Altria's Q2 Volume and Margin Performance Show Tobacco Is a Safe Haven Amid Commodity Inflation
by Philip Gorham, CFA, FRM | Morningstar Research Services LLC | 07-30-21

Altria beat our estimates of both net revenue growth and margins in the second quarter, allowing management to raise the bottom end of its full-year guidance. This was a strong set of results that supports our belief that the tobacco group is likely to be a safe haven from the commodity cost inflation that is plaguing manufacturers in other consumer product categories. Trade inventory movements played a large role in the volume beat, however, and as this should reverse in the coming quarters, we retain our $52 per share fair value estimate.

After adjusting for channel inventory movements, second-quarter cigarette volume declined by 4.5%, which we believe is tracking slightly better than the U.S. market. Price/mix was once again very strong, at 8.5%. Mix was likely positive again, as Altria's retail share of the premium segment ticked up by about 50 basis points over the second quarter last year to 43.2% and by 10 basis points sequentially, while the company's discount share of 3.5% was down 40 basis points year over year and 10 basis points sequentially. Nevertheless, price would have accounted for the majority of this impressive figure, and there may be even more pricing to come in the second half of the year. BAT stated it had raised prices in the high single digits and that share had remained roughly stable. For this reason, we remain comfortable with our adjusted earnings estimate being at the high end of Altria's full year guidance of $4.56 to $4.62 in earnings per share. The timing of the disposal of Ste. Michelle wines may affect this, however.

Margins were also above our estimates. Gross margin of 66.5% and adjusted operating margin of 58.4% were both over 2 percentage points above our forecasts, boosted by higher volume--which will reverse; and by mix and price, which will not. It is also notable that marketing spending and capital expenditure have been constrained through the uncertainty of COVID-19, and that levels of spending should normalize soon.

Comcast Continues to Post Exceptional Customer Growth; Fair Value Estimate to $60
by Michael Hodel, CFA | Morningstar Research Services LLC | 07-29-21

Comcast continued to put up stellar cable metrics and resumed share repurchases during the second quarter. Management also reiterated its view that Comcast doesn't need to undertake acquisitions to gain scale in the media business and announced that Peacock will be made available to Sky customers for free. We're increasing our fair value estimate to $60 from $54. We believe the stock is fairly valued, but we also view it as a core portfolio holding at current prices.

Comcast added 354,000 net broadband customers during the quarter, 10% more than a year ago despite the bump in growth fueled by the onset of the pandemic. Through the first half of 2021, broadband customer additions are running around 30% higher than the typical prepandemic year. The wireless initiative also continues to gain momentum, with 280,000 net additions taking the customer base to 3.4 million lines. We estimate around 4%-5% of Comcast's residential customers now take its wireless service.

Cable revenue increased 11% year over year thanks to strong customer gains and a rebound in commercial services and the advertising market from depressed levels in 2020. The cable segment EBITDA margin expanded 1 percentage point versus a year ago to 44.2%, another record high. While growth will likely slow from here as comparisons become more difficult, this business continues to perform exceptionally well in our view.

NBCU revenue increased 39% year over year, with all segments rebounding sharply on the return of live sports, a modest return to theaters, and the reopening of theme parks, particularly in Orlando. The new media segment, which encompasses the cable and broadcast networks, increased revenue 26% year over year on both strong advertising and distribution results. Management indicated that cable subscribers were flat sequentially and that 54 million customers have signed up for Peacock. About 20 million customers used Peacock monthly during the quarter, up 50% sequentially.

Lithium Stocks Rally on Infrastructure Bill, but Our View Is Unchanged; SQM and Compass Undervalued
by Seth Goldstein, CFA | Morningstar Research Services LLC | 07-29-21

On July 29, lithium producer stocks rallied on the news that the U.S. infrastructure bill was advancing in the Senate. The bill features $7.5 billion of funds that would be used to build 500,000 high powered electric vehicle chargers throughout the country. We had expected this to occur and had already incorporated this into our outlook for EV adoption and subsequently lithium demand, lithium prices, and producer profits. With our outlook unchanged, we maintain our fair value estimates of $145 per share for narrow-moat Albemarle, $88 per share for wide-moat Compass Minerals, $17 per share for narrow-moat Livent, and $58 per share for narrow-moat SQM.

At current prices, we view Albemarle as overvalued on a risk adjusted basis, with the stock trading in 2-star territory. Livent is slightly overvalued with the stock trading above our fair value estimate but in 3-star territory. However, we view SQM and Compass Minerals as undervalued, with each stock trading in 4-star territory.

For Compass, we think the market is not pricing in the potential long-term earnings from the company's fully restored cost-advantaged salt production and from higher salt prices in the upcoming bid season. While the company's entrance into lithium production is still in the early development phase, we see the project as relatively less risky versus new greenfield entrants as lithium would be a by-product produced from existing potash production.

Edison's Growth Plan Receives Regulatory Support; One of Few Deeply Undervalued Utilities
by Travis Miller | Morningstar Research Services LLC | 07-30-21

We are reaffirming our $70 fair value estimate for Edison International after it reported $0.94 core earnings per share during the second quarter and received a constructive regulatory decision that keeps it on track to meet our full-year forecast. We are also maintaining our narrow moat and stable moat trend ratings.

Edison is one of the cheapest U.S. utilities as of July 29, trading at an 18% discount to our fair value estimate with a 4.7% dividend yield. Edison trades at 13 times our 2021 earnings estimate, well below the sector's 18 median P/E.

We think the market will better appreciate Edison's long-term value after it receives a final decision in its long-delayed general rate case and avoids any large fire-related liabilities this fire season. On July 9, regulators issued a proposed GRC decision that supports $14 billion of capital investment in 2021-23, or 90% of Edison's budget request, in line with our assumption. We expect regulators in their final decision might add back some of Edison's wildfire safety spending that the proposed decision excluded or shift the spending to Edison's other wildfire safety programs.

Regulators' near-full support of Edison's investment plan shows that California utility regulation remains constructive and that regulators are willing to support utilities' role in implementing the state's public policies related to safety, clean energy, and electrification.

A final GRC ruling possibly in mid-August will boost second-half earnings as Edison collects new base rates retroactive to January. We expect regulators will continue to support nearly $5 billion of annual investment beyond 2023, supporting our 7% annual average earnings growth outlook through 2025.

We continue to incorporate a $7.25 per share discount in our fair value estimate for $2 billion of unpaid claims related to 2017-18 wildfires and mudslides. Edison reported it resolved $560 million of those unpaid claims in the second quarter.

Enterprise's Q2 Volumes Are Approaching 2019 Levels, Generating Substantial Excess Free Cash Flows
by Stephen Ellis | Morningstar Research Services LLC | 07-28-21

Enterprise Products Partners reported a solid second quarter, as key volume metrics are now approaching 2019 levels in many cases and are already at record volumes elsewhere. Liquids pipelines, natural gas pipelines, natural gas liquids fractionation, and liquids marine terminal volumes are very close to or at 2019 volume levels, while petrochemical volumes are at record levels. After updating our model, we are maintaining our $25.50 fair value estimate and wide moat rating. The drivers of Enterprise's business have shifted from storage profits to volumes with petrochemicals leading the way. Gross operating margins only increased slightly to $2.1 billion from $2 billion last year, primarily due to ongoing strength in the propylene business offset mainly by lower marketing contributions. Materially lower marketing contributions due to the absence of Winter Uri contributions also led to the quarter-over quarter decline. With the volume recoveries, Enterprise is now considering new projects, and while none of them have been sanctioned yet, 2022 growth capital spending is likely to increase from the current projected $800 million to between $1 billion and $1.4 billion by our estimates. Medium- and long-term growth capital spending is now expected be at a midpoint of $1.75 billion. We estimate free cash flow after distributions to unitholders to be around $735 million so far this year, putting the partnership on track to generate over $1 billion in excess cash flows this year. At least part of that is now expected to be allocated toward unit buybacks, as management expects to buy back $200 million in units in the second half of the year. With the expected increase in growth capital spending next year, free cash flow after distributions should decline. However, as Enterprise's leverage is at very reasonable levels, we still forecast there could be over $1 billion in cash available for further unit buybacks.

Exxon Improves Cash Flow and Reduces Debt, but Increased Shareholder Returns Still on Hold
by Allen Good, CFA | Morningstar Research Services LLC | 07-30-21

Exxon turned in a strong second quarter buoyed by a recovery in commodity prices and a record quarter from its chemical segment. Downstream improved but continued to be a drag due in part to planned maintenance and weak market conditions. Adjusted earnings improved to $4.7 billion from a loss of $3.0 billion last year. Meanwhile, operating cash flow surged to $10.3 billion from $1.5 billion the year before as debt fell another $2.7 billion during the quarter bringing the total reduction to $7 billion since year-end 2020. As a result, net debt to capital fell to 26.5% from 28.7% at the end of 2020. Our fair value estimate and narrow moat rating are unchanged.

Unlike peers, Exxon has yet to introduce repurchases, while the dividend has remained flat for two years. However, fundamental improvement is ongoing while higher commodity prices should assist in deleveraging. Exxon delivered over $1 billion in structural efficiencies improvements during the first half of the year and remains on track to deliver its $6 billion target by 2023. We expect Exxon to maintain focus on capital discipline given recent activist pressure, new board members, and past relative underperformance. Management reiterated that capital spending will come in at the low end of its $16 billion-$19 billion guided range. As such, shareholder returns should follow once debt falls into management's preferred range of 20%-25%. Given valuation and potential for improvement, we think Exxon remains an attractive option in the sector.

Remediation Costs Hurt Lloyds' Second Quarter, but Underlying Performance Was Decent
by Niklas Kammer, CFA | Morningstar Research Services LLC | 07-29-21

Narrow-moat Lloyds reported a second-quarter underling profit of GBP 1,994 million, down nearly 4% versus the first quarter this year based on higher remediation costs. These charges come as a result of ongoing legacy issues related to HBOS and miscommunications around insurance renewals. Excluding these charges, performance was decent. Net interest income came in 2% higher. Importantly, margins at a group level remained robust, and Lloyds now guides for net interest margins around 250 basis points versus its previous guidance of above 245 basis points. Mortgage margins are coming down modestly, which we expect to continue as risk appetite of the banks is returning and all are looking to pick up volumes. However, current margins still remain above front book margins. Unsecured volumes continue to be a drag on group margins as volumes have not materially recovered towards prepandemic levels just yet. Going forward, we see greater upside risk than downside risk to our net interest margin assumptions. Operating costs came in 2% higher as well, primarily due to higher variable pay. Finally, Lloyds booked another set of loan loss reversals this quarter to the amount of GBP 333 million on the improving macroeconomic outlook. The bank retains a GBP 1.2 billion overlay buffer still. For the full year, Lloyds now expects loan losses to come in below 10 basis points. We will adjust our near-term loan loss assumptions as a result but don't anticipate any changes to our medium-term forecast or fair value estimate of GBX 62 per share ($3.40 for U.S. shares).

A Charge on Classified Program Mars an Otherwise Solid Q2 at Lockheed; Lowering FVE to $425
by Burkett Huey, CFA | Morningstar Research Services LLC | 07-26-21

Wide-moat-rated Lockheed Martin reported a solid second quarter aside from a $225 million charge on a classified aeronautics program. Management maintained its top- and bottom-line guidance and repurchased another $500 million of stock on top of the $1 billion it repurchased in the first quarter. We are decreasing our fair value estimate to $425 per share from $436 as we incorporate Morningstar's assumption of higher taxes in our model, but we still think the stock is somewhat undervalued. We think the significant repurchases show that management agrees with our assessment that the stock is cheap.

The firm posted sales growth of 5.0% due to mid-single-digit growth across the portfolio, with space systems outperforming the portfolio considerably. During the quarter, the company faced some pressure from customers on the cost of sustaining the F-35 aircraft, and management is pushing to have sustainment programs wrapped up into a broad performance based logistics contract that Lockheed anticipates would reduce maintenance costs by ensuring better spare-parts availability. We expect that as production stabilizes, additional capabilities will go toward ensuring the availability of spares, which should reduce maintenance costs significantly by increasing labor efficiency. Separately, Lockheed won a $5.5 billion contract to provide the F-35 to Switzerland.

Segment margins contracted 60 basis points to 10.4% due to the $225 million charge on a classified program, and EPS of $6.52 missed FactSet consensus by 0.2%. The classified portfolio generally consists of smaller programs, so we were interested to see that this charge was on a single program. We think this charge may be an early indication that Lockheed has a position on the secretive Next Generation Air Dominance platform. Otherwise, margins expanded across the rest of the portfolio, likely due to easy comparisons in the second quarter of 2020 because of manufacturing holdups during the pandemic.

Magellan Reports Solid Q2 Results, While 2021 Guidance Remains Unchanged; Buys Backs More Units
by Stephen Ellis | Morningstar Research Services LLC | 07-29-21

Magellan's second-quarter results were solid, as its 2021 guidance for distributable cash flow at $1.07 billion remained unchanged. After updating our model, our $52 fair value estimate and wide moat rating remain unchanged. Second-quarter trends for the refined products and crude-oil segments have continued to meet management's and our expectations, while product sales have outperformed slightly as a result of better blending opportunities in the first half. This benefit is expected to be offset in the second half of the year, given weaker expected margins and the fact that Magellan has now hedged 80% of its exposure. Magellan's capital allocation continues to support our Exemplary rating. Growth capital spending is still expected to be $75 million in 2021 demonstrating rigorous investment evaluation, though we expect it to increase to around $200 million in 2022, as Magellan has several small opportunities that we expect it to move forward on. However, asset sales of $271 million in 2021 and another $435 million awaiting regulatory approvals and expected to be completed in 2022 lift free cash flow after distributions to $350 million this year and over $400 million in 2022. The level of free cash flow allows for buying back of units, and Magellan bought back $82 million during the quarter. With leverage at already at reasonable levels, we think there's considerable scope to continue to buy back units going forward.

McDonald's Supersized Earnings Impress; Fair Value Estimate Raised Despite Tax Rate Increase
by Sean Dunlop | Morningstar Research Services LLC | 07-28-21

Wide-moat McDonald's reported strong third-quarter earnings, with global comparable sales up high single digits (6.9%) relative to 2019 levels. Strength was widespread, with all three operating segments turning positive against a prepandemic baseline, as the famous orders platform, a sustained volume boost from the chicken sandwich launch, and re-opened dining rooms pushed outperformance. We're raising our fair value estimate to $234 per share from $231 prior after adjusting for better digital traction and sustained strength in average check, offset by the incorporation of a 26% U.S. statutory tax rate in 2022 and beyond (up from 21% prior). Shares appear fairly valued at current prices, and we remain optimistic about the long-term benefits of the firm's digital strategy, which could improve guest frequency and reduce customer churn as McDonald's leverages insights from those channels.

Management's "MCD," or marketing, core menu, and digital strategy continues to pay off, with all three pillars bolstering results during the quarter. The BTS "famous orders" platform generated substantial media attention, while crispy chicken sandwiches continued to prove incremental, driving 25.9% U.S. comparable store sales growth (14.9% on a two-year stack), the best two-year domestic comp in 15 years. The firm raised its consolidated guidance from midteens system sales growth to mid- to high-teens, with our forecast now calling for 18% growth in 2021 (from 13.5% prior), as international comparable sales accelerate, and U.S. comps remain in the low double digits through the second half of the year.

Finally, the firm's digital strategy continues to pay dividends, with the much-anticipated MyMcDonald's Rewards launch generating 12 million active users during the quarter, while digital sales ticked up to 19.7% of system sales in the firm's top 6 markets, by our calculations (clocking in at $8 billion, up 70% from a year ago).

Boosting Pfizer's Fair Value Estimate 
by Damien Conover, CFA | Morningstar Research Services LLC | 07-29-21

Pfizer reported strong second-quarter results ahead of our expectations, buoyed by exceptionally strong COVID-19 vaccine sales as well as solid growth from the core portfolio. We've increased our fair value estimate to $42 per share from $40, but we view the stock as largely fairly valued, with the market appropriately valuing Pfizer's current products and pipeline drugs, both of which look well positioned to support Pfizer's wide moat.

In the quarter, total sales increased 86% operationally (up 10% excluding the COVID-19 vaccine sales). However, we expect total sales growth will slow over the next 12 months as COVID-19 vaccine demand shifts toward emerging markets where pricing is lower. Longer term, we expect a tail of COVID-19 vaccine sales of close to $2 billion annually based on booster shots for the elderly and immuno-compromised. Potential upside exists if larger demand for boosters emerges or new vaccines are developed for variants. Pfizer is exploring a new vaccine for the delta variant despite the strong protection already offered by its current vaccine.

The remaining portfolio is performing well, led by cardiovascular drug Eliquis and rare disease drug Vyndamax. We expect Eliquis to continue to take share from the less effective warfarin, and Vyndamax is still early in its launch trajectory. Also, the recent approval of Prevnar 20 should enable continuation of this important franchise, as the new vaccine provides almost one third more coverage than Merck's competitive vaccine.

Pfizer continues to make strides with pipeline drugs. While the JAK inhibitor class is facing increased scrutiny by the FDA, we still expect approval for immunology drug abrocitinib by the end of the year based on a strong safety profile. Over the next 12 months, we expect positive pivotal data for new blockbusters in gene therapies (Duchenne muscular dystrophy and hemophilia A and B) and for a respiratory syncytial virus vaccine based on strong early-stage data.

Moeller Set to Occupy the Corner Office at P&G, Though Changes in Strategic Direction Unlikely
by Erin Lash, CFA | Morningstar Research Services LLC | 07-29-21

After more than six years at the helm and nearly four decades at the firm, wide-moat Procter & Gamble announced CEO David Taylor will step down in November, with Jon Moeller--a 33-year company veteran, who had been CFO since 2009 and more recently assumed the role of chief operating officer and vice chairman--poised to take the reins. Taylor will continue to serve as executive chairman to ensure a smooth transition.

Moeller struck us as the heir apparent, given his grasp of P&G's expansive category and geographic footprint. And because Moeller has been intimately involved in scripting the firm's strategic playbook (centered on stringently extracting costs from its operations while directing additional resources towards product innovations that resonates with consumers and marketing that fare), we don't expect it will pivot off its current course. The success of these efforts is evident in its improved sales trajectory (including 11 consecutive quarters of at least mid-single-digit organic revenue growth and counting) and meaningful profit expansion (with adjusted operating margins up about 300 basis points since Taylor assumed the CEO-position, to just shy of 23% at the end of fiscal 2020).

We also expect bolstering shareholder returns will remain a key capital allocation priority under Moeller's watch (building off of the more than $100 billion returned in total over the last 10 years), with our forecast calling for high-single-digit annual increases in its dividend and a low-single-digit percentage of shares repurchased each year. But this announcement fails to impact our $118 fair value estimate, based on our expectations for 3%-4% annual top-line growth and 24% operating margins by the end of our 10-year explicit forecast, up from an average of 21.8% over the past three years. However, we don't think investors should stock up on the firm's shares at current levels, which trade at a nearly 20% premium to our intrinsic valuation.

Strong U.S. Results Outshine International Pressure; We Raise our Fair Value Estimate for Starbucks
by Sean Dunlop | Morningstar Research Services LLC | 07-27-21

Wide-moat Starbucks reported strong fiscal 2021 third-quarter earnings, with a sharp year-over-year bump in guest traffic driving 84% comparable store sales growth in the Americas segment, or 9% relative to 2019's level, though visits remained 10% below prepandemic volumes. Notably, the segment's operating margin clocked in at 24.4%, the highest since the third quarter of 2017, as cost savings from store footprint rationalization and sales leverage more than offset supply chain pressure and wage increases. While the initial market reaction was negative (shares down about 3% in post-market trading), likely attributable to lowered guidance in the international unit, we anticipate raising our fair value estimate to $109 from $107 prior, on operational improvements, an impressive ability to defray inflationary pressure, and sustained strength in consumer-packaged goods.

Input cost inflation remains one of the most pressing concerns for restaurant operators, with transportation bottlenecks and sharp run-ups in select food prices adding near-term pressure. While Starbucks' management views menu pricing as one lever to defray rising costs, we're encouraged by a tempered approach to price hikes, with the firm preferring to generate operating leverage via higher average checks, premium cold beverage sales, and improved guest frequency. Importantly, management guidance of 17% 2021 operating margin contemplates these impacts, with the firm's green coffee supply price-locked for the next 14 months, blunting the impact of a 70% run-up in the Arabica "C" contract. Our forecast calls for a 16.9% operating margin in fiscal 2021, improving to 19.1% by fiscal 2025.

With its trade area transformation nearly complete, drive-thru transactions ticking up to 75% of U.S. sales, and CPG sales continuing to take share, we view Starbucks' as one of the best positioned operators in the restaurant space, but note that shares trade at about a 12% premium to our fair value estimate.

UPS' Q2 Yields Robust and Underlying Demand Solid, but Comparisons Now Tough and Labor Costs Rising
by Matthew Young, CFA | Morningstar Research Services LLC | 07-27-21

Healthy underlying demand and pricing continued in UPS' second quarter, with revenue up 15% year over year (27% last quarter). Growth was slightly above our forecast as impressive yield gains offset lower-than-expected ground volume trends related to noise from the onset of tough comparisons. Continuing the theme of previous quarters, the pandemic has driven a massive surge in residential package-delivery demand across all segments. At the same time, B2B activity has clawed its way back on economic recovery. Limited airlift capacity continued to bolster the international package unit as well. International and domestic B2C package volumes swung to year-over-year declines, but that's primarily because of incredibly tough comparisons--residential deliveries surged in the same period last year.

Total package yield soared 15% on rising surcharges, constrained last-mile capacity (excellent pricing power), and greater demand from higher-yielding small- and mid-sized customers. Domestic yields rose 13% year over year, while international yields were up 15.5%. U.S. domestic revenue expanded 10% on strong pricing and SMB mix benefits. However, domestic ADV fell 3% as 16% lower B2C activity was only partly offset by 26% B2B volume growth and higher next-day air business. On the positive side, underlying e-commerce tailwinds should persist. International revenue rose 30%, with volume up 13%.

Adjusted EBIT margin improved to 14%, from 11.4%. U.S. margins improved nicely to 11.6%, from 9.3% a year ago and 10.4% last quarter, as the firm continues to benefit from leverage from revenue growth and productivity gains. International package and supply chain adjusted margins also increased. Save for a slight boost from the time value of money, we don't expect to materially alter our DCF-derived $160 fair value estimate as modestly higher revenue forecasts were offset by tempering our near-term domestic margin forecasts on lower-than-anticipated guidance for the second half.

As Fed Holds Rates Steady, Tapering Debate Looms Large
by Eric Compton, CFA | Morningstar Research Services LLC | 07-28-21

In its latest statement, released on July 28, the Federal Open Market Committee unsurprisingly held the federal-funds rate at 0.0%-0.25%. Nobody expected a change in rates at this meeting, instead the big issue on everyone's mind relates to the timing of tapering. As a reminder, this meeting contained no new economic projections, only the press release and press conference.

With the median FOMC participant now expecting roughly two rate hikes by 2023 based on last month's release, Fed chair Jerome Powell's comments at the last press conference that they were "talking about talking about" tapering, and the latest minutes (released July 7) showing a robust discussion about asset purchases, the timing of any tapering and/or tapering announcement is clearly on everyone's mind. To this end, there was a slight change in the language of the release. In regard to the "substantial further progress toward maximum employment and price stability goals" that the FOMC is looking for before starting its tapering, the current release acknowledges that "the economy has made progress toward these goals, and the Committee will continue to assess progress in coming meetings." This is starting to set up a path for the FOMC to begin its tapering process. We believed that the FOMC would telegraph its tapering well in advance, and we see this as the start of that process.

While nothing is certain, and the incoming economic data could shift, we think it's reasonable to expect tapering to start toward the end of 2021 (perhaps at the December meeting) or in the first quarter of 2022 (perhaps at the March meeting). While tapering could theoretically start before then, we think it is unlikely that inflation would prove so high and so persistent over the next several months that it would shift FOMC consensus completely away from its current "transitory" stance by the September meeting, which leaves only the November meeting, a meeting without economic projections.

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