PMI in a Tailspin as Market Overreacts to iQOS Demand Stabilization; Shares Finally Offer Value
by Philip Gorham, CFA, FRM | Morningstar Research Services LLC | 04-20-18

Our long-standing thesis on wide-moat Philip Morris International is that iQOS, the company's market-leading heated tobacco technology, has the potential to prolong the lifespan of the tobacco industry, but that the adoption rate of the category will plateau, and that the effervescent growth expectations being priced into the stock are too optimistic. A first-quarter volume miss suggests that plateau has now been reached. The market's reaction appears extreme (the stock fell by 15% in the aftermath of the call), suggesting that the heated tobacco category is still misunderstood. Nevertheless, we are lowering our forecasts for Heatsticks growth and margins in Asia, although the impact of these changes on our valuation is offset by the weaker U.S. dollar and by a lower effective tax rate, and we are maintaining our $104 fair value estimate.

Two issues stand out from PMI's first-quarter results. First, the company missed volume expectations, reporting a total tobacco volume decline of 2.3%, versus consensus estimates of flat in the quarter and our full-year assumption of a decline of 1.3%. With combustibles in line with expectations, the miss was caused by a significant shortfall in Heatsticks shipments in Japan, which we believe was driven by a pullback in shipments in order to rightsize channel inventory.

Second, a boost from a lower effective tax rate, now being guided to 26%, down from 28%, is not filtering down to earnings in full. We assume 26% to be the ongoing tax rate, but that the customer acquisition cost in the emerging tobacco categories may be higher than originally thought. We have lowered our medium-term margin forecast by around 90 basis points to account for heavier investment behind customer acquisition, and we have increased our estimate of PMI's investment rate in stage II of our model to 14%, to be more consistent with companies in more competitive consumer staples categories.

The headline number shows that PMI's first-quarter shipment volume of Heatsticks in Asia fell by almost half sequentially from the fourth quarter. Several indicators support our belief that category demand has plateaued, rather than collapsed. First, PMI's share was slightly up sequentially, so significant market share shifts to competitive products offered by British American or Japan Tobacco are unlikely to have occurred. Second, retail trends appear to be unchanged. Convenience store operator Lawson recently stated that through March, heated tobacco product sales were continuing to rise in value terms, adding 50 basis points to the company's same-store sales. This indicates that end user demand for Heatsticks is stable. Third, PMI disclosed that demand for devices, a leading indicator of demand for Heatsticks, had slowed. It is most likely that the sharp decrease in shipments is intended to ensure that channel inventory is appropriate for an environment of flat device sales.

Scana Loses Senate Battle but War Long From Over; Still Good Risk-Reward Value Pick
by Travis Miller | Morningstar Research Services LLC | 04-19-18

We are reaffirming our $57 per share fair value estimate for Scana after the South Carolina Senate passed legislation that supports a nine-month temporary 13% electric rate cut, representing about $340 million of annualized revenue.

However, implementation faces a high hurdle. We believe the state House and Governor Henry McMaster might refuse to revise their 18% proposal. Without an agreement, current rates will remain. This year's state House and gubernatorial elections, with primaries in June, could sink any compromise. Regulators also will address a 13% cut proposal that industrial customers recently requested.

A temporary rate cut is likely to elicit a Scana lawsuit and could jeopardize Dominion's $14.6 billion acquisition, including debt. We expect legislators and regulators to stop short of nixing Dominion's offer, which includes customer benefits that dwarf the temporary 13% and 18% proposals. We continue to assume a 75% probability that Dominion will close the deal by next year, adding $2 per share to our Scana fair value estimate based on our $84 fair value for Dominion.

Financially, a temporary rate cut is more of a poke than a punch for Scana. A 13% cut would reduce our 2018 earnings estimate by 40%, and cut our fair value estimate $1 per share. An 18% cut would reduce our 2018 earnings estimate by 50% and our fair value by $2 per share. Neither would jeopardize Scana's credit profile. Our fair value estimate includes full rate collection in 2018 and an equivalent 10% permanent rate cut starting in 2019.

We think Scana has the financial flexibility to make its July and October dividend payments at the current $0.6125 quarterly rate ahead of a final regulatory ruling. But Scana might choose to suspend the dividend to appease politicians and save cash for Dominion to fund rate cuts and refunds. Dividend policy does not impact our fair value estimate. With the stock yielding 6.8%, the market seems to be pricing in a near-50% cut.

Lower Effective Tax Rate, Solid Expense Control Lead to Strong Start to 2018 for BB&T

by Eric Compton | Morningstar Research Services LLC | 04-19-18

Narrow-moat-rated BB&T turned in a strong first quarter, with an adjusted return on average assets of 1.49% and adjusted return on average tangible equity of 19.9%. In a similar theme to other banks this quarter, loan growth was slow, but a lower tax rate, solid net interest margin expansion, and excellent expense control led to superb results overall. These are the best results BB&T has had since the crisis, and there is still room for improvement over the medium term. We are already projecting significant improvements for the bank, and the current results fit well within those projections. We are maintaining our $51 per share fair value estimate.

Perhaps the only less than stellar result this quarter was loan growth, with average loans up only 0.6% annualized quarter over quarter. Some of this was likely seasonal, as direct and indirect retail loans both declined. Planned portfolio runoff within the indirect bucket also played a role, and this should begin to reverse in the second half of the year. This, along with management's comments on overall client confidence lead us to expect a pickup in growth for the remainder of 2018. Interestingly, commercial real estate growth was strong, even as some banks have pulled back due to excessive competition. It is only one quarter's worth of growth, and this is in large part due to a new CRE strategy implementation, so while we will keep a close eye on credit quality here, BB&T's reputation for conservative lending leads us to believe this portfolio should remain well-managed.

Relatedly, credit quality remained pristine all around for the bank, with key measures of asset quality and credit costs remaining range-bound. We would not be surprised, given the strong employment market, if this trend of excellent credit quality continues for the rest of the year. Deposit betas remained quite low, helping net interest margins to outperform slightly. We project that eventually deposit betas will begin to catch up with expanding asset yields as rates continue to rise, although net interest margins should continue to expand over the short term. Finally, expenses remained well-controlled, with adjusted expenses down 1% year over year, and we believe they can remain flat to down for the whole of 2018.

Emerson Retools: Acquires Textron's Tools and Test Equipment Business for $810 million
by Keith Schoonmaker, CFA | Morningstar Research Services LLC | 04-18-18

Wide-moat Emerson announced that it would acquire Textron's tools and test equipment business for $810 million. With the purchase Emerson gets some solid tool brands like Greenlee and Klauke, as well as a leading portfolio of diagnostic and joining technologies. In addition, the deal grows Emerson's exposure in Europe to roughly 12% of Tools & Home Products sales up from just 7% today. The deal makes strategic sense and we think Emerson is well-positioned to optimize this business, which had languished a bit under Textron. As a result, we're increasing our fair value estimate on Emerson to $73 per share from $67. Emerson is trading at a modest discount to our valuation, sporting a price to fair value of around 0.97.

The acquired businesses generated $470 million in revenue last year with EBIT margins coming in at around 11%. Management is reporting that the EV/EBITDA multiple on the deal was bit under 12 times relative to 2018 forecast EBITDA. The acquisition will weigh on earnings per share and cash flows in 2018 relative to Emerson as a stand alone entity, but management anticipates earnings and cash flow accretion in 2019. Emerson thinks they can roughly double operating margins in the business to around 20% by 2021 (excluding amortization costs) and that the business will generate around $100 million of operating cash flow by 2022. We're less bullish than management in our base case pegging operating margins in the high-teens for the acquired businesses in our model. However, the purchase still adds $6 per share to Emerson's valuation under our assumptions for cost efficiencies, working capital improvements, and revenue synergies.

Somewhat Soft Start to Fiscal 2018 Does Not Change Our Outlook for Genuine Parts; Shares Compelling
by Zain Akbari, CFA | Morningstar Research Services LLC | 04-19-18

Despite a slow first quarter, we do not plan a large change for our $100 per share valuation for narrow-moat Genuine Parts. The results do not alter our long-term view of 4% organic sales growth and 8% adjusted operating margins, on average. We believe sentiment underestimates the firm's automotive prospects as short-term headwinds (such as the move of smaller post-financial crisis vehicle cohorts into retailers' sweet spots) have obscured long-term opportunities, leaving the shares attractive.

The firm posted 17% quarterly sales growth (2% organic) and 40 basis points of operating margin deleverage (to 6.9%). Management reaffirmed 2018 guidance, calling for 12%-13% sales growth and $5.60-5.75 adjusted EPS, versus our 12.5% and $5.73 respective marks (targets include a full year of results for S.P. Richards, which is to be spun off by year-end).

We call for about 30 basis points of 2018 operating margin expansion, as we attribute much of the early shortfall to timing, with severe weather leading to store closures in certain regions. Longer term, we believe 2017-18's U.S. winter weather should boost the automotive segment (about 65% of pro forma sales), though the second quarter could see distortion because of unseasonable early-April precipitation. As with its peers, we are encouraged that Genuine Parts has not seen pricing or margin pressure attributable to price transparency in the wake of Amazon's greater attention to the segment (consistent with our view that the digital threat is overblown).

The industrial unit (roughly 35% of pro forma sales; includes electrical group) saw 8% expansion, ahead of our 5% full-year target amid broad-based growth, with sales to equipment and machinery industry clients (Genuine Parts' biggest sector) leading the charge. We expect a relatively solid U.S. economic backdrop and a focus on mission-critical components to propel near-term results, albeit with a modest pull-forward effect as the tax cuts accelerate investmen

Led by the Drug Group Once Again, J&J Posts Solid 1Q Results, Leading to Slight FVE Increase
by Damien Conover, CFA | Morningstar Research Services LLC | 04-17-18

Johnson and Johnson reported solid first-quarter results with sales exceeding both our expectations and those of consensus, and we expect to increase our fair value estimate by close to 5%. However, we view the stock as fairly valued, with the expected cash flows largely reflected in the current stock price. The company continues to support its wide moat with strength from the pharmaceutical division, leading overall sales growth in the quarter. The company's diverse lineup of leading drugs should continue to offset near-term patent losses and drive long-term growth, supporting high returns on invested capital.

In the quarter, the operational drug division growth of 7.5% exceeded our expectations, with solid growth in oncology and immunology. In particular, immunology drugs Stelara and Tremfya posted strong gains, supported by gains in Crohn's disease and psoriasis, respectively. While we expect the close to 15% normalized decline in immunology drug Remicade will continue due to biosimilar pressures, the new immunology drugs should mitigate the pressure. Also, in oncology, Darzalex continues to post strong gains, and we expect the drug to develop into a major blockbuster as the drug moves into earlier lines of multiple myeloma. While we do expect generic competition to prostate cancer Zytiga later this year, ahead of management guidance, the company's strong portfolio of cancer drugs should offset this pressure.

Relative to the drug group, the medical and the consumer groups posted slower operational growth of 1% and 2%, respectively, but we expect growth in these divisions to accelerate to closer to 3% over the long term, as new products are introduced and additional branding campaigns are launched. In particular, new products in the eyecare segment should continue to support robust growth. Also, we expect the negative pressures in the baby care market to recede, with marketing support reinforcing the company's strong brand power in the industry.

Omnicom Kicked Off 2018 with Strong 1Q Results; Maintaining $85 FVE; Shares Remain Undervalued
by Ali Mogharabi | Morningstar Research Services LLC | 04-17-18

Omnicom's 2018 first-quarter results beat our expectations and consensus with strong organic growth partially offset by the impact of dispositions. Management maintained its full-year organic growth guidance of 2%-3%. We slightly adjusted our full-year revenue projection higher, but are maintaining our $85 fair value estimate for the company. While the stock is up 2% in reaction to the strong first quarter numbers, it remains a 4-star name, and we continue to view shares of this narrow-moat name as undervalued. In addition, at current levels, Omnicom's dividend yield stands at over 3%.

First-quarter total revenue came in at $3.6 billion, up 1.2% year over year, driven by 2.4% organic growth and 4% foreign exchange, partially offset by divestures that lowered revenue by 4.2%. Organic decline of 0.1% in North America revenue, which was mostly driven by weakness in Canada and some 2017 client losses cycling through, was more than offset by strong organic growth in most other regions. European, Asia-Pacific, and Latin America regions posted organic growth rates of 12.3%, 7.3%, and 3.1%, respectively. In Europe, sales of services in the U.K. grew 3.1% organically driven mainly by strengths in advertising, media, PR, and healthcare. Latin America was helped by some sequential improvement in the Brazil market, although it continued to experience a year-over-year decline. Revenue from Middle East and Africa declined 8.5% driven mainly due to lower media spending in UAE (United Arab Emirates). For the year, management maintained its 2%-3% organic revenue growth guidance. The firm also expects the second half of 2018 to be stronger than the first.

The firm's reported first quarter operating margin of 11.6%, up nearly 20 basis points from last year as lower salary and services expenses were partially offset by an increase in G&A. While we are impressed with the unexpected margin expansion in the first quarter, we continue to expect higher investments by Omnicom in talent and additional resources in data and analytics for the rest of 2018. For this reason, we are staying with our margin decline assumption for the full year.

During the earnings call, management provided more color regarding the firm's strategy going forward, which we continue to view as encouraging. First, in our view, the firm is very cognizant of the transitions taking place within the ad space as it is increasing its focus on 1-on-1 and highly targeted advertising and marketing.

Second, while the firm is investing in data and analytics, it is also well aware that continuing consumer engagement brought forth more by creativity within the direct and target messages is crucial. As we mentioned in our December 2017 Select report on other companies within the ad space, creativity is what differentiates ad agencies from consulting and technology companies.

Last, Omnicom's recent success in maintaining accounts and/or winning new clients, is indicative of how well the firm is executing those strategies. During the first quarter, Amgen, one of the largest pharmaceutical companies with a $116 billion market capitalization, decided to keep Omnicom as its media agency. Before such a decision, Amgen had initiated a review of the account, for which Publicis and WPP also pitched. Some reports indicate that Amgen's media spending in 2018 may increase around 45% to $350 million this year. Johnson & Johnson has also decided to stay with Omnicom after the ad holding firm provided Johnson & Johnson with more integrated creative and CRM services. We note that Johnson & Johnson is also working with WPP on the creative side. And on the new accounts front, Omnicom's creative agency, Goodby, Silverstein & Partners, landed the BMW account, displacing KBS, which is owned by MDC. Plus, the firm announced today that its BBDO creative ad agency won the Dunkin' Donuts account and replaced IPG, which had been an agency of Dunkin' Donuts since 1998.

Despite P&G's Persisting Sales Cascade, Brand Spend Poised to Shore Up its Edge; Shares Attractive
by Erin Lash, CFA | Morningstar Research Services LLC | 04-19-18

Lagging sales continue to dog wide-moat Procter & Gamble, with organic sales up just 1%, reflecting a 3% benefit from increased volumes and favorable mix, offset by a 2% reduction in price. This weakness (not dissimilar from the past few quarters) was concentrated within the grooming (10% of sales) and baby (27%) segments, which were each down 3% on an organic sales basis. While these results are far from a plus, we're encouraged by the improvement chalked up in its beauty (nearly one fifth of sales, up 5%) and fabric care (one third of sales, up 3%) segments. We think these gains showcase the first fruits of P&G's efforts to rationalize its mix. And while improvement has yet to prove broad-based, we expect the firm's continued investments behind core brands will lead to increasing consolidated sales growth and support its brand intangible asset.

Beyond its quarterly results, P&G also announced it intends to terminate its healthcare joint venture with no-moat Teva and has inked a deal to acquire German-based narrow-moat Merck's consumer healthcare brands for $4 billion (3.7 times trailing-12-month sales and 20 times EBITDA). In our view, this tie up (which is expected to close by the end of the calendar year) stands to replace the scale and technological know-how lost following the dissolution of its joint venture partnership. As such, we don't portend it signals a reversal in the firm's strategy to operate with a leaner brand mix. At just 1%-2% of sales, we surmise this addition evidences management's openness to selectively bolstering its reach in attractive categories (consumer health growing midsingle digits) and geographies. After assessing the quarterly results and the consumer healthcare deal, we don't foresee a material change to our $98 fair value estimate. With shares down around 3% following this news, we'd suggest investors stock on shares, which trade at a more than 20% discount to our valuation and boast a more than 4% annual dividend yield.

Healthcare REITs Lack Moats and Face Near-Term Headwinds, but Valuations Are Compelling
by Kevin Brown | Morningstar Research Services LLC | 04-19-18

We are lowering our moat rating for the healthcare REITs we cover (HCP, Ventas, and Welltower) to none from narrow. However, we believe there is significant value to be found in these companies' high-quality, well-diversified portfolios. All three have sold off in the past few months because of factors that are either short term or already baked into our long-term views, and we believe the market is ignoring long-term industry tailwinds. We see Welltower and Ventas as the most attractive names given their management's exemplary stewardship, and we have a slight preference for Welltower, as we believe its strategy of smaller-scale acquisitions is more viable. All three companies also currently have a dividend yield over 6%, and we see their dividends as well-covered.

After transferring coverage, we have lowered our fair value estimate for Ventas to $65 from $67 and for HCP to $25 from $26. We are maintaining our $74 fair value estimate for Welltower. These changes are the net result of some offsetting changes in our near- and long-term assumptions. While we had previously recognized that 2018 would be a down year for senior housing fundamentals and the next two years would also see slower NOI growth, we've lowered our near-term expectations further based on how the situation has developed.

Additionally, we are modeling more detailed dispositions in 2018 given what the companies have announced to date. This was the primary cause of the decrease in our fair value estimate in March for HCP, as HCP is estimated to dispose of $2 billion more of assets than we were previously expecting in 2018, and is disposing assets at a higher cap rate or lower price than we had previously anticipated. Partially offsetting these negative adjustments, after reassessing longer-term demographic trends, we now include several years of above average NOI growth starting in 2021 as supply growth slows and the baby boomers start to move into these properties.

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