has served as the company's president
and CEO since the spinoff in August 2017. Prior to that, he
held a range of executive positions at MetLife, which he joined
in 1998.
COO Connor Murphy has served as interim CFO since
February, following the departure of Anant Bhalla. He had
been the CFO of MetLife's Retail division since joining the
company in 2014.
BHF investors face risks related to new business strategies
and the possibility that they may not achieve the company's
objectives. They also face the risk that a sustained period of
low equity market prices, and lower interest rates than those
assumed when BHF issued its variable annuity products, could
materially impact its operations, capitalization, and financial
position. In addition, a downgrade or potential downgrade of
 GROWTH / VALUE STOCKS
BHF's credit ratings could hurt its operational results and
financial condition, as could changes in tax laws that might
make certain products less attractive to consumers.
COMPANY DESCRIPTION
Brighthouse Financial provides life insurance and annuity
products in the U.S. The company was spun off from MetLife
in August 2017. BHF's in-force book of products consisted of
approximately 2.5 million insurance policies and annuity
contracts as of December 31, 2018.
Although Brighthouse had about $500 billion of in-force
life insurance policies at the end of 2Q19, its life insurance
operations account for a very small portion of earnings, as the
company has reduced these activities in recent years.
VALUATION
BHF shares trade at just 4.3-times our forward
four-quarter EPS forecast, below the historical average of 5.1
(since the stock began trading in July 2017) and the average of
6.0 for a peer group that includes Primerica, AXA Equitable,
and Athene Holdings. They are also trading at a price/book
multiple of 0.3, below the historical average of 0.4 and the
peer average of 0.7. The company has substantially reduced its
roster of policies and appears to have limited prospects for
revenue and earnings growth over the next several years. In
addition, we note that the shares do not pay a dividend, though
the new stock buyback program is encouraging. We believe
that BHF is fairly valued at current levels and that a HOLD
rating remains appropriate.
On September 24 at midday, HOLD-rated BHF traded at
$40.68, up $0.06. (Jacob Kilstein, CFA, 9/24/19)
Cracker Barrel Old Country Sto (CBRL)
Current Rating: BUY Publication Date: 9/20/19
HIGHLIGHTS
*CBRL: Strong 4Q19; maintaining BUY
*Cracker Barrel posted strong fiscal 4Q results and
appears on track for continued growth in comp sales and
margins in FY20.
*We expect Cracker Barrel, with its many locations near
interstate highways, to benefit from strong travel trends.
*We are maintaining our EPS estimates of $9.88 for FY20
and setting an estimate of $10.70 for FY21.
*CBRL appears favorably valued at 16.7-times our FY20
estimate. Based on prospects for continued price increases and
new store openings, we see room for P/E multiple expansion
over the next 12 months.
ANALYSIS
INVESTMENT THESIS
We are reiterating our BUY rating and target price of
$210 on Cracker Barrel Old Country Store Inc. (NGS: CBRL).
Cracker Barrel posted better-than-expected fiscal 4Q19 comps,
Section 2.10
driven by 'value pricing,' enhanced marketing efforts, and new
menu items, such as premium coffee; operating margins also
rose despite higher labor costs. We expect continued growth in
both comp sales and margins in the coming quarters, and are
maintaining our above-consensus EPS estimates for this year
and next. Our long-term rating is also BUY.
RECENT DEVELOPMENTS
On September 17, CBRL reported fiscal 4Q19 revenue of
$787 million, down 3% from the prior year and above the
consensus estimate of $775 million. However, we note that
FY18 benefited from a 53rd week. Adjusting for the extra
week, CBRL revenue was up 4.6%. Reflecting a 1.3% increase
in product mix, 2.3% higher prices and a 20-basis-point
increase in customer traffic, same-store sales at Cracker Barrel
restaurants rose 3.8%, up from a 0.4% decline in the prior-year
period. Consensus estimates had called for comps to increase
by 280 basis points. Comp growth exceeded the average for
other casual-dining companies. Comp sales at the company's
retail stores rose 0.4%, above the consensus estimate of a 1.2%
decline.
Other store operating expenses rose 120 basis points as a
percentage of revenue, to 20.9%, while labor and other related
expenses fell 30 basis points to 35.1% of revenue. The cost of
goods sold decreased 150 basis points to 28.8% of revenue,
below the consensus estimate of 29.6%.
Operating income fell $3 million year-over-year to $79.3
million. The operating margin declined 10 basis point to
10.1%, and topped the consensus forecast by 30 basis points.
General and administrative expenses increased by 70 basis
points to 5.1% of revenue. EPS increased 6%, to $2.70, above
the consensus estimate of $2.49. The positive earnings surprise
reflected stronger-than-anticipated revenue and restaurant
comps, as well as a lower-than-expected tax rate. The share
count rose slightly from the prior year to just above 24.1
million.
In FY19, revenue increased 1% to $3.1 billion and
earnings rose to $9.27 from $9.23 per share.
Cracker Barrel project FY20 adjusted earnings of
$9.30-$9.45, and revenue of $3.15-$3.20 billion. It expects
comps at restaurants to grow 2%-3%. Comps at retail stores
are projected to be up 1%. It forecasts an operating margin of
9.0%. It looks for capital spending of $115-$125 million and
an effective tax rate of approximately 17%.
As discussed in a previous note, on July 23, Cracker
Barrel announced it would pay $140 million to acquire a
minority interest in Punch Bowl Social (PBS). The agreement
includes an option to acquire a majority interest or obtain full
ownership.
Punch Bowl Social is a restaurant and bar chain where
 GROWTH / VALUE STOCKS
customers can bowl, play videogames and sing karaoke,
among other activities. Punch Bowl operates 17 restaurants
with 11 more planned to be added before the end of 2020. It
estimates it can grow to more than 100 stores within the U.S.
Punch Bowl's founder, Robert Thompson, will remain active in
the day-to-day management of the business and Cracker Barrel
management's team will serve in an advisory capacity as Punch
Bowl Social adds to its restaurant count.
EARNINGS & GROWTH ANALYSIS
We continue to expect Cracker Barrel to post
mid-single-digit earnings growth over the next several years.
Reflecting prospects for improving same-store sales and
prospects for better margins, as well as positive earnings
surprises in eight of the past nine quarters, we are maintaining
our FY20 estimate of $9.88 and setting an estimate of $10.70
for FY21.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating for CBRL remains
Medium-Low, the second-lowest point on our five-point scale.
The long-term debt/capitalization ratio declined to 39.8% at
the end of 4Q19 from 40.7% at the end of 4Q18. The interest
coverage ratio rose to 20.3 in 4Q19 from 19.3 in 4Q18.
On June 4, 2019, the company announced a 4% increase
in its quarterly dividend to $1.30 per share, or $5.20 annually,
for a projected yield of about 3.4%. It also paid a special
dividend of $3 per share on August 2, 2019 to holders of
record as of July 19. In FY18, the company paid a regular
dividend of $4.85 per share and a special dividend of $3.75
per share, for a total of $8.60 per share. Our regular dividend
estimates are $5.60 for FY20 and $6.00 for FY21.
RISKS
Cracker Barrel is vulnerable to significant increases in
gasoline prices, which could hurt traffic at the company's
locations along interstate highways, though it should benefit
from lower gas prices in the near term. The company also
faces risks related to higher food costs, which could lead to
increased prices and reduced customer traffic. In addition,
increases in the minimum wage could raise the company's
labor costs.
COMPANY DESCRIPTION
Cracker Barrel Old Country Store, based in Lebanon,
Tennessee, operates 655 Cracker Barrel restaurants and gift
shops in 45 states, primarily in the Southeast and the Midwest.
With a market cap of about $3.9 billion, the shares are
generally regarded as mid-cap growth.
VALUATION
The shares were up 3% on September 17 after the
company announced better-than-expected revenue and
earnings and solid guidance. CBRL shares appear favorably
valued at 16.7-times our FY20 estimate. Based on prospects
for continued price increases and new store openings, we see
Section 2.11
room for P/E multiple expansion over the next 12 months. As
such, we are maintaining our BUY rating with a price target of
$210.
On September 19, BUY-rated CBRL closed at $166.26,
up $0.80. (John Staszak, CFA, 9/19/19)
Darden Restaurants, Inc. (DRI)
Current Rating: BUY Publication Date: 9/23/19
HIGHLIGHTS
*DRI: Solid earnings; maintaining BUY
*We have a favorable view of Darden's strong brands,
everyday value menu, and high customer satisfaction ratings.
*The company's long history of dividend hikes and share
buybacks should continue to attract growth-income investors.
*The company recently reported fiscal 1Q20 EPS that
rose 3% and topped consensus estimates.
*We note that DRI has topped earnings estimates for the
past 11 quarters.
ANALYSIS
INVESTMENT THESIS
We are maintaining our BUY rating and $140 price target
on Darden Restaurants Inc. (NYSE: DRI). We believe that
Darden's initiatives to price aggressively, lower costs and
increase customer traffic at Olive Garden are transferable, and
may be used to boost results at its specialty brand restaurants.
The company's long history of dividend hikes and share
buybacks should also continue to attract growth-income
investors.
Our long-term rating on Darden remains BUY, as we
believe that share buybacks, unit expansion, and further cost
reductions will lead to EPS growth over time. We also believe
that Darden remains one of the best-managed casual dining
companies in our coverage group.
RECENT DEVELOPMENTS
The company recently reported fiscal 1Q20 EPS that rose
3% and topped consensus estimates. On September 19, Darden
reported adjusted 1Q20 earnings of $1.38 per share, up 3%
year-over-year and two cents ahead of consensus. Total sales
increased 3.5% to $2.1 billion. The operating margin widened
to 9.4% from 9.2%. EPS growth also benefited from lower
SG&A, depreciation and amortization, and interest expense.
During the quarter, Darden spent $95 million to
repurchase 800,000 of its shares. The company authorized a
new $500 million share buyback program with no expiration
date.
Along with the results, management maintained its
outlook for FY20. Management projects full-year earnings of
$6.30-$6.45 per share and sales growth of 5.3%-6.3%.
Blended same-store sales at legacy brands are expected to
 GROWTH / VALUE STOCKS
grow 1%-2%. Management expects 50 gross and 44 net
restaurant openings. The company still expects to repurchase
$150-$250 million of its stock in FY20.
As discussed in a previous note, in FY19, total sales
increased 5% to $8.5 billion and adjusted diluted EPS rose
12% to $5.82.
EARNINGS & GROWTH ANALYSIS
Darden organizes its portfolio of restaurants into the
following categories: Olive Garden (50% of FY19 sales),
Longhorn Steakhouse (21%), Fine Dining (7%) and Other
Business (21%).
Blended same-store sales at Darden's brands rose 0.9% in
1Q20 and 3.3% in 1Q19. Blended same-store sales have
advanced for 20 straight quarters and were better than the
1.2% decline reported by other casual diners in the quarter,
according to Knapp-Track data. In 1Q20, same-store sales rose
2.2% at Olive Garden (60 basis points above consensus); 2.6%
at LongHorn Steakhouse (10 basis points above consensus);
and1.5% at The Capital Grille (60 basis points below
consensus). Same-store sales at Bahama Breeze fell 4.2% in
1Q20. However, we believe value pricing and deliveries can
eventually return Bahama Breeze's comps to positive territory.
Management keeps a close eye on costs. In 1Q20, the
operating margin rose 20 basis points to 9.4%, as food and
beverage costs rose at a slower pace than sales.
We note that DRI has topped earnings estimates for the
past 11 quarters. We are maintaining our FY20 estimate of
$6.50, which is above the high end of management's guidance
range and implies growth of 12%. We look for continued
growth in FY21 and are keeping our estimate at $7.20. Our
long-term earnings growth rate forecast is 11%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Darden Restaurants is
Medium. The company's operating margin increased 20 basis
points from the prior year, to 9.4%, in 1Q20. The consensus
estimate had called for an operating margin of 9.4%.
Long-term debt as a percentage of total capital increased to
39% at the end of 1Q20 from 38.9% at the end of 4Q19.
Standard & Poor's rates Darden's credit as BBB, an
investment-grade rating. The company also has
investment-grade ratings from Moody's and Fitch.
In June 2019, Darden raised its quarterly dividend by 17%
to $0.88 per share, or $3.52 annually, for a yield of about
2.9%. Our dividend estimates are $3.48 for FY20 and $3.90
for FY21.
MANAGEMENT & RISKS
The CEO of Darden is Eugene I. Lee, Jr. He has served in
the position since 2015. Ricardo Cardenas has served as CFO
since 2016.
Section 2.12
Darden faces the risk that a weak economy and a soft
housing market could lead to further reductions in restaurant
spending. Like other restaurant companies, Darden could also
be hurt by rising food and beverage costs as well as by
increases in the federal minimum wage.
COMPANY DESCRIPTION
Darden Restaurants, based in Orlando, is a leading U.S.
restaurant operator. The company operates more than 1,500
restaurants in the United States and Canada under the Olive
Garden, Bahama Breeze, Seasons 52, Capital Grille,
LongHorn Steakhouse, Eddie V's and Yard House brand
names. Darden has a market cap of $14.7 billion and is
generally regarded as a large-cap growth company.
VALUATION
DRI shares appear attractively valued at current prices
near $120. Over the past 52 weeks, the shares have traded
between $95 and $125 and are currently near the high end of
the range. The shares have been in a bullish pattern of higher
highs and higher lows for the past five years.
Given prospects for stronger comp growth at the
company's core and specialty restaurant chains, we believe that
DRI shares are undervalued at 18.5-times our FY20 EPS
estimate. Our target price remains $140. Our target, combined
with the dividend, implies a total potential return of nearly
20% from current levels.
On September 23 at midday, BUY-rated DRI traded at
$119.75, down $0.08. (John Staszak, CFA, 9/23/19)
Emergent BioSolutions Inc (EBS)
Current Rating: BUY Publication Date: 9/18/19
HIGHLIGHTS
*EBS: Attractive valuation and new government contract
*Emergent has been awarded a 10-year, $2 billion
government contract to supply ACAM2000, a smallpox
vaccination, and expects to deliver most of the doses under its
base performance period by the end of 2019.
*The company has also won approval to manufacture its
cholera vaccine in Switzerland, which should strengthen its
supply chain and help it to expand into new markets.
*We are maintaining our 2019 EPS estimate of $2.94 and
raising our 2020 forecast to $3.90 from $3.60.
*Valuations are attractive against the peer group. Our
target price of $60 implies a return of about 13% from current
levels.
ANALYSIS
INVESTMENT THESIS
Our rating on Emergent BioSolutions Inc. (NYSE: EBS),
a maker of vaccines and other products that address public
health threats, is BUY. We believe that EBS is on track to post
 GROWTH / VALUE STOCKS
solid earnings growth over the next several years, driven by
strong U.S. military demand for its anthrax and smallpox
vaccine portfolios, as well as continued sales of its Narcan
nasal spray for the treatment of opioid overdoses. We also
expect it to benefit from its new product pipeline, including its
antibody candidates for the treatment of serious influenza A
and the Chikungunya virus spread by mosquitoes. Although
Emergent relies heavily on sales to the U.S. government, a fact
that can often lead to uneven quarterly results due to contract
timing, it is working to diversify its revenue by developing
new products for both government and nongovernment
customers, and by expanding internationally. On valuation,
following several earnings misses, the EBS shares trade at
18.0-times our 2019 EPS estimate, below the average multiple
of 25.2 for peer biotech companies. Based on the company's
heavy reliance on sales to the USG, and the uneven quarterly
results, we believe that a modest valuation discount is
warranted. However, we think the current discount is too great
given our expectations for more than 20% annual earnings
growth in both 2019 and 2020. Our target price of $60 implies
a 2019 P/E of 20.4, still below the peer average, and a return
of about 13% from current levels.
RECENT DEVELOPMENTS
EBS shares have outperformed over the past quarter,
gaining 18.4% compared to a 3.8% advance for the S&P 500.
However, they have underperformed over the past year, falling
17.3% versus an increase 3.8% for the index and a 9.5%
decline for the iShares Nasdaq Biotech Industry ETF IBB.
They have outperformed over the past two- and five-year
periods against both benchmarks. The beta on the EBS is 1.24,
above the peer average of 1.20.
The EBS share price is heavily influenced by R&D and
M&A developments. On June 4, Emergent announced that the
FDA had approved a change in storage conditions for its
cholera vaccine, Vaxchora, allowing for the vaccine to be
stored in a refrigerated setting at 2-8 degrees Celsius;
Vaxchora had previously only been approved to be stored at
freezing temperatures. The FDA also approved the production
of Vaxchora at the company's Bern, Switzerland facility, in
addition to its current production site in San Diego.
Management said that these approvals would allow for 'a more
robust supply chain process' and better capacity utilization,
while also helping the company to enter new markets. For
reference, Vaxchora is the only FDA-licensed vaccine for the
prevention of cholera caused by Vibrio cholerae serogroup
O1, a potentially serious intestinal disease.
On May 20 the company announced that it had obtained
marketing authorization for its oral typhoid vaccine, Vivotif, in
France, Portugal, Poland, Czech Republic, and Slovakia; the
company also won approval for harmonized prescribing
information in the EU, also known as the Summary of Product
Characteristics, or SmPC.
Section 2.13
The EBS stock price has been influenced by the
announcement of certain government contracts. Most recently,
on September 3, Emergent announced that the U.S.
Department of Health and Human Services (HHS) had granted
the company a $2 billion, 10-year contract for the continued
supply of ACAM2000, the company's smallpox vaccine. The
contract consists of a one-year base performance period,
valued at approximately $170 million, followed by nine option
years. Management expects to deliver most of the doses for the
base year by the end of 2019, consistent with its prior
guidance. The ACAM2000 announcement follows the June 3
announcement that HHS had awarded Emergent a 10-year
contract to supply VIGIV. Coupled with the ACAM2000
smallpox vaccine, VIGIV (which is used to treat complications
from smallpox vaccination) offers a robust solution for the
U.S. Strategic National Stockpile (SNS). Under the terms of
the contract, Emergent will begin a one-year base period in
which it will use plasma provided by the U.S. government to
manufacture VIGIV. This will be followed by nine option
years in which Emergent will itself lead the plasma collection
and production effort. The first year of the contract is valued at
$23 million, while the full 10-year contract is valued at $535
million.
On the pipeline front, as of September 16, 2019, Emergent
had eight product candidates, including three in clinical
development, as well as four device candidates. Of its
clinical-stage product candidates, AV7909, a next-generation
anthrax vaccine, entered Phase 3 trials in March. FLU-IGIV, a
human polyclonal antibody for the treatment of serious
influenza A, and Chikungunya VLP, an antibody for the
Chikungunya virus, are expected to enter Phase 3 trials in
2020. The company is also studying potential products to treat
the Zika virus under FDA fast-track designations. Regarding
its device candidates, the company is conducting formative
studies on a nerve agent antidote multidrug autoinjector and on
a stabilized isoamyl nitrate. It is also conducting registration
studies on a Naxalone prefilled syringe and on a Naxalone
bi-dose spray.
Emergent recently reported 2Q19 results that missed the
consensus earnings estimate but beat on revenue. On August 1,
the company reported 2Q total revenue of $243.2 million, up
10.4% and roughly $25 million above consensus. The adjusted
net loss was $0.12 per share, down from adjusted net income
of $1.07 per share in 2Q18 as expenses rose faster than
revenue, but within management's expectations. The results
missed the consensus forecast calling for earnings of $0.11 per
share.
Along with the 2Q results, management reaffirmed its
full-year guidance for 2019. It continues to expect 2019
revenue of $1.06-$1.14 billion, adjusted net income of
$150-$180 million, and adjusted EBITDA of $280-$310
million. It also expects 3Q19 revenue of $245-$275 million,
and looks for revenue and earnings to be weighted to the
 GROWTH / VALUE STOCKS
second half of the year.
Management is also working on a new five-year strategic
plan for 2020-2024. It expects to share details with investors at
an Analyst and Investor Day in 4Q19.
EARNINGS & GROWTH ANALYSIS
The company has three revenue drivers: Product Sales
(75.5% of 2Q sales); Contracts and Grants (16.9%); and
Contract Manufacturing (7.7%).
In 2Q, Product Sales grew 1.9%, driven by a $73 million
contribution from the addition of Narcan and 65% growth in
the company's Other category, to $76 million. Conversely,
ACAM2000 sales fell 88% to $6.5 million, largely due to the
timing of deliveries, while BioThrax sales fell 64% to $28
million as the USG began to scale back procurement in
anticipation of the company's next-generation anthrax vaccine,
AV7909. Still, management noted that it expects the USG to
continue to buy BioThrax due to its unique indication for
pre-exposure use.
In Contracts and Grants, sales rose 148% to $41 million,
reflecting increased R&D activities related to certain ongoing
funded development programs, particularly the company's
next-generation anthrax vaccine candidate AV7909.
Contract Manufacturing sales fell 21% to $18.7 million,
reflecting contracted service revenue from a single customer in
2Q18 that did not recur in 2Q19.
While management has traditionally kept a close watch on
expenses, the company incurred significantly higher expenses
during the second quarter. Net R&D expense rose 179% to
$22.9 million due to an increase in costs related to the
development of CHIKV-VLP, for the chikungunya virus; the
FLU-IGIV program; and various programs related to opioid
overdose response. As a result of these investments,
Emergent's net R&D expense was 11% of adjusted revenue, up
from 4% of adjusted revenue in 2Q18. SG&A expense rose
79% to $70.8 million, primarily due to the PaxVax and Adapt
Pharma acquisitions. In addition, the cost of product sales and
contract manufacturing rose 18% in 2Q, to $100.8 million,
primarily due to increased sales of Narcan nasal spray, Vivotif,
and Vaxchora, which were all acquired in 4Q18, as well as
increased facility expenses. Given that the higher costs were
driven primarily by acquisitions, we expect the impact to be
temporary and look for a return to margin growth later in
2019.
Turning to our estimates, we are maintaining our 2019
EPS estimate of $2.94 following the announcement of the
company's contract to supply ACAM2000 to the U.S. Strategic
National Stockpile. We believe that the signing of this
contract, as well as the earlier VIGIV contract, represents a
long-term opportunity for Emergent and demonstrates the U.S.
Section 2.14
government's reliance on its products. We expect continued
growth in 2020 and are raising our EPS forecast to $3.90 from
$3.60.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on EBS is Medium, the
middle rank on our five-point scale. At the end of the second
quarter, Emergent had cash and equivalents of $177.4 million,
up from $112.2 million at the end of 2018. Total debt was
$857.0 million, up from $794.6 million at the end of 2018, and
accounted for 46% of total capital, up from 44% and above the
peer average of 31%. We view average levels as 50%-55%,
but note that the current ratio is well above the five-year
historical average of 26% as the company issued $768 million
of debt in October 2018 in order to finance the acquisitions of
PaxVax and Adapt Pharma. The company generated a 2Q19
operating loss of $7 million compared to operating income of
$66.8 million in 2Q18. Operating cash flow was negative
$35.8 million, compared to a positive cash flow of $34.6
million in the prior-year period. Neither Moody's nor Standard
and Poor's have rated the company's debt.
The company does not pay a dividend.
EBS has a buyback plan. In March 2018, it authorized the
repurchase of up to $50 million of common stock through the
end of 2019. As of June 30, 2019, the company had not made
any repurchases under this program.
MANAGEMENT & RISKS
On April 1, 2019, Robert G. Kramer became Emergent's
new CEO, succeeding Daniel Abdun-Nabi following his
planned retirement. Mr. Kramer also replaced Mr.
Abdun-Nabi on Emergent's board.
There are risks to owning EBS shares. EBS faces
significant customer-concentration risk, as it derives a
substantial portion of its revenue from the sale of vaccines to
the USG. In 2Q19, EBS derived 55% of total revenue from the
USG, down from 84% at the end of 2Q18. While part of the
decrease related to the timing of government purchases,
management noted that the government was in the early stages
of transitioning its anthrax vaccine stockpiling orders.
Specifically, the government began to slow its procurement of
BioThrax in early 2019, while at the same time signaling its
intent to procure AV7909, the company's next-generation
anthrax vaccine candidate, resulting in a 64% year-over-year
decline in BioThrax orders in 2Q19. Nevertheless,
management expects the government to continue to purchase
BioThrax given its unique indication as a pre-exposure
immunization for anthrax. While Emergent plans to start
delivering AV7909 later in the third quarter, the transition
highlights the risks that such a concentrated customer base can
have on the company's results.
The company operates in a highly competitive field.
 GROWTH / VALUE STOCKS
Although Emergent's BioThrax is the only currently
FDA-approved vaccine for anthrax, several other companies
(Altimmune, Pfenex, Soligenix, Immunovaccine and NanoBio
Corp.) are currently developing competing products.
The company also faces risks related to the process of
competitive bidding on government contracts, as well as
regulatory risks related to the development of AV7909.
COMPANY DESCRIPTION
Emergent BioSolutions makes vaccines and other
products intended to protect civilian and military populations
from emerging infectious diseases and chemical, biological or
nuclear attacks. The company generates most of its revenue
from Narcan nasal spray, a treatment for opioid overdoses, as
well as from ACAM2000 (for smallpox) and BioThrax (for the
prevention and treatment of anthrax). The USG is the
company's primary customer, and provides it with significant
product development funding.
VALUATION
We think that EBS shares are attractively valued at current
prices near $53. Over the past 52 weeks, the shares have
traded in a range of $39-$74 and are currently below the
midpoint of the range. From a technical standpoint, the shares
had been in a bearish pattern of lower highs and lower lows
following an all-time-high of $73.89 in December 2018, but
were able to break free from the pattern in early September on
news of the ACAM2000 contract. While the stock has now
retraced some of these recent gains, we view this positively as
it is no longer showing signs of being overbought. Having now
found initial support near the 38.2% Fibonacci retracement
level (as measured between its December 2018 peak and
August 2019 low), we believe that current conditions have
positioned EBS for a continued recovery to the 61.8%
retracement level near $60 per share.
On the fundamentals, EBS shares trade at 18.0-times our
2019 EPS estimate, below the average multiple of 25.2 for
peer biotech companies and below the five-year historical
average of 22.6. Based on the company's heavy reliance on
sales to the USG, and uneven quarterly results (due to the
timing of certain government contracts), we believe that a
modest valuation discount is warranted. However, we think the
current discount is too great given our expectations for more
than 20% annual earnings growth in both 2019 and 2020. Our
target price of $60 implies a 2019 P/E of 20.4, still well below
the peer average, and a return of about 13% from current
levels.
On September 18 at midday, BUY-rated EBS traded at
$53.12, down $0.20. (Jasper Hellweg, 9/18/19)
Fedex Corp (FDX)
Current Rating: BUY Publication Date: 9/19/19
HIGHLIGHTS
Section 2.15
*FDX: Reiterating BUY following fiscal 1Q results
*The volatile FDX shares have underperformed over the
past quarter, declining 10% compared to a 3% increase in the
S&P 500.
*Trade and tariff issues have been especially challenging
for this global air transport company.
*The company's balance sheet remains solid, and we look
for earnings to recover in FY21.
*On valuation, the shares are trading near range-low
levels.
ANALYSIS
INVESTMENT THESIS
Our rating on FedEx Corp. (NYSE: FDX) is BUY. This
large-cap blue-chip industrial company has benefited over the
past few years from solid growth in the consumer sector, and
especially from growth in e-commerce. The company's
well-respected management team continues to inject cash back
into operations, which we think sets the stage for future
efficiencies and margin improvement. The shares have fallen
sharply in 2018-2019 though, on concerns over trade and
tariffs as well as weakening economic conditions overseas.
Management has lowered guidance several times, and
multiples are depressed, suggesting value. That said, until the
outlook for global economic growth improves, investors are
unlikely to assign high multiples to FedEx's earnings. Our
target price is now $165 (reduced from $190), which implies a
below-market P/E ratio of 12-times projected FY21 earnings.
RECENT DEVELOPMENTS
The volatile FDX shares have underperformed over the
past quarter, declining 10% compared to a 3% increase in the
S&P 500. The shares have also underperformed over the past
year, with a decline of 38% versus a 3% gain for the S&P 500.
The beta on FDX shares is 1.75.
On September 18, FDX reported fiscal 1Q20 results that
fell short of consensus forecasts, knocking 13% off the
company's market value. Revenue in 1Q was flat
year-over-year -- down from the 3% growth recorded in the
prior two quarters -- at $17.0 billion. Adjusted operating
earnings declined 12%, as the operating margin narrowed by
90 basis points to 6.1%. Adjusted diluted EPS declined 12% to
$3.05, below the consensus forecast of $3.15.
Along with the earnings release, management lowered its
guidance for FY20. The company now expects adjusted EPS
of $11-$13, compared to its previous forecast of a
mid-single-digit percentage point decline in adjusted EPS
(from FY19's $15.52). Management cited pressures from the
trade war, weakening global economic conditions, and the loss
of business from Amazon.com (FedEx's choice) as reasons for
the lower outlook.
EARNINGS & GROWTH ANALYSIS
FedEx operates three major segments: FedEx Express
 GROWTH / VALUE STOCKS
(52% of 1Q revenue), which now includes the recently
acquired TNT Express subsidiary; Ground (30%); and Freight
(11%).
First-quarter revenue in the Express segment declined 3%
-- it was down 1% in the prior two quarters. CFO Alan Graf
commented during the 1Q conference call that weakening
global trade and industrial production resulted in
lower-than-expected demand for the company's most profitable
Express package and Freight services. Express yields were
also negatively impacted by the resulting mix shift, lower
weight per package, and customer trade-down to slower
lower-price services. These conditions were especially
challenging in Europe. Revenues in the Ground segment rose
8% year-over-year, benefiting from strong e-commerce
volume growth. In the Freight segment, revenue reversed
course and declined 3%.
Management continues to focus on margins amid the
challenging top-line environment. During 1Q, the operating
margin narrowed by 90 basis points to 6.1%. Management
noted that FedEx Ground operating costs were higher due
primarily to the expansion of operations to six days per week,
higher purchase transportation costs attributable to volume
growth, and higher self-insurance expenses. FedEx is
implementing cost-reduction actions to improve margins,
including a voluntary buyout program, a reduction in
international network capacity at FedEx Express, and
post-peak reductions in its aircraft fleet.
Turning to our estimates, based on the weakened
international economic conditions and margin pressures, we
are lowering our FY20 diluted EPS estimate to $12.80 from
$15.20. Our estimate implies a decline of 18% this year. We
look for growth to return in FY21 as management's
cost-reduction actions take hold, but are lowering our EPS
estimate to $13.95 from $16.65. Our five-year earnings growth
rate forecast is now 8%, down from 10%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on FDX is now Medium, the
midpoint on our five-point scale. The company receives
average scores on our scorecard measuring debt levels,
fixed-cost coverage and profitability.
The company had $2.3 billion in cash at the end of FY19,
down from $3.3 billion at the end of FY18. Total debt was
$17.6 billion or 50% of total capital, up from 30% prior to the
acquisition of TNT. Cash flow covered interest expense last
year by a factor of 18. The company's operating margins are
typically in the high single-digit, low double-digit range,
though they are currently depressed.
FedEx pays a dividend. The current rate is $2.60 annually.
FedEx has a history of double-digit dividend growth, but lately
has opted to keep the dividend constant. We think the current
Section 2.16
dividend is secure but unlikely to grow until EPS growth
resumes. Our dividend estimates are $2.60 for FY20 and $2.80
for FY21.
The company also has a share repurchase plan.
MANAGEMENT & RISKS
Fred Smith founded FedEx in 1971 and still serves as
Chairman and CEO. Alan Graf has been the CFO since 1998.
The company has established key long-term financial
goals, including:
-- A 10%+ operating margin
-- 10%-15% EPS growth per year
-- Grow revenue
-- Improve cash flows
-- Increase ROIC
-- Increase returns to shareholders
To achieve these goals, management is banking on
continued growth in e-commerce and global trade, and plans to
generate profitable growth in the Express, Ground and Freight
segments by controlling costs.
The air freight industry is expected to grow at a 10% rate
through 2026, at which time forecasters estimate that 100
million packages will be delivered each day. The current
market is about half that size, and FedEx has a market share of
approximately 30%.
In addition to organic growth, FedEx also has a
growth-by-acquisition strategy. In May 2016, the company
completed the acquisition of TNT Express for $4.8 billion.
The acquisition has enhanced FDX's position in the European
delivery market, though that market has recently weakened due
to Brexit and the slowdown in Germany. FedEx also was
forced to manage the fallout from a cyber-attack on TNT
Express in 2016, shortly after it was acquired. The impact of
Brexit uncertainty and the cyberattack have delayed FedEx
from improving margins at TNT as fast as had been expected.
Investors in FedEx face numerous risks.
The shares have been exposed to the trade and tariff
tweets and threats.
The company's earnings are susceptible to volatile fuel
costs, and although the company has been able to pass most of
the additional costs on to customers in the form of fuel
surcharges, these surcharges typically face a one-month time
 GROWTH / VALUE STOCKS
lag.
FedEx is also sensitive to changes in overall economic
growth in the U.S. and abroad.
In addition, the company faces the risk of increased
competition as rivals - and even former customers, such as
Amazon.com (AMZN: BUY) seek to gain market share in a
business that is highly sensitive to price and quality of service.
FedEx mitigates this risk with its broad-based network, which
allows international customers to reach a number of U.S.
destinations not served by competitors. In the past, FDX
management has noted that Amazon represents 1.3% of total
revenue. During 4Q19, FedEx ended its domestic express
shipping relationship with Amazon.com in order to focus on
other customers. In 1Q20, FedEx also ended its
ground-shipping contract with Amazon.
COMPANY DESCRIPTION
FedEx Corp. is a leading international provider of
package delivery, e-commerce and related services. The
company's business segments are FedEx Express, FedEx
Ground and FedEx Freight.
VALUATION
We think that FDX shares are attractively valued at
current prices near $151. The shares are trading near the low
end of their 52-week range of $147-$250, and are down almost
45% from their highs. On a technical basis, the shares are in a
bearish pattern of lower lows and lower highs since
establishing an all-time high of $274 in January 2018. The
next level of support is around $125.
To value the stock on a fundamental basis, we use a peer
and multiple comparison model, as well as a dividend discount
model. FDX shares are trading at 12-times our FY20 EPS
estimate, near the bottom of the historical range of 10-20 and
below the peer average of 16. On a price/sales basis, the shares
are trading at a multiple of 0.6, near the low end of the
five-year range. The yield of about 1.5% is above the midpoint
of the five-year range but below the peer average of 2.0%. The
shares are clearly trading at bargain valuation levels. That said,
until the outlook for global economic growth improves,
investors are unlikely to assign high multiples to FedEx's
earnings. Our target price is now $165, down from $190,
which implies a below-market P/E ratio of 12-times projected
FY21 earnings.
On September 19 at midday, BUY-rated FDX traded at
$150.22, down $0.69. (John Eade, 9/19/19)
Hartford Finl Servs Grp Inc (HIG)
Current Rating: HOLD Publication Date: 9/19/19
HIGHLIGHTS
*HIG: Stock fully valued; maintaining HOLD
*We expect Hartford to generate a lower ROE than peers
Section 2.17
over the next few years despite efforts to raise prices, improve
margins, and lift profitability to industry-standard levels.
*On August 1, Hartford reported 2Q19 core earnings of
$485 million, up 18% from the prior year, driven by better
results in the Personal Lines, Group Benefits, and Corporate
segments. Core EPS rose 18% to $1.33, above our estimate of
$1.21 and the consensus estimate of $1.14.
*We are raising our 2019 EPS estimate to $5.28 from
$5.13 and our 2020 forecast to $5.52 from $5.51. Results for
the second quarter beat our estimate and the profit margin is
expanding. Our long-term EPS growth rate forecast is 8%.
*On May 23, the company completed its acquisition of
The Navigators Group, a specialty underwriter, for $70 per
share or $2.1 billion. Management projects annual core
earnings of about $200 million from this business within 4-5
years.
ANALYSIS
INVESTMENT THESIS
We are maintaining our HOLD rating on Hartford
Financial Services Group Inc. (NYSE: HIG) following 2Q
earnings. We expect Hartford to generate a lower ROE than
peers over the next few years despite management's efforts to
raise prices, improve margins, and lift profitability to
industry-standard levels. HIG shares are trading below the peer
average for P/E and price/book; however, the price/book
multiple is high by historical standards and the earnings
outlook is weak; as such, we believe that a HOLD rating
remains appropriate.
In 2019, management expects underwriting margins and
earnings in P&C to improve. Assuming lower catastrophe
losses, management expects Personal Lines to improve, but
looks for underlying margins to face modest pressure in the
workers' compensation business. Lastly, it expects the Group
Benefits core earnings margin to be down slightly from 2018
due to lower limited partnership returns.
HIG's strategic priorities include maintaining core ROE
well above its cost of equity capital. Operational goals include
expanding product capabilities and deepening distribution
relationships. In Commercial Lines, a top priority for 2019 is
the integration of the recently acquired Navigators Group
business.
HIG has been rumored as a potential buyout candidate
given its small size and below-industry-average profitability.
However, even as a takeover target, we do not expect it to
command a significantly higher valuation.
RECENT DEVELOPMENTS
HIG shares have outperformed the broad market over the
past three months, rising 11% compared to a 4% gain for the
S&P 500. The shares have also outperformed over the past
year, rising 22% versus a 4% gain for the index. The beta on
HIG is 0.95, above the peer average of 0.85.
 GROWTH / VALUE STOCKS
On August 1, Hartford reported 2Q19 core earnings of
$485 million, up 18% from the prior year, driven by better
results in the Personal Lines, Group Benefits, and Corporate
segments. Core EPS rose 18% to $1.33, above our estimate of
$1.21 and the consensus estimate of $1.14. On a GAAP basis,
net income declined 36% to $372 million, or $1.02 per share,
due to charges related to its acquisition of Navigators, a
specialty underwriter.
Revenue rose 6% to $5.1 billion, above both our estimate
and the consensus forecast of $5.0 billion. Book value at the
end of 2Q19 was $41.00 per share, up 19% from the prior
year, reflecting higher net income. The operating margin
narrowed to 10.2% in 2Q from 12.8% a year earlier due to
higher expenses.
Net investment income rose 14% to $488 million, driven
by higher assets under management and alternative investment
returns. The annualized yield was 4.2%.
On May 23, the company completed its acquisition of The
Navigators Group, a specialty underwriter, for $70 per share or
$2.1 billion in cash. Management projects annual core
earnings from this business of about $200 million within 4-5
years.
In 2Q18, Hartford sold Talcott Resolution, its life and
annuity business, to a group of investors, including Atlas
Merchant Capital, a private equity firm, for $2.05 billion. The
payment consisted of $1.4 billion in cash, a 9.7% interest in
the new company, transferred debt, and a pre-closing dividend.
In November 2017, Hartford acquired Aetna's group life
and disability business for $1.45 billion. The deal should be
accretive to EPS, though it may be dilutive in the near term.
When the deal was announced in October 2017, CEO Chris
Swift said the company would suspend buybacks, and that
Talcott Resolution would pay $800 million in dividends to
help fund the purchase. (The company has since reinstated its
repurchase program.) HIG shares fell about 5% following the
announcement on concerns that the acquisition would make
Hartford a less attractive buyout candidate. On the positive
side, the deal makes sense as part of the company's effort to
focus more on group benefits and P&C insurance and less on
market-related investments.
EARNINGS & GROWTH ANALYSIS
Hartford has taken steps in recent years to strengthen its
balance sheet, reduce risk and improve returns in its business.
These steps have included asset sales and restructuring.
Hartford organizes its operations into five segments:
Commercial Lines, Personal Lines, P&C Other Operations,
which are all part of the Property and Casualty business,
Group Benefits, and Hartford Funds, its mutual fund business.
Section 2.18
We summarize key second-quarter business trends and
outlooks for the divisions below.
Commercial Lines. This segment, which accounts for a
majority of Hartford's operating earnings, reported $304
million in 2Q core earnings, down from $341 million a year
earlier due to higher property and Small Commercial workers'
compensation losses. Written premiums were up 20% to $2.1
billion, aided by new business across its Small, Medium &
Large, and Specialty subsegments. The underlying combined
ratio worsened by 3.2 points from 2Q18 to 93.2, hurt by higher
loss and expense ratios. Middle market is a competitive part of
the business, and we expect to see Hartford generate
mid-single-digit growth over time. The Commercial Lines
underlying combined ratio is expected to be 91.0-93.0 in 2019,
compared to 91.5 in 2018, reflecting modest pressure on
workers' compensation from reduced premium rates. For
2H19, the ratio is expected to be in a range of 92.0-94.0 -
worse than the initial full-year outlook.
Personal Lines. This segment, which includes car and
home insurance, saw core earnings rise to $55 million from $2
million due to lower catastrophe losses and less unfavorable
reserve development. Written premiums fell 4%, to $824
million, mainly due to lower auto premium retention. The
underlying combined ratio worsened by 0.6 points from the
prior year to 89.1, reflecting higher expenses. Management has
sought to improve profitability in this segment, particularly in
homeowners, and has made progress in recent years. Auto
insurance remains challenging, as accident frequency and
bodily injury claims are at ten-year highs, partly due to texting
while driving. Management is working to address this
weakness through price hikes and underwriting initiatives.
Looking ahead, we expect mid-single-digit growth in core
earnings over the next year, likely driven by underwriting
improvements rather than sales growth. Management expects a
Personal Lines underlying combined ratio of 91.0-93.0 in
2019, versus 91.5 in 2018, with strong auto insurance results
and new business growth in both auto and homeowners.
P&C Other Operations. This segment includes P&C
operations that have discontinued writing new business and
asbestos and environmental exposures. The segment's core
earnings were $8 million in 2Q19, compared to $3 million in
2Q18.
Group Benefits. This segment reported core earnings of
$115 million, up from $104 million a year earlier. The
increase reflected better disability results and higher net
investment income. Earned premiums rose 2% to $1.4 billion.
The loss ratio decreased 0.9 points from the prior year to
74.6%, with improvement in disability insurance. The expense
ratio was unchanged at 23.9%, due to expense synergies from
acquisitions offsetting technology investments and higher
commissions paid. Although this business faces intense
competition, we expect results to improve modestly over time
 GROWTH / VALUE STOCKS
with help from rising employment. Management expects a
Group Benefits core earnings margin of 6.0%-7.0% in 2019,
versus 7.0% in 2018.
Hartford Funds. This segment reported 2Q core earnings
of $38 million, flat with 2Q18. Net outflows totaled $105
million. Mutual Fund AUM was $121.3 billion at quarter-end.
We expect a mid-single-digit increase in core earnings in this
group over the next 12 months.
To generate our EPS estimates for the insurance industry,
we focus on returns on equity. In 2Q19, Hartford's core ROE
for the trailing four quarters was 11.7%, up from 8.4% a year
earlier and above the industry median of 8.8%. Management's
goals include sustaining core ROE well above the company's
cost of capital.
We are raising our 2019 EPS estimate to $5.28 from
$5.13 and our 2020 forecast to $5.52 from $5.51. Results for
the second quarter beat our estimate and the profit margin is
expanding. Our long-term EPS growth rate forecast is 8%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Hartford is Medium,
raised from Medium-Low. The company achieves mixed
scores on our three main measures of financial strength:
leverage based on debt-to-capital, interest coverage, and
profitability. The debt-to-capital ratio was 24% at the end of
2Q19, in line with peers. Operating income in 2Q19 covered
interest expense by a factor of 7.9, below the peer median of
12.6. The second-quarter adjusted profit margin was 9.5%, up
from 8.6% in 2Q18 and above the 8.2% median for peers.
Hartford pays a quarterly dividend of $0.30 per share, or
$1.20 annually, for a yield of about 2.0% - slightly below the
2.1% peer median. Over the past five years, the company has
raised the dividend at a compound annual rate of 13.8%. Our
dividend estimates are $1.20 for 2019, lowered from $1.21,
and $1.28 for 2020, raised from $1.26.
During the quarter, the company repurchased 500,000
shares for $27 million, the first purchases under its new $1.0
billion authorization, which will run through December 2020.
HIG expects most of the authorization to be used in 2020.
MANAGEMENT & RISKS
Christopher Swift became Hartford's CEO in 2014 after
previously serving as CFO. We expect Mr. Swift to continue
the company's restructuring.
Hartford faces macroeconomic risks related to the impact
of slow economic growth and volatile equity markets on the
company's balance sheet, capital levels, interest rates, credit
ratings, revenues and income.
COMPANY DESCRIPTION
Hartford Financial Services Group Inc., is a leading
Section 2.19
property and casualty insurance company. The company
distributes its insurance products and other financial services
through independent agencies. The shares are a component of
the S&P 500.
VALUATION
We view HIG shares as fairly valued at current prices near
$61. Over the past 52 weeks, the shares have traded in a range
of $41-$61. The current price/book multiple of 1.5 is at the
high end of the five-year historical range of 0.8-1.5, but below
the peer median of 1.6. On P/E, the stock trades at 10.4-times
our forward four-quarter EPS estimate, below the midpoint of
the five-year range of 8.9-18.0 and below the peer median of
13.4. We believe that lower multiples are warranted given
HIG's below-peer-average earnings growth and ROE over the
past few quarters, and do not expect these metrics to improve
meaningfully over the next 12 months.
We would prefer to see signs of consistently stronger
ROE before returning the stock to our BUY list.
On September 19 at midday, HOLD-rated HIG traded at
$61.06, up $0.24. (Jacob Kilstein, CFA, 9/19/19)
Illumina Inc (ILMN)
Current Rating: BUY Publication Date: 9/25/19
HIGHLIGHTS
*ILMN: Raising target to $340
*Illumina is currently managing a product transition.
Management believes that this multiyear upgrade cycle will
reach its halfway mark by the end of 2019.
*However, the company has recently posted uneven
quarterly results, leading to a 30% drop in the stock from its
July highs.
*We are reiterating our 2019 adjusted EPS estimate of
$6.07, reflecting the company's decelerating sales growth,
shrinking margins, and revised guidance.
*That said, we expect that many of the issues facing
Illumina will be temporary and look for a return to
double-digit earnings growth in 2020. Our 2020 EPS estimate
is $6.89.
ANALYSIS
INVESTMENT THESIS
We are maintaining our BUY rating on Illumina Inc.
(NGS: ILMN) and raising our target price to $340 from $300.
This well-managed company makes integrated systems for
sequencing and analyzing DNA; the company serves genomic
research centers, hospitals, and pharmaceutical and biotech
companies, and its products play a critical role in developing
targeted, genetic-based treatments for a wide range of medical
conditions. While the shares have performed well over the past
five years, they have suffered recently as a series of
sales-related issues have led to uneven quarterly results.
However, with the exception of the weakness in the DTC
 GROWTH / VALUE STOCKS
market (which generates only 13% of revenue), we view these
issues as temporary, and expect that population genomics
programs will return to growth in the coming quarters.
Meanwhile, Illumina continues to invest in its platform,
lowering the barriers to entry for smaller labs while increasing
the functionality of its products. It has also agreed to acquire
Pacific Biosciences. This acquisition would extend Illumina's
reach beyond its current short-read sequencing platforms and
into long-reads, which are better suited for certain functions.
RECENT DEVELOPMENTS
ILMN shares have underperformed over the past quarter,
falling 14.5% while the S&P 500 has gained 1.6%. They have
also underperformed over the past year, falling 14.6% versus a
gain of 2.5% for the S&P 500. Over the past two years, the
shares have gained 53.5% compared to an 18.8% increase for
the index and a 12.5% gain for the industry ETF IYH. Over
the past five years, the shares have gained 87% compared to
the market's 52% and IYH's 43% returns. The beta on ILMN is
1.33.
Illumina reported second-quarter results that beat both the
earnings and revenue consensus, although the consensus had
fallen following the company's preliminary results a few weeks
earlier. On July 29, ILMN reported 2Q19 adjusted net income
of $200 million or $1.35 per diluted share, down from $212
million or $1.43 per share a year earlier. Adjusted EPS topped
the consensus by $0.01. Revenue rose just 1% from the prior
year to $838 million, reflecting the timing of population
genomics initiatives, lower-than-expected DTC revenue, and
lower-than-expected revenue associated with its
non-high-throughput portfolio, all consistent with the
preliminary earnings announcement. Revenue topped the
consensus forecast by $2.9 million. The adjusted gross margin,
which excludes the amortization of acquired intangible assets,
fell 80 basis points to 70.2%. The adjusted operating margin
fell 60 basis points to 26.6%. The adjusted profit margin was
23.9%, down from 25.2% in 2Q18. The company reduced its
SG&A spending, excluding acquisition-related expenses, to
23.1% of revenue from 23.7%, and expects to further reduce
spending over the remainder of the year. Nevertheless, R&D
expenses as a percentage of revenue rose to 19.8% in 2Q19
from 18.2% in 2Q18.
Along with the results, management updated its 2019
guidance. The company now expects GAAP EPS of
$6.41-$6.51 and non-GAAP EPS of $6.00-$6.10. It also
expects revenue growth of 6%, largely due to lower near-term
expectations in DTC, the company's performance in 1H19, and
caution regarding the ramp-up of certain population genomics
initiatives. Management noted that its guidance excludes any
impact from the pending $1.2 billion acquisition of Pacific
Biosciences, which it expects to complete in 4Q19. Pacific is a
medical device company focused on long-read sequencing
technologies. While most sequencing work relies on short-read
platforms, such as Illumina's current devices, certain
Section 2.20
applications are better addressed with long-reads. We believe
that Illumina could gain a significant market opportunity if the
acquisition is successful, although margins would likely be
hurt by integration costs in the near term.
Illumina is currently managing a product transition. Its
top-of-the-line machines have been the HiSeq X and HiSeq
Series. However, in recent years, it has also launched less
expensive desktop-sized products - MiniSeq, MiSeq iSeq, and
NextSeq - that have been popular with users, as well as a more
advanced option, the NovaSeq. Management expects that
about half of its original HiSeq customer base will have either
started or completed their conversion by the end of the year,
although sales have experienced lumpiness due to the timing of
certain purchases. During the second quarter, the average
selling price of the NovaSeq decreased due to several
multi-unit orders and the company's HiSeq trade-in program,
but shipment volumes exceeded expectations. We expect the
average selling price to recover in the coming quarters. The
company also achieved record sales of its NextSeq Dx systems
in 2Q.
In addition to introducing new sequencing machines,
Illumina has developed flow cells for different output levels:
the low output SP and S1 flow cells, the medium output S2,
and the high output S4. The company most recently launched
its S Prime (SP) flow cell, which can deliver up to 250 GB of
data, or up to 1.6 billion reads, enabling smaller batch sizes
and lower output sequencing methods on the NovaSeq System.
During the second quarter, shipments of the S Prime flow cell
more than doubled from 1Q19, which offset lower pricing on
S1 and S2 flow cells. Management expects the new flow cells
and pricing adjustments to accelerate the transition to its
NovaSeq sequencer. Regarding its S4 flow cell, shipments
exceeded $100 million for the first time in 2Q19.
The company also recently released the TruSight
Oncology 500 (TSO 500) genomic profiling assay, which is
intended to complement the lab services offered by Illumina's
partners. The TSO 500 enables the comprehensive detection of
known and novel fusions associated with a range of cancers as
it is able to detect both DNA and RNA variances. The
company has partnered with three pharma companies to
develop a companion diagnostic for indications associated
with certain fusions. Management expects additional partners
to leverage the system over time.
On April 25, 2019, Illumina deconsolidated its interests in
Helix, a population and consumer genomics company. As a
result, Illumina no longer holds equity or board participation in
Helix. Nevertheless, expenses related to Helix were incurred in
April before the deconsolidation was complete and have been
included in the second-quarter results.
EARNINGS & GROWTH ANALYSIS
Illumina provides genetic sequencing and analysis for
 GROWTH / VALUE STOCKS
genomic research centers, government laboratories, hospitals,
and pharmaceutical and biotech companies. Its machines are
large and expensive, and earn revenue based on their usage.
The company has two business segments: Product (84%
of 2Q sales) and Service and Other (16%). Product revenue
rose 4.6% to $704 million in 2Q19. Within the Product
segment, second-quarter consumable revenue rose 4.8%
year-over-year to $571 million, while instrument revenue rose
3.9% to $133 million. Consumable revenue was driven by an
8% increase in sequencing consumables (to $497 million),
partially offset by a 13% decrease in microarray consumables
(to $74 million). Instrument revenue reflected a 4% increase in
sequencing instruments (to $129 million) and flat sales of
microarray instruments (at $4 million). Service and Other
revenue fell 14.6% to $134 million, driven by a 37% decrease
in revenue from array services (to $32 million) and a 4%
decrease in sequencing services (to $102 million).
Illumina reports results for four geographic regions:
Americas (57% of 2Q19 sales), Europe, Middle East, & Africa
(EMEA) (25%), Greater China (12%), and Asia-Pacific (7%).
In 2Q19, Illumina grew Americas sales by 2.1% to $476
million, EMEA sales by 3.0% to $208 million, and
Asia-Pacific sales by 3.6% to $57 million; sales in Greater
China fell by 9.3% to $97 million, primarily due to the effects
of tariffs.
Turning to our estimates, we are reiterating our 2019
adjusted EPS estimate of $6.07, reflecting the company's
decelerating sales growth, shrinking margins, and revised
guidance. That said, we expect that many of the issues facing
Illumina will be temporary and look for a return to
double-digit earnings growth in 2020. Our 2020 estimate is
$6.89. Our five-year earnings growth rate forecast is 13%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on ILMN is Medium-High,
the second-highest point on our five-point scale. The company
receives average to above-average marks on our three main
financial strength criteria: fixed-cost coverage, debt levels, and
profitability.
At the end of the second quarter, Illumina had cash, cash
equivalents, and short-term investments of $3.17 billion, down
from $3.51 billion at the end of 2018. Total debt was $1.86
billion, down from $2.00 billion at the end of 2018, and
accounted for 30% of total capital, down from 34% at the end
of the prior-year period and below the peer average of 41%.
We view average levels as 50%-55%. Operating income of
$205 million was down 9.7% and covered interest expense by
a factor of 13.7, down from 20.6 in 2Q18; our view of an
average interest coverage ratio is in the range of 10-12. The
adjusted profit margin was 23.9%, down from 25.5% in the
prior-year period. Operating cash flow of $143 million was
down 51.5%, while free cash flow of $96 million was down
Section 2.21
56% from the prior-year period. Inventory rose 8.8% from the
end of 2018, to $420 million.
Illumina has a share repurchase program, but did not
repurchase any shares during the second quarter. As of June
30, 2019, the company had $488 million available for
repurchases on its 1Q19 buyback authorization.
The company does not pay a dividend.
MANAGEMENT & RISKS
Francis deSouza became Illumina's CEO in July 2016.
Mr. deSouza joined the company in 2013 as president. He
previously held senior positions at Symantec, IMlogic and
Microsoft. The former CEO, Jay Flatley, is now the company's
executive chairman. Sam Samad became the CFO in 2017. He
previously served as treasurer of Cardinal Health, CFO of
Cardinal Health's pharmaceutical segment, and CFO of the
Canadian affiliate of Eli Lilly. Susan E. Siegel joined the
company's board in February 2019. Ms. Siegel currently serves
as the chief innovation officer at General Electric (GE).
Investors in ILMN shares face regulatory and competitive
risks, including the risk that Illumina products and services
could be displaced by stronger or more cost-effective
technology. The stock also trades at high valuation multiples,
reflecting the company's strong growth and investors' lofty
expectations. This makes the stock susceptible to selloffs on
disappointing earnings reports or other negative news, as was
seen following the release of the company's preliminary
second-quarter results.
COMPANY DESCRIPTION
Illumina Inc., based in San Diego, provides sequencing
and array-based solutions for genetic analysis. The company's
products and services are sold to genomic research centers,
academic institutions, government and commercial
laboratories, and hospitals, as well as to pharmaceutical,
biotech, agrigenomics, and consumer genomics businesses.
The company's portfolio of products and services are
designed to accelerate and simplify genetic analysis. The
company also invests in early-stage companies that are
pursuing promising genomic-related opportunities. ILMN
shares are included in the S&P 500 index.
VALUATION
ILMN shares have traded between $263 and $381 over
the past 52 weeks, and are currently below the midpoint of this
range. On a technical basis, after a strong run from the end of
January 2019 to early July 2019, in which the stock advanced
nearly 40%, the price plummeted following the release of
preliminary second-quarter results. Falling about 30% to a low
of $263.30 on September 10, the stock reached an
upward-sloping support line that it has bounced up from on
three other occasions since 2005, notably in March 2005,
December 2011, and December 2016. In each of these cases,
 GROWTH / VALUE STOCKS
despite a preceding sharp decline, ILMN has recovered
impressively, with double-digit growth in subsequent months.
In this case, the stock has now risen about 15% in the roughly
two weeks since reaching its low. Given the strong recovery,
and the fact that the relative strength index is only around 61,
we expect the stock to post additional gains.
To value the stock on a fundamental basis, we use peer
and historical multiple comparisons. At current prices, the
shares are trading at 50.4-times our 2019 EPS estimate, below
the company's historical average of 52.6 but well above the
average of 33.5 for life science equipment companies such as
BDX, TMO, and WAT; the shares are also trading at
13.2-times sales, above the peer average of 7.1. Our revised
target price of $340, raised from $300, assumes a P/E of
56.0-times projected 2019 earnings, above its historical
average, but appropriate, in our view, for a high-growth
company at this stage of its product replacement cycle.
On September 24, BUY-rated ILMN closed at $295.28,
down $10.55. (Jasper Hellweg 9/24/19)
Jabil Inc (JBL)
Current Rating: BUY Publication Date: 9/25/19
HIGHLIGHTS
*JBL: Tops consensus; positive outlook; raising target to
$40
*Jabil delivered above-consensus fiscal 4Q19 core EPS. It
also guided for mid-teens EPS growth in FY20 based on
margin expansion and single-digit revenue growth.
*Apple, Jabil's largest customer, is selling the new iPhone
11 at a popular price point. We believe that could help
mitigate anticipated unit declines and related margin
contraction.
*Although mobility and digital lifestyle revenue could
decrease $700 million in FY20, Jabil expects an additional
$800 million in healthcare and packaging revenue, partly
reflecting the JJMD partnership.
*We are reiterating our BUY rating on JBL and raising
our 12-month target price to $40 from $36.
ANALYSIS
INVESTMENT THESIS
BUY-rated Jabil Inc. (NYSE: JBL) rallied by 5% on
9/24/19 in a down market after delivering above-consensus
core EPS for fiscal 4Q19. The company also offered a positive
outlook for the August 2020 fiscal year, which implies
mid-teens EPS growth on margin expansion and single-digit
revenue growth.
Jabil is best known to technology investors for making
casings for the iPhone; it also makes components for some of
Apple's wearables, including the hugely popular Air Pods. JBL
fell hard between September and December 2018 after last
year's iPhone lineup was greeted with a 'meh.' This year, with
Section 2.22
the iPhone maker perceived to be in a holding pattern ahead of
next year's 5G launch, Apple is selling the iPhone 11 at a
popular price point. We believe that this could drive unit
growth.
The DMS business showed little to no growth in FY19
and will face continued challenges in FY20. Management
expects excess capacity in mobility and end-of-life for some
digital lifestyle products to shave $700 million from FY20
revenue. But Jabil will more than make up for that with an
additional $800 million in healthcare and packaging revenue.
An expanded relationship with Johnson & Johnson Medical
Devices could add up to $1 billion in FY20 revenue.
Jabil has set a three-year framework for growth in
revenue, core EPS and cash flow from operations. This
outlook, in our view, signals continued growth for key
customer Apple, along with ongoing strength in healthcare,
packaging and the Greenpoint business within DMS; and
continued outperformance in EMS. We look for mobility to
roar back when 5G goes mainstream in the next 1-2 years,
beginning with the September 2020 smartphone cycle.
JBL shares, which appear attractively valued in the low
$30s, trade at a discount on comparable historical valuations.
The stock also trades at discounts to the peer group, even as
growth prospects remain strong. Incorporating DFCF
valuation, our blended model for JBL indicates a fair value in
the high $40s, in a rising trend and well above current prices.
We are reiterating our BUY rating on JBL and raising our
12-month target price to $40 from $36.
RECENT DEVELOPMENTS
JBL is up 28% year-to-date in 2019, versus 20% for peers
(excluding CLS, peers are up 33%). JBL shares declined 6%
in 2018, compared to a 27% decline for the peer group of
contract manufacturers in Argus coverage. JBL rose 11% in
2017, ahead of the 4% average gain for peers, though lagging
the 19% gain for the S&P 500. JBL shares rose just 2% in
2016, compared to a 29% gain for peers and an 11% gain for
the S&P 500. Jabil rose 7% in 2015 and 25% in 2014.
For fiscal 4Q19 (ended August 31, 2019), Jabil reported
revenue of $6.57 billion, which was up 14% year-over-year
and 7% sequentially. Revenue was just below the $6.6 billion
midpoint of management's $6.3-$6.9 billion guidance range
and below the $6.61 billion consensus forecast. Non-GAAP or
'core' earnings totaled $0.88 per diluted share in 4Q19, up 26%
from $0.70 a year earlier and up $0.31 sequentially. Fiscal
4Q19 EPS topped the $0.86 midpoint of management's
typically wide guidance range of $0.76-$0.96, and also beat
the consensus forecast of $0.86.
Jabil wrapped up a successful FY19 in which revenue of
$25.3 billion increased 14% and non-GAAP EPS of $2.98 also
rose 14%. Back in FY15-FY16, Jabil's diversified
 GROWTH / VALUE STOCKS
manufacturing services (DMS) business averaged 40% growth,
while electronic manufacturing services (EMS) was flat for
both years. In FY17-FY18, DMS averaged mid-teens growth,
while EMS grew in the mid-single digits.
Dial forward to the present, and in FY19 DMS was flat,
while EMS grew 27%. Growth momentum has shifted to EMS,
and on a preliminary basis management looks for that pattern
to persist in FY20. In broad strokes, management is looking
for DMS revenue to grow 1%-2% in FY20 and EMS to grow
3%-5%. Overall, the company is forecasting low single-digit
revenue growth in FY20.
At the same time, Jabil is generating higher cash flows on
a richer business mix. Fiscal 2019 cash flow from operations
totaled $1.2 billion, versus an adjusted $1.0 billion in FY18
(GAAP cash use from operations of $1.1 billion in FY18); and
adjusted free cash flow was $500 million in FY19.
Management is guiding for further growth in adjusted free cash
flow in FY20 based on earnings expansion, working capital
efficiencies, and disciplined investment.
The company believes it can translate its higher
value-added business mix into higher core operating margins.
In FY19, the core operating margin of 3.5% was flat with
FY18. Management is targeting a core operating margin of
3.7% for FY20 and 4.0% for FY21.
Jabil earned $2.98 on a core or non-GAAP basis in FY19.
Given expectations for modest single-digit top-line growth in
both years along with margin expansion, Jabil is guiding for
non-GAAP EPS of $3.45 for FY20 and $4.00 for FY21. The
company thus sees significant operating leverage in its
business mix.
To translate low to mid-single-digit revenue growth into
mid-teens EPS growth, as its forecasts imply, Jabil expects
growth in certain key markets. Specifically, Jabil expects the
long-lagging semiconductor capital equipment end-market to
normalize in the summer of calendar 2020, assuming recovery
in memory end-market demand. Jabil also looks for an
increase in mobility volumes in fiscal 2021, driven by the
widespread availability of 5G devices. Additionally, Jabil
expects to sustain recent strong trends in healthcare and
packaging, including double-digit growth in those end markets.
The semi cap equipment, mobile device, and healthcare
and packaging segments are all within the DMS business.
DMS margins have slipped in recent years, from 4%-5% in
FY15-FY16, to the 3% range in FY17-FY18. DMS margins
improved to 4% in FY19, but that mainly reflected early-year
strength; 2H19 DMS margins were below 3%. End-market
recoveries in all those segments would permit better overhead
absorption and also imply a richer business mix, leading to
DMS core operating margin expansion.
Section 2.23
For the combined company including DMS and EMS,
Jabil's is not assuming any material contribution from M&A;
we do not look for Jabil to be major asset acquirer, but
complementary acquisitions are a possibility. Jabil is also
assuming a stable economic environment as a prerequisite for
hitting its top-line, margin, EPS and cash flow goals.
For fiscal 4Q19, Electronic Manufacturing Services
(EMS) revenue of $4.14 billion (63% of total revenue) rose
24% annually and 4% sequentially. The EMS margin of 4.3%
improved 100 basis points sequentially while dipping from
4.4% a year earlier. Strength in EMS was widespread, with
good growth coming from the 5G wireless & cloud, energy,
and automotive end markets.
Full-year FY19 EMS revenue of $15.5 billion rose 27%
from the prior year; core operating income of $482 million
increased 8% annually; and the FY19 EMS margin of 3.1%
declined from 3.7% a year earlier.
FY19 EMS revenue growth exceeded early-year
expectations. According to the CFO, Jabil's value proposition
has been well received in the areas of 5G wireless & cloud,
energy, and retail infrastructure. EMS margin weakness in
FY19 relative to FY18 primarily reflected costs related to
accelerated new business ramps, along with ongoing softness
in the semiconductor capital equipment market.
Diversified Manufacturing Services revenue of $2.43
billion (37% of total) was up 2% year-over-year and 13%
sequentially at the beginning of the seasonally strong period
for mobility. Within DMS, growth was mainly attributable to
ongoing strength in healthcare and packaging. The DMS
margin of 2.9% improved 30 basis points sequentially and 20
basis points from the prior year.
Full-year FY19 DMS revenue of $9.9 billion was
consistent with the prior year; core operating income of $395
million increased 25% annually; and the FY19 DMS margin
was 4.0% versus 3.9% a year earlier.
Even as the DMS business works to reduce its reliance on
mobile device unit sales, Apple remains the largest single
customer by far. Apple accounted for 28% of Jabil's FY18
revenue, or $6.2 billion, versus 24% of total sales in FY17 and
FY16; we assume that the Apple contribution in FY19 was
little changed from FY18.
Jabil makes casings for the iPhone along with components
for Apple's hugely popular Air Pods. Between September and
December 2018, JBL shares fell from $30 to $21 after last
year's iPhone lineup generated weak unit sales.
For fall 2019, Apple is offering its basic iPhone 11 model
at $699; that is $50 below a comparable Samsung Galaxy S10
and about $300 lower than iPhone 10S a year ago. We believe
 GROWTH / VALUE STOCKS
this popular pricing strategy could drive unit growth. That
would benefit Jabil's DMS business, which showed little
growth in FY19.
In a highly positive sign for both JBL and AAPL
investors, CFO Mike Dastoor stated that 'the seasonal launch
within our mobility business which began in fiscal 4Q19 is
going extremely well.' The mobility team's strong execution
throughout the year, focus on supporting its key customer, and
tight cost management have all contributed to a strong
customer relationship.
Apple, like all handset makers, is really banking on the
fall 2020 season, when all mobile device makers are expected
to roll out full rosters of 5G phones. At present, with 5G
device ubiquity still a year away, Jabil believes that the overall
mobility supply chain is 'over-capacitied' for current and
near-future demand. Mobility margins improved in FY19 but
remain a constraint on overall DMS margins.
On that basis, Jabil is taking steps to proactively 'optimize'
its manufacturing footprint. Reduction in mobility capacity
should enable Jabil to more efficiently utilize fixed assets and
normalize its cost structure. Noncore expenses associated with
these optimization efforts are expected to be $85 million.
Overall in FY20, Jabil expects mobility and lifestyle
revenue to decline by about $700 million. The company
intends to more than replace that
revenue with $800 million in additional healthcare and
packaging revenue. Jabil has significantly enhanced its
relationship with Johnson & Johnson, specifically with the J&J
Medical Devices (JJMD) business. Revenues from this
relationship remains on target to reach $800 million-$1.0
billion in FY20, according to CEO Mark Mondello.
Jabil has set a three-year framework for growth in
revenue, core EPS and cash flow from operations. This
outlook, in our view, signals continued growth for key
customer Apple along with ongoing strength in healthcare,
packaging and the Greenpoint business within DMS; and
continued outperformance in EMS. We look for mobility to
roar back when 5G goes mainstream in the next 1-2 years,
beginning with the September 2020 smartphone cycle.
EARNINGS & GROWTH ANALYSIS
For fiscal 4Q19 (ended August 31, 2019), Jabil reported
revenue of $6.57 billion, which was up 14% year-over-year
and 7% sequentially. Revenue was just below the $6.6 billion
midpoint of management's $6.3-$6.9 billion guidance range
and below the $6.61 billion consensus forecast.
The gross margin expanded sequentially to 7.5% in fiscal
4Q19 from 7.2% in fiscal 3Q19 but was down from 7.7% a
year earlier. The core or non-GAAP operating margin was
3.7% in 4Q19, up from 3.0% in fiscal 3Q19 and flat with the
Section 2.24
prior year.
Non-GAAP earnings totaled $0.88 per diluted share in
4Q19, up 26% from $0.70 a year earlier and up $0.31
sequentially. Fiscal 4Q19 EPS topped the $0.86 midpoint of
management's typically wide guidance range of $0.76-$0.96,
and also beat the consensus forecast of $0.86.
For all of FY19, Jabil generated revenue of $25.3 billion,
up 14% from $22.1 billion in FY18. On an adjusted basis,
FY19 non-GAAP core earnings came to $2.98 per diluted
share, up 14% from $2.61 in FY18.
For fiscal 1Q20, a seasonally strong quarter, Jabil projects
revenue of $6.65-$7.35 billion; at the $7.0 billion midpoint,
revenue would be up about 8% annually. Core or non-GAAP
EPS for 1Q20 was forecast at $0.82-$1.04; at the $0.93
midpoint, core EPS would be up 4%.
For fiscal 2020, Jabil guided for revenue of approximately
$26 billion and non-GAAP EPS of $3.45. The prereporting
consensus called for revenue of $26.4 billion and non-GAAP
EPS of $3.40.
We are raising our FY20 earnings forecast to $3.54 per
diluted share from $3.50. We are also establishing an FY21
forecast of $4.12. Our long-term EPS growth rate forecast for
Jabil is 10%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating for Jabil is Medium-High, the
second-highest rank on our five-point scale. The company has
stepped up shareholder returns, launching an aggressive
buyback in fiscal 1Q19 and carrying it forward in 2Q19 and
3Q19.
Cash & equivalents were $1.19 billion at the end of 4Q19.
Cash & equivalents were $1.26 billion at the end of FY18,
$1.19 billion at the end of FY17, $912 million at the end of
FY16, and $914 million at the end of FY15.
Debt was $2.56 billion at the end of 4Q19. During fiscal
2Q18, Jabil improved its capital structure with the refinancing
of 10-year senior notes at a more favorable interest rate while
pushing out maturities. Debt was $2.52 billion at the end of
FY18, $2.08 billion at the end of FY17, $2.12 billion at the
end of FY16, and $1.67 billion at the end of FY15.
Jabil generated cash flow from operations of $1.19 billion
in FY19. Cash flow from operations was $1.10 billion
(adjusted) in FY18, $1.26 billion in FY17, $916 million in
FY16, and $1.24 billion in FY15.
Capital spending in FY19 was $1.0 billion versus $800
million in FY18. Jabil's capital spending moderated to $717
million in FY17 from $924 million in FY16 and $963 million
 GROWTH / VALUE STOCKS
in FY15.
Under its capital allocation framework, Jabil intends to
return 60% of free cash flow to shareholders via buybacks and
dividends. Since fiscal 2016, Jabil has returned over $1.4
billion to shareholders, primarily via buybacks. The share base
has been reduced from 193 million outstanding in FY16 to 155
million as of the end of FY19.
In terms of shareholder returns, the board is prioritizing
buybacks over dividend hikes. Jabil has not raised its dividend
since October 2011, when it boosted the quarterly payout by
14% to $0.08. Our dividend estimates are $0.32 for both FY20
and FY21.
MANAGEMENT & RISKS
Mark Mondello has been CEO since 2013. Bill Peters is
president. Longtime CFO Forbes Alexander has retired and
has been succeeded by company insider Michael Dastoor.
Former CEO Tim Main became chairman in January 2013,
replacing William Morean (the son of the founder). Chairman
Main was the architect of Jabil's extensive transition.
The turbulence with top DMS customer Apple
underscores the current turbulence in the mobile device
category, as well as the cost of the company's heavy reliance
on one customer. We believe this relationship remains strong,
and we expect Apple to remain an important and profitable
customer. However, Jabil also needs to accelerate efforts to
diversify its revenue base.
Another risk is that Jabil will be unable to improve its
operating metrics to match past performance. However,
because the company has experienced substantial growth as a
result of business development and new contract wins, we are
confident that, over time, management can restore margins.
COMPANY DESCRIPTION
St. Petersburg, Florida-based Jabil Circuit is a top-tier
global player in the Electronic Manufacturing Services (EMS)
industry. By segment, approximately 60% of total revenue is
derived from the Electronics Manufacturing Services (EMS)
segment and 40% from the Diversified Manufacturing Services
(DMS) segment. The additions of Green Point and Nypro
increased the size of the DMS business and added vertical
manufacturing capabilities.
INDUSTRY
Our rating on the Technology sector is Over-Weight, as
we see value in Tech stocks following the late 2018 selloff.
Over the long term, we expect the Tech sector to benefit
from pervasive digitization across the economy, greater
acceptance of transformative technologies, and the
development of the Internet of Things (IoT). Healthy company
and sector fundamentals are also positive. For individual
companies, these include high cash levels, low debt, and broad
Section 2.25
international business exposure.
The shift of social media platforms and digital information
companies such as Facebook and Alphabet into
Communication Services will moderately impact sector
characteristics. In general, the removal of those giants slightly
reduces the EPS growth outlook, reduces sector-weighted beta;
and raises sector-weighted dividend yield.
The sector is outperforming the market thus far in 2019,
with a gain of 28.0%. It outperformed the S&P 500 in 2018,
with a loss of 1.6%, and in 2017, with a gain of 36.9%.
Fundamentals for the Technology sector look reasonably
balanced. By our calculations, the P/E ratio on projected 2020
earnings is 18.6, above the market multiple of 16.1. Earnings
are expected to grow 15.0% in 2020 and 2.6% in 2019 after
rising 25.9% in 2018. Earnings rose in the low single digits in
2015-2016. The sector's debt ratios are below the market
average, as is the average dividend yield.
VALUATION
JBL shares trade at 8.9-times our FY20 non-GAAP EPS
forecast and at 7.6-times our FY21 projection. The two-year
average P/E for FY20-FY21 of 8.2 is below the trailing
five-year (FY15-19) P/E of 10.7. The shares trade at 51% of
the market multiple, compared to a historical relative P/E of
61%. Overall comparable historical valuation is in the upper
$30s, in a lower trend only because the high-multiple FY14
has dropped off historical comparables.
Despite its superior growth prospects, JBL trades at
discounts to the peer group on absolute P/E, relative P/E and
EV/EBITDA; peer indicated value is around $35, in a rising
trend. Our discounted free cash flow model points to a value in
the upper $50s, in a rising trend. Incorporating historical
comparables, peer-indicated value, and DFCF valuation, our
blended model for JBL indicates fair value in the upper $40s,
in a stable to rising trend and well above current prices.
We believe that Jabil has moved beyond past execution
stumbles and is now positioned for multiple years of
peer-leading top-line growth and margin expansion.
Risk-adjusted appreciation to our 12-month price target of $40
(raised from $36), along with the 1.0% annual yield, now
exceeds our forecast return range for the broad market and is
consistent with a BUY rating.
On September 24, BUY-rated JBL closed at $32.85, up
$1.52. (Jim Kelleher, CFA, 9/24/19)
KLA Corp (KLAC)
Current Rating: BUY Publication Date: 9/20/19
HIGHLIGHTS
*KLAC: Dividend hike and new buyback; raising target to
 GROWTH / VALUE STOCKS
$175
*KLA Corp. has announced a 13% hike in its quarterly
dividend, to $0.85 per share, for a yield of about 2.2%.
*The company has also implemented a new $1 billion
share repurchase program, adding to its existing authorization.
*The company's goals include increasing revenue from an
estimated $5.5 billion in FY20 to $7.0-$7.5 billion by FY23,
and boosting non-GAAP EPS from the current $9.50 range to
$14.50-$15.50 over that span.
*KLAC shares appear attractive on all valuation metrics
and particularly based on our discounted free cash flow model.
ANALYSIS
INVESTMENT THESIS
BUY-rated KLA Corp. (NGS: KLAC), formerly
KLA-Tencor, has announced a 13% hike in its quarterly
dividend, to $0.85 per share. The company has also
implemented a new $1 billion share repurchase program,
adding to its existing authorization.
The company hosted an investor day on September 17 in
which it announced its more shareholder-friendly
capital-allocation plans and laid out its strategy in the wake of
the recently concluded Orbotech acquisition. Orbotech extends
KLA's reach in the global electronics value chain, according to
CEO Rick Wallace, and will contribute to KLA's ability to
execute its profitable growth strategy. The company's goals
include increasing revenue from an estimated $5.5 billion in
FY20 to $7.0-$7.5 billion by FY23, and boosting non-GAAP
EPS from the current $9.50 range to $14.50-$15.50 over that
span.
Orbotech Ltd. is a maker of printed circuit boards,
flat-panel display packaging, and semiconductor
manufacturing tools. Orbotech adds capabilities and customers
in KLA-Tencor's core market of semiconductor fabrication
equipment, while also diversifying KLA into complementary
areas. Based on 4Q19 results, Orbotech provides regional
expansion, while also contributing to end-customer diversity.
KLA reiterated its fiscal 1Q20 guidance, which calls for
revenue of $1.31-$1.39 billion and non-GAAP EPS of
$2.04-$2.34. At the $1.35 billion midpoint, revenue would be
up 7% sequentially and about 20% annually. The top-line
guidance reflects both the Orbotech contribution as well as
organic growth.
KLAC shares appear attractive at current levels. On a
two-year forward average basis, KLAC shares are trading at
discounts to five-year absolute P/E and relative P/E. For the
long-term investor, KLAC appears particularly attractive based
on our discounted free cash flow model. We are reiterating our
BUY rating to a 12-month target price of $175 (raised from
$155).
RECENT DEVELOPMENTS
Section 2.26
KLAC is up 77% in 2019, slightly exceeding the 70%
WFE peer-group gain and well ahead of the 33% rise for
Argus-covered semiconductor companies. KLAC shares
declined 15% in 2018, compared to a 25% decline for the peer
group of Argus-covered semiconductor capital equipment
companies; the peer group includes Applied Materials and
Lam Research. KLAC rose 37% in 2018, trailing gains of 56%
for the peer group, while tracking the 38% gain in the
Philadelphia Semiconductor index. KLAC advanced 13% in
2016.
On 9/17/19, KLA Corp. hosted an investor day featuring
presentations by CEO Rick Wallace, CFO Bren Higgins, and
other senior executives. The headline events of the day were
related to capital allocation rather than operations. But changes
in shareholder returns have been driven by the successful
execution of KLA's growth strategy, as well as by the so-far
smooth integration of the newly acquired Orbotech business.
KLA announced a 13% hike in the quarterly dividend, to
$0.85 per common share from a prior $0.75. At current prices,
the $3.40 annual dividend would provide a yield of about
2.2%. KLA has hiked its dividend for 10 consecutive years.
The board also announced a new authorization to
repurchase up to $1 billion of the company's stock. This is in
addition to the existing share repurchase authorization, which,
according to the company, had $859 million remaining as of
6/30/19.
CEO Rick Wallace, reminiscing about his introduction to
the semiconductor industry 35 year earlier, recalled when the
industry was driven by PC production. Semiconductor demand
has evolved in what the CEO called the data era. He noted that
the rapid evolution of artificial intelligence (AI) reflects lower
costs for AI computing power, partly driven by advances in
semiconductor capability.
Another looming demand driver is 5G mobility. KLA sees
this technology, which the CEO noted provides 'essentially
fiber optic speed over the air,' as having a 5- to 10-year
timeline for driving infrastructure, mobile device, and IoT
investments. In the hyperscale data center space, KLAC is
seeing many large customers designing their own chips.
Particularly for new semiconductor entrants, such as
hyperscale data center operators, these developments all
present new opportunities for KLA's process controls business.
KLA called out another major semiconductor industry growth
opportunity in automotive & transportation, based on
advanced connectivity, safety systems, autonomous driving,
and electrification of the power train.
KLA has traditionally derived 75% of revenue from the
systems business and 25% from services. Most of the
company's business has historically been in the process
 GROWTH / VALUE STOCKS
controls area, in areas in including wafer inspection, metrology
and patterning. A few years ago, KLA's management set a goal
of deriving 20% of revenue from outside process controls.
This desire to broaden the business mix was behind the
Orbotech acquisition.
KLA, which had $1 billion in revenue before adding
Tencor, grew to $4 billion in revenue as KLA-Tencor. With
Orbotech's partial contribution, KLA's fiscal 2019 revenue
reached $4.6 billion; given a full contribution, the Street and
Argus are modeling fiscal 2020 revenue in the $5.5 billion
range. Non-GAAP earnings, which totaled $8.46 per diluted
share in FY19, are forecast to rise to $9.50 in FY20, based on
Street consensus.
CEO Wallace laid out the company's longer-term growth
objectives. The company believes it can get to $7.0-$7.5
billion in revenue by 2023. KLA has expanded its TAM and
its service addressable market (SAM) by $10 billion with
Orbotech's acquired competencies. Simultaneously, the core
KLA businesses are benefiting from AI, 5G, and increased
semiconductor content in technology and industrial end
markets. Off the higher base, KLA believes it can deliver EPS
of $14.50-$15.50 by 2023.
EVP of Global Products Ahmad Khan began at KLA in
metrology, moved to inspection, and now is responsible for all
process controls. He stated that the factors in KLA's success
are differentiated equipment and tight relationships with
customers. In terms of product differentiation, KLA has moved
away from a role as a systems integrator, in which it buys
components such as lasers off the shelf, integrates the
purchased equipment, and then builds and sells a finished
system.
Instead, KLA has created a dedicated supply chain within
the company. Customers value KLA's precision gear because it
prevents wasted wafer production. EVP Khan offered the
example of company producing 50,000 wafers daily but not
finding out for 60 or 90 days that the chips do not work in the
end product - say, a mobile phone.
KLA makes equipment enabling customers to produce
reticles, which are specialized photomasks, to inspect them
and ensure that they are defect-free. Once the customer's
reticles and photomasks are used to make silicon products,
KLA offers a range of metrology and inspection tools. These
tools span multiple uses, ranging from highly differentiated to
best cost of ownership, depending on the application. Once the
silicon is fully formed, KLA offers packaging tools to integrate
the silicon into chipsets and other components.
Semiconductor capital equipment demand can fluctuate
with semiconductor demand, which in turn is driven by key
markets including memory, logic and foundry. KLA has been
better able than rivals Applied Materials and Lam Research to
Section 2.27
sustain its growth based on several factors. First,
semiconductor are becoming more complex; at the same time,
process nodes (as measured in circuit widths) are getting
smaller. These factors have created more room for failure in
the production process, and thus a higher need for inspection
equipment to reduce wasted wafers.
EVP Ahmad called out the transition from thin flat
transistor to 3D transistors on the device as another driver for
increased inspection gear. Producing chips that have a 3D
rather than a flat array of transistors requires new metrology
and inspection tools in the front end. Additionally, advances in
memory are driving the need for new inspection tools, based
on shrinkage in DRAM and new stacking techniques in
NAND.
KLA believes the systems business can rise from its
current $3.1 billion revenue run rate to about $4 billion by
2023. Although the WFE growth rate could be an impediment,
KLA expects to grow this business by driving 'intensity' in
market share. Important new tools, such as Gen 5 EUV
(extreme ultraviolet lithography), give the company leadership
in EUV qualification and EUV reticle inspection.
The company also has new products coming for advanced
EUV multi-column inspection, for 3 nm and high-resolution
applications. KLA has also developed what it calls the
industry's first X-ray metrology tool, the CD-SAXS, which it
believes will be needed to accurately inspect stacked (3D)
devices. KLA also intends to enter the e-beam market; e-beam
is a kind of inspection that is an alternative to optically based
inspection systems.
One of the structural changes in management at KLA is to
bring the services business up to the level of a CEO report.
SVP & GM of Global Support Services Brian Lorig noted that
services, like the products business, have benefited from the
proliferation of best practices throughout the organization. The
strategy in services is to tailor product-specific offerings to
individual customers, in order to 'get maximum value out of
the asset.' Global services currently generate about $1.3 billion
in annual revenue. KLA is targeting growth to $1.5 billion by
2023.
Acquired in February 2019, Orbotech is a maker of
printed circuit boards, flat-panel display testing fear and
packaging, and semiconductor manufacturing tools. Orbotech
adds capabilities and customers in KLA-Tencor's core market
of semiconductor fabrication equipment, while
also diversifying KLA-Tencor into complementary areas.
KLA believes that it can expand Orbotech's TAM, and
intends to leverage the KLA operating model in Orbotech's
operations. One new SAM being targeted is advanced
packaging, a $1 billion incremental market opportunity.
 GROWTH / VALUE STOCKS
Orbotech, which generated about $900 million ion 2017
revenue, generated approximately $1.0 billion in KLA's fiscal
2019, but contributed for less than half the year. KLA believes
it can grow the Orbotech part of its business to $1.4-$1.5
billion in revenue, based on share gains in existing areas and
new market opportunities.
One key growth opportunity for KLA overall,
management believes, is the automotive and transportation
market. Automotive is the fast-growing industry for
semiconductor demand. Moreover, transportation offers
multiple growth venues, including connectivity, electrification,
and autonomous.
Semiconductors for the transportation industry must be
highly reliable given safety concerns; at the same time, these
devices operate in harsh environments. KLA's goal in this
business is to 'find latent defects before they escape the fab.'
The key message from KLA's investor day is that the
company expects to sustain and expand its leadership in
process controls for semiconductor capital equipment and
wafer front-end equipment. The company is now strengthening
its capital allocation to shareholders based on confidence in
the long-term track record of strong cash flow generation.
EARNINGS & GROWTH ANALYSIS
For fiscal 4Q19 (calendar 2Q19), KLA-Tencor posted
revenue of $1.26 billion, which was up 19% annually and 15%
sequentially, reflecting a first-ever full-quarter Orbotech
contribution. Revenue was toward the top of management's
guidance range of $1.21-$1.29 billion and in line with the
consensus forecast of $1.26 billion.
Reflecting the new asset portfolio of Orbotech, the fiscal
4Q non-GAAP gross margin of 60.0% narrowed from 63.6%
in 2Q19 (no Orbotech); the non-GAAP GM was 64.8% a year
earlier.
The non-GAAP operating margin of 29.5% for 4Q19
narrowed sequentially from 31.6% in 3Q19 and annually from
39.9% a year earlier. Non-GAAP EPS of $1.78 declined 20%
year-over-year and two cents sequentially. Non-GAAP EPS
exceeded the $1.73 consensus call.
For all of FY19, KLAC generated revenue of $4.47
billion, up 13% from $4.04 billion in FY18. Full-year FY19
non-GAAP earnings of $8.49 per diluted share rose 6% from
$8.01 in FY18.
For fiscal 1Q20, KLA is guiding for revenue of
$1.31-$1.39 billion, which at the $1.35 billion midpoint would
be up about 20% annually and 7% sequentially. KLA also
guided for non-GAAP EPS of $2.04-$2.34, which at the $2.19
midpoint would be down 11% year-over-year, reflecting gross
margin and operating margin compression related to the
Section 2.28
Orbotech mix.
Our fiscal 2020 non-GAAP earnings estimate is $9.48 per
diluted share and our fiscal 2021 forecast is $11.14. Our
five-year earnings growth rate forecast is 11%, unchanged
following the Orbotech acquisition.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating for KLAC is Medium-High.
Cash & investments were $1.74 billion at the end of 4Q19
following the Orbotech deal, compared with $2.69 billion at
the end of 2Q19. Cash was $3.06 billion at the end of FY18,
$3.02 billion at the end of FY17, $2.49 billion at the end of
FY16, and $2.39 billion at the end of FY15.
Debt was $3.42 billion at the close of 4Q19, compared
with $2.24 billion at the end of 2Q19. Debt was $2.77 billion
at the end of FY18, $2.68 billion at the end of FY17, $3.06
billion at the end of FY16, and $3.17 billion at the end of
FY15.
Cash flow from operations was $1.23 billion in FY18.
Cash flow from operations was $1.08 billion in FY17, $760
million in FY16, and $606 million in FY15.
In September 2019, the KLA board announced a new
authorization to repurchase up to $1 billion of the company's
stock. This is in addition to the existing share repurchase
authorization, which, according to the company, had $859
million remaining as of 6/30/19.
In September 2019, KLA raised its quarterly dividend by
13%, to $0.85 per share. In June 2018, the company raised its
quarterly dividend by 27% to $0.75 per share. Those increases
follow a 9.3% hike to $0.59 per share in September 2017. In
late December 2014, KLAC declared a special cash dividend
of $16.50 per share. Excluding the special dividend, KLA has
grown its dividend at a 15% compound annual rate since 2007.
Our dividend estimates are $3.40 (reduced from $3.45)
for FY20 and $3.68 (raised from $3.45) for FY21.
MANAGEMENT & RISKS
CEO Rick Wallace has been with KLAC for 29 years,
starting as an applications engineer in 1998 and subsequently
serving in several management positions. Bren Higgins has
been CFO since 2013. He joined KLAC in 1999 and was
previously division controller and VP of Corporate Finance.
Ahmad Khan is EVP of Global Products; as head of process
controls, he may be in line to be the next CEO.
The now completed acquisition of Orbotech carries
numerous risks, including potential misalignment in corporate
culture, and participation in weak-return industries. However,
we believe that the deal makes strategic sense as it positions
 GROWTH / VALUE STOCKS
KLA-Tencor in adjacent industries within the electronics
supply chain, with limited to no overlap in geography,
customers, or product categories. We also believe the
acquisition was reasonably priced.
KLAC is subject to the usual risks of cyclicality in the
semiconductor-equipment industry. As revenues slow, margins
also typically suffer, leading to sharp declines in earnings.
Industry downturns may be precipitated by economic
recessions, and may also be affected by changes in demand for
consumer products (mobile phones, tablets, and PCs), as well
as for data center communications systems, and industrial uses.
Similarly, the company must be ready with new products
when the next cyclical upturn arrives - if new semiconductor
equipment arrives too soon before the upturn, it may be
viewed as out-of-date when semiconductor sales accelerate; if
it arrives too late, it may result in the loss of equipment sales
to competitors.
In the semiconductor industry, companies must spend
heavily on R&D to maintain competitiveness. The percentage
of revenue that is spent on R&D will tend to be larger during
industry downturns and smaller during upturns, while absolute
spending on R&D tends to be stable. KLAC spent $526
million on R&D in FY17, representing 15% of revenue, down
from 16% in FY16 and 19% in FY15.
The company also faces customer-concentration risk, as it
relies on a small number of large customers with significant
bargaining power. The company's customer and product mix
may also vary significantly from quarter to quarter. Products
are often tailored to customer specifications. As a result, if
sales are delayed, the company may be unable to recapture the
business at a later date.
KLAC also faces risks from regulation and unfavorable
currency translation, as well as from the debt incurred to
support capital expenditures and acquisitions. Like its peers, it
also faces the challenge of attracting top technical talent.
COMPANY DESCRIPTION
KLA-Tencor Corp. is a top-tier supplier of
process-control and yield-management solutions for the
semiconductor and related nanoelectronics industries. The
company was formed in April 1997 from the merger of KLA
Instruments Corp. and Tencor Instruments. The company's
major products are inspection and metrology tools that help
integrated circuit manufacturers manage yield throughout the
semiconductor manufacturing process.
VALUATION
KLAC shares trade at 16.3-times our FY20 non-GAAP
EPS forecast and at 13.9-times our FY21 projection; the
two-year average forward P/E of 15.1 is in line with the
five-year (FY15-FY19) trailing multiple of 15.2. The shares,
Section 2.29
which have historically traded at a 13% discount to the market
multiple, currently trade at a two-year forward relative P/E of
0.93, or at a slight premium to the historical norm. We note
that KLAC is growing EPS much faster now than in past
periods. Other historical comparables also signal
undervaluation; our price-based historical comparable
valuation points to a value in the upper $160s, in a rising
trend.
KLAC trades at a modest premium to peers on most
metrics, including absolute and relative P/E and price/sales.
Peer indicated value is around $145, below current levels but
in a clear rising trend; KLAC historically commanded
premiums to its peer group. Our discounted free cash flow
analysis values the stock above $230, in a rising trend and well
above current prices.
Our blended valuation estimate now exceeds $200, in a
rising trend. Appreciation to our 12-month target price of $175
(raised from $155), along with the 2.2% forward yield (based
on the upcoming hike), implies a risk-adjusted return in the
low-teens. That is in excess of our total forecast return for the
broad market and is thus consistent with a BUY rating.
On September 20 at midday, BUY-rated KLAC traded at
$157.87, up $0.65. (Jim Kelleher, CFA, 9/20/20)
Mondelez International Inc. (MDLZ)
Current Rating: HOLD Publication Date: 9/23/19
HIGHLIGHTS
*MDLZ: Maintaining HOLD with shares near fair value
*We think that MDLZ will need to further raise its ROIC
to be rewarded with higher multiples. To do that, the company
must grow net income faster than sales, and sales faster than
assets. Based on Bloomberg's calculation, the company's ROIC
of 8.3% is slightly above its cost of capital at 6.6%. Faster or
more sustainable growth would also boost valuation.
*Using a very simple two-stage dividend discount model
that assumes 9% growth for five years followed by steady rate
growth of 3% with an 80% payout, and a cost of equity of
7.5% (later declining to 7%), we believe that a fair multiple
would be 22-times.
*At 20-times our non-GAAP EBIT estimate for 2019,
(note that we are switching from a GAAP basis to a
non-GAAP basis because that is the basis of our forecast.
MDLZ will typically trade at a lower multiple to adjusted
EBIT because adjusted EBIT is usually higher than the GAAP
number), which is the same multiple we used in our previous
note, the shares would be worth about $50 in one year.
*We like the company's compound annual dividend
growth of 13% over the last five years and the $23 billion of
capital returned to shareholders since 2012, including
approximately $16 billion in share repurchases. The shares
yield 2%.
 GROWTH / VALUE STOCKS
ANALYSIS
INVESTMENT THESIS
We rate Mondelez International Inc. (NGS: MDLZ) as
HOLD. The shares are trading close to our fair value estimate.
The company has posted solid results in recent quarters.
Adjusted EPS has topped consensus in 10 straight quarters.
Sales have missed analyst expectations in five of the last 10
quarters, with currency pressure dampening organic results,
but 2Q19 showed promise, with better-than-expected organic
revenue and a boost to the full-year outlook, with sales and
good performance in the important Oreo and Cadbury Dairy
Milk lines.
Of greater concern is that sales of packaged foods in
North America are expected to increase just 1% annually over
the next five years, according to a Bloomberg analysis of data
from Euromonitor International. That's actually an
improvement from 0.5% compound annual growth over the
last nine years.
That said, we see an opportunity to grow the company's
brand portfolio. In 2018, the company gained or maintained
market share in 60% of the segments in which it competes. It is
also emphasizing local brands and trying to make its
advertising more culturally relevant in markets such as China
and India.
We like the company's compound annual dividend growth
of 13% over the last five years and the $23 billion of capital
returned to shareholders since 2012, including approximately
$16 billion in share repurchases. The shares yield 2%.
Our long-term rating remains BUY, as we expect the
company to benefit over time from economies of scale,
investment in its brands, and lower procurement costs than
many of its competitors.
RECENT DEVELOPMENTS
On July 30, Mondelez reported adjusted 2Q19 earnings of
$0.57 per share, up 3.6% year-over-year and above our
estimate of $0.56. The StreetAccount consensus was $0.57. On
a constant-currency basis, adjusted EPS rose 9%. Operating
income slipped 0.8% on an adjusted basis.
Revenue slipped 0.7% year-over-year to an adjusted $6.04
billion. This just beat the StreetAccount consensus of $6.02
billion, but missed our estimate of $6.05 billion. This is hardly
a major deviation. Currency pressure was the main drag on
sales.
Organic revenue, which excludes the impact of
acquisitions, divestitures and currency fluctuations, increased
4.6%. The StreetAccount consensus called for a 2.6%
increase. Volume and product mix added 1.6 percentage points
Section 2.30
and pricing contributed 3 percentage points to organic growth.
Emerging markets posted a 7.6% increase in organic revenue
while developed markets were up 2.8%.
The adjusted operating margin was flat at 16.7% of sales,
as the company had efficiencies from higher organic sales and
cost controls offset by investments in the business. Our
estimate was 17.1%. Operating income was $1.008 billion on
an adjusted basis, which was below our estimate of $1.035
billion but above the StreetAccount consensus of $859 million.
On a GAAP basis, 2Q EPS rose 162% to $0.55 as the
company lapped pension charges and costs related to the early
retirement of debt.
The company generated $1.05 billion in cash from
operations in 1H19, versus $1.18 billion in 1H18. The
company generated $581 million of free cash flow in the first
half of the year.
EARNINGS & GROWTH ANALYSIS
In the 2Q earnings release, MDLZ raised its guidance for
organic revenue growth to 3% from a previous range of 2%
-3% and adjusted EPS growth of 5% on a constant-currency
basis from a previous range of 3%-5% on the same basis.
MDLZ also reiterated that currency translation would reduce
revenue growth by three percentage points. It also said that
currency translation would reduce full-year adjusted EPS by
$0.11, compared to $0.09 at the end of 1Q and $0.07 at the
end of 4Q18. Interest expense is likely to be slightly lower
than the company expected previously and the tax rate may be
in the low-to-mid 20s rather than in the low 20s.
We will work through the 2019 earnings guidance. Back
in 2018, adjusted earnings were $2.43 per share and $2.46 on
a constant-currency basis. A 5% increase takes 2019 guidance
to $2.58 on an adjusted, constant-currency basis. Subtracting
the expected currency impact for 2019 takes adjusted EPS to
$2.47 on an adjusted basis, which is the basis for our forecast.
We are reducing our 2019 EPS estimate to $2.49 from
$2.50. This is on an adjusted basis and includes an additional
$0.02 of drag from currency fluctuations. Second-quarter
adjusted earnings were $0.01 higher than we expected. We are
maintaining our 3Q estimate at $0.61 per share. We are
reducing our 4Q estimate to $0.65 from $0.67 on the prospect
for a bit more currency pressure than we had modeled and a
slightly higher tax rate. The current Bloomberg consensus is
$2.48. Management still expects free cash flow of
approximately $2.8 billion.
We are raising our 2020 EPS estimate to $2.65 from
$2.60 on an adjusted basis. We expect approximately 3.5%
sales growth, up from 3% previously because we expect
slightly better 3Q and 4Q sales as a result of investments to
drive sales of key products. We are modeling a 20-basis-point
increase in the operating margin to 18%, as a result of small
 GROWTH / VALUE STOCKS
productivity improvements. We did not change our estimate of
the share count. The current consensus is $2.68, down from
$2.69 previously.
At its analyst meeting in September 2018, management
outlined its long-term financial goals. It is targeting 3%
organic revenue growth, high single-digit growth in adjusted
EPS, dividend growth faster than EPS growth, and free cash
flow generation of more than $3 billion a year.
Our long-term earnings growth rate forecast is 9%. The
Bloomberg consensus is 8.5 with a range of 6% - 11%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Mondelez is Medium, the
midpoint on our five-point scale. MDLZ ended 2Q19 with
$12.2 billion in long-term debt and $7.7 billion in short-term
debt, representing a combined 43% of capital, down from 44%
a year earlier. The median for a group of peers selected by
Bloomberg is about 42%.
The company's debt is rated Baa1 by Moody's and BBB
by Standard and Poor's. Both agencies have stable outlooks.
These ratings are toward the bottom of the investment-grade
range. Most of the company's competitors are also rated in the
BBBs. The company's short-term debt is rated A-2/P-2. These
are second-tier ratings, but they should give the company
access to commercial paper markets in all but the most
distressed environments.
The company ended 2018 with a net pension liability of
$1.11 billion, down from $1.57 billion a year earlier and $1.88
billion at the end of 2016. While this is significant, it does not
strike us as overly burdensome for a company this size. The
company made contributions of $23 million to its U.S. pension
funds and $470 million to its international funds in 2017. In
2018, it contributed $39 million to its U.S. funds and $243
million to its international funds. The company expects to
make contributions of $237 million in 2019.
Mondelez hiked its quarterly dividend to $0.26 per share
from $0.22 in July 2018. In 2018, dividends totaled $0.92. In
July of 2019 the company raised the dividend by 10% to
$0.285 effective with the October payment. We are raising our
2019 dividend estimate by $0.005 to $1.065. This estimate
reflects three payments at the former quarterly rate of $0.26
and one payment at $0.285 which is a half cent more than we
expected. We are raising our 2020 dividend estimate by $0.02
to $1.16 per share. Over the last five years, the company has
increased the dividend at an annual rate of 13.2%. The 2017
payout was 43% of EPS and the 2018 payout was 40%. Our
projected 2019 payouts represent 43% of our earnings estimate
for the year. Based on our share count estimate, the company
will spend about $1.5 billion on the dividend, well below its
projected free cash flow of $2.8 billion.
Section 2.31
Between 2013 and 2018, the company repurchased an
impressive $15 billion of its stock. It repurchased
approximately $1 billion in 1H19 and has $3.7 billion
remaining on its buyback authorization.
MANAGEMENT & RISKS
Our biggest concern is relevance. While MDLZ is an
innovative company that owns some of the best known and
most loved brands in the world, our concern is that consumer
tastes are turning from packaged snacks to foods that are fresh,
local, natural and organic. A new generation is also more
concerned with ingredients such as genetically modified
organisms (GMOs), and about nut allergies and gluten. Whole
Foods had made it easier to be vegetarian, vegan or to at least
be concerned about the quality of ingredients and the welfare
and sustainability of animal populations. In the process, many
shoppers have found alternatives to traditional packaged foods
- namely, products that have very simple ingredients like
organic flour, water, butter, and organic cane sugar. To its
credit, the company stopped making the Oreo filling out of
pork lard in 1997.
Food trucks were once a place to get strong coffee and
pre-made sandwiches on a construction site. Now, because of
evolving preferences that favor fresh, unique and locally made
foods, they are the centerpiece of foodie festivals and
corporate events. New Yorkers track the locations of trucks
that specialize in delicacies including ox tails, dumplings,
empanadas, pupusas, jerk chicken, Belgian waffles, Korean
BBQ, lobster rolls and even grilled cheese sandwiches. We
recently asked a grocery-store executive to define 'foodie.' He
said that a foodie is someone who posts pictures of meals on
social media.
Kroger has a rapidly expanding fresh and natural brand
and recently purchased Murray's, the Greenwich Village
cheese and specialty shop, because it provides uniqueness,
product authority and differentiation over a cardboard
container of powder to shake on your spaghetti. Walmart
showcases local foods, and the offering of fresh, grab-and-go
meals in Whole Foods stores ranks with the highest grossing
restaurants in New York City. Grocery stores are increasingly
offering prepared foods and targeting their shoppers' entire
food budget - not just what they have traditionally cooked at
home. Baked goods, including bread, cookies, cakes and pies
are part of this strategy. We have even seen a doughnut bar in
a Whole Foods store.
MDLZ and other consumer products companies compete
intensely with each other and must also contend with
private-label brands at a host of retailers, including
value-focused stores like Aldi, and the Trader Joe's chain,
which is known for unique foods (and wine) at very low prices.
While older shoppers may have a great affinity for Oreos or
Ritz crackers, younger shoppers may be more price-conscious
or very comfortable with store brands. This is potentially a
 GROWTH / VALUE STOCKS
bigger issue if market share is migrating to a declining number
of retailers like Amazon, Walmart, Kroger, Target and Costco,
whose private Kirkland Signature brand had sales of $39
billion in FY18. That was up 11%, which is an astounding
growth rate in the slow-growing consumer goods sector. That's
about the size of General Mills, Kellogg, and Campbell Soup -
combined. Costco uses the brand to pressure companies like
P&G to lower prices. Kroger's private brands generate annual
sales of about $30 billion, which is bigger than Mondelez.
Another issue is that the top five sweet biscuits and bars,
according to Bloomberg, include Nature Valley, Clif Bar and
Kind, which, in our opinion, appear to be healthier than Oreo
and Chips Ahoy!
Dirk Van de Put, the former CEO of McCain Foods,
succeeded Irene Rosensfeld as CEO of Mondelez following
her retirement. Mr. Van de Put has more than 30 years of
experience in the food industry at companies including
Coca-Cola and Mars. We expect him to focus on boosting
growth in developed markets. We like his recent purchase of
Tate's Bake Shop, which is known for its simple ingredients
and roots in the exclusive Hamptons. We believe that the
purchase is very much in sync with shoppers' current
preferences.
The company has refined its product portfolio as part of
its 2014-2018 restructuring program. The program intended to
lower supply chain costs, reduce headcount, sell assets, and
implement zero-based budgets. We expect an update on the
company's progress, along with the company's next long-term
strategic plan, at an analyst meeting on September 7.
In June 2017, the company's computer systems for global
sales, distribution and finance were attacked by malware. The
company has recovered with a minimal impact on revenue, and
management does not believe that any data was released
externally; however, incremental costs of $84 million highlight
the growing risk of hacking and cyber-attacks.
The company does not have any customers that accounted
for 10% or more of revenue. Its five largest customers
accounted for 16.8% of 2018 revenue from continuing
operations, and its 10 largest customers represented 23% of
revenue.
Currency exchange poses a significant risk for Mondelez,
as the company generates more than 75% of its revenue
outside the U.S. in currencies. Mondelez hedges some
international transactions, but does not hedge against currency
translation. Mondelez monitors and hedges against rising costs
for commodities such as cocoa, corn, wheat, sugar, and dairy
products, but says that it cannot fully hedge or protect against
all fluctuations.
The company is poised to benefit from growth in
emerging markets, though some of these markets have elevated
Section 2.32
currency and political risk.
MDLZ could also be hurt by tariffs, quotas and other trade
barriers. The company must also exercise care in its
local-market business practices. While some activities may be
common in local markets, MDLZ, as a U.S. company, must
comply with the stringent Foreign Corrupt Practices Act.
Mondelez has been about 15% less volatile than the S&P 500
based on its beta over the last five years.
PricewaterhouseCoopers has been the company's auditor
since 2001.
COMPANY DESCRIPTION
Mondelez International Inc., (pronounced Mon-del-ease),
headquartered in the Chicago suburb of Deerfield, Illinois, is
one of two successor companies from the October 1, 2012
split-up of Kraft Foods. The company name was created by
employees and is hybrid of the Latin word for world (mundus)
and a modification of 'delicious.' The other company is now
called Kraft Heinz. Mondelez generated $25.9 billion in
revenue in calendar 2018, with 39% from Europe; 27% from
North America; 22% from Asia, Middle East and Africa; and
12% from Latin America. Biscuits, including Oreos, represent
the largest product category at 43% of sales. Chocolate,
including Cadbury, represents 31%; Gum & Candy, including
Trident, are 13% of revenue; Beverages, including Tang, are
5%; and cheese and groceries are 8%.
Looking at the matrix of segments and product categories,
North American Biscuits (22%), European Chocolates (20%)
and European Biscuits (12%) are the most important
contributors to sales.
The company regularly uses the term 'Power Brands,' to
describe its largest global and regional brands. Under the
biscuit banner, these include Oreo cookies, Chips Ahoy, Ritz
crackers, and TUC/Club Social (buttery-tasting salty crackers),
belvita biscuits (a European-style breakfast biscuit that aims to
be a nutritious alternative to cereal). The chocolate power
brands include Cadbury Dairy Milk.
The company sells products in 160 countries and has 132
manufacturing and processing facilities in 52 countries. The
company's financials are on a calendar-year basis.
VALUATION
In our opinion, MDLZ shares are fairly valued at current
prices near $55. Over the past 52 weeks, the shares have
traded in a range of $39-$57. Over the last year, they have
risen about 28%, topping the 13% return of the S&P 500
Consumer Staples index and the 5% return of the S&P 500.
The shares are trading at 22-times our 2019 adjusted
earnings estimate. The company's five year average is
23.9-times. A broad group of peers selected by Bloomberg
 GROWTH / VALUE STOCKS
trades at a median of 22.9-times consensus 2019 earnings. The
company's adjusted operating margin of about 17% is higher
than peer average of 14%. To be sure, the GAAP operating
margin was 12.5% in 2018 while the adjusted operating
margin was substantially higher at 16.7%.
Using a very simple two-stage dividend discount model
that assumes 9% growth for five years followed by steady rate
growth of 3% with an 80% payout, and a cost of equity of
7.5% (later declining to 7%), we believe that a fair multiple
would be 22-times.
We think that MDLZ will need to further raise its ROIC to
be rewarded with higher multiples. To do that, the company
must grow net income faster than sales, and sales faster than
assets. Based on Bloomberg's calculation, the company's ROIC
of 8.3% is slightly above its cost of capital at 6.6%. Faster or
more sustainable growth would also boost valuation.
The shares are currently trading at an enterprise value of
26.5-times GAAP EBIT, which is above the company's
five-year average of 23.7. The shares trade at a premium to
peers based on Bloomberg's numbers. We normally value
Consumer Discretionary retailers at about 12-times, but MDLZ
sells Consumer Staples, owns valuable brands and, despite
room for improvement, has a higher operating margin than
almost all companies in our retail coverage universe. At
20-times our non-GAAP EBIT estimate for 2019, (note that
we are switching from a GAAP basis to a non-GAAP basis
because that is the basis of our forecast. MDLZ will typically
trade at a lower multiple to adjusted EBIT because adjusted
EBIT is usually higher than the GAAP number), which is the
same multiple we used in our previous note, the shares would
be worth about $50 in one year.
On September 20, HOLD-rated MDLZ closed at $54.65,
down $0.39. (Christopher Graja, CFA, 9/20/19)
Netflix Inc (NFLX)
Current Rating: HOLD Publication Date: 9/23/19
HIGHLIGHTS
*NFLX: Acquires 'Seinfeld' as OTT content wars heat up
*Netflix has acquired global video streaming rights to the
iconic 1990's television series 'Seinfeld' - the latest salvo in the
increasingly competitive video streaming wars.
*NFLX shares have suffered recently from the Street's
perception of increased OTT competition and the company's
disappointing subscriber acquisition numbers in 2Q19.
*We are maintaining our 2019 EPS estimate of $3.80 and
our 2020 forecast of $5.49.
*Netflix continues to trade at a significant valuation
premium to peers on both a historical and forward basis.
ANALYSIS
INVESTMENT THESIS
Section 2.33
We are maintaining our HOLD rating on Netflix Inc.
(NGM: NFLX). NFLX shares are down nearly 30% from their
early May highs as the market has reacted to the company's
disappointing 2Q subscriber acquisition numbers and the
threat of increased OTT video competition, with Apple's
Apple TV Plus, Disney's Disney Plus, Comcast's Peacock, and
AT&T/WarnerMedia's HBO MAX all poised to enter the
video streaming market in the coming months.
These new services are likely to peel off some Netflix
subscribers, with perhaps Disney Plus as the biggest threat.
The company's January price increase is also likely to increase
customer churn, particularly in the U.S. The question we will
be unable to answer for some time is just how many
subscribers Netflix could lose and whether that number will be
material to its growth. This uncertainty itself could create an
overhang for NFLX shares. In addition, the costs associated
with the ramp-up in original productions and content licensing
have led the company to take on more debt. They have also
resulted in a stunningly high cash-burn rate that management
expects to go even higher in 2019.
Netflix's valuation metrics remain significantly higher than
those of peers on both a historical and forward basis.
RECENT DEVELOPMENTS
Netflix acquired the global video streaming rights to the
1990's hit comedy sitcom 'Seinfeld' on September 15 for a
period of five years beginning in 2021. While financial terms
were not disclosed, industry talk puts the price tag north of
$500 million for the 180-episode series, which completed its
nine-year primetime run in 1998. Reruns of Seinfeld have
already been exploited for years on advertising-supported
cable. This makes the large price tag all the more surprising,
but also highlights several challenges for Netflix in the
over-the-top (OTT) streaming video business.
First, Netflix recently lost bidding wars for the streaming
rights to 'The Office' (to Comcast/NBC Universal) and to
'Friends' (to AT&T/WarnerMedia). After the 'Seinfeld' deal,
Netflix also lost in the bidding for 'The Big Bang Theory' to
WarnerMedia. The pattern that we see here is that studios like
NBC Universal or WarnerMedia, with a major production
interest in series such as 'The Office,' 'Friends,' and 'The Big
Bang Theory,' also have a structural advantage in the bidding
process against Netflix. Aside from paying talent points, these
studios are essentially just taking money out of one pocket and
putting it into another. The difference with 'Seinfeld' is that it
was owned by Sony Pictures Television, which does not have a
competitive streaming service. This evened the playing field
such that Netflix could grab 'Seinfeld' and may have paid up to
do so. Both NBC/Universal and WarnerMedia plan to compete
head-to-head with Netflix in streaming in the near future, so
acquiring the 'Seinfeld' asset also has the effect of keeping it
from competitors. These also include Disney's Hulu service in
the U.S. and Amazon Prime internationally, which both
 GROWTH / VALUE STOCKS
currently stream 'Seinfeld.'
What makes reruns of an old television sitcom so valuable
to Netflix when the company's professed strategy is to produce
enough high-profile original content to continue to attract new
subscribers (and build on its already large 152 million global
subscriber base)? While Netflix does not release content
ratings or engagement metrics, third parties have estimated
that reruns of popular older television shows are some of the
most popular content on Netflix. Primetime television hits
already have built-in audiences who are familiar with their
brands from their years on network television, not to mention
additional years in post-network syndication. Moreover, reruns
of iconic shows like 'Seinfeld' can get 'discovered' by new
generations of Netflix viewers. The popularity of reruns helps
explain management's decision to bid up for 'Seinfeld' as
Netflix will lose 'The Office' and 'Friends' to other services. In
addition, Netflix may not get many more opportunities to
acquire similar premium television content.
The recent land grab for popular reruns comes amid an
increasingly competitive OTT landscape with powerful new
entrants. That said, Netflix is the video streaming incumbent,
with first-mover advantage in more than 190 countries and a
large global subscriber base. Until now, HBO and Amazon
Prime have been its only global competitors, with Hulu
competing only in the U.S. HBO has a reported 130 million
global subscribers and Hulu has a reported 28 million U.S.
subscribers. The U.S market is also rife with smaller
competitors, including Dish's Sling TV, CBS All Access, and
Sony's PlayStation Vue.
Global competition is about to ramp up substantially.
Apple announced that its Apple TV Plus steaming service will
launch on November 1 at $5 per month. Disney will launch
Disney Plus on November 11 at $6 per month for 12 months or
$7 per month. Disney will also provide the option to bundle
Disney Plus with Hulu and ESPN Plus, which we see as a
particularly formidable content bundle, for $13 per month (this
just so happens to be the price of Netflix's most popular
'Standard' service). Comcast/NBC Universal plans to launch its
new Peacock service in April 2020. Peacock will be free to
Comcast subscribers, though it has yet to announce a price for
other customers. WarnerMedia's new streaming service HBO
MAX is also slated to launch in spring 2020.
NFLX shares have suffered recently from the Street's
perception of increased OTT competition and the company's
disappointing subscriber acquisition numbers in 2Q19. While
Netflix's subscriber acquisition metrics may bounce back, the
market's perception of increased competitive intensity will
likely last well through the launches of Apple TV Plus, Disney
Plus, Peacock, and HBO MAX, i.e., well into 2020. These
factors could create an overhang for NFLX shares. Some
research has suggested that consumers may be willing to pay
for two or three streaming services, which points to an
Section 2.34
eventual industry shakeout. It is also unclear if consumers,
rather than sticking with their existing services, may decide to
jump to competing services throughout the year depending on
their content offerings at a particular time. Monthly
subscriptions and OTT video application aggregator systems
like Roku make switching relatively frictionless from a
technical standpoint. However, other factors, like the
stickiness of a particular service, fear of missing out (FOMO)
on upcoming content, and simple consumer laziness, work
against the service-switching paradigm.
At this point, we think that Apple TV Plus will not be
much of a competitive threat to Netflix given Apple TV's
relative lack of content and somewhat muddled strategy. We
are unclear as to whether Apple is truly jumping into OTT
video streaming or whether it just wants to use streaming to
sell more iPhones, iPads, or Apple TV boxes. We think that
Apple may pursue the Amazon Prime model of using video
streaming as an add-on service to cement customer loyalty
rather than try to compete directly with Netflix. However, we
believe that Disney Plus, Peacock, and HBO MAX aim to
compete head-to-head with Netflix, as evidenced by their
withdrawal of content from Netflix and their
multi-hundred-million dollar bids on licenses for 'The Office,'
'Friends,' and 'The Big Bang Theory.'
Our 2019 EPS estimate is $3.80 and our 2020 forecast is
$5.49. Netflix expects to continue to spend heavily on content.
Netflix's 2019 operating margin goal is 13%, an almost
300-basis-point increase from 2018. However, management
has stressed that it will balance growth with profitability, i.e.,
by maintaining its global leadership in internet television while
gradually increasing operating margins. Our long-term EPS
growth rate estimate is 28%.
MANAGEMENT & RISKS
Central to Netflix's success is its ability to attract new
members and increase member engagement. The company has
worked to enhance its value proposition by producing more
original content and by improving the streaming/download
experience to make both sign-ups and viewing essentially
frictionless. However, it must also maintain the affordability of
its service amid rising content production and acquisition costs
and an increasingly competitive landscape. Any decline in
Netflix's ability to attract and retain members would be a
strong fundamental negative and likely lead to a share price
selloff.
While Netflix has some clear first-mover advantages
versus Hulu and Amazon Prime, currently its only significant
competitors in long-form digital video streaming, the market is
getting much more crowded. Over the next year, media giants
Disney, AT&T/WarnerMedia, and Comcast plan to introduce
new streaming video services. These new services will join an
already crowded field of alternative streaming services
including, Dish's Sling, Sony Vue, CBS, and
 GROWTH / VALUE STOCKS
AT&T/WarnerMedia's HBO. Also, Disney is pulling content
from Netflix on the expiration of its contract in order to
populate its own new services. Netflix also cannot ignore the
large players in short-form internet video: Google's YouTube
and Facebook. In the rapidly developing internet-video
landscape, Netflix's position is by no means secure.
Netflix's licenses from content providers are typically
fixed-price and long-term. While these contracts provide
upside in the case of popular content, their fixed-price nature
makes payments for less popular content burdensome.
Agreements with content providers also typically require large
upfront payments. The large payments impair cash flow and
liquidity. The company has also ramped production of its own
original content. While producing its own content has the
advantage of exclusivity, it also means that Netflix is taking all
the risk of production on itself, again with large upfront
payments. Also, Netflix relies on internet service providers
and network operators (collectively 'ISPs'), such as cable and
telecom companies, to provide the capacity that allows
members to stream Netflix programming on a variety of
devices. As Netflix has become a major user of network
capacity in the U.S. (representing about 35% of download
traffic during peak hours in the U.S., by some estimates), ISPs
have demanded and obtained higher payments to provide
faster interconnections to Netflix servers.
While internet-based video streaming has become
Netflix's core business, the company still runs its precursor
DVD-by-mail business, which generates cash for business
development. This business is in long-term secular decline and
a faster-than-anticipated decline could crimp the company's
cash flow even more than it already is. Also, as an
internet-based business, Netflix is expected to provide 24/7
reliability as well as data security. With its widely known
brand, the company could be a target for hacker attacks aimed
at shutting down the service or compromising member data.
Any successful attack would be a black eye for Netflix, at a
minimum, and could lead to large subscription cancellations
and/or member litigation.
As discussed above, Netflix is scaling its business
internationally. Management will need to manage the
technological and cultural complexities involved in expanding
into new markets.
Investors should recognize that NFLX shares are highly
volatile and could react negatively if the company does not
meet its own guidance or consensus estimates for sales,
earnings, and subscriber growth.
Netflix appointed Spencer Neumann as its new CFO on
January 2. Former longtime CFO David Wells had announced
his intention to retire in August 2018, though he stayed on
through Mr. Neumann's appointment. Mr. Neumann was most
recently the CFO of videogame distributor Activision
Section 2.35
Blizzard, though for only about 18 months. Prior to Activision,
Mr. Neumann held a number of executive positions at Disney,
including CFO of the Parks and Resorts division. He also
worked for private equity firms Providence Equity Partners
and Summit Partners.
COMPANY DESCRIPTION
Netflix is an internet subscription video-on-demand
distributor of movies and television shows worldwide (except
China). Members have unlimited access to the Netflix content
library for a fixed monthly subscription fee. The company also
runs a DVD-by-mail rental business in the U.S. Netflix derives
about 49% of its revenue from outside the U.S.
VALUATION
NFLX shares have traded between $231 and $387 over
the past year and are currently below the midpoint of that
range and down nearly 30% from their early May highs. The
shares are up 3% year-to-date, compared to a 20% capital
return for the S&P 500, a 25% return for the S&P Media &
Entertainment Industry Group, and an 18.5% gain for the
NYSE Fang Plus Index. NFLX's forward enterprise value/sales
multiple of 5.5 is 33% above the peer average, below the
historical average premium of 65% over the past two years.
On September 20, HOLD-rated NFLX closed at $270.75,
down $15.85. (Joseph Bonner, CFA, 9/20/19)
New Relic Inc (NEWR)
Current Rating: BUY Publication Date: 9/20/19
HIGHLIGHTS
*NEWR: Guidance cut and management transition
*New Relic lowered its FY20 revenue guidance on
September 16, essentially shaving three percentage points from
its growth forecast.
*At the same time, the company announced the
resignations of Chief Technology Officer Jim Gochee and
Chief Revenue Officer Erica Schultz, and the appointment of
board member Michael Christenson as COO.
*NEWR shares have risen in the wake of these
announcements. However, they have recovered only modestly
from their sharp drop following the fiscal 1Q earnings report
on August 6.
*We note that management has reaffirmed its fiscal 2Q
EPS guidance and has not changed its full-year EPS guidance.
We are lowering our FY20 non-GAAP EPS estimate to $0.61
from $0.66 and our FY21 forecast to $0.92 from $1.01.
ANALYSIS
INVESTMENT THESIS
We are maintaining our BUY rating on New Relic Inc.
(NYSE: NEWR) to a target price of $93. We see the sharp
selloff in the shares following the company's 1Q20 earnings
report as a buying opportunity. We think that investor
concerns about the company's competitive position are
 GROWTH / VALUE STOCKS
overblown, though it may take several quarters for
management to demonstrate that the fiscal 1Q issues were due
to poor execution rather than to competitive pressures. That
said, we would rather be a little early than too late in our
upgrade, and are now much more comfortable with the stock's
valuation.
We see New Relic as an early-stage tech company in the
burgeoning market for big data analytics, and at the center of
three ramping technology trends: cloud computing, enterprise
digital transformation, and DevOps. We expect the company
to benefit over time as enterprise IT becomes increasingly
application- and cloud-centric.
New Relic began by providing 'break/fix' IT services to
small and medium-sized businesses, but now focuses on
helping larger global enterprises to digitize their businesses
through the rapid development of applications and the
increased use of cloud-based services. New Relic's value
proposition is based on its big data analytics platform, which
offers business enterprise clients visibility into their IT
systems. The company is looking to grow by adding new
enterprise clients and increasing its wallet share of existing
clients. Its goals include expanding the installed base through
increasing usage, cross-selling additional products, increasing
application coverage, and expanding its platform with
additional paid offerings and capabilities. It is also working to
expand internationally. Management has set a long-term
revenue run-rate target of $1 billion by the end of FY22
(March 2022), implying 28% compound annual revenue
growth over the next three years. As the company scales, it is
also rapidly expanding margins.
RECENT DEVELOPMENTS
On September 16, New Relic lowered its FY20 revenue
guidance to $586-$593 million, down from previous guidance
of $600-$607 million. The new guidance implies growth of
22%-24%, down from its previous guidance of 25%-27%
growth. The company reaffirmed its fiscal 2Q20 guidance.
New Relic's FY20 ends in March 2020.
In addition to lowering its FY20 guidance, New Relic
announced the resignations of Chief Technology Officer Jim
Gochee and Chief Revenue Officer Erica Schultz, and the
appointment of board member Michael Christenson as COO.
Founder Lew Cirne remains CEO. Mr. Christenson was most
recently a managing director at investment banking firm Allen
& Co. and has also been COO of software company CA, Inc.
NEWR shares have reacted positively to these
announcements. However, the shares were pummeled after the
company reported fiscal 1Q20 results on August 6.
Management acknowledged poor execution in 1Q, which led
to shortfalls in sales and headcount targets, as well as to
lower-than-expected deferred revenue. It attributed the poor
execution to its aggressive efforts to both complete a new
Section 2.36
product platform, New Relic One, and reorganize its sales
force. The shares fell 29% on August 7, and while they have
recovered some ground, they remain 24% below their August
6 close. We took advantage of the drastic decline to raise our
rating to BUY on August 9.
We are lowering our FY20 non-GAAP EPS estimate to
$0.61 from $0.66 and our FY21 forecast to $0.92 from $1.01.
Our FY20 estimate is within management's unchanged EPS
guidance range of $0.55-$0.63.
Management's FY22 financial objectives include a
revenue run-rate target of $1 billion by the end of the fiscal
year (March 2022), implying 28% compound annual growth
over the next three years. Management expects to bring the
non-GAAP operating margin to 10%-14% by FY22 and to
exceed 25% over the long term. Our long-term EPS growth
rate forecast is 28%.
MANAGEMENT & RISKS
New Relic has a history of operating losses, with an
accumulated shareholder deficit of $321 million. While
operating losses are common for early stage tech companies as
they scale up new technologies and reach for market share,
management's operating plans may not generate the expected
results. This risk is exacerbated by the company's limited
operating history. Investors could lose faith in the company,
and the share price could plummet if operating results are
erratic or disappointing as was the case in fiscal 1Q20.
Management will also need to skillfully manage the company's
growth as it enters new market segments and expands
internationally.
New Relic's Application Performance Monitoring (APM)
software generates most of the company's revenue and cash
flow. While the company is broadening its product portfolio,
which should lessen its reliance on APM, any near-term
problems with this product could have a significant negative
impact on New Relic's financial outlook.
New Relic partners with Amazon Web Services and other
public cloud providers in order to deliver integrated solutions
to clients, and could be hurt by any problems in its relationship
with AWS. Given its large size and market presence, AWS
could also expand its services to compete with New Relic on
service offerings.
New Relic's competitors fall into three categories and
include some of the largest and most well-funded companies in
the technology sector. Competitors include firms that offer IT
systems performance monitoring, such as AppDynamics (a
division of Cisco Systems), Datadog Inc., Dynatrace LLC, and
Splunk Inc. The company also faces competition from large
enterprise software companies such as HP Enterprise, IBM,
Microsoft and Oracle, BMC Software, and CA Inc.
(Broadcom), as well as from providers of analytics products
 GROWTH / VALUE STOCKS
such as AWS and Google Cloud Platform.
New Relic is subject to the usual risks of a high-growth
tech company. Successful cyberattacks, breaches of customer
data, or service outages could damage the company's
reputation. The company must also manage the transition from
its current high-growth phase to a period of slower growth,
while also building its product portfolio and field sales force.
The company must also ensure the reliability of its service
platform and the smooth integration of its software with
clients' IT systems.
New Relic operates in an industry with considerable
intellectual property development, and faces a range of
IP-related risks. In particular, adverse rulings in patent
infringement cases could force the company to pay
confiscatory license fees, design patent workarounds, or
abandon certain technologies. The company is involved in
patent litigation with CA, and a negative outcome for NEWR
could have a material negative impact on its business. New
Relic continues to fight the case vigorously. Additional
technical and legal costs related to this litigation could have a
negative impact on the company's results.
New Relic expects sales to become more seasonal as
mid-market and large enterprises become a larger portion of its
business. In particular, it is likely to see stronger revenue in the
second half of its fiscal year (the December and March
quarters) than in the first half.
Lewis Cirne is the founder and CEO of New Relic. Before
founding the company, he held senior technical positions at
Apple and at venture capital firm Benchmark Capital. The
company's former president, Hilarie Koplow-McAdams,
retired in June 2017 and her duties were assumed by Mr.
Cirne.
COMPANY DESCRIPTION
New Relic is an enterprise software technology firm
focused on the emerging technology of big data software
analytics. New Relic's Digital Intelligence Platform enables
enterprise clients to 'collect, store and analyze' data generated
by applications and IT infrastructure, and provides visibility
into software and systems performance across desktop, mobile,
browser, and cloud environments. The company uses a
software-as-a-service (SaaS) delivery model. With a market
cap of $3.7 billion, New Relic is considered a mid-cap
company. New Relic was founded in September 2007 and
completed its initial public offering on December 12, 2014 at
$23 per share. New Relic derives about 32% of revenue from
outside the U.S.
VALUATION
Our valuation methodology is multistage, including peer
analysis, a multiple-analysis matrix applied to our proprietary
forecasts, and discounted cash flow modeling. NEWR shares
Section 2.37
have traded between $50 and $109 over the past year, and are
currently toward the low end of that range. The shares are
down 23% year-to-date, with the entire decline coming after
the release of 1Q20 results in August. This compares to an
20% capital return for the Russell 2000 index and a 29%
increase for the Russell 2000 Technology index.
The trailing EV/revenue multiple of 6.5 is below the low
end of the five-year historical average range of 8.8-11.9. On a
forward basis, the EV/revenue multiple of 5.2 is 24% below
the peer average, compared to a historical average premium of
13%. Our DCF analysis indicates a fair value for NEWR of
$91 per share, above current levels. We are maintaining our
BUY rating to a target price of $93.
On September 19, BUY-rated NEWR closed at $62.72,
up $2.62. (Joseph Bonner, CFA, 9/19/19)
Qualcomm, Inc. (QCOM)
Current Rating: BUY Publication Date: 9/19/19
HIGHLIGHTS
*QCOM: Stronger RF presence and multiple 5G solutions
*Qualcomm has acquired the remaining interest in the
RF360 Holdings JV. The venture produces RF front-end
(RFFE) filters that enable Qualcomm to deliver complete 4G
and 5G solutions.
*Qualcomm has announced an expanded product set
across the Snapdragon 8 Series, 7 Series, and 6 Series, to be
available later in 2019 and in 2020.
*The expanded Snapdragon portfolio rollout has the
potential to make 5G available to more than two billion
smartphone users.
*Qualcomm has not yet begun to monetize its significant
intellectual capital and multigeneration lead in 5G technology;
once it does, we look for a significant boost to revenue,
margins, and EPS.
ANALYSIS
INVESTMENT THESIS
BUY-rated Qualcomm Inc. (NGS: QCOM) has acquired
the remaining interest in RF360 Holdings from JV partner
TDK Corp. The joint venture produces RF front-end (RFFE)
filters that enable Qualcomm to deliver complete 4G and 5G
solutions. The acquisition gives Qualcomm more content per
mobile device, from modem to antenna. Qualcomm's
acquisition of TDK's portion of the JV is timed to align with
the upcoming ramp of 5G devices, which should become
meaningful in 2020.
At the IFA Conference earlier in September, Qualcomm
announced an expanded product set across the Snapdragon 8
Series, 7 Series, and 6 Series, to be available later in 2019 and
in 2020. The expanded portfolio rollout aims to support
features and frequency bands globally, and has the potential to
make 5G available to more than two billion smartphone users.
 GROWTH / VALUE STOCKS
QCOM shares have had a volatile 2019, featuring
early-year gloom related to the IP battle with Apple and
government-led attacks on Qualcomm's core licensing model.
Although QCOM took off after the Apple settlement, failure to
win relief from the ITC and moderating smartphone sales have
weighed on the stock.
Through it all, the company has kept its eyes on the prize,
which is the coming global 5G device rollout. Qualcomm is
uniquely positioned to benefit from 5G, which investors expect
to drive a meaningful device upgrade cycle beginning in the
second half of 2020.
Worsening trade tensions represent an ongoing risk for all
chip companies with business in China. On the other hand,
Qualcomm has not yet started to monetize its significant
intellectual capital and multigeneration lead in 5G technology;
once it does, we look for a significant boost to revenue,
margins, and EPS. We are reiterating our BUY rating on
QCOM and our 12-month target price of $95.
RECENT DEVELOPMENTS
QCOM is up 38% in 2019, while peers are up 33%.
QCOM shares declined 11% in 2018, compared to a 4%
decline for a peer group of communications and information
processing semiconductor companies in Argus coverage.
QCOM declined 2% in 2017, compared to a 31% simple
average gain for peers. QCOM rose 30% in 2016, versus 60%
for peers, and declined 33% in 2015, lagging the 9% gain for
the peer group.
On 9/16/19, Qualcomm announced what it called a
'significant milestone' in its 5G strategy and leadership.
Qualcomm Technologies has completed the acquisition of the
remaining interest in RF360 Holdings Singapore Pte. Ltd., a
joint venture with TDK Corp. TDK's interest in the JV was
valued at $1.15 billion. The total purchase price paid by
Qualcomm is approximately $3.1 billion. This price reflects
TDK's initial investment, payments to TDK based on sales by
the JV, and development obligations.
Qualcomm called the acquisition the 'final step' to
formally bring in-house more than 20 years of expertise in
RFFE filtering. The RFFE portfolio now includes integrated
and discrete components utilizing filter technology variants
including BAW, SAW, thin film and TC-SAW. These
technologies are integral to producing and developing filters,
duplexers, multiplexers, n-plexers and extractors for the 'very
complex' front end necessary for the upcoming generation of
smartphones.
Together with Qualcomm Technologies, the joint venture
has produced RF front-end (RFFE) filters that enable
Qualcomm Technologies to deliver complete 4G/5G RFFE
solutions. By gaining full ownership of this RFFE business,
Section 2.38
Qualcomm Technologies is able to provide device customers
with a complete end-to-end solution from modem to antenna.
These devices include the world's first commercial 5G NR
sub-6 and mmWave solutions, integrating power amplifiers,
filters, multiplexers, antenna tuning, LNAs (low noise amps),
switching and envelope tracking products.
According to the company, Qualcomm Technologies'
second-generation RFFE solutions for 5G will enable
customers to design thin, high-performance, and
battery-efficient 5G multimode devices 'at scale and on time.'
The company's innovations including wideband envelope
tracking ad adaptive antenna tuning, intelligently combine the
modem and RFFE to help achieve best-in-class 4G/5G power
efficiency, data speeds and coverage.
On 9/6/19, Qualcomm used the forum of IFA 2019 to
announce multiple tiers of Snapdragon 5G platforms launching
in 2020. IFA, or Internationale Funkausstellung, is Europe's
biggest trade show, sort of a cross between the Mobile World
Congress held every March in Barcelona and the Consumer
Electronics Show held every January in Las Vegas. For the
three-day show, representatives from Huawei, Roku, and
Qualcomm gave the opening daily keynote speeches. Huawei's
Richard Wu oddly gave a products-only presentation, failing to
even mention the allegations that landed the company on the
Entities List maintained by the U.S. Commerce Department.
Qualcomm President Christian Amon used his keynote to
lay out Qualcomm's 5G strategy. Two key elements of this
strategy are to bring 5G technology to multiple smartphone
ties, thus bringing 5G to billions of users; and to develop new
use cases whereby 5G can emerge as an alternative to wired
home broadband.
The big news from Qualcomm at IFA was the company's
plan to accelerate 5G global commercialization at scale.
Qualcomm is expanding its portfolio of 5G mobile platforms
across its Snapdragon 8, Snapdragon 7 and Snapdragon 6
series, with device availability across late 2019 and into 2020.
Snapdragon 8 chipsets have already been developed for
premium tier smartphones. Developing 5G platforms for
Snapdragon Series 7 and Series 6 chipsets will better able
Qualcomm to penetrate value markets in the developing world
and in nations such as China and India. Altogether, the
expansion of 5G to the Snapdragon Series 7 and Series 6 'aims
to support features and frequency bands globally and has the
potential to make 5G accessible to more than two billion
smartphone users,' according to the company.
Qualcomm announced that it was giving its 5G chipset a
new name; from now on, chipsets containing Qualcomm's 5G
modem will be known as 'Qualcomm 5G modem-RF systems.'
These comprehensive modem-to-antenna 5G solutions include
the 5G multimode modem, mmWave antenna modules, and RF
 GROWTH / VALUE STOCKS
transceiver and RFFE components.
Mobile device makers have launched or are developing
over 150 5G designs incorporating Qualcomm 5G modem-RF
systems. At IFA, Qualcomm stated that 12 OEMs have signed
to use Series 7 5G modem-RF systems in 7 nm process. These
customers include device makers serving middle and lower
tiers such as Oppo, Redmi, Motorola, HMD Global (Nokia
phones), and LG.
The Snapdragon Series 8 is already powering some of the
first 5G devices launched in 2019; details on next-generation
Snapdragon Series 8 will be released later in 2019. Series 7
chipsets began sampling to customers in the second quarter of
2019. Current plans are for Qualcomm to make the Series 7
chipsets in system-on-a-chip (SoC) format broadly available in
the fourth quarter of 2019. Devices based on Snapdragon
Series 6 SoCs are expected to be commercially available in the
second half of 2020.
QCOM shares have had a volatile 2019, featuring
early-year gloom related to the IP battle with Apple and
government-led attacks on Qualcomm's core licensing model.
Qualcomm settled with Apple last spring and in fiscal 3Q19
(calendar 2Q19) recorded a one-time $4.7 billion catch-up
royalty payment from the iPhone maker. Qualcomm in fiscal
3Q19 also received a partial royalty payment of $150 million
from Huawei, which may indicate that a final royalty
arrangement with the Chinese giant is pending.
Despite the Apple settlement, Qualcomm faces continued
issues with regulatory agencies. QCOM shares fell in May
after a U.S. district judge ordered the company to renegotiate
its existing licenses and stop its 'no license, no chips' practice.
The legal case, and the full investment implications of the
judge's decision, will play out over time. In a worst case, the
ruling will decimate Qualcomm's licensing model. In a best
case, Qualcomm will win on appeal. The final outcome of this
particular case is likely somewhere in the middle, with
Qualcomm again paying a hefty fine.
Fiscal 4Q19 guidance from Qualcomm was below
consensus and reflects the ongoing soft handset demand
environment. We look for a meaningful ramp in fiscal 2020
revenue and EPS, however, with both Apple and Huawei fully
on board and with 5G handset demand beginning to percolate.
Through it all, the company has kept its eyes on the prize,
which is the coming global 5G device rollout. Qualcomm is
uniquely positioned to benefit from 5G, which investors expect
to drive a meaningful device upgrade cycle beginning in the
second half of 2020. Attaining full ownership of the RFFE JV
and announcing Snapdragon 5G modem-RF chipsets across
multiple device tiers are important steps in this process. These
developments further extend Qualcomm's competitive lead in
the race to 5G.
Section 2.39
EARNINGS & GROWTH ANALYSIS
For fiscal 3Q19 (calendar 2Q19), Qualcomm reported
GAAP revenue of $9.64 billion, which was up 72% annually;
GAAP revenue included the Apple catch-up revenue.
Excluding the one-time Apple contribution, non-GAAP
revenue of $4.89 billion declined 13% year-over-year.
Non-GAAP revenue was below the $5.1 billion midpoint of
management's typically wide $4.7-$5.5 billion guidance range
and missed the $5.08 billion consensus forecast.
Including the catch-up payment, non-GAAP gross margin
expanded sequentially to 78.1% in 3Q19 from 56.3% in 2Q19
and 55.5% a year earlier. The non-GAAP operating margin
narrowed to 12.6% in 3Q19 from 23.7% in 2Q19 and 25.4% a
year earlier.
Non-GAAP EPS of $0.80 was down 21% from the prior
year, at the high end of management's $$0.70-$0.80
non-GAAP guidance range and above the $0.75 consensus
forecast.
We look for 3Q19 to be the trough earnings quarter for
Qualcomm. As Apple royalty revenue returns and Apple
chipset revenues return more gradually, Apple is expected to
add $2.00 per share to annual EPS.
For 4Q19, Qualcomm guided for revenue of $4.3-$5.1
billion and non-GAAP diluted EPS of $0.65-$0.75. The Street,
baking in the Apple contribution but likely not anticipating the
weak handset environment, was modeling revenue of $5.63
billion and non-GAAP EPS of $1.08.
Our FY19 non-GAAP earnings estimate for QCOM is
$3.53 per diluted share. For FY20, we are maintaining our
above-consensus forecast of $5.10 per diluted share; we regard
this estimate as highly fluid. Our forecast five-year earnings
CAGR is 10%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating for Qualcomm is
Medium-High. Apple and Qualcomm settled their dispute in
mid-April 2019. The following is based on Qualcomm's
balance sheet as of 6/30/19 and does reflect the roughly $4.7
billion catch-up payment from Apple.
As a result of the two repurchase programs announced
since July 2018, when the company failed to acquire NXP,
Qualcomm's cash position is meaningfully reduced. Apple will
provide a nice cash infusion, and a more normal royalty
revenue stream going forward may enable Qualcomm to
resume growth in cash on the balance sheet.
Cash was $14.4 billion at the end of 3Q19, up from $10.3
billion at the end of 2Q19. Cash was $12.1 billion at the end of
fiscal 2018, $39.8 billion at the end of fiscal 2017, and $32.4
 GROWTH / VALUE STOCKS
billion at the end of fiscal 2016.
Cash flow from operations was $3.90 billion in FY18,
$5.00 billion in FY17, and $7.40 billion in FY16.
Debt was $16.4 billion at the end of 3Q19. Debt was
$16.4 billion at the end of fiscal 2018, $21.9 billion at the end
of FY17, and $11.8 billion at the end of FY16. To pay for a
major increase in its capital-return program, early in FY15
Qualcomm announced plans to access the credit markets.
Previously, Qualcomm had not had any debt since FY12.
Currently, Qualcomm is repurchasing up to $30 billion of
its stock, equivalent to one-third of its market cap. As of
6/30/19, $7.8 billion remained on its share buyback
authorization; that was little changed from 3/31/19. Outside
this program, Qualcomm's capital-allocation strategy targets a
return of at least 75% of free cash flow to shareholders.
Qualcomm has returned a cumulative $87 billion to
shareholders since 2007.
Qualcomm has not announced a dividend hike in 2019, as
it typically does in the spring. On 3/8/18, Qualcomm
announced a 9% increase in its quarterly dividend to $0.62 per
share or $2.48 annually. Given the absence of a 2019 dividend
hike, our tentative dividend estimates are $2.52 for both FY19
and FY20.
MANAGEMENT & RISKS
Steve Mollenkopf has served as CEO since 2014.
Christiano Amon is president. Jeffery Henderson, an
independent director since 2016, has become the company's
chairman; the post of executive chairman has been
discontinued.
In April 2019, George Davis left the company after
serving for six years as CFO to become CFO at Intel. SVP and
Treasurer David Wise briefly served as interim CFO but has
since announced his retirement; SVP Finance Akash
Palikhwala is now the second interim CFO. Donald Rosenberg
has long served as chief counsel, a role of significant
importance at a litigation target such as Qualcomm.
The search for a full-time CFO is ongoing. We do not
regard the CFO transition as meaningful to Qualcomm's
operations.
The FTC victory poses risks to Qualcomm's fundamental
royalty licensing model. For now, assuming Qualcomm loses
all appeals, we would expect royalty rates to be lowered. But
we would also expect the fundamental principles of perpetual,
comprehensive, and based on device pricing to be validated.
The settlement with Apple significantly reduces risks to
Qualcomm's licensing model but does not eliminate them
altogether. Qualcomm still must settle with national regulatory
Section 2.40
agencies including those in the U.S., EU, and Korea.
An ongoing risk for Qualcomm is that a KFTC and FTC
investigations, along with an ongoing EU investigation, might
materially impact results. Regarding the FTC investigation,
Qualcomm has in the past won court decisions related to
allegations that its marketing practices violated FRAND. For
the EU investigation, the language regarding the use of rebates
and incentives for silicon sales smacks of a smaller vendor
objecting to volume discounts for larger vendors (Apple and
Samsung, for example). In Korea, we expect Qualcomm to pay
a fine and renegotiate royalty rates with Samsung and LG; the
amount of the fine may be negotiable.
COMPANY DESCRIPTION
Qualcomm is a designer and manufacturer of advanced
semiconductors for mobile phones and commercial wireless
applications. It provides integrated solutions, including
processors, GPS, WiFi, basebands and other applications, for
smartphones, tablets, and mobile PCs. Qualcomm has
extended its leadership in the 3G CDMA wireless standard
into the 4G LTE niche. It derives substantial royalty and
licensing revenue from its extensive intellectual-property
portfolio for 3G, 4G and now 5G technologies.
VALUATION
QCOM shares are trading at 22.3-times our FY19
non-GAAP EPS forecast and at 15.4-times our FY20
projection; the two-year forward P/E of 18.9 is now well above
the average P/E of 14.3 for FY14-FY18. The shares, which
have historically traded at a 15% discount to the market P/E,
now trade at an average 10% premium for FY19-FY20. The
shift in valuation relates to the decline in near-term earnings
prospects as well as the bump in the shares since the Apple
settlement. However, settlement with Apple (and Huawei)
significantly improves the medium- and long-term earnings
outlook.
Our historical comparables model signals value in the
high $80s to low $90s, in a stable trend. Our peer-indicated
value is in the mid $90s, also on the rise and above current
prices. Our discounted free cash flow model signals value
above $160, now moderating after having risen sharply based
on prospects for higher long-term EPS and cash flow growth in
the wake of the Apple settlement. Our blended valuation for
QCOM is in the $140s, rising modestly and above current
prices.
Throughout the Apple dispute, revenue and EPS
continued to grow across the company's broad base of
customers. That operating strength is based on technology
leadership and mix dynamics at QCT and growth in the total
addressable market and in reported devices. The FTC outcome
represents another threat. In our view, challenges to
Qualcomm's licensing model have long obscured the enormous
potential of 5G on Qualcomm's top and bottom line.
 GROWTH / VALUE STOCKS
Appreciation to our 12-month target price of $95, along
with the annualized dividend yield of about 3.2%, implies a
risk-adjusted return exceeding our benchmark forecast.
Investors should be aware of the risks of owning QCOM
shares, which continue to include the FTC's ruling, and the
trade conflict between the U.S. and China.
On September 18, BUY-rated QCOM closed at $78.90,
up $0.21 (Jim Kelleher, CFA, 9/18/19)
Regency Centers Corporation (REG)
Current Rating: BUY Publication Date: 9/20/19
HIGHLIGHTS
*REG: Maintaining BUY and $73 target
*Regency has largely completed the repositioning of its
portfolio and the integration of Equity One, a shopping center
REIT acquired in March 2017. It has also maintained a strong
balance sheet by matching development spending with sales of
noncore assets.
*On August 1, concurrent with earnings, Regency
announced that CFO and President Lisa Palmer would succeed
Martin 'Hap' Stein as CEO in January.
*The company reported second-quarter NAREIT FFO of
$160 million or $0.95 per share, up from $157 million or
$0.93 per share in 2Q18. The increase was largely due to
higher earnings from investments in real estate partnerships.
However, FFO per share missed our estimate and the
consensus forecast of $0.96.
*REG is trading at 17.5-times our forward four-quarter
FFO per share forecast, below the five-year historical average
of 19.5 but above the peer median of 13.3. However, we feel
the premium to peers is appropriate given REG's superior
growth profile and relatively lower exposure to troubled
retailers.
ANALYSIS
INVESTMENT THESIS
We are maintaining our BUY rating on Regency Centers
Corp. (NYSE: REG) and our target price of $73. The company
has largely completed the repositioning of its portfolio and the
integration of Equity One, a shopping center REIT acquired in
March 2017. It has also maintained a strong balance sheet by
matching development spending with sales of noncore assets.
While the stock trades at 17.5-times our forward four-quarter
FFO per share forecast, above the peer median of 13.3, we
believe that the premium is appropriate given REG's superior
growth profile, improved margins from the Equity One
merger, and relatively lower exposure to troubled retailers.
RECENT DEVELOPMENTS
REG shares have underperformed the S&P 500 over the
last three months, declining 3%, compared to a gain of 3% for
the index. The shares have outperformed over the past year,
however, rising 45%, compared to a gain of 4% for the S&P.
Section 2.41
The beta on REG is 0.72.
On August 1, the company reported second-quarter
NAREIT FFO of $160 million or $0.95 per share, up from
$157 million or $0.93 per share in 2Q18. The increase was
largely due to higher earnings from investments in real estate
partnerships. However, FFO per share missed both our
estimate and the consensus forecast of $0.96. Core operating
earnings (formerly called 'operating FFO') rose to $152 million
or $0.91 per share from $151 million or $0.89 per share in
2Q18. Same-property real estate revenues rose 3% to $285
million. Total revenues declined 2% to $276 million, due to
lower lease income, and came in below our estimate of $277
million but above the consensus forecast of $271 million.
Same-property net operating income (NOI) rose 1.4%, a
particularly poor result, partly reflecting the bankruptcy of
Sears.
Concurrent with earnings, Regency announced that CFO
and President Lisa Palmer would succeed Martin 'Hap' Stein as
CEO in January. Mr. Stein will transition to executive
chairman from chairman, a position he has held since 1999. He
has served as CEO since REG went public in 1993. Ms.
Palmer has worked at Regency for 22 years. On August 16,
she was succeeded as CFO by Managing Director of Finance
Mike Mas.
Along with the 2Q results, management narrowed its 2019
NAREIT FFO guidance to $3.81-$3.85 per share from
$3.80-$3.86. The midpoint was unchanged, at $3.83, and came
in below our estimate of $3.87 and the consensus forecast of
$3.85. Management expects same-property occupancy of
95.5%. It also projected NOI growth of 2.0%-2.5%. It looks
for $150-$250 million in development and redevelopment
starts in 2019, unchanged from previous years.
During the quarter, Regency acquired a multitenant retail
building in Seattle for $4 million. The property is next to a
company shopping center, anchored by Whole Foods. In July,
Regency bought a 280,000-square-foot shopping center,
anchored by Trader Joe's, in Silicon Valley, for $213 million.
Year-to-date, the company has made $232 million in
acquisitions. Management does not plan on making additional
acquisitions in 2019.
Regency did not dispose of any assets during the second
quarter. However, management increased its disposition
guidance for the year to $300 million from $200 million.
Year-to-date, the company has sold $137 million of properties.
As a result of these asset sales, the company will have less
income-generating real estate in the near term.
During the second quarter, REG started one development
project in Los Angeles, at a cost of $27 million, and four
redevelopment projects. The redevelopments include a $52
million project at Harvard Square in Cambridge,
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Massachusetts.
The stock prices of retailers and retail REITs have
suffered as online sales continue to rise at the expense of sales
at physical stores. Companies such as Sears and Payless Shoes
have filed for bankruptcy, and department stores such as
Macy's, J.C. Penney, and Victoria's Secret have announced
store closings. We believe that Regency has relatively low
exposure to problematic retailers, as six of its top 12 tenants
are grocery stores.
On September 18, the Federal Reserve lowered its
benchmark short-term interest rate by 25 basis points to a
range of 1.75%-2.0%. Lower interest rates generally help the
performance of REITs, as their dividend yields then appear
more attractive compared to lower-yielding bonds. On the
other hand, lower rates may signal weaker consumer
confidence, inflation, and job growth, all of which hinder retail
sales.
EARNINGS & GROWTH ANALYSIS
Regency's operating metrics were positive in the second
quarter.
-- NOI rose 1.4% from the prior year, a particularly poor
result, partly affected by the Sears bankruptcy. The result came
in below the full-year guidance range of 2.0%-2.5%.
Management wants to achieve 3.0% NOI by 2020.
-- Same-space occupancy declined 60 basis points from
the prior year to 95.1%. In general, the company is benefiting
from a favorable supply environment and strong demand for
better shopping centers from expanding retailers. We expect
this trend to continue. Additionally, anchor-store occupancy
has been consistently above the peer average, as the company
has less exposure to troubled retailers. Anchor-store
occupancy declined 40 basis points year-over-year to 97.2% in
2Q19.
-- The same-space rental rate on a cash basis (for space
vacant less than 12 months), or rent spreads, rose 8.9% to
$21.66 in 2Q19, continuing recent strong growth. We like the
company's use of rent steps in new leases, which should
support future growth in rental rates.
-- REG has 23 properties under development or
redevelopment at a cost of $474 million. The development
projects are 89% leased and are expected to earn an average
return of 7.6%.
We are lowering our 2019 FFO estimate to $3.84 per
share from $3.87, reflecting the 2Q FFO miss. We are also
lowering our 2020 estimate to $3.98 per share from $4.02. Our
five-year FFO growth rate estimate is 3% (lowered from 4%).
FINANCIAL STRENGTH & DIVIDEND
Section 2.42
Our financial strength rating for REG is Medium-High.
The company's debt is rated BBB+/positive by S&P and
Baa1/stable by Moody's. At the end of the quarter, Regency's
cash stood at $37 million, down from $45 million at the end of
2018. The company also had $3.7 billion in debt, $37 million
lower than at the end of 2018. The debt/capitalization ratio
was 38%, below the peer average of 49%; almost 99% of its
consolidated debt is fixed rate. EBITDA covered interest
expense by a factor of 4.3 in 2Q19, above the peer average of
4.1. The company posted 2Q NOI growth of 1.4%, above the
peer average of 2.6%. Lastly, the EBITDA margin for the
quarter was 72%, compared to a 58% average for peers.
We do not expect Regency to have difficulty repaying
principal or refinancing debt, at least over the next two years,
as it has sufficient access to capital.
Regency pays a quarterly dividend of $0.585 per share or
$2.34 annually, for a yield of about 3.4%. Over the past five
years, REG has increased its dividend at an average annual
rate of 4.1%. Our 2019 dividend estimate is $2.34 and our
2020 estimate is $2.46.
In February 2019, the Regency board authorized a $250
million share repurchase program. The company has not yet
made any repurchases under this authorization.
MANAGEMENT & RISKS
On August 1, Regency announced that CFO and President
Lisa Palmer would succeed Martin 'Hap' Stein as CEO in
January. Mr. Stein will transition to executive chairman from
chairman, a position he has held since 1999. He has served as
CEO since REG went public in 1993. He has also served as
chairman of the industry association NAREIT. Mr. Stein's
parents were the company's founders. Ms. Palmer has worked
at Regency for 22 years. On August 16, she was succeeded as
CFO by Managing Director of Finance Mike Mas.
In addition to the normal risks associated with REITs,
Regency's specific risks include changes in consumer spending
-- which could lower the company's rental rates, and
competition from e-commerce, which could lower market
share and margins among its tenants. The company also faces
risks from tenant bankruptcies. Regency's top tenants are
Kroger, Publix, and Albertsons/Safeway (each with 3% of
annualized base rent).
The company has the following lease expiration schedule:
4% of leases will expire in 2019, including month-to-month
leases, and 11% in 2020.
COMPANY DESCRIPTION
Regency Centers Corp. is one of the largest U.S. owners,
operators and developers of community shopping centers.
Headquartered in Jacksonville, Florida, the company,
including joint ventures, operates 421 shopping centers with
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nearly 53 million square feet of space. Regency's shopping
centers are usually anchored by major grocery store chains,
such as Kroger and Publix. The stock is included in the S&P
500 Index.
VALUATION
REG shares are trading above the midpoint of their
52-week range of $56-$69.
From a fundamental standpoint, REG is trading at
17.5-times our forward four-quarter FFO per share forecast,
below the five-year historical average of 19.5, but above the
peer median of 13.3. However, we feel the premium to peers is
appropriate given REG's superior growth profile and relatively
lower exposure to troubled retailers.
Regency has posted solid operating results, and has both a
strong balance sheet and a healthy development pipeline. We
believe that REITs are attractive in light of low interest rates
and that REG's valuation makes the stock a compelling BUY
at this time. Our price target of $73 implies a forward
price/FFO multiple of 18.6, still below the five-year historical
average.
On September 19, BUY-rated REG closed at $68.00, up
$0.11. (Jacob Kilstein, CFA, 9/19/19)
State Auto Financial Corp. (STFC)
Current Rating: HOLD Publication Date: 9/24/19
HIGHLIGHTS
*STFC: Stock fairly valued; reiterating HOLD
*STFC is a regional player that has struggled to post
consistent results. However, it is taking steps to improve
underwriting, including the introduction of a digital platform,
and has exited unprofitable business lines.
*On August 1, State Auto posted a net loss from
operations for the second quarter of $14 million or $0.33 per
share, compared to a loss of $3 million or $0.08 per share in
2Q18. The loss was due to catastrophe and noncatastrophe
weather-related losses, which are typically greatest during the
second quarter.
*The 2Q combined ratio worsened to 111.4 from 107.0 a
year earlier. The return on equity for the trailing 12-month
period was 6.0%, compared to a negative 1.3% a year earlier.
*At current prices near $32, STFC shares are trading near
our fair value estimate, below peer average P/E multiples but
above the midpoint of their five-year historical range for
price/book.
ANALYSIS
INVESTMENT THESIS
Our rating on State Auto Financial Corp. (NGS: STFC), a
mid-cap P/C insurance company, is HOLD. The company is a
regional player that has struggled to post consistent results.
CEO Michael LaRocco has attributed STFC's recent weak
Section 2.43
performance variously to adverse prior-year loss development,
ongoing deterioration in the auto business, increased bodily
injury severity, and poor underwriting. However, State Auto is
taking steps to improve underwriting, including the
introduction of a digital platform, and has exited unprofitable
business lines. After exiting specialty insurance, the company
is now focused on writing personal auto and home, small and
middle market commercial, farm and ranch, and workers'
compensation policies.
At current prices near $32, STFC shares are trading near
our fair value estimate, below peer average P/E multiples but
above the midpoint of the five-year historical range for
price/book. We would consider raising our rating on signs of
more consistent ROE and improved combined ratios. We note,
however, that the company significantly improved its ROE in
2Q, to 6.0%, well above the 1.5% achieved in 2018.
RECENT DEVELOPMENTS
STFC shares have underperformed the Russell 2000 over
the past quarter, falling 5.8%, compared to a 2.1% increase for
the index. The shares have outperformed over the past year,
however, rising 4.2% versus a 8.4% decrease for the index.
The beta on STFC is 0.81.
On August 1, State Auto posted a net loss from operations
for the second quarter of $14 million or $0.33 per share,
compared to a loss of $3 million or $0.08 per share in 2Q18.
The loss was due to catastrophe and noncatastrophe
weather-related losses, which are typically greatest during the
second quarter. Revenues fell 0.5% to $340 million.
We note that 2Q19 was the sixth unprofitable quarter for
State Auto in the past ten quarters.
The 2Q combined ratio worsened to 111.4 from 107.0 a
year earlier. Book value at the end of the second quarter rose
to $21.07 per share, up from $18.85 at the end of 2Q18, due to
investment gains. The return on equity for the trailing
12-month period was 6.0%, compared to a negative 1.3% a
year earlier.
EARNINGS & GROWTH ANALYSIS
To build models for insurance companies, we typically
focus on ROE. The top companies in the industry, operating at
optimum efficiency, can generate ROEs in the high teens. The
average is in the 8%-12% range. We have yet to see STFC
consistently reach the industry average. Based on the
company's catastrophe losses, we are lowering our 2019 EPS
estimate to $1.25 from $1.76. We are also lowering our 2020
forecast to $1.97 from $2.04. Our long-term earnings growth
rate estimate is 4%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on State Auto is Medium, the
middle rank on our five-point scale. The company achieves
mixed scores on our three main measures of financial strength:
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leverage based on debt-to-cap, profitability, and interest
coverage.
At the end of 2Q19, the company had long-term debt of
$122 million (unchanged from the end of 2018) and
shareholders' equity of $895 million (up from $819 million).
The 2Q debt/capitalization ratio was 12% versus an average of
18% for peers. The company's operating income for the
trailing 12 months covered interest expense by a factor of 124,
compared to 8 for peers. For the trailing 12 months, the
company's profit margin was 3.9%, below the peer average
margin of 6.5%. Lastly, ROE was 6.0% in the trailing
12-month period, below the industry average of 12.1%, but a
substantial improvement from recent periods.
State Auto pays a quarterly dividend of $0.10 per share, or
$0.40 annually. The yield is about 1.2%, below the industry
average of 1.8%. The dividend has remained unchanged over
the past five years. We expect the payout to remain at $0.40
per share in 2019 and 2020.
MANAGEMENT & RISKS
The CEO of State Auto is Michael LaRocco. He has more
than 37 years of experience in the insurance industry,
including roles as COO at Safeco Insurance Companies and
CEO at Fireman's Fund Insurance. Mr. LaRocco most recently
served as president and CEO of AssureStart, a technology
startup selling insurance to small businesses online.
Mr. LaRocco joined the company in August 2015 with the
goal of helping it to emerge from several years of weak results.
Indeed, results have been so erratic that in April 2015 the
insurance rating company A.M. Best lowered State Auto's
financial strength rating to 'bbb-' from 'bbb.' The downgrade
was due to poor underwriting and operating results relative to
the private passenger standard auto and homeowners'
composite, weak 2014 results due to adverse run-off
development in large commercial trucking and restaurant
specialty lines programs, and the potential for continued
adverse development in these programs.
The most significant risk for State Auto is underwriting
deterioration in the property casualty market. Management is
addressing this risk through aggressive pricing. Other risks to
earnings and the balance sheet include insured losses related to
major property catastrophe events.
COMPANY DESCRIPTION
State Auto Financial Corp., based in Columbus, Ohio,
writes personal (60%) and business (40%) insurance. Products
include personal and commercial automobile, homeowners,
farm owners, multiple-peril, workers' compensation, and other
lines. The company sells products and services through a
network of 3,400 independent insurance agencies in the central
and eastern United States. The company is 62%-owned by
State Automobile Mutual Insurance Co.
Section 2.44
VALUATION
We believe that STFC shares are fairly valued at current
prices near $32, near the midpoint of their 52-week range of
$28-$36. They are trading at a projected forward four-quarter
P/E of 17.0, below the 18.0 peer average and STFC's own
historical five-year average of 21.7. The stock also trades at
1.6-times book value, in line with peers, and above the
midpoint of the five-year historical range of 0.8-1.8.
Given the company's low profitability, we think that the
current P/E discount to peers is warranted, while the
historically high price/book multiple is not. As such, our rating
remains HOLD.
On September 24 at midday, HOLD-rated STFC traded at
$32.16, up $0.01. (Jacob Kilstein, CFA, 9/24/19)
Texas Instruments Inc. (TXN)
Current Rating: BUY Publication Date: 9/23/19
HIGHLIGHTS
*TXN: Hikes dividend 17%; BUY to $145
*Texas Instruments announced that it would raise its
quarterly dividend by 17%, to $0.90 per share from $0.77. TI
has raised its annual dividend for 16 consecutive years.
*The company has a long-standing commitment to
returning value to shareholders.
*TI has been able to moderate the annual cost of its
payout thanks to the multi-year share repurchase program. TI
has reduced shares outstanding by 46% since the end of 2004.
*While our 2019 EPS forecast for Texas Instruments
implies a year-over-year decline, we have a positive outlook
for 2020 earnings.
ANALYSIS
INVESTMENT THESIS
BUY-rated Texas Instruments Inc. (NGS: TXN) rose
modestly on 9/20/19 after the company announced plans to
hike its dividend by 17%. The new quarterly dividend rate is
$0.90, up from a prior $0.77. The higher dividend will be
payable 11/8/19 to shareholders of record as of 10/31/19.
TI has raised its annual dividend for 16 consecutive years.
The company has a long-standing commitment to returning
value to shareholders. Even as the company continues to hike
its dividend aggressively, TI has been able to moderate the
annual cost of its payout thanks to the multi-year share
repurchase program. TI has reduced shares outstanding by
46% since the end of 2004.
In July, TXN shares rallied after the analog chip maker
topped consensus sales and earnings expectations for 2Q19.
GAAP EPS of $1.36 bested the $1.22 consensus forecast while
declining just 3% year-over-year. The company held the
annual decline in revenue to single-digit percentages and
offered a positive if cautious outlook for the third quarter.
 GROWTH / VALUE STOCKS
In response to the downswing in the semiconductor
demand cycle, TI reduced wafer starts earlier in 2019 while
simultaneously increasing the portion of wafer production
dedicated to consignment shipments. While these actions can
have a near-term negative impact on revenue and gross
margins, they preempt deeper margin erosion over the
intermediate term.
Timing of any semiconductor downturn is uncertain. We
believe the current cyclical decline is closer to the end than
beginning, and will not be severe by historical standards.
While our 2019 EPS forecast for Texas Instruments implies a
year-over-year decline, we have a positive outlook for 2020
earnings.
Given prospects for revenue and EPS acceleration in the
coming year, our blended valuation is well above current
prices, and we believe TXN continues to offer good value. The
relentless focus on shareholder return should keep both
institutional and individual investors highly engaged with
TXN. We are reiterating our 12-month target price of $145,
and reiterating our BUY rating on TXN
RECENT DEVELOPMENTS
TXN is up 37% year-to-date in 2019, vs. 32% for peers.
TXN declined 10% in 2018, compared to a 4% decline for the
peer group of Argus-covered semiconductor stocks. The shares
rose 43% in 2017, ahead of a 31% gain for the peer group and
a 37% gain for the SOX (semiconductor) index. TXN rose
33% in 2016, while lagging the extraordinary 70% peer-group
gain, driven by the graphics-processing stocks. TXN advanced
2.5% in 2015, also lagging the 9% peer-group gain. TXN rose
22% in 2014, versus 18% for peers.
On 9/19/19 after the market close, Texas Instruments
announced it would raise its quarterly dividend by 17%, to
$0.90 per share from $0.77. The higher dividend will be
payable 11/8/19 to shareholders of record as of 10/31/19.
Along with three quarterly payouts of $0.77 in the first three
quarters, the $0.90 payout for 4Q19 will result in a full-year
2019 dividend of $3.21. Going forward, the annualized
dividend is $3.60.
Texas Instruments has a long-standing commitment to
capital allocation. It begins with a capital management
strategy. The objective of TI's capital management strategy is
to maximize long-term growth of free cash flow per share. The
company's strategy is based on executing its business model
that is built around sustainable competitive advantages. TI has
a disciplined program to allocate capital to the best
opportunities.
In 2018, TI set a goal of growing free cash flow per share
by 25%-35%; actual growth was 38%. Management intended
to hold capital spending at 4% of revenues, but in fact capital
Section 2.45
spending was equal to 7% of revenue. The company's pensions
remained fully funded in 2018.
During 2018, TI achieved its objective of returning all or
more than all of free cash flow to shareholders via dividends
and share buybacks. The company similarly attained its goals
of returning 40%-60% of free cash flow via dividends, and to
return the balance after dividends via share repurchases. Like
many other companies in Argus technology coverage, TI has
gradually shifted shareholder returns within its capital
allocation toward dividends and away from repurchases.
For 2019, TI continue to target growing free cash flow per
share by 25%-35%. Management expects capital spending in
2019 to be equivalent to 6% of revenue. As in 2018, the
company's goal is to return all or more than all of 2019 free
cash flow to shareholders, allocated 40%-60% to dividends
with the remainder used to repurchase stock.
In 2Q19, TI returned $1.6 billion to shareholders with
roughly equal contributions from dividends and share
buybacks. Trailing 12-month free cash flow exceeded $6.0
billion. The company has returned $8.0 billion to shareholders
over the past 12 months, consistent with management's
strategy of returning all or more than all free cash flow to
shareholders.
The company has an impressive decade-long record of
returning free cash flow to shareholders. Between 2009 and
2018, TI allocated $77 billion in capital. That includes R&D,
sales & marketing, capital spending and investments. Key
investments in this period included buying National
semiconductor; acquiring semiconductor fabs in Japan and
Richardson, Texas, from Spansion, along with other fab assets
acquired at 'fire-sale' prices; and investing in 300 mm analog
WFE equipment ahead of rivals.
Texas Instruments has reduced its outstanding shares by
46% since 2004, through share repurchases. That has allowed
the company to aggressively raise its dividend per share each
year while moderating the aggregate cost of its dividend.
Between 2009 and 2018, Ti grew its annual dividend at a
20.8% compound annual growth rate; over that span, the cost
of the dividend grew at about a 25% CAGR.
Historically free cash flow has covered TI's annual
dividend cost by 2.00-times to 3.00-times. We estimate that
free cash flow will cover TI's annual dividend cost by
2.2-times for 2019 and about 2.2-times for 2020.
TI's capital allocation strategy is enabled by the company's
competitive advantages, market leadership, and strong cash
flow generation. We expect the company to continue to
prioritize shareholder returns going forward.
For 2Q19, Texas Instruments reported revenue of $3.67
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billion, which was down 9% year-over-year and up 2%
sequentially. Revenue was above the midpoint of
management's guidance range of $3.46-$3.74 billion, and
topped the $3.60 billion consensus estimate. GAAP earnings
were $1.36 per diluted share, down 3% from $1.40 a year
earlier. GAAP EPS for 2Q19 were above the high end of
management's guidance of $1.12-$1.32, and easily beat the
$1.22 consensus estimate. Although EPS benefited from a
one-time $0.07 gain, adjusted EPS of $1.29 would have also
topped consensus.
Management stated that 2Q19 unfolded largely as the
company expected, with revenue declining in single digits in
Analog and in double digits in embedded processing. Amid
this cyclical demand downturn, which has been complicated by
the increasingly global trade war, TI continues to focus its
strategy on the industrial and automotive end markets. In these
end markets, TI is allocating capital and making investments
while 'driving initiatives to strengthen our position.'
During the 2Q19 conference call in July 2019,
management offered a neutral assessment of the demand
environment; that was an improvement from the downbeat
outlook offered in April. Midpoint revenue guidance for 3Q19
was indicative of mid-single-digit sequential top-line growth,
which is below the normal seasonal trend but at least indicative
of slightly improving customer demand.
In this still-uncertain environment, management stressed
that TI was ready to respond to any shifts in demand,
regardless of whether the economy strengthens, weakens, or
stands still. This readiness reflects both the deliberate focus on
key end markets, as well as how the company positions its
inventory, supply chain, and semiconductor production.
Additionally, the company's long-term investment in 300-mm
wafer fabrication provides an operating cost advantage over
competitors still largely producing 200-mm wafers.
Over the past four quarters, TI has increased the portion
of its production dedicated to wafers intended for the
consignment portion of its demand. Consignment shipments to
distributors generally serving highly fragmented end markets,
particularly industrial, have grown to about two-thirds of TI's
shipments in any quarter. While the wafer reduction and
reallocation to consignment have near-term impacts on
revenue and gross margin, they provide intermediate-term
benefits by buffering the negative impacts on margins from
over-production.
Within its consignment strategy in 2Q19, TI's overall
inventories declined. At the same time, inventories reflected a
higher percentage of low-volume parts that can be more
difficult to build profitably. Should demand turn up for these
low-volume parts, TI will be ready to serve its customer
without stretching out lead times.
Section 2.46
TI also reiterated that its 'plans remained on hold' to add
new 300-mm wafer production capacity in Richardson, TX.
The company already has production facilities in Richardson,
and the new site will benefit from proximity to the existing
plant. Upon completion, the new Richardson facility will be
staffed with up to 500 employees and represent a $3.1 billion
capital investment. We believe it could be a year or more
before TI begins work on this site.
Although timing of any semiconductor downturn is
uncertain, we believe this cyclical decline will not be severe.
TI showed sequential momentum in every end market during
2Q19 with the exception of communications infrastructure,
which is in a growth phase and expected to be lumpy. Given
prospects for revenue and EPS acceleration in coming
quarters, particularly on a sequential basis in 2H19, our
blended valuation is well above current prices and
TXN continues to offer good value. The relentless focus
on shareholder return should keep both institutional and
individual investors highly engaged with TXN.
EARNINGS & GROWTH ANALYSIS
For 2Q19, Texas Instruments reported revenue of $3.67
billion, which was down 9% year-over-year and up 2%
sequentially. Revenue was above the midpoint of
management's guidance range of $3.46-$3.74 billion, and
topped the $3.60 billion consensus estimate. GAAP gross
margin widened sequentially to 64.3% for 2Q19 from 62.9%
for 1Q19 while narrowing from 65.2% a year earlier.
GAAP operating margin narrowed to 41.1% for 2Q19
from 42.6% a year earlier, while also expanding sequentially
from 38.4% for 1Q19. GAAP earnings were $1.36 per diluted
share, down 3% from $1.40 a year earlier. GAAP EPS for
2Q19 were above the high end of management's guidance of
$1.12-$1.32, and easily beat the $1.22 consensus estimate.
Although EPS benefited from a one-time $0.07 gain, adjusted
EPS of $1.29 would have also topped consensus.
For all of 2018, revenue of $15.78 billion increased 6%
from $15.0 billion for 2017. GAAP EPS of $5.59 per diluted
share increased from a tax-impacted $3.60 per diluted share
for 2017.
For 3Q19, Texas Instruments is guiding for sales of
$3.65-$3.95 billion, which at the $3.80 billion midpoint would
be down 10% year-over-year. The guidance midpoint was
close to the prereporting consensus of $3.84 billion, but TI
routinely tops its mid-point guidance. TI projects GAAP EPS
of $1.31-$1.53, or $1.42 at the midpoint of the range, which
would be down 12% from a year earlier.
In keeping with Street convention, we are modeling and
valuing TXN shares based on GAAP EPS. Our 2019 GAAP
forecast for TI is $5.35 per diluted share. Our 2020 GAAP
EPS estimate is $5.78 per diluted share; we regard our 2020
 GROWTH / VALUE STOCKS
forecast as fluid and dependent on multiple factors, including
resolution of the trade war. Our five-year EPS growth rate
forecast for TXN remains 10%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Texas Instruments is
Medium-High. Debt was $5.81 billion at the end of 2Q19.
Debt was $5.07 billion at the end of 2018, $4.08 billion at
year-end 2017, $3.61 billion at year-end 2016, and $4.13
billion at year-end 2015.
Cash was $4.22 billion at the end of 2Q19, reduced by
buybacks and dividends. Cash and equivalents were $4.23
billion at the end of 2018, $4.47 billion at year-end 2017,
$3.49 billion at year-end 2016, and $3.22 billion at the close
of 2015.
Cash flow from operations was $7.19 billion in 2018.
Cash flow from operations was $5.36 billion in 2017, $4.61
billion in 2016, and $4.27 billion in 2015.
Free cash flow was $6.1 billion for 2018, compared with
$4.67 billion in 2017, $4.08 billion in 2016, and $4.45 billion
in 2015.
The company has returned $8.0 billion to shareholders
over the past 12 months through mid-2019, consistent with
management's strategy of returning all or more than all free
cash flow to shareholders. In 2018, TI's board authorized an
additional $12 billion in share repurchases, on top of an
existing authorization with $7.4 billion remaining as of
6/30/18. In 2017, TI returned $4.7 billion to shareholders via
buybacks and dividend payments. In 2016, the company
returned $4.2 billion to shareholders via $2.15 billion in
buybacks and $1.65 billion in dividends. The common stock
base, including CSEs, has fallen more than 46% since the end
of 2004.
In September 2019, TI raised its quarterly dividend by
17%, to $0.90 per share. This followed a 24% hike to $0.77
per share In September 2018, and a 24% hike to $0.59 in
September 2017. TI previously raised its payout by 32%, to
$0.50 per share, in October 2016; and by 12%, to $0.38 per
share, in 2015. Texas Instruments increased its annual
dividend at a compound annual rate of more than 20%
between 2009 and 2018 and has boosted its payout for 16
straight years. We forecast annual dividends of $3.21 for 2019
and $3.70 for 2020.
MANAGEMENT & RISKS
In July 2018, Rich Templeton - who had stepped down as
CEO on 6/1/18 - resumed that role following the resignation of
new CEO Brian Crutcher, who had been in the job for only six
weeks. CEO Templeton's appointment is not temporary, and
the board will not search for another CEO.
Section 2.47
In February 2017, veteran executive Rafael Lizardi took
over as CFO from Kevin March, who had served as CFO for
13 years. Gregory Delagi is SVP and GM of Embedded
Processing. Steve Anderson, former head of High Performance
Analog, succeeded EVP Crutcher as head of the Analog
business.
While the sudden dismissal of a CEO is never good news,
TI was fortunate that CEO Templeton had left the job just six
weeks earlier. We think that Mr. Templeton is highly regarded
on Wall Street for his prescient and even against-the-grain
purchases of semiconductor assets at fire sale prices, and at a
time when most industry players were still gripped with
recession fears. We have little doubt that his reinstallation
marks an 'upgrade' in the CEO suite during another crucial
period for the company and the industry.
A key risk for Texas Instruments is that long-term demand
fails to justify its significant asset expansion, even though that
expansion was conducted at very low cost. National
Semiconductor, which brings a different customer base and
presumably a different corporate culture, must be integrated
into Texas Instruments' go-to-market mechanism. Texas
Instruments added several major fabrication sites and acquired
National Semi in little more than a year, and appears to be
wrestling with production planning as it seeks to incorporate
all these new assets. For the long term, we note that Texas
Instruments is a decades-old company that has successfully
integrated assets while simultaneously spinning off noncore
businesses.
Other end markets present risks, particularly computer
peripherals and other, more-consumer-oriented, niches.
Demand could weaken if consumer spending falters. Still, we
believe that the diversity of TXN's customer base lessens the
risks of weakness in any particular niche.
COMPANY DESCRIPTION
Dallas-based Texas Instruments is a global, vertically
integrated producer of analog and embedded processing
semiconductors. It serves key end markets including industrial,
automotive, and communications infrastructure. Recent
acquisitions and divestitures have increased the focus on
nontraditional end markets while lessening the company's
exposure to computing, mobile communications, and
consumer electronics.
The September 2011 acquisition of National
Semiconductor (now Silicon Valley Analog) significantly
increased exposure to industrial, automotive,
aerospace-defense, instrumentation, and other
high-value-added and long-cycle markets. The company is
exiting consumer-device apps processing and connectivity and
is completing its exit from the DSP baseband business.
INDUSTRY
 GROWTH / VALUE STOCKS
Our rating on the Technology sector is Over-Weight, as
we see value in Tech stocks following the late 2018 selloff.
Over the long term, we expect the Tech sector to benefit
from pervasive digitization across the economy, greater
acceptance of transformative technologies, and the
development of the Internet of Things (IoT). Healthy company
and sector fundamentals are also positive. For individual
companies, these include high cash levels, low debt, and broad
international business exposure.
The shift of social media platforms and digital information
companies such as Facebook and Alphabet into
Communication Services will moderately impact sector
characteristics. In general, the removal of those giants slightly
reduces the EPS growth outlook, reduces sector-weighted beta;
and raises sector-weighted dividend yield.
The sector is outperforming the market thus far in 2019,
with a gain of 30.2%. It outperformed the S&P 500 in 2018,
with a loss of 1.6%, and in 2017, with a gain of 36.9%.
Fundamentals for the Technology sector look reasonably
balanced. By our calculations, the P/E ratio on projected 2020
earnings is 19.0, above the market multiple of 16.5. Earnings
are expected to grow 15.5% in 2020 and 3.1% in 2019 after
rising 25.9% in 2018. Earnings rose in the low single digits in
2015-2016. The sector's debt ratios are below the market
average, as is the average dividend yield.
VALUATION
TXN shares are trading at 24.0-times our GAAP earnings
projection for 2019 and at 22.3-times our 2020 forecast; the
two-year average forward P/E of 23.2 is now at a premium to
the five-year (2014-18) average P/E of 19.7. At a current
two-year forward relative P/E of 1.37, TXN is trading above
its historical relative P/E of 1.19. Based on other measures of
comparable analysis (such as price/sales, price/book, and
price/cash flow), we value the shares in the upper $90s, in a
rising trend though below current prices.
Compared with peers, TXN trades at slight premiums on
EV/EBITDA, price/sales, relative P/E and PEGY. However,
the company is growing sales and earnings faster than the
market and most peers, and peer-indicated value is only
slightly below current levels. Discounted free cash flow
analysis renders a fair value above $170, and is no longer in a
slightly declining trend.
Our blended model now suggests a fair value in the
upper-$140s, in a rising trend and above current levels.
Appreciation to our 12-month target price of $145 along with
the 2.5% (indicated) annual dividend yield, implies a
risk-adjusted return that exceeds our forecast for the broad
market. On that basis, we are reiterating our BUY rating on
TXN.
Section 2.48
On September 20, BUY-rated TXN closed at $126.67,
down $2.16. (Jim Kelleher, CFA, 9/20/19)
Xilinx, Inc. (XLNX)
Current Rating: BUY Publication Date: 9/24/19
HIGHLIGHTS
*XLNX: CFO transition fears overdone; reiterating BUY
*XLNX shares fell 8% on 9/20/19 following news that
CFO Lorenzo Flores would leave the company.
*Given the alleged improprieties that have driven other
tech executives out of office, Mr. Flores may have been tarred
with the same brush. However, Mr. Flores is leaving for a
more prestigious job, not for cause.
*We believe that the market over-reacted to this
resignation, and expect Xilinx to fill the role without
disruption.
*Adjusted for current geopolitical turmoil, Xilinx's
superior growth prospects relative to peers signal continued
good value in the stock.
ANALYSIS
INVESTMENT THESIS
BUY-rated Xilinx Inc. (NGS: XLNX) fell 8% on 9/20/19
following news that CFO Lorenzo Flores would leave the
company. Although the CFO's departure was sudden, he had
another job waiting: as vice chairman of Toshiba Memory.
The tech sector has seen notable and sudden executive
departures, driven by performance or concerns about
impropriety. We believe the market over-reacted to an
executive moving on, and we expect Xilinx to fill the role
without disruption.
XLNX has come off its highs, which were briefly in the
$130s; the 200-day trendline is currently around $111. The
stock has been hit by the erratic trend in demand among North
American and global data center and hyperscale customers. In
July, Xilinx offered cautious 2Q20 guidance that reflected
exposure to Huawei and other Chinese companies impacted by
the trade war, along with weakness in North American data
center demand.
Like all semiconductor companies, Xilinx is experiencing
geopolitical volatility; but the company's fundamental
strengths are intact. Based on its system-on-a chip and
programmable logic device solutions, Xilinx is strengthening
its position in diverse industrial and consumer markets, in AI
and cloud data center, and in communications infrastructure as
5G gets going. The company has also made complementary
niche acquisitions, including NGCodec, which provides a
differentiated video encoding technology; and Solarflare,
which provides high-performance networking solutions.
Xilinx has led the FPGA industry in key process nodes
such as 28 nm, 20 nm, and 16 nm, and is now on track to lead
 GROWTH / VALUE STOCKS
in a new technology in 7 nm process node. Even as annual
comparisons become more challenging following multiple
quarters of sharply above-consensus results, Xilinx continues
to grow faster than the peer group on an annual basis.
The company's superior growth prospects relative to peers
signal continued good value in the stock. Top-line growth
prospects are accelerating, and margins are expanding on
higher volumes. XLNX appears attractive at current levels,
and we are reiterating our BUY rating to a 12-month target
price of $145.
RECENT DEVELOPMENTS
XLNX is up 13% in 2019, while peers have risen 29%.
XLNX shares advanced 26% in 2018, versus a 4% decline for
the Argus semiconductor peer group. XLNX rose 12% in
2017, lagging the 31% gain for the peer group and the 38%
gain for the SOX (Philadelphia Semiconductor) index. XLNX
shares rose 29% in 2016, while the peer group was up a simple
average 70% (fueled by NVDA and AMD).
As of July 2019, XLNX shares were up 50% year-to-date.
The stock sold off on cautious 2Q20 guidance, continued to
work lower across late summer, and has failed to participate in
the recent tech recovery rally. We believe that selling in the
stock is overdone.
Xilinx provided midpoint revenue guidance for fiscal
2Q20 of $825 million; the Street had been modeling $857
million. Xilinx's Wired & Wireless group (WWG) and Data
Center Group (DCG) are both being impacted by the
suspension of shipments to Huawei. Demand from other
Chinese wireless infrastructure customers has been hurt by
hesitancy related to the ongoing trade war. The stock has also
been hit by the erratic trend in demand among data center and
hyperscale customers.
The stock took another step down following news of a
transition in the C-suite. On 9/19/19, Xilinx announced that
CFO Lorenzo Flores was stepping down. The CFO will leave
the company after Xilinx reports its fiscal 2Q20 (calendar
3Q19) results on 10/23/19. On 9/20/19, Toshiba Memory
Holdings announced that Mr. Flores would join the company
as vice chairman. Toshiba Memory Holdings, which is no
longer affiliated with Toshiba, will be renamed Kioxia
Holdings on 10/1/19.
XLNX shares tumbled on the news; we regard the
knee-jerk selloff as an over-reaction. The technology universe
has seen multiple executive changes prompted by alleged
impropriety. Among mature technology companies, both
Texas Instruments and Intel had CEOs leave because of past
behavior deemed inappropriate.
Among newer companies, Uber dumped founder and CEO
Travis Kalanick as an investor perquisite before going public.
Section 2.49
WeWork has been heavily featured in the business press lately,
as investor Softbank has pushed to replace founder and CEO
Adam Neumann.
The sometimes seamy details surrounding these executive
transitions have lent a taint to any C-level movement, in our
view. Particularly when the departure is unanticipated, the
response from investors has been to shoot first and ask
questions later.
Soon-to-be-former CFO Flores is leaving Xilinx based on
opportunity. Xilinx has begun its search for a successor, and
we expect the transition to be orderly. Although a new CFO
may not be in place by the earnings release on 10/23/19, the
company should be well along in the process by then.
We also believe that leadership at the very top of Xilinx is
strong. CEO Victor Peng took over in January 2018, moving
up from COO. Coming up from the engineering ranks, CEO
Peng engineered and developed Xilinx's product lineup over
the past decade. His work prior to assuming the CEO role has
led to Xilinx establishing leadership in all advanced process
nodes such as 28 nm, 20 nm, and 16 nm. And Xilinx is now on
track to lead in a new technology in 7 nm process node. The
company has also advanced its SoC leadership and is
developing other promising growth venues.
Xilinx spent five years developing ACAP (adaptive
computing acceleration products), which management regards
as the company's most significant engineering accomplishment
since the invention of the FPGA. ACAP combines multiple
components on a single chip, connected by on-chip
networking. Elements within ACAP include multiple FPGA,
memory, digital signal processing, compute processing, and
programmable compute engines.
ACAP chips can be changed at both the hardware and
software levels to dynamically adapt to the needs of a wide
range of applications and workloads. Markets to be served by
ACAP devices include data center, automotive, 5G wireless,
wireline communications, and aerospace-defense.
Earlier in 2019, the company announced it had taped out
its Versal ACAP in 7 nm process node. In June, Xilinx
achieved a milestone with its first customer shipments of the
Versal ACAP in 7 nm process. Versal AI delivers the
portfolio's highest compute and lowest latency, enabling
breakthrough AI inference throughput and performance.
Versal Prime is designed for broad applicability across
multiple markets and is optimized for connectivity and in-line
acceleration of diverse workloads.
In October 2018, Xilinx launched its Alveo portfolio of
adaptable application acceleration line cards to increase
performance in industry standard (x86) servers. CEO Peng
expects the Alveo revenue contribution to be meaningful
 GROWTH / VALUE STOCKS
beginning late in fiscal 2020.
In April 2019, Xilinx announced the acquisition of
Solarflare, a leading provider of high-performance,
low-latency networking solutions. Xilinx intends to combine
its FPGA, multi-processor SoCs (MPSoC), and ACAP
products with Solarflare's network interface card (NIC)
technology and Onload applications acceleration software. The
goal is to develop new converged Smart NICs.
In July 2019, Xilinx acquired NGCodec, which provides a
differentiated video encoding technology. Combined with the
Xilinx acceleration platform, the NGCodec solution is
expected to deliver greater visual quality at lower bandwidth.
The goal of internal developments such as ACAP and Alveo
and acquisitions such as Solarflare and NGCodec is accelerate
Xilinx's transition to a platform company, while reducing its
reliance on legacy FPGAs.
We believe that Xilinx has a sure hand at the tiller with
CEO Peng. The 59-year-old CEO should have multiple years
in the chief executive role, allowing sufficient continuity for
the management team to carry out its strategy. We expect the
CFO transition to be smooth.
XLNX shares have failed to participate in the technology
recovery rally for multiple reasons. In the hyperscale and data
center space, fluctuations in demand are consistent with the
historical experience in other growth niches. We expect to see
the same scenario play out in the 5G market in the coming
years, as periods of inventory fill are followed by periods of
inventory digestion.
Exposure to Huawei and the trade war is beyond the
company's control. Excluding those factors, the overall
top-line trend and margin performance signal ongoing
profitable growth. And the CFO transition at Xilinx was driven
by opportunity rather than impropriety, calling the Street's
reaction into question.
We regard XLNX as undervalued at current levels, given
multiple growth levers for the company, and are reiterating our
BUY rating.
EARNINGS & GROWTH ANALYSIS
For the first quarter of the March 2020 fiscal year
(calendar 2Q19), Xilinx reported revenue of $850 million,
which was up 24% annually and 3% sequentially. Revenue
came in at the midpoint of management's $835-$865 million
guidance range and $1 million below the $851 million
consensus estimate.
The gross margin narrowed to 66.2% in 1Q20 from 67.5%
in 4Q19 and 69.8% a year earlier; the margin compression
reflects a higher wireless infrastructure contribution. The
GAAP operating margin tightened to 29.5% in 1Q20 from
Section 2.50
30.2% in 4Q19 and 31.5% a year earlier.
Xilinx provides directional line-item guidance rather than
explicit EPS guidance. GAAP earnings of $0.94 per diluted
share rose 26% from $0.74 a year earlier, and dipped by a
penny sequentially; the results matched the Street estimate of
$0.94.
For all of FY19, Xilinx posted revenue of $3.06 billion,
up 23% from $2.54 billion in fiscal 2018. On a GAAP basis,
Xilinx earned $3.47 per diluted share in fiscal 2019, up 87%
from $1.97 per diluted share in fiscal 2018.
For fiscal 2Q20, Xilinx guided for revenue of $800-$850
million; at the $825 million midpoint, sales would be up 11%
annually and down in the single digits sequentially. The Street
had been modeling $857 million.
Much of the sequential revenue weakness is anticipated in
WWG. That partly reflects Huawei headwinds. Additionally,
in the early stages of a massive development such as 5G, we
anticipate demand among the broad group of customers to be
lumpy, as carriers over-order in some quarters and then cut
orders in subsequent periods to allow for inventory digestion.
Also for 2Q20, DCG is expected to rebound strongly. AIT is
forecast slightly down, and ABC slightly higher.
Xilinx guided for a 2Q20 GAAP gross margin of 65%
-66%, operating costs of $326 million, and a tax rate of zero.
That points to EPS of $0.86-$0.92 in 2Q20, which at the
midpoint would indicate mid-single-digit growth on a GAAP
basis.
Our FY20 non-GAAP forecast for Xilinx is $3.78 per
diluted share and our FY21 forecast is $4.29. Our five-year
EPS growth rate forecast for XLNX is 12%.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength ranking on Xilinx is Medium-High.
In 1Q18, Xilinx issued $750 million of 2.95% debt with a
seven-year term. It also redeemed the remaining $458 million
balance on its convertible debt on 6/15/17.
Cash was $2.94 billion at the end of 1Q20, reduced by
buybacks. Cash was $3.23 billion at the end of FY19, $3.55
billion at the end of FY18, $3.44 billion at the end of FY17,
$3.56 billion at the end of FY16, and $3.66 billion at the end
of FY15.
Debt was $1.25 billion at the end of 1Q20. Debt was
$1.24 billion at the end of FY19, $1.71 billion at the end of
fiscal FY18, $1.45 billion at the end of FY17, $1.58 billion at
the end of FY16, and $1.61 billion at the end of FY15. In
4Q14, Xilinx redeemed $400 million of convertible debt
issued in FY07 and issued $1 billion of senior notes.
 GROWTH / VALUE STOCKS
The debt/cap ratio was 30.1% at the end of FY19, 42.4%
at the end of FY18, 36.7% at the end of FY17, 39.0% at the
end of FY16, 37.3% at the end of FY15, and 36.2% at the
close of FY14. Debt/cap has risen from 22.0% at the end of
3Q14, reflecting lower stockholders' equity as Xilinx adds to
its Treasury (repurchased) shares.
In October 2016, the company announced that it would
amend its former 'opportunistic' buyback policy and instead
repurchase stock at a 'deliberate' pace. Xilinx returned $526
million to shareholders in FY19, including $364 million in
dividends and 4162 million in buybacks.
Xilinx has raised its dividend every year for the past 13
years. On 4/25/18, it raised its quarterly payout by 6% to $0.36
per share. Our dividend estimates are $1.48 for FY20 and
$1.52 for FY21.
MANAGEMENT & RISKS
Victor Peng succeeded Moshe Gavrielov as CEO and
president in January 2018. Formerly SVP of the
Programmable Products Group, Mr. Peng had been promoted
to COO in April 2017.
In September 2019, Xilinx announced that Lorenzo Flores
would step down as CFO following the company's fiscal 2Q20
earnings release on 10/23/19. Mr. Flores left to pursue a new
job (vice chairman at Toshiba Memory), not because of the
alleged improprieties that have driven other tech executives
out of office.
CEO Peng engineered and developed Xilinx's product
lineup over the past decade, resulting in leadership in all
advanced process nodes. He has been proactive in developing
the company's software capabilities while strengthening its
presence in the cloud data center. His leadership sends a
positive signal to Wall Street.
ACAP will be immaterial to FY18 and likely even FY19
results. Nonetheless, we see the launch as strategic to the
company's long-term results and operations. We also applaud
the timing of Xilinx elevating a new leader at the same time
that it announces its most significant product development in
recent years
Long operating within a virtual duopoly in PLDs, Xilinx
could fall behind its chief competitor now that Altera is part of
powerful Intel. In our view, the PLD industry leaders have a
larger opportunity in displacing non-PLD vendors, including
ASIC and ASSP companies, than in battling one another for
market share. Additionally, Xilinx believes it has claimed four
percentage points of PLD market share in recent years.
As a fabless semiconductor company, Xilinx is at risk
should one or more of its foundry partners encounter
Section 2.51
production issues, product defects, or work stoppages. Altera's
partnership with Intel adds a new wrinkle to the industry.
Xilinx primarily uses United Microelectronics as its fab
partner and industry leader Taiwan Semiconductor for its 28
nm products.
COMPANY DESCRIPTION
Based in San Jose, California, Xilinx designs, produces
and markets programmable logic devices (PLDs);
system-on-a-chip (SoC) products encompassing FPGAs and an
ARM core processor; 3D IC chips combining transceivers and
FPGAs that are used in telecommunications networks; and
software and development tools. Xilinx's PLDs consist of
field-programmable gate arrays (FPGAs) and complex
programmable logic devices (CPLDs). Xilinx serves customers
in communications, data center & data storage,
instrumentation, medical, automotive, aerospace-defense, and
other industries.
INDUSTRY
Our rating on the Technology sector is Over-Weight, as
we see value in Tech stocks following the late 2018 selloff.
Over the long term, we expect the Tech sector to benefit
from pervasive digitization across the economy, greater
acceptance of transformative technologies, and the
development of the Internet of Things (IoT). Healthy company
and sector fundamentals are also positive. For individual
companies, these include high cash levels, low debt, and broad
international business exposure.
The shift of social media platforms and digital information
companies such as Facebook and Alphabet into
Communication Services will moderately impact sector
characteristics. In general, the removal of those giants slightly
reduces the EPS growth outlook, reduces sector-weighted beta;
and raises sector-weighted dividend yield.
The sector is outperforming the market thus far in 2019,
with a gain of 28.0%. It outperformed the S&P 500 in 2018,
with a loss of 1.6%, and in 2017, with a gain of 36.9%.
Fundamentals for the Technology sector look reasonably
balanced. By our calculations, the P/E ratio on projected 2020
earnings is 18.6, above the market multiple of 16.1. Earnings
are expected to grow 15.0% in 2020 and 2.6% in 2019 after
rising 25.9% in 2018. Earnings rose in the low single digits in
2015-2016. The sector's debt ratios are below the market
average, as is the average dividend yield.
VALUATION
XLNX shares trade at 34.4-times our FY20 forecast and at
30.3-times our FY21 projection; the two-year forward average
P/E of 32.3 is now above the five-year (FY15-FY19) historical
average of 23.3. We believe that premium is warranted given
that XLNX is now growing revenue and EPS much faster than
in prior years and much faster than peers. The shares, which
 GROWTH / VALUE STOCKS
have historically commanded a 45% premium to the market
P/E multiple, now trade at an 100% premium based on fiscal
2020-2021 EPS projections for Xilinx and calendar 2019-2020
EPS projections for the S&P 500. Our valuation based on
historical comparables is in the low $90s, in an accelerating
trend though below current prices.

While XLNX trades at a premium to its historical

comparable valuation, per share earnings are now growing
more rapidly and more consistently than in prior periods.
XLNX now trades at premium multiples relative to peers
based on P/E, EV/EBITDA, and PEGY ratios.

Discounted free cash flow modeling signals value in the

$170s, in a stabilizing trend. Our blended fair-value
calculation is in the upper $140 range, in a rising trend.
Appreciation to our 12-month target price of $145, along with
the current dividend yield of about 1.5%, implies a
risk-adjusted return in excess of our forecast for the broad
market and thus consistent with a BUY rating.
On September 23, BUY-rated XLNX closed at $98.05, up
$1.50. (Jim Kelleher, CFA, 9/23/19)

Section 2.52
 UTILITY SCOPE
Utility Scope Stocks in this Report
PRICE
AS OF
TICKER 9/25/19
El Paso Electric Company $66.73
EE
Sempra Energy SRE 144.24
Southwest Gas Holdings Inc SWX 90.27
El Paso Electric Company (EE)
Current Rating: HOLD Publication Date: 9/19/19
HIGHLIGHTS
*EE: Buyout bid on table for $68.25
*El Paso Electric Co. and the Infrastructure Investments
Fund have announced that they have entered into a definitive
agreement under which IIF will purchase El Paso Electric.
*The per share purchase price represented a 17%
premium to EPE's closing price on May 31, 2019, the last
trading day prior to the announcement of the agreement.
*The agreement has been unanimously approved by El
Paso Electric's board of directors and is expected to close in
the first half of 2020.
*The $68.25 bid price from IIF does not offer much of a
premium -- approximately 2.3%-from current levels and we
are maintaining our HOLD rating.
ANALYSIS
INVESTMENT THESIS
We are reiterating our HOLD rating on El Paso Electric
Co. (NYSE: EE). El Paso Electric and the Infrastructure
Investments Fund, an investment vehicle advised by J.P.
Morgan Investment Management Inc. (IIF), announced on
June 1 that they have entered into a definitive agreement under
which IIF will purchase El Paso for $68.25 in cash per share.
The per share purchase price represented a 17% premium to
EE's closing price on May 31, 2019, the last trading day prior
to the announcement of the agreement.
EE trades at 23.5-times our 2020 operating EPS estimate
of $2.84, at the high end of the P/E range for comparable
electric utilities with nonregulated operations. EE's dividend
yield of about 2.3% is below the peer average of 3.3%. The
stock also trades at a premium to peers based on price/cash
flow and price/book multiples. Looking ahead, the $68.25 bid
price from IIF does not offer much of a premium -
approximately 2.3% -- from current levels and we are
maintaining our HOLD rating.
RECENT DEVELOPMENTS
Over the past three months, EE shares have gained 2.2%,
compared to a gain of 4.1% for the S&P 500. Over the past 52
weeks, the shares have advanced 8.1%, compared to a gain of
4.1% for the index. The five-year track record shows an
Section 2.53
increase of 82.7% for DUK, versus 51.6% for the S&P 500.
The beta on DUK shares is 0.70.
On August 6, and for 2Q19, El Paso Electric Co. reported
GAAP net income of $26.1 million or $0.64 diluted earnings
per share, compared to $33.3 million or EPS of $0.82 in 2Q18.
On an adjusted basis, El Paso reported 2Q19 earnings of $21.9
million or $0.54 per share, compared with $30.8 million or
$0.76 per share in 2Q18.
Earnings for 2Q19 were negatively impacted by decreased
revenues from residential customers of $9.5 million caused by
a 13.9% decrease in kilowatt-hour (kWh) sales; small
commercial and industrial customers of $1.9 million caused by
a 5.6% decrease in kWh sales; and sales to public authorities
of $0.9 million caused by a 7.1% decrease in kWh sales. The
decrease in residential kWh sales primarily resulted from
overall milder weather, partially offset by customer growth of
1.6% in 2Q19.
Earnings for 2Q19 were positively affected by decreased
O&M expenses and increased investment and interest income.
On June 1, El Paso Electric Co. and the Infrastructure
Investments Fund, an investment vehicle advised by J.P.
Morgan Investment Management Inc. (IIF), announced that
they have entered into a definitive agreement under which IIF
will purchase El Paso Electric for $68.25 in cash per share.
The per share purchase price represented a 17% premium
to EPE's closing price on May 31, 2019, the last trading day
prior to the announcement of the agreement. The agreement
has been unanimously approved by EPE's board of directors
and is expected to close in the first half of 2020, subject to the
approval of EPE's shareholders, the receipt of regulatory
approvals and other customary closing conditions. Dividends
payable to EPE shareholders will continue in the ordinary
course through the closing.
EARNINGS & GROWTH ANALYSIS
In light of the proposed merger, the company will no
longer provide guidance nor is it affirming past guidance.
Results for 3Q19 are scheduled to be released October 30.
Over the last two years, El Paso has seen
above-industry-average growth in both retail and commercial
kilowatt-hour sales. Most of this growth has been in the
residential customer segment, and although per customer usage
has been falling due to customer conservation measures, it
remains well above the industry average. In all, we believe that
economic growth in El Paso's service territory will remain
strong for the foreseeable future and expect it to result in
above-industry-average customer and load growth. Customer
growth has averaged about 1.4% annually (above the industry
average of 0.7% - 0.8%) over the last five years.
 UTILITY SCOPE
Based on operating trends, as well as the impacts from
rate cases, we are maintaining our 2019 EPS estimate of $2.74
on a stand-alone basis. Our estimate is above the midpoint of
management's guidance range of $2.25-$2.95 per share. We
look for modest growth in 2020 and have established an EPS
estimate of $2.84. The estimate is likely to be moot, however,
in the wake of the acquisition announcement.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating for El Paso Electric is
Medium, the midpoint on our five-point scale. Moody's rates
the company's debt as investment grade. Common stock equity
represented 43% of El Paso's capitalization at the end of 2Q19.
Cash and equivalents totaled $12.8 million at the end of 2Q19,
compared to $12.4 million at the end of 2018. Cash flows from
operations for 2H19 were $57.6 million, compared to $74.4
million in 2H18.
The company's 2Q19 capital spending was primarily for
additions and improvements to its electric utility plant, which
totaled $60.1 million, down from $64.6 million in 2Q18.
Based on current projections, we believe the company will
have adequate liquidity through its current cash balances, cash
flow from operations and available borrowings under its
revolving credit facility to meet all expected cash requirements
through 2020.
El Paso pays a dividend. In May, the board boosted the
quarterly dividend 7% to $0.385 per share, or $1.54 on
annualized basis, for a yield of about 2.3%. On a standalone
basis, our 2019 dividend payout estimate is $1.52 and our
2020 estimate is $1.54.
MANAGEMENT & RISKS
The interim CEO for El Paso Electric Co. is Adrian J.
Rodriguez. The CFO is Nathan Hirschi, who has served in the
role since October 2013.
Management is committed to electric service expansion
strategies in the company's regulated service territories. We
think the company's platform for growth is solid, and we are
confident in management's ability to provide EE shareholders
with increased value over the long term.
Key risks for stocks in our electric utility universe include
commodity price risk, adverse weather conditions, regulatory
risk (especially when it involves construction cost recovery),
and potential environmental and safety liabilities. The
capital-intensive nature of the utility industry also creates
ongoing liquidity risk that must be actively managed by each
company. We would probably lower our earnings estimates on
El Paso if the economy weakens. Finally, we note that nuclear
power issues pose risks for investors because of the company's
15.8% stake in the Palo Verde nuclear plant in Arizona.
COMPANY DESCRIPTION
Section 2.54
El Paso Electric is a regional electric utility providing
generation, transmission and distribution service to
approximately 400,000 retail and wholesale customers in the
Rio Grande Valley in western Texas and southern New
Mexico, including the cities of El Paso, Texas, and Las
Cruces, New Mexico. El Paso Electric has a net generating
capability of 2,080 MW.
INDUSTRY
Our rating on the Utility sector is Under-Weight. The
sector is underperforming the market thus far in 2019, with a
gain of 12.4%. It outperformed in 2018, with a gain of 0.5%,
but underperformed in 2017, with a gain of 8.3%.
The sector accounts for 3.3% of the S&P 500. Over the
past five years, the weighting has ranged from 2.0% to 4.0%.
We think the sector should account for about 2% of diversified
portfolios. The sector includes the electric, gas and water
utility industries.
By our calculations (using 2020 EPS), the sector
price/earnings multiple is 18.2, above the market multiple.
Earnings are expected to rise 5.8% in 2020 and 2.1% in 2019
after rising 6.1% in 2018. The sector's debt-to-cap ratio is
about 55%, above the market average. This represents a risk,
given the current state of the credit markets, particularly if
corporate bond rates rise. The sector dividend yield of 2.7% is
above the market average of 1.9%.
VALUATION
We think the EE shares are fairly valued at recent prices
near $67. Over the past 52 weeks, EE shares have traded
between $48 and $67. From a technical standpoint, the shares
have been in a bullish pattern of higher highs and higher lows
that dates to January 2019.
EE trades at 23.5-times our 2020 operating EPS estimate
of $2.84, at the high end of the P/E range for comparable
electric and gas distribution utilities with nonregulated
operations. The EE dividend yield of about 2.3% is below the
peer average of 3.3%. The stock also trades at a premium to
peers based on price/cash flow and price/book multiples.
Looking ahead, the $68.25 bid price from IIF does not
offer much of a premium -- approximately2.3% -- from current
levels and we are maintaining our HOLD rating.
On September 19 at midday, HOLD-rated EE traded at
$66.85, up $0.14. (Gary Hovis, 9/19/19)
Sempra Energy (SRE)
Current Rating: BUY Publication Date: 9/24/19
HIGHLIGHTS
*SRE: Raising target by $6 to $156 on deals and outlook
*Management expects the company's recent purchase of a
majority stake in Oncor, a Texas electric utility, to boost
 UTILITY SCOPE
annual EPS by $0.10-$0.20 over the next four years.
*The company has begun the sales process of its South
American businesses, as the business no longer meets Sempra's
strategic needs. The sale should close by the end of the year.
*We are raising our 2019 EPS estimate to $6.14 from
$6.04, based on higher 2Q results than we had expected and
initial Cameron LNG operations. We are also raising our 2020
estimate to $7.82 per share from $7.07.
*Our target of $156 implies a projected 2019 P/E of 24.4,
above the peer median of 19.6, which we believe is
appropriate given SRE's dividend growth, margin expansion,
new business prospects and above-peer-average sales and EPS.
ANALYSIS
INVESTMENT THESIS
We are maintaining our BUY rating on Sempra Energy
(NYSE: SRE) and raising our target price to $156 from $150
on higher expected EPS in 2019 and 2020. Management
expects the company's recent purchase of a majority stake in
Oncor, a Texas electric utility, to boost annual EPS by
$0.10-$0.20 over the next four years. Earnings should also
benefit from favorable regulation and a growing rate base at
the company's California utilities, as well as from investments
in Mexican midstream infrastructure and the eventual
completion of the Cameron LNG (liquid natural gas) project.
Lastly, the company is focusing on optimal capital allocation
acquired from the sale of South American businesses.
SRE shares are trading at 22.2-times our forward
four-quarter EPS estimate, above the average multiple of 19.6
for comparable utilities and above the midpoint of the
five-year historical range of 16.5-25.4. While the dividend
yield of about 2.7% is below the peer average, management
has raised the dividend at a compound annual rate of 8.0%
over the last five years. We believe that SRE merits a premium
valuation based on its above-peer-average sales and earnings
growth, as well as margin expansion. We also see the
involvement of activist investor Elliot Management as a
positive catalyst for the stock. Our relative value analysis
yields a fair value of $156 per share, which is our revised
target price.
RECENT DEVELOPMENTS
Sempra shares have underperformed the S&P 500 over
the past three months, rising 1.0%, compared to a 1.4% gain
for the index. The shares have outperformed over the past
year, however, rising 23.6%, compared to a 2.2% gain for the
broad market. The beta on SRE is 0.66.
On August 2, Sempra reported adjusted earnings of $309
million or $1.10 per share, down from $361 million or $1.35
per share in 2Q18. The decline was due to Mexico foreign
exchange losses and the sale of the solar and wind businesses.
EPS missed our estimate of $1.26 and the consensus forecast
of $1.16. Sempra posted GAAP net income of $354 million or
$1.26 per share, compared to a net loss of $561 million or
Section 2.55
$2.11 per share in 2Q18. The rise was due to the absence of
impairment charges in the year-ago period.
Second-quarter revenue rose 3% year-over-year to $2.2
billion on higher sales at SDG&E and SoCalGas. Revenue
missed our estimate of $2.5 billion and the $2.8 billion
consensus.
Concurrent with earnings, management reiterated its 2019
adjusted EPS guidance of $5.70-$6.30. Management is
targeting 13% compound annual growth in adjusted earnings
through 2020, above the utility industry average. However,
this may be difficult to achieve if growth slows in Latin
America. The Cameron LNG project began initial operations
in May and shipped its first liquid natural gas cargo to France
from its Louisiana base. Management's forecast assumes
earnings of $400-$450 million upon full stabilization.
The company has begun the sales process of its South
American businesses, which according to CFO Trevor Mihalik
no longer meets Sempra's strategic needs. The sales are
expected to close by the end of the year.
In April, SRE finalized the divestiture of U.S. renewables
business and non-utility natural gas storage assets, which
generated approximately $2.5 billion in proceeds.
Additionally, Sempra completed the sale of its remaining wind
assets to American Electric Power (AEP) for $584 million.
EARNINGS & GROWTH ANALYSIS
Sempra Energy has two business segments: Sempra
Utilities (85% of 2018 sales) and Sempra Energy-related
business (15%). Second-quarter operating results by segment
are discussed below.
The Sempra Utilities segment includes San Diego Gas &
Electric (SDG&E), Southern California Gas Company
(SoCalGas), Sempra Texas Utility, and Sempra Mexico.
SDG&E earnings decreased 2% to $143 million, reflecting
lower margins as a rate case decision was delayed. SoCalGas
earnings declined 45% to $30 million, also mostly due to
higher costs related to the rate case delay. The Sempra Texas
Utility segment represents SRE's 80% investment in Oncor. In
its sixth full reporting quarter, the utility recorded $113 million
in GAAP net income, down from $114 million in 2Q18.
Sempra Energy includes Sempra Mexico, Sempra
Renewables, and Sempra LNG, which builds liquid natural gas
and midstream facilities. Sempra Mexico's second-quarter
GAAP earnings declined to $73 million from $97 million a
year earlier due to foreign currency and inflation effects.
Sempra Renewables saw adjusted earnings fall to $1 million
from $36 million, reflecting lower earnings from assets sold in
December 2018. Lastly, Sempra LNG reported adjusted
earnings of $6 million, compared to a loss of $9 million in
2Q18, as a result of higher earnings from marketing operations
 UTILITY SCOPE
driven by natural gas price changes.
We are raising our 2019 EPS estimate to $6.14 from
$6.04, based on higher 2Q results than we had expected and
initial Cameron LNG operations. We are also raising our 2020
estimate to $7.82 per share from $7.07.
We expect Sempra's long-term earnings to be driven by a
robust capital plan and effective cost controls. In particular, we
expect earnings to benefit from the Cameron facility coming
online. We also see additional potential upside to our
long-term earnings forecast based on new pipeline and solar
projects in Mexico, and note that several new pipelines have
already entered service. These projects follow changes in the
Mexican energy sector that allow private sector participation
in exploration and production; oil and gas transport;
petrochemicals; refining; storage; and electricity generation
transmission and distribution.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Sempra Energy is
Medium. Moody's rates Sempra's debt at Baa1/negative, while
S&P and Fitch rate it at BBB+/negative and BBB+/stable,
respectively.
Total debt was $24.4 billion at the end of 2Q19, slightly
down from $24.5 billion at the end of 2018. The debt/capital
ratio was 57%, in line with peers. Second-quarter EBIT
covered interest expense by a factor of 1.9, also in line with
peers. The 2Q profit margin was 12.0%, above the 9.7%
average for peers. Cash flow from operations rose to $1.70
billion in 1H19 from $1.67 billion a year earlier.
Sempra pays a quarterly dividend of $0.9675, or $3.87
annually, for a yield of about 2.7%. On September 6, the board
of directors declared a quarterly dividend of $0.9675 per
share, payable October 15 to shareholders of record on
September 20. Over the past five years, the company has
raised the dividend at a compound annual rate of 8.0%. Our
dividend estimates are $3.80 for 2019 and $4.13 for 2020.
MANAGEMENT & RISKS
Jeff Martin became Sempra's CEO in May 2018. Mr.
Martin had previously served as CFO since January 2017.
Specific risks to Sempra include credit issues, commodity
price fluctuations, the effect of adverse weather on revenue,
regulatory risk (especially construction cost recovery), and
potential environmental and safety liabilities. In addition, the
capital-intensive nature of the utility industry creates ongoing
liquidity risk that must be actively managed by each company.
COMPANY DESCRIPTION
Sempra Energy, based in San Diego, is an energy services
holding company. Its 20,000 employees serve more than 40
million customers worldwide. The company's two regulated
utilities are San Diego Gas & Electric and Southern California
Section 2.56
Gas.
VALUATION
Sempra shares appear attractively valued at recent prices
near $142, toward the high end of their 52-week range of
$105-$145.
SRE shares are trading at 22.2-times our forward
four-quarter EPS estimate, above the median multiple of 19.6
for comparable utilities and above the midpoint of the
five-year historical range of 16.5-25.4. Our relative value
analysis yields a fair value of $156 per share, which is our
revised target price. Our target implies a projected forward P/E
of 24.4, which we believe is appropriate given the company's
above-peer-average sales and earnings growth, as well as
margins. Our target, combined with the dividend, implies a
total potential return of 13% from current levels.
On September 23, BUY-rated SRE closed at $141.87,
down $0.35. (Jacob Kilstein, CFA, 9/23/19)
Southwest Gas Holdings Inc (SWX)
Current Rating: HOLD Publication Date: 9/23/19
HIGHLIGHTS
*SWX: Looking for favorable entry point
*With SWX trading well above technical support in the
low $80s, we see an unexciting total return potential over the
next 12 months.
*On August 6, the company reported 2Q19 diluted EPS of
$0.41, compared to $0.44 in 2Q18.
*Management continues to project 2019 EPS of
$3.75-$4.00. We are maintaining our 2019 EPS estimate of
$3.95, implying 2% growth for the year, and our 2020 estimate
of $4.25.
*SWX trades at 21-times our 2020 operating EPS
estimate, at the high end of the P/E range for comparable gas
distribution utilities with nonregulated operations. We would
consider a more aggressive posture on SWX at the $82-$83
level in a normally trending market and absent any
deterioration in the company's fundamentals.
ANALYSIS
INVESTMENT THESIS
Our rating on Southwest Gas Holdings Inc. (NYSE:
SWX) is HOLD, based primarily on valuation. SWX shares
have risen 85% over the last five years and appear to have
moved ahead of company fundamentals. With the stock trading
well above technical support in the low $80s, we see an
unexciting total return potential for SWX over the next 12
months.
Even so, we are reiterating our long-term BUY rating,
reflecting the company's favorable regulatory environment and
improved earnings transparency. The company's expanding
infrastructure improvement program and a focus on cost
 UTILITY SCOPE
controls are also strong positives. We expect above-average
growth in the company's rate base from infrastructure
investments, as well as continued profitability in its
nonregulated operations. In addition, we expect annual
dividend growth of 4.5%-5.0% over the next several years.
The shares currently yield about 2.4%.
The company's recent favorable rate case decisions and
strong financial position are benefiting margins and earnings.
In addition, the housing markets in its Arizona and California
service territories are strengthening, and management is seeing
increased economic activity in the nonhousing sectors of its
Nevada service territory.
Management also believes that the company has adequate
liquidity through its cash balances, cash from operations, and
credit facility to meet all anticipated cash requirements through
2020. In our view, these factors make SWX shares a sound
long-term holding for investors seeking moderate share price
appreciation and a solid and growing dividend. We think the
current annualized dividend payout of $2.18 per share is
secure based on the company's growing cash flow. These
factors should combine to generate total returns to
shareholders of about 5.0%-6.0% annually over the next four
to five years.
RECENT DEVELOPMENTS
Over the last three months, SWX shares have gained
1.1%, compared to an advance of 1.3% for the S&P 500. Over
the past 52 weeks, the shares have gained 14.6%, compared to
a 2.2% increase for the index. The five-year track record
shows an increase of 86.3% for SWX, versus a gain of 51.6%
for the S&P 500. The beta on SWX is 0.31.
On August 6, the company reported 2Q19 diluted EPS of
$0.41, compared to $0.44 in 2Q18. Consolidated net income
was $22.1 million, compared to $21.6 million in 2Q18.
Southwest Gas Holdings has two business segments:
Southwest Gas, which supplies natural gas service to over two
million customers in Arizona, Nevada, and California; and
Utility Infrastructure Services, which serves the North
American utility, energy, and industrial markets.
By business unit, the Natural Gas segment posted earnings
of $3.4 million in 2Q19, compared to $2.6 million in 2Q18,
while the Utility Infrastructure Services segment posted
earnings of $18.9 million in 2Q19, compared to $19.2 million
in 2Q18.
Results in the Utility Infrastructure Services segment were
bolstered by $57.3 million of incremental revenues and $3.1
million of earnings from Linetec, which the company acquired
in November 2018. Linetec, which continues to exceed
management's projections, has expanded the company's
geographic footprint and diversified its Utility Infrastructure
Section 2.57
Services segment.
Natural Gas segment earnings improved year-over-year as
34,000 net new customers boosted operating margins. The
segment has posted record revenues of more than $3 billion
over the past 12 months. The company continues to invest in
its utility infrastructure to ensure reliable natural gas service to
a growing customer base.
EARNINGS & GROWTH ANALYSIS
Management affirms estimated 2019 diluted earnings per
share of $3.75-$4.00. The company is scheduled to report
3Q19 financial results on November 4.
We are maintaining our 2019 EPS estimate of $3.95,
which is at the high end of management's range and implies
growth of 2%. Our estimate reflects the carry-over effects of
favorable rate case decisions over the last three years, as well
as our expectations for lower depreciation and interest expense
going forward. Sales of natural gas over the next 4-5 years are
also expected to be stronger than average. A growing
population in the southwestern U.S. over the last three years
has also led to wider margins. In addition, the California and
Arizona housing markets are now rebounding, and sales of
natural gas to industrial and commercial customers have fully
recovered in Nevada, the company's primary service area.
Based on these positive trends, we look for growth to
accelerate in 2020. Our EPS estimate is $4.25.
Capital expenditures in 2019 are estimated at
approximately $710 million, in support of customer growth,
system improvements, and accelerated pipe replacement
programs.
Overall, we think that Southwest's regulated gas
distribution business is performing well, and that the company
has a solid business plan as it moves further into nonregulated
pipeline and infrastructure construction. In all, we see
numerous elements in the Southwest Gas portfolio that could
lead to average annual earnings growth of 4%-5% over the
next four to five years. We also expect the company to benefit
from continued positive relations with regulators.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating for Southwest Gas is
Medium-High, the second-highest rank on our five-point scale.
At the end of 2Q19, long-term debt totaled $2.373 billion,
compared to $2.107 billion at the end of 2018. Cash and cash
equivalents at the end of 2Q19 totaled $38.4 million,
compared to $85.3 million at the end of 2018. Cash flow from
operations in the first six months of 2019 was $278.4 million,
compared to $247.1 million in the same period a year earlier.
The 2Q19 profit margin was 11.9%, up from 10.2% in 2Q18.
The current annualized dividend is $2.18 per share, for a
yield of about 2.4%. Southwest plans to increase the dividend
 UTILITY SCOPE
such that the payout ratio approaches the gas distribution peer
average of 70%-75%, while also maintaining its strong credit
ratings. Based on the company's improving cash flow and solid
financial position, we project dividend payouts of $2.16 for
2019 and $2.26 for 2020.
MANAGEMENT & RISKS
John P. Hester is president and CEO of Southwest
Holdings, and Gregory J. Peterson is senior vice president and
CFO.
Management is committed to gas-service expansion
strategies in the company's regulated service territories. Given
the company's strong and growing customer base, we believe
that management should be able to rely more on internal
resources and less on external financing to fund construction
programs and make acquisitions.
Risks that could cause SWX shares to fall involve
liquidity and credit issues, as well as commodity price
increases, adverse weather conditions, regulatory problems,
and potential environmental and safety-related liabilities. We
would also likely lower our earnings estimates in the event of a
prolonged economic downturn in the company's service
territories.
COMPANY DESCRIPTION
Southwest Gas Holdings has two business segments:
Southwest Gas Holdings, which provides natural gas service to
approximately 2 million customers in Arizona, Nevada, and
California, and Utility Infrastructure Services, a construction
services operation serving the North American utility, energy,
and industrial markets. Southwest Gas Corp. was founded in
1931 and is headquartered in Las Vegas.
INDUSTRY
We have raised our rating on Utilities to Market-Weight
from Under-Weight. The reduction in domestic interest rates
now appears likely to be a prolonged phenomenon, based on
weakening global economic trends; lower global interest rates
that are, in some cases, negative; and a safe-haven rush
worldwide to own U.S. Treasuries. Utilities are also benefiting
from lower statutory tax rates from the Tax Cut and Jobs Act,
and rotation into equities perceived as being insulated from
trade-war effects.
are expected to rise 5.9% in 2020 and 1.8% in 2019 after
rising 6.1% in 2018. The sector's debt-to-cap ratio is about
55%, above the market average. This represents a risk, given
the current state of the credit markets, particularly if corporate
bond rates rise. The sector dividend yield of 2.7% is above the
market average of 1.8%.
VALUATION
We think that SWX shares are fairly valued at recent
prices near $91, near the high end of the 52-week range of
$73-$93. From a technical standpoint, the shares have been in
a bullish pattern of higher highs and higher lows that dates to
January 2019.
SWX trades at 21-times our 2020 operating EPS estimate
of $4.25, at the high end of the P/E range for comparable gas
distribution utilities with nonregulated operations. The stock
also trades at a premium to peers based on price/cash flow and
price/book multiples. We would consider a more aggressive
posture on SWX at the $82-$83 level in a normally trending
market and absent any deterioration in the company's
fundamentals.
Even so, we believe that the company's growing financial
strength, limited risk profile, visible forward earnings stream,
and attractive integrated structure are long-term positives for
investors. Added benefits are the company's strong operating
efficiencies and well-maintained and operated gas distribution
facilities. Moreover, we view recent rate increases in the
company's Arizona, California and Nevada service territories
as strong positives.
On September 23 at midday, HOLD-rated SWX traded at
$91.58, up $0.07. (Gary Hovis, 9/23/19)

The sector is outperforming the market thus far in 2019,

with a gain of 17.6%. It outperformed in 2018, with a gain of
0.5%, but underperformed in 2017, with a gain of 8.3%. The
sector accounts for 3.5% of the S&P 500. Over the past five
years, the weighting has ranged from 2.0% to 4.0%. We think
the sector should account for about 2% of diversified
portfolios. The sector includes the electric, gas and water
utility industries.

By our calculations (using 2020 EPS), the sector price/

earnings multiple is 18.9, above the market multiple. Earnings
Section 2.58
 STOCKS TO AVOID
There are no companies updated in the Stocks to
Avoid category this week.

Section 2.59
 ECONOMIC TRADING CALENDAR

Release:
Release: ISM PMI Release: Construction Spending Release:
Release: Factory Orders
Date:
Date: 10/1/2019 Date: 10/1/2019 Date:
Date: 10/3/2019
Month:
Month: September Month: August Month:
Month: August
Previous
PreviousReport:
Report: 49.1 Previous Report: 0.1% Previous Re-
Previous Report: 1.4%
Argus
ArgusEstiStreet
Estimate: 49.4 Argus Estimate: 0.2% port:
Argus Estimate: 0.5%
Estimate:
Street Estimate: 50.5 Street Estimate: 0.5% Argus Esti-
Street Estimate: -0.4%
60 0.02 mate:
4%

2%
55 0.00
0%
50 -0.02
-2%
Source: Institute of Supply Management Source: U.S. Census Bureau
Source: U.S. Census Bureau
45 -0.04 -4%
Sep-18 Dec-18 Mar-19 Jun-19 Aug-18 Nov-18 Feb-19 May-19 Aug-18 Nov-18 Feb-19 May-19

Release:
Release: ISM Non-Manufacturing Release: Non-farm Payrolls Release:
Release: Unemployment Rate
Date:
Date: 10/3/2019 Date: 10/4/2019 Date:
Date: 10/4/2019
Month:
Month: September Month: September Month:
Month: September
Previous
PreviousReport:
Report: 56.4 Previous Report: 130000 Previous Re-
Previous Report: 3.7%
Argus
ArgusEstiStreet
Estimate: 56.0 Argus Estimate: 150000 port:
Argus Estimate: 3.7%
Estimate:
Street Estimate: 55.2 Street Estimate: 140000 Argus Esti-
Street Estimate: 3.7%
65 400000 mate:
4.2%
Source: Bureau of Labor Statistics
300000 4.0%
60
200000 3.8%
55
100000 3.6%
Source: Institute of Supply Management
Source: Bureau of Labor Statistics
50 0 3.4%
Sep-18 Dec-18 Mar-19 Jun-19 Sep-18 Dec-18 Mar-19 Jun-19 Sep-18 Dec-18 Mar-19 Jun-19

Release: International Trade

Date: 10/4/2019
Month: August
Previous Report: -$54.0 Bln.
Argus Estimate: -$54.0 Bln.
Street Estimate: -$55.0 Bln.
-$65 Bln.

-$60 Bln.

-$55 Bln.

-$50 Bln.
Source: Bureau of Economic Analysis
-$45 Bln.
Aug-18 Nov-18 Feb-19 May-19

Previous Week’s Releases and Next Week’s Releases on next page.

- Section 3 -
 ECONOMIC TRADING CALENDAR (CONT.)

Previous Week's Releases

Previous Argus Street
Date Release Month Report Estimate Estimate Actual
25-Sep New Home Sales August 635k 650k 656k NA

26-Sep U.S. Gross Domestic Product 2Q 2.0% 2.0% 2.0% NA

GDP Price Index 2Q 2.4% 2.2% 2.4% NA

27-Sep Personal Income August 0.1% 0.2% 0.4% NA

Consumer Spending August 0.6% 0.2% 0.3% NA
U. of Michigan Sentiment** September 92.0 92.0 92.1 NA
\

Next Week's Releases

Previous Argus Street
Date Release Month Report Estimate Estimate Actual
7-Oct Consumer Credit August $23.3B $24B NA NA

8-Oct Producer Price Index September 0.1% 0.2% NA NA

PPI ex-Food & Energy September 0.3% 0.2% NA NA

9-Oct FOMC Minutes NA NA NA NA NA

10-Sep Consumer Price Index September 0.1% 0.2% NA NA

CPI ex-Food & Energy September 0.3% 0.2% NA NA

11-Oct Import Price Index September -0.5% 0.3% NA NA

U. of Michigan Sentiment* September NA NA NA NA

* Preliminary
** Final
^Final

- Section 3 -
 SPECIAL SITUATIONS & SCREENS

ARGUS RESEARCH RATING DISTRIBUTION MASTER LIST CHANGES

Rating Date
900 Stock From To Change
800 881 AECOM ACM HOLD BUY 9/20/19
700
RECENT BUY UPGRADES
600
500 579 Stock Raised to BUY
Symbol On this date
400 AECOM ACM 9/20/19
300
200
100 176
0
Buy Hold Sell

ARGUS RATING SYSTEM

Argus uses three ratings for stocks: BUY, HOLD and SELL. Stocks
are rated relative to a benchmark, the S&P 500.

A BUY-rated stock is expected to outperform the S&P 500 on a

risk-adjusted basis over a 12-month period. To make this determi-
nation, Argus Analysts set target prices, use beta as the measure
of risk, and compare risk-adjusted stock returns to the S&P 500
forecasts set by the Argus Market Strategist.

A HOLD-rated stock is expected to perform in line with the

S&P 500.

A SELL-rated stock is expected to underperform the S&P 500.

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