Recovery for Coke Will Be Prolonged, but Strategic Initiatives Sound and Should Support Valuation
by Nicholas Johnson | Morningstar Research Services LLC | 10-22-20

Wide-moat Coca-Cola's third-quarter earnings were bound to be fraught, as investors would not only be looking for details about results and outlook but also insight into the slew of recent strategic announcements (the internal reorganization and partnership with no-moat Molson Coors for Topo Chico Hard Seltzer being the most prominent). Ultimately, the results were solid (ahead of CapIQ consensus expectations on both the top and bottom lines), and while it's still unclear when coronavirus-induced pressures will reach their coda, the firm's strategic initiatives support our confidence in its long-term prospects. We don't plan to change our $54 fair value estimate, and despite rallying meaningfully from the lows in March, the shares still strike us as modestly undervalued.

Revenue came in at $8.65 billion, down 9% year over year and 6% organically, with both price/mix and concentrate volume down 3%. The narratives surrounding these two levers were unchanged, with adverse channel and packaging mix affecting the former, and weakness in on-premises channels, which remain beleaguered by COVID-19 restrictions, hitting the latter. Geographically, markets like the United States and Brazil were bright spots, but other core markets like Mexico, India, and countries across Europe remained an albatross.

A core tenet of the firm's reorganization entails cutting the tail of the innovation pipeline and reducing the number of brands across the portfolio. It expects to transition to a portfolio of 200 master brands, down from roughly 400 today, with trademarks like Odwalla and Zico being jettisoned. While there are puts and takes, we view the portfolio approach constructively. Most of the discontinued brands are likely to be noncarbonates, which may reduce scale in some categories that have different production processes and ingredient profiles. Nevertheless, we expect this to be offset by the streamlining of processes and more scalable innovation.

Enbridge: Line 3 Receives Two Key Permits
by Joe Gemino, CPA | Morningstar Research Services LLC | 10-20-20

On Monday, Oct. 19, Minnesota's Department of Natural Resources issued two of the 10 required permits for the Line 3 replacement project. The permit approvals signal that the DNR believes that the pipeline meets Minnesota's environmental and regulatory requirements. The approvals indicate that the project is moving toward completion. We still expect the probability that Line 3 is built and fully operational is 80% and Line 3 is protected by its integrity replacement status is 20%. The remaining eight DNR permit applications are still outstanding, but we don't foresee any issues with the pipeline receiving the permits.

The DNR permits were approved on the heels of favorable news regarding the state 401 draft water permit. Last week, Minnesota Administrative Law Judge James LaFave confirmed that the draft 401 water permit issued by the Minnesota Pollution Control Agency for the Line 3 replacement project was done so correctly. The judge determined that the MPCA and Enbridge identified by the best method of each of the water crossings, identified the entire acreage of wetlands that will be impacted, and determined the best methods of protection for each body of water and wetland that will be impacted by the pipeline. The judge also determined that the opposition failed to prove that Line 3 would permanently impact the state's water quality and wetlands. The ruling clears the way for the MPCA to issue the 401 water quality permits within the next 30 days.

Enbridge is trading in 4-star territory and remains one of our top picks in the Canadian energy sector. We think the market is mistaken to price Enbridge as if oil prices will remain weak forever. However, we do not expect the market's concerns will be fully addressed for some time, which can lead to volatile swings in the stock.

Genuine Parts' On-Track Quarterly Earnings Indicate the Pandemic Has Not Diminished Its Strengths
by Zain Akbari, CFA | Morningstar Research Services LLC | 10-22-20

Our $90 per share fair value estimate for narrow-moat Genuine Parts should not see a large change after the firm posted third-quarter earnings that leave it poised to approximate our full-year targets. While the pandemic continues to disrupt Genuine Parts' auto-parts sales to professionals and its industrial component distribution unit, we still believe its long-term standing will endure after the present situation eases. We expect low- to mid-single-digit top-line growth and mid- to high-single-digit adjusted operating margins long term but would suggest investors await a greater margin of safety.

Year-to-date revenue dips of 2% in automotive and 16% in industrial (including EIS) are not far from our prior calls for 3% and 14% respective shortfalls in 2020. Genuine Parts' flat adjusted operating margin so far in 2020 remains somewhat above our earlier full-year calls for a roughly 20-basis-point decline to 5.6%, but costs should rise as the sales environment normalizes.

The automotive unit (roughly 65% of pro forma sales) recovered from a 14% U.S. second-quarter comparable decline to a 3% shortfall in the third period, with DIY sales a strength and signs of recovery in the professional division. Genuine Parts' strong skew toward the professional segment (around 80% of automotive part sales) limits its exposure to recent DIY growth as motorists look to save repair costs. However, we look to its 12% comparable growth in Europe and 15% expansion in Australasia as indicative of its ability to rebound in markets in which COVID-19 was better controlled than in the United States.

The industrial division saw a 9% comparable sales slide, an improvement from the second quarter's 17% swoon as the industrial economy strengthened. We expect it will take time for a full recovery but believe the unit's focus on critical components will accelerate its rebound (as was the case in 2010, when the segment saw 22% growth after a recession-induced 18% plunge in the prior year).

Philip Morris Posts Decent Q3, but Market's Reaction Shows Negative Sentiment
by Philip Gorham, CFA, FRM | Morningstar Research Services LLC | 10-21-20

Philip Morris International reported what we consider to be a fairly strong third-quarter performance, with revenue and operating profit slightly above our estimates. Management raised guidance for the full year by 2%, to $5.05-$5.10 in adjusted earnings per share, but did not pass through the full benefit of the third-quarter beat. We think this explains the surprisingly strong negative market reaction. We have raised our full-year assumptions modestly, as we already expected EPS to come in at the high end of the previous guidance range, but this does not affect our $98 fair value estimate. We think there is material upside to PMI, which will become evident if heatsticks continue to be accretive to margins, but the sell-off of the shares after a solid set of quarterly results is a reminder of the negative sentiment around the tobacco group at present.

Third-quarter adjusted EPS of $1.42 increased 5.6% organically from a year ago, with revenue down 1.5% on a similar basis. Volume was down 7.6% year over year, implying continued strong price/mix of around 6% in the quarter, which we expect to be well above that of most large-cap consumer product companies this reporting season. Reduced-risk products now account for around one fourth of PMI's volume.

The key metric investors should be looking at is PMI's operating margin development, and once again, PMI delivered a strong performance, with 180 basis points of organic gross margin expansion over the same period a year ago and 260 basis points of expansion in the EBIT margin. While this was boosted by cost savings and delaying expenses into the fourth quarter, it was achieved without the benefit of the high-margin travel retail business and also signals the continued mix benefit of heatsticks, which are clearly margin-accretive at this stage.

Wide-Moat P&G Q1 Sales Soar, but This Lofty Trajectory Won't Always Persist
by Erin Lash, CFA | Morningstar Research Services LLC | 10-20-20

Procter & Gamble knocked the ball out of the park again to start its fiscal 2021, posting 9% organic sales growth (on top of 7% growth a year ago), 170 basis points of gross margin expansion to 52.7%, and 320 basis points of adjusted operating margin improvement to 27.3%. Although we acknowledge that a portion of this progress is attributable to consumers' penchant for the leading home, health, and hygiene fare within its mix over the past few months (with sales in the U.S. up 16% in the quarter), we surmise that P&G had begun to steady its footing long before COVID-19 arrived. More specifically, we've held that the decision to ratchet down materially the size of its brand mix (to just 65, after shedding more than 100) was a critical step that has facilitated its ability to hone its resources on the highest return opportunities and more nimbly respond to evolving consumer trends.

With its solid start to the year, management opted to raise its fiscal 2021 sales (now calling for 3%-4% reported sales growth, up from 1%-3%) and profit expectations (5%-8% increase in adjusted EPS, from 3%-7%). As such, we intend to edge up our $111 fair value estimate by a low-single-digit percentage to reflect more pronounced sales prospects this year combined with a time value of money benefit. Even though we anticipate that a portion of these sales gains will prove sticky (as consumers have adopted a greater proclivity for home and personal cleaning), we don't expect to alter our longer-term outlook (nearly 4% average annual sales growth and a 150-basis-point bump in operating margins relative to fiscal 2020, to more than 24%, by fiscal 2030) as we expect competitive pressures will eventually constrain its pace. And while shares ticked up by a low-single-digit percentage on the print, we don't believe investors should rush to stock up on this wide-moat name, which trades at a more than 20% premium to our assessment of intrinsic value and a lofty mid-20s times forward earnings.

Texas Instruments' Strong Q3 Boosted by Personal Electronics Demand; Maintain $120 FVE

by Brian Colello, CPA | Morningstar Research Services LLC | 10-20-20

Texas Instruments reported strong third-quarter results, thanks to a snapback in automotive manufacturing and better than expected demand from personal electronics, at least partially tied to electronics upgrades during the coronavirus pandemic. TI's fourth-quarter guidance also exceeded CapIQ consensus estimates, but management still expressed caution around future demand and is striving to maintain optionality regarding its expansion plans and inventory management. We will maintain our $120 fair value estimate for wide-moat TI. Trading at 28 times trailing earnings, which is above historical norms, we continue to view this high-quality business as overvalued and would wait for a wider margin of safety before investing.

Revenue in the September quarter was $3.82 billion, up 18% sequentially, up 1% year over year and well above the company's previously forecast range of $3.26 billion-$3.54 billion as provided in July. Automotive chip sales were the bright spot, up over 75% sequentially and roughly even with the year-ago quarter before COVID-19, as car manufacturing in North America and Europe picked back up. Personal electronics chip demand was also strong, up about 20% sequentially and 15% year over year. TI not only saw demand in PCs and other remote working tools, but also at-home electronics like TVs and smart speakers, opining that people are upgrading their personal electronics while stuck at home during COVID-19. Industrial chip sales were roughly flattish year over year. Despite higher sales levels, gross margins remained flat sequentially at 64.3%, but operating expenses were held in check such that operating margins expanded 430 basis points sequentially to 42.2%.

For the December quarter, TI expects revenue of $3.55 billion at the midpoint, which would represent a 7% sequential decline during the seasonally soft fourth quarter but 6% year-over-year growth.

Verizon Bounces Back in the Third Quarter
by Michael Hodel, CFA | Morningstar Research Services LLC | 10-21-20

Verizon gradually rebounded from the effects of the pandemic during the third quarter, and it expects that trend to continue. While reported revenue dropped 4% versus a year ago, most of the decline was the result of weak phone sales. The core wireless-services business returned to growth, albeit with revenue up only 0.3% year over year, but management said it expects further acceleration during the fourth quarter to at least 2%. At that pace, Verizon would be nearly back to what we consider a reasonable expectation for long-term wireless-services revenue growth (3%-4%). Free cash flow also remained solid during the quarter. The firm has generated $18.3 billion so far this year, more than it produced in all of 2019. Cash flow may come under some pressure during the fourth quarter, given heavy promotions around the iPhone 12 launch, but we expect the impact will be easily manageable. We don't plan to materially change our $59 fair value estimate or narrow moat rating and consider Verizon shares fairly valued.

Wireless activity remained muted during the quarter. Relatively few customers upgraded phones or switched carriers, which helped boost margins and cash flow. Verizon has been pleased with its ability to manage delinquent accounts and said it expects only a modest increase in involuntary customer deactivations during the fourth quarter. About 3% of accounts are on its Stay Connected plan to help these customers, and 90% of those have made at least some payment. Despite the economic turbulence, Verizon again reported a net gain in wireless postpaid phone customers (283,000 versus 445,000 a year ago), leaving its base about 1% larger than a year ago at 91.1 million. Importantly, average revenue per postpaid account bounced back nicely, increasing 2.4% from the prior quarter and 0.2% year over year. International roaming revenue remains a headwind, but the firm has continued to successfully move customers to unlimited and higher-tier rate plans.

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