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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

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

Not for the Fainthearted: Our Monthly Surveyof the Economy, Interest Rates, and Markets

After a strong start to the year that carried across most of January, stocks struggledat month’s end and were slammed early in February. In fact, stocks are now experiencingtheir first meaningful selloffs since the twin corrections around Brexit (-3.8%) and theU.S. pre-election 2016 summer (-4.5%). The S&P 500 experienced a steeper selloff (-11.2%) from December 2015 to February 2016 amid the trough in energy prices. TheU.S. stock market did not experience a single sizable (5%) correction in 2017.

Why are stocks selling off now? Investors cannot point to the usual suspects. Un-like two years ago, when investors feared that weakness in energy prices signaled declin-ing global demand, the global macro environment is at its strongest level in years; after3.7% growth in 2017, the IMF forecast global GDP growth of 3.9% in 2018. The weakdollar is helping to lift commodity prices, whereas two years ago the strong dollar wasmaking oil cheap and most oil producers unprofitable.

Regardless of why stocks are selling off, we see no signs that this long-running bullmarket is at risk of falling into a bear market. The economic and earnings fundamentalsremain compelling, as we detail below.

THE ECONOMY, INTEREST RATES, AND EARNINGSThe preliminary 4Q17 GDP report showed an unexpected slowing in U.S. economic activity in the year’s final quarter. GDPgrowth of 2.6% slipped from 3.2% in the third quarter; economists had forecast 3.0% growth in 4Q17. The consumer roared inthe fourth quarter, as the PCE (personal consumption expenditures) indicator rose to 3.8%, its highest reading since 2Q16.Consumer demand for durable goods increased more than 14%, and even nondurables were up 5.2%.

After a strong midyear in which growth averaged about 8%, gross private domestic investment slipped to 3.6% in 4Q17.Imports, which subtract from GDP, increased 14%, rising at their fastest pace in seven years; that partly reflected higherconsumer demand but also the spike in energy prices. Exports grew at a healthy clip, but still only at half the pace of importgrowth. Government spending, which has been suppressed in recent years, grew at a rapid 3.0% pace, fueled by defensespending.

One silver lining is that full-year 2017 GDP grew 2.3%, much better than the 1.5% growth recorded in 2016. After theslippage in 4Q17 relative to 3Q17, however, further challenges await when the first GDP data for 2018 is reported in April.Since 2013, first-quarter GDP growth has averaged just 0.3%. Even excluding the 2.1% decline in 2014, the first quarter has

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February 12, 2018Vol. 85, No. 19

®

IN THIS ISSUE

SECTION 1ECONOMIC & MARKET COMMENTARYTECHNICAL TRENDS COMMENTARY

SECTION 2FOCUS STOCKSCHANGES IN RATINGGROWTH & VALUE STOCKSUTILITYSCOPESTOCKS TO AVOID

SECTION 3U.S. MACROECONOMIC DATAECONOMIC CALENDARSPECIAL SITUATIONS & SCREENSMASTER LIST CHANGESRECENT ARGUS BUY UPGRADES

averaged less than 1% growth since 2013. Really bad 1QGDP reports are often associated with bad weather, andthis year, we have seen harsh weather, particularly in theMidwest and Northeast. On the upside, the recently en-acted tax cuts should begin to benefit corporate profits andconsumer wallets, which could help the overall trend.

For all of 2018, and factoring in positive drivers thatinclude global growth, domestic deregulation, and tax cuts,we now forecast GDP growth in the 2.3%-2.8% range; wehad previously forecast midpoint GDP growth of 2.25%.Annual GDP growth for 2018 will depend in part on dodg-ing a big winter falloff in 1Q18, as well as on theadministration’s ability to drive fiscal stimulus from taxreform and infrastructure investment.

As the Fed continues pushing rates gradually higher,we expect some negative impact on economic activity in2018 and particularly in 2019. Our first GDP forecast for2019 shows growth slipping back into the low 2% range.But before we can model 2019 with any confidence, weneed to see how 2018 plays out.

The yield curve, which spent much of 2017 in a gen-erally flattening trend, has now completely changed thenarrative. Long rates, which seemed stuck at the 2.5% mark,are now surging since breaking through that psychologi-cally important level. The Fed moved with painful slow-ness early in this restrictive monetary cycle. But it hikedthree times in 2017, and investors now know that the Fedmeans business. With the Fed expected to stay aggressiveon rate hikes in 2018, we see plenty more upside in bondyields – and downside in bond prices.

The short end of the curve continues to move higher;that has not changed. Over the past year, the 3-month billyield has moved up 101 basis points, to about 1.48%. Thetwo-year note yield has also advanced 101 basis points inthe past year, to 2.16 %.

As we move into the middle maturities, the rate ofchange is suddenly more aggressive. The five-year Trea-sury note currently yields 2.58%, up 30 basis points in justthe past month and about 75 basis points from the prioryear. The 10-year yield, at 2.85%, is 44 basis points higherthan it was in February 2017, after being just 12 basis pointshigher one month ago. And the 30-year yield, at 3.08%, isfinally higher than it was a year ago.

During 2017, investors asked if the flattening yieldcurve signaled heightened risk of recession. Although theslope is increasing, investors need to remain alert for signsof slowing activity. The Fed is actively pushing up rates;there is always the risk that it will push too hard. Still, aswe stated while the curve was flattening, we see limitedinflation or recession risks ahead in a well-balancedeconomy.

ECONOMIC & MARKET COMMENTARY (CONT.)

- Section 1 -

MAJOR INDEXDATA AS OF FEBRUARY 2, 2018

SECTOR PERFORMANCE

INTERNATIONAL EQUITYMARKET PERFORMANCE

Year-To-Date Return

Year-To-Date Return

Year-To-Date Performance

Source: Dow Jones, Argus Research

(continued on next page)

5.2%

4.9%

3.4%

3.3%

2.0%

0.8%

-1.8%

-5% 0% 5% 10%

Growth Stocks (Wilshire Large Growth)

Nasdaq Composite

S&P 500

DJIA

Value Stocks (Wilshire Large Value)

Russell 2000

Lehman US Aggregate Bond Index

7.2%

5.3%

5.2%

4.4%

3.0%

0.6%

0.4%

0.0%

-0.7%

-5.3%

-10% -5% 0% 5% 10%

Consumer Discretionary

Health Care

Financials

Technology

Industrials

Energy

Telecom

Materials

Consumer Staples

Utilities

11.9%

10.2%

10.0%

3.8%

3.4%

3.0%

2.2%

2.1%

0.8%

-3.1%

-3.5%

-10% -5% 0% 5% 10% 15%

Russia

China

Brazil

DJ World Index

S&P 500

India

Japan

Mexico

Euro Zone

UK

Canada

- Section 1 -


We had been looking for long-term rates to move up,and that now appears to be happening. Too rapid a risewon’t be good for stocks, but the equity market can with-stand several more Fed rate hikes as long as they are mea-sured and restrained.

The fourth-quarter earnings season is coming instrongly, as expected. At a time of declining bond and stockprices, the trend in EPS growth is a reminder that the stockmarket, even as it wobbles, has firm underpinnings.

Last month, we raised our forecast for S&P 500 earn-ings from continuing operations for 2018 to $149.50 froma prior $145.25. The weak dollar remains a key EPS growthdriver on a sector-wide basis. The rebound in energy pricesis important obviously for energy earnings, but also forrelated areas such as industrial.

We have increased our 2019 EPS growth forecast to$169 from $154. As weak dollar effects begin to recede,the gain next year should primarily be driven by globalgrowth. We expect both the anticipation and the reality oftax cuts to drive higher consumer spending and businessactivity.

Our revised estimates imply EPS growth of 12.6%for 2018 and 13.0% for 2019, respectively. We also expectlarge corporations to return more value to shareholders inthe form of higher dividends. We look for 7.6% dividendgrowth in 2018, with additional mid- to high single-digitgrowth in 2019.

DOMESTIC AND GLOBAL MARKETSPlainly, the late January and early February stock sellinghave cut into what was a very strong start to the year. Whatis surprising, however, is how closely the start of 2018mirrors the start of 2017. As was the case last winter, theNasdaq and the Wilshire Large-Cap Growth lead amongmajor domestic indices. In the middle of the pack are theblue-chip S&P 500 and Dow Jones Industrial Average. Andjust like last February, the Russell 2000 is lagging the av-erage, as investors continue to avoid small-cap stocks.

One thing that has changed is bond performance. Ayear ago the Lehman US aggregate bond index was frac-tionally positive. As of early 2018, this index is down about2% year-to-date. We think the Fed will enact three addi-tional rate hikes in 2018. If longer maturity yields con-tinue their recent turn higher, this index could not onlyunderperform in 2018 but could also sustain a negativeperformance for the full year.

Sector leadership in 2017 favored risk-on, economi-cally sensitive names over defensive and income-orientedstocks. Thus far in 2018, risk-on, economically sensitivestocks remain in the lead at the expense of defensive andincome-oriented names. We note that the top-performingsectors in 2017 have been hit hard by the early Februaryselling, but that no sector has been immune.

While economically sensitive stocks continue to out-perform defensive and income-oriented groups in 2018,the leadership deck has been reshuffled. Technology had afantastic 2017, as digital transformation – including cloud,analytics and everything-as-a-service – moved from plan-ning stages to reality. In 2018, however, Technology is onlythe fourth-best sector. The best performances in descend-ing order have come from Consumer Discretionary,Healthcare and Financials.

Particularly late in 2017, investors rotated into infla-tion beneficiaries with “wealth in the ground” – meaningEnergy and Materials. Those sectors are little changed thisyear as investors seek to determine if they have come toofar too fast. The most defensive and income-oriented sec-tors have fared the worst in 2018, with Utilities and Con-sumer Staples in the negative column and Telecom cling-ing to breakeven. We do not expect 2018 to be the year ofdefensive rotation and would continue to underweight po-sitions in those areas.

Despite the wild swoops in the market thus far in2018, for now sector leadership is pretty much intact from2017. That may not be true a month from now, particularlyif economic fundamentals show signs of deterioration.Assuming positive fundamentals remain intact, the currentselling jag may be seen retrospectively as an opportunityto buy into 2017 darlings that had a rough start in 2018.

Note that our month-end sector table does not cap-ture the whipsaw selling of early February. In January, Tech-nology built on its market leadership to increase its sectorweight within the S&P 500 by 40 basis points, to 24.2%.That is not quite a peak reading, but close to it. ConsumerDiscretionary also expanded by 40 basis points, ashomebuilders bounced back and retailers remained infavor even after the holidays. Other sectors that gainedmonth-over-month include Financial Services andHealthcare.

The sectors that continue to lose weight also includeTelecom Services. At 1.9%, Telecom is now below 2.0%for the first time in our multiyear model. Real Estate,Telecom, and Utilities all lost 20 basis points of marketweight in January. Given that all three are small sectors tobegin with, those are significant declines and continue thedownsizing pattern among defensive and rate-sensitivesectors that persisted in 2017. At present, we do notexpect the sector leadership map for 2018 to vary muchfrom 2017, though again, this assumes continued glo-bal growth.

The U.S. enjoyed a strong stock market in 2017 butstill lagged world stock performance. The same is true for2018 to date, at least in the very early going.

Among international stock indices, the BRIC nationshave the best aggregate performance, up just under 9% year-to-date. Close behind are resources nations, which are up

Volatility has returned with a vengeance. For its part,CME Group, a large options and futures market operator,reported that its January volumes were up 18%, year overyear, with equity index, energy and metals contracts allshowing gains above 20%, and interest rate contracts up15%, as investors speculated for, or hedged against, mar-ket moves.

When a stock sell-off is raging, even if just for a briefspan, every stock and every sector seems to be swept up inthe general panic. There are, of course, degrees to whichany one sector participates. This sell-off has surprisinglytaken aim at “wealth in the ground” sectors such as En-ergy and Materials.

At its peak, the S&P 500 was up 7% for 2018 in thefinal week of January; remember that stocks also lostground in the final trading days of that month. Before the

TECHNICAL TRENDS COMMENTARY

current correction really got going, the S&P 500 was hold-ing a 5% plus gain. Then, in a single session on February2, that gain was shaved to 3.3%. But in that same session,Energy went from a 5.4% YTD gain to a 0.2% YTD de-cline. Materials fell from a 4.5% YTD gain to a 0.3% YTDdecline.

Other sectors that declined more than 2% in that sell-off include Technology and Industrials.

After the huge dip on February 5, defensive sectors,which did not have a lot of gain to give away, are firmly inthe red year to date. Consumer Staples, Utilities, and RealEstate were already in the red even before the market’sepic 4% correction on 2/5/18. This correction may takesome time to play out; so far, we expect to recommendbargain buying when the selling stops.

Jim Kelleher, CFA,Director of Research


about 6%. The DJ world index is up 3.8%, putting it slightlyahead of 3.4% for the S&P 500 – which has retraced froma gain of 7%.

While the S&P 500 is underperforming the world, itis at least positive. The UK is down 3% and that has im-pacted the 1.5% gain in our mature markets basket. Canadais also down 3%; our Americas basket is up 3%, however,thanks to strength in Brazil.

For the present at least, foreign investors have beenturned off by the weak dollar, which is eroding their re-turns on U.S. stocks. That is one of several reasons to as-sume that even if the U.S. has another good stock year, itlikely won’t match the global average gain.

CONCLUSIONThe stock selloff in early 2018 has several causes. The risein bond yields has been interpreted as a preemptive strikeagainst inflation; and inflation has proven in the past to bea surefire stock rally killer. After several strong years, the

U.S. consumer may finally be taking a pause. In addition,apart from post-hurricane rebuilding, neither housing notautomotive appear particularly robust.

The main correction driver may simply be profit-tak-ing following a strong 2017 and an eye-popping January2018. Stock selloffs are nerve-wracking but necessary.Market complacency such as that seen in 2017 saves in-vestors from short-term worries about wealth accumula-tion. The lack of periodic selloffs, however, increases therisk that the market will become toppy and prone to steeperfalls. Corrections can be thought of as bad-tasting medi-cine that, like castor oil, can keep the market mechanismfunctioning smoothly.

We continue to see good value in the U.S. stock mar-ket. We also favor risk-on and economically sensitive stockswith good growth prospects over defensive and income-oriented names that actually offer limited defense in anenvironment of rising interest rates.

Jim Kelleher,Director of Research

FOCUS LIST

Focus List Stocks

TICKER

PRICE

AS OF

2/7/18

Basic Materials

Arconic Inc ARNC $25.28

Newmont Mining Corp. NEM 37.63

Consumer Discretionary

Carnival Corporation CCL 69.27

Darden Restaurants Inc DRI 94.38

International Game Tech PL IGT 28.05

Consumer Staples

Anheuser-Busch In Bev SA/NV BUD 108.96

Estee Lauder Companies Inc EL 137.22

Kroger Co KR 29.07

Monster Beverage Corp MNST 64.21

Energy

Devon Energy Corp. DVN 38.38

Royal Dutch Shell PLC RDS/A 65.73

Financial

Bank of America Corp BAC 31.20

Capital One Financial Corp COF 98.44

Charles Schwab Corp SCHW 52.86

US Bancorp USB 54.62

Healthcare

AstraZeneca PLC AZN 34.30

Celgene Corp CELG 96.25

Humana Inc. HUM 269.12

Vertex Pharmaceuticals Inc VRTX 159.27

Industrials

Cummins Inc (Ex. Cummins Engin CMI 174.83

Lockheed Martin Corp LMT 337.59

Owens Corning Inc OC 87.59

Real Estate

Vornado Realty Trust VNO 67.79

Technology

Adobe Systems Inc ADBE 194.47

Broadcom Limited AVGO 240.38

HP Inc HPQ 21.43

Lam Research Corp LRCX 178.34

Microsoft Corp MSFT 91.33

Utility

Aqua America Inc WTR 34.03

NextEra Energy Inc NEE 149.56

Focus List Stocks in this Report

PRICE

AS OFTICKER 2/7/18

Estee Lauder Companies Inc EL $137.22

Lockheed Martin Corp LMT 337.59

Microsoft Corp MSFT 91.33

Estee Lauder Companies Inc (EL)

Publication Date: 2/5/18Current Rating: BUY

HIGHLIGHTS

*EL: Raising target by $16 to $158

*Estee Lauder has invested heavily in its businesses in

recent years and continues to benefit from strong demand for

high-end beauty products. We also like the company's mix of

retail stores, e-commerce and 'travel retail' sales at major

airports.

*We believe that Estee Lauder can reach its revised

targets of 8%-9% local-currency revenue growth and

double-digit earnings growth over the next three years.

*Reflecting management's guidance and the company's

history of positive earnings surprises, we are raising our FY18

EPS estimate from $4.20 to $4.42. For FY19, we are

increasing our estimate from $4.65 to $4.95.

*Our $158 target implies a multiple of 35.7-times our

revised FY18 earnings estimate, and a potential total return of

18% including the dividend.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY-rating on Estee Lauder

Companies Inc. (NYSE: EL) and raising our target price from

$142 to $158. The company continues to benefit from strong

demand for high-end beauty products, and about one-third of

its brands are posting double-digit revenue growth. We also

like its mix of retail stores, e-commerce and 'travel retail' sales

at major airports, and its efforts to invest in developing the

business. We believe that Estee Lauder can reach its targets of

8%-9% local-currency revenue growth and double-digit

earnings growth over the next three years. The company has

also steadily raised its dividend, which currently yields about

1.1%.

We are keeping our long-term rating at BUY.

RECENT DEVELOPMENTS

On February 2, Estee Lauder reported fiscal 2Q18

earnings of $1.52 per share, up nearly 25% from $1.22 in the

prior-year period and above the consensus estimate of $1.44.

Management's guidance had called for earnings of

$1.38-$1.41. EPS benefited from higher-than-expected

revenue and the acquisitions of Too Faced and Becca, which

outweighed a disappointing gross margin.

Second-quarter sales rose 17% to $3.74 billion, above

Section 2.1

FOCUS LIST

management's estimate of 13%-15% and the consensus

estimate of $3.67 billion. In constant currency, net sales rose

14.0%, above the consensus estimate of 10.7%. Half the

company's brands reported double-digit revenue growth and

organic revenue was up 12%. In constant dollars, the Skincare

category posted a 17% increase in revenue, reflecting

double-digit gains for the La Mer and Estee Lauder brands, as

well as strong growth in Clinique. In constant currency, sales

rose 10% in the Fragrance business, and were up 4% in the

Hair Care segment. Driven by a double-digit increase in the

Tom Ford brand and strong growth in namesake Estee Lauder

products, as well as acquisitions, Makeup sales rose 13% in

constant currency.

The 2Q adjusted gross margin fell 40 basis points to

79.9%, but matched the consensus estimate. However,

reflecting carefully managed SG&A costs, the adjusted

operating margin rose 40 basis points to 20.9%. The

consensus estimate had called for an adjusted operating

margin of 20.9%.

By geographic region, reported sales in the Americas rose

5% to $1.3 billion, reflecting strong sales of Estee Lauder

fragrance and skin care products as well as double-digits gains

in sales of La Mer. Operating income rose 14% to $98

million, driven by carefully managed expenses and solid sales

of established brands.

In the Europe, Middle East and Africa (EMEA) region,

reported sales grew 20%, to $1.6 billion. Operating income

rose 12% to $463 million, due primarily to double-digit

earnings growth in the Travel Retail business, partially offset

by lower earnings in the U.K., Germany and France.

Asia/Pacific sales rose 33% to $874 million, reflecting

double-digit growth in China, Hong Kong and Thailand.

Operating income rose 36% to $218 million, driven by strong

revenue growth in China, Hong Kong, Thailand, Japan and

Taiwan.

EARNINGS & GROWTH ANALYSIS

In 3Q18, the company projects 12%-13% revenue growth

as reported and earnings of $1.02-$1.04 per share. Prior to the

earnings announcement, the consensus estimate had been

$1.01 per share.

Management now expects FY18 revenue to grow 12.5%

-13.5%, up from a prior 10%-11% on a reported basis and

10%-11% in constant currency, up from a previous forecast of

8%-9%. It now projects full-year EPS of $4.27-$4.32, up from

prior guidance of $4.04-$4.12. The consensus EPS estimate

prior to the release was $4.20. Management often issues

conservative guidance, which it then surpasses.

Reflecting management's guidance and the company's

history of positive earnings surprises, we are raising our FY18

EPS estimate from $4.20 to $4.42. For FY19, we are

increasing our estimate from $4.54 to $4.95. Our long-term

earnings growth rate forecast remains 14%.

FINANCIAL STRENGTH & DIVIDEND

Our financial strength rating for Estee Lauder is

Medium-High, the second-highest rank on our five-point

scale.

S&P's credit rating on Estee Lauder is an

investment-grade A-.

In 2Q18, the company's adjusted gross margin decreased

40 basis points to 79.9%, while the adjusted operating margin

rose 40 basis points to 20.9%. The Street had called for a

gross margin of 79.9% and an adjusted operating margin of

20.9%. Cash and cash equivalents totaled $2.1 billion at the

end of 2Q18. At the end of the quarter, Estee Lauder had $3.4

billion in long-term debt and a long-term debt/capital ratio of

42.5%, up from 33.2% a year earlier.

In November 2017, the company raised its quarterly

dividend 12% from $0.34 to $0.38. The annualized dividend

of $1.52 yields about 1.1%. The new dividend was paid on

December 15, 2017 to shareholders of record as of November

30, 2017. Our dividend estimates are $1.48 for FY18 and

$1.64 for FY19.

RISKS

Estee Lauder generates more than 60% of its revenue

internationally and could thus be hurt by unfavorable currency

effects.

While Estee Lauder's products target affluent consumers

and have thus been relatively resistant to economic weakness,

we think that sales would be hurt in the event of a deep

recession.

Estee Lauder sells many of its products at airports and

any decline in air travel could hurt results in the Travel Retail

segment, which contributes about 20% of the company's

earnings. It also generates about 30% of sales in Western

Europe, and could be hurt by weakness in this region.

COMPANY DESCRIPTION

Estee Lauder manufactures and markets skin care,

makeup, fragrance and hair care products. The company's

products are sold in over 150 countries and territories under a

range of brand names, including Estee Lauder, Aramis,

Clinique, Origins, M.A.C., Bobbi Brown, La Mer, and Aveda.

Estee Lauder also licenses fragrances and cosmetics under the

brand names Tommy Hilfiger, Donna Karan, Michael Kors,

and Coach. The company's sells its products through more

than 30,000 retail locations, including upscale department

stores, specialty retailers, high-end perfumeries, pharmacies,

and salons and spas.

VALUATION

In our view, EL shares are favorably valued at 30.5-times

our revised FY18 EPS estimate, near the five-year average of

31.0. We believe that Estee Lauder's above-peer-average

growth rate, strong return on equity, and demonstrated record

of cost cutting justify a higher multiple. Our revised $158

target implies a multiple of 35.7-times our FY18 earnings

estimate, and a potential total return of approximately 18%

including the dividend.

On February 5 at midday, BUY-rated EL traded at

$136.44, up $2.05. (John Staszak, CFA, 2/5/18)

Section 2.2

FOCUS LIST

Lockheed Martin Corp (LMT)


HIGHLIGHTS

*LMT: Raising target price to $385

*LMT shares have outperformed the market over the past

quarter, rising 12% while the S&P 500 has advanced 5.1%.

*The company topped Street expectations with 4Q results

and is forecasting double-digit EPS - aided by a lower tax rate

- in 2018.

*Management has a history of managing through

challenges, and a GOP-controlled House, Senate and White

House should bode well for defense spending.

*We believe that LMT shares are favorably valued at

current levels. Our revised target of $385 assumes continued

strong earnings based on increased U.S. and international

defense spending.

ANALYSIS

INVESTMENT THESIS

Our rating on Lockheed Martin Corp. (NYSE: LMT) is

BUY. Lockheed has consistently surprised the Street in recent

years, regardless of whether defense spending is rising or

falling. In recent quarters, government spending has started to

accelerate again, which is expected to provide a boost to

earnings. We have a favorable view of the company's focus on

international revenue diversification (now 25% of sales), and

expect increased geopolitical tension to benefit sales and

earnings going forward. The shares face ongoing headline

risk, as the company's F-35 fighter jet program has been

targeted by President Trump from time to time. But

management has a history of navigating through challenges.

The company is mindful of shareholder returns and has raised

the dividend at a double-digit rate for the past 15 years while

also aggressively buying back stock. The current yield of

2.25% is high for the industry. Our target price for this

blue-chip defense company is $385, raised from $340. The

shares are a suitable core holding in a diversified portfolio.

RECENT DEVELOPMENTS

LMT shares have outperformed the market over the past

quarter, rising 12% while the S&P 500 has advanced 5.1%.

Over the past year, the shares have also outperformed, gaining

36% compared to a 19% increase in the broad market. The

shares have outperformed the industrial sector IYJ ETF over

the past year, as well as over the longer five-year period. The

beta on LMT is 0.63.

On January 29, Lockheed reported 4Q17 earnings that

topped analyst expectations. Revenue increased a sequentially

stronger 9%, to $15.1 billion. Segment operating profit rose

15% as the segment operating profit margin widened 50 basis

points to 9.8%. On a per share basis, adjusted net earnings

from continuing operations jumped 32% to $4.30, above the

consensus of $4.07. For the full year, the company earned

$13.33 per share on an adjusted basis, above the $13.15 high

end of the guidance range and up 8% year-over-year. Sales for

the year rose 8% to $51 billion.

The company also provided 2018 guidance. Net sales are

expected to increase 2% -- below trend due to an accounting

rule change. Total business segment operating margin in 2018

is expected to be in the 10.3% to 10.5% range and cash from

operations is expected to be greater than or equal to $3.0

billion, after a $5 billion contribution to the pension program.

Management expects EPS of $15.20-$15.50. We note that

Lockheed has a history of lowering investor expectations early

in the year and then boosting its outlook as the year

progresses.


Lockheed Martin has four primary business segments:

Aeronautics (approximately 40% of 2017 sales); Missiles and

Fire Control (15%); Rotary and Mission Systems (28%); and

Space Systems (18%).

Except for Space Systems, all segments once again posted

revenue growth in 4Q. The Aeronautics division benefited

from higher net sales in the F-35 and C-130 programs, offset

by a slight decline in C-5 deliveries, as the top line grew 12%.

Rotary and Mission Systems, which includes the recently

acquired Sikorsky operations, posted 14% revenue growth as

increases for training and logistics programs were boosted by

higher helicopter deliveries. In Missiles and Fire Control,

revenue rose 31% due to higher net sales for air and missile

defense programs, tactical missile programs and fire control

programs. Space Systems' revenue declined 12% due to a

reduction in launch-related events.

LMT finished the quarter with a backlog of $100 billion,

down $4 billion from the prior quarter. Within the pipeline,

management anticipates delivering 90 F-35s this year, up from

66 in 2017. In Missile and Fire Control, Lockheed participated

in a signing agreement with the U.S. and Romania that

provides Romania with the opportunity to upgrade its air

defense system, and also received an order of more than $900

million for PAC-3 missiles for the U.S. and allied military

forces.

On the expense side, the total business segment operating

margin was 9.8% in 4Q17, up 50 basis points. Operating

margins increased Aeronautics, Rotary and Mission Systems

and Space. We look for continued strengthening of margins in

Rotary and Mission Systems as the Sikorsky operations are

fully integrated. Management is targeting overall margin

expansion in 2018.

Based on the solid sales growth, expectations for higher

margins and a lower tax rate, we are raising our 2018 EPS

forecast to $15.50 from $13.75. Our estimate is at the high end

of management's guidance range and implies growth of about

16% for the year. We look for further growth in 2019 and are

implementing a preliminary EPS forecast of $18.00. Our

long-term EPS growth rate forecast remains 9%.


Our financial strength rating for Lockheed Martin is

Medium. The company scores about average on our three

main components of financial strength: debt levels (including

Section 2.3

FOCUS LIST

the impact of unfunded pension assets), fixed-cost coverage,

and profitability.

The company has a stock buyback plan. At the end of the

most recent quarter, shares outstanding were down 3.0%

year-over-year.

Lockheed pays a dividend. In September, it raised its

quarterly payout by 10% to $2.00 per share, or $8.00

annually, for an above-industry-average yield of about 2.24%.

We think the payout is secure and expect it to grow. Our

dividend forecasts are $8.40 for 2018 and $9.84 for 2019.

Lockheed has increased its dividend at a double-digit pace for

15 consecutive years.

MANAGEMENT & RISKS

Marillyn Hewson is the chairman and CEO of Lockheed.

Bruce Tanner has served as CFO since 2007.

Investors in LMT shares face risks. Lockheed is a key

supplier to the U.S. military and thus vulnerable to cuts in

defense spending. Approximately three quarters of the

company's current revenue comes from U.S. government

contracts. However, LMT and other defense contractors have

been expanding internationally to offset volatile Defense

spending trends, particularly on short-cycle programs.

And in any event, with a Republican in the White House

and the House and Senate both controlled by the GOP, the

outlook for defense spending has brightened.

On a more micro basis, President Trump has focused his

attention (and tweets) on Lockheed Martin's important F-35

program. LMT management has gone to great lengths to

demonstrate that F-35 costs are falling and remain below

government forecasts.

COMPANY DESCRIPTION

Lockheed Martin provides advanced technology systems,

products and services to the U.S. government and

international defense customers. The company is organized

into four businesses: Aeronautics, Missiles and Fire Control

(MFC), Rotary and Mission Systems, and Space Systems. The

shares are a component of the S&P 500.

VALUATION

LMT shares appear attractively valued at current prices

near $344, near the high end of their 52-week range of

$251-$354. On a technical basis, the shares have been in a

positive trend of higher highs and higher lows that dates to

August 2011.

To value the stock on a fundamental basis, we use peer

and historical multiple comparisons, as well as a dividend

discount model. LMT shares are trading at 22-times projected

2018 earnings, near the top of the historical range of 15-24.

On a price/sales basis, the shares are also trading near the top

of the five-year range. But the dividend yield of about 2.25%

is above the midpoint of the five-year range, signaling value.

The shares are mixed compared to the peer group, with a high

P/E, in-line P/S ratio and higher-than-average yield. Given

management's history of topping expectations, we think the

shares deserve to trade at above-peer-average multiples. Our

dividend discount model, taking into account our revised

estimates, points to a fair value of around $400 per share.

Blending our approaches, we arrive at a new target price of

$385.

On February 5, BUY-rated LMT closed at $336.46, down

$16.20. (John Eade, 2/5/18)

Microsoft Corp (MSFT)


HIGHLIGHTS

*MSFT: Raising target price to $107

*Given Microsoft's massive commercial user base and

long-term relationships, we believe that the company is well

positioned to grow commercial revenue as the process of

digital transformation continues both in the U.S. and

internationally.

*We see Azure cloud services, Dynamics 365, and Office

365 as primary growth drivers for Microsoft as the Consumer

side of the business remains steady.

*We are raising our FY18 EPS forecast to $3.66 from

$3.39 and our FY19 forecast to $3.82 from $3.62.

*MSFT shares have already had a strong run, but we

think they could move higher as the company's commercial

and public cloud business drive growth.

ANALYSIS

INVESTMENT THESIS

We are reiterating our BUY rating on Microsoft Corp.

(NGS: MSFT) and raising our target price to $107 from $95.

CEO Satya Nadella has pivoted Microsoft toward high-value

commercial and cloud application businesses as the company

has shaken off past missteps in the wireless phone handset

market. According to industry tracker Gartner, Microsoft has a

roughly 7% market share in the public cloud, a distant second

to Amazon but still much greater than that of other

competitors. Given Microsoft's massive commercial user base

and long-term relationships, we believe that the company is

well positioned to grow commercial revenue as the process of

digital transformation continues to gain traction, both in the

U.S. and internationally. The company's large consumer

business is growing more slowly, though it may show better

profitability in 2018.

MSFT shares have already had a strong run, but we think

they could move higher as the company's commercial and

public cloud business drive growth. Microsoft is also one of

the few tech companies in our coverage group that pays a

growing dividend.

RECENT DEVELOPMENTS

Microsoft reported fiscal 2Q18 results (for the quarter

ended December 31) after the market close on January 31.

EPS topped the consensus forecast by $0.10 and sales topped

the consensus by almost $528 million.

Second-quarter revenue rose 12% to $28.9 billion.

Section 2.4

FOCUS LIST

Positive foreign exchange effects added 1% to revenue

growth. Operating income rose 10% to $8.7 billion. The

acquisition of LinkedIn in December 2016 again contributed

four percentage points to revenue growth. Excluding

LinkedIn, revenue was driven by the Productivity and

Business Processes and Intelligent Cloud segments, while the

More Personal Computing segment posted 2% growth. The

gross margin was flat with the prior year at 62%. The

company held adjusted operating expense growth to 3%,

excluding the impact of LinkedIn amortization expense. The

operating margin narrowed by 60 basis points to 30% as the

company invested in cloud engineering, artificial intelligence,

and increased sales capacity. Adjusted diluted EPS rose 20%

to $0.96. The company took a $13.8 billion charge related to

the new tax law in 2Q18. The GAAP loss was $0.82 per share.

On December 8, 2016, Microsoft completed its

acquisition of professional social networking website

LinkedIn. Microsoft acquired LinkedIn for $196 per share, a

50% premium to the June 10, 2016 LNKD closing price.

LinkedIn is Microsoft's largest-ever acquisition. The

transaction was all-cash, with a total value of $26.2 billion,

including LinkedIn's net cash. Jeff Weiner remains CEO of

LinkedIn and reports to Microsoft CEO Satya Nadella.

Microsoft expects the acquisition to become accretive in

FY19, though excluding purchase accounting, it could be

accretive in FY18. Microsoft management believes that

LinkedIn will both expand its total addressable market and

help it to leverage current trends in technology. In addition, it

believes that LinkedIn fits with Microsoft's industry

positioning and goal of making people more productive.

Microsoft thinks that it can make powerful use of the data

supplied by LinkedIn's more than 500 million members.

Management believes that LinkedIn will be able to leverage

Microsoft's sales force, channels, and enterprise customer base

to expand its core Talent Solutions business. The companies

also believe that LinkedIn's current total addressable market of

$115 billion will increase the TAM in Microsoft's Productivity

& Business Process segment by 58%, from $200 billion to

$315 billion. Microsoft believes that its market share is

currently only 9% of the TAM, so its sees an opportunity to

grow share.


We are raising our FY18 EPS forecast to $3.66 from

$3.39 and our FY19 forecast to $3.82 from $3.62. Like many

companies, Microsoft has lowered its effective tax rate

forecasts for FY18 and FY19. It also expects a flat gross

margin and slightly higher operating expenses in FY18. Our

EPS estimates imply 8.4% growth over the next two years,

above our five-year growth rate forecast of 5.0%.

Mr. Nadella has outlined some first principles based on

his vision for Microsoft as a productivity and platform

company for the 'mobile-first, cloud-first world.' His ambition

is for Microsoft to 'change the nature of work through digital

technology.' This means putting Microsoft at the center of

business process transformation through Microsoft products

that improve productivity and security while also providing

hybrid cloud and AI and 'intelligent edge' platforms. He has

refocused the company on investments in core productivity

experiences and platform development. We think that this

means business systems like the company's Azure cloud

service, Dynamics 365, and SQL Server as well as the

traditional stalwarts Windows and Office. He also plans to

eliminate duplicative products. Other than the Surface

tablet/laptop, we think that Microsoft has given up on its

mobile strategy.

In the Productivity and Business Processes division,

first-quarter revenue rose 25% from the prior year to $8.95

billion; some 15 percentage points of this growth came from

the LinkedIn acquisition, though legacy product growth was

also reasonably strong, with 10% growth in Office

Commercial products, 12% growth in Office Consumer

Products, and 10% growth in Dynamics. Segment operating

income rose 9%, to $3.4 billion, including amortization

charges related to the LinkedIn acquisition. Excluding

LinkedIn, pro forma operating income would have grown

11%.

The Intelligent Cloud Division exhibited another quarter

of strong growth, with total revenue rising 15% from the prior

year to $7.8 billion. Within this division, Azure cloud revenue

rose 99%. Server products and cloud services revenue rose

18% as enterprise services rose 5%. Operating income rose

24% to $2.8 billion.

In the More Personal Computing segment, 2Q revenue

rose 2% to $12.2 billion, driven by growth in the Gaming and

Search business. Microsoft released an update to its Xbox

gaming console, the Xbox One X, in November 2017. Xbox

Live active users continued to grow, rising 7% year-over-year

in the December quarter. Microsoft's Windows OEM business

grew 4% in 2Q18, again topping the 0.7% increase in the

overall PC OEM market, according to industry tracker

International Data Corp. Growth was again driven by the

business-oriented Windows Pro subsegment, with a gain of

11%, while non-Pro subsegment revenue fell 5%. Segment

operating income declined 2% to $2.5 billion.


Our financial strength rating for Microsoft is High, the

top of our five-point scale. Microsoft took on $31 billion in

incremental debt in 1H17 to finance the LinkedIn acquisition.

Total debt now stands at $85.8 billion, of which $12.5 billion

is current. Microsoft still has an extremely large cash and

short-term investment balance of $143 billion. Trailing

12-month free cash flow rose 20% in FY17 to $33 billion.

Microsoft is triple A-rated by the credit agencies and outlooks

are stable. Moody's raised its outlook to stable in December

2017.

Microsoft's quarterly dividend is $0.42 per share, or $1.68

annually, for a yield of about 1.8%. Our FY18 dividend

estimate is $1.65 and our FY19 forecast is $1.69. Microsoft

bought back $4.6 billion of its stock in 1H18, $11.8 billion in

FY17, and $16 billion in FY16.

Section 2.5

FOCUS LIST

RISKS

Investors in Microsoft face potential losses if the

company's operating performance falls short of expectations.

For example, Microsoft took a $7.5 billion write-off for Nokia

Devices and Services (NDS), writing down 80% of the

purchase price in a little more than a year following the

acquisition. The company has also taken additional large

write-offs. Other risks include the migration of consumers

away from the PC to mobile devices that do not use a

Microsoft-based operating system (e.g. Apple's iPad); the

potential for a prolonged downturn in global software

investment spending; the well-publicized security

vulnerabilities in the company's products; the possible

adoption of Linux, and/or other open-source software

applications; increased competition in the internet space; and

legal risks. Also, piracy of the company's software in

developing markets like China and India is an ongoing

problem and presents the company with huge missed revenue

opportunities. Another risk is management's ability to execute

its business plan and deliver new products on schedule.

In the case of the Xbox 360, highly aggressive pricing

from both Sony and Nintendo, as well as a generally soft

game console market, may hamper Microsoft's efforts to

generate acceptable long-term profits in this area.

The company also faces intense direct competition from

Google in many areas, including internet search, mobile

operating system software and internet-based software

applications. This competition could potentially erode the

dominance of Microsoft's core operating system and Office

applications. Google has established itself as the dominant

online search player, and has used its position to branch out

into direct competition with Microsoft with its Chrome

internet browser and operating system software. Microsoft has

struck back through its alliance between its internet search

engine Bing and Yahoo.

On the mobile smartphone operating system front, we

think that Apple's iPhone operating system and Google's

Android platform are clearly dominant, a fact that Microsoft

itself acknowledged when it restructured its NDS operations

in 4Q15. Without a mobile platform, other than the also-ran

Surface tablet computer, Microsoft is missing a key future

growth vector.

COMPANY DESCRIPTION

Microsoft is the world's largest independent software

developer. The company was founded on the MS Windows

operating system and MS Office business applications suite

for PCs. As it has grown, Microsoft has expanded into

enterprise software with Windows Server, SQL Server,

Dynamics CRM, SharePoint, Azure and Lync; hardware with

the Xbox gaming/media platform; and online services through

MSN and Bing. Microsoft acquired Skype, the internet VoIP

communications service, in October 2011. The company

acquired Nokia's Devices and Services Business in April

2014. About 47% of revenue is generated outside the U.S.

VALUATION

Microsoft shares have risen 47% in the last year on a

total-return basis, compared to a 23% increase for the S&P

500 and a 37% increase in the S&P Information Technology

Sector Index. With a trailing enterprise value/EBITDA

multiple of 16.1, MSFT trades near the peer median and above

the high end of its five-year historical average range of

9.9-11.9. Microsoft's forward enterprise value/EBITDA

multiple of 14.0 is 11% below the peer average, less than the

average discount of 21% over the past two years. We are

maintaining our BUY rating on Microsoft with a revised

target price of $107.

On February 5, BUY-rated MSFT closed at $88.00, down

$3.78. (Joseph Bonner, CFA, 2/5/18)

Section 2.6

CHANGE IN RATING / INITIATION OF COVERAGE

Change in Rating / Initiation of

Coverage in this Report

PRICE

AS OFTICKER 2/7/18

Advanced Micro Devices Inc. AMD $11.65

Mastercard Incorporated MA 169.28

Advanced Micro Devices Inc. (AMD)


HIGHLIGHTS

*AMD: Upgrading to BUY on sustainable growth

prospects

*We are raising our rating on Advanced Micro Devices to

BUY from HOLD.

*In our view, recent quarterly results have demonstrated

the sustainability of AMD's return to consistent profitability

and top and bottom-line growth.

*Although profit margins are not yet industry

competitive, we believe the company's profit potential can

increase as new and existing businesses - including desktop

CPU, notebook APU, server CPU, and GPU for multiple

application, including professional graphics and blockchain -

help AMD scale its business.

*Our long-term rating is also BUY. We are setting a

12-month price target of $18.

ANALYSIS

INVESTMENT THESIS

We are raising our rating on Advanced Micro Devices

Inc. (NYSE: AMD) to BUY from HOLD. In our view, recent

quarterly results have demonstrated the sustainability of

AMD's return to consistent profitability and top- and

bottom-line growth.

Fourth-quarter sales and non-GAAP profitability were

well above expectations. Adoption of a new accounting

standard governing revenue recognition complicates

year-over-year comparisons, but the overarching trend is

positive.

Even as the company moves beyond its seasonally strong

second half, the outlook appears favorable for additional

growth in 2018 and beyond. Top-line guidance for 1Q18 was

25% ahead of consensus and signals the company's growing

success in multiple markets.

AMD is benefiting from its improving execution with

cost-effective, high performance products. More broadly, the

company is well-positioned for the global digital

transformation based on its presence in key markets such as

client and server compute, graphics processing, consumer

gaming and electronics. AMD is also well positioned in

promising markets including cloud data center, AI & machine

learning, IoT, and blockchain as that technology moves

beyond cryptocurrency and into transaction authentication and

other niches.

Although profit margins are not yet industry competitive,

we believe the company's profit potential can increase as new

and existing businesses - including desktop CPU, notebook

APU, server CPU, and GPU for multiple application,

including professional graphics and blockchain - help AMD

scale its business. Our long-term rating is also BUY. We are

setting a 12-month price target of $18.

RECENT DEVELOPMENTS

AMD is up 28% year-to-date in 2018, compared with a

9% gain for the Argus semiconductor peer group. In 2017,

AMD declined 9% following a spectacular 2016. AMD shares

rose 295% in 2016, compared with a 70% peer-group gain;

the shares began 2016 below $3 and bottomed at $1.90, before

rallying to $11 by year-end. AMD shares rose 7% in 2015;

dropped 31% for 2014; rose 61% in 2013; declined 58% in

2012; declined 34% in 2011; and fell 15% in 2010.

For 4Q17, Advanced Micro Devices reported revenue of

$1.48 billion, which was up 34% year-over-year and down

10% sequentially from seasonally strong 3Q17. Revenue was

above management's guidance of $1.34-$1.44 billion; and

above the $1.40 billion consensus estimate. Non-GAAP profit

for 4Q17 totaled $0.08 per diluted share, compared with a

non-GAAP loss of $0.01 a year earlier and non-GAAP profit

of $0.10 in 3Q17. The Street had been modeling non-GAAP

EPS of $0.05 for the quarter.

For 4Q17, Computing & Graphics (C&G) revenue of

$958 million (65% of total) rose 60% annually and 17%

sequentially. C&G operating profit expanded to $85 million in

4Q17, versus $70 million in 3Q17 and a year-earlier loss of

$21 million. C&G margin expanded to 8.9% in 4Q17 from

8.5% in 3Q17. Profit growth partly reflects some mix

improvement but mainly reflects better overhead absorption

on rising revenue levels in the segment.

Growth at C&G was principally driven by Ryzen desktop

processors and new offerings in the Radeon graphics product

family. GPU growth reflected both OEM demand,

supplemented by growing demand for new opportunities

including professional graphics and blockchain. We think

GPU and ASIC development in the blockchain space could be

promising as companies moved beyond cryptocurrency and

into business-related niches including transaction

authentication, supply chain & parts tracking, and other.

Ryzen for desktop client (PC) is a stand-alone part.

Management stated that desktop Ryzen did 'incredibly well,'

despite lower ASPs based on popular demand for the lower

end Ryzen 3 chip. The company expects ASP trends to

improve based on growing OEM demand for

higher-performance Ryzen 5 and Ryzen 7 chips.

The company launched its Ryzen-based offering for the

notebook PC space during 4Q17. For the notebook market,

AMD is offering APUs (accelerated processing units) that

combine Ryzen CPU and a Vega GPU in smaller format on a

single die.

EE&SC (Enterprise, Embedded and Semi-Custom)

Section 2.7


revenue of $522 million (35% of total) increased 3%

year-over-year while declining 37% sequentially as console

makers Sony and Microsoft have concluded their holiday

season. Segment profit of $19 million declined 60% as the

company spent to roll out its EPYC server CPU product

family.

With Sony and Microsoft in the fifth season for their

current generation consoles, the semi-custom part of the

business likely remains subdued. Any new console generation

could potentially entail VR, 3D and other advanced graphic

capabilities that would benefit AMD.

The real excitement in EE&SC is on the enterprise server

side, where AMC's EPYC family finally appears able to

compete with Intel's Xeon juggernaut. Management stated that

the company continues to record design wins and

qualifications for EPYC. The company's goal would appear to

be exiting 2018 with single-digit percentage market share in

server processors. While that may not sound like much, it

would be more than any other company currently not named

Intel.

As with Ryzen and its APUs, EPYC seeks to beat the

competition partly on performance and partly on price. In

some SKUs, EPYC offers a 1P (one-socket) configuration

capable of handling as much I/O as 2P (two-socket) Intel

parts.

For 1Q18, AMD blew away expectations with a revenue

forecast of $1.55 billon. The Street had been modeling an 'old

AMD' revenue cutback to the $1.24 billion range. The current

guidance is more than $300 million, or 25%, above

pre-reporting expectations.

Although profit margins are not yet industry competitive,

we believe the company's profit potential can increase as new

and existing businesses - including desktop CPU, notebook

APU, server CPU, and GPU for multiple application,

including professional graphics and blockchain - help AMD

scale its business. While the company provides only top-line

guidance, based on recent gross margin and operating cost

trends we believe AMD could more than double non-GAAP

EPS in 2018 compared with 2017.


For 4Q17, Advanced Micro Devices reported revenue of

$1.48 billion, which was up 34% year-over-year and down

10% sequentially from seasonally strong 3Q17. Revenue was

above management's guidance of $1.34-$1.44 billion; and

above the $1.40 billion consensus estimate. Non-GAAP profit

for 4Q17 totaled $0.08 per diluted share, compared with

non-GAAP loss of $0.01 a year earlier and non-GAAP profit

of $0.10 in 3Q17. The Street had been modeling non-GAAP

EPS of $0.05 for the quarter.

For all of 2017, AMD posted revenue of $5.33 billion, up

25% from $4.27 billion in 2015. On a non-GAAP basis, AMD

posted a profit of $0.17 per diluted share in 2017, compared to

a loss of $0.15 per share in 2016.

For 1Q18, AMD forecast revenue of $1.55 billon, which

would be up over 50% annually and was miles above the

$1.24 billion pre-reporting consensus. Note that AMD has

adopted the revenue recognition standard ASC 606. This will

allow AMD to recognize revenue when it has inventory on

hand and a non-cancellable order; previously, revenue

recognition was triggered when product went out the door.

While this will distort near-term year-over-year comparisons,

the new standard will have no effect on full-year revenue.

We are raising our 2018 non-GAAP profit forecast to

$0.37 per diluted share, from $0.27. We are implementing a

preliminary 2019 non-GAAP EPS forecast of $0.55 per

diluted share. Our GAAP estimates are a profit of $0.22 per

diluted share for 2018 and a profit of $0.40 per diluted share

for 2019.


Our financial strength rating for AMD is Medium. AMD

has successfully re-profiled its debt, which is helping the

company save on annual interest costs.

Cash was $1.19 billion at year-end 2017, reduced from

year-end 2016 by use of cash in working capital (related to

wafer purchases in anticipation of a strong 3Q17). Cash was

$1.26 billion at the end of 2016, $785 million at year-end

2015, $1.04 billion at the end of 2014, $1.19 billion at

year-end 2013, and $1.18 billion at year-end 2012. Cash &

securities totaled $1.9 billion at the end of 2011, $1.79 billion

at year-end 2010, and $2.67 billion at the end of 2009.

Debt was $1.40 billion at year-end 2017. Debt was $1.44

billion at the end of 2016, reduced from $2.24 billion at 2Q16.

Debt was $2.26 billion at year-end 2015, $2.21 billion at the

end of 2014, $2.05 billion at year-end 2013, $2.04 billion at

year-end 2012, $2.0 billion at the end of 2011, and $2.18

billion at year-end 2010. As a result of the debt pay-downs

(from Intel settlement proceeds) in 1Q10 and the transfer of

debt obligations to GF, debt was reduced from $4.55 billion at

the end of 2009 and peak debt of $5.86 billion at the end of

3Q09.

Net debt was $210 million at year-end 2017, rising from

year-end 2016 on cash use for wafer purchases. Net debt was

$171 million at the end of 2016, reduced from $1.63 billion at

2Q16. Net debt was $1.48 billion at year-end 2015, $1.17

billion at year-end 2014, and $871 million at the end of 2013.

Net debt at year-end 2012 was $859 million, compared to

$102 million at year-end 2011, $403 million at the end of

2010, $1.88 billion at the end of 2009, and $3.89 billion at the

end of 2008.

Cash flow from operations was $63 million for 2017,

compared with $90 million for 2016. Cash use from

operations was $237 million for 2015; $98 million in 2014;

$148 million in 2013; and $338 million in 2012. Cash flow

from operations was $382 million in 2011. AMD had a cash

use from operations of $412 million in 2010, and generated

cash flow from operations of $473 million in 2009.

We do not expect AMD to pay a dividend in 2018 or

2019. Share repurchases are primarily used to offset dilution

from stock-based compensation.

MANAGEMENT & RISKS

Section 2.8


Dr. Lisa Su became CEO in October 2014. The CFO is

Devinder Kumar, appointed to that role early in 2013.

We believe the IP monetization strategy, as well as

success in EE&SC, could give CEO Su a longer leash than

was given to prior CEOs. But the company is also battling

structural decline in PCs, lending uncertainty to CEO tenure at

AMD.

AMD has been betting heavily on nontraditional

businesses including embedded, micro-server, and

semi-custom (gaming console). Simultaneously, AMD is

supporting both stand-alone CPU and GPU lines as well as its

APU line that combines compute and graphics processing on a

single die. The new CEO must consider exiting some

businesses. Spinning off the ATMP Asian operations into the

NFME JV is part of that plan.

A long-running risk for AMD is that the decline in PC

demand is more structural than cyclical, and that AMD is

exposed to industry niches that are feeling the structural

impact more sharply than its more diversified rival, Intel. In

our view, tablets and smartphones will not displace PCs,

although they have clearly changed the industry dynamic.

AMD must demonstrate its ability to compete in all parts of

the compute value chain, including tablets and smartphones,

and eventually as an ARM licensee as well.

An ongoing risk for AMD is the perception that the

exceptional executive turnover under CEO Read signals

unusual turmoil in the executive suite. We believe that Wall

Street will give the new CEO a pass as long as the company

executes on its strategic priorities.

AMD also faces the risk that the sharp sequential

step-down is more than a reflection of global softness and

represents significant share loss. While AMD may have lost

some share, we think the company's ASP Fusion strategy and

price-leader tactics will help it preserve most of its current

share, though market share gains now look more difficult.

COMPANY DESCRIPTION

Advanced Micro Devices is the number-two player in

x86-based microprocessors, behind Intel, and - with the 2008

acquisition of ATI - a top player in graphic processors. During

2009, Advanced Micro Devices spun off its foundry

operations into a joint venture called Global Foundries. In

2013, Advanced Micro Devices reported $5.3 billion in

revenue. In mid-2014, AMD underwent an internal

reorganization, aligning businesses along functional lines and

creating a single internal infrastructure.

INDUSTRY

Our rating on the Technology sector is Over-Weight.

Technology is showing clear investor momentum, topping the

market in the year-to-date. At the same time, the average

two-year-forward EPS growth rate exceeds our broad-market

estimate and sector averages, which has kept technology

sector PEG valuations from becoming too rich.

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.

In terms of performance, the sector rose 12.0% in 2016,

above the market average, after rising 4.3% in 2015. It

strongly outperformed 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 2018

earnings is 19.0, above the market multiple of 18.2. Earnings

are expected to grow 19.5% in 2018 and 30.3% in 2017

following low single-digit growth in 2015-2016. The sector's

debt ratios are below the market average, as is the average

dividend yield.

VALUATION

AMD shares is trading at a P/E of 29.0-times on a

two-year forward average basis, compared with 57-times for

recent profitable years (2014 and 2017). Historical

comparable valuation for AMD indicates value slightly in the

$20-plus range, in a fast accelerating trend. Our discounted

free cash flow assumptions render a fair value in the $20

range, also rising. Blending these approaches, we arrive at a

blended value in the low $20s per share, in a rising trend.

We are encouraged by progress in EE&SC, particularly

with EPYC, and the successful launch of Ryzen CPU for

desktop PCs and Ryzen APU for notebook PCs. We believe

the company's profit potential can increase as new and

existing businesses help AMD scale its business. We are

raising our rating to BUY and setting a 12-month price target

of $18.

On January 31, BUY-rated AMD closed at $13.74, up

$0.87. (Jim Kelleher, CFA, 1/31/18)

Mastercard Incorporated (MA)


HIGHLIGHTS

*MA: Upgrading to BUY with $200 target

*Based on strong cyclical and secular trends in the

payment processing industry, we believe that MasterCard

should trade above its historical average earnings multiple in

the high 20s.

*On February 1, MasterCard reported adjusted 4Q17

operating earnings of $1.14 per share, up from $0.86 in 4Q16

and two cents above consensus.

*Management projects a 20% effective tax rate in 2018,

down from 27% in 2017, due to the recent cut in the U.S.

corporate tax rate. Based on the lower tax rate and prospects

for strong revenue growth, we are raising our 2018 EPS

estimate to $5.74 from $5.24, implying 25% growth from

2017. We are also setting a 2019 forecast of $6.46, implying

13% growth next year.

*Our new 12-month price target of $200 implies a total

potential return of 17% from current levels.

Section 2.9


ANALYSIS

INVESTMENT THESIS

We are upgrading MasterCard Inc. (NYSE: MA) to BUY

following 4Q17 earnings, which showed continued strong

purchase volumes and growth in cross-border volumes and

processed transactions. Based on strong cyclical and secular

trends in the payment processing industry, we believe that

MasterCard should trade above its historical average earnings

multiple in the high 20s.

At the company's most recent Investor Day in September

2017, management emphasized that it would drive growth by

capturing more payment flows through its consumer and

commercial cards and virtual cards; leveraging its recent

acquisition of VocaLink; targeting the affluent card market;

and increasing merchant acceptance.

For 2016-2018, MasterCard projects annual revenue

growth in the low teens (in constant currency), an operating

margin of at least 50%, and EPS growth in the mid-20% range

(above its earlier guidance of 20%).

We like MasterCard's overall growth story, particularly

relative to the broad market, and are maintaining long-term

BUY rating. We expect the company to continue to benefit

from the cyclical and secular trends of higher global consumer

spending, and the shift from cash to charge cards. Our new

12-month price target of $200 implies a total return potential

of 17%.

RECENT DEVELOPMENTS

MA shares have risen 64% over the past year, versus a

24% gain for the broad market.

On February 1, MasterCard reported adjusted 4Q17

operating earnings of $1.14 per share, up from $0.86 in 4Q16

and two cents above consensus. The 4Q17 results exclude

$0.92 of nonrecurring charges, mostly related to assessments

for repatriation and the revaluation of deferred tax assets. Net

revenue of $3.3 billion rose 20%, while currency-neutral

revenue rose 18%.

Gross dollar volume rose 13% from the prior year, to $1.4

trillion, and switched transactions (formerly processed

transactions, or transactions that MasterCard has authorized,

cleared or settled) rose 17% to 17.7 billion.

Adjusted operating expenses increased 17%, reflecting

spending on strategic initiatives and advertising/marketing, as

well as acquisition costs. The 4Q operating margin increased

to 51.0% from 49.8%. Net income rose 28%, to $1.21 billion.

EPS rose a stronger 33%, helped by a 2.5% reduction in the

share count.

For all of 2017, net revenues increased 16% to $12.5

billion, and EPS rose 21% to $4.58 from $3.77.

In April 2017, the company acquired a 92.4% interest in

VocaLink, a leader in bank account-based payments in the

U.K., Singapore and Thailand, for $929 million.


Longer-term secular trends remain favorable and include

the continued shift from cash to credit cards, both for

convenience/security and for the opportunity to take

advantage of rewards programs. MasterCard also continues to

benefit from emerging market growth and expanded merchant

acceptance.

Along with the 4Q17 results, management offered 2018

financial guidance that included currency-neutral revenue

growth in the mid-teens, and low double-digit growth in

operating expenses. Its three-year outlook (for the 2016-2018

period) calls for revenue growth of 13%-14%, an operating

margin of at least 50%, and compound annual EPS growth in

the mid-20s.

We look for 13% revenue growth in 2018, and believe

that currency translation will be favorable for MasterCard,

which generates substantial revenue outside the U.S. We

expect expense growth of 11% in 2018, reflecting investments

in digital initiatives and data processing, and efforts to take

advantage of the opening of the Chinese card-processing

market. We expect these factors to result in a higher operating

margin.

Management projects a 20% effective tax rate in 2018,

down from 27% in 2017, following the recent passage of the

Tax Cuts and Jobs Act. Based on the lower tax rate and

prospects for stronger revenue growth, we are raising our

2018 EPS estimate to $5.74 from $5.24, implying 25% growth

from 2017. We are also setting a 2019 forecast of $6.46,

implying 13% growth next year.


We rate MasterCard's financial strength as High, the

highest point on our five-point scale.

In March 2014, MasterCard completed its first debt

offering. The company sold $1.5 billion of 5- and 10-year

notes at very attractive spreads over comparable Treasuries.

Long-term debt at the end of 4Q was $5.4 billion, for a

debt/total capital ratio of 25%.

We believe that MasterCard will continue to buy back

stock and increase dividend payments given its strong free

cash flow. MasterCard reduced its average diluted share count

by 2% in 2017. In 4Q17, the company repurchased 6.9 million

shares of common stock for $1 billion. As of February 1,

MasterCard had $5.0 billion remaining under its existing

authorizations.

MasterCard recently announced a 13.6% increase in its

quarterly dividend to $0.25 per share, or $1.00 annually, for a

projected yield of about 0.6%. The first payment at the new

rate will be made on February 9, 2018 to holders of record as

of January 9. Our dividend estimates are $1.04 per share for

2018 and $1.12 per share for 2019.

MANAGEMENT & RISKS

MasterCard's president and CEO, Ajay Banga, has been

with the company since 2009 and was previously the CEO of

Citigroup Asia Pacific.

Government regulation remains a risk for the company. In

particular, interchange fees are being reviewed in the U.S.

under the Dodd-Frank Act as well as in other countries.

While the secular shift from cash to electronic payments

Section 2.10


remains a long-term tailwind, MasterCard's revenues remain

subject to near-term trends in consumer spending.

Cross-border transactions may also face pressure from

geopolitical developments and international travel restrictions.

COMPANY DESCRIPTION

MasterCard operates the world's second-largest electronic

payments network, providing processing services and

payment product platforms, including credit, debit, ATM,

prepaid and commercial payments under the MasterCard,

Maestro, and Cirrus brands. MasterCard went public in 2006

and is a member of the S&P 500.

INDUSTRY























dividend yield.

VALUATION

MA shares trade at 30.1-times our revised 2018 EPS

estimate of $5.74, above the company's medium-term average

multiple in the mid-20s.

Given strong cyclical and secular trends in the payments

processing industry, we expect revenue at MasterCard to grow

at a healthy mid-teens rate over the next several years.

Operating margins in the low 50% range are also enviable,

even if slightly below those of peer Visa Inc. We believe that

MasterCard's overall operating metrics merit a valuation

above the stock's historical average. Our 12-month price target

of $200 implies multiples of 35-times our 2018 EPS estimate

and 31-times our 2019 forecast.

On February 1, BUY-rated MA closed at $172.93, up

$3.93. (Stephen Biggar, 2/1/18)

Section 2.11

GROWTH / VALUE STOCKS

Growth / Value Stocks in this Report

PRICE

AS OFTICKER 2/7/18

AbbVie Inc ABBV $111.20

Alphabet Inc GOOGL 1,084.43

Amazon.Com Inc AMZN 1,442.84

Apple Inc AAPL 163.03

AT&T, Inc. T 36.83

Autozone Inc AZO 745.07

Boeing Co BA 340.91

Boston Scientific Corp BSX 26.72

Brinker International Inc EAT 33.70

CA Inc CA 33.70

Caterpillar Inc. CAT 156.41

Check Point Software Teches Lt CHKP 101.44

CME Group Inc CME 157.65

Corning Inc GLW 29.80

Danaher Corp DHR 97.05

Facebook Inc FB 185.31

Flextronics International Ltd FLEX 17.31

Harley-Davidson, Inc. HOG 48.62

Hawaiian Holdings, Inc. HA 35.95

Helmerich & Payne Inc HP 68.69

Hershey Company HSY 101.29

Ingersoll-Rand PLC IR 91.75

International Paper Co IP 59.57

Invesco Ltd IVZ 33.61

JetBlue Airways Corp JBLU 20.35

Lazard Ltd LAZ 56.80

Lululemon Athletica Inc LULU 78.62

McDonald's Corp MCD 165.18

Northrop Grumman Corp NOC 327.50

Nucor Corp NUE 63.60

Parker-Hannifin Corp PH 186.92

PayPal Holdings Inc PYPL 75.68

Praxair Inc PX 155.31

Progressive Corp. PGR 52.87

Qualcomm Inc QCOM 64.40

Ralph Lauren Corp RL 106.73

Raytheon Co. RTN 201.13

Sherwin-Williams Co SHW 405.00

Tractor Supply Co TSCO 67.28

Union Pacific Corp UNP 131.15

United Parcel Service, Inc. UPS 112.71

Visa Inc V 119.97

Wells Fargo & Co WFC 57.28

AbbVie Inc (ABBV)


HIGHLIGHTS

*ABBV: Strong 4Q17; raising target to $145

*AbbVie delivered solid 4Q17 results on January 26, as

well as an upbeat outlook that included a substantial boost

from lower tax rates.

*We expect the company to submit applications in 2018

both for new products and expanded indications of existing

drugs.

*AbbVie now expects 2018 adjusted EPS of $7.33-$7.43,

up from its prior forecast of $6.37-$6.57 and implying 43%

growth at the midpoint of the range.

*Based on the company's updated guidance and strong

4Q17 performance, we are raising our 2018 adjusted EPS

estimate to $7.25 from $6.63. We are also establishing a 2019

estimate of $8.35.

ANALYSIS

INVESTMENT THESIS

We are reaffirming our BUY rating on AbbVie Inc.

(NYSE: ABBV) with a revised price target of $145, raised

from $120. ABBV delivered strong 4Q17 results as well as an

upbeat outlook that included a substantial boost from lower

tax rates. We are also encouraged that the company is

developing new growth drivers (Imbruvica and Mavyret) to

complement the current large contribution from Humira, and

seeking expanded indications for existing drugs.

RECENT DEVELOPMENTS

On January 26, AbbVie posted 4Q17 adjusted EPS of

$1.48, up 23.3% from the prior year and above the consensus

forecast of $1.45. Revenue rose 12.6% on an operational basis

to $7.739 billion.

While Humira and Imbruvica were the primary drivers of

top-line growth, revenue also benefited from the uptake of hep

C drug Mavyret following its U.S. launch in August 2017. In

all, hepatitis C drugs generated $510 million in worldwide 4Q

sales, an increase of 62.7% from the prior year. Humira sales

rose to $18.4 billion (+10.1% worldwide; +14.1% U.S.). Sales

of Imbruvica, a treatment for blood cancers, rose to $708

million (+38.7%).

Fourth-quarter GAAP net income was $52 million or

$0.03 per share, down from $1.391 billion or $0.85 per share

a year earlier. The 4Q17 results included a net charge of $0.77

per share related to recent changes in the U.S. tax code. This

charge includes a $4.5 billion impact from the taxation of

repatriated overseas earnings.

The company also provided an upbeat 2018 outlook. It

now expects full-year adjusted EPS of $7.33-$7.43, up from

its prior forecast of $6.37-$6.57. This guidance assumes

strong operational performance as well as benefits from a

lower effective tax rate.

With the passage of the new tax law, the company will

also repatriate overseas cash at a lower tax rate. Over the next

five years, it plans to invest $2.5 billion of this repatriated

cash in capital projects in the U.S. It will also make a one-time

Section 2.12


$350 million contribution to charitable organizations in 2018,

and enhance nonexecutive compensation and other benefits.

AbbVie expects a non-GAAP tax rate of 9% in 2018, with a

gradual increase to 13% over the next five years due to

increased domestic income and investment. By comparison,

the company had non-GAAP effective tax rates of 18.9% in

2017 and 20.2% in 2016.

The 4Q adjusted gross margin was 79.0%, down 210

basis points due to partnership accounting and currency

hedges. The adjusted operating margin was 38.1%, up 90

basis points.

For all of 2017, the company posted adjusted EPS of

$5.60, up 16.2% from 2016. GAAP net income came to

$5.309 billion or $5.60 per share, compared to $5.953 billion

or $4.82 per share a year earlier. The higher EPS on lower net

income reflected the impact of stock buybacks over the last

year. Revenue rose 10.1% on an operational basis to $28.2

billion.

ABBV is seeking new growth drivers to complement

Humira, which accounted for 65% of 2017 revenue. It made

progress on that front in 4Q with help from newly launched

products and solid uptake of Imbruvica. Reflecting strong

initial sales of Mavyret, the company expects revenue of $2.5

billion from hepatitis C drugs in 2018. Imbruvica exceeded

$2.5 billion in sales in 2017. Other pipeline developments are

summarized below:

ABBV is seeking to expand the use of Imbruvica for

different groups of hematology patients, either as a single

agent or in combination with other drugs. Later this year, it

expects Phase 3 data for Imbruvica in combination with

Gazyva as a first-line treatment for diffuse large B-cell

lymphoma.

The company expects to receive approval later this year

for Venclexta in combination with Rituxan as a treatment for

relapsed/refractory chronic lymphocytic leukemia (CLL). The

filing is supported by the Murano trial, which showed

improvements in progression-free survival. This combination

has the potential to be the new standard chemo-free treatment

option for patients with relapsed/refractory CLL.

-- AbbVie also plans to submit an application for

Venclexta as a treatment for acute myeloid leukemia (AML),

setting up potential approval for this indication in late 2018 or

early 2019. Venclexta has been approved for previously

treated CLL patients with the 17p deletion, which is a

mutation of chromosome 17.

-- Risankizumab, a psoriasis drug still under

development, has shown very strong results in several studies.

The drug appears on track for a launch in 2019 and could be

used to treat patients who do not benefit from Humira.

-- Elagolix, a potential blockbuster treatment for

endometriosis, was granted priority-review status by the FDA

in late October. A decision is expected in 2Q18.

-- The company is also studying Rova-T

(Rovalpituzumab tesirine) as a single agent and in

combination with Opdivo as a treatment for small-cell lung

cancer. Data from the Phase 3 Trinity study is expected in

2Q18 and will serve as the basis for a regulatory filing.

The settlement of the Humira patent dispute with Amgen

has improved investor sentiment toward ABBV. Under the

terms of the settlement, Amgen must wait until January 2023

to sell its biosimilar version of Humira in the U.S., though it

will be able to sell the product in Europe by October 2018.

Amgen has acknowledged the validity of the Humira patents

and will pay undisclosed royalties to AbbVie.

Although the settlement removes one legal threat for

AbbVie, we note that other biosimilar companies, including

Boehringer Ingelheim, are challenging the Humira patents.

Boehringer has an approved biosimilar but has not begun sales

in the U.S. due to the patent dispute; however, Amgen's

acknowledgement of the validity of the Humira patents may

undercut the cases of the challengers. (While Humira's

composition-of-matter patent expired in December 2016 in the

U.S. and will expire in 2018 in the EU, AbbVie has other

patents covering Humira's formulation, manufacturing process

and dosing schedule that in some cases extend out to 2027.)

The settlement with Amgen gives AbbVie additional time

to diversify away from Humira, which currently accounts for

more than 60% of revenue. However, the settlement applies

only in the U.S. as AbbVie is preparing for competition from

Humira biosimilars in Europe and other overseas markets by

October. It expects overseas sales of Humira to peak at about

$6.2 billion in 2018, and then to plateau or decline. It is taking

proactive steps, such as negotiating with larger hospital

customers in Southern Europe, in order to maintain volume

and market positioning. We will be watching the impact of

these negotiations on Humira sales and pricing.

By way of perspective, it is worth noting the competitive

impact that biosimilars have had on Remicade, another

anti-TNF drug, in the U.S. and overseas markets. In 4Q17,

Remicade sales fell 8.5% in the U.S. and 22.6% overseas.


AbbVie now expects 2018 adjusted EPS of $7.33-$7.43,

implying growth of 43% at the midpoint of the range. The

revised guidance assumes stronger operating performance and

benefits from a lower U.S. tax rate. The new forecast is $1.78

higher than adjusted 2017 EPS, and assumes a $0.95

incremental contribution from stronger operating performance

and an $0.83 contribution from lower taxes. The company

also expects 2018 revenue to rise about 13% to $32 billion.

Based on the company's updated guidance and strong

4Q17 performance, we are raising our 2018 adjusted EPS

estimate to $7.25 from $6.63. We are also establishing a 2019

estimate of $8.35.

FINANCIAL STRENGTH ANALYSIS and DIVIDEND

We rate AbbVie's financial strength as Medium, the

midpoint on our five-point scale. At the end of 3Q17, the

debt/total capitalization ratio was 85%, compared to 89% at

the end of 4Q16. Cash flow from operations was $7.376

billion in the first nine months of 2017, compared to $5.50

billion in the year-earlier period. We will update these

numbers when the company files its 10-K for 2017.

Section 2.13


ABBV pays an annualized dividend of $2.84. Our

dividend estimates are $2.96 for 2018 and $3.08 for 2019.

RISKS

AbbVie faces a range of risks. The development of new

drugs from clinical trials to final approval may take several

years and cost hundreds of millions of dollars, and many

drugs do not make it through this process. The company also

faces risks related to the integration of acquired businesses.

COMPANY DESCRIPTION

AbbVie, a research-based biopharmaceutical company,

was spun off from Abbott Laboratories in January 2013. The

company is based in suburban Chicago. The shares are a

component of the S&P 500.

VALUATION

ABBV shares trade at 15.4-times our 2018 EPS estimate,

above the average multiple of 14.7 for our coverage universe

of pharmaceutical stocks. We believe that this valuation is

supported by continued strong sales of Humira and by the

company's ability to develop new growth drivers. We are

reaffirming our BUY rating with a revised target price of

$145.

On February 1, BUY-rated ABBV closed at $116.34, up

$4.12. (David Toung, 2/1/18)

Alphabet Inc (GOOGL)


HIGHLIGHTS

*GOOGL: Boosting target price to $1,300

*Although Google took a nearly $10 billion tax

adjustment charge to reflect the impact of the new tax law, its

operating results were fairly steady in 4Q18.

*The company's 'Other' segment, including the Google

Cloud Platform, Google Play, and Hardware, posted 38%

revenue growth, to $4.7 billion.

*We are raising our 2018 EPS estimate to $50.60 from

$49.45 and establishing a 2019 forecast of $61.05. Our

estimates imply 19% EPS growth on average over the next

two years.

*We believe that GOOGL shares are attractively valued

given the company's rapidly expanding businesses.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on Alphabet Inc.

(NGS: GOOGL) and raising our target price to $1,300 from

$1,220.

We see Alphabet as one of the tech industry's leaders,

along with Facebook, Apple and Amazon. These companies

have come to dominate new developments in mobile, public

cloud, and big data analytics, as well as emerging areas such

as artificial intelligence and virtual/augmented reality.

The bear case on Alphabet has been that as users move to

mobile, they will abandon search for other mobile apps. Bears

have also argued that Alphabet will be less successful in

monetizing mobile search advertising than it has been with

desktop search. However, mobile search advertising appears

to be growing strongly, even as it generates lower margins

than desktop. Meanwhile, the company's next-generation

businesses, YouTube, Google Cloud, and Google Play, have

all begun to generate significant revenue growth.

While the 2015 transition to the Alphabet holding

company structure has been a source of confusion for some,

investors should not be fooled into thinking that the company

has changed in any fundamental way: it continues to be driven

by digital advertising revenue, with search advertising at its

core, and by its extraordinary positioning as the search engine

leader in both desktop and mobile. The company's robust and

consistent advertising revenue growth is evidence that it

continues to successfully navigate this paradigm shift -- from

desktop to mobile. We think that the Alphabet reorganization

should help to develop the company's next generation of

leaders, as well as new ideas, products, and businesses.

As 2017's record fine in Europe suggests, Google may be

a victim of its own astounding success in internet/mobile

search. The company has come to dominate search in Europe

even more than in the U.S., weighing on competitors who, in

turn, pressured the European Commission to act. While

Google is appealing the European Commission's order, the

company is also complying with the EC's dictates. The

outcome of other Google-related EC antitrust investigations is

also uncertain. While the company can certainly afford the

fine, the more important issue concerns the impact of the case

on the company's future business practices and competitive

position.

We believe that GOOGL shares are attractively valued

given the company's rapidly expanding businesses.

RECENT DEVELOPMENTS

Alphabet reported fourth-quarter and full-year results on

February 1 after the market close. Adjusted EPS missed the

consensus forecast by about 4%. Advertising revenue, at 85%

of gross revenue, continues to drive results in the Google

segment, and indeed for the company as a whole. Advertising

revenue rose 22%.

Gross revenue rose 24% year-over-year to $32.3 billion.

Including traffic acquisition costs (TAC), non-GAAP net

revenue rose 22% to $25.9 billion. Management again

highlighted strong growth in mobile and desktop search

revenue, along with significant contributions from YouTube

and programmatic advertising sales. It also noted 'substantial

growth' from Google Cloud, Google Play, and Hardware.

These businesses are included in the 'Other' segment, where

revenue rose 38% from the prior year to $4.7 billion.

Traffic acquisition costs (TAC) rose 200 basis points

from the prior year to 24% of advertising revenue. The TAC

ratio has been rising over the last year as Google has seen a

mix shift toward mobile search and programmatic advertising,

which carry higher TAC. CFO Ruth Porat has previously

Section 2.14


noted management's strategic choice to keep Google focused

on long-term dollar growth rather than margins.

Paid clicks rose a strong 43%. Cost per click (CPC) again

declined, however, falling 14%. (Remember that 'paid clicks'

is a volume metric and that 'cost per click' is akin to average

selling price. CPC has continued to decline as paid clicks have

risen due to a variety of factors, including a mix shift from

higher-yielding desktop search ads to lower-yielding mobile

search and YouTube ads, and efforts to reduce lower-quality

advertising inventory.) The 4Q non-GAAP operating margin

contracted by 320 basis points from the prior year to 36.8%.

As forecast by management, the 4Q operating margin was

negatively impacted by launch and marketing expenses for the

company's new line of 'Made by Google' products as well as

by holiday seasonality. Non-GAAP EPS rose 24% to $11.58.

The GAAP net loss was $4.35 per share, which included a

$9.86 billion charge due to a one-time transition tax on

accumulated foreign subsidiary earnings and the deferred tax

impact of the new tax law.

For all of 2017, non-GAAP net revenue rose 21% to

$89.2 billion. Non-GAAP EPS increased 25% to $43.00.

In December 2016, Alphabet separated its Waymo

self-driving car business from its X incubator lab; Waymo

LLC now functions as an independent subsidiary. Waymo has

begun to accelerate, passing 4 million real world miles driven

(with the last million in just six months versus 18 months for

its first million). Waymo has been road-testing its systems

(including with a human driver) in Phoenix, and plans to

launch the first autonomous vehicle commercial ride service

in Phoenix in 2018. It has also been conducting tests in more

than 25 other cities.

We think that Waymo is significantly ahead of most of its

competitors. Management has stressed the concept of 'safety

first' in its autonomous vehicle technology. The emerging

autonomous vehicle (Waymo calls it 'self-driving,' others

'driverless') car market has become more crowded than when

Google first began the project in 2009 (provoking laughter

about the hubris of tech companies and the waste of

resources). Ride-hailing upstarts like Uber, old-line auto

industry giants, and big tech companies like Amazon and Intel

are now racing to develop the technologies needed to produce

a commercially viable autonomous vehicle (AV). We think

that AV technology is clearly building momentum, though it

is uncertain how quickly the technology will be broadly

commercialized and who will end up making the

highest-value components of driverless vehicles: Silicon

Valley tech companies like Google, traditional auto

manufacturers, or component suppliers. Intel's agreement to

pay $15.3 billion to acquire MobileEye, a key supplier of

autonomous vehicle sensor components, in August 2017, and

Delphi's agreement to acquire driverless tech company

Nutonomy on October 24 (for $50 million) reflect the serious

interest of both major tech firms and auto industry players in

this emerging industry. The greatest hurdle for self-driving

technology may be to change the 50 different state motor

vehicle laws in the U.S.


We are raising our 2018 EPS estimate to $50.60 from


estimates imply 19% EPS growth on average over the next

two years. Alphabet does not issue formal guidance. Our

long-term earnings growth rate forecast is 17%.

Search advertising, whether on Google sites or through its

third-party Google Network (on desktop or mobile), remains a

crucial revenue driver, even as other businesses, like YouTube

Google Play and Google Cloud Platform, the so-called 'second

wave' have ramped up. Investors may be concerned about the

double-digit decline in CPC, while also being heartened by the

even stronger double-digit increase in paid clicks. However,

advertising revenue growth has been remarkably consistent,

rising at a high-teens rate over most of the last five years and

accelerating to 20% in 2017. We think that Google has

successfully made the transition to mobile search.

Management has noted that Google has indexed more than

100 billion links within third-party applications - so much for

the idea that other applications would kill mobile search. With

more than 50% of search queries now on mobile, and the

success of the YouTube, Google Maps, and Google Play

mobile apps, Alphabet is certainly growing in the right

direction.

Aside from advertising, Google is looking to apply its

deep research into artificial intelligence across the company's

platforms and applications. Its three primary 'bets' for the

future are YouTube, the Google Cloud Platform (GCP), and

hardware. YouTube took some heat early in 2017 on press

reports of advertising that appeared alongside noxious

content. As usual, Google responded with technical solutions,

using AI to prevent advertising from being matched with

inappropriate content. However, we see nothing in Google's

results to indicate a severe advertiser backlash. With GCP,

Google has provided a continuous stream of improvements, as

it does with most of its products. It has also moved to provide

discounts, competing on price against Amazon. In addition, it

has made strategic acquisitions in the space, acquiring Kaggle,

w h i c h f o c u s e s o n A I , a n d A p p B r i d g e , a

data-premises-to-cloud migration application. Google is

generally thought to be in third place in the hyper-scale public

cloud market, behind Amazon and Microsoft. Google is also

partnering with multinational giants, as in its deals with SAP

and Cisco to integrate business software systems into GCP.

Management clearly views GCP as critical to the company's

future.

Google's YouTube announced its new streaming

television channel service, called 'YouTubeTV,' on February

28, 2017. It had previously been referred to as 'Unplugged.'

The new service, technically a virtual multichannel video

program distribution service ('VMVPD'), becomes another

formidable competitor in the over-the-top (OTT) streaming

video market. This market already includes Hulu Live TV,

Dish's Sling, Sony's PlayStation Vue, and AT&T's DirecTV

Now, as well as a host of other OTT services like Netflix,

Section 2.15


Amazon Prime Video, and CBS All Access. We say

'formidable' because YouTube users already spend over a

billion hours a day watching its short-form content offerings;

it thus has a huge potential customer base. YouTube TV

recently got one more leg up with its debut on both the Roku

and Apple TV streaming devices. YouTubeTV charges a $35

per month subscription fee for an initial lineup of 40 channels,

including the major broadcast networks (CBS, NBC, ABC,

and FOX) as well as an assortment of cable channels like the

ESPN and FOX sports channels and nearly all of

NBC/Universal's Disney's and FOX's other cable channels.

YouTube TV subscribers have access to the content on

YouTube's cheaper $9.95 per month content subscription

service, YouTube Red.


Our financial strength rating for Alphabet is High, our

highest rating. The company's credit ratings are in the high

A's, high-quality investment grade, with stable outlooks.

The company does not pay a dividend. Alphabet

repurchased $4.85 billion of its stock in 2017. The board also

reauthorized repurchases of up to $8.6 billion of Class C

capital stock in January 2018. As usual, actual repurchases are

made at the discretion of management. The share count rose

less than 1% year-over-year in 2017.

RISKS

Like Microsoft and Intel, Alphabet has begun to run into

serious antitrust issues in Europe. The European Commission

levied a record fine of 2.42 billion euros ($2.71 billion)

against Alphabet/Google in June 2017 for alleged antitrust

violations. While these issues will likely take years to play

out, Alphabet could one day be subject to onerous regulation

as a result of its market power, as well as to additional fines.

Alphabet's internet advertising-based businesses are

highly competitive and subject to rapid and disruptive

technological change. Alphabet must keep up with, if not lead,

such changes to remain relevant. One recent change is the

rapid adoption of mobile connectivity, which has provided

Google competitor Facebook with a platform to challenge

Google's hegemony in digital advertising. Mobile search,

particularly important to Alphabet, remains a vibrant business.

While mobile search queries are accelerating, mobile

advertising typically carries a lower rate. Alphabet must find

ways to profitably capitalize on emerging platforms in order to

sustain its growth. The company boosted R&D spending by

19% in the first nine months of 2017, though this spending

remained at about 15% of gross revenue.

The success of Alphabet's Android software for mobile

devices has generated a raft of patent infringement suits from

the likes of Oracle, Apple, and Microsoft, both directly against

Alphabet and indirectly against its handset manufacturing

partners, including Samsung and HTC. We think the

motivation for Alphabet's acquisition of Motorola in May

2012 was to obtain its patent portfolio, thereby providing a

shield against patent lawsuits. Alphabet sold the loss-ridden

Motorola Mobility operations to Lenovo in October 2014.

The Snowden revelations of National Security

Administration spying on personal e-mails and

communications collected from internet service providers,

including Alphabet, have led a number of governments to

explore the possibility of enacting legislation that would

ensure that data traffic remains stored within national

boundaries. China passed a new internet law in July, 2017 that

mandated that all data from Chinese users be kept within its

national boundaries. As illogical as this idea sounds given the

global nature of the worldwide web, the threat of such laws to

Alphabet's business is real. For example, Alphabet's capex and

opex costs would increase substantially if it were required to

maintain a data center in each country in which it operates

rather than using its current regional data center model. The

Snowden revelations related to cooperation with U.S.

government agencies have also tarnished the reputation of

Alphabet and other American internet technology companies,

which could make it harder for them to penetrate foreign

markets. In response, Alphabet and its peers have begun to

implement encryption systems intended to make user data

invulnerable even to government spy agencies, a move that

has been opposed by U.S. officials.

Alphabet's growth could slow if it is unable to acquire the

technologies, talent, and customers that management believes

are necessary to sustain long-term performance. Other risks

relate to the integration of acquisitions and the retention of

key personnel in the highly competitive internet technology

sector. The company lost Regina Dugan, the head of Google's

Advanced Technologies and Products Group, to Facebook, in

April 2016 - another in a long line of senior executives who

have moved on to other companies. These include Chief

Business Officer Nikesh Aurora, who resigned in July 2014 to

become COO of Japanese telecom SoftBank; Sheryl

Sandberg, now the COO of Facebook; and Marissa Mayer,

who became CEO of Yahoo. We think the reorganization into

Alphabet was, in part, designed to stem the brain drain to

other companies by giving business unit leaders more

responsibility and freedom.

If Alphabet's financial results fall short of expectations in

any given period, shareholders could quickly lose a significant

portion of their investment. Indeed, momentum investors

typically abandon a stock that is in decline, exacerbating the

pullback. Investors should recognize that Alphabet's operating

expenditures are driven by management's desire to capitalize

on long-term growth opportunities - not by Wall Street's

financial models or focus on quarterly results. Moreover,

analysts have sometimes overestimated Alphabet's bottom

line. Another risk for Alphabet is the growing complexity of

managing global operations, with foreign exchange risk and

hedging becoming a greater factor in the company's results.

Management does not provide forecasts and instead

discusses the business only in general terms which leads to a

large variances positive or negative between the analyst

consensus estimates and actual results. In addition, while the

first and fourth quarters are seasonally strong, the second and

third quarters are seasonally slower - and the investment

Section 2.16


community may underestimate or overestimate these seasonal

effects. Large negative variances to consensus are likely to

hurt GOOGL shares.

Finally, management may not be able to efficiently guide

the company's rapid growth. Competitive pressures are also

likely to increase as Alphabet's rivals - Apple, Facebook,

Amazon, Yahoo, and Microsoft - continue their attempts to

capture market share in the online advertising space,

enterprise cloud computing, internet video and other

competitive markets.

COMPANY DESCRIPTION

Alphabet, formerly called Google, maintains the largest

online index of websites accessible through automated search

technology and generates revenue through online advertising.

Google is now an operating segment of Alphabet. The

company was founded in 1998 by Sergey Brin and Larry Page

and went public in 2004.

Google's AdWords is an auction-based program that lets

businesses display ads along with particular search results.

Google's AdSense program enables websites in the company's

network to serve targeted ads, based on search terms or web

content, from AdWords advertisers. Most of the revenue

generated through AdSense is shared with network partners.

Alphabet also owns YouTube.com, the web-based video site,

and has expanded into mobile telephony with its Android

smartphone operating system. About 54% of Alphabet's

revenue is generated outside the United States.

On April 3, 2014, Alphabet's new nonvoting class C

shares began trading under the ticker 'GOOG.' Alphabet's

publicly held class A shares switched to the ticker 'GOOGL.'

The effect of the new class C share issuance was a

noneconomic 2-for-1 stock split.

VALUATION

Alphabet shares are up 37% in the last year, compared to

a 22% increase for the S&P 500 and a 37% gain for the S&P

500 Information Technology Sector Index. We believe that

the shares remain attractively valued given the company's

rapidly expanding businesses. Alphabet's lagging

EV/EBITDA multiple of 20.5 is near the peer median. The

forward EV/EBITDA multiple of 12.8 is 13% below the peer

average, slightly less than the average discount of 14% over

the past two years. We are raising out target price on Google

to $1,300, implying potential upside of 16% from current

levels.

On February 2, BUY-rated GOOGL closed at $1119.20,

down $62.39. (Joseph Bonner, CFA, 2/2/18)

Amazon.Com Inc (AMZN)


HIGHLIGHTS

*AMZN: Volume, efficiency drive huge profit beat; BUY

to $1,550

*Amazon.com reported above-consensus revenue and

GAAP EPS for 4Q17.

*The company's volume leverage is increasingly driving

margin expansion and EPS growth, led by Prime membership

and growth in North American Retail sales and profits.

*Further contributing to margin expansion, Amazon's

best-selling SKUs in 2017 were Amazon products, including

Fire TV Stick and Echo Dot.

*AMZN has not been fully immune to the recent stock

correction while holding its value better than rival companies.

Amazon is a true multi-industry disruptor and, in the age of

cloud, an essential portfolio holding in most accounts.

ANALYSIS

INVESTMENT THESIS

BUY-rated Amazon.com (NGS: AMZN) reported

above-consensus revenue and GAAP EPS for 4Q17, as the

company's volume leverage is increasingly driving margin

expansion and EPS growth. Fourth-quarter 2017 revenue of

$60.5 billion increased 38% annually while topping midpoint

guidance and the Street consensus. GAAP EPS of $3.75 per

diluted share rose 143% and more than doubled the Street

GAAP consensus call of $1.85.

Amazon had a strong holiday season across the board,

driving slightly better than average 38% sequential revenue

growth (from 3Q17). Total North American retail grew 42%,

while AWS grew 47% year-over-year; NA retail profits more

than doubled, while AWS profit growth tracked sales growth.

Although international operations remained unprofitable, total

retail profits more than doubled year-over-year.

Amazon's best-selling SKUs in 2017 were Amazon

products, including Fire TV Stick and Echo Dot. Alexa has

spawned perhaps the biggest developer community this side of

the Apple Apps store; Alexa Skills store now offers over

30,000 skills.

Amazon is a true multi-industry disruptor and, in the age

of cloud, an essential portfolio holding in most accounts.

AMZN has not been fully immune to the recent stock

correction while holding its value better than rival companies.

With GAAP EPS now growing strongly and predictably,

AMZN valuations remain attractive even given the strong run

up in the stock. Our valuation analysis points to a fair value

for AMZN above $1,550 per share. We are reiterating our

BUY rating on AMZN while raising our 12-month target price

to $1,550 (from $1,250).

RECENT DEVELOPMENTS

AMZN is up 16% in 2018, while peers are up in single

digits and the market is down slightly. AMZN shares rose

60% in 2017, compared to a 39% gain for a basket of

Argus-covered internet service & cloud providers and a 19%

gain for the S&P 500. AMZN rose 11% in 2016, compared

with a 2% decline for internet service providers in Argus

coverage. AMZN surged by 118% in 2015, and was down

22% in 2014.

For 4Q17, Amazon posted revenue of $60.5 billion,

which was up 38% year-over-year and a slightly stronger than

Section 2.17


seasonal 38% on a sequential basis from 3Q17. Fourth-quarter

2017 revenue was at the high end of guidance of $56.0-$60.5

billion and exceeded the consensus estimate of $59.8 billion.

GAAP earnings of $3.75 per diluted share for 4Q17 were up

143% year-over-year from $1.54 in 4Q16; GAAP EPS blew

away the consensus forecast of $1.85.

Amazon surprised the Street in 4Q17 by generating $2.1

billion in GAAP operating income, which was up 69%

year-over-year. North American Retail was the star in 4Q17,

delivering record profits that approximately doubled the

year-earlier tally.

North American retail of $37.3 billion (62% of total) was

up 42% year-over-year; backing out $4.5 billion in physical

store sales, nearly all from Whole Foods, NA sales would still

have risen 25%. NA operating profits exploded to $1.69

billion, up 107% from 4Q16. NA retail margin improved to

4.5% in seasonally strong 4Q17, up 140 bps year-over-year

from 3.1% for 4Q16.

Amazon's best-selling SKUs in 2017 were Amazon

products, including Fire TV Stick and Echo Dot. Demand for

the two Alexa enabling devices, Echo and Echo Dot, has

brought Alexa into homes and offices nationwide, which in

turn has created a sub-industry of Alexa-based applications or

'skills.' Alexa has spawned perhaps the biggest developer

community this side of the Apple Apps store; Alexa Skills

Store now offers over 30,000 skills.

International retail revenue of $18.0 billion was up 29%

and came in above consensus. The overseas loss remains

significant, amounting to $919 million in 4Q17, but narrowed

slightly from $936 million for 3Q17. Amazon is less able to

monetize Prime in overseas markets compared to the U.S., but

CFO Brian Olsavsky noted that Prime International is starting

to gain more and more traction. The strategy to ramp Prime

overseas matches the U.S. strategy of incrementally adding

services, benefits, video content and devices.

AWS revenue of $5.1 billion grew 47% annually, while

AWS operating profit of $1.35 billion improved 46%

year-over-year. AWS is now on track for annualized revenue

in the $20 billion range, up from the $18 billion annualized

range as recently as 3Q17.

Segment margin of 26.5% for 4Q17 contracted by 100

basis points year-over-year. Although AWS has faced fierce

pricing in key markets such as IaaS and PaaS, margin

contraction has begun to moderate, reflecting scale

efficiencies and volume leverage. AWS faced price hikes a

year ago that suppressed revenue momentum in the early

quarters of 2017. With no meaningful price hikes in December

2017, new customer growth is strong, and existing customers

are stepping up their use of services. Management pushed

back against the suggested split-off of AWS from retail,

noting that Amazon Retail is one of the biggest, if not the

biggest, customer for AWS services.

For 1Q18, Amazon.com guided for revenue of

$47.75-$50.75 billion, which at midpoint signals sales growth

in the 35% range. Based on operating income guidance in the

$300 million-$1.0 billion range, Amazon is positioned to earn

about $1.25-$1.45 for 1Q18, compared with $1.48 for 1Q17.

Although Amazon has long thumbed its nose at Wall Street

analyst estimates, the significant beat against expectations has

many investors assuming Amazon is guiding cautiously for

the current first quarter.

With GAAP EPS now growing strongly and predictably,

AMZN valuations remain attractive even given the strong run

up in the stock. AMZN has not been fully immune to the

recent stock correction while holding its value better than rival

companies. Amazon is a true multi-industry disruptor and, in

the age of cloud, an essential portfolio holding in most

accounts.


For 4Q17, Amazon posted revenue of $60.5 billion,

which was up 38% year-over-year and a slightly stronger than

seasonal 38% on a sequential basis from 3Q17. Fourth-quarter

2017 revenue was at the high end of guidance of $56.0-$60.5

billion and exceeded the consensus estimate of $59.8 billion.

Amazon in 4Q17 generated $2.1 billion in GAAP

operating income, which was up 69% year-over-year and

principally driven by profit growth in North American Retail.

GAAP earnings of $3.75 per diluted share for 4Q17 were up

143% year-over-year from $1.54 in 4Q16; GAAP EPS blew

away the consensus forecast of $1.85.

For all of 2017, Amazon.com posted revenue of $177.90

billion, up 31% from $136.0 billion for 2016. GAAP EPS

totaled $6.16 per diluted share in 2017, up 26% from $4.90

per diluted share in 2016.

For 1Q18, Amazon.com guided for revenue of

$47.75-$50.75 billion, which at the midpoint signals sales

growth in the 35% range. Based on operating income

guidance in the $300 million-$1.0 billion range, Amazon is

positioned to earn about $1.25-$1.45 for 1Q18, compared

with $1.48 for 1Q17.

We are raising our GAAP EPS forecast for 2018 to $9.96

per diluted share, from a prior $9.03. We are implementing a

2019 GAAP EPS projection of $15.77 per diluted share. Our

five-year earnings growth rate projection is 14%.


Our financial strength rating on Amazon is

Medium-High, the second-highest rating on our five-point

scale. Amazon added debt to pay for the WFM merger, but

has strong cash flows that suggest the new higher debt level is

manageable.

Cash was $31.0 billion at year-end 2017. Amazon had

$25.98 billion of cash & marketable securities at the end of

2016 and $19.9 billion at year-end 2015.

Total debt was $24.7 billion at year-end 2017. Debt

increased from $7.68 billion at mid-year 2017, principally to

pay for acquiring Whole Foods. Total debt as of year-end

2016 was $7.69 billion.

Amazon generates significant cash. Cash flow from

operations was $18.4 billion for 2017. Cash flow from

operations for 2016 was $17.27 billion, compared to $11.92

billion in 2015.

Section 2.18


The credit agencies rate Amazon's debt as investment

grade. There is a substantial difference in agency ratings

between the Baa1 at Moody's and the very strong AA- at

S&P. Both agencies have stable outlooks.

Amazon does not pay and is unlikely to implement a

dividend. The company does not actively repurchase shares.

MANAGEMENT & RISKS

Founder Jeff Bezos remains CEO of Amazon. Brian

Olsavsky is CFO, and Jeffrey Wilke is chief executive officer

of Worldwide Consumer.

The addition of Whole Foods positions Amazon in a low

margined business. Amazon has extensive experience in

operating efficiently in the low-margined online retail

business. We expect the company to pursue margin expansion

at WFM not from conservative pricing (AMZN is already

aggressively pricing WFM goods) but through increased

efficiency and leverage from customer growth.

We give Amazon's management high marks for

continually making their 'store' cheaper, easier and more

secure for shoppers. We think the security and convenience of

Amazon's site has given many former critics of e-commerce

the confidence to shop online. Also, innovations like Amazon

Prime, Amazon Web Services and Kindle have made Amazon

an internet powerhouse.

The Whole Foods deal represents a modest but not

immaterial risk to Amazon. The company has long used

volume leverage to overcome the daunting margin challenges

in retail. Amazon will now operate expensive stores in a

business where margins are relentlessly compressing. On the

upside, the combination of significantly more natural and

organic products available for delivery, along with Amazon's

ability to run this business as a loss leader for years if

necessary, may enable Amazon to improve the margin profile

at WFM, while creating nightmares for legacy grocery

industry players.

Our biggest concern is that Amazon is likely to face fierce

competition over the next several years as more companies

expand online sales and match Amazon's prices offline. These

competitive strategies may make it more difficult for the

company to boost profits. We think that competitors will

include everyone from giant brick-and-mortar retailer

Wal-Mart to internet upstarts and designers/manufacturers like

Under Armour or Black & Decker.

Amazon typically receives payments from customers

before its obligations to suppliers are due. This is an important

enhancement to cash flow relative to many traditional

retailers, because Amazon has not needed to use increasing

amounts of short-term debt to support the company's growth.

One risk is that cash flow could be hurt if the company's wider

assortments mean that it needs to carry more inventory and

can't turn it over quickly.

Another risk is that the company may be forced to collect

sales tax on an increasing number of purchases. Currently,

Amazon collects taxes on about 50% of its revenue base.

While the potential need to collect taxes in additional states

would weigh on the company, we don't believe that simply

avoiding state taxes is an indispensable component of the

company's value proposition to consumers.

The company could also be hurt in the event of a

significant security breach, theft of client information, or

outages at its Amazon Web Services unit. This is a risk for all

e-commerce businesses, but may be heightened in the case of

a well-known consumer company like Amazon.

COMPANY DESCRIPTION

Amazon.com is the leading U.S. eCommerce retailer and

among the top eCommerce sites globally. Amazon.com also

provides Amazon Web Services (AWS), which is the global

leader in cloud-based Infrastructure-as-a-Service (IaaS)

platforms. The company's Prime membership platform is s a

key online retail differentiator, providing customers with free

shipping (after an annual fee) along with exclusive media

content (music, video, audible books, etc.). The company's

Kindle reader and Alexa-based Echo and Dot digital voice

assistants are category leaders. Amazon acquired Whole

Foods Market in August 2017.

VALUATION

While the growth engine at Amazon is unmatched, the

stock has been difficult to time from a valuation perspective.

Based on our historical comparables analysis and discounted

free cash flow valuation, we believe that Amazon's growth

prospects are accelerating more rapidly than the share price,

thus creating a favorable entry point.

On a historical comparables basis, AMZN trades at rich

multiples, but these are well below historical multiples. The

AMZN shares trade at an average two-year forward P/E of

114-times on GAAP EPS; the trailing 3-year multiple

(2015-2017) is 229-times. The two-year forward relative P/E

of 6.7-times, though rich, is about one-half the trailing

two-year relative P/E of 13.2-times.

AMZN trades at a 25.4-times EBITDA/Enterprise Value

multiple for 2018, at a modest premium to the trailing

five-year (2013-2017) EBITDA/EV multiple of 23.9-times.

We believe this modest premium to historical EBITDA/EV is

well earned, given overall growth in higher-end offerings such

as Prime, superior growth in AWS, and exciting new

opportunities such as Alexa and now Whole Foods Market.

Using our two- and three-stage discounted free cash flow

model, we calculate a value in the $2,000 range. Our blended

valuation model suggests a 12-month value for Amazon above

$1,650.

Appreciation to our 12-month target price of $1,550

(raised from $1,350) implies a risk-adjusted return of 15%,

greater than our forecast for the broad market. Given the

company's indisputable franchise leadership, its ability to

leverage its vendor relationships in the retail space, and its

m a r k e t d o m i n a n c e a n d s u p e r i o r g r o w t h i n

infrastructure-as-a-service, we believe AMZN warrants

long-term accumulation in most equity accounts.

On February 6 at midday, BUY-rated AMZN traded at

$1421.12, up $31.12. (Jim Kelleher, CFA, 2/6/18)

Section 2.19


Apple Inc (AAPL)


HIGHLIGHTS

*AAPL: iPhone units disappoint, but ASP drives revenue;

reiterate BUY

*Apple grew revenue 13% year-over-year, led by record

ASPs for iPhone.

*On the downside, iPhone unit sales missed expectations;

and Mac units declined.

*On balance, we believe fiscal 1Q18 vindicates Apple's

strategy of being a premium vendor in the smartphone space.

*The current crop of phones appears to be driving an

upgrade cycle worldwide, which we expect to carry through

into fiscal 2Q18. Although the unit outlook is disappointing,

ability to command premium pricing should power revenue

growth and margin expansion going forward.

ANALYSIS

INVESTMENT THESIS

BUY-rated Apple Inc. (NGS: AAPL) posted a mixed

performance for its fiscal 1Q18 (calendar 4Q17). Revenue

grew 13% year-over-year, led by iPhone pricing; services

remains a massive growth driver; and non-mature Asia is a

fast-growing opportunity. On the downside, iPhone unit sales

missed expectations; and Mac units declined. On balance, we

believe fiscal 1Q18 was a positive quarter for Apple, and one

that vindicates its strategy of being a premium vendor in the

smartphone space. Quarterly guidance for 2Q18 was

somewhat soft, although Apple beats its guidance fairly

consistently.

Apple's top-line growth is outpacing expense growth,

leading to expanding margins. The legal battle with

Qualcomm rages on, but is likely a bigger deal for Qualcomm

than for Apple. Following recovery in fiscal 4Q17, China

delivered even stronger year-over-year growth in fiscal 1Q18.

We regard this rebound as indicative of ongoing growth in the

Chinese market. Asia outside Japan and China was among the

fastest-growing markets for Apple.

The current crop of phones appears to be driving an





AAPL, particularly after the recent selloff, is well ahead

of the market and peers year-to-date and is particularly

inexpensive based on relative valuation. We believe that

Apple's positives are not fully reflected in the share price. We

are reiterating our BUY rating with a target price of $210.

RECENT DEVELOPMENTS

AAPL is down 7% year-to-date in 2018, versus a slight

gain for peers. AAPL rose 46% in 2017; the peer group of

computing, storage & information-processing companies in

Argus coverage was up 18%. AAPL is also running ahead of

the XLK technology SPDR and all Argus-covered technology

hardware names, which are up 22% and 12%, respectively.

AAPL rose 10% in 2016, slightly lagging the 12% gain for the

peer group. In 2015, AAPL fell 5% (after holding a 12% gain

as of early November), its first down year in a decade, while

the peer group declined 16%. AAPL shares rose 38% in 2014,

ahead of the peer group's 16% gain and the 11.4% capital

appreciation (13% total return) of the S&P 500.

For fiscal 1Q18 (calendar 4Q17), Apple posted revenue

of $88.3 billion, up 13% year-over-year, revenue growth was

the highest since fiscal 4Q15. For this still hugely seasonal

company, revenue came in above the top of management's

$84-$87 billion guidance range and bested the $86.2 billion

consensus call by over $2 billion. GAAP earnings totaled

$3.89 per diluted share, up 16% year-over-year and up $1.82

sequentially from 4Q17. Fourth-quarter EPS also came to

$0.22, above the consensus call.

Apple achieved more than $10 billion in annual revenue

growth in 1Q18, even though the recent quarter had 13 weeks

while 1Q17 had 14 weeks. Apple's secret sauce, so to speak, is

composed equally of global scale and strong customer loyalty.

CEO Cook pointed out that Apple's current installed device

base is 1.3 billion, an all-time high for the company's major

products. Although both Mac and iPad have presence within

that number, iPhone is plainly the major driver. More

impressive than the size of the installed base is its growth; the

base is up 30% in just two years.

In past, we have compared Apple not to an innovator but

to a farmer, forever acquiring and cultivating more land. On

that theme, Apple grew its acreage and yield in nearly every

market. Revenue from Japan grew 26% annually and reached

8% of revenue, as the iPhone X met a strong reception in

affluent and tech-savvy Japan. Rest of Asia-Pacific, which

excludes Japan and China, posted 17% annual sales growth to

reach 8% of total sales, an all-time high.

Greater China (20% of revenue) grew 11% on top of

similar annual growth in fiscal 4Q17; this market is 'back'

after multiple negative quarters. The mature markets of

Americas and Europe, which comprise a total 64% of revenue,

were up in low teens year-over-year.

In the first full quarter, shipping iPhone 8/8 Plus and a

nearly full quarter shipping iPhone X, Apple shipped 77.32

million phones, which was down 1% annually. iPhone

revenue of $61.6 billion, however, was up 13% and reached

an all-time high level. Average selling price (ASP) per iPhone

was $796, up 15% annually and a stunning 29% annually;

iPhone ASP was also an all-time record.

The iPhone X offers 3D sensing-enabled Face ID,

studio-quality lighting effects for the camera, and the ability to

play immersive augmented-reality games. The phone's A11

processor has a neural engine that has been in development for

years, with a focus on machine learning. According to the

industry analysis firm Canalys, IPhone X was the best-selling

smartphone in the December quarter, crowding out the next

two rivals - which were iPhone 8 and 8 Plus.

Section 2.20


In terms of other key product categories, iPad shipments

of 13.2 million units were up 1% annually; sequential growth

of 28% was actually pretty weak for the holiday quarter. Like

iPhone, however, iPad surprised with its ASP performance.

Although we assumed iPad Mini would dominate in the

quarter, acceptance of iPad Air drove 5% annual growth in

ASP to $455 in 1Q18 from $423 in 1Q17. ASP progress

suggests strength in enterprise applications.

The biggest disappointment against our model came from

the Mac. Unit sales for Apple's PCs were down 5%

year-over-year, to 5.1 million - actually a sequential decline

from 5.4 million in fiscal 4Q17. Mac ASPs were about flat

annually at $1,349 per device. Total Mac revenue of $6.9

billion declined 5%. Momentum from notebook refreshes

introduced in June did not carry past the September quarter.

Despite the setback, we expect the MacOS High Sierra

operating system to continue driving sales by making Mac

more capable and responsive.

Service revenue of $8.5 billion rose 18% annually and

was flat sequentially. Apple is well on its way to meeting its

goal of doubling services revenue from $24 billion in fiscal

2016 to $48 billion by fiscal 2020. The products category

grew 36% annually, to $5.52 billion, but will now dwindle to

a fraction of that level with the holiday season mainly behind

(Chinese New Year lies ahead).

For fiscal 2Q18, Apple disappointed with revenue

guidance of $60-$62 billion, which at the midpoint would be

up 15% annually. The Street was looking for sales in the $64

billion range; even with a typical $1-$2 billion beat against

top-of-range guidance, Apple would fall short of expectations.

Based on favorable gross margin and OpEx guidance, along

with lower tax rate, Apple should be able to hit EPS

expectations in the $2.90 range, which would be consistent

with 35%-40% annual growth.

The current crop of phones appears to be driving an






For fiscal 1Q18 (calendar 4Q17), Apple posted revenue

of $88.3 billion, up 13% year-over-year, revenue growth was

the highest since fiscal 4Q15. For this still hugely seasonal

company, revenue came in above the top of management's

$84-$87 billion guidance range and bested the $86.2 billion

consensus call by over $2 billion.

The 1Q18 GAAP gross margin of 38.4% expanded

sequentially from 37.9% in 4Q17 but compressed slightly

from 38.5% a year earlier. The GAAP operating margin

expanded sequentially to 29.8% in 1Q18 from 25.0% in 4Q17

on volume leverage, and was flat with a year earlier.

GAAP earnings totaled $3.89 per diluted share, up 16%

year-over-year and up $1.82 sequentially from 4Q17.

Fourth-quarter EPS also came to $0.22 above the consensus

call.

For all of FY17, revenue of $229.26 billion rose 6% from

$215.6 billion in FY16. Apple earned $9.19 per share for the

year, up 10% from $8.28 in FY16.

For fiscal 2Q18, Apple disappointed with revenue

guidance of $60-$62 billion, which at the midpoint would be

up 15% annually. The Street was looking for sales in the $64

billion range; even with a typical $1-$2 billion beat against

top-of-range guidance, Apple would fall short of expectations.

Based on favorable gross margin and OpEx guidance, along

with lower tax rate, Apple should be able to hit 2Q18 EPS

expectations in the $2.90 range, which would be consistent

with 35%-40% annual growth.

Primarily to reflect a lower tax rate, we are raising our

fiscal 2018 earnings forecast to $12.14 per diluted share from

$11.85. We are trimming our fiscal 2019 forecast to $13.28

per diluted share, from an initial $13.63. With no significant

adjustments, events or charges in any period, our GAAP and

non-GAAP earnings estimates are identical. Our long-term

EPS growth rate forecast for AAPL is 13%.


Our financial strength rating on Apple is High, the top of

our five-point scale.

Cash was $285.1 billion at 1Q18. Cash was $277.0 billion

at the end of fiscal 2017, $237.6 billion at the end of fiscal

2016, $206 billion at the end of fiscal 2015, and $155.3 billion

at the end of fiscal 2014.

Debt was $122.4 billion at 1Q18. Debt was $115.7 billion

at the end of 4Q17, and $87.0 billion at the end of fiscal 2016.

In recent years, Apple has levered up in anticipation of more

aggressive capital allocation. Debt was $64.5 billion at the end

of fiscal 2015 and $32.3 billion at the end of fiscal 2014. The

use of debt gives the company operating flexibility without

the need to bring back cash from overseas at onerous tax rates.

Cash flow from operations was $63.6 billion in fiscal

2017, $65.8 billion in fiscal 2016, and $81.3 billion in fiscal

2015. Fiscal 2016 free cash flow was an estimated $53.1

billion, down from $70.0 billion in fiscal 2015.

Management believes the Tax and Jobs Act will promote

a more optimal capital structure for the company. We expect

details on these changes in April 2018. In April 2017, Apple

announced a $50 billion increase in its capital return program;

the company announced a similar $50 billion increment in

April 2016. The company is committed to returning $300

billion to shareholders by the end of March 2019, raised from

its previous target of $250 billion by the end of March 2018.

Within the new capital allocation program, in April 2017

Apple hiked its quarterly dividend by 10.5%, to $0.63 per

share. Prior hikes include 10% in April 2016, 11% in April

2015, 8% in April 2014, and 15% in April 2013. Apple

declared its first quarterly dividend in April 2012. Our

dividend forecasts are $2.60 for FY18 and $2.78 for FY19.

MANAGEMENT & RISKS

Timothy Cook has served as CEO since industry legend

Steve Jobs passed away in 2011. Former Apple controller and

former Xerox CFO Luca Maestri became CFO in September

Section 2.21


2013, succeeding Peter Oppenheimer. Phil Schiller is the head

of worldwide marketing, and Jon Ivey is the chief of design.

Apple has a deep bench of executive, engineering and

marketing talent. We think that it will continue to attract

high-quality talent, both from an engineering perspective as

well as in the corporate leadership ranks.

While investors have criticized Apple for its closed

ecosystem, that system does have the effect of prompting

consumers to buy iPads and Macs for system compatibility.

Even more compelling to brand loyalty are Apple's services,

including iTunes, App Store, and iCloud, as consumers do not

want the cost and complexity of pulling their media libraries

out of the comfortable arms of Mother Apple.

Despite its enormous revenue base, Apple continues to

grow phone units and revenue at a double-digit pace. The

shares are always at risk from the perception that growth

could slow as the law of large numbers catches up with Apple.

The company has mitigated that risk, in our view, with very

aggressive shareholder return policies, which will likely

remain paramount. Despite the company's growing largesse,

we expect institutional investors to continue to demand more

aggressive dividend growth and a larger share repurchase

plan.

COMPANY DESCRIPTION

Apple manufactures PCs, MP3 players, smartphones,

tablet computers, software and peripherals for a worldwide

customer base. Its products include the Macintosh line of

desktop and mobile PCs, the iPod MP3 line, the iPhone, the

iPad, and various consumer products, including Apple TV.

Apple also owns and operates iTunes, the world's largest

vendor of recorded music. Apple derives 40%-45% of its

revenue from the Americas, 20%-25% from Europe/MEA,

12%-16% from Asia-Pacific, and 15%-18% from its own

retail stores.

VALUATION

AAPL trades at 12.9-times our FY18 EPS forecast and at

11.8-times our FY19 forecast; the two-year average P/E of

12.3 is below the five-year (FY13-FY17) trailing multiple of

13.6. In a market that has reached record highs, Apple is

trading at a discount to historical relative multiples. During

the past five years, AAPL has traded at an average 16%

discount to the market multiple, or at a relative P/E of 0.84.

The stock currently trades at a 33% discount to the market on

a two-year-average forward basis, or at a relative P/E of 0.67.

Less net cash per share, AAPL trades at an average of

9.7-times GAAP EPS for FY18 and FY19, or at about 53% of

the market multiple - at a time when AAPL is poised to

deliver 22% two-year average EPS growth and is the largest

single component of S&P 500 earnings.

AAPL also trades at discounts to the technology hardware

peer group on EV/EBITDA and PEGY. We believe that a

significant premium to peers is justified given Apple's ability

to expand globally and to generate healthy demand for its

products in every kind of economy.

Our more forward-looking two- and three-stage

discounted free cash flow model renders a value north of $330

per share, in a slight rising trend and well above current

levels. Our blended fundamental valuation model points to a

price above $290, also in a rising trend. Appreciation to our

12-month target price of $210, along with the dividend yield

of about 1.7%, implies a risk-adjusted total return exceeding

our 12-month forecast for the broad market.

On February 6 at midday, BUY-rated AAPL traded at

$160.66, up $4.17. (Jim Kelleher, CFA, 2/6/18)

AT&T, Inc. (T)


HIGHLIGHTS

*T: Reiterating BUY following mixed 4Q17

*While revenue fell marginally and the adjusted operating

margin contracted in 4Q17, AT&T delivered strong postpaid

wireless net additions. It also expects a lower effective tax rate

to boost 2018 EPS by $0.45.

*AT&T has been busy with strategic acquisitions,

completing a major deal with the First Responder Network as

it fights in court to save its planned purchase of Time Warner.

*These deals should help the company to maintain its

industry position in terms of both spectrum and content as it

prepares for new developments in the U.S. wireless market.


$3.01 and establishing a 2019 forecast of $3.65. AT&T's

valuation metrics remain favorable.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on AT&T Inc.

(NYSE: T) to a target price of $48. While revenue fell

marginally and the adjusted operating margin contracted in

4Q17, AT&T delivered strong postpaid wireless net additions.

It also expects a lower effective tax rate to boost 2018 EPS by

$0.45.

AT&T has been busy with strategic acquisitions,

completing a major deal with the First Responder Network as

it fights in court to save its Time Warner acquisition. These

deals should help the company to maintain its industry

position in terms of both spectrum and content as it prepares

for new developments in the U.S. wireless market, including

mobile video, 5G, and the Internet of Things.

At the same time, AT&T continues to face intense

competition as the U.S. wireless industry has moved back to

unlimited data plans after prodding first from T-Mobile and

then from Sprint. The saturation of the U.S. market has led to

a price war and white-hot competition for both high-value

postpaid and lower-value prepaid subscribers, with the

predictable impact of narrower margins. Although the

competitive environment has become quieter with the

beginning of a new iPhone/smartphone refresh cycle, it

remains to be seen whether this will continue as the cycle

matures.

Section 2.22


We think that the competitive wireless environment in the

U.S. strengthens management's case for diversification into

satellite video and Mexico/South America - now with the

possible addition of premium branded content from Time

Warner. Though the moves south of the border carry

significant risks, including greater exchange rate exposure,

AT&T sees opportunities in upgrading its Mexican wireless

networks to 4G LTE as it integrates them into a common

North American calling area.

AT&T's valuation metrics remain favorable.

RECENT DEVELOPMENTS

AT&T reported fourth-quarter results on January 31 after

the market close. Revenue fell 0.4% year-over-year to $41.7

billion, reflecting the long-term secular decline in legacy

wireline services, lower wireless service revenue (as

subscribers flock to cheaper unlimited data plans), and lower

domestic video, partly offset by higher equipment sales and

stronger international results. Wireless service revenue

declined 2.5% from 4Q16. The adjusted consolidated

operating margin fell 130 basis points from the prior year to

16.2%. However, adjusted EPS rose 18% to $0.78 from $0.66

in 4Q16. Adjusted EPS excluded $3.16 from a deferred tax

liability remeasurement gain, due to the new tax law, and

$0.19 in merger-related and amortization costs in 4Q17, and

$0.17 for these costs in 4Q16. It also excluded $0.19 in

actuarial losses on benefit plans in 4Q17 and $0.10 for these

costs in 4Q16, and $0.41 in asset write-offs and natural

disaster charges in 4Q17 and $0.05 for these costs in 4Q16,

among other smaller charges/gains. GAAP EPS rose to $3.08

from $0.39 a year earlier.

For all of 2017, revenue fell 2% to $160.55 billion.

Adjusted EPS increased 7.4% to $3.05.

AT&T gained a net 541,000 postpaid subscribers,

including 329,000 postpaid phone net adds, and a net 140,000

lower-value prepaid phone subscribers in 4Q17. Postpaid net

adds rose 4% while prepaid net adds fell 65.5%. The company

also lost 529,000 lower-value reseller subscribers in 4Q17.

AT&T, along with Verizon, has been forced by competitors to

tweak its wireless plans to add more unlimited data packages.

AT&T has created bundles of wireless plans with its DirecTV

video offers in order to improve the value of its plans and

thereby boost subscriber loyalty. Postpaid churn was 1.12%,

down 4 basis points from the prior year but up 5 basis points

sequentially. Phone-only postpaid ARPU declined 2.6% to

$57.33, and phone-only postpaid ARPU plus EIP payments

fell 1.9% from the prior year to $68.20 due to continued

subscriber migration to no-device subsidy and no-overage

plans.

On November 20, the U.S. Department of Justice filed

suit in federal court to block AT&T's acquisition of Time

Warner on antitrust grounds. Far from backing down, AT&T

has chosen to fight the U.S. government in court. The

scheduled trial date is March 19, and a ruling is expected in

April or May. Time Warner's current share price remains 13%

below AT&T's $107.50 offer price, which we believe reflects

market uncertainty about the deal.

The DOJ's case hinges on the potential increase in

AT&T's market power, relative competitors, as a result of the

merger. Time Warner has a portfolio of highly valued media

content, including sports broadcasts from the Turner cable

channels, hit television programming from premium cable

subscription service HBO, and movies from Warner Bros. The

DOJ complaint alleges that a merger would harm the market

in two ways. First, as we expected, the DOJ asserts that

AT&T would try to gouge competitors in the licensing of

Time Warner's Turner channels (or withhold access

altogether). The DOJ also asserts that the merger would result

in fewer innovative offerings and higher bills for consumers.

AT&T has repeatedly noted that the DOJ has not blocked

a 'vertical' merger of complementary (rather than competitive)

businesses in more than 40 years - which would make the

current case a radical departure from antitrust practice. The

2009 Comcast acquisition of NBC Universal - a deal

remarkably similar to the AT&T/Time Warner merger - was

approved with conditions intended to curb anticompetitive

behavior and has actually worked quite well over the years.

We do not believe it would be in AT&T's interest to withhold

the Time Warner channels from distribution on other services.

Withholding these channels from distribution would

essentially mean lowering their advertising and distribution

revenue - something the company could ill afford.

We think that AT&T has a reasonable case, though

litigation is always risky, especially when the opponent is the

U.S. government. We believe that the DOJ is trying to fight

yesterday's battle, as it does not consider the erosion of the

cable bundle universe through cord cutting - a clear

counterweight to any market power AT&T might gain. In our

view, the DOJ also fails to consider the evolution of cable

distribution. Comcast, the industry leader, has already begun

to open its platform to over-the-top digital streaming services

like Dish's Sling, Netflix, and YouTube, and has jumped into

wireless telecom services through a mobile virtual network

operator deal, piggy-backing on Verizon's network.

We do not understand the DOJ's sudden allergy to

negotiating conditions for approval, and its insistence on

forcing AT&T to divest key assets like the Turner Channels or

DirecTV. The DOJ's position strikes us as ideological rather

than practical, and has of course raised concerns about

political interference given the contentious relationship

between the White House and Time Warner's CNN. Whether

real or not, the specter of interference has only served to

weaken the DOJ's case.

In December 2017, AT&T raised its quarterly dividend

by 2% to $0.50 per share, or $2.00 annually, for a yield of

about 5.3%. We are adjusting our dividend estimates to $2.00

for 2018 and $2.04 for 2019. AT&T has a five-year

compound annual dividend growth rate of 2%.



$3.01 and establishing a 2019 forecast of $3.65. Our 2018

Section 2.23


estimate is above management's adjusted EPS forecast of

$3.50, which includes a projected $0.45 boost from a lower

effective tax rate. Our EPS estimates imply growth of about

10% on average over the next two years, above our long-term

growth rate forecast of 5%.

AT&T's strategic philosophy, like that of its cable

company peers, is now all about 'selling the bundle.' However,

in AT&T's case, the difference is that its bundle includes

wireless as well as video, high-speed internet, and VoIP. The

company added 170,000 wireless bundle customers in 4Q17,

and has 700,000 wireless subscribers bundled with its

DirecTV satellite TV service. Management sees the service

bundle as a key future profit driver as well as a driver of

customer loyalty and lower churn.

AT&T's has several strategic initiatives for 2018.

-- Closing the Time Warner acquisition. This will, of

course, depend on successful litigation against the Department

of Justice.

-- Strengthening the network. This is also no surprise.

Like its wireless industry peers, AT&T is upgrading its

network infrastructure to 5-G, a so-called 'gigabit network.'

The company is targeting $1 billion in incremental investment

in 2018, mostly for network fiber deployment. This

investment will be funded in part by savings from the reduced

tax rate.

-- Launching DirecTV NOW 2.0, the next iteration of the

company's nascent internet video streaming service.

-- Creating a new platform for targeted advertising across

its services.

-- Boosting subscriber numbers and profitability in its

Mexican operations.

-- Lowering its cost structure. Management has noted that

55% of the company's network operations are already

virtualized. It expects to boost this to 75% by 2020 with, we

expect, concomitant cost savings.

In the Entertainment Group, 4Q revenue fell 3.5% to

12.75 billion due to declines in legacy services and traditional

TV subscribers. DirecTV lost 147,000 subscribers. However,

subscriber gains at DIRECTV NOW offset losses at DirecTV

and Uverse, leading to 161,000 video net adds in 4Q17.

On March 30, 2017, AT&T announced an agreement with

the federal First Responder Network Authority (FirstNet) to

build and operate a dedicated national wireless broadband

network for police, firefighters and emergency medical

services. Emergency workers currently use commercial

wireless networks that can become clogged during

emergencies. FirstNet will provide 20 MHz of national 700

MHz low-band telecommunications spectrum, and

success-based payments of $6.5 billion over the next five

years to support the buildout of the new network. Under the

terms of the agreement, AT&T will spend $40 billion over the

25-year life of the agreement to build, operate and maintain

the network, including upgrading to 5G. The FirstNet network

will also integrate with AT&T's own network assets. In

addition, AT&T will be able to use/resell unused time on the

FirstNet network.

We think the FirstNet deal is a positive for AT&T,

particularly since it has had 100% buy-in from the individual

states. From AT&T's standpoint, greater network coverage is

an obvious plus. FirstNet provides opportunities for AT&T to

expand its service network footprint into geographic areas

with lower population density that may be uneconomical on a

commercial basis alone. The addition of the 20MHz of

adjacent 700 MHz spectrum to the 40MHz of currently

unused spectrum held by the company should also benefit

network capacity, putting AT&T in a strong strategic position

as wireless data usage continues to explode.

While the Time Warner acquisition is in litigation and

therefore remains in doubt, we think acquiring a premium

content provider like Time Warner would a plus for AT&T. It

would also take a particularly valuable piece off the

entertainment industry M&A game board, preventing Time

Warner's sale to another industry player. Time Warner is one

of the largest integrated media companies in the world, with

industry-leading assets in film, TV, and videogame

production, as well as basic and premium cable channels. We

see this acquisition as a strategic move by AT&T to ensure

access to premium branded content not only for its DirecTV

direct satellite video distribution business, but also for its

nascent wireless video business. Management has been clear

that it sees mobile video as the future of the wireless business

as wireless bandwidth increases and as network technology

evolves from LTE to 5G. Verizon has taken a similar, though

more conservative approach, in a series of smaller

acquisitions, including AOL, the Huffington Post, and Yahoo.

AT&T management has justified the deal by projecting

accretion to both adjusted EPS and free cash flow per share in

the first year after the closing. However, we expect adjusted

results to ignore merger integration costs. AT&T looks for $1

billion in run-rate cost synergies within three years of the

closing. Management also expects to rapidly delever after the

closing and to return to historically normal debt levels by

2022.


Our financial strength rating on AT&T is Medium, the

midpoint on our five-point scale. The Time Warner

transaction will add more than $23 billion in debt to AT&T's

balance sheet. Despite the increase in leverage, the company

expects to maintain its investment-grade credit rating and to

return to its target debt/EBITDA multiple of 1.8 by the end of

the fourth year after the closing. AT&T's credit ratings are in

the high B's, solidly investment grade. However, the ratings

agencies put the company on negative credit watch on

October 24, 2016, the day after the Time Warner acquisition

was announced.

RISKS

The Time Warner acquisition, if it happens, will present

significant integration risk as well as regulatory risk for

AT&T. Time Warner will be run as a separate subsidiary of

AT&T. However, the combined company will still have to

integrate two very different corporate cultures: the relatively

Section 2.24


staid culture of AT&T, a regulated telecom, and the more

free-wheeling, entertainment-oriented culture of Time Warner.

If the DOJ is successful in blocking the acquisition, the

market could interpret this as a negative for AT&T.

AT&T faces a number of traditional and newer

competitors, as the telecom industry continues to evolve from

a voice-centered to a wireless data and fixed broadband data

model. In addition, the U.S. wireless industry is essentially at

saturation which has led to increased competitive intensity to

win subscribers and narrower margins. These trends have

been partially offset by the rapid adoption of smartphones,

which come with higher-priced data plans, and by other data

devices like tablets that generally carry lower-priced plans

though smartphones and tablets are also now beginning to

close in on saturation. AT&T has diversified its handset

portfolio from an over-reliance on Apple's iPhone

(notwithstanding its blockbuster status), into Android,

Windows Phone and other smartphones. On the wireline side,

cable companies are fierce competitors for video and

broadband internet services, and have also made large inroads

with VoIP and into communications for small and

medium-sized business customers.

Following its spinoff from Deutsche Telekom and

acquisition of regional wireless telecom MetroPCS, a

resurgent T-Mobile has been particularly effective in

challenging the larger wireless industry incumbents with

discounts and inventive new service plans. Sprint joined the

fray in 2015 with cut rate plans of its own, and has gone even

further by offering a promotion for a year of free service.

AT&T has responded to this heightened competition with new

plans and incentives of its own, including unlimited data -

though this is pressuring margins. The new no-subsidy

equipment installment plans will also shift revenue out of

service and into the equipment line in the short term, while

increasing risks related to long-term accounts receivable.

Management has pledged to value receivables conservatively

and may be able to reduce this risk by factoring.

Through its recent moves into Mexico and elsewhere in

Latin America, AT&T will be entering foreign markets that

may not have the same demand dynamics as its home U.S.

market. Mexico has, at least initially, been a capex drain on

AT&T as it upgrades wireless networks to the 4G LTE

standard of its U.S. network. Issues such as corruption and

organized crime are also more prevalent in these markets than

in the U.S., and could entangle AT&T. In addition, the

company's foreign exchange risk will increase.

Another risk is that the market continues to shift rapidly

to new communications formats, such as VoIP, Wi-Max and

wireless/IP integration. The danger is that AT&T will be

unable to adapt quickly enough to keep pace with the new

technology.

AT&T also has a large retiree population and

correspondingly large pension and benefit obligations. Retiree

benefit plans could become more of a burden in the future.

The company is acting to minimize the risk of future OPEB

payments through its pension plan trust preferred equity plan.

AT&T is highly regulated on the federal, state and local

levels. As a regulated entity, it is vulnerable to changes in

regulatory philosophy that could put it at a disadvantage

relative to other industry players. We think this risk may have

lessened with the change in administration in Washington.

COMPANY DESCRIPTION

AT&T provides telecommunications and entertainment

services to consumers in the U.S. and Latin America and to

businesses worldwide. SBC acquired the old AT&T in

November 2005 and took the AT&T name shortly thereafter.

The combined company acquired BellSouth Corp. in

December 2006 and spun out its Directories business in May

2012. The company acquired Mexican wireless telecoms

Iusacell and Nextel Mexico in January 2015, and direct

broadcast satellite video operator DirecTV in July 2015.

VALUATION

AT&T shares have lost 7% in the last year, compared to a

total return of 16% for the S&P 500 and a loss of 1% for the

S&P 500 Telecommunication Services Index. AT&T is

trading near the middle of its five-year average range for

trailing enterprise value/EBITDA (7.5 versus a range of

6.9-8.0). Close rival Verizon has a multiple of 7.3. AT&T's

forward enterprise value/EBITDA multiple of 6.4 is 8% below

the peer average, greater than the average discount of 4% over

the last two years. We are maintaining our BUY rating on

AT&T to a target price of $48.

On February 6, BUY-rated T closed at $36.83, up $0.20.

(Joseph Bonner, CFA, 2/6/18)

Autozone Inc (AZO)


HIGHLIGHTS

*AZO: Boosting target to $875 on lower tax rate

*We expect AutoZone to benefit from solid industry

fundamentals, which include an aging vehicle fleet, low

gasoline prices, and increasing miles driven per car.

*We are raising our FY18 EPS estimate to $53 from $47.

The main driver is the reduction in our full-year tax rate

estimate to 27% from 34%,

*We are also boosting our FY19 EPS estimate to $59.75

from $51.50, representing a 13% increase from our FY18

estimate. We look for approximately 4% sales growth and a

small reduction in shares outstanding. AutoZone will also

benefit from the lower tax rate for the entire year.

*At a multiple of 16-times our forward-four-quarter EPS

estimate of $55.40, AZO shares would be worth

approximately $886 in one year.

ANALYSIS

INVESTMENT THESIS

We are reiterating our BUY rating on AutoZone Inc.

(NYSE: AZO) and raising our target price to $875 from $675,

reflecting the increase in our FY18 and FY19 earnings

Section 2.25


estimates due to a lower tax rate. We have also raised our

forward-four-quarter EPS estimate, which is important to our

valuation, to $55.40 from $47.00. We expect AutoZone to

benefit from solid industry fundamentals, which include an

aging vehicle fleet, low gasoline prices, and increasing miles

driven per car.

The average age of an American car is approaching 12

years and there are a growing number of cars that are more

than seven years old. If vehicles are driven approximately

12,500 miles per year, a car would have 87,500 miles after

seven years. These stats continue to point to a fleet of vehicles

that are no longer under warranty and in need of extra

maintenance.

Miles driven increased by 3.5% in 2015, which AZO said

was the largest increase in more than a decade. Miles driven

was up 1% in 2016 and up about 1.5% in the first half of

2017. The price of unleaded gasoline is still relatively low, at

about $2.48 per gallon. It is up slightly on a year-over-year

basis, but down over the last month as hurricane-related

disruptions have eased.

Collectively these indicators point to a U.S. vehicle fleet

that should need repairs as a result of age and use. Relatively

low gas prices should enable drivers to put even more miles

on their mature vehicles. Low prices at the gas pump should

also leave consumers with a little extra discretionary income

that can be spent on repairs.

Near-term sales of auto parts have recently been

pressured by strong U.S. new-car sales, but in the longer term,

growth in the overall fleet of cars should be beneficial to

AZO. There has been a bit of noise from a mild winter and

from a delay in tax returns, but we would expect those two

issues to be largely resolved as we head into FY18.

We expect the company to focus on improving inventory

availability to drive sales. We expect this to be accomplished

by having more inventory in individual stores, by adding more

large-format 'Hub' and 'Mega Hub' stores to significantly

improve product availability and by increasing the number of

replenishment deliveries to individual stores.

Despite the added cost of more inventories, deliveries,

and warehousing, management expects the initiative to deliver

significant internal rates of return. This expectation could be

challenged if the softness in comp sales continues.

We expect management to add services for commercial

customers to more stores and to improve recently-launched

commercial programs as they mature. We also expect AZO to

offer a wider assortment of parts through its programs.

The auto parts sector is relatively insulated from internet

competition because of in-store service, relationships with

parts suppliers and established delivery to commercial

customers. We also expect AZO to improve its own online

offering.

AMZN has reportedly inked some deals with some major

makers of auto parts. While it will be tough for AMZN to

match the customer service and immediate-availability that the

parts stores offer, a greater presence by Amazon is an ongoing

risk because the online giant has been willing to operate at

very low levels of profitability. It is a risk for the stock

because some investors are reluctant to invest anywhere that

Amazon might be a competitor. Another very long-term risk

could be the potential for sales of many engine and exhaust

parts to decline as electric cars become a bigger segment of

the U.S. market.

RECENT DEVELOPMENTS

AutoZone reported first-quarter sales and earnings on

December 5. Sales and EPS were stronger than we expected.

SG&A was slightly higher than we modeled because of

hurricane-related expenses. While the storms helped sales,

costs and store damage reduced 1Q EPS by about $0.07 in a

quarter where the company earned $10.00 per share.

Sales rose 4.9% to $2.59 billion versus our estimate of

$2.54 billion. Domestic comparable sales increased by 2.3%,

compared with the Bloomberg consensus call for a 0.9% gain.

Management said that commercial sales accelerated as AZO

gained market share.

Gross margin, at 52.8%, was up by 10 basis points and 20

basis points above our estimate. Profitability was helped by

higher merchandise margins, offset by 'shrink' or loss of

inventory. SG&A was 10 basis points higher than we

modeled, mostly as a result of hurricane costs and occupancy

costs growing faster than sales. SG&A dollars were $897

million, about $20 million above our estimate. Going forward,

management is optimistic that supply-chain costs will be well

controlled over the remainder of the year. Some wage pressure

is likely to remain.

The operating margin was in line with our estimate and

very healthy at 18.1%. The net result was that fiscal 1Q net

income came to $281 million, above our estimate of $278

million. EPS came to $10.00, above our estimate of $9.86.

A longer term issue getting a lot of attention is that

Amazon appears to be encroaching on the profitable turf of

the auto parts stores - and the grocery stores - and the

appliance stores. While we think AZO and its peers have a lot

going for them, we wouldn't dismiss Amazon's disruptive

power. AutoZone has stressed the value of its in-store service

and the ability to help customers diagnose their problem and

make sure they have exactly the right part for the year and

model of the customer's vehicle. AZO also believes that its

in-stock position and its proximity within eight miles of 80%

of the U.S. population are advantages. AZO has the potential

to gain market share in a very fragmented commercial market.

Another concern in the marketplace is the potential for

electric vehicles to take share from vehicles with internal

combustion engines. While a noticeable erosion could take 10

- 15 years it could still weigh on the shares. While our

intuition is that electric cars will need fewer parts than cars

with an internal combustion engine, that is really hard to know

at this point. Electric cars will still, presumably need tires,

rims, wipers, belts, wires, connectors, shocks, brakes,

bearings, floor mats, cleaning supplies and, of course, air

fresheners.


Section 2.26


We are raising our FY18 EPS estimate to $53 from $47.

The main driver is the reduction in our full-year tax rate

estimate to 27% from 34%, with a rate of 25% from January 1

through the end of the fiscal year. The reduction is based on

the new federal tax law. We have also reduced our interest

expense estimate based on 1Q debt levels. In addition, we

made a small increase in our 2Q sales forecast because of

frigid weather on the East Coast, and note that 1Q earnings

were slightly higher than we modeled. Our operating margin

estimate is about 10 basis points higher at 19.2%.

We are raising our FY19 EPS estimate to $59.75 from

$51.50, representing a 13% increase from our FY18 estimate.

We are modeling approximately 4% sales growth and a small

reduction in shares outstanding. Our model assumes a

20-basis-point increase in the operating margin, with an

improvement in the expense rate offsetting a slight reduction

in the gross margin, and a lower tax rate for the entire year.

Our five-year growth rate for AutoZone is 10%. We are

modeling continuing repurchase activity. Our growth rate

assumes domestic square footage growth of approximately 3%

-4% with comp-store sales also growing approximately 3%,

though somewhat slower in the near term. We expect comp

growth to be bolstered by the company's plan to add and

enhance commercial programs and improve its in-stock

position. We also expect modest international expansion,

initiatives to grow the IMC business, a better e-commerce

presence which could add incremental sales and ongoing share

repurchases. We are modeling repurchases at $1 billion or

slightly more which could represent more than 4% of the

current market cap.

At the end of fiscal 1Q18, AutoZone had 6,049 stores,

including 5,480 AutoZone stores in the U.S., 529 in Mexico,

14 in Brazil and 26 IMC branches. As industry sales have

grown, the company's broad geographic presence has enabled

it to gain market share.

FINANCIAL STRENGTH

We rate the financial strength of AutoZone as Medium,

the midpoint on our five-point scale. The company has

significant debt and it is in a very competitive sector, but the

company has excellent consistency, producing solid margins

and positive EPS in every year that it has been a public

company, going back to 1991. The company also generated

positive free cash flow in 2000 and in every fiscal year since.

AZO's debt is rated Baa1 with a stable outlook from

Moody's and BBB with a stable outlook from Standard &

Poor's. These are investment-grade ratings. The company's

short-term ratings are A-2 from S&P and P-2 from Moody's.

These are below the top tier, but they should allow the

company to access the commercial paper market.

At the end of 1Q18, the company's total debt/total

capitalization ratio was 144% (reflecting a stockholders'

deficit of $1.5 billion). The company has been solidly

profitable over the last 20 years. The stockholders deficit is a

result of the company repurchasing $18 billion of its stock

over the last 18 years at prices that were far above the IPO

price.

Total debt, which includes both long-term and short-term

debt as well as capital leases, was $5 billion at the end of

1Q18, about the same as a year earlier. The 1Q balance sheet

lists no short-term debt, but we think it is important to note

that the company had $1 billion of outstanding commercial

paper which it classified as long-term debt. We would

normally regard CP as short-term debt.The company's

rationale for classifying this debt as long term is it has $1.99

billion of borrowing capacity under its $2 billion revolving

credit facility, which now matures in 2022. If the amount of

CP and debt maturing in less than one year was less than the

available balance on the revolver, the company would show

no short-term debt. The company said that the calculation of

short-term debt is based on guidance from its auditor. We

understand the rationale and the disclosure in the financial

statements is clear. The total amount of debt is the same either

way, but all things considered, we would prefer to see the

commercial paper and the near-term debt maturity classified

under short-term debt - debt maturing in less than a year.

Like most of the other retailers in our universe, AZO has

operating leases. The company owns about half of its 39.7

million square feet of store space, which is a fairly high

percentage. Argus treats the operating lease payments as fixed

obligations. If we add the estimated $1.5 billion present value

of operating leases to the balance sheet, debt is about 130% of

capital.

At the end of 1Q18, the adjusted four-quarter trailing

debt/EBITDAR ratio was 2.5, flat with the prior year. The

company has targeted a ratio at or below 2.5. AZO uses a

multiple of 6 to capitalize leases. We normally use a factor of

8 which would put adjusted debt slightly higher at

approximately 2.75-times EBITDAR. The company told us

that the factor of 6-times is based on the cost of its actual

leases.

AutoZone had cash and equivalents of $258 million at the

end of 1Q18, compared to $293 million at the end of 1Q18.

From a historical perspective, AutoZone repurchased 1.9

million of shares for about $1.5 billion in FY16, 2.0 million

shares of its common stock for $1.3 billion in FY15 and it

repurchased 2.2 million shares of common stock for $1.1

billion in FY14. In fact, the company has purchased over $1

billion of shares in each of the last seven years.

AutoZone repurchased $400 million of shares in fiscal

1Q16, $150 million in 2Q, $533 million in 3Q, and $370

million in 4Q. The company repurchased $560 million of its

stock in the first half of FY17 and $284 million in 3Q17 and

$227 million in the fourth quarter. AZO repurchased $353

million in 1Q18. The remaining authorization was $471

million at the end of 1Q.

On a trailing four-quarter basis, AutoZone's return on

invested capital (ROIC) was 29.6% at the end of 1Q, down

slightly from 31.3% in the prior-year period. This is a very

healthy number that is bolstered by strong margins and by the

shareholders deficit reducing total capital.

AZO shares do not carry a dividend, and given the

Section 2.27


company's current share buyback plans, and plans to open

stores, we do not expect one to be implemented in FY18 or

FY19.

RISKS

The two long-term concerns regarding Auto Zone and the

other auto parts stores are competition from Amazon and the

possibility of a decline in business as electric cars gain a

bigger share of the road over the next 10 - 20 years.

While Amazon is adding inventory and may be a viable

competitor for the do-it-yourself customer who is very

knowledgeable, most DIYers can probably benefit from the

assistance they get at a parts store. And pro customers can

benefit from parts-store delivery networks that are currently

faster than Amazon can offer.

The countercyclical nature of the auto parts industry

suggests that when new auto sales are strong, sales at parts

retailers will typically be weak, as the need for repairs

declines. On the other hand, although DIY sales have fallen

due to the increasing complexity of new vehicles, we

recognize that repair and maintenance work by DIYers will

often increase during periods of economic hardship.

Most aftermarket parts retailers experienced solid sales

growth after the great recession as tight lending conditions,

slow wage growth and fragile consumer balance sheets

provided an incentive to keep cars on the road. We expect the

DIY side to face the most pressure because the increasing

complexity of new vehicles is making it harder and harder for

consumers to work on their own cars.

The sector generally benefits from an older fleet of

American cars, which needs more repairs. More than 75% of

the U.S. auto fleet is more than six years old, according to

data recently cited by competitor Genuine Parts. The average

age is 11.7 years. The average annual repair cost is just over

$800 per year for cars that are 6-12 years old, according to

GPC.

Auto parts retailers also benefit if consumers are driving

more miles. While higher gas prices could crimp driving and

the need for auto parts, miles driven were up 2.8% in 2016

bolstered by low and stable gasoline prices. And it appears

that they rose approximately 1.25% in calendar 2017, helped

by relatively low gasoline prices. Gas prices remain low at

approximately $2.60 a gallon.

Weather is another factor. The company doesn't benefit if

the weather is so mild that parts aren't being used or worn out,

but they don't want such harsh weather that people stay home.

The company also doesn't want the economy to be so bad that

people can't afford to make DIY repairs and companies are

laying off workers, but neither do they want consumers to be

flush enough to buy a new car, although their used vehicle

would probably still remain in the auto fleet and be in need of

repairs.

During 2015, the number of registered vehicles grew by

2.1% to 258 million vehicles and the scrappage rate was the

lowest in more than a decade, according to AAP. We'd

estimate that vehicle registrations increased by approximately

2% in 2016. These statistics are reported with a lag.

The products sold by auto parts stores generally fall into

three categories: Failure, which includes belts, hoses, fuel

pumps and alternators; Maintenance, which includes

antifreeze, brake fluid, brake pads, spark plugs and windshield

wipers; and Discretionary items, such as air fresheners,

decorative floor mats, stereos and washes and cleaning

supplies. The failure and maintenance categories represent

84% of total sales.

An additional risk is that some manufacturers won't make

diagnostic tools or part designs available to aftermarket part

makers or repair chains. We once owned a European car that

had to receive all major repairs at the dealership because none

of the local mechanics wanted to spend the high amount for

the manufacturer's diagnostic software.

The auto parts sector has generally been more sheltered

from internet competition. It is likely that online competition

or at least the cost of building and upgrading internal

capabilities could weigh on profitability. Shares of AZO and

other parts stores recently declined following a press report

that Amazon was making agreements with some major makers

of auto parts.

Earnings could be crimped if the company is fulfilling

more online orders with shipping that is free to customers.

Another risk is that companies are likely to be faced with

more threats from computer hackers and upgrading systems

could be a bigger use of cash.

A growing concern is that Amazon is attempting to

increase its share of the auto parts market. A longer-term risk

is that sales at parts stores could be hurt by an increase in the

number of electric cars.

COMPANY DESCRIPTION

AutoZone Inc. was founded in 1979 and is based in

Memphis, Tennessee. The company is a leading retailer and a

leading distributor of automotive replacement parts and

accessories with almost $11 billion of FY17 sales through

almost 5,500 stores in the United States and Puerto Rico and

more than 500 in Mexico. Each AutoZone store carries an

extensive product line for cars, sport utility vehicles, vans and

light trucks, including new and remanufactured automotive

hard parts, maintenance items, accessories, and nonautomotive

products.

Over 80% of stores also have a commercial sales program

that provides commercial credit and prompt delivery of parts

and other products to local, regional and national repair

garages, dealers, service stations, and public sector accounts.

IMC branches carry an extensive line of original equipment

import replacement parts. AutoZone also sells ALLDATA

diagnostic and repair software through alldata.com.

The company has more than 6,000 total stores and offers

national brand and private-label products. According to

management, more than 50% of the sales mix is private label.

The margins on these private-label products are higher than on

branded products because AZO is able to benefit from direct

sourcing.

Section 2.28


VALUATION

AutoZone shares have risen about 7% over the last year.

We believe that concerns about competition from Amazon and

softness in comparable sales have weighed on the share price.

We believe that the company can gain share in the market and

compete with Amazon, and we expect comps to improve as

the company moves past the lull in repairs that resulted from

two mild winters.

The shares trade at 14-times our FY18 EPS forecast and

at 13-times our FY19 forecast. AZO is trading at 17.5-times

trailing earnings. The five-year average is 17.6, with a range

of 11.5-22.0. The company's closest peers are trading at

approximately 22-times trailing earnings. We believe the

shares are attractively valued at a discount to peers based on

the company's record and prospects for earnings growth. One

issue is that AZO has more exposure to the retail DIY market.

While this is beneficial to margins, the DIY market is more

vulnerable to competition from Amazon than the commercial

market.

At a multiple of 16-times our EPS estimate of $55.40 for

the next four quarters, the shares would be worth

approximately $886 in one year. This multiple is up from the

15 that we used in our previous note based on the solid sales

performance in 1Q.

Using a simple discounted earnings model with our FY18

and FY19 estimates and the assumption that EPS will grow at

10% for the next three years puts the value of the shares at

$850. This is based on EPS of about $80 and a terminal

multiple of 16, which puts the value of the shares at about

$1,280 in four years. We then discount to the present at 8.5%.

We are raising our one-year price objective to $875 from

$675.

On February 1, BUY-rated AZO closed at $764.38, down

$1.06. (Christopher Graja, CFA, 2/1/18)

Boeing Co (BA)


HIGHLIGHTS

*BA: Raising target price to $395

*BA shares have been strong performers over the past

quarter, gaining 40% compared to an increase of 10% for the

S&P 500.

*Boeing's 4Q results once again topped consensus, and

we look for solid growth over the next two years.

*We note that the shares are susceptible to headlines or

presidential tweets about defense spending or trade with

China. We would view any headline-related pullbacks as

buying opportunities.

*Management recently increased the dividend by 20%,

signaling confidence in its outlook.

ANALYSIS

INVESTMENT THESIS

BUY-rated Boeing Co. (NYSE: BA) is the largest

aerospace and defense company in our coverage universe, and

we believe that it has superior prospects due to its significant

backlog and strong presence in the growing commercial

aerospace industry. In the near term, the company is managing

shifts in customer demand in order to prepare for stronger and

more profitable growth in 2018 and beyond. At the same time,

the management team is clearly focused on delivering strong

shareholder returns and continues to boost the dividend and

repurchase stock. We note that the shares are susceptible to

headlines or presidential tweets about defense spending or

trade with China. We would view any headline-related

pullbacks as buying opportunities. Our dividend discount

model renders a fair value above $420 per share. Blending our

valuation approaches, we see value up to $395 per share, our

new target price, up from a prior $290. The BA shares are a

suitable core holding in a diversified portfolio.

RECENT DEVELOPMENTS

BA shares have been strong performers over the past

quarter, gaining 40% compared to an increase of 10% for the

S&P 500. Over the past 12 months, the shares have also

outperformed, rising 120% compared to a 24% advance for

the broad market. BA shares have also outperformed the

industrial sector ETF IYJ over the past one-, five- and

ten-year periods. The beta on BA is 1.29.

On January 31, Boeing reported quarterly earnings that

once again topped expectations. The company posted

consolidated revenue of $25.4 billion, up a sequentially

stronger 9% from the prior-year period. Non-GAAP core

operating earnings rose 30% as the operating margin increased

160 basis points to 10.5%. Non-GAAP core earnings were

$3.06 per share, ahead of the consensus forecast of $2.89.

For the full year, the company earned $10.30 per share,

above management's guidance range of $9.90-$10.10. Boeing

delivered 763 commercial aircraft last year, up from 748 in

2016.

Along with the 4Q results, management established

guidance for 2018. The company expects revenue of $96-$98

billion (up 2%-4%), and EPS of $13.80-$14.00. This forecast

implies 13% growth from 2017, at the midpoint of the range,

after including the impact of the lower tax rate on an

apples-to-apples basis in both periods. Management is also

forecasting that operating cash flow will grow 13% to 415

billion. Management forecasts full-year deliveries of 810-815

aircraft in 2017.


Boeing organizes its operations into two manufacturing

businesses: Commercial Airplanes, which includes key

products such as the single-aisle 737MAX, the 787

Dreamliner series, and the 777X (the largest twin-engine jet in

the world, with first scheduled deliveries in 2020); and

Defense, Space and Security, which manufactures products

such as the F-18 Hornet, the AH-64 Apache helicopter, P-8

Poseidon aircraft, and the KC-46 Tanker. Boeing also has a

Capital segment, which provides aircraft financing, and a

Global Services business, which 'captures value over the life

Section 2.29


cycle' of the company's products.

In the Commercial Airplanes segment, revenues were up

8% year-over-year in 4Q, to $15.5 billion. The operating

margin increased 320 basis points to 11.5%. The company

delivered 209 commercial airplanes in the quarter, up from

202 in 3Q and 185 a year earlier. It booked 414 net orders for

commercial airplanes, resulting in a backlog of $421 billion,

up from $412 billion at the end of the previous quarter. The

backlog includes orders for more than 5,800 aircraft

(approximately 75% of the backlog is for 737s and 10%-12%

is for 787s), representing about seven years of production.

Management has been adjusting the product mix to meet

changing demand. Last year, 737 production increased from

42 airplanes per month to 47, and the expectation is for 52 per

month this year and 57 per month in 2019. Last year,

management also lowered production of the higher-priced 777

model to 5 per month. The production rate for 787s is

expected to increase from 12 to 14 airplanes per month in

2019; Boeing expects to deliver the first 787-10 to launch

customer Singapore Airlines in March.

The Defense, Space and Security segment reported 4Q

revenue of $5.5 billion, up 5% from the prior year due to

higher weapons deliveries. The operating margin rose 10 basis

points to 10.0%. The segment backlog rose by $4 billion to

$50 billion at the end of the quarter. International orders

represented about 40% of the total. Looking ahead, we

forecast low-single-digit sales growth this year and stable to

slightly higher margins.

The new Global Services segment reported 4Q revenue of

$4.0 billion, up 17%. The operating margin contracted 120

basis points to 15.4%. During the quarter, Global Services

was awarded a contract for F-15 Qatar Sustainment. It also

signed an agreement with All Nippon for the 787 landing gear

exchange program, and was selected for P-8I Poseidon

training in India. Global Services began flight testing on the

first 737-800 Boeing Converted Freighter and received an

order from GECAS for seven conversions. Digital Solutions

approached an annual revenue run rate of $1 billion in the

quarter. Looking ahead, we estimate mid-single-digit sales

growth and mid-teens margins in this segment.

At Boeing Capital, the net portfolio balance was $3.0

billion at the end of 4Q, down $300 million from the

beginning of the quarter. Boeing Capital reported

fourth-quarter revenue of $73 million, down from $87 million

in the same period a year earlier, and operating income of $27

million, up from $23 million a year earlier.

Turning to our estimates, and factoring in expectations for

low single-digit top-line growth, better margins, lower taxes,

and continued share buybacks, we are raising our 2018 EPS

estimate from $11.00 to $13.90. Based on expectations for

further top-line growth in 2019, we are implementing a

preliminary forecast of $15.30 per share.


Our financial strength rating on Boeing is Medium-High,

the second-highest rank on our five-point scale. The company

scores above-average on our key criteria of debt levels,

fixed-cost coverage and profitability. The company has A

ratings from the major credit rating agencies.

Boeing has a share repurchase program. At the end of 4Q,

shares outstanding were down 4% year-over-year.

The company also pays a dividend, which it raised by

20% in December. The quarterly payout is $1.71, or $6.84

annually, for a yield of about 2.0%. We think the dividend is

secure and expect it to grow. Our dividend estimates are $6.84

for 2018 and $7.80 for 2019.

MANAGEMENT & RISKS

Boeing recently named Dennis Muilenburg, 53, as its new

CEO, succeeding James McNerney. Mr. Muilenburg

previously served as Boeing's vice chairman and chief

operating officer. Gregory Smith serves as CFO.

Investors in BA shares face numerous risks.

BA was in the headlines early in the Trump presidency,

related to stories about defense spending and jobs. The

headline events underscore Boeing's delicate situation. The

company is among the largest U.S. exporters and employs tens

of thousands of people, and aggressive tariffs and other trade

barriers could cost the company future orders. That said, we

expect that Boeing management - and the entire aerospace &

defense industry -- will ultimately work closely with the

Trump economic team on these issues.

The company is also vulnerable to a cyclical downturn in

the commercial aviation market, though the geographic

diversification of its product portfolio provides some stability.

Much of the company's backlog consists of orders from

rapidly growing international customers. The current deferral

rate is approximately 2% of the backlog, below the historical

average of 6%. Meanwhile, demand trends remain favorable

for Boeing as customers continue to upgrade to more

technologically advanced aircraft with improved fuel

efficiency. In addition, airline profitability has improved due

to lower fuel costs, and air traffic trends remain generally

positive; through November 2017, passenger traffic has grown

an impressive 7%, above the 10-year average of 5.5%, and

cargo traffic has turned positive, rising 9%. Based on these

trends, Boeing management now projects demand for 41,000

new commercial aircraft over the next 20 years, which it

expects to meet with three key products: its single-aisle

737MAX; the 787 Dreamliner series; and the 777X, the

largest twin-engine jet in the world, with first scheduled

deliveries in 2020. The service business represents

opportunity as well. Boeing estimates the services market at

$2.6 trillion over the next 10 years.

Fixed costs are high in the airline manufacturing industry,

and from time to time the company takes charges if it

determines that investments are not generating the expected

return or that more investment is needed.

Like most military contractors, Boeing also faces risks

related to the cancellation or curtailment of new and existing

Defense Department contracts. However, Boeing has seen

solid support for its Defense, Space and Security programs,

Section 2.30


and management continues to anticipate modest defense

spending growth over the next five years.

Boeing also faces risks associated with its pension

obligations.

COMPANY DESCRIPTION

Boeing manufactures commercial jetliners and military

aircraft as well as rotorcraft, electronic and defense systems,

missiles, satellites, launch vehicles, and advanced information

and communication systems. The company was founded in

1916 and is based in Chicago. The shares are a component of

the Dow Jones Industrial Average and the S&P 500.

VALUATION

We think that BA shares are attractively valued at current

prices near $358, near the high end of the 52-week range of

$160-$361. The shares have been in a bullish pattern of higher

highs and higher lows since falling to support at $126 in

September 2016.


and historical multiple comparisons, along with a dividend

discount model. BA shares are trading at 25.7-times projected

2018 earnings, near the high end of the historical range of

12-26. On a price/sales basis, the shares are trading at the high

end of the five-year range of 0.7-2.4. The dividend yield of

about 2.0% is near the midpoint of the five-year range.

Compared to the peer group, valuations are mixed: high on

P/E, but below average on price/sales and dividend yield. Our

dividend discount model renders a fair value above $420.

Blending our approaches, we arrive at a revised target price of

$395.

On February 1 at midday, BUY-rated BA traded at

$360.29, up $5.92. (John Eade, 2/1/18)

Boston Scientific Corp (BSX)


HIGHLIGHTS

*BSX: Reaffirming BUY with $32 target

*BSX continues to deliver solid sales growth, with

fourth-quarter and full-year organic revenue up in all three

segments and across all regions. At the same time, the

company is facing remediation costs for its Lotus heart valve,

which was recalled in Europe in February.

*On February 1, the company posted better-than-expected

4Q17 sales of $2.41 billion. Adjusted EPS rose to $0.34, in

line with consensus and up from $0.30 a year earlier.

*Management projects adjusted 2018 EPS of

$1.35-$1.39, with organic revenue growth of 5%-6%. We are

reaffirming our 2018 adjusted EPS estimate of $1.38 and

establishing a 2019 estimate of $1.52.

*BSX trades at 19.7-times our adjusted 2018 EPS

estimate, compared to an average multiple of 17.6 for our

coverage universe of med-tech stocks. We believe this

premium is warranted based on the company's growth

opportunities through new product launches and acquisitions,

expansion into higher-growth markets, and success in

boosting margins.

ANALYSIS

INVESTMENT THESIS

We are reaffirming our BUY rating on Boston Scientific

Corp. (NYSE: BSX) and our price target of $32. BSX

continues to deliver solid sales growth, with fourth-quarter

and full-year organic revenue up in all three segments and

across all regions. At the same time, the company is facing

remediation costs for its Lotus heart valve, which was recalled

in Europe in February. Management reiterated its goal for a

relaunch of the Lotus in Europe and an initial launch in the

U.S in 2019. Despite this setback, we believe that BSX has

compelling long-term growth opportunities, driven by strength

in the Medsurg and Cardiovascular segments.

RECENT DEVELOPMENTS

We are monitoring the company's efforts to resolve issues

surrounding its Lotus heart valve device. This device, which

essentially replaces the aortic valve in a catheter-based

minimally invasive procedure, was recalled in European

markets in February 2017 due to a problem with the release of

the valve from the catheter. Its U.S. marketing application was

also delayed. Nevertheless, we believe that the Lotus valve

has a large addressable market and the potential to be a

significant revenue driver over time.

We note that BSX shares fell sharply in late November

after the company announced delays in its planned

reintroduction of the Lotus in Europe and its launch in the

U.S. Management is now targeting a relaunch in Europe and

an initial launch in the U.S. in 2019.

On February 1, BSX posted 4Q17 adjusted EPS of $0.34,

in line with consensus and up from $0.30 a year earlier. The

GAAP net loss was $615 million or $0.45 per share, including

a one-time $861 million charge related to recent changes in

the U.S. tax code, down from GAAP earnings of $124 million

or $0.09 per share in 4Q16. Net sales rose to $2.41 billion, up

9.9% on a reported basis and 8.1% operationally, above the

consensus forecast and management's guidance.

On an organic basis, which excludes acquisitions and

divestitures as well as the impact of currency translation, sales

rose 6.8% in the fourth quarter. Organic sales rose in all

segments, with growth of 11.2% in MedSurg (which includes

endoscopy, neuromodulation, and urology devices); 4.9% in

Cardiovascular (which includes cardiology, structural heart

and peripheral devices); and 3.2% in Rhythm Management

(which consists of electrophysiology and cardiac rhythm

management products). By geographic region, 4Q organic

revenue rose 7.5% in the U.S., 4.4% in Europe, 7.8% in

AMEA (Asia-Pacific, Middle East and Africa), and 12.9% in

other emerging markets.

The fourth-quarter adjusted gross margin was 72.6%, flat

with the prior year, and the adjusted operating margin was

25.6%, up 190 basis points. Margin growth was driven mainly

by operational improvement in the Rhythm Management and

Section 2.31


MedSurg segments, and by an 80-basis-point reduction in

SG&A spending to 35.7% of revenue.

For all of 2017, BSX posted adjusted EPS of $1.26, up

from $1.11 in 2016, and GAAP EPS of $0.08, down from

$0.25 a year earlier. Net sales for fiscal 2017 were $9.05

billion, up 7.9% on a reported basis and 7.8% operationally.

The adjusted gross margin for the full year rose 10 basis

points to 72.1%, and the operating margin rose 90 basis points

to 25%. SG&A spending fell 50 basis points from the prior

year to 35.6% of revenue.

In the transcatheter aortic valve replacement market

(TAVR), Edwards Lifescience and Medtronic are the leading

players. The TAVR market is expected to grow to $5 billion

worldwide by 2021, according to Edwards. The TAVR

devices, which are implanted through a catheter, eliminate the

need for surgical replacement of the aortic valve. Although the

Lotus valve has strong clinical data showing its benefits to

patients, BSX will be playing catch-up as it seeks U.S.

marketing approval and works to relaunch the product in

Europe.

In January 2018, Boston Scientific announced a $90

million investment and an acquisition option agreement with

Millipede Inc., a privately held cardiology device maker. In

May 2017, BSX completed its $435 million acquisition of

Symetis SA, a privately held Swiss company specializing in

structural heart products. The acquisition will enable BSX to

expand its offerings in the TAVR market. In October, it

acquired Apama Medical, Inc., which is developing a

single-shot RF balloon catheter system for more efficient Afib

treatment.


Management projects 1Q18 adjusted EPS of $0.30-$0.32

and organic revenue growth of 5%-6%. For the full year, it

expects adjusted EPS of $1.35-$1.39, with organic revenue

growth of 5%-6%. The revenue growth projections exclude

contributions of about 80 basis points in 1Q18 and 30 basis

points in FY18 from the Symetis acquisition.

We are reaffirming our 2018 EPS estimate of $1.38 and

establishing a 2019 estimate of $1.52.

RISKS

Boston Scientific faces regulatory and technological risks.

The company is developing new products to fill its product

pipeline, which is also benefiting from acquisitions. However,

these products must complete clinical trials and clear

regulatory hurdles before reaching the market.

BSX's cardiac rhythm management products face

competition from industry leader Medtronic and from the St.

Jude Medical business now owned by Abbott. Its coronary

stents also face challenges from Abbott and Medtronic.

We note that product pricing and customer demand

depend on the reimbursement policies set by government

agencies and managed care companies. Governments in

Europe and Japan, in particular, have imposed significant

price cuts on medical devices.

COMPANY DESCRIPTION

Based in Marlborough, Massachusetts, Boston Scientific

is a developer, manufacturer and marketer of medical devices

used in a range of interventional medical specialties, including

interventional cardiology, peripheral interventions, vascular

surgery, electrophysiology, oncology, endoscopy, urology,

gynecology and neuromodulation.

VALUATION

BSX trades at 19.7-times our adjusted 2018 EPS estimate,

compared to an average multiple of 17.6 for our coverage

universe of med-tech stocks. We believe this premium is

warranted based on the company's growth opportunities

through new product launches and acquisitions, expansion

into higher-growth markets, and success in boosting margins.

Our target price is $32.

On February 6 at midday, BUY-rated BSX traded at

$26.35, down $0.05. (Deborah Ciervo, CFA, 2/6/18)

Brinker International Inc (EAT)

Publication Date: 2/2/18Current Rating: HOLD

HIGHLIGHTS

*EAT: Earnings top estimates but comps disappoint

*While Brinker has traditionally relied on

above-peer-average increases in same-store sales to drive

earnings growth, it has seen weaker comps in recent quarters.

*In addition, management now appears to be relying

mainly on stock buybacks, as well as delayed G&A spending

and other cost-reduction efforts, to drive growth in EPS.

*We are concerned that Brinker will need to boost G&A

spending in the coming quarters, and that competitors'

promotions will require it to lower menu prices. We believe

this could weigh on earnings going forward.

*For investors seeking to invest in a restaurant company

with stronger growth prospects, we recommend the shares of

BUY-rated McDonald's Corp. (MCD).

ANALYSIS

INVESTMENT THESIS

We are maintaining our HOLD rating on Brinker

International Inc. (NYSE: EAT). While Brinker has

traditionally relied on above-peer-average increases in

same-store sales to drive earnings growth, it has seen weaker

comps in recent quarters. In addition, management now

appears to be relying mainly on stock buybacks, as well as

delayed G&A spending and other cost-reduction efforts, to

drive growth in EPS. We are concerned that the company will

need to boost G&A spending in the coming quarters, and that

competitors' promotions will require it to lower menu prices.

We believe this could weigh on earnings going forward. If

comp sales recover more than we anticipate or food costs

moderate significantly, we would consider returning the stock

to our BUY list. For investors seeking to invest in a restaurant

company with stronger growth prospects, we recommend the

Section 2.32


shares of BUY-rated McDonald's Corp. (MCD).

Based on potential benefits from additional refranchising,

our long-term rating remains BUY.

RECENT DEVELOPMENTS

On January 30, Brinker reported results for fiscal 2Q18

(ended December 27). Second-quarter revenue fell 0.6% from

the prior year to $766 million. The decline reflected 1.6%

lower comps at domestic Chili's, offset in part by 1.8% higher

same-store sales at Maggiano's. Revenue came in $8 million

below the consensus estimate. Excluding special items, EPS

rose 22.5% from the prior year to $0.87 and topped the

consensus estimate by $0.16.

Reflecting a 4.4% decline in restaurant traffic, offset in

part by a 0.6% contribution from a more favorable product

mix and a 2.3% contribution from improved pricing,

second-quarter same-store sales at company-owned Chili's in

the U.S. fell 1.5%. We believe the disappointing comps also

reflected aggressive promotions by quick-service restaurants

and overall weakness in the casual dining industry. The

consensus estimate had called for comps to increase 20 basis

points.

Maggiano's saw comps increase 180 basis points, as a

1.1% pricing increase and a 1.1% improvement in product

mix were partially offset by a 0.4% decline in restaurant

traffic. The consensus estimate had called for comps to

decline 0.4%.

Systemwide comps were down 1.0%, below the

consensus call for a 10-basis-point increase. Domestic

franchise comps fell 160 basis points from the prior year,

while international franchise comps increased 0.1%. G&A fell

to $33.1 million from $33.5 million, but held steady as a

percentage of revenue, at 4.3%. The consensus estimate had

called for G&A of 4.6% of revenue. Reflecting higher

restaurant labor costs, offset in part by a lower cost of sales,

the restaurant-level margin fell 20 basis points to 14.9%,

below the consensus estimate of 12.9%. Shares outstanding

fell to 46.4 million at the end of the quarter, down 8.1% from

the prior year. Interest expense rose from $13.6 million to

$14.3 million.

As discussed in a previous note, for all of FY17, revenue

decreased 3.3% to $3.1 billion, while earnings fell to $3.29

from $3.58 in FY16.


In fiscal 2Q18, the restaurant-level margin missed our

estimate by 10 basis points, and fell 20 basis points to 14.9%.

The margin deterioration reflected higher restaurant labor

costs, partially offset by a lower cost of sales. However, we

expect technology initiatives and kitchen upgrades

implemented over the last several years to benefit margins

over time. To further lower the cost of sales, management is

spending $20 million on new fryers, which are expected to

add 100 basis points to the restaurant-level margin.

For FY18, reflecting the positive impact of tax reform,

management now projects EPS of $3.42-$3.52. It expects

same-store sales to be flat to 1.5% higher and full-year

revenue to be up 0.5%-1.5%. It also looks for the FY18

restaurant-level margin to decline 25-40 basis points. The

company continues to buy back stock and has authorized an

additional $250 million in share buybacks, bringing the total

available authorization to $365 million. It expects a year-end

share count of 47-49 million.

Reflecting management's current guidance, we are raising

our FY18 EPS estimate from $3.40 to $3.50. For FY19, we

are increasing our estimate from $3.50 to $3.70. Both

estimates are above consensus.


We rate Brinker's financial strength as Medium, the

midpoint on our five-point scale. Over the past 12 months, the

shareholders' deficit fell by $3 million to $1.4 billion, and

long-term debt fell from $9.6 billion to $8.3 billion. Interest

expense rose from $13.6 million to $14.3 million. The credit

agencies rate Brinker's debt as investment grade.

Brinker has raised its quarterly dividend from $0.34 to

$0.38 per share, or $1.52 annually, for a yield of about 4.2%.

Our dividend estimates are $1.52 for FY18 and $1.72 for

FY19.

RISKS

Like all restaurant companies, Brinker faces the risk that

higher food and beverage costs may reduce earnings. The

company's results could also be affected by issues related to

food contamination at restaurants or increased public

perceptions of disease risk.

COMPANY DESCRIPTION

Brinker International, based in Dallas, Texas, is a leading

casual restaurant operator. The company owns or franchises

more than 1,600 restaurants under the Chili's Grill & Bar and

Maggiano's Little Italy brand names. Brinker also holds a

minority investment in Romano's Macaroni Grill. The shares

are included in the S&P MidCap 400.

VALUATION

EAT shares trade at 10.3-times our revised FY18 EPS

estimate and at 9.9-times our new FY19 estimate, versus a

three-year historical range of 5-18. Based on prospects for

continued weak same-store sales and management's current

guidance, we believe that the shares are fairly valued. If comp

sales recover more than we anticipate or food costs moderate

significantly, we would consider returning the stock to our

BUY list.

On February 1, HOLD-rated EAT closed at $36.94, up

$0.60. (John Staszak, CFA, 2/1/18)

CA Inc (CA)


HIGHLIGHTS

*CA: Better bookings trend; reiterating BUY and $40

target

*CA Inc. posted 3% GAAP revenue growth in fiscal

Section 2.33


1Q18, the strongest quarterly top-line comparison (on a

year-over-year basis) in six years.

*CA's mainframe solutions business has benefited from

IBM's release of the (relatively) new z14 mainframe; although

mainframe revenue was flat, earnings rose in the high single

digits.

*In the enterprise space, CA has issued an extensive list

of new offerings and product enhancements. Across its

portfolio, CA is positioning itself 'as the preeminent partner

for customers to build a Modern Software Factory.'

*On revenue, bookings and profit growth, fiscal 3Q18

demonstrated that CA is stabilizing its Mainframe Solutions

business and growing its Enterprise business.

ANALYSIS

INVESTMENT THESIS

BUY-rated CA Inc. (NGS: CA) posted 3% GAAP

revenue growth in fiscal 1Q18, the strongest quarterly top-line

comparison (on a year-over-year basis) in six years.

Non-GAAP EPS rose a healthy 20% from the prior year, the

first double-digit gain since 3Q14.

CA has benefited in its mainframe solutions business

from IBM's release of the (relatively) new z14 mainframe;

although mainframe revenue was flat, earnings rose in the

high single digits. In the enterprise space, CA has issued an

extensive list of new offerings and product enhancements.

Across its portfolio, CA is positioning itself 'as the preeminent

partner for customers to build a Modern Software Factory.'

Enterprise revenue was up a sharp 19% annually, although

profits declined on costs for new business development.

After multiple quarters in which weak contract renewals

caused overall bookings to decline significantly from the prior

year, CA experienced a rebound in bookings in 3Q18 and a

book-to-bill ratio above 1.0. Software bookings were

particularly strong; international bookings led on a regional

basis. In November 2017, the company had forecast a more

'normalized' renewal opportunity in the second half of fiscal

2018; even so, 3Q18 bookings exceeded our expectations.

On revenue, bookings and profit growth, fiscal 3Q18


business and growing its Enterprise business. We see room for

further earnings growth in FY18, leading to a promising

FY19. We are reiterating our BUY rating on CA to a

12-month target price of $40.

RECENT DEVELOPMENTS

CA shares are flat year-to-date in 2018, versus a 3% gain

for peers. The shares rose 5% in 2017, while the peer group of

information processing, storage & computing services

companies in Argus coverage was up 17%. CA rose 11% in

2016, approximately in line with the 12% gain for the peer

group. CA shares declined 6% in 2015, better than the 16%

average decline for the peers. Since our launch of coverage on

July 8, 2013, CA shares are up about 20%, while providing an

above-market yield ranging from 3.0% to as much as 3.8%.

For fiscal 3Q18 (calendar 4Q17), CA reported revenue of

$1.09 billion, which was up 9% year-over-year (7% in

constant currency) and 6% sequentially. Revenue topped the

$1.07 billion consensus forecast; management does not

provide quarterly top-line guidance. Adjusted earnings of

$0.75 per diluted share advanced 20% from the prior year and

were up $0.12 from fiscal 2Q18. The consensus had called for

2Q18 non-GAAP earnings of $0.60 per diluted share.

By business segment, Enterprise Solutions (ES) revenue

of $461 million (42% of total) was up 19% on a GAAP basis

and 16% in constant currency. ES revenue growth was driven

mainly by the Automic and Veracode acquisitions. CA

incurred higher costs to support the strong top-line growth,

causing ES profits to fall and margins to contract. The fiscal

3Q segment margin of 11.0% declined from 14.4% a year

earlier, but widened from 10.0% in 2Q18. The year-over-year

margin contraction had a positive side as it was driven by

higher commission costs related to an increase in sales.

Mainframe Solutions (MS) revenue of $552 million (51%

of total) was up 1% on a GAAP basis and flat in constant

currency. MS segment operating income advanced 8%

year-over-year, while supporting rich margins of 65.0%; the

margin growth was driven by a decrease in corporate

overhead. CA has a dominant position in mainframe software

alongside IBM, which produces z systems (mainframe) and

supporting software.

The (relatively) new z14 mainframe from IBM appears to

be driving higher levels of activity in this business, which

rarely posts a positive revenue comparison. Software

development will typically lag a new mainframe launch by

one or more quarters. Given that IBM is recording strong

system shipments for the z14, CA is confident about the

strength of the new hardware cycle.

Services revenue (7% of total) increased 11% annually

(9% in constant currency) mainly driven by service revenue

from the Automic and Veracode acquisitions. This business,

which has typically operated at a loss, posted a positive 2.0%

operating margin in 3Q18, aided by a decrease in personnel

costs.

After multiple quarters in which weak contract renewals

caused overall bookings to decline significantly from the prior

year, CA experienced a rebound in bookings in 3Q18 and a

book-to-bill ratio in excess of 1.0. In the seasonally strongest

bookings quarter, total bookings of $1.13 billion, though

down 10% annually, broke the weak first-half trend and

increased 56% sequentially. The book-to-bill ratio was 1.03.

Software bookings were particularly strong, with 61%

annual growth; that offset a 21% contraction in subscription &

maintenance bookings. In November 2017, the company had

forecast a more 'normalized' renewal opportunity in the second

half of fiscal 2018; even so, 3Q18 bookings exceeded our

expectations.

The company reiterated its fiscal 2018 outlook calling for

5% GAAP revenue growth (4% in constant currency). Based

on more favorable tax guidance, CA boosted its non-GAAP

EPS forecast, though GAAP earnings will be negatively

impacted by transitory effects of the new tax law.

Section 2.34


On revenue, bookings and profit growth, fiscal 3Q18


business and growing its Enterprise business. We see room for

further earnings growth in FY18, leading to a promising

FY19.


For fiscal 3Q18 (calendar 4Q17), CA reported revenue of

$1.09 billion, which was up 9% year-over-year (7% in

constant currency) and 6% sequentially. Revenue topped the

$1.07 billion consensus forecast; management does not

provide quarterly top-line guidance.

Adjusted earnings of $0.75 per diluted share advanced

20% from the prior year and were up $0.12 from fiscal 2Q18.

The consensus had modeled 2Q18 non-GAAP earnings of

$0.60 per diluted share.

For all of fiscal 2017, revenue of $4.04 billion was

approximately flat on a GAAP basis (up 1% in constant

currency), compared to $4.03 billion in FY16. Full-year

non-GAAP EPS came to $2.51, up 3% from $2.44 in FY16.

This was the first year of revenue growth since FY12 and the

first year of EPS growth since FY14.

The company reiterated its fiscal 2018 outlook calling for

5% GAAP revenue growth at the midpoint of the range (4% in

constant currency), to $4.22-$4.425 billion. Based on more

favorable tax guidance, CA boosted its non-GAAP EPS

outlook. It now projects 2018 non-GAAP EPS of $2.54-$2.60,

up from a prior $2.42-$2.48. However, GAAP earnings will

be negatively impacted by the transitory effects of the new tax

law.

Given the change in the effective tax rate as well as the

strong 3Q18 results, we are raising our FY18 non-GAAP

earnings forecast to $2.58 per diluted share from $2.44. We

are also boosting our FY19 forecast to $2.65 per diluted share

from $2.53. Our five-year EPS growth rate forecast is 8%.


Our financial strength rating on CA is Medium-High, the

second-highest rank on our five-point scale. CA issued $750

million in new debt at favorable interest rates in 4Q17. The

company is adding to liquidity as it steps up its M&A activity.

Cash & equivalents and investments were $2.97 billion at

the end of 3Q18. Cash was $2.77 billion at the end of FY17,

$2.81 billion at the end of FY16, and $2.80 billion at the end

of FY15.

Debt was $2.79 billion at the end of 3Q18. Debt was

$2.79 billion at the end of FY17, $1.95 billion at the end of

FY16, and $1.26 billion at the end of FY15. CA's debt is rated

investment grade by Moody's and S&P; both have stable

outlooks.

CA pays a quarterly dividend of $0.255 per share, or

$1.02 annually, for a yield of about 3.0%. The company has

not changed the dividend since 2011. Our dividend estimates

are $1.02 for both FY18 and FY19. The dividend appears

secure and sustainable. In FY13- FY17, cash flow from

operations covered the dividend by a factor of 2.0-3.0.

Management has said that cash flow is adequate to fund both

the dividend and share buybacks.

MANAGEMENT & RISKS

Michael Gregoire has been CEO since January 2013.

Kiernan McGrath has been appointed interim CFO, replacing

Richard Beckert, who retired on July 26, 2016. Adam Elster,

formerly head of Global Sales, is now president of Global

Field Operations.

Amit Chatterjee became head of Enterprise in May 2014.

The July 2013 hiring of chief marketing officer Lauren

Flaherty, previously with Juniper and IBM, should aid in CA's

goal of revitalizing the CA brand and leveraging increased

investment in R&D. The company has added Otto Berkes as

its chief technology officer, and Ayman Sayed as chief

product officer.

CA faces risks from general weakness in the economy,

which could lead many customers to postpone or cancel

software upgrades. It also competes with some of the world's

largest technology firms, including Oracle, IBM, and

Microsoft, and must continue to invest in new product

development.

COMPANY DESCRIPTION

CA Inc., a provider of enterprise information technology

management software, has three main business segments:

Mainframe Solutions, Enterprise Solutions, and Services.

CA's core business strengths are in IT management and

security products, and its largest clients include financial

services firms and government agencies.

INDUSTRY

We have raised our rating on the Technology sector to

Over-Weight from Market-Weight. Technology is showing

clear investor momentum, topping the market in the

year-to-date and trailing one-month and three-month periods.

At the same time, the average two-year-forward EPS growth

rate exceeds our broad-market estimate and sector averages.

This has kept technology sector valuations from becoming too

rich, and resulted in PEG ratios that are below the median for

all sectors.









above the market average, after rising 4.3% in 2015. The

sector is outperforming thus far in 2017, with a gain of 23.7%.







dividend yield.

Section 2.35


VALUATION

CA shares are trading at 13.0-times our FY18 EPS

forecast and at 12.7-times our FY19 forecast, compared to a

five-year (FY13-FY17) average P/E of 11.0. Lower historical

P/E's date to the years in which CA's revenue was contracting,

not growing as it is now. Within the software space, CA trades

at a discount to peers based on price/book, price/sales, and

price/cash flow.

Our two- and three-stage dividend discount models point

to a fair value for CA in the low $50s, in a stable trend. The

free cash flow yield is above the peer group average,

suggesting that the company could increase dividends and

stock buybacks. We are not looking for a dividend hike, but

we expect the company to continue its measured share

repurchase program while also investing in niche acquisitions.

We calculate a blended fair value for CA in the mid-$40s,

in a rising trend. Appreciation to our 12-month price target of

$40, combined with the dividend yield of about 3.0%, implies

a potential risk-adjusted return in excess of our forecast return

for the S&P 500, and is thus consistent with a BUY rating.

On February 6, BUY-rated CA closed at $33.70, up


Caterpillar Inc. (CAT)


HIGHLIGHTS

*CAT: Raising target price to $185

*CAT shares have shown strength relative to the market

over the past quarter, rising 20% compared to a 9.8% gain in

the S&P 500.

*In its latest earnings report, management was optimistic

about the outlook.

*We are boosting our 2018 adjusted EPS estimate to

$9.20 from $8.30 and expect continued growth in 2019.

*Despite the recent share price advance from cycle lows,

the shares appear to offer value, and we see strong growth

ahead.

ANALYSIS

INVESTMENT THESIS

Our rating on Caterpillar Inc. (NYSE: CAT) is BUY, as

operating results continue to improve. Valuations also remain

attractive, despite recent gains in the share price. This

well-managed firm has a strong balance sheet and a focus on

returning capital to shareholders. The business is highly

cyclical, and various commodity and currency trends are now

turning in the company's favor. Meanwhile, management has

been aggressively cutting costs. In recent conference calls,

management has highlighted positive developments in its end

markets. Moreover, on a macro basis, key commodity prices

have begun to firm, which could lead to better results over the

next several quarters. Despite the recent share price advance

from cycle lows, the shares appear to offer value, and we see

strong growth ahead. Our target price, based on our multipart

valuation model, is now $185, raised from $155.

RECENT DEVELOPMENTS

CAT shares have shown strength relative to the market

over the past quarter, rising 20% compared to a 9.8% gain in

the S&P 500. Over the past year, the shares are up 70%, while

the market has advanced 24%. The shares have outperformed

the industry ETF IYJ over the past 12 months but have

underperformed over the past five years. The beta on CAT is

1.60.

On January 25, Caterpillar reported 4Q17 results that

were up sharply from the prior year and ahead of consensus

forecasts. Sales of $12.9 billion rose a sequentially stronger

35% year-over-year, while operating margins improved 630

basis points to 12.8%, driven by volume gains and the

company's aggressive restructuring program. Adjusted EPS of

$2.16 rose 160% from the prior year and topped the consensus

forecast of $1.79. For the full year, CAT earned $6.88 per

share, well ahead of management's guidance of $6.25.

Along with the 4Q results, Caterpillar provided guidance

for 2018. The company projects adjusted EPS of $8.25-$9.25,

including a 24% tax rate.

Management noted that 'after four challenging years,' the

company is beginning 2018 with 'strong sales momentum'

resulting from strong order rates, lean dealer inventories, and

an increasing backlog. Caterpillar is preparing its factories and

suppliers to be ready for continued growth.


Caterpillar has four primary segments: Construction

Industries (approximately 40% of 4Q sales), Resource

Industries (17%), Energy & Transportation (36%) and

Financial Products (6%). Fourth-quarter results and segment

outlooks are summarized below.

In Construction Industries, sales soared 47% -- ahead of

the 37% gain in 3Q -- due to higher volume and pricing.

Operating profit grew 151% as the operating margin jumped

to 15.9% from 9.3%. Sales were higher across all regions. The

recovery in this segment is underway.

In Resource Industries, sales jumped 53% on higher

volume, and the segment once again rebounded from an

operating loss last year. The segment operating margin was

9.5%. This segment is driven by trends in the mining sector.

Commodity prices have bounced off multiyear lows in recent

months, which is a positive sign. Demand for parts remains

solid. We think the mining sector has moved past a trough, as

dealers are adding to inventories. But commodity prices will

need to stay at current levels.

In the Energy & Transportation segment, operating profit

increased 38%. This was driven in part by a 22% increase in

sales, which accelerated from 12% growth in the prior quarter.

Sales increased in all businesses: Industrial, Oil and Gas,

Power Generation and Transportation. The operating margin

rose 210 basis points to 18.7%. Stable-to-higher oil prices

should continue to support drilling and well-servicing in

North America, improving the growth profile.

Section 2.36


In the Financial Products division, operating profit rose

6% due in part to an increase in rates in North America and

higher earning assets in EAME and Asia/Pacific. The

allowance for credit losses at the end of the year was 1.33% of

finance receivables, compared to 1.29% at the end of 2016.

Against the backdrop of challenging global markets in

2014-2016, management took steps to cut costs. In 2017

restructuring costs totaled $1.256 billion due to the

consolidation of manufacturing facilities in Europe and the

U.S. Other costs are also likely to rise as business picks up.

Total worldwide employment rose 10% in 2017, to 116,700.

Based on expectations for stable-to-higher commodity

prices, a favorable pricing environment, and higher volume,

aided by management's restructuring activities, we are raising

our 2018 diluted adjusted EPS estimate to $9.20 from $8.30.

Our estimate is near the high end of management's guidance

range. We look for another recovery year in 2019, and are

implementing a preliminary EPS forecast of $10.55.


We rate Caterpillar's financial strength as Medium-High,

the second-highest point on our five-point scale. The company

receives above-average scores on our key financial tests of

leverage, fixed-cost coverage, cash flow generation, and

profitability.

At the end of 2017, CAT's debt/capitalization ratio,

excluding the Financial Products division, was 57%.

Caterpillar had cash and equivalents of $8.2 billion at the end

of the year. We keep a close eye on inventories at CAT. In

4Q, inventories were up 16% from the end of 2016 and

accounted for 13% of total assets, in line with recent trends.

CAT pays a dividend. The current rate is $0.78 per

quarter or $3.12 annually, for a yield of about 1.8%. The

company has paid dividends since 1933. Our dividend

estimates are $3.24 for 2018 and $3.50 for 2019.

Caterpillar also has a share repurchase plan.

RISKS

Caterpillar is undergoing a change in the executive suite,

as Chairman and CEO Doug Oberhelman has retired after

serving in those roles since 2010. The new CEO is Jim

Umpleby, formerly a Caterpillar group president with

responsibility for Energy & Transportation. Mr. Umpleby has

worked for Caterpillar for 35 years. The new chairman is

Dave Calhoun, a Caterpillar board member and a senior

managing director at Blackstone Group.

Caterpillar has a history of providing transparent results

to investors.

The company faces a range of operational and financial

risks, and its performance could be hurt by rising interest

rates, unfavorable exchange rate movements, declining

commodity prices, and weakness in the construction and

mining industries.

Caterpillar generates more than 50% of its revenue

overseas and its results are typically linked to global economic

trends, which are improving. Worldwide, we estimate that

global GDP is rebounding from a 3.1% growth rate in 2016 to

3.6% in 2018.

Caterpillar's results are also sensitive to trends in the

dollar. Looking ahead, we think the greenback is fairly valued

and likely to move in a trading range, particularly if the

Federal Reserve continues to slowly to raise short-term rates.

A stable or falling dollar would be a positive development for

the Industrial sector and Caterpillar.

The company also has an underfunded pension plan.

COMPANY DESCRIPTION

Caterpillar is the world's leading manufacturer of

construction and mining equipment, diesel and natural gas

engines, industrial gas turbines, and diesel-electric

locomotives. The company was founded in 1925. It is a

component of the Dow Jones Industrial Average and the S&P

500 Index.

VALUATION

We think that CAT shares are attractively valued at

current prices near $163. Caterpillar shares have traded

between $90 and $173 over the past 52 weeks, and are

currently near the high end of the range. From a technical

standpoint, the shares had been in a bearish pattern of lower

highs and lower lows that dated to the peak commodity-price

period of June-July 2014. However, since bottoming below

$60 in late January 2016, they have been in a bullish pattern

of higher highs and higher lows.

The shares tend to experience volatile swings to the

downside, and then recover. For example, on four occasions

in the past 15 years, CAT shares have fallen at least 35% in a

period of six months. On average during these downturns, the

shares have fallen 52% over a period of 14 months. The most

recent downswing lasted 22 months and saw the shares fall

50%. The shares have now recovered well above the

preceding high of $110.

On the fundamentals, CAT shares are trading at

17.8-times our 2018 EPS forecast, compared to a 15-year

annual average range of 13-25. On other metrics, the shares

are trading at a trailing price/book multiple of 7.1, near the

high end of the historical range of 2.5-7.5; and at a price/sales

multiple of 2.1, at the high end of the range of 0.8-2.1.

Compared to the peer group, the shares offer a higher yield

and a lower P/E. Our dividend discount model points to a fair

value above $200.

Despite their recent run, the shares appear to offer value,

and we see strong earnings growth ahead. We are raising our

price target to $185.

On January 31, BUY-rated CAT closed at $162.78, down

$0.98. (John Eade, 1/31/18)

Check Point Software Teches Lt (CHKP)


HIGHLIGHTS

*CHKP: Mixed 4Q17; reiterating $124 target

*Checkpoint posted 4Q sales and earnings in line with

Section 2.37


management's guidance, while continuing to work on a

turnaround of its U.S. business after a sales force

reorganization. Management expects two more quarters of

sales execution issues in the U.S.


$5.78 and establishing a 2019 forecast of $6.54.

*Our 2018 estimate is in the upper half of the company's

guidance range of $5.50-$5.90. Our long-term earnings

growth rate forecast is 10%.

*Due to the company's transition to a subscription-based

business model, more revenue is shifting into deferred

revenue - leading to slower growth in reported revenue.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on Check Point

Software Technologies Ltd. (NGS: CHKP to a target price of

$124. We see Check Point as one of the few players in

internet security with both the technology and the

management stability needed to take advantage of an

increasingly toxic malware threat environment. We also

believe that Check Point's focus on unified advanced threat

protection architecture and mobile services addresses the

needs of most companies, not just for the perimeter defense of

IT networks but also for the detection and neutralization of

advanced threats, including 'zero-day' attacks and the

emerging threat of 'ransomware.'

We also note that Checkpoint has been accelerating

investment in new technologies through tuck-in acquisitions

and new product development in order to expand its lead in

network security technology. Management also expects U.S.

sales to improve by the end of 2Q18 as execution issues are

resolved.

RECENT DEVELOPMENTS

Check Point reported fourth-quarter and full-year results

for 2017 on January 31. Fourth-quarter revenue rose 4%

year-over-year to $506 million, just above the $505 million

midpoint of management's guidance range but below the

consensus of $508.5 million. Deferred revenue rose 11% to

$1.187 billion. Management attributed the relatively weak

sales to continued execution issues in the U.S. and expects

these effects to continue in the near term. The sales execution

issues arose as the company reorganized its sales force and

placed new reps in key positions. It typically takes new reps a

few quarters to ramp up productivity. On the positive side,

Security Subscriptions revenue rose 18% as the company

revised its product offerings.

The 4Q non-GAAP operating margin expanded by 300

basis points to 57.7%. However, management mentioned on

the call that it expects full-year margins in the 53%-54%

range. Non-GAAP EPS rose 8% year-over-year to $1.58, well

above management's guidance of $1.30-$1.40 and the

consensus of $1.51. Non-GAAP EPS excluded a $0.13 impact

from stock-based compensation in 4Q17 and 4Q16 and $0.02

for the amortization of intangibles and acquisition expenses in

both 4Q17 and 4Q16. GAAP EPS rose 11% to $1.46.

Transactions above the $50,000 level accounted for 75%

of total order value, similar to 4Q16. Some 110 customers had

transactions greater than $1 million in the fourth quarter, up

11% from 4Q16.

For the full year, revenue rose 7% to $1.855 billion.

Non-GAAP EPS rose 13% to $5.33 in 2017 from $4.72 in

2016.



$5.78 and establishing a 2019 forecast of $6.54. Management

has noted that due to the company's transition to a

subscription-based business model, more revenue is shifting

into deferred revenue. Our 2018 estimate is in the upper half

of the company's guidance range of $5.50-$5.90. Our


To address the emerging IT security landscape,

Checkpoint began significantly expanding its product

development, sales, and marketing teams more than a year

ago. The company has also been hiring additional 'feet on the

street' in a sales force expansion. While this has led to some

short-term sales execution issues in the U.S., management

expects these to dissipate over the next few quarters as the

new reps become more productive. Further, Checkpoint has

strengthened its technological edge through the introduction

of new software and appliances designed to meet advanced

cyber threats. R&D spending increased to more than 10% of

revenue in 2017, up from 9.2% in 2015. Still, despite

continued reports of new and more dangerous cyberattacks,

Checkpoint believes that most enterprises' internet security

systems are at least two generations behind the attackers and

unequipped to handle next-generation cyber-security threats.

Management sees this as an extraordinary market opportunity.

In 2018, the company remains focused on expanding security

applications related to cloud computing; mobile, including the

emerging Internet of Things; and as usual, threat prevention.

The company announced a new consolidated security

architecture called Check Point Infinity on April 20, 2017

during its user conference. The company calls Check Point

Infinity 'the first consolidated security (platform) across

networks, cloud and mobile, providing the highest level of

threat prevention against both known and unknown targeted

attacks.' However, we know that other security software

companies, including Symantec and Palo Alto (both under

Argus coverage), have been emphasizing integrated security

platforms for some time. Still, we think that Checkpoint's solid

technology base, along with its focus on threat prevention and

remediation management rather than simply on detection,

provide a coherent value proposition to clients. Checkpoint

also introduced a host of other new security

applications/updates at its user conference. The company

refreshed its security appliance lines, and Check Point vSEC

Cloud security updated its portfolio of private/public cloud

security applications. Other introductions were a new

SandBlast mobile firewall and Check Point Anti-Ransomware

Section 2.38


to address a growing security threat.

Checkpoint has pinpointed two major threats to cyber

security. They are, first, attacks by next-generation malware

that can be programmed and remotely controlled, and that can

disguise itself by morphing within a system; and, second, the

vulnerability caused by the increase in mobile computing and

the Internet of Things. Checkpoint has initiated its 'one step

ahead' program to stay ahead of the curve on cyber threats. In

2015, it launched Mobile Threat Prevention security solutions

with its trademarked SandBlast technology. Sandblast, an

advanced sandbox solution that restricts files with unknown

malware, is combined with Checkpoint's proprietary

CPU-level threat emulation technology.

FINANCIAL STRENGTH

Our financial strength rating for Check Point is High, the

top of our five-point scale. Trailing 12-month free cash flow

rose 16% to $1.04 billion. Management expects 2018 free

cash flow to be 'in line' with 2017, i.e., a little over $1 billion.

Check Point repurchases about $250 million of common

stock per quarter. It bought back 9.5 million shares for $995

million in 2017. The share count has fallen 3% over the last

year. The company does not pay a dividend.

MANAGEMENT & RISKS

Risks to Check Point's growth include downturns in

software investment spending; increased competition,

including Microsoft's entry into IT security; and the

company's ability to execute its business plans. Volatility in

CHKP shares may be affected by the company's ability to

meet financial expectations.

The market for software security is intensely competitive,

with many large players (Cisco, Juniper, IBM, Microsoft, and

Symantec) and smaller startups like Palo Alto Networks and

FireEye that offer competing solutions to Check Point. Cisco

stepped up its security offerings with its acquisition of

cyber-security firm Sourcefire for $2.7 billion in 2013. The

software security market is fast-changing, which requires

Check Point to continually update and upgrade its product

offerings to remain ahead of the curve. It is of utmost

importance to clients that the company's security software

solutions be designed to be both highly secure, i.e., without

holes that might allow an attacker to penetrate, and extremely

stable, to prevent clients' systems from crashing. If new Check

Point products fail either of these critical tests, clients may go

elsewhere.

Check Point carries significant client concentration risk.

Most of its sales are through third-party distributors. In 2016,

about 52% of the company's sales were generated by its top

ten distributors; the top two distributors accounted for about

37% of sales.

Check Point faces integration risk from recent and

potential future acquisitions. We judge the risk to be modest

since the company tends to acquire intellectual property that

complements its existing technologies. The downside risk is

that the company could overpay for intellectual property or

find it less useful than expected.

Another downturn in global software investment

spending would likely translate into a significant drop in the

CHKP share price. In addition, rapid technological changes

and shifts in the industry's competitive structure could affect

the company's growth prospects. As with many enterprise

technology companies, Checkpoint's results are seasonal, with

a large portion of revenue falling into the fourth (December)

quarter and a corresponding falloff in the first (March)

quarter. The market could misread this revenue seasonality.

Check Point, which is headquartered in Israel, could also

be adversely affected by geopolitical turmoil in the Middle

East.

COMPANY DESCRIPTION

Check Point Software Technologies Ltd. creates and

markets internet security products for enterprises and high-end

networks, internet service providers, small and medium-sized

businesses, and consumers. The company's perimeter security

products include virtual private network and firewall products,

security management products, and ZoneAlarm security suites

for consumers and small businesses. Check Point's revenue

base consists of subscription and perpetual software licenses,

product sales, subscription-based fees for updates, and

maintenance and consulting fees. Incorporated in 1993, Check

Point has a global workforce and maintains headquarters in

Tel Aviv, Israel. About 51% of the company's revenue is

derived from outside the U.S.

VALUATION

CHKP shares are trading below the midpoint of their

52-week range of $98-$119. The shares have risen 4% in the

last year, well below the 32% return for the Nasdaq and the

41% gain for the Nasdaq Computer Index. Checkpoint's

enterprise value to trailing 12-month EBITDA multiple of 14

is near the peer median. The forward enterprise

value/EBITDA multiple of 11.9 is 24% below the peer

average, greater than the average discount of 16% over the

past two years. As Checkpoint is a market leader, we believe it

deserves to trade at a premium. We are maintaining our BUY

rating on CHKP with a target price of $124.

On January 31, BUY-rated CHKP closed at $103.41,

down $1.00. (Joseph Bonner, CFA, 1/31/18)

CME Group Inc (CME)


HIGHLIGHTS

*CME: Lifting target to $174 as tax cuts boost outlook

*On February 1, CME reported adjusted 4Q17 earnings

of $1.12 per share, down from $1.14 in the prior-year period

but $0.03 above consensus.

*After generally sluggish trading volume in 2017,

management noted that average daily trading volume has risen

15% thus far in 2018.

*Management projects an effective tax rate of 24.5% in

2018, down from 35.0% in 2017. It also expects relatively flat

Section 2.39


operating expenses this year.

*With operating margins near record highs, we believe

that CME shares should trade at a premium to historic

valuation levels.

ANALYSIS

INVESTMENT THESIS

Our rating on CME Group Inc. (NGS: CME) remains

BUY following the company's 4Q results. Our target price is

$174, raised from $142 to reflect the expected earnings benefit

from a lower tax rate. CME Group is a futures and derivatives

exchange and clearing company offering risk management

products across six major asset classes.

Continued market volatility in most of these asset classes

should drive high contract volume, particularly in equity,

interest rate, energy and commodity products. Geopolitical

developments that lead to portfolio repositioning, as well as

hedging and speculative activities, should also continue to

result in elevated trading volumes. Contract volume eased a

bit to 15.9 million in 4Q, although the company referenced a

15% improvement in volume through the end of January. We

expect revenue leverage in 2018 as the company holds

operating expenses largely flat with 2017.

With operating margins near record highs, we believe that

CME shares should trade at a premium to historic valuation

levels.

RECENT DEVELOPMENTS

Over the past year, CME shares have risen 28%, versus a

24% increase in the broad market.

On February 1, CME reported adjusted 4Q17 earnings of

$1.12 per share, down from $1.14 in the prior-year period but

$0.03 ahead of consensus. The adjusted results exclude a net

$7.51 per share of nonrecurring gains, mainly related to a

reduction in deferred tax liabilities following the passage of

the new tax law.

Fourth-quarter revenue declined 1.4% to $900 million,

with lower clearing outweighing higher market data revenue.

Average daily contract volume fell 2.5% to 15.9 million.

Adjusted operating expenses rose less than 1%, as higher

compensation costs were offset by lower professional fees and

outside services, while adjusted net income declined 1.1% to

$383.0 million.

For all of 2017, revenues rose 1.4%, while adjusted EPS

climbed to $4.77 from $4.53.


Revenue growth for CME is mainly driven by increases

in average daily contract volume (ADV), a measure of the

average number of contracts traded and/or cleared in a day,

and by growth in the rate per contract (RPC), the average

transaction and clearing fee generated from a contract.

Average contract volume was down 2.5% in 4Q, with

weakness in interest rate and equity products partly offset by

strength in foreign exchange products. Despite sluggish

trading activity in 2017, CME was able to grow overall

contract volumes with help from product additions. We

believe that the revenue growth outlook remains healthy for

most CME products, which include derivative contracts

related to interest rates, equities, foreign exchange, energy,

agricultural commodities, and metals. We expect contract

volume to remain near recent highs as investors speculate or

hedge positions based on geopolitical developments, currency

volatility, and prospects for additional interest rate hikes.

Indeed, 2018 volumes have started off much stronger than the

2017 run rate. We look for 8% revenue growth in 2018, up

from 1% in 2017.

After surpassing $100 million in each quarter of 2016,

market data fees fell below that mark in all but the fourth

quarter of 2017. We expect some rebound in this line in 2018

as the company implements price increases in the second

quarter.

Management projects relatively flat operating expenses in

2018 as it continues to tightly manage costs. Compensation

costs have been well controlled at around 15%-16% of

revenues.

Management has guided toward an effective tax rate of

24.5% for 2018, down from 35.0% in 2017, following the

recent passage of the Tax Cuts and Jobs Act. Reflecting this

lower rate, we are raising our 2018 EPS estimate to $6.20

from $5.37. We are also initiating a 2019 forecast of $6.68.

Our long-term EPS growth rate forecast is 8%.


Our financial strength rating on CME Group is High, the

highest point on our five-point scale. The company scores

above average on important financial criteria such as debt

levels, interest coverage, and profitability.

CME had $1.9 billion in cash and cash equivalents and

$2.2 billion in debt as of December 31, 2017. The

debt/shareholders' equity ratio at that time was 10.0%. The

operating income/interest coverage ratio was a robust 18.5 in

4Q17 and the operating margin was a healthy 60%.

In March 2017, the company raised its quarterly dividend

by 10% to $0.66, or $2.64 annually, for a yield of about 1.7%.

The company has a strong record of increasing its payout. The

payout ratio on projected 2018 earnings is 48%. Management

is committed to returning excess capital to shareholders, and

we expect a payout ratio in the low to mid-50s over the next

several years. Our dividend estimates are $3.00 for 2018 and

$3.20 for 2019.

The company also occasionally pays an annual special

dividend based on operating results, potential merger and

acquisition activity, and other forms of capital return,

including regular dividends and share buybacks. It paid a

$3.25 per share special dividend in January 2017.

MANAGEMENT & RISKS

Terry Duffy became chairman and CEO at the end of

2016 following the retirement of Phupinder Gill. Mr. Duffy

had been president of CME Group since 2012. Bryan Durkin,

previously chief commercial officer, was named president as

part of the transition.

Section 2.40


Management's growth strategy focuses on new product

development, new customer acquisition, and global

expansion. In our view, management has done a good job of

launching new products that respond to regulatory changes. It

also provides helpful financial guidance to the investment

community.

Price competition is a key risk for CME. Key exchange

competitors include Intercontinental Exchange, Hong Kong

Exchanges and Clearing, and the Eurex Group. The

company's clearing operations also face increasingly stiff

competition due to the implementation of Dodd-Frank. Many

exchanges, such as ICE, have their own clearing houses.

Other clearing houses include Depository Trust & Clearing

Corp.

New regulations and regulatory uncertainty also pose

risks for CME. The company is subject to regulation by the

CFTC in the U.S. as well as by overseas regulators. Other

risks include market weakness in Europe, cyber security

threats, and legal and counterparty risks.

COMPANY DESCRIPTION

CME Group is a futures and derivatives exchange and

clearing company. It operates exchanges such as the Chicago

Mercantile Exchange (CME), Chicago Board of Trade

(CBOT), New York Mercantile Exchange (NYMEX),

Commodity Exchange (COMEX) and the Kansas City Board

of Trade (KCBT). In addition, CME offers a range of market

data and information services. CME shares are a component

of the S&P 500.

VALUATION

CME shares have traded in a range of $115-$158 over the

past 52 weeks, and are currently at the high end of that range.

We approach valuation from a few angles. CME's P/E

ratio of 25.0-times our revised 2018 EPS estimate is above the

midpoint of the historical range of 9-27. However, based on

favorable operating metrics and a healthy industry

environment, we believe that the shares merit a higher

multiple. Compared to the peer group, CME shares trade at a

premium P/E, which we think is warranted based on the

company's above-peer-average (and generally expanding)

operating margins above 60%. Our target price of $174, raised

from $142, implies a multiple of 28-times our 2018 EPS

estimate. A recurring annual dividend adds to the total return

potential.

On February 1 at midday, BUY-rated CME traded at

$157.92, up $4.44. (Stephen Biggar, 2/1/18)

Corning Inc (GLW)


HIGHLIGHTS

*GLW: Solid finish to 2017; reiterating BUY

*Corning posted solid results for 4Q17. Core revenue and

EPS were impacted by unfavorable currency movements and

investments in future growth, and non-GAAP EPS dipped 2%

year-over-year.

*Despite the currency headwind, the Display business

continues to benefit from less onerous price declines.

Environmental is being helped by global growth positively

impacting the North American trucking industry.

*Corning has returned over $9.0 billion to shareholders

via buybacks and dividends within a larger plan to return

$12.5 billion by 2019.

*Although GLW is ahead of peers and the market over

the past 12 months, we believe the shares remain attractively

valued given a multiyear period of underperformance and

growth prospects ahead.

ANALYSIS

INVESTMENT THESIS

BUY-rated Corning Inc. (NYSE: GLW) posted solid

results for 4Q17, led by now familiar strength in Gorilla Glass

and Optical Communications. Despite the currency headwind

related to yen strength, the Display business continues to

benefit from less onerous price declines. Among the smaller

units, Environmental is being helped by global growth

positively impacting the trucking industry, while Life

Sciences grew in high single digits for 4Q17.

Corning's leadership priorities through 2019 are to focus

the portfolio of assets and utilize financial strength. This

includes enhancing five market access portfolios while

deploying $26-$30 billion in cash through 2019. The company

has generally maintained its strategy across the market access

portfolios, while tweaking its goals. Corning is expanding the

opportunity set in automotive, environmental and life

sciences.

In a generally rising environment for technology shares,

GLW topped $32.60 late in 2017 before backing down amid

profit-taking in technology shares. Given a multiyear period

of underperformance, we believe the shares remain

attractively valued. The tighter focus on core operations,

leadership in optical and Gorilla, signs of improving growth in

the smaller businesses, and stabilizing trends in display

highlight GLW's positive prospects. We are reiterating our

BUY rating to a 12-month target price of $36.

RECENT DEVELOPMENTS

GLW shares are up 1% year-to-date, versus a 2% gain for

the peer group of Argus-covered Communications Equipment

companies. That follows a strong 2017 for GLW, in which the

stock rose 32% while peers were up just 7%. GLW also

surged 33% in 2016, compared to a 9% gain for the peer

group. GLW declined 20% in 2015, compared to a 6% decline

for the peer group. The shares rose 29% in 2014 and 41% in

2013.

For 4Q17, Corning reported core (non-GAAP,

currency-adjusted) revenue of $2.74 billion, which was up 7%

annually; and above the $2.65 billion consensus forecast.

Non-GAAP EPS of $0.49 per diluted share for 4Q17 was

down 2% year-over-year and was $0.02 above consensus

expectations.

Section 2.41


More so than many technology companies, Corning uses

the year-end quarter to advance and refine its business model

and financial structure for the years ahead. Corning's strategy

and priorities are generally intact from earlier in the year,

although there have been slight emphasis shifts in several

market access platforms, including Environmental and Life

Sciences. The opportunity set in Automotive has also been

expanded.

Broadly speaking, Corning's leadership priorities through

2019 are to focus the portfolio of assets and to utilize financial

strength. This includes enhancing five market access

portfolios while deploying $26-$30 billion in cash through

2019.

In terms of focusing the portfolio across the company's

five market access platforms, Corning believes Optical

Communications can be a $5 billion annual revenue business

by 2020. In the mobile consumer electronics platform, the

goal is to double sales in coming years, led by Gorilla Glass.

In automotive, Corning seeks to build a $500 million GPF

(gasoline particulate filter) while pushing into display and

tough window glass. In Display, the goal remains stabilizing

returns while winning in new display categories. And in Life

Sciences, Corning seeks to build out its pharmaceutical

packaging business while growing faster than markets served.

In terms of utilizing financial strength, Corning plans to

return $12.5 billion to shareholders through 2019 via share

buybacks and a dividend increase of at least 10% annually.

The company will also invest approximately $10 billion in the

business in order to enhance growth and sustain leadership.

Within its Strategy and Capital Allocation Framework, since

October 2015 Corning has returned over $9 billion to

shareholders while investing $4.5 billion in R&D, capital

spending, and M&A. Corning will also maintain a ratio of

target debt/EBITDA of about 2.0.

During 4Q17, on a core basis, Corning posted

double-digit annual growth in three businesses - Optical

Communications, Environmental, and Specialty Materials -

and high single-digit growth in Life Sciences. Only the

display business declined annually. Operating profit improved

in double digits in Environmental, Life Sciences, and

Specialty Materials.

At the segment level and on a core basis, Display

technology core revenue of $847 million was down 6%

annually. Display net profit of $221 million declined 20%

annually; margin compressed to 26.1% in 4Q17 from 30.5% a

year earlier.

Display volumes were up slightly on a sequential basis, in

line with market growth and ahead of internal expectations.

Volume growth in this business has historically been driven

by larger screen sizes, which is helping offset the shrinking

pace of notebook and (in particular) desktop PC sales.

Corning's display business confronts a relentless

reduction in display glass pricing, although downtrend

moderated in the past year. Display pricing in 4Q17continued

its moderating trend, declining less on a sequential basis than

in 3Q17.

Display prices have declined less in every year since

2014, and were in high single digit in 2017. For 2018,

Corning expects mid-single-digit price declines, with three

factors driving the positive trend. Glass supply is balanced

with demand, and in some places tight. Corning's Gen 10.5

plant supports expected growth of large-sized TVs and

produces in cooperation with a major customer. Below gen

10.5, demand continues to grow and capacity additions are not

keeping up.

The second factor is that competitors are unprofitable at

current prices, and will have to slow their price declines to

survive. Finally, customers recognize that LCD manufacturing

requires investments that must be paid for with rational glass

pricing. Also for 2018, Corning forecasts LCD market glass

volume to grow mid-single-digits, mainly tracking higher

average TV screen size. Corning expects its volumes to grow

faster than the market in 2018.

In 2017, Optical Communications (OC) reclaimed the

mantle as Corning's largest business by revenue contribution.

OC revenue of $928 million for 4Q17 was up 13% annually

and at its highest level since 3Q01 (immediately before this

business was cut in half by the internet implosion and 9/11).

OC segment profits of $84 million, however, backed down

6% annually and also sequentially from $111 million in 3Q17

as the company invested to support growth in 2018 and

beyond. Corning added new fiber and cable capacity and new

products for Saudi Telecom. During 2017, OC sales to carrier

customers (77% of OC revenue) rose 20%, while sales to

enterprise and data center customers were up 13%.

For 2018, Corning is modeling low double-digit revenue

growth excluding any contribution from the pending

acquisition of 3M's communications market division; this

business will add $200 million in annual sales, be neutral to

2028 core earnings, and be accretive thereafter. Management

expects OC profitability to rise through the course of 2018 as

the division ramps to meet committed customer demand.

Management has pledged to attain $5 billion in annual sales

for its optical communications market-access platform by

2020.

For 4Q17, Specialty Materials (SM) again posted all-time

high revenue and profits. Sales of $393 million increased 17%

annually, while profits of $73 million increased 12%. SM

operating margin was 18.6%, down from 19.3% a year earlier.

Full-year 2017 sales growth for SM rose 25%, and annual

profits rose 32%.

SM sales and profit growth in 4Q17 was driven by strong

shipments of Gorilla Glass 5th generation tough cover glass to

support multiple new smartphone launches. Although the

holiday season is over, positive trends should continue and

management forecasts further growth for 2018; as always, the

magnitude of growth is dependent on new OEM product

launches and consumer acceptance.

Corning's two smaller businesses, Environmental and Life

Sciences, surprised with high-single- to low-double-digit

growth in 4Q17. Environmental revenue (11% of total)

improved 19%, representing the best quarterly growth for the

Section 2.42


2017 year, as the North American heavy duty diesel market

continues to improve. Environmental segment profits grew

33%.

Life sciences revenue (8% of total) rose 9% in 4Q17,

while core profits were up 18%. For 2018, revenue for both

Environmental and Life Sciences is expected up in

high-single-digits for the year.

The display glass business is primarily conducted in

Japanese yen, not dollars, and is influenced by movements in

the yen and the Korean Won (KRW). Corning employs

translation hedges to add more certainty to earnings and cash

flow while protecting against adverse currency swings. Hedge

contracts settled in any quarter substantially offset the change

in Display earnings and cash flow related to currency

movements. Corning is adjusting its constant currency rates

for 2018-2020 to yen 107 and KRW 1,175 to align with the

company's economic exposure.

For 2018, Corning is modeling core sales growth of 7%,

to about $11 billion. Core gross margin for the year is forecast

sequentially stable with the 41.3% level from 2017; core

operating costs should be about $2.2 billion; and the core tax

rate is forecast at 20%-22%. According to our model, that

supports mid- to upper-single-digit percentage EPS growth,

despite ongoing investments in the business and the declining

price trend in display glass.

In a generally rising environment for technology shares,

GLW topped $32.60 late in 2017 before backing down amid

profit-taking in technology shares. Given a multiyear period

of underperformance, we believe the shares remain

attractively valued. The tighter focus on core operations,

leadership in optical and Gorilla, signs of improving growth in

the smaller businesses, and stabilizing trends in display

highlight GLW's positive prospects. We are reiterating our

BUY rating to a 12-month target price of $36.


For 4Q17, Corning reported core (non-GAAP,

currency-adjusted) revenue of $2.74 billion, which was up 7%

annually; and above the $2.65 billion consensus forecast. Core

or non-GAAP gross margin was 41.0% for 4Q17 versus

42.0% for 3Q17 and 40.0% a year earlier.

The core operating margin was 18.7% for 4Q17, down

from 20.4% for 3Q17 and 23.1% a year earlier. Non-GAAP

EPS of $0.49 per diluted share for 4Q17 was down 2%

year-over-year and was $0.02 above consensus expectations.

Corning posted a GAAP loss of $1.45 per share, reflecting a

one-time $1.4 billion tax charge.

For all of 2017, Corning's core revenue of $10.51 billion

increased 8% from $9.71 billion for 2016. Non-GAAP core

earnings totaled $1.72 per diluted share for 2017, up 10%

from $1.57 per diluted share for 2016.

Corning provides directional rather than explicit

guidance. For 2018, Corning is modeling core sales growth of

7% to about $11 billion. Core gross margin for the year is

forecast sequentially stable with the 41.3% level from 2017;

core operating costs should be about $2.2 billion; net

non-operating expense of about $200 million; Core equity

income of $200 million; and core tax rate is forecast at 20%

-22%.

Principally on the higher tax rate, we are reducing our

2018 core earnings forecast to $1.82 per diluted share, from

$1.98. We are initiating a 2019 core EPS forecast of $1.93 per

diluted share. Our long-term earnings growth rate forecast is

10%.


Our financial strength rating for Corning is


scale. The Dow Corning transaction added $4.8 billion to the

balance sheet. Corning also reduced cash with aggressive

buybacks. In October 2015, Corning announced a new capital

allocation plan. The plan proposed returning $10 billion to

shareholders and investing $10 billion in the business into

2020. Following the Dow Corning deal close, Corning raised

its shareholder return target to more than $12.5 billion by

2019.

Cash & investments were $4.3 billion at year-end 2017.

Cash & investments were $5.2 billion at year-end 2016, down

from $7.1 billion at the end of 2Q16 following a $2 billion

accelerated stock repurchase executed in summer 2016.

Before the infusion from the Dow Corning transaction, cash

was $3.54 billion at the end of 1Q16. Cash at the end of 1Q16

was reduced by more than $2 billion in share repurchases

under the revised capital allocation plan. Cash & investments

were $4.6 billion at the end of 2015, $6.1 billion at the end of

2014, and $5.23 billion at the end of 2013.

Debt was $5.13 billion at year-end 2017. Debt was $3.90

billion at year-end 2016. Debt/cap was 23.5% at 3Q17.

Debt/cap was 20.0% at year-end 2016, down from 22.1% at

the end of 1Q16. Debt/cap was 21.4% at year-end 2015,

15.9% at the end of 2014, and 13.5% at the end of 2013.

Net debt was $811 million at year-end 2017. Net cash

was $1.39 billion at year-end 2016, reduced from $2.95

billion at the end of 2Q16. Net cash was $118 million at the

end of 2015, $2.42 billion at the end of 2014, and $1.96

billion at the end of 2013.

Cash flow from operations was $2.00 billion for 2017.

Cash flow from operations was $2.50 billion in 2016, $2.81

billion in 2015, $4.71 billion in 2014, and $2.8 billion in

2013; 2014 included a $1.4 billion currency hedge gain.

In October 2015, within its multiyear capital allocation

plan, Corning's board authorized a new $4 billion buyback

program. The company executed an accelerated $1.25 billion

buyback in 4Q15, spent $750 million to repurchase shares in

1Q16, and spent $810 million to buy shares in 2Q16. On

7/27/16, Corning announced and then executed an additional

accelerated $2 billion buyback. The buyback will largely

offset the EPS impact from the loss of Dow Corning equity

earnings.

Corning has pledged to raise the dividend by at least 10%

annually through 2019. In February 2017, it raised its

quarterly dividend 14.8% to $0.155. Corning previously

Section 2.43


raised its dividend to $0.135 per common share in February

2016, to $0.12 per share in December 2015, to $0.10 in April

2013, and to $0.09 in October 2012. Corning had paid a

quarterly dividend for much of its 150-year history before

suspending the payment in July 2001.

Reflecting management's capital allocation guidance and

the February 2017 hike, our annual dividend forecasts are

$0.70 for 2018 and $0.78 for 2019.

MANAGEMENT & RISKS

Wendell Weeks is the highly regarded chairman and CEO

of Corning. CFO Jim Flaws retired in November 2015 after

more than 40 years with the company. Tony Tripeny is CFO.

Corning's division leaders report directly to CEO Weeks.

The entire executive team is well regarded by investors and

industry participants. James Clappin is president of Corning

Glass Technologies. Richard Eglan is VP and general

manager of the Life Sciences business. Mark Beck leads the

Environmental Technologies segment.

Corning's exit from Dow Corning makes strategic sense.

The deal allows Corning to end exposure to a noncore

business, while significantly enhancing balance sheet cash for

future strategic actions.

We also believe the buyout of SCP was a sound move.

Corning will now have more direct exposure to the coming

wave of low-cost Chinese display glass producers. However,

Corning is experiencing strong demand in its role as market

leader.

A key risk is the uneven demand for flat-panel televisions

from quarter to quarter. The company has managed through

such a period and now expects improving demand. Lesser

risks include the threat of competitive inroads; Nippon

Electric Glass is now producing bulk quantities of

generation-5 glass. For the telecom business, risks include a

further contraction in carrier capital spending after some

modest signs of recovery.

Both in display and telecom, demand risks are mitigated

by Corning's proprietary technology, low-cost operations, and

well-established relationships with leading customers. While

global demand for LCD sets may soften for a few quarters, we

do not anticipate a multiyear collapse in global demand, as

occurred in telecom in 2000-2002.

COMPANY DESCRIPTION

Corning Inc. is the leading global supplier of precision

glass for liquid crystal displays, and a leader in the

manufacture and sale of optical fiber and cable. It participates

in the environmental business, with a focus on emission

substrates for gasoline and diesel engines, and is also active in

the life sciences business. Specialty Materials operations

produce Gorilla Glass, the fast-growing, tough-cover glass

used in smartphones and tablets.

INDUSTRY























dividend yield.

VALUATION

GLW is trading at 17.8-times our 2018 non-GAAP core

EPS estimate and at 16.8-times our 2019 forecast; the

five-year (2013-2017) historical average P/E is 14.0. In a

rising market, relative P/E of 0.94-times remains reasonably

close with historical relative P/E multiples in the 0.82 range.

GLW trades at a discount to peers on absolute P/E, relative

P/E and on EV/EBITDA. Overall comparable historical

valuation points to a fair value near $30, in a rising trend

though below current prices.

Our discounted free cash flow model now renders a value

for GLW in the high-$60s, in a rising trend. Corning's major

capital expenditures (glass tanks) have largely been

completed, supporting ongoing cash flow strength.

On a blended basis, we calculate a fair value in the upper

$50s, in a rising trend. Appreciation to our 12-month target

price of $36 along with the indicated dividend yield of about

1.9%, implies a risk-adjusted total return of about 15%, which

exceeds our forecast for the broad market and is thus

consistent with a BUY rating.

On January 31, BUY-rated GLW closed at $31.22, down


Danaher Corp (DHR)


HIGHLIGHTS

*DHR: Raising target price to $115

*DHR shares have performed in line with the market over

the past quarter, rising 10%.

*On January 30, the company reported 4Q results that

rose from the prior year and topped analyst expectations.

*Management has a history of double-digit dividend

growth, and we expect an increase in the payout in the next

few weeks.

Section 2.44


*Our target price of $115 assumes a P/E of 23-times our

2019 earnings estimate, within the normal historical range.

ANALYSIS

INVESTMENT THESIS

Our rating on Danaher Corp. (NYSE: DHR) is BUY. This

leading blue-chip industrial company appears poised to

deliver mid-single-digit core sales growth, which, along with

acquisitions and margin expansion, has the potential to drive

low double-digit earnings growth over time. Danaher typically

pursues acquisitions in niche markets with little competition,

and drives improvement in operational efficiency and product

quality through its 'Danaher Business System.' We believe the

coming years will present a favorable environment for

acquisitions, and expect Danaher to continue to streamline

operations and boost margins at acquired companies. The

company recently completed the transformative acquisition of

Pall Corp., and has now separated into two independent

companies. The new Danaher is focused on Med-Tech

businesses. Since the split, management has gotten back to

making new deals and the outlook is positive. Our revised

target price of $115, raised from $100, implies a multiple of

23-times our 2019 EPS estimate, still within the normal

historical range for this well-managed company. We think the

DHR shares are a suitable core holding in a diversified

portfolio.

RECENT DEVELOPMENTS

DHR shares have performed in line with the market over

the past quarter, rising 10%. Over the past year, the shares

have underperformed the market (21% versus 24%), as well as

the industry ETF IYJ (27%). Over longer periods - 5 and 10

years - DHR has outperformed the market and the industry by

wide margins. The beta on DHR shares is 0.98.

The company is emerging from a transformative period.

On July 5, 2016, Danaher split into two companies, the

ongoing Danaher and the new Fortive (NYSE: FTV). Fortive

is an industrial growth company comprised of Danaher's

former Professional Instrumentation and Industrial

Technologies businesses. Danaher is now more focused on

medical technology.

On January 30, the company reported 4Q results that rose

from the prior year and topped analyst expectations. For the

quarter, overall revenue, including acquisitions, grew 11%,

and organic revenue grew a sequentially stronger 5.5% to $5.1

billion. The operating profit margin rose 105 basis points on a

core basis to 18.6%, and adjusted diluted EPS increased 13%

to $1.19. This was above the high end of management's

guidance range and the consensus forecast of $1.16. For the

full year, the company earned $4.03 per share, up 12% over

the prior year.

Along with the 4Q results, management provided

guidance for 2018. Management's EPS target range for 2018

is $4.25-$4.35. For the first quarter, management expects EPS

of $0.90-$0.93.

The company employs a growth-by-acquisition strategy.

In 2017, Danaher deployed nearly $400 million of capital on

10 strategic bolt-on acquisitions. CEO Thomas Joyce

commented on the 4Q conference call that he remains

encouraged by recent larger acquisitions (Cepheid,

Phenomenex, Pall) and that Danaher is well-positioned 'for a

more significant capital deployment in 2018.' On the 3Q call,

he noted that Danaher values the high gross margins in the

consumable portions of its markets.


Danaher operates four business segments: Life Sciences

(31% of sales), which provides filtration, separation and

purification technologies to the pharma/biotech, government,

clinical and hospital research businesses; Diagnostics (31%),

which provides pathology support services, molecular

diagnostics, blood sample testing and other services; Dental

(15%) and Environmental & Applied Solutions (22%). Each is

expected to contribute to revenue and earnings growth.

Fourth-quarter results and outlooks by segment are

summarized below.

The Life Sciences segment has about 13% of a $40

billion market. Danaher's 2015 acquisition of Pall Corp. has

spurred growth in this business. In the Life Sciences segment,

core revenue rose a sequentially stronger 7.5% in 4Q. The

core operating margin increased 305 basis points to 20% as

management more deeply integrated the operations acquired

through the Pall transaction. Management noted strong growth

in Western Europe and in China, as the government invests in

healthcare. For 2018, we look for mid-single-digit sales

growth, driven by new products, along with further margin

expansion.

Diagnostics has about a 14% share of a $35 billion

market supporting hospital labs, reference labs and hospital

critical care facilities. In 4Q, core revenue rose 6.0%, while

overall revenue rose 13.5% due to the Cepheid acquisition.

The core operating margin rose 105 basis points. Management

commented that China was again a growth market in the

fourth quarter. For 2018, we look for mid-single-digit sales

growth and margin improvement in this segment as

management applies the Danaher Business System to the

acquired Cepheid assets.

Core sales in the Dental segment declined 0.5%, with

growth in specialty consumables and implants offset by

persistent weakness in traditional consumables. The core

operating margin declined 100 basis points to 13.1%.

Management is focused on profit improvement in this group.

We look for flat revenue but better margins in 2018.

The Environmental & Applied Solutions segment has two

major businesses: Water Quality and Product Identification.

Both of these businesses are experiencing increased demand,

as municipalities and businesses focus on water monitoring

and disposal, and corporations focus on brand consistency and

product safety. Revenue in the Environmental and Applied

Solutions segment rose 6.0% on a core basis, driven by solid

sales of water quality platforms and coding equipment. The

core operating margin declined 50 basis points to 23.1% due

Section 2.45


to acquisition integration expenses. For 2018, we look for low

single-digit sales growth and for margins to stabilize.

Turning to our estimates, we are raising our 2018 EPS

estimate to $4.38 from $4.36, just above management's

guidance range, based on expectations for mid-single-digit

sales growth and margin improvement. We are also expecting

growth in 2019 and are establishing a preliminary EPS

estimate of $4.78. Our five-year earnings growth rate forecast

is 12%.


Our financial strength rating on DHR is Medium-High,

the second-highest rank on our five-point scale. The company

receives above-average marks on our four main criteria of

debt levels, fixed-cost coverage, cash flow generation, and

profitability. Danaher stands out among the peer group for its

consistently high free cash flow conversion ratio. The

company has a 26-year record of generating more free cash

flow than net income, for a ratio greater than 100%.

Danaher has a share buyback program, though shares

outstanding were up 1.1% year-over-year at the end of 3Q.

Danaher pays a quarterly dividend. In February 2017, the

company raised its quarterly payout by 12% to $0.14 per

share, or $0.56 annually, for a yield of about 0.6%. Our


MANAGEMENT & RISKS

In our view, Danaher is one of the best-run industrial

conglomerates, consistently identifying acquisition targets in

niche markets that boost ROIC. Tom Joyce, the former head

of the Life Sciences & Diagnostics segment, became the CEO

in 2014. He replaced Larry Culp, who had led the company

since 2001. CEO Joyce is a 25-year veteran of Danaher.

Management's long-term strategy of growing through

acquisitions has resulted in mid-teens annualized EPS growth

over the past five years. In keeping with its long experience in

business development, the company has generally paid fair

prices for acquisitions and has generated the returns that it

expected. In this way, DHR has been able to minimize

write-downs of goodwill and intangibles.

There are risks to owning DHR shares.

A global company, Danaher's results are typically linked

to global economic trends, which are not always positive. In

4Q, China and India led the way for growth, while conditions

improved in the US and Western Europe. Global GDP growth

is expected to reach 3.6% in 2018, up from 3.5% growth in

2017.

DHR is also sensitive to trends in the dollar. A stable or

falling dollar would be a positive development for the

Industrial sector and Danaher.

The bear case against Danaher always includes the point

that the company faces integration risks emanating from its

growth-by-acquisition strategy. A step-back in bottom-line

growth earlier in 2017 led to a brief period of

underperformance.

COMPANY DESCRIPTION

Danaher is a diversified Med-Tech company with global

operations. It recently spun off its industrial growth businesses

into a new company called Fortive. DHR shares are a


VALUATION

DHR shares appear attractively valued at current prices

near $100, near the high end of their 52-week range of

$78-$104. On a technical basis, the shares have been in a

long-term positive trend of higher highs and higher lows that

dates to August 2010.



discount model. DHR shares are trading at 23-times projected

2018 earnings, near the high end of the historical range of

17-24. On a price/sales basis, the shares are trading near the

top of the five-year range. The dividend yield of about 0.6% is

at the low end of the five-year range. Compared to the peer

group, the DHR shares are priced at a premium. We think

these multiples are justified given the company's growth

record and clean balance sheet. Reflecting the company's

strong free cash flow growth, our DCF model points to a

value for DHR near $120 per share. We are reiterating our

BUY rating. Our revised target price of $115, raised from

$100, implies a multiple of 23-times our 2019 EPS estimate,

still within the normal historical range for this well-managed

company.

On January 31, BUY-rated DHR closed at $101.28, down

$0.32. (John Eade, 1/31/18)

Facebook Inc (FB)


HIGHLIGHTS

*FB: Raising target price by $22 to $237

*Facebook's strong 4Q17 was overshadowed by

management's proactive steps to enhance user interaction,

possibly at the expense of short-term company profit.

*Facebook for the first time reported a 5% decline in time

spent on the site and a 700,000 decline daily active users in

the U.S. and Canada in 4Q17.

*While the decline in user metrics could give some

investors pause, we believe that making user engagement

more relevant could actually increase the value of time spent

on its sites, thereby increasing advertising rates and revenue.


$7.38 and establishing a 2019 forecast of $10.45.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on Facebook Inc.

(NGM: FB) and raising our target price to $237. Facebook's

strong 4Q17 was overshadowed by management's proactive

steps to enhance user interaction, possibly at the expense of

short-term company profit. While the decline in user metrics

Section 2.46


could give some investors pause, we believe that making user

engagement more relevant could actually increase the value of

time spent on its sites, thereby increasing advertising rates and

revenue.

We think that Facebook is well positioned to take

advantage of the ongoing movement of audiences and

advertisers to mobile digital video. Facebook also continues to

post double-digit growth in its user base and average revenue

per user, a remarkable feat for a company this size.

In our view, Facebook's valuation metrics do not

adequately reflect the company's status as an industry leader.

RECENT DEVELOPMENTS

Facebook posted strong 4Q17 and full-year results after

the close on January 31, beating the consensus EPS estimate

by $0.13 and consensus revenue forecast by $424 million.

Fourth-quarter revenue rose 47% year-over-year to $13

billion. Growth slowed from 51% in 4Q16 but was on par

with 3Q17. Revenue benefited from a $329 million foreign

exchange tailwind in 4Q17 which contributed about three

percentage points to growth. Advertising revenue, the

company's core earnings driver, rose 48% from the prior year.

Total costs rose 32% and the operating margin rose by five

percentage points to 57%. GAAP diluted EPS rose 19% to

$1.44. The new tax law caused the company to take an

extraordinary tax charge of $2.27 billion in 4Q17. Excluding

the tax charge, non-GAAP EPS rose 83% to $2.21.

For all of 2017, revenue rose 47% to $40.65 billion.

Non-GAAP EPS increased 65% to $6.97 from $4.23 in 2016.

Over the past year, Facebook became embroiled in

political controversy over the false and divisive content placed

on Facebook during the 2016 presidential campaign by

accounts linked to the Russian government. Further, Facebook

has come in for criticism from third parties, former executives,

and even its own research as often making users feel worse

about themselves. CEO Mark Zuckerberg has made

addressing these related issues the company's top priority in

2018 and reiterated on the quarterly call that the initiatives to

address these issues will impact the company's profitability

going forward. Mr. Zuckerberg' thesis is that Facebook has a

responsibility to make users' engagement more valuable

through meaningful interactions rather than simply increasing

the amount of time users spend on the platform passively

watching entertainment. The company is implementing

changes in its user Newsfeed as a first step in addressing its

issues around content. Facebook will de-emphasize

advertising and news in favor of personal interactions.

Facebook is using artificial intelligence to quickly take down

false or offensive content while also promoting more

trustworthy news sources like national newspapers. The

company recognizes that changes to the Newsfeed could lead

to a decline in the amount of time users spend on Facebook

and/or in the number of active users. Indeed, Mr. Zuckerberg

noted that the company estimated that its changes to the

Newsfeed decrease time spent on Facebook by 5% or 50

million hours per day. We note that Facebook has 1.4 billion

daily active users (DAU's) so even a small decline is

magnified. CFO Dave Wehner pointed out that the company

had for the first time actually lost 700,000 DAU's in the U.S.

and Canada in 4Q17. He stressed that management did not

identify the loss as the beginning of a trend though DAU's

could 'fluctuate' going forward due to the high penetration

rates in the U.S. and Canada.




estimates imply 22% average annual earnings growth over the

next two years. Our long-term earnings growth rate forecast is

24%.

CEO Mark Zuckerberg's visionary goal for Facebook has

morphed just a little from the original idea - to 'connect

everyone in the world.' His goal is now to 'give people the

power to build community and bring the world closer

together.' Mr. Zuckerberg's original vision underpinned the

2014 acquisition of the WhatsApp message service, Facebook

Messenger, and the Facebook Lite and Free Basics services

(which have been rolled out in India and other developing

markets). The company now has more than 1 billion

WhatsApp daily active users, and has rolled out VoIP and

video calling using this service. Facebook Messenger reached

1 billion monthly users in 2Q16. Instagram Stories now has

250 million daily actives. WhatsApp, Instagram and Facebook

Messenger, are what management calls its 'next-generation'

services. As these services have reached critical mass, the time

has come for monetization. Facebook is in the process of

testing advertising formats, and though management is

typically cautious, it is not a stretch to see these services

powering future revenue growth as advertising on the

company's main Newsfeed application has reached saturation.

The controversies over the past year have led Facebook to

tinker with its critical user Newsfeed platform and this throws

another layer of uncertainty on top of ongoing risks related to

the deceleration of ad loads on the main Facebook site. For

now, however, the value of the company's advertising

continues to move robustly higher. The average price per ad

increased 43% in 4Q17 and the number of ad impressions rose

4%. Fourth-quarter average revenue per user (ARPU) rose

28% year-over-year to $6.18.

Facebook's key growth drivers are increasing

membership, member engagement, advertising loads (the

number of ads it places), and ad prices. Facebook claimed 2.1

billion monthly active users as of the end of 2017, up 14.5%

from 2016 - including 57 million in 4Q alone. These figures

do not include users of Instagram, WhatsApp or Oculus. The

increase reflects strong membership growth in India, Brazil,

and Indonesia - all key markets for the company. As noted in

Recent Developments, the company actually lost 700,000

DAU's in the US & Canada in 4Q17 for the first time. While

one data point does not make a trend, we will be keeping a

watchful eye on these metrics to ensure that Facebook is not

trading high value developed economy subscribers for much

Section 2.47


lower value emerging economy subs.

Under Mr. Zuckerberg, Facebook has three operating

priorities: capitalizing on the shift of computing/internet to

mobile devices, growing the number of marketers that use

Facebook's advertising products, and making its advertising

more relevant and effective. The underlying goal is always to

increase member engagement with the site. This is why

Facebook's push into video has become almost as critical as its

shift to a mobile communications platform. Mr. Zuckerberg

believes that video will be key to fueling Facebook's next

growth stage and is one of the primary investment areas

ou t l ined for 2018 .Management f i r s t iden t i f ied

member-generated short-form video as a key opportunity to

boost engagement. It has more recently also begun to move

into long-form professionally produced video with the 'Watch'

tab. For advertisers, the company has invested heavily in

ad-technology to measure reach, engagement, and sales

conversion. An unintended consequence has been the use of

Facebook Live video to record some grisly scenes of violence.

Facebook is working to remedy this live video issue. While

Facebook currently relies on human checkers to flag

objectionable content, the company plans to apply AI

technology across its product portfolio, including News Feed,

search, advertising, security, and spam filtering.

China remains the one gaping hole in Mr. Zuckerberg's

plan to 'connect the world.' Facebook, along with Twitter,

have been blocked in China since 2009 after accusations that

ethnic protesters had used the site as a platform for organizing

protests. Mr. Zuckerberg now characterizes a China reentry as

a 'long-term' goal, which we take to mean about 10 years. In

the meantime, Chinese domestic social network champions

WeChat, Weibo, and QQ have come to dominate the Chinese

market.

Management has often mentioned the gap between the

media time consumers spend on mobile and the small

percentage of ad budgets spent on mobile advertising. We

believe that Facebook is well positioned to close this gap over

time. The company is also pursuing growth opportunities

among small and medium-sized businesses, and has 65 million

monthly active business pages. However, this opportunity

includes the one-third of U.S. SMB's that have no web

presence at all, and the even larger proportion that have no

mobile presence. While setting up a Facebook page is fairly

easy, the company has introduced tools to simplify the process

of becoming a Facebook advertiser.

While Facebook (and its investors) are relying on

Instagram, WhatsApp, and Facebook Messenger to drive

growth as the Facebook site matures, the company's foray into

virtual and augmented reality is seen as a more long-range

opportunity. Virtual reality is not expected to have an impact

on Facebook's revenue in the near term. The company

launched both the Samsung-produced Oculus mobile 'Gear

VR' headset in late 2015 and its own Oculus 'Rift' headset in

early 2016 after some delays. While somewhat promising,

these were just the initial commercial launches of this new

technology. Facebook expects to launch the Oculus Go, its

latest development in VR technology, in 2018. The Oculus Go

is expected to be an untethered VR headset, i.e. mobile. The

company also realizes that it needs to invest in the buildout of

the virtual reality ecosystem, particularly games, in order for

VR to become a more popular mass market device. Oculus has

also begun to line up content programming partners, including

Netflix, 20th Century Fox, and Lionsgate for streaming

movies and TV; and Microsoft for video games such as

'Minecraft.'

Over the next ten years, Facebook plans to focus on three

broad technological areas. The first of these is virtual

reality/augmented reality (VR/AR), as exemplified by Oculus

VR. Second, the company will focus on internet connectivity -

with the goal of connecting more than 4 billion potential

Facebook users who currently have no access to mobile

broadband, who are too poor to afford a handset, or who are

simply unaware that Facebook exists. Facebook's introduction

of its Free Basics service in developing countries; its

development of more efficient antennae for mobile broadband;

and its experiments with drones, solar powered planes,

satellites, and laser beams are part of the connectivity

initiative. The company's third focus area is artificial

intelligence, which has already begun to underpin new

applications.

Mr. Zuckerberg's vision is certainly grand, even if every

idea or product does not perform as expected. Of course, the

company's goals are not simply altruistic; their purpose is to

keep the Facebook user base and user engagement growing.


We rate Facebook's financial strength as High, the highest

rating on our five-point scale.

The company had cash, equivalents and marketable

securities of $41.7 billion at the end of 2017, and no debt. It

generated $17.5 billion in free cash flow in 2017, up 50%

year-over-year.

Facebook does not intend to pay a dividend in the near

term. Facebook's board authorized a $6 billion share

repurchase program beginning in 2017. The company

repurchased $2 billion in stock in 2017 and remains

committed to further repurchases to offset expected share

dilution from stock option grants. Share count rose 1% in

2017.

MANAGEMENT & RISKS

Facebook is almost entirely dependent on advertising

revenue, which has grown to about 98% of total revenue. The

secular trend of advertisers devoting more and more of their

advertising dollars to internet-based advertising has generally

softened the impact of cyclical swings in the online

advertising market; however, this trend may not continue

indefinitely.

Facebook is the repository of a vast amount of personal

information on its members and their habits. It will thus need

to tread very carefully in how it uses and monetizes this

information, and is vulnerable to member and regulatory

backlash of perceived misuse of members' private

Section 2.48


information. Even inadvertent leaks of personal member

information could generate headline risk, legal liability, and

regulatory scrutiny. Facebook may also be subject to attacks

from individuals or organizations attempting to steal member

information.

Mobile is a critical growth engine for Facebook and the

company derives 88% of its advertising revenue from mobile

applications. Management has also warned that it is willing to

sacrifice short-term margin expansion for long-term

membership growth and increased member engagement.

Investors could find themselves in the position of waiting for

profitability that may never come.

Competition in the internet space is intense and Facebook

is up against a number of larger companies with greater

resources, including Google, Microsoft, and Apple. As

Facebook expands internationally, it must manage its entry

into new markets, where it may have limited understanding of

the local culture. It also faces pressure from 'national

champion' competitors, especially in China from which it is

legally banned. Government regulation and the possible

censorship of site content could also become much more

burdensome in coming years in both the U.S. and international

markets. The Snowden revelations involving the use of

American internet company data by the NSA could make

Facebook's penetration of foreign markets much more

difficult, and result in restrictions or outright bans by foreign

governments.

Facebook has expanded its role from simple interpersonal

communications, i.e., timeline posts, to become a broad-based

news media outlet. However, this expansion has been fraught

with allegations of bias. It has also raised concerns about the

company's role in disseminating fake news, in which bad

actors game Facebook's news algorithms to plant false news

stories or propaganda. Management is now in an 'arms race'

with individuals trying to use its service to distribute fake

news. The Russian government's usage of the company's

advertising systems has brought this issue into a harsher light.

Like any start-up, Facebook must successfully manage its

explosive growth trajectory. It must also ensure 24/7 system

reliability in the face of increasingly toxic computer network

attacks from sources who would like nothing more than the

headlines from a successful attack on a high-profile target like

Facebook.

Goodwill and intangible assets are a significant 24% of

total assets. Though Facebook does not have a history of

write-downs, such assets are always subject to reappraisal.

Moreover, since they are such a significant part of the

company's assets, any write-down could be a serious negative

for FB shares.

More than most internet start-ups, Facebook is identified

with its founder, chairman and CEO Mark Zuckerberg, and

his possible loss would undoubtedly be a major blow to the

company.

COMPANY DESCRIPTION

Facebook operates the world's largest social networking

website. The site enables users to communicate with friends

and family by posting to the site; commenting on others' posts;

sharing photographs, website links, and videos; messaging

and playing games. Facebook also partners with application

developers to add functionality to the site, and allows users to

pay for virtual goods and services through its Payments

function. In recent years, the company has acquired

photo-sharing and social networking site Instagram,

messaging service WhatsApp, and virtual reality developer

Oculus VR. Facebook derives about 55% of its revenue from

outside the U.S. and Canada. Facebook went public on May

18, 2012.

VALUATION

Facebook shares have risen 46% in the last year,

compared to a 24% increase for the S&P 500 and a 40%

increase for the S&P Information Technology Index.

Facebook's EV/EBITDA multiple of 22.6 is near the peer

median. The forward enterprise value/EBITDA multiple of

15.3 is 14% below the peer average, compared to an average

premium of 9% over the past two years. We are maintaining

our BUY rating on Facebook and raising our target price to

$237, up from $215.

On February 1, BUY-rated FB closed at $193.09, up

$6.20. (Joseph Bonner, CFA, 2/1/18)

Flextronics International Ltd (FLEX)


HIGHLIGHTS

*FLEX: Diverse business model offsets legacy weakness

*Flex Ltd. was able to offset weakness in traditional EMS

services in fiscal 3Q18 with strong sales and earnings in its

nontraditional businesses.

*During the quar ter , prof i t s f rom legacy

technology-related businesses, including Communications,

Enterprise Compute and Consumer were down in the double

digits.

*However, both Industrial & Emerging (IEI) and High

Reliability Solutions (HRS), set new quarterly records for

revenue and adjusted operating profit.

*Flex is on track for a positive revenue growth for the

March 2018 fiscal year. We also look for strong EPS growth

in FY19.

ANALYSIS

INVESTMENT THESIS

BUY-rated Flex Ltd. (NGS: FLEX) - formerly

Flextronics International Ltd. - was able to offset weakness in

traditional EMS services, and particularly in communications

equipment, with strength at nontraditional customers in 3Q18.

That weakness slammed rivals Sanmina and Celestica, two

companies with higher legacy concentration, during the

current earnings season. The diversity of Flex's model and end

markets has prevented heavy concentration in the

Section 2.49


communications space, where growth has slowed ahead of the

anticipated 5G spending splurge in 2019 and beyond.

For fiscal 3Q18, Flex posted revenue of $6.75 billion,

which was up 10% annually; non-GAAP EPS of $0.31

declined 8% year-over-year, reflecting lower margins and a

doubling in the tax rate. Flex continues to shift its portfolio

toward 'sketch-to-scale' solutions for customers in

high-value-added markets, including industrial, automotive,

clean energy, and other nontraditional areas.

During the quarter, profits in legacy technology-related

businesses, including Communications, Enterprise Compute

and Consumer, were down in the double digits. Profits in

Industrial & Emerging (IEI) and High Reliability Solutions

(HRS), however, grew sharply, offsetting the legacy loss.

Both IEI and HRS set new quarterly records for revenue and

adjusted operating profits.

Flex has historically benefited from the diversity of its

customer base, as well as from its unmatched ability to meet

the global design, manufacturing, and logistics needs of even

the world's largest companies. Disengagement from former

major customers (Lenovo, in the personal devices space, and

bankrupt SunEdison, in solar panels) has begun to improve

revenue comps.

After three years (FY15-FY17) of flat to lower top-line

comparisons, Flex is on track for a positive revenue growth

for the March 2018 fiscal year, along with a slight

year-over-year decline in non-GAAP EPS. We are modeling

continued top-line growth in FY19; given expected

improvements in operating efficiency and revenue mix, we

look for margin expansion and positive EPS growth in fiscal

2019. FLEX remains attractive on historical comparable and

discounted free cash flow valuation, and in relation to its

slow- to no-growth peer group. We are reiterating our BUY

rating to a 12-month target price of $23.

RECENT DEVELOPMENTS

FLEX is up 2% year-to-date in 2018, compared with a

5% peer group decline. FLEX shares appreciated 25% in

2017, ahead of the 4% gain for the peer group of

Argus-covered electronic manufacturing services (EMS)

companies. FLEX shares rose 28% in 2016, in line with peers.

FLEX appreciated less than 1% in 2015, while the peer group

was down 3%; and in 2014 finished with a 44% gain while

outpacing the 31% gain for the peer group.

For fiscal 3Q18 (calendar 4Q17), Flex reported revenue

of $6.75 billion, which was up 10% annually and 8%

sequentially; above the high end of management's $6.3-$6.7

billion guidance range; and comfortably above the $6.50

billion consensus forecast. Non-GAAP earnings totaled $0.31

per diluted share, which was down 8% year-over-year though

up $0.04 sequentially; toward the high end of management's

$0.28-$0.32 guidance range; and one cent above the

consensus estimate. Flex posted a non-GAAP tax rate of 13%

in 3Q18; at the 7% tax rate from 3Q17, Flex would have

earned $0.33 per diluted share.

For Flex Ltd., fiscal 3Q18 reflected diverging

performance between legacy businesses linked to

communications and enterprise computing on the one hand;

and focus businesses that provide higher growth and margin

opportunities in areas including industrial, aerospace-defense,

medical devices, appliances, automotive, renewable energy,

and automotive. In short, legacy end markets weakened in the

quarter, causing margin compression. Focus business areas

grew, leading to segment margin expansion and preventing a

steeper EPS decline in a challenging legacy environment.

Given this mix shift and change in focus at Flex, the

company was able to dodge the weakness reported by industry

rivals Sanmina and Celestica. Hurt by weak communications

customer demand and inability to absorb overhead costs,

Sanmina posted a 33% decline in non-GAAP EPS for its fiscal

1Q18 (calendar 4Q17). Although Celestica was not impacted

as deeply, the Canadian company too reported challenging

comps as its legacy customers cut demand in the period.

During the fiscal third quarter (calendar 4Q17), legacy

communications and compute end markets were challenging;

and top-line challenges were reflected in profits. Although

Flex's personal devices business posted double-digit revenue

growth in a seasonally strong quarter, this unit, too,

experienced margin pressure as smartphones continued to

move into the commodity category.

For 3Q18, Consumer Technology Group (CTG) revenue

of $2.06 billion (30% of total) was up 11% annually and 17%

sequentially in a seasonally strong holiday quarter. The CTG

operating margin remains challenged, coming in at 1.9% in

3Q18 - down from 3.2% a year earlier. The CTG operating

margin missed the 2%-4% target range. Beyond anticipated

margin pressure attributable to elevated costs for the Nike

partnership, most parts of this business experienced sequential

improvement in profits.

CTG has recovered from its 1Q17 low, which included

most of the costs associated with closure of the

Lenovo-Motorola China operations. With the Lenovo

wind-down out of the way and with Flex better managing

Nike costs, we look for CTG margins to recover to

management's target range in coming quarters.

Flex's largest business, Communications & Enterprise

Compute, posted a 6% annual sales decline to $1.98 billion

(29% of revenue). The CEC operating margin of 2.5% was at

the low end of the 2.5%-3.5% target range, and operating

profit declined 19% year-over-year for a second consecutive

quarter. Margin pressure in CEC reflected both lower

overhead absorption on decreased volume and costs related to

building the cloud data center business.

Flex's Industrial & Emerging Industries (IEI) and High

Reliability Solutions (HRS) units, however, set new quarterly

records for revenue and adjusted operating profits. Industrial

& Emerging Industries (IEI) group revenue of $1.49 billion

(22% of total) increased 31% annually and 3% sequentially.

The IEI operating margin expanded sequentially to 4.1% in

3Q18 from 3.5% in 2Q18; margin edged back into the low

end of the target range of 4%-6%. Impacts from the

bankruptcy at SunEdison, at one time IEI's largest customer,

Section 2.50


continue to recede. IEI is now encountering costs related to

ramping up substantial new business. While positive for the

long term, this investment could weigh on IEI margins in

coming quarters.

For the long term, IEI is building a much more diversified

energy business, with a particular focus on its NEXTracker

technology (which positions solar panels to take advantage of

the movement of the sun). Since acquiring the business, IEI

has doubled the number of NEXTracker customers and

countries in which this business operates. Other IEI new

customers and projects should help this business sustain 4%

-6% operating margins in the coming quarters.

High Reliability Systems (HRS) revenue of $1.22 billion

was up 20 year-over-year and 6% sequentially. The HRS

operating margin expanded to 8.2% in 3Q18 from 7.9% in

2Q18; the margin remained well above the midpoint of the 6%

-9% target range, as the group continues its solid operational

execution. Flex is making investments to ramp up programs,

particularly in the automotive and medical groups.

For fiscal 4Q18, Flex forecast an annual sales decline of

5%-10% in its Communications & Enterprise Compute group.

The other three units are all forecast to grow annually: CTG

by 5%-10%, IEI by 15%-25%, and HRS by 10%-20%. In all,

Flex forecast fiscal 4Q18 revenue of $6.1-$6.5 billion, which

at midpoint would be up 7% annually. Non-GAAP EPS

guidance of $0.28-$0.32, at the midpoint, implies low-teens

EPS growth. Both midpoints were ahead of the prereporting

consensus.

After three years (FY15-FY17) of flat to down top-line

comparisons, Flex is on track for a positive revenue

comparison for the March 2018 fiscal year, along with a slight

year-over-year decline in non-GAAP EPS. We are modeling

continued top-line growth in FY19; given expected

improvements in operating efficiency and revenue mix, we

also look for margin expansion and positive EPS growth.


For fiscal 3Q18 (calendar 4Q17), Flex reported revenue

of $6.75 billion, which was up 10% annually and 8%

sequentially; above the high end of management's $6.3-$6.7

billion guidance range; and comfortably above the $6.5 billion

consensus forecast.

Non-GAAP gross margins were sequentially stable at

6.7% in 3Q18 compared with 2Q18, while narrowing from

7.1% a year earlier. Despite the gross margin contraction, the

non-GAAP operating margin expanded to 3.3% for 3Q18

from 3.0% in 2Q18 while contracting from 3.6% a year

earlier.

Non-GAAP earnings totaled $0.31 per diluted share,

which was down 8% year-over-year though up $0.04

sequentially; toward the high end of management's

$0.28-$0.32 guidance range; and one cent above the

consensus estimate. Flex posted a non-GAAP tax rate of 13%

in 3Q18; at the 7% tax rate from 3Q17, Flex would have

earned $0.33 per diluted share, or one cent below year-earlier

earnings.

For all of FY17, sales of $23.9 billion declined 2% from

the $24.4 billion recorded in FY16. On a non-GAAP basis,

Flextronics earned $1.17 per diluted share in FY17, up 14%

from $1.03 per share in FY16.

Flex forecast fiscal 4Q18 revenue of $6.1-$6.5 billion,

which at the midpoint would be up 7% annually. Management

is modeling $200-$230 million in non-GAAP operating

income, along with $35-$40 million in net interest expense

and a 10%-15% tax rate. Non-GAAP EPS guidance of

$0.28-$0.32 at the midpoint of the range implies low-teens

annual EPS growth. Both midpoints were ahead of the

prereporting consensus.

We are raising our non-GAAP earnings forecast for the

March 2018 fiscal year to $1.13 per diluted share from a prior

$1.12. Despite expectations for a higher blended tax rate and

higher interest costs, we are also increasing our non-GAAP

forecast for FY19 to $1.38 per diluted share from $1.37. On a

GAAP basis, our forecasts are $1.08 for FY18 and $1.06 for

FY19. Our long-term earnings growth rate forecast is 10%.


Our financial strength rating for FLEX remains


scale. In our view, the company's cash management during its

transition to higher-margin businesses has been solid.

Debt was $2.95 billion at the end of 3Q18. Debt was

$2.874 billion at the end of FY17, $2.77 billion at the end of

FY16 and $2.08 billion at the end of FY15.Debt/cap was

49.7% at the close of 3Q18. Debt/cap was 52.0% at the close

of FY17, 51.6% at the end of FY16, and 46.5% at year-end

FY15.

Cash & equivalents were $1.29 billion at the end of

3Q18. Cash was reduced from year-end FY17 by higher

capital spending and purchases of niche assets. Cash &

equivalents were $1.83 billion at the end of FY17, $1.61

billion at year-end FY16, reduced from $2.33 billion at the

end of 1Q16 by the cost of acquiring MCi as well as by capital

allocation.

Cash flow from operations was $1.15 billion in FY17,

$1.14 billion in FY16, and $794 million in FY15. Free cash

flow was $600 million in FY17, $626 million in FY16, and

$554 million in FY15.

Flex spent $180 million to repurchase shares in the first

nine months of the fiscal 2018 year. Since launching its

capital return program in 2011, Flex has spent more than $2.5

billion on buybacks, reducing its share count by over 34%.

We do not expect Flex to pay a common dividend in

FY18 or FY19.

MANAGEMENT & RISKS

Mike McNamara has served as CEO since January 2006.

Christopher Collier became CFO in May 2013. Francois

Barbier is president of Global Operations and Components,

and Paul Humphries is president of High Reliability Solutions.

The chief risk for globally diversified Flex is that its

operations will need substantial restructuring in the event of a

global economic crisis. We think the company has in the past

Section 2.51


shown a willingness to act decisively in response to dynamic

situations, and we believe that it has the financial solvency to

survive.

Flex faces risks related to the integration of assets, though

it is adept at integrating smaller acquisitions. Flex is also at

risk from its vertical manufacturing strategy, which includes

ownership of significant component assets. The company is a

leader in non-EMS adjacencies, such as plastic and metal

enclosures, PCB fabrication, and power modules. We believe

that risks in these noncore businesses are offset by their higher

margins.

COMPANY DESCRIPTION

Flex is the largest global provider of electronic

manufacturing services (EMS) and related competencies. In

addition to its core printed circuit board (PCB) assembly and

systems assembly businesses, the company provides design,

logistics, components, enclosures and PCB manufacturing.

Flex has expanded its customer base from OEM companies in

traditional electronics and technology to nontraditional niches,

such as consumer, medical and instrumentation,

aerospace-defense and automotive. In FY17, revenue was

$23.9 billion, down 2% from $24.4 billion in FY16.

INDUSTRY























dividend yield.

VALUATION

FLEX shares are trading at 16.1-times our FY18

non-GAAP EPS forecast and at 13.2-times our FY19 forecast,

versus a five-year (FY13-FY17) average multiple of 10.1.

Although at a two-year forward P/E of 14.7, the shares trade

at a premium to historical P/E, Flex has now returned to top-

and bottom-line growth. In an appreciated market, FLEX is

trading at a relative P/E of 0.72 for FY18 and FY19, only

slightly above its historical relative P/E of 0.66. Based on

historical price-based comparisons, FLEX shares now trade

above calculated fair value; we believe the premium is

warranted given top-line growth and the margin expansion

now underway.

Flex now trades at slight premiums to peers; we believe

the premiums are warranted given little to no growth among

EMS rivals. Our discounted free cash flow model indicates a

fair value in the high $30s, in a stable trend. Our blended

valuation model indicates a fair value in the low $30s, in a

positive trend.

Appreciation to our 12-month target price of $23 implies

a risk-adjusted return in excess of our forecast for the broad

market. Based on valuation and the company's accelerating

fundamentals, we believe that FLEX shares warrant both near-

and long-term BUY ratings.

On January 31 at midday, BUY-rated FLEX traded at

$18.05, down $0.18. (Jim Kelleher, CFA, 1/31/18)

Harley-Davidson, Inc. (HOG)


HIGHLIGHTS

*HOG: Maintaining BUY on strong 4Q and cost-cutting

initiatives

*In an effort to lower costs, Harley will shift operations at

its Kansas City, Missouri factory to its plant in York,

Pennsylvania. We believe that this consolidation will enable

the company to improve production efficiency both for legacy

models and the 100 new 'high impact' models that it plans to

introduce over the next 10 years.

*On January 30, Harley reported 4Q17 adjusted EPS of

$0.48, up from $0.27 a year earlier. The results matched our

estimate and topped the consensus of $0.46.

*We are lowering our 2018 adjusted EPS estimate from

$3.77 to $3.50 and setting a 2019 estimate of $3.77. Our

estimates assume higher costs as the company consolidates its

plants, partly offset by benefits from a lower effective tax rate.

*HOG shares are trading below historical and peer

average P/E, price/sales, and price/book multiples; however,

we believe that higher valuations are warranted. Our target

price of $53, combined with the dividend, implies a potential

total return of 15% from current levels.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on Harley-Davidson

Inc. (NYSE: HOG) fol lowing the company's

better-than-expected 4Q17 earnings. Our target price is $53.

Despite industrywide pricing pressures, the company is

gaining market share and strengthening its product mix. It

continues to reduce its inventory of older motorcycles and has

begun an ambitious effort to launch 100 new models by 2027.

We have been impressed with the first of these new models,

and believe that they live up to the company's reputation for

Section 2.52


solid, powerful motorcycles. Although the new models and

styles will not entirely replace personal customization, they

should enable most buyers to get the look, sound, and feel that

they want directly from the sales floor, without costly

upgrades. We note that Harley is also designing an electric

motorcycle that should appeal to a new group of customers.

HOG shares are trading below historical and peer average

P/E, price/sales, and price/book multiples; however, we

believe that higher valuations are warranted based on the

company's rising market share, improved product mix, and

potential to attract new customers. Our target price of $53,

combined with the dividend, implies a potential total return of

15% from current levels.

RECENT DEVELOPMENTS

HOG shares have underperformed over the past quarter,

rising 7.7% compared to a gain of 9.7% for the S&P 500.

Over the past year, they have fallen 13.9%, compared to a

gain of 23% for the index. The beta on HOG is 0.96.

On January 30, Harley reported 4Q17 adjusted EPS of

$0.48, up from $0.27 a year earlier. The results matched our

estimate and topped the consensus of $0.46. Fourth-quarter

net income came to $8.3 million on consolidated revenue of

$1.23 billion, compared to net income of $47.2 million on

revenue of $1.11 billion in 4Q16. Revenue rose due to higher

shipments, while the new tax cut law impacted earnings by

$53.1 million. Harley motorcycle unit sales fell 9.6%

worldwide and 11.1% in the U.S., while overall industry sales

fell 6.5%. The gross margin rose to 30.9% from 30.7% a year

earlier, reflecting the increase in shipments of motorcycles and

related products.

At Harley-Davidson Financial Services (HDFS), revenue

rose 2.4% to $182 million and operating profit rose 5.9%.

For all of 2017, diluted EPS fell to $3.02 from $3.83 in

2016. Net income was $521.8 million on consolidated revenue

of $5.65 billion, versus net income of $692.2 million on

consolidated revenue of $6.00 billion a year earlier. In 2017,

Harley motorcycle unit sales fell 6.7% worldwide, 8.5% in the

U.S., and 3.9% in international markets.

In an effort to lower costs, on January 25, the board

approved a plan to shift operations at the company's Kansas

City, Missouri factory to its plant in York, Pennsylvania. The

move is expected to cost $170-$200 million through 2019 and

is expected to save $65-$75 million per year after 2020. We

believe that this consolidation will enable the company to

improve production efficiency both for legacy models and the

100 new 'high impact' models that it plans to introduce over

the next 10 years.

Along with the 4Q release, management issued shipment

and margin guidance for 2018. It expects full-year shipments

of 231,000-236,000 motorcycles, down from 241,498 in 2017.

It also projects 1Q shipments of 60,000-65,000 motorcycles. It

expects full-year operating margins of 9.5%-10.5% and

capital spending of $250-$270 million.


Although Harley's U.S. motorcycle sales fell in 2017, the

company was able to maintain its No.1 spot in the 601+cc

category, as well as its leading market share in the U.S.,

Canada, Japan, Australia and India. As noted above, Harley is

also broadening its product line, with 100 new models slated

to be introduced by 2027. We believe that this wider range of

models will help to attract customers who might otherwise

prefer to purchase a 'fully custom' motorcycle. Nevertheless,

Harley is likely to face pressure from continued weak

industrywide pricing as well as from higher production costs

as it adds new models. We note that the company is also

planning to launch its first electric motorcycle within the next

18 months.

*We are lowering our 2018 adjusted EPS estimate from

$3.77 to $3.50 and setting a 2019 estimate of $3.77. Our

estimates assume higher costs as the company consolidates its

plants, partly offset by benefits from a lower effective tax rate.


Our financial strength rating on Harley-Davidson is

Medium-High, the second-highest point on our five-point

scale. Harley's debt is rated A3/stable by Moody's, A/stable by

Fitch, and A-/stable by Standard & Poor's.

At the end of 4Q17, the debt/capitalization ratio was

79.1%, compared to 78.0% at the end of 4Q16. Long-term

debt at the end of 2017 stood at $4.59 billion, down from

$4.67 billion a year earlier. The company generated $1.01

billion in cash from operating activities in 2017, compared to

$765.5 million in 2016. For 2017, Harley-Davidson's effective

tax rate was 39.6%, up from 32.4% in 2016, reflecting the

write-down of deferred tax assets following the passage of the

2017 Tax Cuts and Jobs Act. However, due to the new law,

Harley expects a significantly lower effective tax rate of

23.5%-25.0% in 2018.

The company pays a quarterly dividend of $0.365 per



The company repurchased 8.7 million shares for $456.1

million in 2017. At the end of the year, it had 10.6 million

shares remaining on its buyback authorization.

RISKS

Knowing that it cannot rely solely on its traditional

clientele, predominantly white male baby boomers, Harley has

been working hard to appeal to women, minorities, and

younger Gen X and Millennial consumers, as demonstrated by

its plan to launch 100 new 'high-impact' models over the next

10 years. Although the company will need time to roll out

these new motorcycles, and will face higher production costs

in the near term, we expect the wide variety of new models to

better address customer preferences and believe that they

could be a game-changer for the company. Harley currently

plans to launch 14 new high-impact models in 2018 and plans

to launch its first electric motorcycle within 18 months.

Harley-Davidson and its peers are highly sensitive to

economic weakness, which can limit consumer credit and

have an outsized impact on discretionary spending. The

company also faces risks from aggressive price competition.

Section 2.53


Motorcycle manufacturers are also subject to regulatory

changes (such as new engine emissions standards) over which

they have limited control.

COMPANY DESCRIPTION

Founded in 1903 and based in Milwaukee,

Harley-Davidson became a public company in 1986. The

Motorcycle segment designs, manufactures and sells

heavyweight Harley-Davidson motorcycles (engine

displacement of 651+ cubic centimeters), as well as

motorcycle parts, accessories, general merchandise, and

related services. The company plans to launch 100 new

motorcycle models over the next 10 years in an effort to

attract new riders, and has also begun to manufacture smaller

500-750 cubic centimeter motorcycles. Harley-Davidson

Financial Services (HDFS) provides wholesale and retail

financing and insurance to Harley-Davidson dealers and their

retail customers in the United States, Canada and other

international markets. The company's products are sold to

retail customers through a network of independent dealers.

INDUSTRY

We have raised our rating on the Consumer Discretionary

sector to Over-Weight from Market-Weight. The sector has

shown solid market momentum, reflecting investor

expectations for strong durable goods demand in the wake of

tax cuts. At the same time, Consumer Discretionary stocks

have been out of favor for multiple quarters, and appear

undervalued relative to peers.

The sector accounts for 12.1% of the S&P 500. We think

investors should consider allocating 13%-14% of their

diversified portfolios to the group. Over the past five years,

the weighting has ranged from 8% to 13%. The sector

underperformed in 2016, with a gain of 4.3%, after

outperforming in 2015, with a gain of 8.4%. It slightly

outperformed in 2017, with a gain of 21.2%.

Consumer Discretionary earnings are expected to increase

8.7% in 2018 and 3.6% in 2017 after rising 9.4% in 2016 and

9.9% in 2015. On valuation, the 2018 projected P/E ratio is

20.3, above the market multiple of 18.2. The sector's debt

ratios are high, with an average debt-to-cap ratio of 52%.

Yields are below average at 1.0%.

VALUATION

HOG shares are trading toward the low end of their

52-week range of $45.52-$63.40. They are trading at

13.8-times our 2018 EPS estimate and 12.8-times our 2019

estimate, compared to a five-year historical range of

10.3-21.3. The 2018 peer average P/E is 23.3. The price/sales

ratio is 1.5, near the low end of the five-year range of 1.3-2.7

and below the peer average of 1.9. The price/book ratio of 4.4

is below the midpoint of the historical range of 3.4-5.8 and

below the peer average of 4.6. Despite Harley's current

challenges, we believe that the shares merit higher multiples

based on the company's forward-looking restructuring plan,

improved product mix, and potential to attract new customers.

Our target price of $53, combined with the dividend, implies a

potential total return of 15% from current levels. We believe

that the recent pullback in the stock provides investors with a

favorable entry point.

On February 2, BUY-rated HOG closed at $47.50, down

$1.18. (David Coleman, 2/2/18)

Hawaiian Holdings, Inc. (HA)


HIGHLIGHTS

*HA: Maintaining HOLD on heightened competition

*With both United Continental and Southwest Airlines

entering the West Coast-to-Hawaii market and a competitor

expanding aggressively in the intra-island market, we expect

HA's yields to deteriorate.

*We note that Southwest has typically reduced fares by

15%-25% when entering new markets.

*In addition, Hawaiian Holdings' costs have recently been

rising at a 6%-7% pace. Given these challenges and the

absence of positive catalysts, we believe that a HOLD rating

remains appropriate.

*If the company is able to offset the impact of new

competition and hold the line on costs, we would consider

returning the stock to our BUY list.

ANALYSIS

INVESTMENT THESIS

We are maintaining our HOLD rating on Hawaiian

Holdings Inc. (NGS: HA) on concerns about increased

competition and rising costs. With both United Continental

(UAL, not covered by Argus) and Southwest Airlines (LUV:

BUY) entering the West Coast-to-Hawaii market and a

competitor expanding aggressively in the intra-island market,

we expect HA's yields to deteriorate. Southwest management

believes that passenger fares to Hawaii are too high, and has

typically reduced fares by 15%-25% when entering new

markets. In addition, Hawaiian Holdings' costs have recently

been rising at a 6%-7% pace. Given these challenges and the

absence of positive catalysts, we believe that a HOLD rating

remains appropriate. If the company is able to offset the

impact of new competition and hold the line on costs, we

would consider returning the stock to our BUY list.

RECENT DEVELOPMENTS.

On January 29, HA reported 4Q17 EPS that topped the

consensus estimate by $0.02, reflecting lower-than-expected

fuel costs, a 5% decline in total operating expenses, and a

nearly 3% decline in the share count. Fourth-quarter adjusted

net income fell $11.3 million year-over-year to $57.5 million.

Passenger revenue grew 7.8% to $596.8 million, and other

revenue rose 13% to $89.7 million. Total revenue grew more

than 8.5% year-over-year to $686.5 million. Total operating

expenses fell 5.0%. Aircraft fuel costs, including taxes and

delivery, rose 29% to $124 million. Interest expense dropped

from $8.2 million to $7.6 million. The share count fell by 1.6

million to 52.3 million.

Section 2.54


In 2017, revenue increased 10% year-over-year to $2.7

billion, while earnings rose to $5.64 per share from $5.21 in

2016.

In the first quarter, management expects costs per

available seat mile (CASM) to rise 3.5%-6.5%. For the full

year, management expects CASM, less fuel and special items,

to be down 0.5% to up 2.5%. %. It expects available seat

miles to increase 5%-8% and economic fuel cost per gallon of

$1.97-$2.07.

As discussed in a previous note, on January 8, 2018,

Hawaiian Holdings announced that it had flown a record 11.5

million passengers in 2017, up 4.1% from the prior year.

In March 2017, Hawaiian Airlines pilots ratified a new

63-month labor contract, ending a long-running dispute. The

new contract provides for salary increases of 36%-86% over

the term of the agreement and retroactive pay dating back to

September 15, 2015. It also includes improved work rules and

maintains pilots' existing healthcare benefits.


Although the company is working to control costs, it will

face higher labor costs following recent contract agreements

with its pilots, dispatchers, and machinists. On the positive

side, it is upgrading its fleet to boost efficiency. It recently

took delivery of its 24th A330-200. The company plans to

lease two A321 neos beginning in 1Q18 and to retire its

remaining fleet of 767s by the end of 2018.

We are maintaining our 2018 EPS estimate of $4.50,

below the consensus estimate of $4.54. Our 2018 estimate

assumes slower revenue growth as the company competes

against Southwest and United Continental in the West

Coast-to-Hawaii market. For 2019, we are setting an estimate

of $4.90. Our five-year earnings growth rate forecast remains

5%.


Our financial strength rating on Hawaiian Holdings is

Medium-Low. The company scores below average on our

three main financial strength criteria of debt levels, interest

coverage and profitability. The company's debt is rated

B1/stable by Moody's, BB-/stable by S&P, and B+/positive by

Fitch.

The company ended 4Q17 with $460 million in cash and

investment securities, down from $694 million at the end of

4Q16. At the end of 4Q17, the company had $571 million of

outstanding debt and capital lease obligations, compared to

$565 million at the end of 4Q16. It repurchased $100 million

of its stock in 2017 and has reauthorized another $100 million

in buybacks through May 2019. Given the company's strong

free cash flow, we expect continued debt retirement and stock

buybacks going forward.

In November 2017, Hawaiian initiated a $0.12 per share

quarterly dividend. The current yield is about 1.3%. Our


MANAGEMENT & RISKS

Mark B. Dunkerley has been the CEO of Hawaiian

Holdings and its subsidiary, Hawaiian Airlines, since 2005. In

2011, he began to expand the carrier's route network beyond

inter-island flights with service from Hawaii to Asia and the

West Coast.

Airline financials, labor negotiations, ticket prices, and

fuel costs all represent potential catalysts for share price

movement. In addition, the risk of a major terrorist attack or

health scare that reduces airline travel is ever-present.

The company faces stiff competition from other low-cost

airlines and from legacy carriers that have cut ticket prices

over the past several years.

In times of high oil prices, fuel costs represent more than

a third of an airline's costs. Hawaiian Holdings' earnings and

share price could suffer if oil prices increase significantly.

COMPANY DESCRIPTION

Hawaiian Holdings, through its subsidiary Hawaiian

Airlines, is a leading carrier for inter-island flights, which

account for about a quarter of revenue. The airline also has the

largest share of flights between Hawaii and the West Coast,

which account for half of revenue.

INDUSTRY

Our rating on the Industrial sector is Market-Weight.

Industrial stocks have been lagging the market, reflecting the

stronger U.S. dollar and concerns about trade restrictions. In

addition, Industrial sector EPS growth is below the market

average, while the two-year-forward P/E is above both the

five-year historical average and the market average.

The Industrial sector accounts for 10.1% 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 9%-11% of their diversified portfolios to the group.

The sector includes industries such as transportation,

aerospace & defense, heavy machinery and electrical

equipment.

The sector outperformed the market in 2016, with a gain

of 16.1%, after underperforming in 2015, with a loss of 4.7%.

It also underperformed in 2017, with a gain of 18.5%.

By our calculations, the 2018 P/E ratio is 18.8, slightly

above the market multiple. Earnings are now expected to rise

9.2% in 2018 and 10.3% in 2017 after declining 3.3% in

2016. The sector's debt/cap ratio of 50% is above the market

average. The yield of 1.4% is below the market average of

1.8%.

VALUATION

HA shares fell on January 29 after the company issued

disappointing fourth-quarter earnings. The shares appear fairly

valued at current prices near $37, toward the low end of their

52-week range of $32-$59.

On the fundamentals, the shares are trading at 8.1-times

our 2018 estimate. The five-year historical P/E range is

3.4-19.6. The price/sales multiple of 0.8 is below the peer

average of 1.0, but above the midpoint of the five-year

historical range. The price/cash flow ratio is 6.9, above the

peer average of 5.9 and just below the midpoint of the

Section 2.55


five-year range of 0.9-14.1. Given management's projections

for higher costs and heightened competition, we think the

shares are fairly valued. As such, our rating remains HOLD.

On February 5, HOLD-rated HA closed at $35.60, down

$1.80. (John Staszak, CFA, 2/5/18)

Helmerich & Payne Inc (HP)


HIGHLIGHTS

*HP: Boosting target to $87

*Our revised target reflects the recent improvement in

crude oil prices and the decision by OPEC to maintain

production at current levels through the end of 2018.

*On January 25, Helmerich & Payne reported an adjusted

fiscal 1Q18 net loss of $2.54 million or $0.02 per share,

compared to an adjusted net loss of $43.2 million or $0.41 per

share in the prior-year quarter. The net loss was in line with

our loss estimate but narrower than the consensus loss

estimate of $0.13.

*We are reaffirming our FY18 EPS estimate of 0.32, as

we expect continued improvement in rig utilization, rig

margins and overall sales this year. The current FY18

consensus estimate calls for a profit of $0.03 per share.

* We are raising our FY19 EPS estimate to $0.60 from

$0.45 to reflect our expectations for positive industry

fundamentals and modestly higher crude oil prices next year.

The FY19 consensus is $0.74.

ANALYSIS

INVESTMENT THESIS

We are reaffirming our BUY rating on Helmerich &

Payne Inc. (NYSE: HP) and raising our price target to $87

from $65. Our revised target reflects the recent improvement

in crude oil prices and the decision by OPEC to maintain

production at current levels through the end of 2018. Looking

ahead, we expect drilling activity by E&P companies to

continue to increase, though at a slightly slower pace than in

recent quarters. We also expect new drilling to be

concentrated in regions with relatively low production costs,

such as the Permian basin and the Bakken and Eagle Ford

shales, where HP is better-positioned relative to peers. Our

revised target of $87, combined with the dividend, implies a

total potential return of 25% from current levels.

RECENT DEVELOPMENTS

HP shares have outperformed thus far in 2018, rising

11.9% while the S&P 500 Energy index has increased 3.4%.

However, the shares have underperformed over the past year,

climbing 1.7% while the Energy index has increased 3.3%.

On January 25, Helmerich & Payne reported an adjusted

fiscal 1Q18 net loss (for the period ended December 31, 2017)

of $2.54 million or $0.02 per share, compared to an adjusted

net loss of $43.2 million or $0.41 per share in the prior-year

quarter. The net loss was in line with our loss estimate but

narrower than the consensus loss estimate of $0.13.

The narrower net loss was primarily attributable to higher

revenue in the U.S. Land segment. The segment posted a 75%

increase in sales and benefited from higher rig utilization.

Helmerich & Payne's segments are U.S. Land (80% of

FY17 sales), Offshore (8% of FY17 sales), and International

Land (12% of FY17 sales). We discuss fiscal 1Q18 results for

these segments below.

The U.S. Land segment posted an operating profit of

$24.8 million in fiscal 1Q18, compared to an operating loss of

$30.9 million in fiscal 1Q17. The swing to an operating profit

was primarily attributable to higher drill rig sales, which rose

75%. The division also benefited from lower average rig

expenses. Rig utilization averaged 57% in 1Q18, up from 31%

in the year-earlier period. As of January 25, 2018, Helmerich

& Payne's U.S. Land division had approximately 206

contracted rigs (109 term contract and 97 spot contract)

generating revenue. This compares to 197 contracted rigs at

the end of September 2017.

The Offshore drilling segment reported operating income

of $8.73 million, up from $6.78 million in the prior-year

period. The improvement reflected an 18% gain in the average

rig margin and a 14% increase in rig revenue per day.

The International Land segment reported an operating

profit of $3.53 million in 1Q18, up from $825,000 in 1Q17,

reflecting lower rig expense and higher utilization.

As of January 26, 2018, the total active U.S. rig count, as

calculated by Baker Hughes, was 947, up 33% from the prior

year. This compares to a peak rig count of 1,609 in October

2014.

As discussed in past notes, on June 2, 2017, HP

completed the acquisition of MOTIVE Drilling Technologies,

a software company that uses cognitive computing to improve

results in directional drilling. The company has drilled

extensively in all major U.S. shale plays using this

technology.


In its January 25 earnings release, HP management said

that it was encouraged by an improving macroeconomic

environment for oil and by prospects for increased drill rig

activity this year.

In fiscal 2Q18, management expects average rig revenue

in the U.S. Land segment to be flat with or slightly higher than

in 1Q18, with average rig expense of about $13,900 per day.

In the Offshore segment, it expects revenue days to decrease

2% sequentially in 2Q18, with an average rig margin of

$11,500. Management contracts are expected to generate $4

million in operating income. In the International Land

segment, the company expects revenue days to decrease from

the prior quarter by about 4%, with an average rig margin of

$8,000.

We are reaffirming our FY18 EPS estimate of 0.32, as we

expect continued improvement in rig utilization, rig margins

and overall sales this year. The current FY18 consensus

estimate calls for a profit of $0.03 per share. Our full-year

Section 2.56


revenue forecast is now $2.27 billion, up 2% from our prior

estimate.

We are raising our FY19 EPS estimate to $0.60 from

$0.45 to reflect our expectations for positive industry

fundamentals and modestly higher crude oil prices next year.

The FY19 consensus is $0.74.


We rate HP's financial strength as Medium-High, the

second-highest rating on our five-point scale. The company's

debt is rated BBB+/stable by Standard & Poor's.

At the end of fiscal 1Q18, HP's total debt/capitalization

ratio was 9.7%, down from 9.9% a year earlier. The total

debt/cap ratio remains well below the peer average and has

averaged 7.5% over the past five years.

Helmerich & Payne had total debt of $493.17 million at

the end of 1Q18, compared to $492.11 million at the end of

1Q17. The company has access to $300 million in liquidity

under its revolving credit facility.

HP had cash and cash equivalents of $384 million at the

end of 1Q18, compared to $826 million at the end of 1Q17.

Cash from operating activities totaled $72.2 million in 1Q17,

compared to $70.7 million a year earlier.

HP pays a quarterly dividend of $0.70, or $2.80 annually.

Our FY18 and FY19 dividend estimates are $2.82 per share.

The shares currently yield about 3.8%, above the peer average

of 3.4%. We believe that the dividend remains secure given

the company's relatively low debt and ample liquidity.

MANAGEMENT & RISKS

HP is subject to fluctuations in demand associated with

volatility in oil and natural gas prices, which can impact

operator spending. Another risk for drilling firms is the loss of

revenue from rig breakdowns or other operational problems.

However, this risk is lower for HP than for some competitors,

as its fleet is larger, newer, and more land-based.

COMPANY DESCRIPTION

Helmerich & Payne, Inc. is a contract drilling company.

As of January 26, 2017, the company's fleet included 350 land

rigs in the U.S., 38 international land rigs, and nine offshore

platform rigs. The company was founded in 1920 and is based

in Tulsa, Oklahoma.

INDUSTRY

We have raised our rating on the Energy sector to

Over-Weight from Market-Weight. Investors remain skeptical

about the sector despite prospects for significant earnings

acceleration in 2018-2019. We also expect Energy stocks to

benefit as OPEC continues to limit production in order to

boost oil prices. The sector accounts for 6.1% of the S&P 500.

Over the past five years, the weighting has ranged from 5% to

14%. We think that investors should consider allocating 6%

-8% of their diversified portfolios to the Energy group. The

sector includes the major integrated firms, as well as

exploration & production, refining, and oilfield & drilling

services companies.

By our calculations, the projected P/E ratio on 2018

earnings is 25.0, above the market multiple of 18.5.

We forecast that West Texas Intermediate crude oil

(WTI) will average $56 per barrel in 2018, up from $50 in

2017 and $43 in 2016 but well below the average price of $93

in 2014. At the same time, we expect oil prices to remain

volatile. We look for a full-year price range of $48-$64 per

barrel.

Our 2018 forecast for the average wellhead price of

Henry Hub natural gas is $2.90 per MMbtu with a range of

$2.75-$3.05, compared to $3.00 per MMbtu in 2017.

VALUATION

HP shares have traded between $42.16 and $75.02 over

the past 52 weeks and are currently in the upper half of that

range. P/E multiples are not useful for valuation purposes

given our low EPS estimates for both FY18 and FY19. The

shares are trading at a trailing price/book multiple of 1.8,

above the midpoint of the historical range of 1.2-2.1; at a

price/sales multiple of 4.0, above the high end of the range of

1.8-3.4; and at a price/cash flow multiple of 22.5, above the

high end of the range of 6.3-11.2.

Looking ahead, we expect increased drilling to be

concentrated in regions with relatively low production costs,

such as the Permian basin and the Bakken and Eagle Ford

shales, where HP is well positioned relative to peers. We also

expect the company to benefit from higher oil prices and

increased rig utilization in 2018. We are reaffirming our BUY

rating with a revised target price of $87.

On January 31, BUY-rated HP closed at $72.03, down

$0.68. (Bill Selesky, 1/31/18)

Hershey Company (HSY)


HIGHLIGHTS

*HSY: Maintaining BUY; lowering target to $120

*Hershey reported disappointing 4Q results on February

1, as net sales fell 1.6%. Non-GAAP earnings came to $1.03

per share, missing our estimate by $0.06.

*Looking ahead, we expect new CEO Michele Buck to be

aggressive in controlling costs and in introducing new

products.


$5.29 and initiating a 2019 forecast of $5.56.

*We believe that the recent selloff in HSY offers

investors a favorable entry point.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on Hershey Co.

(NYSE: HSY) with a target price of $120, reduced from $125.

This financially strong company has a focus on shareholder

returns, with a stock buyback program and a record of

increased dividend payments. The shares yield a relatively

Section 2.57


high 2.5%. The company reported disappointing 4Q adjusted

EPS on February 1, but provided positive guidance for 2018.

We believe that the stock remains attractive based on most

standard metrics and that the recent selloff offers investors a

favorable entry point. Our revised target of $120, combined

with the dividend, implies a potential total return of 22% from

current levels.

RECENT DEVELOPMENTS

HSY shares have outperformed over the past three

months, rising 5.9% compared to an increase of 1.4% for the

S&P 500. The stock has underperformed over the past year,

however, falling 3.4% compared to a gain of 23.1% for the

S&P 500.

In an effort to expand into the salty snack market, in

December 2017, Hershey agreed to acquire Amplify Snack

Brands for $1.6 billion including debt. The company expects

the acquisition to boost 2018 sales by 5%.

On February 1, Hershey posted 4Q17 revenue of $1.94

billion, down 1.6% from 4Q16, with a slight benefit from

currency translation. The decline reflected shipment timing

and a difficult comparison with 4Q16, which benefited from

the launch of the Cookie Layer Crunch Bar.

North American earnings fell 0.9% to $1.67 billion, as

lower volume outweighed higher realized prices and positive

currency translation.

Fourth-quarter net sales in the International and Other

segment declined 5.4% to $65.0 million, reflecting lower

volume. The segment loss narrowed to $15 million from $16.7

million a year earlier.

Fourth-quarter reported net income rose to $181.1 million

or $0.85 per diluted share from $116.9 million or $0.55 per

share a year earlier. Non-GAAP earnings came to $1.03 per

share, missing our estimate by $0.06. The adjusted gross

margin contracted by 180 basis points to 42.7%, as higher

freight and distribution costs and an unfavorable product mix

more than offset the impact of supply-chain improvements

and other cost-savings initiatives.

For all of 2017, adjusted net income came to $1.02 billion

or $4.76 per share, up from $948.5 million or $4.41 per share

in 2016.


Along with the 4Q results, the company issued 2018

guidance. It expects adjusted EPS to increase 12%-14% to

$5.33-$5.43, including gains from the Amplify acquisition and

the impact of a lower tax rate. It expects reported net sales to

increase 5%-7%, and organic net sales to increase

approximately 2%. It also looks for an adjusted gross margin

in line with 2017, a largely neutral impact from currency

translation, and an effective tax rate of 20%-22%.


$5.29 and initiating a 2019 forecast of $5.56.


Our financial strength rating for Hershey is

Medium-High, the second-highest point on our five-point

scale. Moody's rates Hershey's long-term debt as A1. Standard

& Poor's has an A rating with a negative outlook.

Debt was $2.92 billion at the end of 2017, compared to

$2.98 billion at the end of 2016. Cash and equivalents totaled

$380 million, up from $297 million a year earlier.

Hershey purchased $300.3 million of its common stock in

the first nine months of 2017 but did not repurchase any

shares in the fourth quarter. In October 2017, the board

approved an additional $100 million buyback authorization,

which will begin after the current authorization is completed.

HSY pays a dividend. In September 2017, it raised its

quarterly dividend by 6% to $0.656 per share, or $2.62

annually, for a yield of about 2.5%. Our dividend estimates

are $2.69 (reduced from $2.70) for 2018 and $2.82 for 2019.

MANAGEMENT & RISKS

Michele Buck became the company's new CEO on March

1, 2017 following the retirement of John Bilbrey.

As a snack and confectionary company, Hershey is

subject to input cost inflation, which has been high in recent

years. The company requires large amounts of sugar,

sweetener, peanuts, cocoa, dairy products, and plastic

packaging.

Health concerns related to diabetes are always a concern,

and producers of confectionary products have been a frequent

target of critics. We note that after years of growth, the

number of diabetes cases in the U.S. appears to have

stabilized.

Hershey is also facing additional international

competition following Kraft's acquisition of Cadbury. At the

same time, the company has relatively less exposure to

exchange rate movements given that most of its business is

still based in the U.S.

COMPANY DESCRIPTION

Hershey Co. produces and markets chocolate and other

confections, as well as chocolate-related grocery products. Its

major brands include Hershey's, Jolly Rancher, Kit Kat,

Heath, Twizzlers, Reese's, Ice Breakers and SkinnyPop.

Hershey has expanded into new categories and markets in

recent years with the acquisitions of Brookside, Krave,

Shanghai Golden Monkey, Ripple Brand Collective, and

Amplify Snack Brands. The company's largest shareholder is

the Hershey Trust Company.

INDUSTRY

Our rating on the Consumer Staples sector is

Under-Weight. Investors are voting with their feet in this

sector, recently reducing the sector's weighting in the S&P

500 to a multiyear low. We note that consumers who shifted

to generic products when money was tighter are simply not

returning to familiar brand names. The sector accounts for

8.1% of the S&P 500, with a five-year range of 8%-13%. We

think investors should consider allocating 7%-8% of their

diversified portfolios to this group. The sector includes

industries such as food, beverages, household products and

grocery stores. The sector underperformed in 2016, with a

Section 2.58


gain of 2.6%, but outperformed in 2015, with a gain of 3.8%.

It underperformed in 2017, with a gain of 10.5%.

According to our models, the projected P/E ratio on 2018

earnings is 19.3, ahead of the market multiple of 18.2. Sector

earnings are expected to increase 8.6% in 2018 and 7.0% in

2017 after rising 4.2% in 2016. The sector's debt ratios are

reasonable, with an average debt-to-cap ratio of 45%, in line

with the market average. Yields of 2.6% on average are higher

than the market's yield of about 1.8%.

VALUATION

We think that HSY shares are attractively valued at recent

prices near $102, near the low end of their 52-week range of

$101-$116.

On the fundamentals, the metrics point to value. The

stock trades at 19.1-times our 2018 non-GAAP EPS forecast,

below the peer average of 20.7 and the five-year historical

range of 20.5-29.3. Peers include, but are not limited to,

Kellogg (K), Tyson Foods (TSN), Hormel Foods (HRL),

General Mills (GES) and Campbell Soup (CPB). The

price/sales multiple of 2.9 is above the peer average of 2.0 and

near the midpoint of the historical range of 2.5-3.4. The

price/cash flow multiple of 18.5 is above the peer average of

15.2 but in the lower half of the historical range of 14.8-29.1.

We are maintaining our BUY rating. Our revised target

price of $120, combined with the dividend, implies a potential

total return of 22% from current levels.

On February 5, BUY-rated HSY closed at $100.17, down

$2.80. (David Coleman, 2/5/18)

Ingersoll-Rand PLC (IR)


HIGHLIGHTS

*IR: Raising target price to $105

*IR shares have outperformed over the last quarter,

gaining 5% while the S&P 500 has risen 2.2%.

*Over the past year, the shares have underperformed,

advancing 13% while the market has gained 15.6%.

*On January 31, the company reported 4Q EPS that rose

more than 20% but fell just shy of Street expectations.

*Management recently increased the dividend by 12.5%,

signaling confidence in its outlook.

ANALYSIS

INVESTMENT THESIS

Our rating on Ingersoll-Rand plc (NYSE: IR) is BUY.

Going forward, we expect IR to benefit from improving

economic conditions and strength in U.S. construction

markets, and look for the Climate segment to continue to

deliver mid-single-digit growth, driven by strength in the U.S.,

Europe - and more recently Latin America and China. We also

expect the company to benefit from recent acquisitions.

Management has been focused on rewarding shareholders; it

recently boosted the dividend by 12.5% and has a share

repurchase program. The stock appears favorably valued

relative to peers based on P/E and price/sales. We are

reiterating our BUY rating and raising our target price to

$105. We think the shares are a suitable core holding in a

diversified portfolio.

RECENT DEVELOPMENTS

IR shares have outperformed over the last quarter, gaining

5% while the S&P 500 has risen 2.2%. Over the past year, the

shares have underperformed, advancing 13% while the market

has gained 15.6%. IR shares have also underperformed the

industry ETF IYJ over the past year but have outperformed

over the past 5- and 10-year periods. The beta on IR shares is

1.24.

On January 31, the company reported 4Q EPS that rose

more than 20% but fell just shy of Street expectations.

Fourth-quarter revenue grew 6% on an organic basis to $3.7

billion. Bookings advanced a stronger 5% to $3.6 billion. The

adjusted operating margin rose 20 basis points to 11.1%.

Adjusted EPS increased 21% to $1.02, compared to the

consensus forecast of $1.03. For the full year, the company

earned $4.51 per share, once cent above management's target.

On a conference call to discuss 4Q results, management

established guidance for 2018. It expects adjusted EPS from

continuing operations of $5.00-$5.20, and organic revenue

growth of 3.0%-3.5%.


Ingersoll-Rand has two primary business segments:

Climate (78% of 4Q sales) and Industrial (22%). The Climate

segment provides heating, ventilation and air conditioning

(HVAC) systems, and consists of brands such as Trane and

Thermo King. The Industrial segment provides a diverse

range of products and services, including compressed air

systems, power tools, and golf carts. Fourth-quarter results

and outlooks by segment are summarized below.

In the Climate segment, revenue rose a solid 6%

year-over-year on an organic basis. The operating margin was

12.6%, down 100 basis points from the prior year. Bookings

rose 7% organically. In the Residential HVAC business, sales

and bookings picked up to low-teens and high-single digit

rates. In Transportation Refrigeration, the company noted

improvement in revenue but a decline in bookings due to

weakness in North America trailer and marine. Commercial

HVAC reported that organic revenue growth was up in the

mid-single digits, while bookings rose at higher rates; margins

declined as the company targeted underpenetrated markets in

China, but this initiative is expected to be accretive to EPS in

2018 and beyond.

Revenue in the Industrial segment rose 5% on an organic

basis, above the long-term trend. Bookings increased 12%,

signaling even better growth ahead. The segment adjusted

operating margin rose 220 basis points from the prior year to

12.9%. This business, which has been exposed to challenging

macro trends in commodities and energy, appears on the road

to recovery. Management has been focusing on cost-cutting

and expects continued margin improvement in 2018. In a sign

Section 2.59


that energy markets are recovering, bookings in Compression

Technologies increased in the mid-teens. Bookings in

Industrial Products and Club Car were both higher. We

continue to look for solid growth in 2018.

Turning to our estimates, based on bookings and margin

trends, as well as expectations of a lower tax rate, we are

raising our 2018 estimate to $5.19 from $5.17. Our estimate is

just above the low end of management's guidance range and

implies growth of 15% for the year. We look for continued

growth in 2019 and are implementing a preliminary EPS

estimate of $5.81. Our five-year earnings growth rate forecast

remains 10%.


Our financial strength rating on IR is Medium-High. The

company receives above-average scores on our key financial

strength criteria of debt levels, fixed-cost coverage, cash flow

conversion and profitability.

IR had $1.5 billion in cash and cash equivalents at the end

of 4Q17, down from $1.7 billion at the end of 2016. Total

debt was $4.0 billion or 36% of total capital. Operating

income covered net interest expense by a factor of 8.5 last

year. The company's free cash flow to net income ratio was an

impressive 118%.

The company has a share repurchase plan.

Ingersoll-Rand pays a dividend. In August, it increased its

payout by 12.5% to $0.45 per quarter, or $1.80 annually, for a

yield of about 1.9%. We think the dividend is secure and

likely to grow. Our dividend forecasts are $1.94 for 2018 and

$2.14 for 2019.

MANAGEMENT & RISKS

Mike Lamach has been the company's CEO since early

2010, and previously served as chief operating officer. Susan

Carter has been the CFO since September 2013.

The company's strategy is to deliver reliable,

energy-efficient and environmentally friendly products in

growing markets. The company's businesses are typically

among the top 2 in each industry.

Investors in IR shares face risks.

IR, based in Ireland, faces the risk that the U.S.

government, led by Donald Trump, who ran on the campaign

of 'Make America First,' may rescind tax benefits and deny

contracts to U.S. companies that have reincorporated abroad.

The Homeland Security Act of 2002, for example, prohibits

such companies from receiving contracts from the Department

of Homeland Security. Further restrictions may also be

imposed by state and local governments.

The company continues to grow both organically and

through acquisitions. In January 2018 it acquired ICS Cool

Energy, a privately owned temperature control and HVAC

solutions and services company that specializes in temporary

rental of energy efficient chillers for commercial and

industrial buildings across Europe. Acquisitions such as these

acquisitions pose integration risks.

Ingersoll-Rand has reduced its exposure to

heavy-equipment sales cycles, providing some protection from

weak construction activity. The acquisition of Trane, the sales

of Bobcat and Dresser-Rand, and the expansion of the

Security Technologies product portfolio have also helped to

create a more diversified business.

IR generates substantial revenue overseas and its results

are typically linked to global economic trends. Worldwide, we

estimate that global GDP advanced at a 3.1% rate in 2016; we

and the IMF look for growth of 3.7% in 2017 and 3.9% in

2018.

Ingersoll Rand is also sensitive to trends in the dollar.

Looking ahead, we think the greenback is fairly valued and in

a trading range, particularly if the Federal Reserve continues

to move slowly to raise short-term rates. A stable or falling

dollar would be a positive development for the Industrial

sector and Ingersoll-Rand.

COMPANY DESCRIPTION

Ingersoll-Rand is a diversified large-cap industrial

company headquartered in Ireland. The company's two

operating divisions are Climate and Industrial.

VALUATION

We think that IR shares are favorably valued at current

prices near $90, above the midpoint of their 52-week range of

$77-$96. On a technical basis, the shares, after establishing a

triple-bottom near $49 in January-February 2016, have

embarked on a bullish pattern of higher highs and higher lows.

To value the stock on a fundamental basis, we use a peer

and historical comparison model, as well as a dividend

discount model. IR shares are trading at 17.4-times our 2018

estimate, just above midpoint of the historical range of 12-21.

On a price/sales basis, the shares are trading near the midpoint

of the five-year range. The dividend yield of 1.9% is above

the midpoint of the five-year range. Compared to the peer

group, IR's multiples generally point to undervaluation. Our

dividend discount model renders fair value near $120.

Blending our approaches, we arrive at a revised target price of

$105.

On February 5, BUY-rated IR closed at $90.53, down

$4.71. (John Eade, 2/5/18)

International Paper Co (IP)


HIGHLIGHTS

*IP: Boosting target by $8 to $70

*Despite rising input costs, International Paper has been

able to pass along price increases, increase production, reduce

planned maintenance outages, and improve manufacturing

efficiency.

*On February 1, the company reported 4Q17 non-GAAP

net income of $530 million or $1.27 per diluted share, up from

$279 million or $0.67 per share in 4Q16. EPS topped the

consensus of $1.19 and our estimate of $1.18.

*We are increasing our 2018 EPS estimate from $4.35 to

$4.70, which assumes further acquisition-related synergies

Section 2.60


along with higher production and pricing. We are also setting

a 2019 estimate of $5.15.

*On valuation, IP is trading at 13.2-times our 2018 EPS

forecast, below the midpoint of the five-year annual range of

7.8-21.2 and the average multiple of 17.7 for close

competitors.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on International

Paper Co. (NYSE: IP) and raising our target price to $70 from

$62. We believe that IP's purchase of assets from

Weyerhaeuser will continue to strengthen its product line and

expand its customer base. The company has also acquired a

newsprint mill in Spain from Holmen Paper, which it will

convert to produce recycled container board, and has sold a

range of underperforming assets. In addition, it is buying back

stock and has a steady record of increasing its dividend, with a

3% increase in November 2017. The company has also

implemented effective cost-cutting measures while integrating

acquisitions; in all, it expects acquisition-related synergies of

$200 million in 2018, which should help to offset rising input

costs. On valuation, IP is trading at 13.2-times our 2018 EPS

forecast, below the midpoint of the five-year annual range of

7.8-21.2 and the average multiple of 17.7 for close

competitors. The dividend yield of about 3.1% is above the

peer average of 2.3%, indicating value. Our target price of $70

implies a multiple of 14.9-times our 2018 EPS estimate, near

the midpoint of the five-year range and below the peer

average. We believe that the recent decline in share price

offers investors an attractive entry point.

RECENT DEVELOPMENTS

IP shares have outperformed the S&P 500 over the past

three months, rising 8.8% while the index has gained 6.7%.

They have gained 17.3% over the past year, compared to a

gain of 20.2% for the index. The beta on the stock is 1.5.

On February 1, the company reported 4Q17 non-GAAP

net income of $530 million or $1.27 per diluted share, up from

$279 million or $0.67 per share in 4Q16. EPS topped the

consensus of $1.19 and our estimate of $1.18. Non-GAAP

earnings excluded a provisional net tax benefit of $1.2 billion

($2.93 per diluted share) related to the passage of the Tax

Cuts and Jobs Act of 2017. Fourth-quarter revenue rose to

$5.71 billion from $5.38 billion in 4Q16, but fell short of the

consensus forecast. The year-over-year increase in revenue

reflected higher realized prices, and record volume in North

American Industrial Packaging and Global Cellulose Fiber.

For the full year, IP posted adjusted EPS of $3.60, up

from $3.36 in 2016. Revenue was $22.9 billion, up from

$21.1 billion a year earlier.

On September 26, 2017, International Paper agreed to

purchase a group annuity contract from Prudential Insurance

and transfer to Prudential future pension benefit obligations

and annuity administration for approximately 45,000

participating employees. The agreement will reduce IP's $14

billion in pension plan liabilities by approximately 9%.

On September 22, IP announced plans to convert its #15

paper machine at Riverdale Mill from uncoated freesheet to

high-quality whitetop linerboard and containerboard. The

conversion, which is expected to be completed by 2019, will

add 450,000 tons of annual capacity and provide the ability to

shift manufacturing among different containerboard products.

IP will invest $300 million in the project.


We expect IP to generate $200 million in

acquisition-related synergies in 2018. We are boosting our

2018 EPS estimate from $4.35 to $4.70, which assumes

further acquisition synergies along with increased production

and higher pricing. We are initiating a 2019 estimate of $5.15.

Assuming further global economic recovery, we believe that

IP will continue to leverage its geographically diverse revenue

base to generate stronger earnings and cash flow.


We rate International Paper's financial strength as

Medium, the midpoint on our five-point scale. IP's debt is

rated Baa2/stable by Moody's and BBB/stable by Standard &

Poor's. Fitch no longer rates IP's debt.

At the end of 4Q17, IP's debt/capitalization ratio was

63%, down from 72% at the end of 4Q16 but above the peer

average of 48%. IP had cash and equivalents of $1.02 billion

at the end of 2017, compared to $1.03 billion at the end of

2016, and debt of $11.2 billion, compared to $11.3 billion a

year earlier.

In November 2017, the company raised its quarterly

dividend by 3% to $0.475, or $1.90 annually, for a yield of

about 3.1% - above the peer average of 2.3%. Our dividend


We expect IP to continue to repurchase stock

opportunistically, and to announce a new buyback

authorization when its current program is completed.

MANAGEMENT & RISKS

Mark S. Sutton became IP's CEO on November 1, 2014

and chairman of the board on January 1, 2015. Mr. Sutton was

previously the company's chief operating officer. He

succeeded John Faraci, who had served as CEO and chairman

since November 2003. Glenn Landau, formerly senior vice

president of Finance, recently succeeded Carol Roberts as the

company's CFO. IP has a deep bench of executive talent, and

we expect future management changes to be smooth.

Executive bonuses are tied to free cash flow, return on

investment, and total shareholder return, which we consider

appropriate.

Investors owning shares in International Paper face a

range of risks. In addition to the industry-wide issues of

competition, operational efficiency, environmental compliance

and potential litigation, the firm has significant debt. Pulp and

paper prices can also be highly volatile.

COMPANY DESCRIPTION

Section 2.61


International Paper is a global producer of renewable

fiber-based packaging, pulp and paper products with

manufacturing operations in North America, Latin America,

Europe, North Africa, India and Russia. It produces

corrugated packaging products; pulp for diapers, tissue and

other personal hygiene products; and printing and writing

papers. The company was founded in 1898 and is based in

Memphis, Tennessee.

VALUATION

We think that IP shares are attractively valued at current

prices near $62. Over the past 52 weeks, the shares have

traded between $49 and $67.

On the fundamentals, IP is trading at 13.2-times our 2018

EPS forecast, below the midpoint of the five-year annual

range of 7.8-21.2 and the average multiple of 17.7 for close

competitors such as Westrock Co. (WRK), Packaging Corp.

of America (PKG), Avery Dennison (AVY) and Sonoco

Products (SON). The price/sales ratio is 1.1, near the top of

the five-year range of 0.6-1.2 but below the peer average of

1.3. The price/book ratio is 3.9, in the middle of the five-year

range of 2.4-5.5 and below the peer average of 4.2. The

dividend yield of 3.1% is above the peer average of 2.3%,

indicating value. Our target price of $70 implies a multiple of

14.9-times our 2018 EPS estimate, near the midpoint of the

five-year range and below the peer average.

On February 5 at midday, BUY-rated IP traded at $62.23,

up $0.06. (David Coleman, 2/5/18)

Invesco Ltd (IVZ)


HIGHLIGHTS

*IVZ: Favorable AUM trends continue in 4Q

*On January 31, Invesco reported adjusted 4Q17 adjusted

EPS of $0.73, up from $0.59 in the prior-year quarter and

above the consensus of $0.70.

*Average assets under management rose 15% from the

prior year. Net inflows were light at $2.7 million, but AUM

benefited from a strong quarter for market appreciation and

positive currency translation.

*In late September 2017, Invesco agreed to acquire the

ETF business of Guggenheim Investments, with $36.7 billion

of assets under management.

*IVZ trades at 11.6-times our 2018 EPS estimate, below

the industry average multiple of 15.0. Our target price of $41

implies a multiple of 13.2-times our forward four-quarter EPS

estimate, closer to the industry average.

ANALYSIS

INVESTMENT THESIS

We are reaffirming our BUY rating on Invesco Ltd.

(NYSE: IVZ) following the company's fourth-quarter results.

AUM trends showing 15% growth were favorable in 4Q, with

a combination of net inflows ($2.7 billion), market

appreciation ($14.9 billion), and currency translation ($2.5

billion). The addition of Source, a European-based ETF

provider with $26 billion in total AUM (in-house and

externally managed), also boosted 3Q results.

The company agreed in late September to acquire the

ETF business of Guggenheim Investments, with $36.7 billion

of assets under management. The transaction is expected to

close in 2Q18. We view the acquisition favorably, based both

on price (which is 4% of AUM) and the range of ETFs being

acquired (which include smart-beta and index funds).

Invesco is among the largest independent investment

management firms, with a large retail equity business that we

believe is well positioned to benefit from improving equity

market values. AUM is leveraged toward equities, with 46%

in stocks and 24% in bonds. We believe that recent strength in

equity market values bodes well for profitability.

IVZ trades below industry-average levels for P/E and

price/book. As management focuses on cost controls and

boosts operating margins toward the level of the industry

leaders, we expect earnings and valuation multiples to

increase.

RECENT DEVELOPMENTS

Over the past year, IVZ shares have risen 25%, similar to

the broad market.

On January 31, Invesco reported adjusted 4Q17 adjusted

EPS of $0.73, up from $0.59 in the prior-year quarter and

above the consensus of $0.70. Net revenue of $985 million

rose 17%, aided by gains in investment management fees from

growth in average assets under management, sharply higher

performance fees, and the acquisition of Source. Average

AUM rose 15% to $930.3 billion.

Adjusted operating expenses rose 15%, which the

company attributed in part to higher marketing expenses

related to the Source acquisition. Adjusted net income rose

25% to $299.18 million.

For all of 2017, net revenues rose 11% to $3.7 billion,

while adjusted EPS climbed to $2.70 from $2.23.

In September 2017, Invesco agreed to acquire the ETF

business of Guggenheim Investments, with $36.7 billion of

assets under management, for $1.5 billion in cash. The

company noted that the acquisition would expand its active,

passive and alternative investment capabilities.

In August 2017, Invesco acquired Source, an independent

specialist ETF provider in Europe with $26 billion in equity,

fixed-income, and commodity ETF assets, including smart

beta and active ETFs. The purchase was made using available

cash.


Invesco reported average assets under management of

$930.3 billion in 4Q17, up 15% from the prior year, aided by

the integration of Source, which was acquired in August. We

look for a 9% rise in average AUM in 2018, aided by healthy

equity markets and the acquisition of Guggenheim's ETF

business. Management has guided toward organic AUM

growth of 3%-5%, including dividend reinvestment, and

Section 2.62


expects additional growth to come through acquisitions.

Long-term net inflows in 4Q were $4.4 billion, down from

$5.2 billion in 3Q, though a strong quarter for market

appreciation added $14.9 billion. The Source acquisition

boosted assets by $26 billion in 3Q.

Most of the company's actively managed funds have

performed in the top half of their peer group range over the

past five years - generally a good sign that the company has

the ability to attract and retain investment assets.

The net revenue yield (investment revenues divided by

AUM) has generally been declining due to lower fees in a

competitive asset management environment; however,

margins have benefited from the company's increased scale.

Growth in employee compensation costs has been better

contained in recent quarters, benefiting from a business

optimization program. However, headcount continues to

increase to support growth initiatives. The company had 7,030

employees as of December 31, up from 6,790 a year earlier.

The business optimization program (announced in 4Q15)

focused on making support functions more efficient. IVZ

recorded a 4Q charge of $16.2 million for this program,

including $12.2 million for staff severance costs. IVZ noted

that the initiative delivered $43 million in run-rate expense

savings in 2017.

Management projects a 20%-21% effective tax rate in

2018, down from the 27% paid in 2017, following the recent

passage of the Tax Cuts and Jobs Act. Largely reflecting the

lower effective tax rate, we are raising our 2018 EPS estimate

to $3.11 from $2.96. We are also setting a 2019 forecast of

$3.40.

Over the long term, we expect strong investment results

to lead to fund inflows and higher performance fees, and

project long-term earnings growth of 8%.


Our financial strength rating for Invesco is Medium, the

midpoint on our five-point scale. The company scores well on

our three-point test of debt levels, fixed-cost coverage, and

profitability. In 4Q17, the adjusted operating margin was a

robust 39.7%. Cash and cash equivalents totaled $2.0 billion

at the end of 4Q17, and long-term debt totaled $2.1 billion

(excluding debt of consolidated investment products).

In 1Q17, the company raised its quarterly dividend by

3.6% to $0.29 per share, or $1.16 annually, for a yield of

about 3.2%. Our dividend estimates are $1.28 (raised from

$1.19) for 2018 and $1.38 for 2019.

In 4Q16, the company repurchased $150 million of its

common stock, or 4.8 million shares, at a weighted-average

price of $31.43 per share. Invesco did not repurchase any

shares in 2017, which it attributed to the acquisition of Source

and the pending acquisition of Guggenheim's ETF business.

MANAGEMENT & RISKS

Martin Flanagan, 57, has been president and CEO of

Invesco since 2005, and has worked to improve the firm's

operational efficiency and position it for growth. Prior to

joining Invesco, Mr. Flanagan worked for Templeton Funds.

Investors in IVZ shares face numerous risks, including

the fact that most of the company's revenues are tied to the

value of assets under management.

Management is under constant pressure to provide the

right products to meet investors' evolving needs. As the

industry consolidates, management will face more pressure to

have the right products to maintain market share.

The company's results are also dependent on product

performance, and a prolonged downturn in investment results

could hurt sales, earnings and the share price.

COMPANY DESCRIPTION

Invesco is an independent global investment manager; it

provides a variety of investment alternatives to high-net-worth

and retail investors, as well as to institutions worldwide.

Headquartered in Atlanta and incorporated in Bermuda, it

offers investors equity, fixed-income and alternative

investment funds. IVZ shares are a component of the S&P

500.

The company's first operations date back to England and

Wales in 1935, and the original Invesco was founded in the

United States in 1978. After a series of smaller mergers in the

1980s, the company merged with AIM in 1997 to form

AMVESCAP, and was then rebranded as Invesco in 2007.

Current subsidiaries, brought in through acquisitions, include

ETF leader PowerShares, among others.

VALUATION

IVZ shares appear attractive at current prices in the

mid-$30s. Over the past 12 months, the shares have traded in

a range of $29-$38. IVZ trades at 11.6-times our revised 2018

earnings estimate, compared to an industry average of 15.0.

The shares also appear inexpensive on a price/book basis,

with a multiple of 1.8, and carry a dividend yield of about

3.2%, above the average for large-cap financials.

Our target price of $41 implies a multiple of 13.2-times

our 2018 EPS estimate, closer to the industry average. Invesco

has lower operating margins than some peers, such as

BlackRock, but continues to benefit from consistent

profitability, a strong industry position, and a clean balance

sheet.

On January 31 at midday, BUY-rated IVZ traded at

$36.22, down $0.46. (Stephen Biggar, 1/31/18)

JetBlue Airways Corp (JBLU)


HIGHLIGHTS

*JBLU: Solid 4Q results; maintaining HOLD

*JBLU shares have had a strong run over the past five

years, with a return of 235%. EPS rose strongly from 2012 to

2016, reflecting impressive traffic and capacity growth and

the impact of low fuel prices.

*However, we expect rising fuel costs and other expenses

to cause some investors to avoid the shares going forward.

*We are maintaining our 2018 estimate of $2.16 and

Section 2.63


setting an estimate of $2.30 per share for 2019.

*We will look to put this well-managed airline back on

the BUY list on signs of improved investor sentiment or a

significant nonfundamental pullback in the share price.

INVESTMENT THESIS

We are maintaining our HOLD rating on JetBlue Airways

Corp. (NGS: JBLU). JBLU shares have had a strong run over

the last five years, with a return of 235%. Earnings rose

strongly in 2012-2016, driven by impressive traffic and

capacity growth, as well as by low fuel prices. However, we

expect rising fuel costs and other expenses to cause some

investors to avoid the shares going forward. We will look to

put this well-managed airline back on the BUY list on signs of

improved investor sentiment or a significant nonfundamental

pullback in the share price.

RECENT DEVELOPMENTS

On January 25, JetBlue reported fourth-quarter results.

Net income fell to $170 million or $0.32 per diluted share

from $274 million or $0.50 per share a year earlier. The

consensus estimate had called for earnings of $0.34 per share.

The decrease reflected an 8.1% increase in CASM.

Management had expected CASM to rise 5.0%-7.0% in the

fourth quarter.

In the fourth quarter, revenue rose 7.0% to $1.76 billion,

above the consensus estimate of $1.75 billion. Passenger

revenue grew 5.9% to $1.56 billion, while 'Other' revenue

grew 16.9%. Revenue passenger miles rose 3.1% to 11.5

billion on a capacity increase of 5.1%. Management had

projected 4.5%-5.5% higher capacity. The fourth-quarter load

factor was 83.1%, down 160 basis points from the prior-year

period. The yield per passenger mile rose 2.8% to $0.136.

Passenger revenue per available seat mile (PRASM) increased

80 basis points from the prior year to $0.113, while operating

revenue per available seat mile (RASM) increased 180 basis

points to $0.127.

Fourth-quarter operating expenses rose 16.5% from the

prior year to $1.57 billion, reflecting rising aircraft fuel costs

and an increase in salaries, wages and benefits. Operating

income fell 36% to $189 million, and the pretax operating

margin decreased to 10.8% from 18.0% in 4Q16.

In 2017, revenue increased 5.8% to $7.0 billion, but

earnings declined from $2.19 to $1.76 per share.

Along with the 4Q results, management provided 2018

guidance. It expects CASM excluding fuel to be 1.0% lower

to 1.0% higher in 2018. It also looks for capacity to increase

6.5%-8.5%.

RASM is expected to be up 2.5%-5.5% year-over-year in

the first quarter of 2018.

Management expects CASM ex-fuel to be up 2.0%-4.0%

in the first quarter. It also expects capacity to increase 3.5%

-5.5%.


For 2018, we expect an 8.5% increase in revenue to $7.6

billion on 8% higher capacity and slightly higher yields.

We expect CASM excluding fuel to rise 1.0% in 2018, at

the high end of management's forecast for 1% lower to 1%

higher CASM. We look for cost-cutting initiatives to continue

to benefit results over the next 12-18 months

We are maintaining our 2018 estimate of $2.16 based on

our expectations for solid revenue growth. For 2019, we are

setting an estimate of $2.30 per share.

FINANCIAL STRENGTH

Our financial strength rating on JetBlue is Medium, the

midpoint on our five-point scale. The company ended 4Q17

with $695 million in cash and investment securities, down

from $1.06 billion at the end of 4Q16. Total debt of $1.20

billion at the end of 4Q17 was down from $1.38 billion at the

end of 2016.

JBLU does not pay a dividend, and we do not expect it to

initiate one in the near term.

The company's long-term debt is rated Ba3/stable by

Moody's, BB-/stable by S&P, and BB-/stable by Fitch. The

company has a debt/cap ratio of 24%, below its 30%-40%

target range.

MANAGEMENT & RISKS

Robin Hayes took the reins as JetBlue's CEO in February

2015, succeeding David Barger. Mr. Hayes previously served

as the company's president.

Investors in the JBLU shares face risks. Airline

financials, labor negotiations, fare and traffic rates, and fuel

costs all represent potential catalysts for share price

movement. In addition, the risk of a major terrorist attack or

health scare is ever-present.

JetBlue faces tough competition from other low-cost

carriers, as well as from legacy airlines that have slashed fares

in recent years. The company's biggest challenge is to expand

its route structure while sustaining margin and earnings

growth. The company hopes that its new and retrofitted Mint

planes and associated in-flight service will help it to maintain

ticket prices amid increased competition.

JBLU's internal operations have not always kept pace

with capacity. As it is based in New York City, the airline also

faces the risk of delays caused by significant traffic

congestion in the area or by major storms. Given JBLU's

relatively high aircraft utilization rate, a major delay could

have a domino effect, hurting the entire network.

We note that JetBlue employees, unlike those of many

airlines, are not unionized. As a result, the company has been

able to design a competitive pay structure that responds well

to market changes, incorporating profit-sharing and

stock-based compensation.

COMPANY DESCRIPTION

JetBlue Airways is a low-cost airline based at New York's

JFK Airport. The airline operates a fleet of Airbus A320s and

Embraer E190s, and runs an average of 1000 daily flights to

101 destinations. JetBlue posted revenues of $7.0 billion in

2017.

Section 2.64


INDUSTRY

Our rating on the Industrial sector is Market-Weight.

Industrial sector EPS growth is below the market average,

while the two-year-forward P/E is above both the five-year

historical average and the market average.

The Industrial sector accounts for 10.3% 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 9%-11% of their diversified portfolios to the group.

The sector includes industries such as transportation,

aerospace & defense, heavy machinery and electrical

equipment.

The sector outperformed the market in 2016, with a gain

of 16.1%, after underperforming in 2015, with a loss of 4.7%.

It underperformed in 2017, with a gain of 18.5%.

By our calculations, the 2018 P/E ratio is 18.8, slightly

above the market multiple. Earnings are now expected to rise

9.2% in 2018 and 10.3% in 2017 after declining 3.3% in

2016. The sector's debt/cap ratio of 50% is above the market

average. The yield of 1.4% is below the market average of

1.8%.

VALUATION

JBLU shares fell 45% from late September 2015 to a

near-term low of $14.76 on June 27, 2016; they then rose to a

high near $23 in early January before trading lower through

most of February and March. The shares rose on October 24

following stronger-than-expected 3Q earnings, but fell sharply

the next day. They are currently trading near $21.


and historical multiple comparisons. JBLU shares are trading

at 9.7-times our 2018 EPS estimate, toward the low end of the

historical range of 7-25 and below the peer average of 15.3.

They are trading at a price/sales multiple of 1.1, in the upper

half of the five-year range of 0.3-1.3 but below the peer

average of 1.3. The price/book ratio of 1.9 is near the

midpoint of the five-year range of 0.7-3.0 and below the peer

average of 3.2. Based on prospects for moderate earnings

growth, we see limited near-term upside for JBLU. Our rating

remains HOLD.

On February 1 at midday, HOLD-rated JBLU traded at

$20.93, up $0.07. (John Staszak, CFA, 2/1/18)

Lazard Ltd (LAZ)


HIGHLIGHTS

*LAZ: Raising target to $62 following 4Q EPS

*On February 1, Lazard reported adjusted 4Q17 earnings

of $1.12 per share, down from $1.13 in the prior year but well

above the consensus of $0.90.

*Advisory revenues softened in 4Q under strong

prior-year comparisons, but a solid gain in asset management

fees was helped by a 16% year-over-year increase in average

AUM.

*The backlog of advisory deals remains healthy, and with

a still favorable macro environment, we expect advisory

revenues at Lazard to rebound.

*We look for Lazard to gain share relative to large and

mid-sized advisors, leading to above-industry-average revenue

growth.

ANALYSIS

INVESTMENT THESIS

We are reiterating our BUY rating on Lazard Ltd.

(NYSE: LAZ) and raising our target price to $62 from $53.

The company is operating in a healthy environment for both

advisory fees and assets under management. It also has a

favorable pipeline of deal activity and is advising on major

transactions that should result in continued strong advisory

fees.

Lazard has benefited from a generally healthy M&A

market that reflects a low cost of capital, CEO optimism,

rising shareholder activism, and efforts by companies to boost

revenue through both domestic and cross-border transactions.

The usage of repatriated cash, as part of the recent Tax Cuts

and Jobs Act, could also spur increased M&A activity as

companies look to expand.

The company is also gaining share relative to large and

mid-sized advisors. It ranks fifth in trailing 12-month financial

advisory revenues, below only Goldman Sachs, JPMorgan,

Morgan Stanley and Bank of America.

In our view, Lazard remains a compelling secular growth

story with a clean balance sheet and a focused business model.

We believe that Lazard's P/E has room to expand as

operating margins and market share improve. Our revised

target price of $62 implies a 15-times multiple on forecasted

2018 EPS. The dividend yields about 2.8%, adding a

significant recurring income component to the total return,

and is amply covered by cash flow. Special dividends the last

several years have also added a solid return component.

RECENT DEVELOPMENTS

Over the past year, LAZ shares are up 28%, compared to

a 15% gain for the broad market.

On February 1, Lazard reported adjusted 4Q17 earnings

of $1.12 per share, down from $1.13 in the prior year but well

above the consensus of $0.90. Revenues were flat at $683

million, as a 23% increase in asset management revenues was

offset by a 17% decline in financial advisory fees. Adjusted

net income was down 1% to $148.1 million.

The financial advisory segment was hurt by lower

strategic advisory and restructuring revenue, while greater

asset management fees reflected higher AUM. Average AUM

rose 22% to $244 billion in 4Q17.

For all of 2017, revenues were up 13% to $2.65 billion,

while adjusted EPS climbed to $3.78 from $3.09.


We believe the market environment for Lazard's broader

advisory practice - which includes restructuring and strategic

advisory - remains robust, and note that the company

Section 2.65


continues to gain advisory market share relative to peers.

Lazard's broad and deep coverage - by geography and industry

- distinguishes it from boutiques, while its focus on advisory

distinguishes it from large banks.

During the fourth quarter, the company advised on a

range of major M&A transactions: Level 3 Communications

on its $34 billion sale to CenturyLink; Gilead's $11.9 billion

acquisition of Kite Pharma; Paysafe's 3.0 billion British Pound

recommended sale to a consortium of funds managed or

advised by Blackstone and CVC; Express Scripts' $3.6 billion

acquisition of eviCore healthcare; and Anheuser-Busch

InBev's $3.2 billion transition of its 54.5% stake in Coca-Cola

Beverages Africa to The Coca-Cola Company. We believe the

pipeline of capital advisory, sovereign advisory, restructuring,

and debt advisory deals remains healthy.

Advisory revenues should continue at a relatively high

pace, as current transactions begin to close. The top-five deals

on which the company is advising totaled more than $175

billion at the end of 4Q. In 2018, we look for a 3% rise in

advisory revenue, which includes difficult comparisons with a

strong 2017.

The asset management business has also been performing

well. Average AUM was up 16% in 2017 to $227 billion, with

recent results benefiting from market appreciation and healthy

inflows. We are projecting 9% growth in asset management

revenues in 2018, leading to 5% growth in overall revenues.

Compensation was 53.8% of revenue in 4Q17, down

from 54.9% the prior year. The company expects to achieve a

compensation ratio in the mid- to high 50% range on both an

awarded and adjusted basis. Noncompensation expense was

18.5% of revenue in 4Q17, up from 16.8% a year earlier; the

company's goal is to keep this ratio between 16% and 20%.

Management is guiding toward an effective tax rate in the

mid-20s in 2018, following recent passage of the Tax Cuts

and Jobs Act. Aided by the lower rate, as well as recent

momentum in the asset management business, we are raising

our 2018 forecast to $4.13 from $3.76. We are initiating a

2019 EPS forecast of $4.39.


Our financial strength rating for Lazard is High. The

company has a low long-term debt/cap ratio and high

liquidity. Lazard acts mainly as an advisor; it does not provide

financing for transactions or otherwise commit its own capital

in order to complete transactions.

In April 2017, Lazard announced an 8% increase in its

quarterly dividend to $0.41 per share, or $1.64 annually, for a

yield of about 2.8%. We estimate regular dividends of $1.70

in 2018 and $1.78 in 2019, representing a payout ratio in the

low-40s for both years. The company declared a special $1.30

per share common stock dividend in January 2018, special

$1.20 per share common stock dividends in January 2017 and

February 2016, and a special $1.00 per share dividend in

February 2015. Special dividends have provided a healthy

boost to total return. The extra yield on the early 2018 special

dividend was about 3.0%.

In 2017, Lazard repurchased 7.0 million shares of

common stock for about $309 million. In October 2017, the

board authorized additional share repurchases of up to $200

million through the end of 2019. Share buybacks primarily

offset dilution from share issuances and have not

meaningfully reduced the diluted share count.

MANAGEMENT & RISKS

Lazard is led by Chairman and CEO Kenneth M. Jacobs,

who has been in those roles since 2009.

While Lazard has diversified its revenue in recent years,

revenue is still highly dependent on fees earned from advising

clients on financial transactions and fees earned on assets

under management. Lazard also earns fees if its investment

funds exceed return hurdles, but these typically account for

only 5%-10% of asset management revenues. Thus, Lazard's

revenues can be volatile and tough to predict from quarter to

quarter.

Advisory revenues are dependent on levels of CEO

confidence as well as stock valuations and conditions in the

financing markets. Large companies are currently flush with

cash, financing markets are functioning well, and interest rates

remain at historically low levels.

With regard to risks related to financial regulatory reform,

we note that Lazard does not have a proprietary trading desk

or commit its own capital to private equity or real estate funds.

As a result, the Volcker Rule has no direct impact on the

company.

COMPANY DESCRIPTION

Lazard Ltd., one of the world's leading financial advisory

and asset management firms, provides advice on mergers and

acquisitions, strategic matters, restructuring and capital

structure, capital raising and corporate finance, as well as

asset management services to corporations, partnerships,

institutions, governments, and individuals.

VALUATION

Lazard derives about 52% of its revenues from corporate

advisory and the balance from institutional asset management.

The asset management piece is tough to benchmark. While

Lazard has been able to consistently grow assets in recent

years, the average 2018 P/E for large publicly traded

traditional active asset managers has been hurt by outflows to

passive index strategies. In comparisons with advisory firms,

Lazard trades well below Greenhill (GHL), with a multiple of

17-times the 2018 consensus. Moelis (MC), a pure-play

advisor that went public in April 2014, trades at about

20-times the 2018 consensus. Advisory revenues for Greenhill

and Moelis are a fraction of those for Lazard, and the growth

rates for those companies will be faster in an improving M&A

market (assuming they don't lose market share).

Assuming a continued healthy M&A environment and

stable to rising assets under management, we believe that LAZ

shares should trade closer to 15-times our 2018 estimate,

closer to the peer average for advisory firms. Our target price

of $62 (raised from $53) implies a multiple of 15-times our

Section 2.66


2018 estimate.

On February 6, BUY-rated LAZ closed at $56.80, up

$0.14. (Stephen Biggar, 2/6/18)

Lululemon Athletica Inc (LULU)


HIGHLIGHTS

*LULU: CEO fails to meet conduct standards, resigns

*After the close of trading on February 5, lululemon

announced that CEO Laurent Potdevin was resigning. Lulu

said in a press release said that it 'expects all employees to

exemplify the highest levels of integrity and respect for one

another, and Mr. Potdevin fell short of these standards.'

*Glenn Murphy will have an expanded role as Executive

Chairman. Mr. Murphy is a proven executive who we met

during his tenure as CEO of GAP. In addition to running the

huge specialty retailer whose Athleta brand competes with

lululemon, he was CEO of Shoppers Drug Mart and a senior

executive at Loblaw Companies, which is the biggest grocery

chain in Canada.

*For FY19, we are raising our full-year estimate to $3.00

per share from $2.65 per share. This reflects about 11% sales

growth, up from 9.5%% previously and an improvement in

our estimate of operating margin to approximately 19% from

18.3% previously.

*We are lowering our FY19 tax rate estimate to 27%

from 31%. Our sales forecast is $2.9 billion, which is close to

consensus. Our estimate of operating income is $558 million

versus consensus of $566 million and our estimate of net

income is $408 million versus the current consensus of $403

million. Consensus EPS is $3.02 per share.

ANALYSIS

INVESTMENT THESIS

Our rating on lululemon athletica inc. (NGS: LULU)

remains HOLD, as the shares are trading close to our fair

value estimate.

Lululemon has been recovering from quality-control

issues, merchandising missteps, supply-chain challenges, and

concerns about management turnover. It appears that demand

is returning and the flow of merchandising is generally

improving.

We believe that the company remains poised for several

years of double-digit earnings growth, driven by an increase

in retail square footage, the expansion of its e-commerce and

international businesses, the development of new products,

and the addition of features and fabrics to enhance existing

product lines. The company's grassroots marketing, in-store

events, product innovation and controlled distribution also

provide a competitive advantage that enhances LULU's

product offering at a time when competition from online

sellers is compressing margins on all but the most unique

merchandise.

The shares may benefit from the company's ability to

maintain industry-leading store productivity. However,

management must continue to restore the product quality and

performance, merchandise availability, and image that are

essential to a premium brand. We believe that the company's

in-store service remains top-notch.

A risk is from both competition and substitution. A whole

range of competitors from Under Armour to Nordstrom are

making competing products. Another risk is that some

retailers are seeing customers switching to 'jeans' that

incorporate more advanced materials and construction to

improve their comfort and fit.

While our analysis currently suggests that the shares are

fairly valued, we would consider raising our recommendation

if it appears that the company can further improve the

efficiency of its design, production and supply chain with

incremental increases to operating margin.

RECENT DEVELOPMENTS

After the close of trading on February 5, lululemon

announced that CEO Laurent Potdevin was resigning for

failing to meet the company's standards of conduct. The

company's press release was vague, but it said that it 'expects

all employees to exemplify the highest levels of integrity and

respect for one another, and Mr. Potdevin fell short of these

standards of conduct.'

Glenn Murphy now has an expanded role as Executive

Chairman. Mr. Murphy is a proven executive who we met

during his tenure as CEO of GAP. In addition to running the

huge specialty retailer whose Athleta brand competes with

lululemon, he was CEO of Shoppers Drug Mart and a senior

executive at Loblaw Companies, which is the biggest grocery

chain in Canada.

The company also announced that three of lululemon's

top managers will take on additional responsibilities, reporting

to Mr. Murphy; Executive VP, Americas Celeste Burgoyne,

will oversee the global business, including stores and

e-commerce, and brand marketing; COO Stuart Haselden will

have responsibility for all operations related to finance, supply

chain, people, and technology; and Sr. VP of Merchandising

Sun Choe will guide all aspects of product development,

design, and merchandising.

The company also confirmed the earnings guidance it

provided on January 8, as discussed below.

On December 6, lululemon reported third-quarter EPS of

$0.43, which was down from the prior year's GAAP EPS of

$0.50 per share. The GAAP result includes about $0.13 per

share of restructuring costs related to the previously-discussed

plan under which the company closed 48 of the company's 55

ivivva stores. Through the third quarter, the company had

largely completed the $45 - $50 million of restructuring, asset

impairment and lease-termination costs. This is at the low end

of the company's initial guidance of $50 - $60 million. The

company plans to run ivivva primarily as an e-commerce

business with just the few remaining brick-and-mortar stores.

On an apples-to-apples basis, the 3Q result exceeded

expectations. The company earned $0.56 per share on an

Section 2.67


adjusted basis, which was above the adjusted $0.47 the

company earned in the prior year. The result also exceeded the

$0.52 per share non-GAAP consensus and the top of

management's non-GAAP guidance, which was also $0.52.

Our estimate was on a GAAP basis and in the middle of the

company's GAAP guidance of $0.33- $0.35. We will discuss

the deviations from our estimates, but one significant factor is

that we modeled 3Q impairments at $30 million, or $0.17 per

share, and they came in at $22 million, or $0.13 per share.

Fiscal third-quarter revenue rose 14% to $619 million,

which topped the StreetAccount consensus of $610 million

and our estimate of $608.5 million.

Total comparable sales, including direct-to-customer and

in-store sales, increased 7% on a constant-dollar basis. This

was better than the StreetAccount consensus of 5.3% growth.

Square footage was up 4% year-over-year. The company

closed a net 33 stores in the quarter with 17 openings offset by

50 stores closed.

Sales in company operated stores increased by 8% to

$425 million. The StreetAccount consensus was $431.5

million. Comparable-sales in company-operated stores were

up 1% in the quarter on a constant-dollar basis. Store comps

were up 2% in dollars. Traffic was down, but conversion

improved as a higher percentage of store visitors made

purchases. The visitors who made purchases also made larger

purchases.

Direct-to-consumer revenue jumped 26% to $131 million.

The StreetAccount consensus was $121.6 million. Direct

revenue was up 25% on a constant dollar basis. Management

has seen increases in traffic, conversion and the average dollar

value of transactions. Direct represented approximately 21.2%

of total revenue in 3Q, which was up 210 basis points

year-over-year.

The 2Q gross margin increased by 90 basis points to 52%

of sales. Most of the benefit came from higher product

margins. Gross margin was hurt by approximately 20 basis

points related to repositioning ivivva. There was a drag of

about 20 basis point from unfavorable exchange rates, and 20

basis points of drag from occupancy and depreciation costs.

The StreetAccount consensus was 51.2%. Our estimate was

50.9%.

SG&A dollars of $215 million rose 16% year-over-year

on a GAAP basis. The company had higher store labor costs,

technology spending and digital marketing. SG&A increased

by 70 basis points to 34.8% of sales. The StreetAccount

consensus was 34.8%. Our estimate was 34.7%. LULU also

had $21 million in asset impairments on a separate line of the

income statement. We had modeled $30 million of

impairments.

Adjusted income from operations, which excludes

impairments and restructuring costs was $74.14 million, little

changed in dollars. The adjusted operating margin was 17.4%,

which was up 30 basis points from the prior year and 80 basis

points better than the StreetAccount consensus. GAAP

operating margin decreased by 330 basis points to 13.8% of

sales. The result was better than the 11.3% we modeled

because our estimate of impairments was too high and actual

sales were higher than we expected. GAAP operating income

dollars were $17 million higher than we modeled with $9

million being a result of lower impairments. The remainder of

the outperformance is from better-than-expected gross margin

dollars offset by $4 million from higher SG&A.

Below the operating line, the tax rate of 32% was 20 basis

points below our estimate.

Total inventory was 9% higher than in the prior-year

quarter, but we don't see any markdown risk as inventory

growth is less than the projected growth in sales. Going

forward management expects inventories to grow in line with

sales expectations.

Cash generated from operations came to $131 million in

the first three quarters, up from $99 million a year earlier.


We are raising our FY18 diluted EPS estimate to $2.27

per share from $2.10 per share, which includes approximately

$0.25 per share of expense to restructure ivivva. Our estimate

is on a GAAP basis. Nine cents of this increase is a result of

3Q earnings coming in above our estimate with $0.04 of the

outperformance coming from lower-than-expected

restructuring and the rest coming from better sales and gross

margin than we expected. The remaining $0.08 of the increase

is from raising our 4Q GAAP estimate to $1.25 per share from

$1.17. This is based on the company's post-holiday guidance

of $1.24-$1.26 per share, which is up by $0.05 from guidance

issued at the end of 3Q. There are a few notable changes to

our estimate. The first is that we expect stronger sales than we

had modeled. The sales increase to nearly $910 million

reflects stronger comp-store and direct-to-customer growth

than we had modeled offset by slightly lower square footage.

We are also raising our estimate of operating margin. One

important clarification is that our estimate and the guidance

reflect a tax rate of 30.4%. Lulu expects to incur a significant

4Q repatriation tax on foreign earnings.

For FY19, we are raising our full-year estimate to $3.00

per share from $2.65 per share. This reflects about 11% sales

growth, up from 9.5%% previously and an improvement in

our estimate of operating margin to approximately 19% from

18.3% previously. About 40 basis points of this increase is

from our expectation for gross margin improvement. This

estimate does not include any restructuring costs, but we are

reducing our estimate of the tax rate to 27% from 31%. Our

sales forecast is $2.9 billion, which is close to consensus. Our

estimate of operating income is $558 million versus consensus

of $566 million and our estimate of net income is $408 million

versus the current consensus of $403 million. Consensus EPS

is $3.02 per share. We suspect that there is a fair amount of

uncertainty on the tax rate.

We are maintaining our five-year compound annual EPS

growth rate forecast of 20%. We will reevaluate this after the

4Q call. We still see significant growth opportunities in the

domestic, international and men's businesses. Sector-wide

demand appears strong, but LULU's leadership position is

Section 2.68


being challenged by growing competition and the potential for

competitors to seek new, lower priced distribution channels as

Under Armour did in choosing to sell merchandise through

Kohl's.

In our view, the company has the potential to open

additional stores in the U.S. and internationally. The

challenge, of course, isn't to simply open stores. The challenge

is to open highly productive stores, and the company has an

innovative process that is helping it to achieve sales of over

$1,100 per square foot in the first year a store is open,

compared with an old target of about $750 per square foot.

The more mature Canadian stores, with sales of approximately

$2,800 per square foot, are approximately 40% more

productive than the U.S. stores. This implies potential for

further gains in the U.S. stores as they build a loyal customer

base in their trade areas. The average store has sales of about

$1,500 per square foot.

Lululemon typically looks for street and mall locations

that are close to yoga studios and fitness centers. Initially, the

company will enter a new market with a showroom that is

roughly 700-1,000 square feet in a less expensive location.

These showrooms operate on a limited schedule to enable the

manager to build relationships in the community by visiting

the best yoga instructors, running coaches and trainers in the

area. Lululemon tries to find the professionals who share the

company's values as part of its word-of-mouth marketing. The

manager will hold trunk shows, in addition to running the

showroom, to build awareness and reach customers. The

company intends to expand its showroom presence in Europe

and Asia. We estimate that showrooms have recently

generated sales per store of approximately $500,000 per year.

Once a store is open, the staff members - called educators

- try to maintain a connection with customers by hosting

weekly yoga classes. The stores have community bulletin

boards designed to position the store as a hub of information

for core customers. Stores also have a community coordinator

whose job is to build a marketing plan with connections to

important athletic and charity events in the area.

The company's product development is also very

connected with influential professionals, or ambassadors, who

like the brand. The designers regularly meet with athletes and

practitioners in local markets and they also work in stores to

get direct feedback from guests.

It takes the company approximately nine months to get

products from design to market but it can get a select number

of products to market in as little as two months. Shortening

cycle times is an ongoing goal for retailers and apparel makers

because it allows them to have a better read on styles and

shopper demand before they commit to a major order. This

highlights the fact that LULU is both a manufacturer and a

retailer. We like the vertical integration in the current market

because the company has the structure and expertise to

develop unique proprietary merchandise. A differentiated

product offering is important amid the prevalence of internet

price comparisons. The company is constantly testing new

products and incorporating the most promising innovations

into its core products. Lululemon also largely controls its

distribution through its own stores, websites and a very small

wholesale channel that helps to build brand awareness.

On the plus side, controlled distribution provides

insulation from retailers, such as department stores, slashing

prices to drive store traffic and it also gives lulu a double

margin from being both the manufacturer and the retailer. The

company says that it reinvests some of this margin in the

quality of its products. Management believes that the quality

and technical attributes of its products, as well as its store

environment and connections to local communities are major

differentiators against competitors who are trying to gain

business by offering lower prices. Following the Luon fabric

problems, the company stepped up its technical standards and

testing and hired a new CEO, CFO, a new head of product

operations, a new head of logistics and a new chief product

officer.

Going forward, we expect the company to devote more

resources to developing localized assortments that will make

individual stores more productive. The company's operating

margin is very high compared to that of pure retailers,

although investments in the business and supply-chain issues

took the operating margin to approximately 18% in FY17.

The company could probably grow faster in the near term

with an exclusive retail partner, but that could compromise

long-term growth and control of the brand, which we view as

being important. It could also further strain the supply chain.

Managing stores, distribution, inventories, and building a web

presence has become very sophisticated work and it could be a

challenge for a small company to leverage these costs. That

said, we like the company's process for opening new stores

and believe it is the right strategy for maintaining the integrity

of the brand and the unique store experience, which aids its

ability to charge premium prices.

Over the next several years we expect substantial earnings

growth to be driven by store openings in the U.S. and

internationally. The ivivva concept is now poised to grow as

an online product rather than through square footage. The

company may try to add square footage to lulu locations when

it has leases up for renewal, but the company is likely to

maintain its stores at approximately 2,700-3,000 square feet.

Lulu is also aiming to raise eCommerce to well over 20% of

sales from approximately 16.5% in FY14 and 17.9% in FY15

and about 19.5% in FY16 and FY17. This means that even

with significant store openings, the company is expecting

eCommerce to grow faster than retail. We also believe that the

eCommerce business has an operating margin that is 3%-5%

higher than retail. Growth of eCommerce may divert sales and

reduce store comps. It isn't a problem to divert sales to a

higher margin channel; we just want to consider the

possibility when modeling comparable sales. The company is

working to integrate its online and store point of sale systems;

this should help inventory management and product

availability. Lulu recently completed a mobile phone

application to help users find yoga studios. This is a way to

build customer relationships and help the company's product

Section 2.69


ambassadors.

Lulu is planning to grow sales by providing merchandise

for more sports and activities. Running has grown to about

20% of the business and the men's business has significant

upside. The company is expanding its offering of polo shirts

for men. The core men's customer is approximately 35 years

old. The company sees the age range broadening. More men

are buying the products for themselves, and tend to view

LULU as a premium brand rather than a women's brand. The

company also noted that men, unlike women, are more likely

to buy multiple units of products they like.

Lulu's categories include running, swim suits and leisure

gear. That said, yoga-inspired products for women are likely

to remain the dominant component of the business, with new

categories being used to drive incremental traffic and help the

company to explore new directions for the business.

The company also seems intent on developing ways to

make its products more supportive and comfortable. It is

working to develop lighter fabrics and anti-chafe technology,

as well as fabrics that don't retain odors as some polyester

fabrics do.

We expect the company to open more country-specific

web sites with international fulfillment from distribution

centers in Hong Kong and Holland. We believe that LULU

reaches customers in more than 80 countries through a

combination of stores, showrooms and e-commerce.

We expect the company to open stores in international

markets only when e-commerce and showrooms show signs of

success, although management may accelerate the process

slightly. The company is also working to ensure that it has

created an effective ambassador network, trained employees,

and built sufficient infrastructure. To support international

expansion, the company is hiring more executives with

experience outside North America. The company recently

opened stores in Chengdu, Taipei and Munich.

Management has said that the German market may be

attractive, as the climate is conducive to the layering of

products. In addition, the population is sports-oriented and

yoga is popular. Other areas for European expansion could be

Switzerland and the Netherlands. Management has also noted

that it is seeing tourists from throughout Southeast Asia

buying in bulk in Hong Kong.


Our financial strength rating for lululemon is

Medium-High, the second-highest rating on our five-point

scale.

The company ended the third quarter with no debt and

approximately $650 million of cash and equivalents.

Lulu posted a healthy operating margin of about 18% in

both FY16 and FY17 though those levels were lower than

20.9% in FY15, 24.6% in FY14, 28.2% in FY13 and 28.7% in

FY12. We expect the adjusted operating margin to be down in

FY18 because of restructuring costs on the ivivva business,

but we expect operating margin to rebound to about 19% in

FY19.

The company does have fixed obligations in the form of

operating leases. Treating the approximately $400 million

present value of these leases as debt shows that adjusted debt

was approximately 22% of capital at the end of 3Q18. This is

relatively low. Retailers in the Argus universe average

approximately 50%.

One of the reasons the company doesn't have our highest

financial strength assessment is because it sells discretionary

products, it has a significant number of larger competitors and

because the company is still refining its supply chain and

quality control.

The company's lease-adjusted debt (using rental expenses

multiplied by 8) was approximately 1.8-times EBIT plus rent

and depreciation in FY17 (a lower multiple indicates higher

strength), up slightly from 1.56-times EBIT plus rent and

depreciation in FY16, 1.6-times at the end of FY15, but up

from 1.4-times at the end of FY14 and 1.3-times at the end of

FY13. We'd normally equate a multiple of 2.0 with a

Medium-High Argus rating and investment-grade standing

from one of the rating agencies.

Lulu has a $150 million credit facility that may be drawn

in either U.S. dollars, Canadian dollars or euro. At the end of

3H18, there was $149 million of available borrowing capacity

under the facility.

Lululemon does not pay a cash dividend. It did not pay

one in FY18 and we do not expect it to initiate one in FY19

given its plans to open more stores and expand its product

offerings.

We don't have expectations for a significant

share-repurchase plan as the company has the opportunity to

earn high returns on capital by opening new stores and

supporting overall growth by investing in e-commerce,

customer service and logistics. LULU did initiate a $450

million buyback plan in June of 2014. In the 3Q17 earnings

release, LULU announced a new repurchase program for $100

million, which it completed in 3Q18. In the 3Q18 release, the

company announced a new $200 million repurchase plan.

RISKS

Lululemon faces competition from much larger

companies such as Nike, Reebok, Adidas and the Gap's

Athleta, which have attempted to replicate its success selling

women's athletic apparel. Under Armour, is more focused on

men, team and competitive sports, but UA's management also

has strong ambitions of winning more female customers and it

is expanding its distribution. Lucy Activewear focuses on

workout clothes for women that aim to be functional, stylish

and flattering.

Lulu's success and the tremendous sales productivity of

more than $2,000/SF has also drawn the attention of Victoria's

Secret, Express, Macy's, J.C. Penney, Nordstrom, Dick's, the

entrepreneurial actress Kate Hudson's Fabletics, and

long-respected outdoor brands such as Patagonia. Even New

Balance, whose shoes seem to emphasize fit over glitz, has a

line of athleisure gear for women.

While the company's growth, sales productivity and

Section 2.70


margins are likely to attract more entrants into the category,

we like lulu's focused position as a provider of functional,

high-end apparel for affluent, educated enthusiasts.

The company could see sales slip if yoga becomes less

popular or if active wear becomes less popular attire for

mainstream pursuits. We are hearing that denim is regaining

lost ground against active wear because innovative new jeans

are being designed with lycra and other fabrics to make them

more comfortable.

While lulu's merchandise has loyal shoppers, some may

treat it as a discretionary purchase especially when economic

conditions are difficult. The company posted extraordinary

growth during the recession but few companies remain

immune through multiple business cycles. In the year ended

February 1, 2009, comparable-store sales were flat after rising

34% the prior year. In the year ended January 31, 2010,

comps increased 8% before rebounding to 37% growth the

following year.

Another challenge is that yoga is still a relatively small

activity. The company is expanding its addressable market,

but yoga is where it possesses its greatest edge. Running

apparel is a very mature and crowded market.

While competition is undoubtedly a risk, we saw during

the recession that affluent shoppers remained very loyal to

their favorite brands even if it meant trading down within the

brand or buying fewer items. The core lululemon customer is

a highly educated woman, who is 32 years old and makes

$85,000 or more per year. We believe that lulu's appeal is

largely related to the fit and functionality of its merchandise,

as well as the personality of the brand, rather than being

purely based on fashion. For this reason the company needs to

avoid product defects like the problem with overly sheer yoga

tights that management disclosed in March of 2013.

Still, some yoga purists may scoff at paying premium

prices for merchandise that is used in a historically austere

practice.

Overseas suppliers and international store locations make

the company vulnerable to foreign exchange risk from the

Canadian dollar and higher labor costs, particularly in China.

The company also has exposure to higher raw materials costs,

particularly for cotton and for petroleum-based products that

are used in synthetic materials. Defending intellectual

property is another challenge, but one management is willing

to take on. While loyal customers will recognize the feel, fit

and construction of premium merchandise, others may be

looking for the look and the logo.

Rapid expansion is another challenge. The company must

find the right retail locations, maintain merchandise quality

and appeal to a broader range of customers while maintaining

the connection and loyalty with core shoppers as well as the

scarcity required to be a luxury-type brand. Opening retail

locations can be a way to build awareness and increase sales,

but retailers must be mindful of signing long leases in a world

that is gravitating to online shopping. We believe that lulu's

active, upscale customers are probably very connected as

demonstrated by high e-commerce growth. Maintaining

best-in-class e-commerce systems and applications can be an

ongoing use of cash, especially when competing against larger

companies with deeper pockets.

Maintaining staff and systems for financial management

can also be a challenge for small companies, although the

company's image and growth potential may make it easier to

attract talent. Like other companies with an e-commerce

presence, lulu must work to safeguard its customers'

information.

Lulu relies on grass roots marketing through local fitness

practitioners who become brand ambassadors. We like this

strategy. A risk is that as the company grows it may be hard to

build enough of these relationships or that competitors may be

able to be able to build their brand image more quickly

through more aggressive use of mass media or celebrity

endorsements.

The company requires its manufacturers to sign a code of

conduct regarding manufacturing quality, working conditions

and social concerns. We think this is extremely important and

there could be risks if the company's procedures disappoint its

core customers. Scrutiny has risen, especially since the factory

tragedies in Bangladesh.

The company discontinued operations in Japan and it

could be difficult to overcome cultural and language

differences as well as regulatory issues and local preferences

as it attempts to grow internationally. Yoga practitioners may

not wear the same styles and women outside a small number

of affluent countries may be reluctant or unable to pay $150 -

$200 for tights and a top. It is also possible that the company

won't have the same success in grass roots marketing that it

has had in the U.S. and Canada.

The company doesn't own patents or intellectual property

rights in the technology, fabrics or processes underlying its

products. The company also has a relatively high

concentration of products coming from a small number of

suppliers, with about 60% of products coming from five

manufacturers in FY17. No one supplier represents more than

30% of sales. Competitors may be able to sell products with

performance characteristics that are similar to lulu's. Larger

competitors may be able to do so at lower prices. The

company's tee shirts start at about $50. Wal-Mart offers tees

made from 'technical' materials for about $10. That said,

people who are passionate about an activity may pay for

premium apparel if they have the means.

Management turnover is a concern with the February,

2018 resignation of CEO Laurent Potdevin for 'falling short'

of the company's standards of conduct. Mr. Potdevin replaced

Christine Day as CEO in December 2013. J. Crew executive

Stuart Haselden replaced John Currie as CFO on February 2,

2014. Mr. Currie retired after serving as the company's CFO

since 2007.

Dennis Wilson, the company's founder stepped down as

chairman of the board prior to the June 2014 annual meeting.

Media reports said that at the 2014 meeting, Mr. Wilson voted

against Michael Casey's bid for reelection to the board. The

Wall Street Journal said that 'the unusual -- and unusually

Section 2.71


public -- spat between founder and board brings an

unwelcome disruption as Lululemon struggles to recover from

2013's recall of sheer yoga pants and related supply chain

problems.'

COMPANY DESCRIPTION

Founded in 1998, lululemon athletica is based in

Vancouver, Canada, though it is incorporated in Delaware and

its financial results are reported in U.S. dollars. The company

designs and sells athletic apparel, and markets its

yoga-inspired clothing under the lululemon athletica and

ivivva athletica brand names. It also sells fitness pants, shorts,

tops and jackets designed for running and other sports. As of

January 29, 2017, lululemon sold its products through its

e-commerce websites, mobile shopping app and through 406

stores, primarily in Canada, the U.S. and Australia. Sales in

FY17 were $2.3 billion.

The fiscal year ends on the Sunday closest to January 31.

VALUATION

LULU shares have risen approximately 15% over the last

year. We believe that the ratio of reward to risk is balanced.

The shares are trading at 35-times trailing earnings, above

the five-year average of 31, even though operating margin will

end FY18 at about 17%, down from almost 29% at the end of

FY12. We believe that some of the premium is because

investors are anticipating an earnings boost from lower taxes

that is not yet manifest in trailing earnings.

LULU trades at approximately 34-times our FY18

estimate and 26-times our FY19 estimate. The shares are

currently at 26-times consensus estimates for the next four

quarters. The five-year range is 20-to 37-times.

The trailing multiple of 35 compares to a median of 21

for a universe of apparel and footwear tracked by Bloomberg.

In many ways, this comparison is an unfair one for LULU

because its trailing operating margin of 17.2 is above the

peer-group median of 12. Lulu also has substantially more

opportunity to open stores than mature members of this group,

such as Gap.

If EPS grows 20% annually from our FY19 estimate, it

would be approximately $5.20 in about four years. If the

shares trade at a terminal multiple of 16, they would be worth

approximately $83 in four years. Discounted to the present at

9%, they would be worth approximately $60. At a terminal

multiple of 18, the shares would be worth about $95 in 4 years

and about $67 discounted at 9%

Is a multiple of 16-times reasonable? It implies an

additional five years of relatively strong 8% growth at a 9%

cost of equity and then steady state growth at 3.25% with a

payout of 75% of earnings and an 8% cost of equity. We

could argue about the nuances, but we believe this is a

reasonable scenario. An 18 terminal multiple could be

achieved with a 50 basis point lower cost of equity in each

period. This is plausible for a company with strong margins

and no debt, but given the level of competition it does not

offer a big enough margin of safety to justify a BUY

recommendation.

In the current environment, we believe that investors are

concerned that some retailers have too many retail locations

and that they face price competition from Amazon and other

retailers. We believe that lululemon's innovative product line,

small retail footprint, impressive store productivity and

controlled distribution could help the company to trade at a

premium valuation relative to peers. We believe that the

shares are currently trading at close to fair value. We would

consider raising our recommendation to BUY based on

valuation. An offset is that competition is increasing from a

range of sources.

On February 6, at midday, HOLD-rated LULU traded at

$77.82, up $0.41. (Christopher Graja, CFA, 2/6/18)

McDonald's Corp (MCD)


HIGHLIGHTS

*MCD: Strong comps across the board; turnaround

continues

*Our continued optimism reflects our improved revenue

expectations for 2018, driven in part by the launch of new

promotional offers, including $1 soft drinks and the Big Mac

Trio. In addition, we expect revenue to benefit from the

increasing adoption of the company's mobile order and pay

system.

*We also believe that income-oriented investors will be

attracted to MCD's 2.3% dividend yield and record of annual

dividend increases.

*We are raising our 2018 EPS estimate from $7.16 to

$7.80 and setting an estimate of $8.50 per share for 2019. Our


*Our target price of $190 implies a multiple of 24.4-times

our revised 2018 estimate, and a potential total return,

including the dividend, of 13% from current levels.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating and $190 price target

on McDonald's Corp. (NYSE: MCD). Our optimism reflect

the launch of new promotional offers, including $1 soft drinks

and the Big Mac Trio. In addition, we expect revenue to

benefit from the increasing adoption of the company's mobile

order and pay system and from the renewed emphasis on

value menus. We also believe that income-oriented investors

will be attracted to MCD's 2.3% dividend yield and long

history of annual dividend increases.

Based on the company's ongoing turnaround efforts and

prospects for growth in China, our long-term rating remains

BUY.

RECENT DEVELOPMENTS

On January 30, McDonald's posted 4Q17 earnings of

$1.71 per share, up from $1.44 in the same period a year

earlier and $0.12 above consensus. The EPS growth reflected

Section 2.72


higher same-store sales in all segments and the impact of

share buybacks. Fourth-quarter revenue of $5.34 billion fell

11% from the prior year (down 15% in constant currency), but

topped the consensus estimate by $110 million.

Overall same-store sales rose 5.5%, well above the

consensus forecast calling for 4.9% growth. In the U.S.,

same-store sales increased 4.5%. This was better than the

consensus estimate, which called for a 4.3% increase.

Same-store sales rose 6.0% in International Lead Markets

(above the consensus estimate of 4.9% growth), 4.0% in

High-Growth Markets (above the consensus of 3.4%), and

8.0% in Foundational Markets (above the consensus of 7.5%).

SG&A rose 70 basis points as a percentage of revenue to

11.6%, above the consensus estimate of 11.5%. Operating

income of $2.14 billion topped the consensus estimate of

$2.12 billion. The operating margin rose to 40.1% in 4Q17

from 32.7% in 4Q16, reflecting the higher-than-expected

comps and lower SG&A, offset in part by higher labor

expense. The operating margin missed the consensus forecast

by 40 basis points. Interest expense rose 6%, to $235.1

million. In 2017, MCD spent $7.7 billion on dividends and

share repurchases, and the share count fell to 803 million from

830 million a year earlier.

In 2017, revenue fell 7% to $22.8 billion and EPS rose to

$6.64 from $5.77 in 2016. Full-year same-store sales rose

5.3%.

In the press release, management said it will spend $2.4

billion in 2018 to invest in technology to improve 'the

customer experience' and open 1,000 new restaurants.

Investors reacted negatively to the news of

higher-than-expected capital expenditures but we expect these

initiatives to result in market share gains.

As discussed in a previous note, on January 9,

McDonald's announced that it had sold the majority of its

mainland China and Hong Kong businesses to a consortium

led by government-backed CITC and Caryle, a private equity

firm, for $2.1 billion. The new owners will operate as a

McDonald's master franchise for the next 20 years. CITC will

have a 52% stake; Caryle will have 28% and McDonald's

20%.


Following a 7% decrease in 2017, we now expect 2018

revenue to decline 7.8% to $21.0 billion. Our 2018 revenue

forecast assumes a 4.0% increase in comp sales (up from a

prior forecast of 3.8% growth), offset by refranchising and

foreign exchange headwinds. We expect the adjusted

operating margin to rise from 41.9% in 2017 to 42.5% in

2018, driven by the higher margins available from

refranchised restaurants. Lower commodity prices and

stepped-up efforts to reduce operating costs should also

benefit margins, though increases in the minimum wage in

several states will be an offset. Reflecting management's

efforts to reduce SG&A expense, ramp up value menus and

strong comps in 4Q17, we are raising our 2018 estimate from

$7.16 to $7.80 and setting an estimate of $8.50 for 2019. Our



Our financial strength rating for McDonald's remains


scale. We are encouraged by the company's efforts to

refranchise stores, as these locations require no capital

expenditures and improve free cash flow. Long-term debt rose

from $25.9 billion in 4Q16 to just under $28.4 billion in

3Q17. The shareholders' deficit rose from $2.2 billion in 4Q16

to approximately $3.5 billion. Operating income covered

interest expense by a factor of 9.1 in 4Q17.

In the fourth-quarter earnings release, McDonald's raised

its quarterly dividend from $0.94 to $1.01 per share, or $4.04

annually. The new dividend will be paid on March 15, 2017 to

shareholders of record as of March 1. The current yield is

about 2.3%. The company has raised its dividend every year

since 1976. Our dividend estimates are $4.04 for 2018 and

$4.40 for 2019.

RISKS

A key risk to our estimates and target price is the cost of

beef. We estimate that a 7%-9% increase in beef prices would

reduce annual EPS by a penny. Since 65% of the company's

revenue is generated outside the U.S., unfavorable foreign

currency movements have a significant impact on earnings.

COMPANY DESCRIPTION

McDonald's is the world's largest restaurant chain, with

more than 37,000 fast-food restaurants in 119 countries. The

company is a member of the Dow Jones Industrial Average

and the S&P 500. With a market capitalization of $140 billion,

MCD is generally considered a large-cap growth stock.

VALUATION

On January 30, MCD shares fell 3% despite strong

fourth-quarter results as investors appeared to worry about

management's plans to spend $2.5 billion on technology

upgrades and store openings. However, we believe this

spending will enable MCD to gain market share and benefit

long-term earnings growth. We continue to believe that the

current MCD share price inadequately reflects the benefits of

management's turnaround plan. MCD shares are trading at

22.1-times our revised 2018 EPS estimate and at 20.3-times

our new 2019 estimate. Based on our expectations for gains

from restaurant refranchising, as well as benefits from new

promotional offerings and the company's mobile and order

pay system, we believe that a higher multiple is warranted.

Our target price of $190 implies a multiple of 24.4-times our

revised 2018 estimate, and a potential total return, including

the dividend, of 13% from current levels.

On January 31 at midday, BUY-rated MCD traded at

$171.41, down $1.07. (John Staszak, CFA, 1/31/18)

Northrop Grumman Corp (NOC)


Section 2.73


HIGHLIGHTS

*NOC: Raising target by $40 to $375

*NOC shares have outperformed the market over the past

quarter, rising 19% while the S&P 500 has advanced 10%.

*The company recently reported 4Q earnings that topped

expectations.

*Management also boosted the dividend by 10% in

response to the recent reduction in the U.S. corporate tax rate.

*Given Northrop's consistent record of positive earnings

surprises and prospects for growth in 2017-2018, we think

that the stock merits a premium valuation.

ANALYSIS

INVESTMENT THESIS

BUY-rated Northrop Grumman Corp. (NYSE: NOC) is a

leading global defense contractor with a focus on aerospace

and, increasingly, electronic programs, including

cybersecurity. The company's balance sheet is clean, and

management has a history of meeting and beating analyst

expectations. The shares are susceptible to headlines about

cuts in defense spending and budget ceilings. However, we

believe that recent defense spending developments bode well

for the industry for at least the next two years. Management is

aggressively raising the dividend, with a clear focus on

delivering returns to shareholders. The company is in line to

make an accretive acquisition, and EPS estimates appear

poised to rise. Our target price is now $375, raised from $335.

The shares are a suitable core holding for a diversified

portfolio.

RECENT DEVELOPMENTS

NOC shares have outperformed the market over the past

quarter, rising 19% while the S&P 500 has advanced 10%.

Over the past year, the shares have also outperformed, gaining

52% compared to the market's advance of 24%. The shares

have outperformed the industrial sector ETF IYJ over the past

1-, 5- and 10-year periods. The beta on NOC is 0.70.

On January 25, Northrop reported 4Q17 EPS that were

down from the prior year but above management's guidance

and the consensus estimate. Revenue increased 4% to $6.6

billion. Segment operating income fell 7%, as the operating

margin narrowed by 60 basis points to 10.9%. Adjusted EPS

fell to $2.82 from $2.96 a year earlier, but topped the

consensus forecast of $2.74.

For all of 2017, the company earned $13.28 per share,

above management's guidance range of $12.90-$13.10.

Along with the 4Q results, management established

guidance for 2018. It expects revenue to grow 5% to $27.0

billion; the segment operating margin to narrow to the

mid-11% range; free cash flow to total $2.0-$2.3 billion; and

adjusted EPS to increase from $13.28 in 2017 to

$15.00-$15.25 in 2018.

The company also declared a 10% increase in its

quarterly dividend to $1.10 per share. Management indicated

that the increase was prompted by the recent reduction in the

U.S. corporate tax rate.

The company grows through acquisitions as well as

organically. In September 2017, Northrop announced plans to

acquire Orbital ATK (OA: HOLD) for $9.2 billion. Northrop

Grumman plans to establish Orbital ATK as a new, fourth

business segment after the deal closes, which is expected in

the first half of 2018. On a pro forma 2017 basis, Northrop

Grumman expects the business to have sales of $29.5-$30

billion based on current guidance. It expects the transaction to

be accretive to EPS and free cash flow per share in the first

full year after the closing, and to generate annual pretax cost

savings of $150 million by 2020. Management plans to update

its guidance following the closing.


Northrop Grumman has three reporting segments:

Aerospace Systems (42% of 4Q sales), which includes

military aircraft and space systems; Mission Systems (42%),

such as control rooms and cyber solutions; and Technology

Services (17%), such as logistics, systems security and fraud

detection. We provide business updates and outlooks for these

segments below.

In Aerospace Systems, 4Q revenue rose 5%

year-over-year, driven by higher volume in the F/A-18, F-35

and E-2D manned aircraft programs, as well as in autonomous

systems programs (Triton, Global Hawk) and space programs.

The segment operating margin narrowed from 11.4% to

10.5%. Looking ahead, we expect mid- to high single-digit

sales growth in 2018, driven by growth in manned aircraft,

autonomous systems and space programs. We expect segment

margins to remain near 10% as the sales mix shifts slightly

toward lower-margin development contracts.

Mission Systems saw 6% growth in 4Q revenue,

reflecting higher volume in Sensors and Processing programs.

Cyber sales were lower. The operating margin dipped 170

basis points to 12.0%. Margins in this group are expected to

recover to the 13.0% range in 2018 and to be the highest of all

segments. We are modeling 2018 sales of $11.5 billion,

implying low single-digit growth.

Technology Services recorded a 1% decrease in 4Q

revenue, reflecting lower volume in System Modernization

and Services, offset by growth in Global Logistics and

Modernization programs. The segment operating margin

increased to 10.5%. This segment is expected to be the

company's least profitable, with a full-year margin of

approximately 10% in 2018. We look for 2018 sales of $4.5

billion, down about 5% from the prior year.

Turning to our estimates, based on expected sales and

margin trends, as well as a lower tax rate, we are raising our

2018 EPS forecast to $15.30 from $13.75, though this is likely

to change after the Orbital ATK deal closes. We look for

additional growth in 2019 and are implementing a preliminary

EPS estimate of $17.60. Our five-year EPS growth rate

forecast is 10%.


Our financial strength ranking for Northrop Grumman is

Medium, the midpoint on our five-point scale. The company

Section 2.74


receives average scores on our three main financial strength

criteria: debt levels, fixed-cost coverage, and profitability.

The company had $11.2 billion in cash and equivalents at

the end of 4Q17. Total debt was $14.4 billion at the end of the

quarter and the total debt/total capital ratio was 67%, above

the peer group average. The company has issued $8.25 billion

in new debt to finance the Orbital ATK acquisition. Interest

rates range from 2.08% for three-year notes to 4.03% for

30-year notes. Operating income covered interest expense by

a factor of 9 in 4Q17.

Northrop has a share buyback program. At the end of 4Q,

the share count was down 2.7% year-over-year.

Northrop pays a dividend. The company typically reviews

the dividend in May. In December 2017, it raised the quarterly

payout by 10% to $1.10, or $4.40 annually, for a yield of

about 1.3%. We think the dividend is secure and likely to

grow. Our dividend estimates are $4.40 for 2018 and $4.90

for 2019.

MANAGEMENT & RISKS

Wes Bush has been the CEO of Northrop Grumman since

2010. Kathy J. Warden is the new President and COO, as of

January 2018. Ken Bedingfield, previously the national client

leader of the U.S. aerospace and defense audit practice at

KPMG, is the CFO.

Investors in NOC shares face risks. Northrop Grumman is

a key supplier to the U.S. military and thus vulnerable to cuts

in defense spending. About 80% of the company's current

backlog comes from U.S. government contracts. However,

NOC and other defense contractors have been expanding

internationally to offset volatile U.S. defense spending trends,

particularly on short-cycle programs.




In 2015, Northrop was selected by the U.S. Air Force to

build the Long-Range Strike Bomber. This program is

expected to result in 80-100 aircraft, at a cost of $500-$550

million each, over the next 15-20 years. Northrop won the

contract by beating out rival Boeing Co. (BA: BUY), which

had teamed with Lockheed Martin Inc. (LMT: BUY). Boeing

and Lockheed have protested the decision, and Northrop is

awaiting the results of a review of the contract award process.

COMPANY DESCRIPTION

Northrop Grumman is a leading global defense

contractor, providing systems integration, defense electronics,

information technology, and advanced aircraft and space

technology. The shares are a component of the S&P 500.

VALUATION

NOC shares appear attractively valued at current prices in

the lower half of the 52-week range of $229-$349. On a

technical basis, the shares have been in a positive trend of

higher highs and higher lows since August 2011.



discount model. NOC shares are trading at 22-times our 2018

estimate, near the high end of the historical range of 12-23.

On a price/sales basis, the shares are trading above the

midpoint of the five-year range. The dividend yield of about

1.3% is at the low end of the five-year range. NOC's multiples

are generally in line with or slightly above industry averages.

But given the company's consistent record of positive earnings

surprises and prospects for growth in 2018-2019, we think

that the stock merits a premium valuation. Our revised

dividend discount model points to a value above $420 per

share. Blending our valuation approaches, we arrive at a new

target price of $370.

On February 2, BUY-rated NOC closed at $336.79, down

$6.07. (John Eade, 2/2/18)

Nucor Corp (NUE)


HIGHLIGHTS

*NUE: Reiterating BUY and $70 target

*Nucor delivered solid 2017 results and issued a positive

outlook for 2018.

*Nucor shares have risen 15.2% over the past three

months, compared to an increase of 9.8% for the S&P 500.

*NUE appears favorably valued at 12.9-times our 2018

EPS estimate and at 12.2-times our 2019 forecast, compared

to a five-year annual range of 15-37.

*Our target price of $70, combined with the dividend,

implies a potential return of 13% from current levels.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on Nucor Corp.

(NYSE: NUE) with a target price of $70. Nucor delivered

solid 2017 results and issued a positive outlook for 2018. The

company has grown through both internal expansion and

acquisitions. Looking ahead, we expect NUE shares to benefit

from the Trump administration's efforts to limit the dumping

of imported steel, as well as from gradually improving steel

market fundamentals. Our long-term rating also remains BUY.

RECENT DEVELOPMENTS

Nucor shares have risen 15.2% over the past three

months, compared to an increase of 9.8% for the S&P 500.

The shares have gained 14.7% over the past year, compared to

an increase of 24.1% for the index.

On January 30, Nucor reported 4Q17 adjusted net

earnings of $208.7 million or $0.65 per diluted share,

compared to $153.2 million or $0.50 per share in 4Q16.

Fourth-quarter consolidated net revenue rose 29%

year-over-year to $5.09 billion. The average sales price per

ton increased 14% year-over-year, and total steel mill

shipments increased 18%.

The average scrap and scrap-substitute cost in the fourth

quarter was $317 per ton, up 34% from 4Q16. Capacity

Section 2.75


utilization at the company's steel mills was 81%, compared to

72% a year earlier. Total fourth-quarter energy costs were

down about $1 per ton from the prior year.

For all of 2017, Nucor's consolidated net sales increased

25% to $20.25 billion, total tons shipped to outside customers

rose 9%, and the average sales price per ton rose 15%. Net

earnings totaled $1.15 billion or $3.58 per diluted share, up

from $806.4 million or $2.48 per share in 2016.

Nucor has a growth-by-acquisition strategy. On

September 1, 2017, it completed the acquisition of St. Louis

Cold Drawn, a manufacturer of cold-drawn rounds, hexagons,

squares and special sections that serves the U.S. and Mexican

automotive and industrial markets. In January 2017, Nucor

purchased Southland Tube, a manufacturer of hollow

structural section steel tubing, for $130 million. Nucor also

acquired Republic Conduit, a North American manufacturer

of steel electrical conduit, for $335 million.

The company has also grown organically, investing $2.1

billion in capital projects since 3Q16. In September 2016, it

announced plans for a new specialty cold mill complex in

Arkansas. The plant will expand the company's ability to

produce advanced high-strength, motor-lamination and

high-strength, low-alloy steel products. The $230 million

facility is expected to begin operations in the second half of

2018. In May 2017, Nucor announced that it would invest

$176 million to build a hot band galvanizing and pickling line

at its sheet mill in Ghent, Kentucky. The new line will have an

annual capacity of 500,000 tons, and is expected to take two

years to construct. Nucor and JFE Steel have also begun work

on a new galvanizing facility in Mexico, which is expected to

open in the second half of 2019. In November 2017, Nucor

announced that it would build a full-range merchant bar

quality mill at its existing steel mill in Bourbonnais, Illinois.

The project will take approximately two years to complete at a

cost of $180 million. Also in November, Nucor announced

that it would spend $250 million to build a rebar micro mill in

Sedalia, Missouri


Management expects first-quarter earnings to be up from

4Q17, excluding the impact of tax benefits in 4Q. The

company expects stronger results in its raw materials business

and in steel mill products, offset by the impact of higher scrap

prices and weather-related disruptions at certain sheet mills.

Although Nucor continues to face pressure from illegal

steel imports, we expect it to benefit over time from the

administration's actions to limit the dumping of imported steel

as well as from recent acquisitions and gradual improvement

in the nonresidential construction, automotive, energy, heavy

equipment and agricultural markets. We are increasing our

2018 EPS estimate to $4.99 from $4.52. We are initiating a

2019 EPS estimate of $5.25.


We rate Nucor's financial strength as Medium, the

midpoint on our five-point scale. The company's debt is rated

A-/stable by Standard & Poor's and Baa1/stable by Moody's.

Both ratings are investment grade. Nucor is the only North

American steel producer with investment-grade credit ratings.

Nucor ended 2017 with $999.1 million in cash and cash

equivalents and short-term investments. Its $1.5 billion

revolving credit facility remains undrawn.

At the end of 2017, the company's debt/capitalization

ratio was 29.5% down from 34.6% in the year-earlier period.

The company pays a quarterly dividend of $0.38, or $1.52

annually, for a yield of about 2.3%. The company has paid

uninterrupted quarterly dividends for more than 45 years. Our


RISKS

The steel industry is extremely cyclical and highly

competitive. It may also be affected by excess global capacity,

which has limited price increases during periods of economic

growth and led to price decreases during periods of

contraction. In addition, the industry faces competition in

many markets from producers of aluminum, cement,

composites, glass, plastics and wood. Steel producers also

face risks associated with commodity prices, interest and

exchange rates, asbestos liability, and environmental issues.

On the positive side, we expect Nucor and other domestic

steel producers to benefit from new trade legislation that

would limit the negative impact of low-cost imported steel.

COMPANY DESCRIPTION

Founded in 1940 and based in Charlotte, North Carolina,

Nucor Corp. is a manufacturer of steel and steel products and

North America's largest steel recycler. The company's three

main operating units are Steel Mills, Steel Products, and Raw

Materials.

The Steel Mills segment produces hot-rolled steel

products, including angles, rounds, flats, channels, sheet,

wide-flange beams, and cold-rolled steel products. Steel

Products provides steel joists and joist girders, steel deck,

fabricated concrete-reinforcing steel, cold-finished steel, steel

fasteners, steel grating, and metal and wire mesh. The Raw

Materials segment produces direct-reduced iron (DRI);

brokers ferrous and nonferrous metals, pig iron, hot briquetted

iron, and DRI; and processes ferrous and nonferrous scrap

products. The company also has international steel trading

operations.

INDUSTRY

Our recommended weighting for the Basic Materials

sector is Over-Weight, based on stabilizing commodity prices

and signs that the global economy will avoid recession. The

sector accounts for 2.9% of the S&P 500, and includes

industries such as chemicals, paper, metals and mining. Over

the past five years, the weighting has ranged from 2.5% to

4%. We think investors should consider allocating about 4%

of their diversified portfolios to stocks in this sector. The

sector outperformed in 2016, with a gain of 14.1%, and

underperformed in 2015, with a loss of 10.4%. It is

performing largely in line with the market thus far in 2017,

with a gain of 10.5%.

Section 2.76


The P/E ratio on projected 2018 EPS is 17.0, close to the

market multiple. The sector's debt ratios appear sound, as

many in the group have deleveraged over the past three years.

Yields of 2.0% are close to the market average. The Street

consensus calls for earnings growth of 35.6% in 2017 and

15.7% in 2018.

VALUATION

Nucor shares have traded between $51 and $70 over the

past 52 weeks and are currently in the upper half of the range.

The shares are trading at 12.9-times our 2018 EPS estimate

and at 12.2-times our 2019 forecast, compared to a five-year

annual range of 15-37. The shares are trading at a

price/EBITDA ratio of 7.9, below the midpoint of the

five-year range of 6.0-11.4 but above the peer average of 6.8.

The current price/sales multiple is 1.0, compared to a five-year

historical range of 0.6-1.4 and a peer average of 0.7. The

price/book multiple is 2.3, above the midpoint of the five-year

range of 1.5-2.8 and the peer average of 2.0.

We continue to view Nucor as a best-in-class steel

manufacturer with a strong balance sheet. We also expect the

company to benefit from favorable government action on steel

imports, recent acquisitions, and gradual improvement in

nonresidential construction. Our target price of $70, combined

with the dividend, implies a potential return of 13% from

current levels.

On February 5 at midday, BUY-rated NUE traded at

$64.18, down $0.08. (David Coleman, 2/5/18)

Parker-Hannifin Corp (PH)


HIGHLIGHTS

*PH: Recent weakness offers buying opportunity

*PH shares have underperformed the market over the past

quarter, with a flat performance versus an increase of 4.0% for

the S&P 500.

*On February 1, the company reported fiscal 2Q18 EPS

that topped analyst expectations and raised its full-year

guidance.

*Based on our expectations for margin improvement and

growth in new orders, we are once again boosting our EPS

estimates for FY18 and FY19.

*The shares have moved higher over the past year, but we

see the potential for further strong performance.

ANALYSIS

INVESTMENT THESIS

Our rating on Parker-Hannifin Corp. (NYSE: PH) is

BUY. In our view, the company is on track to achieve its

long-term goals of raising margins and growing earnings.

Over time, we expect it to generate high single-digit EPS

growth, driven by 2%-4% revenue growth, margin

improvement, and share buybacks. Near-term trends, which

had been a problem, appear to have turned a corner, and we

see better revenue and earnings growth ahead. We also have a

favorable view of the 2017 acquisition of filtration company

CLARCOR. The shares have moved higher over the past year,

but we see the potential for further strong performance. Our

12-month target price is $210.

RECENT DEVELOPMENTS

PH shares have underperformed the market over the past

quarter, with a flat performance versus an increase of 4.0% for

the S&P 500. The shares have also underperformed the

average industrial stock, as the Industrial ETF IYJ has risen

4.6% in the past quarter. The shares have outperformed over

the past year with a gain of 24%, versus an 18% advance for

the market and a 20.6% gain for the sector. The stock's

long-term performance record, over multiple market cycles, is

solid as well. The beta on PH shares is 1.25.

On February 1, PH reported fiscal second-quarter

earnings that easily topped the consensus estimate. Adjusted

EPS rose 13% to $2.15, and beat the consensus by $0.08.

Revenue rose a solid 10% on an organic basis (26% including

acquisitions) to $3.4 billion. The overall segment operating

margin increased 20 basis points to 14.9%. For the first half,

the company has earned $4.39 per share.

Along with the 2Q results, management raised its

guidance for FY18. It now expects full-year adjusted EPS of

$9.65-$10.05, up from $9.10-$9.70.

The company has scheduled an Analyst Day to review its

strategy and outlook for March 7, 2018.


Parker-Hannifin has three primary segments: Diversified

Industrial North America (46% of 2Q sales), Diversified

Industrial International (37%), and Aerospace Systems (17%).

Second-quarter results and outlooks by segment are

summarized below.

In the Industrial North America segment, revenues rose a

sequentially stronger 12.7% on an organic basis (40%

including the impact of the $4.3 billion CLARCOR

acquisition, completed in February 2017). The adjusted

segment operating margin declined 150 basis points to 15.1%

as the new business is being integrated. Orders were up an

impressive 15%. Looking ahead to the balance of FY18, we

expect 20% growth in sales, including contributions from the

acquisition. We also anticipate slightly lower margins

year-over-year in the 17.0%-17.4% range.

Revenue in the Diversified Industrial International

segment rose 10.7%, while the adjusted operating margin

widened by 110 basis points to 14.2%. Orders rose 13%.

Looking ahead to the balance of FY18, we now expect a

mid-teens increase in sales, with improved margins in the

15.1%-15.5% range.

In Aerospace Systems, organic revenue reversed course

and rose 0.8%. The adjusted operating margin widened 250

basis points to 16.0% and orders rose a sequentially stronger

8% compared to the prior-year quarter. We look for low

single-digit revenue growth in this segment in FY17. We also

expect slightly higher margins in the 16.1%-16.5% range.

Section 2.77


By markets, management is upbeat on the aerospace,

agriculture, construction, distribution, forestry, general

industrial, heavy-duty truck, lawn and turf, mining, oil and

gas, refrigeration and air-conditioning, semiconductor and

telecom. Neutral markets are automotive, power generation,

rail and life sciences.

Management is keeping a close eye on costs. The

second-quarter segment operating margin rose 20 basis points

from the prior year to 14.9%. Management's target range for

the year is 16.1%-16.5%.

Turning to our estimates, based on our expectations for

margin improvement and the recent increase in orders, as well

as expectations for a lower tax rate (28% this year and 23%

next year) we are boosting our FY18 EPS forecast to $9.90

from $9.49. Our estimate implies growth of 22% this year. We

are also boosting our FY19 forecast to $11.30 from $10.67,

implying growth of 14% as margins continue to recover,

revenue improves and the lower tax rate settles in. Our

long-term earnings growth rate forecast for PH is 9%.


Our financial strength rating on Parker-Hannifin is


scale. The company receives above-average scores on our

three main financial strength criteria of debt levels, fixed-cost

coverage and profitability.

The company had $884 million in cash and marketable

securities at the end of the fiscal year. Total debt was $6

billion or 53% of total capital. Pretax income covered net

interest expense by a factor of 8 last year. Management has

said that it is committed to maintaining a high

investment-grade rating and plans to pay down the debt it has

taken on to buy CLARCOR.

The company's priorities for the use of cash are

dividends, acquisitions, and share buybacks - in that order.

Parker pays a dividend and targets a payout ratio of 30%.

The current dividend rate is $2.64 annually, for a yield of

about 1.3%. The company has increased its annual dividends

per share paid to shareholders for 61 consecutive years. Our

dividend forecasts are $2.64 for FY18 and $2.76 for FY19.

MANAGEMENT & RISKS

Tom Williams became the company's CEO in 2015. He

was previously chief operating officer. He spent 22 years at

General Electric before joining Parker-Hannifin as vice

president of the hydraulics business in 2003. Catherine A.

Suever is the CFO.

Management continues to focus on its 'New Win'

Strategy. The plan focuses on engaging team members,

providing a premier customer experience, and generating

profitable growth. With this strategy, management is targeting

sales growth of 150 basis points above the industry rate, 17%

operating margins, and a compound annual growth rate of 8%

by the end of fiscal 2020.

Parker Hannifin is a virtual pure-play on the industrial

economy. PH's exposure to specific market niches (aerospace,

refrigeration, air conditioning, telecom, semiconductors,

construction machinery, trucks and automotive, among others)

is mitigated by its wide range of motion-control customers,

which span virtually every industry and are serviced by its

worldwide distribution network.

PH generates substantial revenue overseas and its results

are typically linked to global economic trends. Worldwide, we

estimate that global GDP rose 3.1% in 2016. We and the IMF

look for stronger growth of 3.7% in 2017 and 3.9% in 2018.

Parker-Hannifin is also sensitive to trends in the dollar.

Looking ahead, we think the greenback is fairly valued and in

a trading range, particularly if the Federal Reserve continues

to move slowly to raise short-term rates. A stable or falling

dollar would be a positive development for the Industrial

sector and Parker-Hannifin.

COMPANY DESCRIPTION

Parker-Hannifin manufactures motion and control

technologies and systems that are used to control fluids, gas,

or air in hydraulic, pneumatic and vacuum applications. It

sells its more than 800,000 products to aerospace, commercial

and industrial customers, which use them to move materials

and operate machines and vehicles. PH shares are a


VALUATION

PH shares appear attractively valued at current prices near

$183, above the midpoint of their 52-week range of

$145-$212. From a technical standpoint, the shares have been

in a bullish trend of higher highs and higher lows since

reaching a low of $83 in January 2016.



discount model. PH shares are trading at 16.3-times our FY19

EPS estimate, just above the midpoint of the historical range

of 10-20. On price/sales, the shares are at the top of their

five-year range. The dividend yield of about 1.3% is near the

midpoint of the five-year range. Compared to the peer group,

PH multiples are mixed, but generally suggest fair valuation.

Our dividend discount model, incorporating our revised

estimates, points to a fair value of $220 per share. Blending

our valuation approaches, our target price remains $210.

On February 5, BUY-rated PH closed at $182.00, down

$8.64. (John Eade, 2/5/18)

PayPal Holdings Inc (PYPL)


HIGHLIGHTS

*PYPL: Raising target to $92 on continued strong

payment volumes

*On January 31, PayPal reported adjusted 4Q17 EPS of

$0.55, up from $0.42 a year earlier and above the $0.52

consensus.

*Management provided revenue growth guidance for

2018 in a range of 15%-17%, including a 1% benefit from

favorable FX but also a 3%-5% reduction from the sale of

Section 2.78


$6.4 billion of consumer receivables to Synchrony Financial

(expected to close in 3Q18).

*We view the Synchrony deal favorably as it will free

cash flow for other uses, reduce credit risk, and improve

operating margins, which should in turn result in a higher

valuation.

*The company also announced an extension of its

agreement with eBay to feature PayPal at checkout on the

eBay Marketplace through July 2023. However, eBay

announced separately that PayPal would no longer be its

primary payments processor, with customers also having an

option to use a competitor processor. We believe weakness in

PYPL shares is likely related to this news, but do not see

considerable fallout on revenue growth prospects.

*Our revised target price of $92 implies a projected 2018

P/E of 40, above the multiples of 30 for Visa and MasterCard,

but merited, in our view, based on PayPal's stronger growth

prospects. The shares also trade at PEG ratio of 1.7, below the

multiples of both Visa and MasterCard.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on PayPal Holdings

Inc. (NYSE: PYPL) following 4Q earnings, while boosting

our target price to $92 from $87. Payment volumes remained

strong, with several metrics accelerating from 3Q. We also

view the recent Synchrony deal favorably as it will free cash

flow for other uses, reduce credit risk, and improve operating

margins, which should in turn result in a higher valuation.

PayPal management noted that cash proceeds from the deal

would be reinvested in its core business, used for M&A, or

returned to shareholders.

PayPal, which was spun off from eBay in July 2015, is

taking advantage of the changing payments landscape, and we

believe that several trends favor the company's growth. These

include greater adoption of mobile devices for payments, and

the technological integration of different payment types and

channels. With 227 million active accounts, PayPal is a leader

in innovative payment mechanisms and has strong brand

recognition.

Unlike MasterCard and Visa, PayPal's network enables

account holders to both pay and be paid for merchandise or

services. PayPal is accepted at more than 75 of the top 100

retailers in the U.S., and we expect even greater penetration in

the next year. Total payment volume rose 32% to $131.4

billion in 4Q17 (the strongest rate of growth for PayPal since

its IPO), and the number of payment transactions rose 25% to

$2.0 billion.

In our view, the company has several strengths that put it

ahead of the competition as it seeks to grow payment volumes.

These include a strong international presence, with 100

million non-U.S. users in more than 200 countries. The

company also provides merchants with end-to-end payment

authorization and settlement capabilities, as well as instant

access to funds.

Our revised target price of $92 implies a projected 2018

P/E of 40, above the multiples of 30 for Visa and MasterCard,

but merited, in our view, based on PayPal's stronger growth

prospects. The shares also trade at a PEG ratio of 1.7, below

the multiples of both Visa and MasterCard.

RECENT DEVELOPMENTS

Over the past year, PYPL shares have risen 116%, versus

a gain of 24% for the broad market.

On January 31, PayPal reported adjusted 4Q17 EPS of

$0.55, up from $0.42 a year earlier and above the $0.52

consensus. Revenues rose 24% to $3.71 billion (also 24% on

an FX-adjusted basis) and adjusted net income rose 31% to

$670 million.

Total 4Q payment volume rose 32% from the prior year

to $131.4 billion, and was primarily responsible for the

revenue gain. The number of active PayPal accounts was 227

million at December 31, 2017, up 15% from a year earlier,

while the number of payment transactions was 2.20 billion, up

25%.

For all of 2017, net revenues increased 20% to $13.1

billion, while adjusted EPS climbed to $1.91 from $1.49.

In November 2017, PayPal announced an agreement

under which Synchrony Financial would acquire about $6.8

billion of PYPL's consumer receivables. The deal, which is

expected to close in 3Q18, would also extend an existing

co-brand consumer credit card program, with Synchrony

becoming the exclusive issuer of PayPal's online consumer

financing program for 10 years. The company said the

receivables were being sold at par value.

In July 2017, PayPal acquired TIO Networks, a bill

payment processor that serves telecom, wireless, cable, and

utility bill issuers in North America, for $238 million.

On July 17, 2015, eBay Inc. completed the spinoff of

PayPal, distributing one share of PayPal stock for each share

of eBay.


We expect revenue growth at PayPal to benefit from

higher consumer spending, increased merchant acceptance of

the company's services, growth in the number of mobile

devices using mobile payment apps, and an increase in

average transactions per active account (the latter increased to

33.6, on an annualized basis, in 4Q17, up 8% from 31.1 a year

earlier). Another encouraging sign is the expansion of active

accounts, which grew 15% year-over-year in 4Q to 227

million. This was also up 9 million sequentially, the fastest

pace since the company's spinoff from eBay. In addition,

PayPal should benefit from trends that have boosted growth

for credit card processors, such as the increasing use of digital

payments over checks and cash for both convenience and

security. We expect further market share gains as the company

leverages its platforms globally and takes advantage of its

strong brand recognition and rapid growth in merchant

acceptance.

Person-to-person volume growth, which includes the

popular social payment app Venmo, is also strong, rising 50%

in 4Q to $27 billion, and now accounting for 20% of total

Section 2.79


payment volume.

The company has noted that the sale of its consumer

credit receivables portfolio to Synchrony will reduce revenues

in 2018 by 3%-5%, assuming a July 1 close.

We look for revenue growth of 17% in 2018, down from

21% in 2017. We see a similar organic growth rate as 2017,

although the Synchrony sale will weigh on overall revenue

growth. We note a continuing decline in net revenue as a

percentage of total payment volume (known as the 'take rate')

as the company adds larger merchants, which tend to have

lower take rates. However, operating margins should also

benefit as the company leverages its network scale.

The company has been transparent with its 2018 financial

goals, which include revenue growth guidance of 14%-16%

on an FX-neutral basis (15%-17% at current spot rates),

including the Synchrony sale. Adjusted EPS guidance is

$2.24-$2.30. PayPal also has a three-year outlook, which calls

for FX-neutral revenue growth of 16%-17% per year, stable to

growing operating margins, and free cash flow growth in line

with revenue gains.

We are maintaining our 2018 EPS estimate of $2.30,

implying 20% growth, while initiating a 2019 forecast of

$2.77, or 21% growth.


Our financial strength rating on PayPal is Medium-High.

Balance sheet metrics are favorable, with cash and short-term

investments as of December 31, 2017 of $5.70 billion and no

long-term debt. The company has a limited operating history

as a public company.

Free cash flow is expected to be reinvested in the

business and used for acquisitions and buybacks. Along with

1Q17 earnings, the company announced a $5 billion share

buyback plan, a considerable increase from a $2 billion

repurchase program authorized in 4Q15. During 2017, PayPal

repurchased 19.7 million common shares for $1.0 billion. The

company does not expect to pay a regular cash dividend.

MANAGEMENT & RISKS

PayPal is led by president and CEO Dan Schulman, who

joined the company in 2014 from American Express. In

August 2015, John Rainey joined PayPal as chief financial

officer. He was previously with United Continental Holdings.

PayPal faces considerable competition in the payments

market from well-established brands, including Apple's

ApplePay, Visa's Checkout, MasterCard's MasterPass, and

American Express's Later Pay services, as well as other digital

products from Facebook and Google. Customers generally

have a range of payment options in addition to PayPal at the

point of sale, and the company must compete on convenience

and transaction price. The company must also respond quickly

to changing customer preferences, including the increasing

demand for mobile payment services.

COMPANY DESCRIPTION

Spun off from eBay in July 2015, PayPal is a technology

platform company that enables digital and mobile payments

on behalf of consumers and merchants worldwide. It accepts

payments from merchant websites, mobile devices and

applications, and at offline retail locations through its PayPal,

PayPal Credit, Venmo and Braintree products.

PayPal processes transactions in more than 200 markets

and in more than 100 currencies, and allows customers to

withdraw funds from bank accounts in 56 currencies and hold

balances in PayPal accounts in 25 currencies.

VALUATION

PayPal trades at 34.5-times our 2018 EPS estimate. The

shares have a 52-week trading range of $39-$86.

We expect PayPal to show steady growth in payment

volumes as it adds merchants, signs additional partnerships,

increases the number of transactions per customer, and

benefits from greater global spending. PayPal competes in the

payments space with American Express, Discover, Visa and

MasterCard, as well as with other mobile payment services

such as ApplePay. Unlike Visa and MasterCard, PayPal

currently offers forms of credit to its customers, although a

recent agreement to sell its receivables portfolio to Synchrony

Financial would remove this element of credit risk. The deal

should also free cash flow for other uses and improve

operating margins, allowing for a higher valuation.

To value the stock, we believe that processing pure-plays

Visa and MasterCard still offer the best peer comparisons.

PayPal is a smaller player in the payments market, though it

also has a strong brand and a record of innovation. As such,

we expect it to post above-industry-average earnings growth

for many years, and believe that it merits a premium multiple.

Our 12-month target price of $92 (raised from $87) implies a

multiple of 40-times our 2018 EPS estimate, above the

multiples of about 28 for Visa and MasterCard. PYPL shares

also trade at a more favorable PEG ratio of 1.7, versus 2.0 for

Visa and MasterCard.

On February 1 at midday, BUY-rated PYPL traded at


Praxair Inc (PX)


HIGHLIGHTS

*PX: Increasing target price by $4 to $175

*We believe that Praxair is well positioned to deliver

stronger EPS growth based on its mix of high-growth

businesses, which have generated above-industry-average

margins, earnings, and returns on invested capital.

*On January 25, Praxair reported 4Q17 adjusted net

income of $441 million or $1.52 per diluted share, up from

$406 million or $1.41 per share in the prior-year quarter. EPS

topped our estimate of $1.48 and the consensus estimate of

$1.47.

*The higher earnings reflected higher volume (+7%),

positive price/mix (+1%), favorable currency translation

(+3%), and positive cost pass-throughs (+1%). Fourth-quarter

revenue came to $2.953 billion, up 12% from the prior year.

Section 2.80



$6.31, reflecting management's 1Q18 guidance, which was

$0.04 above our forecast, and our expectations for increased

volume and positive pricing this year. The 2018 consensus

forecast is $6.62.

ANALYSIS

INVESTMENT THESIS

We are reaffirming our BUY rating on Praxair Inc.

(NYSE: PX) and raising our price target by $4 to $175. We

believe that Praxair remains well positioned to deliver

stronger EPS growth based on its mix of high-growth

businesses, which have generated above-industry-average

margins, earnings, and returns on invested capital. Results in

the last three quarters have surprised to the upside. In

addition, we see the merger with Linde AG as a significant

positive, as we expect the combined company's greater scale

and geographic reach to benefit earnings over time. In all, we

expect Praxair to outperform peers as it works to complete the

merger in 2H18.

RECENT DEVELOPMENTS

PX shares have outperformed since the beginning of

2018, falling 2.8% while the S&P 500 Basic Materials index

has dropped 3.4%. Over the past year, they have risen 29.1%,

while the Materials index has climbed 12.2%.

On January 25, Praxair reported 4Q17 adjusted net

income of $441 million or $1.52 per diluted share, up from

$406 million or $1.41 per share in the prior-year quarter. EPS

topped our estimate of $1.48 and the consensus estimate of

$1.47.

The higher earnings reflected higher volumes (+7%),

positive price/mix (+1%), favorable currency translation

(+3%), and positive cost pass-throughs (+1%). Fourth-quarter

revenue came to $2.953 billion, up 12% from the prior year.

In North America, fourth-quarter sales rose 10% to

$1.542 million, reflecting higher volume and pricing and

positive currency translation. In particular, the company

benefited from higher volume to electronics, downstream

energy, chemicals, and manufacturing customers. Operating

profit rose to $396 million from $359 million a year earlier.

In Europe, fourth-quarter sales rose 17% from the prior

year to $412 million and volume rose 5%, reflecting the

acquisition of a carbon dioxide business serving food and

beverage customers. Management noted particular strength in

Spain, Germany and Italy. Operating profit came to $80

million, up from $71 million a year earlier.

In South America, fourth-quarter sales rose 5% from the

prior year to $370 million. Praxair continues to expect margin

pressure in South America in 2018 due to weak industrial

production. The 4Q operating margin fell to 16.2% from

18.2% in the prior-year quarter. Operating profit fell to $60

million from $64 million.

In Asia, revenue rose 19% to $470 million, reflecting

11% volume growth, a 4% benefit from currency translation, a

1% contribution from cost pass-throughs, and a 3%

contribution from favorable pricing and product mix. The

volume growth was driven by strength in the electronics,

metals and chemicals end-markets. Operating profit rose to

$90 million from $78 million a year earlier.

Praxair Surface Technologies posted fourth-quarter sales

of $159 million, up from $149 million in 4Q16, as growth in

aerospace end markets was partially offset by weaker sales to

utility customers. Operating profit of $27 million was in line

with prior-year results.

On June 1, Praxair and Linde AG (Xetra: LIN) agreed to

combine in an all-stock merger-of-equals transaction. Based

on 2016 reported results, the combined company will have pro

forma revenues of approximately $29 billion, excluding

potential divestitures and other adjustments, and a market cap

of more than $70 billion. The merger is expected to generate

$1.2 billion in annual synergies within three years of the

closing.

The transaction will be structured as an exchange offer

under German law for Linde shareholders and as a merger

under Delaware law for Praxair shareholders. Under the terms

of the agreement, Linde shareholders will receive 1.54 shares

of the new holding company for each Linde share, and Praxair

shareholders will receive one share in the new company for

each Praxair share. Assuming 100% participation in the

exchange offer, Linde shareholders and Praxair shareholders

will each own approximately 50% of the combined company.

The companies expect the transaction to close in the second

half of 2018, subject to customary closing conditions and

regulatory approval.

For all of 2017, Praxair reported adjusted net income of

$1.690 billion or $5.85 per diluted share, up from $1.576

billion or $5.48 per share in 2016.


Praxair management has discontinued its full-year EPS

guidance due to the pending merger with Linde. However, it

has projected 1Q18 EPS of $1.53-$1.58, implying growth of

15% at the midpoint of the range. The 1Q18 consensus prior

to the earnings release was $1.54.


$6.31, reflecting management's 1Q18 guidance, which was

$0.04 above our forecast, and our expectations for increased

volume and positive pricing this year. The 2018 consensus

forecast is $6.62.

We are also initiating a 2019 EPS estimate of $7.41,

implying 12% growth from our 2018 estimate. The 2019

consensus is $7.20.


We rate Praxair's financial strength as Medium, the

midpoint on our five-point scale. The company's debt is rated

A2/stable by Moody's and A/under review by Standard &

Poor's.

At the end of 4Q17, PX's debt/capitalization ratio was

58.0%, down from 63.6% at the end of 4Q16. The company's

debt/cap ratio is modestly higher than that of most peers. Its

average ratio over the past five years is 60.1%.

Section 2.81


Total debt came to $9.0 billion at the end of 4Q17,

including $1.217 billion of short-term borrowings and $7.783

billion of long-term borrowings. This compares to total debt

of $9.515 billion at the end of 4Q16.

Praxair had cash and equivalents of $617 million at the

end of 4Q17, compared to $524 million a year earlier.

Praxair did not repurchase any stock in 4Q17, though it

has $1.1 billion remaining on its existing authorization. In

July 2015, it said that it would initiate a new $1.5 billion

authorization following the completion of its current program.

In conjunction with its 4Q17 earnings release, Praxair

announced a 5% increase in its quarterly dividend to $0.8250

per share or $3.30 annually, for a projected yield of about

2.2%. The company has raised its dividend annually for the

last 25 years. The first payment at the new rate will be made

on March 15, 2018, to shareholders of record as of March 7.

We project payouts of $3.30 in both 2018 and 2019, pending

the completion of the Linde merger.

RISKS

Risks facing Praxair include inflation in raw material and

commodity costs, plant outages, liability lawsuits, regulatory

changes, and exchange rate volatility. The company also faces

a range of country-specific risks.

COMPANY DESCRIPTION

Praxair Inc. is an industrial gases company with

operations in North and South America, Asia and Europe. Its

primary products are atmospheric gases (oxygen, nitrogen,

argon and rare gases) and process gases (carbon dioxide,

helium, hydrogen, electronic gases, specialty gases and

acetylene). Praxair serves customers in approximately 25

industries. The company was founded in 1907 and is

headquartered in Danbury, Connecticut.

INDUSTRY

Our recommended weighting for the Basic Materials

sector is Over-Weight, based on stabilizing commodity prices

and signs that the global economy will avoid recession. The

sector accounts for 3.0% of the S&P 500, and includes

industries such as chemicals, paper, metals and mining. Over

the past five years, the weighting has ranged from 2.5% to

5%. We think investors should consider allocating about 4%

of their diversified portfolios to stocks in this sector. The

sector outperformed in 2016, with a gain of 14.1%, and

underperformed in 2015, with a loss of 10.4%. It slightly

outperformed in 2017, with a gain of 21.4%.

The P/E ratio on projected 2018 EPS is 18.0, close to the

market multiple. The sector's debt ratios appear sound, as

many in the group have deleveraged in recent years. Yields of

1.5% are below the market average. The Street consensus

calls for earnings growth of 35.7% in 2017 and 16.1% in

2018.

VALUATION

Praxair shares are trading in the upper half of their

52-week range of $115.53-$166.95, and at 22.6-times our

2018 EPS estimate and 20.3-times our 2019 estimate,

compared to a 23-year average annual range of 17-23. They

are also trading above the high end of their historical average

range for price/book (7.4 versus a range of 4.1-5.5),

price/sales (3.9 versus a range of 2.0-2.7), and price/EBITDA

(14.6 versus a range of 7.7-10.1), and at a slight premium to

peers. Despite these relatively high valuation metrics, we

believe that increased demand for industrial gases and the

upcoming merger with Linde AG have strengthened the

company's prospects and we expect continued upside for PX

shares. Our revised target price of $175, combined with the

dividend, implies a total potential return of 19% from current

levels.

On February 6 at midday, BUY-rated PX traded at

$153.00, up $2.68. (Bill Selesky, 2/6/18)

Progressive Corp. (PGR)


HIGHLIGHTS

*PGR: Fully valued following 4Q results

*On January 24, Progressive reported 4Q17 operating

EPS of $0.98, above the consensus estimate of $0.77 and our

estimate of $0.63. Operating EPS rose 57% year-over-year,

boosted by premium growth, margin improvement, and tax

benefits. Excluding those benefits, EPS rose 28% to $0.81 per

share.

*Progressive generates a high ROE and has shown steady

growth in premium revenue.

*We are raising our 2018 estimate to $3.49 from $2.86,

which assumes greater increases in net premiums and lower

costs than we previously projected. Additionally, we expect

less severe natural disasters and benefits from lower tax rates.

We are establishing a 2019 estimate of $3.75.

*PGR shares trade at 15.4-times our 2018 EPS estimate,

below the midpoint of the historical range of 14.3-23.5 and in

line with the peer median. They are also trading at a

price/book multiple of 3.4, at the high end of the five-year

historical range of 2.0-3.5 and above the median of 1.5 for

peers.

ANALYSIS

INVESTMENT THESIS

Our rating on Progressive Corp. (NYSE: PGR) is HOLD.

Progressive is a well-managed company with a clean balance

sheet. The company targets the value segment of the

Property-Casualty insurance market and spends aggressively

on marketing in order to gain market share. However,

earnings growth has been uneven in recent quarters, and

valuations are high on a historical basis and relative to peers.

The shares are a suitable core holding for long-term investors,

but we will look for more stable earnings growth or lower

valuations to move them back onto the BUY list.

RECENT DEVELOPMENTS

Section 2.82


PGR shares have outperformed over the past quarter,

rising 9.9% versus a 9.7% gain for the S&P 500. They have

also outperformed over the past year, with a gain of 40.8%,

compared to a 23.0% increase for the index. The beta on PGR

is 0.86, in line with the peer average.

On January 24, Progressive reported 4Q17 operating EPS

of $0.98, above the consensus estimate of $0.77 and our

estimate of $0.63. Operating EPS rose 57% year-over-year,

boosted by premium growth, margin improvement, and tax

benefits. Excluding those benefits, EPS rose 28% to $0.81 per

share, perhaps a better comparison to year-over-year results.

The combined ratio was 91.4%, an improvement from 92.6%

last year. The 4Q combined ratio benefited from $17 million

in favorable reserve development and the company did not

report any catastrophe losses. Revenue rose 16% to $7.2

billion and beat the consensus by $20 million.

In 4Q17, the company reported 17% year-over-year

growth in net premiums earned (the money the company

keeps), to $6.8 billion. Net premiums written, or new policies

signed, rose 22%, to $6.8 billion. Policies in force, or

insurance contracts outstanding, rose 12% year-over-year in

the Personal Auto segment. In Commercial Lines, policies

rose 6%, but the segment accounts for only about 4% of

policies. Progressive appears to be generating much of its

revenue growth through price hikes.

Book value of $15.96 per share was up from $13.72 a

year earlier.

The trailing 12-month return on average shareholders'

equity, using net income as the numerator, was an impressive

17.3% in 4Q, compared to a peer average of 6.3%.

For all of 2017, EPS came to $2.72 per share, a rise of

55% from 2016. Net income rose 54% to $1.6 billion and

revenue rose 14% to $26.8 billion.


We like the fact that Progressive generates a high ROE

and has shown steady growth in premium revenue. The

company's positive investment results allow PGR to maintain

higher loss reserves - which lessen the impact of volatile

catastrophe losses. We also like the growth in policies in force

and book value. The auto insurance business generates

consistent quarterly earnings (as the number of car crashes is

largely steady from quarter to quarter) and has posted strong

results amid rising car sales. The business is marked by steady

earnings and strong prospects. We have also recently seen

greater increases in premiums, which have led to higher

margins. The combined ratio has also improved - indicating

lower loss frequency. Our concerns for the stock include

earnings growth and the current high valuation.

Key fourth-quarter trends for PGR are summarized

below:

-- The combined ratio was 91.4 in 4Q16, down 120 basis

points. In 4Q17, the company's largest business, Personal

Lines - Agency, recorded an average GAAP combined ratio of

89.3, a decrease of 510 basis points from a year earlier. The

combined ratio for the third-largest segment, Personal Lines -

Direct, was 92.4, a decrease of 30 basis points. Commercial

Lines combined ratio increased to 93.8 from 90.8 in 4Q16,

while the property business reported a ratio of 97.3, up from

73.3.

-- Sales growth has been strongest in the property

business, which reported a gain of 20%, helped by the

company's aggressive advertising and push into home

insurance. Separately, auto insurance has been improving.

Progressive's innovative Snapshot program provides new tools

designed to boost profitability. Snapshot monitors driver

behavior and has been popular with customers, as it can

reduce their premiums. Perhaps for the same reasons, it has

been less embraced by insurance agents. The company is also

growing via acquisitions.

CEO Tricia Griffith has helped push the company into the

home insurance business. By bundling car and home

insurance, the company has been able to boost customer

loyalty and reduce switching costs. We see home insurance as

an area for growth and believe that PGR has the potential to

gain share through improved marketing.

-- Progressive's $27 billion investment portfolio returned

an annualized 2.0% in the fourth quarter. This is low by

historical standards and reflects the current low interest rate

environment; some 85% of the investment portfolio is in

fixed-income securities or cash.

To generate our EPS estimates for the insurance industry,

we typically focus on returns on equity, which are more

predictable than catastrophe losses and net favorable

prior-year development. Progressive's ROE (17.3% in 4Q17)

is among the highest in the industry. However, ROE has fallen

from 19% in 2014.

We are raising our 2018 estimate to $3.49 from $2.86,

which assumes greater increases in net premiums and lower

costs than we previously projected. Additionally, we expect

less severe natural disasters and benefits from lower tax rates.

We are establishing a 2019 estimate of $3.75. Our long-term

operating earnings growth rate estimate is 8%.


Our financial strength rating for Progressive is

Medium-High, the second-highest level on our five-point

scale. The company scores highly on our three main criteria of

debt levels, fixed-cost coverage and profitability.

As of the end of 4Q17, Progressive had debt of $3.3

billion, up from $3.1 billion at the end of 4Q16, and

shareholders' equity of $9.3 billion, up from $8.0 billion. The

debt-to-total-capitalization ratio was 26%, down from 28% at

the end of 4Q16 but above the peer average of 20%. Total

assets were $38.7 billion, up from $33.4 billion a year earlier.

Operating income covered interest expense by a factor of

15.5, up from 8.3 last year, and well above the peer average of

1.4. The profit margin was 6.9%, up from 6.1% last year and

above the peer average of 4.6%. Adjusted ROE for the quarter

was 17.3%, up from 13.5% a year earlier and well above the

peer average of 6.3%.

Progressive pays a dividend with a unique policy. The

Section 2.83


annual variable dividend is determined by a formula that is

based on after-tax underwriting income, and a subjective

'gainshare factor,' a measure of the core insurance business.

This is announced early in the calendar year for the previous

year. For example, on December 8, the December earnings

release stated that the annual variable dividend for 2017

would be $1.12 per share, payable on February 9 to holders of

record on February 2. By comparison, the annual variable

dividends in the previous four years were $0.68, $0.28, $0.41,

and $0.69. From time to time, Progressive also pays a special

dividend, most recently in 2013. We think the core dividend

will be $1.26 in 2018 and $1.29 in 2019.

The company did not repurchase shares during the

quarter. The company has 24.2 million shares remaining on its

25.0 million share repurchase authorization announced in

2014.

MANAGEMENT & RISKS

Tricia Griffith, 52, became CEO in July 2016. Ms.

Griffith previously served as chief operating officer. She

joined the firm as a claims representative in 1988.

The shareholder base includes Vanguard and BlackRock

(which each own about 7% of shares outstanding) and State

Street (4%).

Progressive faces macroeconomic risks related to the

economy and volatile equity markets on the company's

balance sheet, capital levels, credit ratings, revenues and

income. Low interest rates are a challenge to investment

returns, though recent Fed rate hikes should help.

The company also faces competitive threats from rivals

such as Geico, Allstate and State Farm. Progressive focuses

on insurance markets in Florida, New Jersey, New York and

Michigan.

COMPANY DESCRIPTION

Progressive Corp., based in Mayfield Village, Ohio, is a

leading property & casualty insurance company. The company

sells through independent agencies and its own direct-sales

website. The shares are included in the S&P 500 index.

VALUATION

We think that PGR shares are fairly valued at current

prices near $54. Over the past 52 weeks, the shares have

traded in a range of $37-$58.

PGR shares are trading at a price/book multiple of 3.4, at

the high end of the five-year historical range of 2.0-3.5 and

above the median of 1.5 for peers. The shares trade at

15.4-times our 2018 EPS estimate, below the midpoint of the

historical range of 14.3-23.5 and in line with the peer median.

The shares are a suitable core holding for long-term investors,

but we will look for more stable earnings growth or lower

valuations before moving them back to the BUY list.

On January 31 at midday, HOLD-rated PGR traded at

$53.88, up $0.39. (Jacob Kilstein, CFA, 1/31/18)

Qualcomm Inc (QCOM)


HIGHLIGHTS

*QCOM: Executing amid Broadcom bid, Apple war;

reiterating BUY to $75

*Qualcomm reported stronger-than-expected results for

its fiscal 1Q18 (calendar 4Q17).

*Qualcomm is executing despite trying to buy NXP,

fending off acquisition by Broadcom, and fighting an IP war

with Apple

*While revenue and earnings may seem like a sideshow,

Qualcomm's operating progress is instrumental to all these

struggles.

*Even with the many impediments in Qualcomm's path,

operating momentum shows that Qualcomm is being

undervalued by Broadcom, can carry on without Apple (as it

has done for about a year), and would be a good landing spot

for NXP.

ANALYSIS

INVESTMENT THESIS

BUY-rated Qualcomm Inc. (NGS: QCOM) reported

stronger-than-expected results for its fiscal 1Q18 (calendar

4Q17), while guiding cautiously for fiscal 2Q18. Revenue of

$6.07 billion was up 1%, the first positive annual revenue

comparison since 1Q17; sales also topped consensus while

coming in above the (broad) guidance midpoint. Non-GAAP

EPS of $0.98 per diluted share were down 17% annually but

exceeded consensus by $0.07.

Qualcomm's EPS reports may seem incidental given the

multiple dramas in which it is engaged. These include fending

off a bid from Broadcom, now sweetened; engaging in a

grueling legal battle with Apple, which may cut QCOM

modems out of future iPhones; and trying to close the NXP

acquisition, which NXPI activists are calling Qualcomm's bid

too low. Qualcomm's also has incurred past and future fines

totaling $3.9 billion since 2015, including from EU, China,

Taiwan and Korea; only the EU fine is still in front of the

company, however.

While revenue and earnings may seem like a sideshow,

Qualcomm's operating progress is instrumental to all these

struggles. Operating momentum, even with the many

impediments in Qualcomm's path, shows that Qualcomm is

being undervalued by Broadcom, can carry on without Apple

(as it has done for about a year), and would be a good landing

spot for NXP. Qualcomm settled past royalty disputes and set

5G royalty terms with one of its largest licensees, Samsung;

this suggests Qualcomm is doubling down on the efficacy and

fairness of its licensing & royalty model, despite Apple's

protests. This settlement also undercuts a key Broadcom

argument -- that Qualcomm can no longer get its customers to

agree to its licensing terms.

We expect resolution in the Apple licensing feud at some

point, potentially within 9-12 months. Even if Apple never

buys another modem from Qualcomm, the leading smartphone

maker is building up a huge pile of licensing revenue due to

Section 2.84


Qualcomm. Whether the court decides on Qualcomm's terms

or Apple's, past royalties due could amount to about $2 billion

from 2017 alone (based on existing royalty rates).

QCOM shares are subject to many cross-currents having

nothing to do with operations, but that actually makes the

focus on fundamentals more important. Despite the absence of

substantial Apple licensing revenue, and potential loss of

Apple parts revenue (which would not be onerous),

Qualcomm was able to post higher sales in 1Q18 and is on

track for flattish sales in 2Q18.

Weakness in QCOM shares has created a deep-value

opportunity, though we caution that the risk of owning the

shares has increased. Investors willing to take on a range of

risks but also potential benefits may be inclined to initiate or

add to positions in QCOM shares. We are reiterating our BUY

rating to a 12-month target price of $75.

RECENT DEVELOPMENTS

QCOM shares are down about 2% in 2018, compared to a

flat performance for peers. QCOM declined 2% in 2017,

compared to a 31% simple average gain for the peer group of

communications and information processing semiconductor

companies in Argus coverage. QCOM was up 30% in 2016,

versus 60% for peers, and declined 33% in 2015, lagging the

9% gain for the peer group.

For fiscal 1Q18 (calendar 4Q17), Qualcomm reported

revenue of $6.07 billion, which was up 1% annually; revenue

was within the $5.5-$6.3 billion guidance range and topped

the $5.93 billion consensus. Non-GAAP EPS of $0.98

declined 17% from the prior year while exceeding the high

end of the $0.85-$0.95 guidance range and the $0.91

consensus forecast.

As in fiscal 2017, revenue was impacted by payments

withheld by an unnamed licensee (not related to Apple).

Separately, Apple has compelled its contract manufacturing

partners (such as Foxconn) to withhold payments.

On a segment basis in 1Q18, Qualcomm CDMA

Technology (QCT) revenue of $4.65 billion was up 13%

year-over-year and flat sequentially. QCT EBIT of $955

million was up 32% year-over-year and generated a 20.5%

EBIT margin, versus 17.7% in 1Q17.

QCT shipped about 237 million chipsets in 1Q18, at the

high end of the guidance range. Chipset shipments include

both thin mobile modems as well as Snapdragon

system-on-a-chip (SoC) apps processors. Qualcomm does not

break out the number of modems versus SoCs in any quarter.

Based on both revenue per device and the high level of

earnings, as well as comments from management regarding

favorable mix, we believe that shipments of Snapdragon SoCs

grew more than 15% annually in the quarter while modems

were about flat year-over-year. Apple has engaged a second

modem vendor (Intel) for the iPhone; a flat annual comparison

is better than the mid-teens declines in recent quarters.

The QTL (Qualcomm Technology Licensing) business is

obviously most impacted by the Apple legal battle. An

additional non-compliant licensee withheld significant

revenue during QCOM's fiscal 1Q18, as it did in 2H17. QTL

revenue is derived on a three-month lag basis, and thus fiscal

1Q18 revenue represents the calendar third quarter from July

through September 2017. QTL 1Q18 revenue totaled $1.30

billion and was down 28% year-over-year, while growing

sequentially by 1%.

QTL margin, which formerly ran in the mid-80s, is now

in the 60%-70% range on lost volume leverage and overhead

absorption. QTL EBIT for 1Q18 of $887 million was down

42% annually; QTL margin of 68.3% for 1Q18 narrowed

from 84.6% for 1Q17, which was the penultimate quarter

before the Apple dispute turned nasty.

Qualcomm is involved in several separate dramas, all of

which could impact the company deeply going forward. But

Qualcomm also had good news to share. Qualcomm

announced several developments central to its relationship

with Samsung, the largest volume smartphone vendor in the

world. Qualcomm has amended and renewed its technology

licensing deal with Samsung through 2023, which includes

device-level royalties consistent with Qualcomm's long-term

model.

Samsung is withdrawing its opposition to Qualcomm's

appeal of the order (fine) imposed by the Korean Fair Trade

Commission. Qualcomm also announced a multi-year

strategic agreement with Samsung in various technology areas

across a range of mobile devices. The agreement encompasses

5G and other technologies.

The central dramas facing Qualcomm include Broadcom's

unsolicited bid; Qualcomm's long quest to purchase NXP; and

the bruising Apple legal battle. Qualcomm's also has incurred

past and future fines totaling $3.9 billion since 2015,

including from EU, China, Taiwan and Korea; only the EU

fine is still in front of the company, while Qualcomm is

battling the EU fine.

CEO Steve Mollenkopf updated investors on the Apple

dispute, stating that Qualcomm 'continues to move closer to a

number of key legal milestones later this year and early next

year.' In numerous global jurisdictions, hearings are scheduled

to determine whether Qualcomm is entitled to injunctive relief

and exclusion orders. And Qualcomm's cases against Apple

contract manufacturers should move to resolution in the same

time frame. While Qualcomm would like to patch things up

with Apple, the CEO stated, it wants to be paid fairly for its

IP.

Apple has signaled an increasing likelihood that it will

stop using Qualcomm modems in its iPhones. We use the

following assumptions for Apple's contribution to QCT

revenue: 230 million iPhones shipped per year; 50% modem

market share split evenly with Intel; and $11 per chip

wholesale price. That suggests QCT's annual Apple revenue

of about $1.2-$1.3 billion. This money could be lost

altogether, although it may entail Apple using a weaker

product from Intel.

More money is at stake for QTL, but Apple will not be

able to fully wiggle out of paying Qualcomm. Using our

annual iPhones shipped data, a wholesale list under $500 and

Section 2.85


a 2.5% net royalty (including royalty rebates), we believe that

QTL's royalties on the iPhone would be in the $2.0-$2.5

billion range in any year; this is according to the pre-lawsuit

terms that prevailed for all iPhones up through iPhone 6S and

6S Plus.

Apple will not be able to fully stop paying for licensing

rights, although it is seeking to pay much less. Apple seeks to

end Qualcomm's practice of charging a percentage rate based

on wholesale device price; Apple believes what it pays

Qualcomm should reflect only Qualcomm's IP and should

have no relationship to the cost of an iPhone. The imminence

of meaningful legal outcomes in the next 9-12 months

increases the incentive on both sides to settle before the court

settles for them.

There are new and recent developments in the Broadcom

saga as well. Qualcomm rebuffed the initial Broadcom bid,

calling it too low and based on pressures on operations related

to Apple and partners withholding revenue due to Qualcomm.

On 2/4/18, Broadcom raised its offer for QCOM to $121

billion, or about $82 per share - 17% higher than the original

bid offered in November. Broadcom called its offer price

'final.'

Broadcom has alleged that Qualcomm is no longer

capable of maintaining its chipset business (QCT) and its

licensing business (QTL) under one roof. According to

Broadcom, QTL is trapped in endless licensing disputes with

companies (Apple, Blackberry) and governments (EU,

Taiwan, Korea, China); Qualcomm would be best served by

spinning off the asset and focusing on chip technology.

Qualcomm's successful renegotiation with the world's largest

smartphone vendor (Samsung) takes some of the juice out of

that argument. Some investors are concluding that Broadcom

gave its 'final' offer with no expectation that Qualcomm would

take it, creating an easier path for Broadcom to walk away

from the deal.

We do not expect Qualcomm to accept $82 per share.

That is partly because Qualcomm expects to acquire NXP and

vastly expand its available market opportunity.

In mid-January, Qualcomm won EU and South Korean

regulatory approval to buy NXP; ironically, both jurisdictions

are seeking to fine Qualcomm for violating FRAND (fair and

reasonable) terms in its licensing contracts. NXP will likely be

required to divest its credit card security-chip business; but

that would still leave its embedded processing business, which

is the largest player in automotive electronics. Chinese

regulators have yet to approve the deal.

Qualcomm will also likely need to sweeten its bid, which

remains at the original $110 per share over a year since the

deal was first proposed. Qualcomm may have been awaiting

early regulatory decisions before offering a new takeout price.

Based on NXP's huge presence in automotive embedded

products along with new markets entered by Qualcomm -

including device niches such as front end and WiFi, and

verticals such as healthcare, IoT, and others - Qualcomm

believes it can expand its addressable market to $150 billion

by 2020, from $23 billion in 2015. Assuming Qualcomm buys

NXP and (presumably) has some settlement with Apple,

Qualcomm believes it can earn $6.75-$7.50 per diluted share

in non-GAAP FY19 EPS.

Street estimates are well below that level, given that so

many uncertainties are baked into that target number. And

Qualcomm did not help its case with below-consensus

current-quarter guidance. For 2Q18, Qualcomm forecast

revenue of $4.8-$5.6 billion, which at the $5.2 billion

midpoint would be flat to down 2% year-over-year.

Non-GAAP EPS was forecast at $0.65-$0.75, compared with

the $1.34 earned in 2Q17 - the last 'normal' quarter before

Apple & its contract manufacturers began withholding

revenue.

QCOM shares are subject to many cross-currents having

nothing to do with operations, but that actually makes the

focus on fundamentals more important. Despite the absence of

substantial Apple licensing revenue, and potential loss of

Apple parts revenue (which would not be onerous),

Qualcomm was able to post higher sales in 1Q18 and is on

track for flattish sales in 2Q18.

Weakness in QCOM shares has created a deep-value

opportunity, though we caution that the risk of owning the

shares has increased. Investors willing to take on a range of

risks but also potential benefits may be inclined to initiate or

add to positions in QCOM shares.


For fiscal 1Q18 (calendar 4Q17), Qualcomm reported

revenue of $6.07 billion, which was up 1% annually; revenue

was within the $5.5-$6.3 billion guidance range and topped

the $5.93 billion consensus.

The GAAP gross margin expanded sequentially to 56.1%

in 1Q18 from 55.1% in 4Q17, while narrowing from 59.3% a

year earlier. The decline reflected lost volume leverage on

lower high-margined QTL revenue. The non-GAAP operating

margin expanded sequentially to 27.5% in 1Q18 from 26.5%

in 4Q17 and declined from 34.6% a year earlier.

Non-GAAP EPS of $0.98 declined 17% from the prior

year while exceeding the high end of the $0.85-$0.95

guidance range and the $0.91 consensus forecast.

For all of fiscal 2017, Qualcomm had sales of $22.9

billion, down 7% from $24.0 billion in fiscal 2016.

Non-GAAP EPS totaled $4.28 in fiscal 2017, down 4% from

$4.45 in fiscal 2016.

For 2Q18, Qualcomm forecast revenue of $4.8-$5.6

billion, which at the $5.2 billion midpoint would be flat to

down 2% year-over-year. Non-GAAP EPS was forecast at

$0.65-$0.75, compared with the $1.34 earned in 2Q17 - the

last 'normal' quarter before Apple & its contract manufacturers

began withholding revenue.

We are modeling a more extended period of missing QTL

royalties and, as a result, tighter QTL margins. We have

reduced our FY18 non-GAAP earnings forecast to $3.65 per

diluted share, from $4.07. We have reduced our preliminary

fiscal 2019 non-GAAP EPS projection to $4.02 per diluted

share from an initial $4.46.

Section 2.86


We are not incorporating NXP into non-GAAP estimates

for FY18 or FY19; in our view, Qualcomm will need to offer

better terms. Our estimates are also not indicative of industry

or Qualcomm fundamentals and reflect our expectations that

resolution of major litigation with Apple, the unnamed

licensee, and regulatory authorities will take place over an

extended period of time.

Our long-term EPS growth rate forecast is 10%.


Our financial strength rating for Qualcomm is High, the

top of our five-point scale. The NXP deal would represent a

strain for any company. Qualcomm could potentially fund

nearly all of the deal with offshore cash should it choose to do

so; however, we expect QCOM to access credit markets to pay

for a significant part of the acquisition. Qualcomm added

approximately $10 billion in debt in 3Q17 in anticipation of

NXP deal close. We will monitor our financial strength

ranking as final deal details begin to emerge.

Note that Qualcomm's withholding of $1 billion due

Apple under the cooperation agreement has increased cash by

that amount while increasing other current liabilities by that

amount. The launch of the RF 365 JV with TDK has bulked

up assets, as this JV is consolidated on Qualcomm's financial

statements.

Cash was $39.9 billion at 1Q18. Cash was $39.8 billion at

the end of fiscal 2017, $32.4 billion at the end of fiscal 2016,

$30.9 billion at the end of fiscal 2015, and $32.0 billion at the

end of fiscal 2014.

Cash flow from operations was $4.79 billion in FY17,

reduced from $7.40 billion in fiscal 2016. Cash flow from

operations was $5.5 billion in fiscal 2015, and free cash flow

was $4.5 billion. Cash flow from operations was $8.9 billion

in fiscal 2014, while free cash flow (non-GAAP) was $8.1

billion.

Debt was $22.8 billion at 1Q18. Debt was $21.9 billion at

the end of FY17, $11.8 billion at the end of FY16 and $10.9

billion at the end of FY15. 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.

Qualcomm's capital allocation strategy targets a return of

at least 75% of free cash flow to shareholders. Qualcomm has

returned a cumulative $57.5 billion to shareholders since

2007. Qualcomm repurchased $3.9 billion of its stock in

FY16, after repurchasing $11.3 billion in FY15. It

repurchased $4.55 billion of its stock in FY14, $4.61 billion in

FY13, and $1.3 billion in FY12. The cumulative return to

shareholders between FY03 and FY16 was about $54 billion.

On 3/7/17, Qualcomm announced a hike in its quarterly

dividend to $0.57 per common share from $0.53. Our annual

dividend estimates are $2.40 for FY18 and $2.54 for FY19.

MANAGEMENT & RISKS

Steve Mollenkopf has served as CEO since 2014. Former

CEO Paul Jacobs is executive chairman of the board. George

Davis is CFO and Derek Abele is president. Christiano Amon

is president of QCT.

The suit and countersuit with Apple significantly

increases risks for Qualcomm; in an unsuccessful outcome,

Qualcomm could end up paying a large legal bill and fine

while also losing a major customer. However, the legal

sparring may not ultimately influence Apple's business

decisions, particularly if this spat is resolved quickly. Apple

currently has only one other qualified baseband supplier -

Intel. Despite its huge fabrication infrastructure, Intel has been

outsourcing baseband production and may not be ready to

supply chips for over 200 million phones.

An ongoing risk for Qualcomm is that the KFTC and

FTC investigations, along with an ongoing EU investigation,

will 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.

The acquisition of NXP is expensive, though it will be

worth the price if it future-proofs the company against the

inevitable decline in the smartphone market. Qualcomm is in a

nearly unique position of being able to finance the deal largely

with offshore cash should it choose to do so. Overall, we see

risks and opportunities being evenly balanced or perhaps

favoring opportunities in this acquisition.

The company's previously announced realignment plan

carries multiple risks, but was a necessary response to a

changing market. Instead of just cutting heads, Qualcomm has

also changed the board, aligned executive compensation to

performance, and cut share-based compensation. While it will

take time for the plan to be judged on its successes and

failures, we think it is a needed step given the current

environment.

The NDRC settlement should allow Qualcomm to reduce

underreporting and noncompliance in its royalty & licensing

business in China.

Qualcomm and Intel formerly controlled discrete parts of

the technology industry. But the two giants - now with almost

identical market caps - compete squarely with one another in

multiple markets. We believe this competition is healthy for

both companies, and do not look for either to gain a

meaningful advantage over the other on an aggregate basis.

COMPANY DESCRIPTION

Qualcomm is a designer and manufacturer of advanced

semiconductors for mobile phones and commercial wireless

applications. Qualcomm 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

Section 2.87


royalty and licensing revenue from its extensive

intellectual-property portfolio for 3G and 4G technologies.

INDUSTRY























dividend yield.

VALUATION

QCOM shares are trading at 16.9-times our FY18

non-GAAP EPS forecast and at 15.3-times our FY19

projection, compared to an average P/E of 13.7 for

FY13-FY17. The shares, which historically traded at a 15%

discount to the market P/E, now trade at an average 12%

discount for FY17-FY18.

Our historical comparables model signals value in the

low-$60s, in line with current levels and down from past

peaks on the reduced QTL contribution. Discounted free cash

flow modeling signals value above $80, also in declining trend

on reduced royalty cash flows but still above current levels.

Outside of disputes with major OEMs, revenue and EPS

continue to recover across the broad base of customers based

on technology leadership at QCT and growth in the total

addressable market and reported devices. The potential

acquisition of NXP argues for a longer-term appraisal of the

value that Qualcomm can generate in the coming decades.

Legal issues remain a wild card.

Appreciation to our 12-month target price of $75, along

with the annualized dividend yield of about 3.5%, implies a

risk-adjusted return exceeding our benchmark forecast. We

are reiterating our BUY rating on QCOM, while reminding

investors of the multiple risk (and opportunity) now in the

shares.

On February 6, BUY-rated QCOM closed at $64.40, up


Ralph Lauren Corp (RL)


HIGHLIGHTS

*RL: Raising EPS estimates but maintaining HOLD

*On February 1, Ralph Lauren posted fiscal 3Q18

adjusted EPS of $2.03, up from $1.86 a year earlier and above

the consensus of $1.87. Net revenue was $1.6 billion, down

4% year-over-year but in line with the company's guidance.

* We are raising our FY18 diluted EPS estimate to $5.83

from $5.62 and our FY19 estimate to $5.87 from $5.65.

*Although management is taking steps to improve results,

we believe that RL shares adequately reflect our expectations

for continued weak apparel sales in the near term. As such,

our rating remains HOLD.

*We would consider raising our rating on signs of

stabilizing revenues and a return to sustainable EPS growth.

ANALYSIS

INVESTMENT THESIS

Despite margin improvement in fiscal 3Q18, we expect

HOLD-rated Ralph Lauren Corp. (NYSE: RL) to face

near-term earnings pressure from internet competition, weak

consumer spending at brick-and-mortar stores, and continued

store closings.

In June 2016, Ralph Lauren announced a restructuring

plan, called the Way Forward, to drive growth by streamlining

operations and focusing on core brands. The strategy calls for

eliminating underperforming stores and department store

distribution points, launching new marketing initiatives,

restructuring the company's global e-commerce platform, and

reducing supply-chain lead times. Together with fewer

shipments, a reduction in surplus inventory, and fewer

promotional markdowns, these initiatives have helped to

expand margins; however, revenues continue to suffer. North

American sales, which account for more than half of total

revenue, declined 11% in the fiscal third quarter. On the

positive side, the company continues to tweak its product and

marketing mix and to expand its digital and international

presence, particularly in China. We believe that these efforts

are gaining traction and expect the company's results to show

improvement in fiscal 2H19. If costs continue to moderate,

revenue stabilizes, and results in North America and Europe

improve, we would consider an upgrade. On the other hand,

we could lower our rating in the event of continued weak

revenue.

RECENT DEVELOPMENTS

Ralph Lauren shares have outperformed over the last 12

months, gaining 42% compared to a 16% increase in the S&P

500. Over the last three months, the shares have surged nearly

20%, outpacing the index's 2.3% gain.

On February 1, Ralph Lauren reported fiscal 3Q18

results. Adjusted EPS rose to $2.03 from $1.86 a year earlier

and topped the consensus estimate by $0.16. Net revenue was

$1.6 billion, down 4% year-over-year on a reported basis and

Section 2.88


6% in constant currency, but in line with management's

guidance.

The adjusted gross margin rose 250 basis points to

60.7%, and the operating margin rose 40 basis points to

13.2%. The improvement was driven by fewer promotional

discounts, as well by a better channel and geographic mix

(i.e., a larger portion of revenue coming from higher-margin

international and retail business). Favorable currency effects

also boosted the gross margin by 50 basis points. Adjusted

operating expenses were nearly flat at $780 million, as a 27%

increase in marketing spending offset the impact of store

closures and other savings. SG&A as a percentage of revenue

dropped by 211 basis points from the prior year, to 47%.

Interest expense rose to $4.8 million from $3.6 million a year

earlier.

The third quarter share count was 81.7 million, down

from 83.3 million a year earlier. Management does not plan to

repurchase shares in FY18, but will review its plans going

forward.

Ralph Lauren opened 15 stand-alone stores and 10

concessions in the third quarter, and closed 3 stand-alone

stores and 4 concessions. At the end of 3Q18, it had 481

stand-alone stores and 628 concessions globally. It expects a

small net increase in both stand-alone stores and concessions

by year-end, with most of the expansion in Asia.

Patrice Louvet became the company's new president and

CEO in July 2017, replacing interim CEO Jane Nielsen. Mr.

Louvet was previously the group president of Procter &

Gamble's Global Beauty division, and has more than 25 years

of experience in the consumer products industry.


Ralph Lauren has three geographic segments.

Third-quarter segment results are summarized below.

Revenue in North America fell 11% to $886 million in

the third quarter, reflecting sales declines in both the

wholesale and retail channels due to the discontinuation of

less profitable brands and distribution points, reduced

promotions, reduced shipments, and weaker consumer

demand. Comparable sales fell 10%, with a 3% decline in

sales at brick-and-mortar stores and a 27% decrease in

e-commerce sales. The adjusted operating margin rose by 160

basis points. North America accounts for approximately 54%

of the company's net revenues.

In Europe, 3Q revenue came to $378 million, up 8% on a

reported basis but flat in constant currency. Comparable sales

fell 8%, with a 9% decline at brick-and-mortar stores and a

1% decline in e-commerce sales, primarily due to fewer

promotions. Wholesale revenue was flat on a reported basis

and up 8% in constant currency. Retail sales fell 8% in

constant currency, reflecting lower tourist spending. Europe

represents about 23% of net revenues.

In Asia, fiscal 3Q revenue rose to $251 million, up 7% on

a reported basis and in constant currency, driven by both the

wholesale and retail channels. Asia accounted for 15% of

3Q18 net revenue. China is expected to be the major growth

driver in Asia. The company is targeting Greater China

revenue of approximately $0.5 billion in five years, driven by

expanded distribution and higher comp sales.

Along with the 3Q earnings release, management

reiterated its FY18 constant-currency revenue guidance, and

again raised the low end of its operating margin guidance. It

continues to expect an 8%-9% decline in revenue, but now

looks for an operating margin of 10.0%-10.5%, up from its

prior forecast of 9.5%-10.5%. It also expects currency

translation to boost operating margins by 30 basis points.

Management expects to restore revenue growth and further

improve operating margins in FY19. It is targeting a mid-teens

operating margin by FY20.

We are raising our FY18 diluted EPS estimate to $5.83

from $5.62 and our FY19 estimate to $5.87 from $5.65.


Our financial strength rating on Ralph Lauren is High.

The company ended 3Q18 with $2.04 billion in cash and

short-term investments, up from $1.4 billion a year earlier.

Total debt was $589 million at the end of 3Q18, flat with

the prior year. Total liabilities were approximately $2.8

billion, up from $2.4 billion. Inventories fell 16% from the

prior year to $825 million.

The company pays a quarterly dividend of $0.50 per


dividend estimates are $2.00 for FY18 and $2.20 for FY19.

RISKS

Ralph Lauren faces risks from slower consumer spending,

especially at brick-and-mortar stores, as well as from higher

input, manufacturing, and labor costs. Management has

limited discounts in recent quarters, but has noted that higher

revenue may not fully offset cost inflation. RL also faces

currency risk, as changes in exchange rates impact reported

sales and earnings in international operations as well as

spending by foreign tourists in the U.S. The company hedges

inventory purchases to reduce the impact of currency

fluctuations.

COMPANY DESCRIPTION

Ralph Lauren, based in New York, designs, markets and

distributes premium apparel, accessories and fragrances, and

home products. The company's brands include Polo by Ralph

Lauren, Ralph Lauren Purple Label, Ralph Lauren Collection,

Black Label, Blue Label, Lauren by Ralph Lauren, RRL,

RLX, Rugby, Ralph Lauren Childrenswear, Chaps (at Kohl's),

and Club Monaco.

VALUATION

RL shares are trading at 18.1-times our FY18 EPS

estimate, within the range of 17-20 for other luxury apparel

manufacturers; however, the company's earnings and revenues

remain weak. At current levels, we believe that the shares

adequately reflect our expectations for continued weak

apparel sales in the near term. As such, our rating remains

HOLD. We would consider raising our rating on signs of

Section 2.89


stabilizing revenues and a return to sustainable EPS growth.

On February 6 at midday, HOLD-rated RL traded at

$106.32, up $0.88. (Deborah Ciervo, CFA, 2/6/18)

Raytheon Co. (RTN)


HIGHLIGHTS

*RTN: Boosting target by $25 to $225

*RTN shares have outperformed the market over the past

quarter with a gain of 16% while the S&P 500 has advanced

10%.

*Raytheon recently posted 4Q results that were up from

the prior year and above consensus expectations.

*Management has raised its outlook based on solid sales

growth and a lower tax rate.

*Our target price of $225 implies premium valuations -

which we believe that Raytheon merits given its

well-positioned portfolio of businesses and its growth outlook.

ANALYSIS

INVESTMENT THESIS

Our rating on Raytheon Co. (NYSE: RTN) is BUY. We

expect management's focus on its international and

cybersecurity businesses to generate stronger growth over the

next three to five years. RTN's business mix appears favorable

compared to that of most defense industry peers, and given

rising geopolitical threats, we like its emphasis on advanced

missile defense, electronic warfare, counter-insurgency and

counter-terrorism systems. The company is also generating

strong cash flow and aggressively returning cash to

shareholders through increased dividends and share buybacks.

Our target price of $225, raised from $200, implies premium

valuations - which we believe that Raytheon merits given its

well-positioned portfolio of businesses and its growth outlook.

The shares are a suitable core holding for a diversified

portfolio.

RECENT DEVELOPMENTS

RTN shares have outperformed the market over the past

quarter with a gain of 16% while the S&P 500 has advanced

10%. Over the past year, the shares have also outperformed,

rising 44% compared to the market's advance of 24%. The

shares have outperformed the industrial sector IYJ ETF over

the past 1-, 5- and 10-year periods. The beta on RTN is 0.75.

On January 25, Raytheon posted quarterly results that

once again topped expectations. Net sales rose 8.0% to $6.8

billion. Income from continuing operations increased 1.1%,

though the total operating margin narrowed 10 basis points.

EPS from continuing operations rose 9% to $2.03. Total

bookings came to $8.5 billion, up 12.6% from the prior year.

For the full year, on an operating basis, Raytheon earned

$7.64, just below the high end of its guidance range of

$7.55-$7.65. Sales rose 5% to $25.3 billion.

Along with the results, management provided guidance

for 2018. The company projects sales growth of 4%, based on

the strong bookings trend and EPS of $9.55-$9.75 for 2018.

Management expects a tax rate for the year of 19%, down

from 25% in 2017.

CEO Thomas Kennedy noted during the call that the

company continues to see a strong global demand for its

innovative solutions.


RTN has five primary business segments: Integrated

Defense Systems (23% of 4Q sales); Intelligence, Information

and Services (23%); Missile Systems (31%); Space and

Airborne Systems (24%); and Forcepoint (2%). Fourth-quarter

results and trends by segment are summarized below.

In Integrated Defense Systems (IDS), which provides

air-and-missile defense systems and naval combat and ship

electronic systems, net sales rose 6% year-over-year,

reflecting higher sales on an international early warning radar

program that started in 1Q17. The segment operating margin

widened to 16.3% from 15.9%, due to operating leverage.

Management commented that the increase in operating income

was primarily driven by higher volume and favorable changes

within the sector program. For 2018, we look for sales to

increase at a mid-single-digit pace, and margins to fluctuate

near 16.5%.

In Intelligence, Information, and Services (IIS), which

provides services to intelligence customers, revenue rose 4%,

while operating income dipped 3% as the operating margin

fell to 7.4% from 7.9%. During the quarter, IIS booked almost

$1 billion of new business, including deals in support of

Warfighter Field Operations Customer Support program, the

US Air Force and a number of classified accounts.

Management expects a low single-digit top-line decline this

year with stable margins around 7.7%.

In Missile Systems, which develops missile and combat

systems, net sales increased 15% year-over-year due to higher

sales on the Paveway and Excalibur programs. Operating

income increased 7%, as the operating margin increased to

13.8%. The segment has benefited from strong sales of

AIM-9X Sidewinder short-range air-to-air missiles; Paveway

laser-guided bombs; and Tube-launched, Optically-Tracked,

Wireless-Guided (TOW) missiles. In 2018, we expect sales to

grow at a mid-single-digit rate, while margins increase slightly

above last year's 13.2%.

In Space and Airborne Systems (SAS), which serves the

satellite and space markets, net sales increased 4%, and

margins increased 9 basis points to 14.5%. In 2018,

management expects sales to grow at a high-single-digit rate,

while margins decrease slightly from last year.

Finally, in Forcepoint, net sales rose 9% from the prior

year to $156 million. Operating income totaled a loss of $8

million, down sharply due to investments in sales and

marketing.

The total company backlog at the end of FY17 was $38.2

billion, up approximately $1.5 billion from FY16.

Turning to our estimates, based on the sales improvement

Section 2.90


and expectations of lower taxes, we are raising our 2018 to

$9.70 from $8.50. We look for another year of double-digit

growth in 2019 and are establishing a preliminary EPS

forecast of $11.15. Our five-year earnings growth rate forecast

is 10%.


Our financial strength rating for Raytheon is


scale. The company receives above-average scores on our

three main financial strength criteria of debt levels, fixed-cost

coverage and profitability.

Raytheon has a stock buyback program. At the end of 4Q,

the share count was down 1.5% year-over-year.

Raytheon pays a quarterly dividend. In March 2017, the

board increased the dividend by 8.9% to $0.7975 per share, or

$3.19 annually, for a yield of about 1.5%. The dividend

appears secure and we expect it to grow. We look for payouts

of $3.50 in 2018 and $3.90 in 2019.

MANAGEMENT & RISKS

Thomas Kennedy is the Chairman and CEO of Raytheon.

Mr. Kennedy has been with Raytheon for more than 30 years,

and previously served as COO. Anthony O'Brien became the

company's CFO in March 2015. Mr. O'Brien joined Raytheon

in 1986 and most recently served as CFO of the Integrated

Defense Systems business.

Raytheon management sees a potential increase in

demand for its products as foreign governments respond to

increased global threats. In addition, Raytheon continues to

see opportunities in the cyber protection market, driven by

evolving threat levels. In 2Q15, it signed an agreement with

Vista Equity Partners to form Raytheon/Websense, a jointly

owned cyber security company that is now called Forcepoint.

Going forward, Raytheon also plans to invest in emerging

areas such as next-generation radar, high-energy lasers, and

hypersonics.

Investors in RTN shares face risks. As a key supplier to

the U.S. military, Raytheon is likely to be impacted by defense

spending pressures over the next decade, especially in its

short-cycle businesses. Most of the company's sales come

from U.S. government contracts, and new or renegotiated

contracts may be on the chopping block in the coming years.

That said, Raytheon has a diverse product base, which

effectively reduces its dependence on any single platform; in

fact, no single program provides more than 5% of total sales.

It also has one of the largest international sales programs in

the defense peer group (approximately 32% of sales in 2017),

which adds stability to revenues.




COMPANY DESCRIPTION

Raytheon's operations encompass a wide range of

government- and defense-related activities. The company is

based in Waltham, Massachusetts and has about 63,000

employees. RTN shares are a component of the S&P 500.

VALUATION

We think that RTN shares are attractively valued at

current prices near $210. The shares are trading near the top

of their 52-week range of $146-$123. On a technical basis,

they have been in a bullish trend of higher highs and higher

lows dating back to September 2011.



discount model. RTN shares are trading at 20.5-times

projected 2018 earnings, at the high end of the historical range

of 12-21. On a price/sales basis, the shares are also trading

close to the top of the five-year range. The dividend yield of

1.5% is below the midpoint of the five-year range. RTN's

multiples are in line with or slightly above industry averages.

But we think that RTN merits a premium valuation, as we

expect management's focus on international and cybersecurity

businesses to pay off over time. Our dividend discount model

renders fair value for RTN above $230. Blending our

valuation approaches, we arrive at a 12-month target price of

$225.

On February 2 at midday, BUY-rated RTN traded at

$209.49, down $1.36. (John Eade and Marisa Janeczek,

2/2/18)

Sherwin-Williams Co (SHW)


HIGHLIGHTS

*SHW: Posts better-than-expected 4Q17; maintaining

BUY

*On January 25, Sherwin-Williams reported an adjusted

4Q17 net profit of $306.8 million or $3.16 per diluted share,

up from $211.0 million or $2.34 per share in the prior-year

quarter. The 4Q earnings beat our estimate of $2.12 and the


*The higher year-over-year net profit reflected the

acquisition of the Valspar Corp. on June 1, 2017 and higher

paint volume in the Americas Group. Valspar increased net

sales in the fourth-quarter by approximately $1 billion.

Consolidated net sales rose 43% in 4Q to $3.98 billion,

including Valspar sales.

*Together with its 4Q17 earnings report, management

provided a 2018 EPS outlook of $18.80-$19.30 per diluted

share, which includes costs related to the acquisition of

Valspar of approximately $3.45 per diluted share. The

company indicated that it will no longer provide quarterly

EPS guidance going forward. The consensus estimate prior to

the earnings release was $18.69.


$18.33, reflecting positive profit trends from the recently

completed 4Q17, as well expected strong industry

fundamentals and improving results in the Consumer Brands

segment. The consensus for 2018 is $19.09.

Section 2.91


ANALYSIS

INVESTMENT THESIS

We believe that BUY-rated Sherwin-Williams Company

(NYSE: SHW) is well positioned as the U.S. housing recovery

matures, home owners seek to improve the value of existing

homes, and contractors build new homes. In addition, we

expect the company to benefit from the recently completed

Valspar acquisition, which should increase its product

portfolio and help it to expand internationally.

We look for continued EPS growth in 2018, reflecting

strong industry fundamentals, ongoing cost reduction

synergies and positive pricing momentum. We expect

improvement in the Consumer Brands Group. Our rating

remains BUY with a price target of $476.

RECENT DEVELOPMENTS

SHW shares have underperformed since the beginning of

2018, falling 1.7% while the S&P 500 Basic Materials Index

has risen 0.1%. However, they have outperformed over the

past year, climbing 32.8% while the Materials Index has

increased 15.8%.

On January 25, Sherwin-Williams reported an adjusted

4Q17 net profit of $306.8 million or $3.16 per diluted share,

up from $211.0 million or $2.34 per share in the prior-year

quarter. The 4Q earnings beat our estimate of $2.12 and the


The higher year-over-year net profit reflected the

acquisition of the Valspar Corp. on June 1, 2017 and higher

paint volume in the Americas Group. Valspar increased net

sales in the fourth-quarter by approximately $1 billion.

Consolidated net sales rose 43% in 4Q to $3.980 billion,

including Valspar sales.

The consolidated gross margin contracted by 470 basis

points to 45.2% of sales due to a change in the classification

of revenue, while SG&A expense rose 27% to $1.32 billion in

the quarter. As a percent of sales, the total dropped to 33.3%

from 37.3% in 4Q16 due to improved operating efficiency.

Foreign exchange increased profit by $6.3 million in the

quarter and $8.7 million for the full year.

As a result of the recent Valspar acquisition and

integration, Sherwin-Williams has changed its reporting

structure. The company now has three reporting segments: the

Americas Group, the Consumer Brands Group, and the

Performance Coatings Group. Fourth-quarter results by

segment are discussed below.

In the Americas Group, revenue rose 9% from the prior

year to $2.19 billion, while operating profit rose 22% to $406

million, reflecting higher architectural paint sales across all

end markets and higher prices. The segment profit margin

improved to 19.4% from 19.1% a year earlier. We expect this

segment to perform well this year, as professional customers

continue to report large project backlogs.

In the Consumer Brands Group, revenue grew 89% from

the prior year to $572 million, while operating profit fell 54%

to $23.6 million. The increase in revenue was primarily the

result of the inclusion of Valspar. However, Consumer sales

were weak in most product categories and market segments

and the division also experienced higher raw material costs.

Management noted again that strong sales to professional

customers may have reduced demand in the do-it-yourself

market. The company looks for slowly improving results in

the Consumer segment in 2018.

In the Performance Coatings Group, revenue rose 160%

to $1.22 billion, while operating profit increased 81% to

$119.4 million. The higher sales reflected a full quarter

contribution from Valspar, higher paint sales, and higher

selling prices. The improvement in earnings was driven by

Valspar contributions and positive currency translation

effects, which increased profit by 9.6% in the quarter.

As noted in previous reports, Sherwin-Williams

completed its acquisition of Valspar on June 1. Under the

terms of the agreement, Valspar shareholders received $113

per share in cash. Sherwin-Williams continues to project $320

million of annual run-rate synergies within three years of the

closing.

Finally, on October 3, 2017, Sherwin-Williams provided

its strategic outlook to the financial community in a NYC

analyst meeting, highlighting how its recent acquisition of

Valspar Corp. will accelerate earnings growth and dividend

payments through the end of the decade. Expanding sales to

new markets outside of North America (industrial and

residential), along with cost and revenue synergies, should

reach about $400 million by 2020, contributing to wider profit

margins and higher profit rates. Altogether, SHW anticipates

spending $3.9 billion on debt reduction, $1.9 billion on

dividends, $1.6 billion in capital expenditures and $1.2 billion

on acquisitions through 2020. On the profit side, the company

expects earnings to rise by 12% a year through 2020.

For all of 2017, the company reported adjusted net

income of $1.772 billion or $15.04 per diluted share,

compared to adjusted net income of $1.133 billion or $12.41

per diluted share in 2016.


Along with its 4Q17 earnings report, management

provided a 2018 EPS outlook of $18.80-$19.30 per diluted

share, which includes costs related to the acquisition of

Valspar of approximately $3.45 per diluted share. The

company indicated that it will no longer provide quarterly

EPS guidance going forward. The consensus estimate prior to

the earnings release was $18.69.

We are increasing our 2018 EPS estimate to $19.37 from

$18.33 to partially reflect positive profit trends from the

recently completed 4Q17, as well as our forecast calling for

strong industry fundamentals and improving results in the

Consumer Brands segment. The consensus for 2018 is $19.09.

At the same time, we are introducing a 2019 EPS estimate

of $22.20 per share. Our estimate implies growth of about

15% from our 2018 estimate. Our estimate assumes positive

industry fundamentals, higher product pricing and ongoing

cost benefit synergies from the recent Valspar acquisition. The

current 2019 consensus is $21.88.

Section 2.92



We rate Sherwin-Williams' financial strength as Medium,

the midpoint on our five-point scale. The company's debt is

rated BBB/stable by Standard & Poor's and Baa3/stable by

Moody's. Fitch rates company debt at BBB/stable. Following

the Valspar acquisition, SHW's debt ratings were lowered by

the credit agencies, due primarily to higher overall debt.

At the end of 4Q17, SHW's total debt/capitalization ratio

was 74.0%, up from 51.0% a year earlier. The total debt/cap

ratio is above the peer average. Over the past five years, the

debt/cap ratio has averaged 61.7%.

Outstanding debt totaled $10.52 billion at the end of

4Q17, up from $1.95 billion at the end of 4Q16. The increase

reflected debt issuance to help fund the Valspar acquisition.

Sherwin-Williams had cash and cash equivalents of $204

million at the end of 4Q17, compared to $890 million a year

earlier.

The company suspended share buybacks from March

2016 to June 2017 as it pursued the Valspar acquisition. With

the merger now complete, we expect buybacks to resume. The

company has 11.65 million shares (12% of total shares

outstanding) on its current authorization. The company did not

buy any shares in 4Q17.

The annualized dividend of $3.40 yields about 0.8%. The

company raised its dividend by just 1.2% in 2017 due to the

Valspar acquisition, down from its substantial 25% increase in

2016. We expect dividend growth to pick up now that the

merger has been completed. Our dividend forecasts are $3.56

for 2018 and $3.60 for 2019.

MANAGEMENT & RISKS

John Morikis succeeded Christopher Connor as the

company's CEO on January 1, 2016, following more than nine

years as president and COO (he retains the title of president).

Mr. Morikis joined Sherwin-Williams in 1984 as a

management trainee, and has held many key positions in his

31+ years with the company.

SHW investors face risks related to the highly cyclical

nature of the company's end markets, particularly

construction, housing and manufacturing. The company also

faces risks related to the integration of its many acquisitions.

COMPANY DESCRIPTION

Sherwin-Williams is the largest U.S. producer of paint,

coatings and related products, which it sells to professional,

industrial, commercial and retail customers. The company

operates over 4,100 retail stores and supplies coatings directly

to retailers, distributors, industrial & commercial customers

and other industry professionals. The company completed its

acquisition of Valspar on 6/1/17.

VALUATION

Sherwin-Williams shares have traded between $301.51

and $435.15 over the past 52 weeks and are currently in the

upper half of that range, which we believe reflects the recent

completion of the Valspar acquisition and strengthening

trends in the U.S. housing market.

The shares are trading at 20.8-times our 2018 EPS

forecast and at 18.2-times our 2019 forecast, compared to a

six-year annual average range of 24-34. The projected 2018

P/E is also slightly below the peer average of 28.1.

The shares are also trading at a trailing price/book

multiple of 10.6, below the low end of the historical range of

11.8-20.7; at a price/sales multiple of 2.6, above the high end

of the range of 1.8-2.4; and at a price/cash flow multiple of

24.3, above the high end of the range of 16.4-23.2. The

price/EBITDA multiple is 22.0, above the high end of the

range of 14.6-19.4.

Looking ahead, we expect the company to benefit from

continued positive housing market fundamentals and look for

strong earnings growth in 2018. We believe that SHW is

favorably valued given the company's current prospects,

including synergies from Valspar, and are reiterating our BUY

rating with a target price of $476.

On February 5 at midday, BUY-rated SHW traded at

$404.51, up $1.38. (Bill Selesky, 2/5/17)

Tractor Supply Co (TSCO)


HIGHLIGHTS

*TSCO: Maintaining HOLD following 4Q17 results

*On January 31, Tractor Supply reported fourth-quarter

adjusted diluted EPS of $0.91, down from $0.94 a year earlier

but in line with the consensus estimate. Fourth-quarter

revenue rose 1.9% to $1.95 billion and comp sales rose 4%,

up from 3.1% growth in 4Q16.

*For 2018, management projects EPS of $3.95-$4.15,

revenue of $7.69-$7.77 billion, comparable-store sales growth

of 2.0%-3.0%, and capital expenditures of $260-$300 million.

*Management also projects a decrease in the company's

effective tax rate to 23.0%-23.5% in 2018 from about 37% in

2017 due to the new tax law.


$3.59 and establishing a 2019 estimate of $4.46. Our five-year

earnings growth rate estimate is 12%.

ANALYSIS

INVESTMENT THESIS

We are maintaining our HOLD rating on Tractor Supply

Co. (NGS: TSCO). Despite 2.7% growth in same-store sales

and 7.1% revenue growth in 2017, TSCO's revenue growth

slowed from 8.9% in 2016 - the fourth consecutive year of

decelerating growth. We expect growth in SG&A expense to

continue to outpace sales growth in 2018 due to higher freight,

wage and incentive costs, leading to a further decrease in

operating margins. In 2017, Tractor Supply added 101 new

stores, slightly ahead of its target of 100; going forward, we

expect it to add fewer new stores than previously planned,

resulting in slower earnings growth. We are also concerned

that weak pricing for agricultural commodities will pressure

Tractor Supply's customer base. If margins expand and

Section 2.93


same-store sales improve more than we anticipate, we would

consider returning the stock to our BUY list.

Our long-term rating remains BUY. Management projects

a decrease in the company's effective tax rate to 23.0%-23.5%

in 2018 from about 37% in 2017 due to the new tax law, and

plans to reinvest the savings in long-term growth initiatives.

We also note that Tractor Supply has few competitors with

similar product lines, and that it typically focuses on markets

that are too small for Lowe's and Home Depot.

RECENT DEVELOPMENTS

On January 31, Tractor Supply reported fourth-quarter

and full-year results for 2017. Fourth-quarter revenue rose

1.9% to $1.95 billion. Comparable sales rose 4%, up from

3.1% growth in 4Q16. Comp sales were driven by a 2.7%

increase in comparable-store transactions and a 1.3% increase

in the average ticket. The increase in the comp-store

transaction count reflected strong sales of 'consumable, usable

and edible' products as well as seasonal items. Adjusted

diluted EPS fell to $0.91 from $0.94 a year earlier, but

matched the consensus estimate. Net income was $109.7

million, down 11.2% from the prior year. We note that the

company faced more difficult sales and net income

comparisons in 4Q17 due to a 53rd week in 2016.

The 4Q17 gross margin rose by 3.5% to $668.6 million,

reflecting fewer promotions and strength in seasonal products,

partly offset by higher freight costs. SG&A expense,

including depreciation and amortization, was 24.8% of sales,

up from 23.6% a year earlier. Interest expense rose to $3.75

million from $1.1 million.

For all of 2017, Tractor Supply reported revenue of $7.26

billion, up 7.1% from the prior year. Adjusted diluted EPS

rose to $3.33, up from $3.27 a year earlier and ahead of both

management's guidance and the consensus forecast. Net

income was $422.6 million, down from $437.1 million in

2016.

For 2018, management projects EPS of $3.95-$4.15,

revenue of $7.69-$7.77 billion, comparable-store sales growth

of 2.0%-3.0%, and capital expenditures of $260-$300 million.

It also expects to reduce shares outstanding by 2.5%-3.5% in

2018 through stock buybacks.

In 2017, the company opened 101 new Tractor Supply

stores, just ahead of its target of 100 openings but down from

113 in 2016. It also opened 25 new Petsense stores and closed

nine Del's stores. It expects to open 80 new Tractor Supply

and 20 new Petsense stores in 2018.

Tractor Supply continues to integrate its physical stores

with its e-commerce business. Management noted that

customers have responded positively to its 'Buy Online, Pick

Up in Store' program, which was rolled out in 2Q17, and to its

Neighbor's Club program, which now has about 7 million

members.


The company's operating margin fell in all four quarters

of 2017, declining to 9.5% for the full year from 10.2% in

2016. The 2017 gross margin was virtually unchanged at

34.3%.

Based on management's guidance and the company's

2017 results, we are raising our 2018 EPS estimate to $3.96

from $3.59 and establishing a 2019 estimate of $4.46. Our

five-year earnings growth rate estimate is 12%.


Our financial strength rating for TSCO is Medium-High,

the second-highest rank on our five-point scale. The total

debt/capitalization ratio was 23% at the end of 2017.

Operating income of $686 million easily covered interest

expense of $14 million.

In June 2017, the company raised its quarterly dividend

by 12.5% to $0.27, or $1.08 annually, for a yield of about

1.5%. Our dividend estimates are $1.14 for 2018 and $1.24

for 2019.

MANAGEMENT & RISKS

The company is less subject to changing consumer trends

than most retailers given the nature of its product line, but is

still vulnerable to overall shifts in the farm, garden supply,

and animal care markets. As such, the company would likely

experience lower sales from any extended or severe changes

in those markets (such as widespread animal disease or

prolonged drought conditions).

Tractor Supply is expanding both the number of its stores

and its geographic reach. The company could experience

much lower-than-anticipated returns from new operations if

its product mix is not properly tailored to new markets.

TSCO shares are likely to move with the overall retail

sector, but with greater-than-average volatility due to the

company's size.

COMPANY DESCRIPTION

Tractor Supply Co. offers a broad range of items for the

farming, ranching and gardening markets, as well as for small

enterprises. The company sells maintenance supplies,

clothing, animal care supplies, hardware and lawn products,

garden products, and truck and trailer products. The

company's stores are geared toward the needs of rural

America. Formed in 1982 from the assets of a catalog

company that had been selling farm supplies since 1938,

Tractor Supply is converting its older stores to larger formats

(17,000-19,000 square feet) and opening new smaller-format

stores and distribution centers beyond its core Southern and

Midwestern markets. With a market capitalization of

approximately $7.5 billion, TSCO is generally classified as a

mid-cap growth company.

VALUATION

TSCO shares are trading at 18.0-times our 2018 EPS

estimate, below the five-year average of 21.7. However, we

remain concerned about the company's margins, rising SG&A

costs, and weaker sales growth, and expect it to add fewer

new stores than previously planned. We expect these factors

to result in less rapid earnings growth and a lower P/E

multiple. As such, our rating remains HOLD. If margins

Section 2.94


expand and same-store sales improve more than we anticipate,

we would consider returning the stock to our BUY list.

On February 2, HOLD-rated TSCO closed at $67.88,

down $3.56. (Deborah Ciervo, CFA, 2/2/18)

Union Pacific Corp (UNP)


HIGHLIGHTS

*UNP: Raising target by $25 to $155

*UNP shares have outperformed the market over the past

quarter, with a gain of 16% compared to an increase of 9.8%

for the S&P 500.

*Management has signaled confidence in its outlook with

a recent double-digit dividend hike; the company is also

aggressively buying back stock.

*The company is expected to benefit from tax reform and

we have raised our 2018 EPS estimate from $6.53 to $7.53.

*Compared to the peer group, UNP's multiples are mixed,

but generally point to undervaluation. We think this

comparison is important because UNP stock has outperformed

peers in past periods.

ANALYSIS

INVESTMENT THESIS

Our rating on Union Pacific Corp. (NYSE: UNP) is BUY

and our target price is $155, raised from $130. UNP shares are

in recovery mode as the energy markets recover. In general,

we see strengthening underlying demand for the rail industry,

and note that overall volume trends are finally turning

positive. Over the long term, we remain upbeat about North

American railroad companies based on strength in the

consumer sector and solid demand for finished goods, as well

as fuel prices that remain well below 2013-2014 levels. In

addition, UNP's industry-low operating ratio helps to boost the

bottom line. Lastly, management is focused on returning

capital to shareholders and has a history of buying back stock

and raising the dividend. Compared to the peer group, UNP's

multiples are mixed, but generally point to undervaluation.

We think this comparison is important because UNP stock has

outperformed peers in past periods. The shares are a suitable

core holding in a diversified portfolio.

RECENT DEVELOPMENTS

UNP shares have outperformed the market over the past

quarter, with a gain of 16% compared to an increase of 9.8%

for the S&P 500. Over the past year, the shares have also

outperformed, rising 26%, versus an increase of 24% for the

index. The shares have performed in line with the Industrial

sector ETF IYJ over the trailing 1- and 5-year periods. The

beta on UNP is 1.06.

On January 25, UNP reported4Q17 earnings that fell a

penny shy of consensus expectations. Operating revenue rose

5% (in line with the gain in 3Q) to $5.5 billion, as volume

rose 1% (versus a 1% decline in 3Q). Operating income of

$2.0 billion was up 4%, as the operating ratio rose 60 basis

points to 62.6%, due largely to higher fuel costs. Diluted EPS

of $1.53 increased 10% year-over-year, benefiting from share

repurchases. For the full year, the company earned $5.80 per

share.

Union Pacific does not give specific guidance. During the

post-earnings conference call and Q&A session, management

noted that its volume growth was below peers and its expenses

were rising. But management remained committed to its

long-term expense reduction goals, and we have confidence

they will reach them.

Management also offers a volume outlook by segment for

the year ahead. On the positive side, management expects the

food, plastics, ethanol exports and construction products

markets to perform well. In the all-important coal segment, the

company sees strong demand for exports but notes that low

natural gas prices remain a challenge. Lower automotive sales

are expected to be a challenge. A stable-to-weaker dollar

could help shipments in the export grain, minerals, and metals

segments.


UNP has six primary segments: Agricultural Products

(18% of freight revenues), Industrial Products (21%), Coal

(13%), Chemicals (18%), Automotive (10%), and Intermodal

(19%).

Agricultural segment revenue declined for the second

quarter in a row after rising four quarters in a row. Revenue

was down 4% as volume dropped 7%. Grain and grain

product exports were weak due to high global inventories.

Management noted growth in ethanol exports and imported

beer. Looking ahead, we anticipate flat volume in this segment

in 2018 as the grain market remains challenging.

In Automotive, revenue declined 1%, as volume dropped

4%. Management noted continued soft vehicle demand.

Shipments of auto parts, which account for 45% of segment

volume, were down 1%. The fourth quarter saw a bit of a

boost from the replacement of vehicles following Hurricane

Harvey, but the outlook remains muted into 2018.

Revenues in the Chemical segment rose 7%, as pricing

improved 2% and volume rose 5%. Petroleum products

volume recovered and jumped 15%. Plastics volume dropped

4%, while Fertilizer rose 6%. We look for low single-digit

sales growth in 2018, driven by improved pricing.

Coal revenue declined 5% as volume fell 3%. Union

Pacific's coal business has now cycled past the trough of the

coal market, though conditions remain challenging. Looking

ahead, we believe that coal inventories are normalizing, which

is positive, but potential weakness in natural gas prices (below

$3 per mcf) could pose a threat.

In Industrial Products, revenue jumped 28% as the oil

patch recovers. Volume was up 17% while pricing was strong

-- up 10%. Rising oil prices have led to higher shipments of

drilling materials. This is one of the segments we expect to

drive performance in 2018.

Finally, in the Intermodal segment (where standard

Section 2.95


shipping containers are transported without any handling of

their contents), revenue rose 4% on flat volume and a 4%

increase in pricing. Management commented that parcel

shipments increased for the holiday season. We look for

mid-single-digit growth in this business for 2018.

The operating ratio (expenses/revenues) is widely used by

railroads to assess efficiency; a declining operating ratio

signals rising margins and is positive. In 4Q, Union Pacific's

operating ratio rose 60 basis points to 62.6%. Fuel expense,

which had been declining for several quarters but hit an

inflection point in 1Q17, rose 27% in 4Q, while compensation

and benefit costs and the cost of purchased services and

materials rose 4-6% year-over-year. Management has targeted

a 60% operating ratio by 2019 and a 55% ratio in subsequent

years; the company plans to take out $300-$350 million in

costs in 2018.

Turning to our estimates, based on strength in the

Industrial and Intermodal segments, as well as a lower

expected tax rate (between 17%-18%), we are raising our

2018 EPS estimate to $7.53. We anticipate another year of

growth in 2019 and are implementing a preliminary EPS

estimate of $8.44. Our long-term growth rate forecast is 10%.


Our financial strength rating on Union Pacific is


scale. The company generally scores above average on our

financial strength tests of debt levels, fixed-cost coverage and

profitability, though we note some recent slippage. The

company ended 2017 with $1.3 billion in cash and

equivalents, level with the end of 2016. Total debt was $17

billion and accounted for 40% of total capital. Full-year

EBITDA covered interest expense by a factor of 14.

UNP has a share buyback program. Shares outstanding

were down almost 4% year-over-year at the end of the quarter.

The company also pays a dividend. In 4Q17, management

raised the dividend by 10%. The current annualized dividend

of $2.66 yields about 1.9%. The company has paid a dividend

for 119 consecutive years. Management's target payout ratio is

35%. Our dividend estimates are $2.66 for 2018 and $2.94 for

2018.

MANAGEMENT & RISKS

Lance M. Fritz has been the company's president, CEO

and chairman since 2015. Mr. Fritz joined Union Pacific in

2000 and previously served as COO. Robert Knight has

served as CFO since 2004 and has worked at UNP since 1980.

UNP remains focused on improving its operating ratio,

and while management stated that it is always looking for

additional efficiencies, we think that the pace of ratio

improvement may slow in the coming quarters. Still, UNP

leads the industry on this metric and has targeted an ongoing

operating ratio of 60% by the end of 2019.

Investors in UNP face risks. Railroads may face a period

of industry consolidation, and pricing dynamics may change.

In January 2017, the former CEO of Canadian Pacific retired

early and, collaborating with an activist investor, joined CSX

Corp. In April 2016, CP terminated its offer to acquire

Norfolk Southern Corp. (NYSE: NSC), a freight railroad

operating mostly in Eastern and Midwestern states in the U.S.

Railroads are also highly sensitive to the macroeconomic

environment, and are subject to risk from fluctuating fuel

prices, fuel hedges, bad weather, strikes and other labor

actions. Union Pacific's main rival in the Western United

States is BNSF Corp., which is owned by the deep-pocketed

Berkshire Hathaway.

UNP also faces risks related to government regulation,

and may incur extraordinary costs related to positive train

control systems, the transportation of flammable liquids, and

braking standards.

The company has a pension plan, which is not fully

funded.

COMPANY DESCRIPTION

Union Pacific provides rail transportation services in

North America. It has approximately 32,000 route miles and

transports agricultural goods, automotive products, chemicals,

coal, industrial products and other commodities between ports

on the West Coast and Eastern gateways, as well to Mexico.

Union Pacific was founded in 1862 and is based in Omaha,

Nebraska. The stock is a component of the S&P 500.

VALUATION

We think that UNP shares offer value at current prices

near $135, toward the high end of their 52-week range of

$101-$143. From a technical standpoint, the shares appear to

be in a bullish pattern of higher highs and higher lows that

dates to January 2016. Prior to this, the shares had been in a

bearish pattern of lower highs and lower lows that dated to

February 2015.

To value the stock on a fundamental basis, we look at

historical P/E ratios and peer group valuations, and also use a

dividend discount model. UNP shares are currently trading at

18-times our 2018 EPS estimate, just above midpoint of the

historical range of 12-23. They are trading at a price/sales

multiple of 5, toward the high end of the range of 2.1-5.2; but

the dividend yield of 1.9% is above the midpoint of the

five-year range. Compared to the peer group, UNP's multiples

are mixed, but generally point to undervaluation. We think

this comparison is important because UNP stock has

outperformed peers in past periods. Based on our dividend

discount model, we see fair value for UNP at more than $170

per share. We are maintaining our BUY rating and raising our

price target to $155 on this well-managed company.

On January 31, BUY-rated UNP closed at $133.50, down

$1.86. (John Eade, 1/31/18)

United Parcel Service, Inc. (UPS)


HIGHLIGHTS

*UPS: Recent sell-off offers buying opportunity

*UPS shares have underperformed the S&P 500 over the

Section 2.96


past quarter, with a decline of 1% compared to an 8% increase

in the broad market.

*On February 1, UPS reported 1Q results that were in line

with analyst expectations but did not show much earnings

power despite impressive e-commerce-fueled top-line growth.

*The company is expected to benefit from lower taxes

and secular e-commerce growth; we estimate 20% EPS

growth in 2018.

*The shares are trading near the low end of the historical

average P/E range, and in our view offer value at current

levels.

ANALYSIS

INVESTMENT THESIS

BUY-rated United Parcel Service Inc. (NYSE: UPS)

remains seemingly well positioned to benefit from a number

of positive trends, including improving consumer confidence

and the continued growth of e-commerce. UPS provides

shipping, logistics and return services for internet retailers,

whose sales are growing three- to four-times faster than those

of brick-and-mortar stores. After several years of

streamlining, we believe that UPS can leverage the solid

volume growth that is taking place in the U.S. domestic

market. The company's EPS growth over the next two years is

expected to be driven by 3%-5% top-line growth, margin

improvement, and share buybacks. The shares are trading near

the low end of the historical average P/E range, and in our

view offer value at current levels. Our target price, based on

our blended valuation approach, is $145.

RECENT DEVELOPMENTS

UPS shares have underperformed the S&P 500 over the

past quarter, with a decline of 1% compared to an 8% increase

in the broad market. Over the past year, the shares have

underperformed, rising 10% versus a 22% gain for the broad

index. Industry rival FedEx Corp. (FDX: BUY) has sharply

outperformed UPS over the past one-, five- and 10-year

periods, as has the Industrial ETF IYJ. The current beta on

UPS shares is 0.81.

On February 1, UPS reported 1Q results that were in line

with analyst expectations but did not show much earnings

power despite impressive e-commerce-fueled top-line growth.

Revenue rose a strong 11% on an organic basis to $18.8

billion. But operating income increased 3% as the operating

margin narrowed 90 basis points to 12.2%. Adjusted earnings

per share came to $1.67, up 2% and a penny ahead of the

Street's forecast of $1.66. For the full year, the company

earned $6.02 per share, above the midpoint of management's

guidance range of $5.85-$6.10.

On a conference call to discuss results, management

provided earnings guidance for 2018. The company expects

EPS of $7.03-$7.37.


UPS has three primary segments: U.S. Domestic Package

(63% of 4Q sales); International Package (20%); and Supply

Chain and Freight (17%). Fourth-quarter results and outlooks

by segment are summarized below.

In the U.S. Domestic Package segment, revenue rose 8%,

driven by a 3% increase in price. Segment operating margin

declined 150 basis points to 12.2%, however, as 'shipments

surged beyond network capacity during Cyber-periods.' For

2018, UPS management projects revenue growth of 5%-6%

with margins under pressure due to lower pension discount

rates, increased roll-out of Saturday services and network

expansion.

Revenue in the International segment was up 13% on a

constant-currency basis in 4Q, and the operating margin was

20.2%, down 100 basis points. For 2018, management

projects revenue growth of 7%-9%. Operating profits are

expected to rise at a faster rate due to operating leverage.

In the Supply Chain and Freight segment, 4Q sales rose

21%, while the operating margin rose 160 basis points to

8.3%. For 2018, management projects core revenue growth of

6%-8% as conditions in the freight sector are improving.

Profits are expected to improve through the balance of the

year.

Turning to our forecasts, based on the positive revenue

trends, expectations for margin pressure in US Domestic and

lower taxes, we are raising our 2018 EPS estimate to $7.20

from $6.50. Our estimate is above the midpoint of

management's guidance range and implies growth of 20%. We

look for further growth in 2019 and are implementing a

preliminary EPS estimate of $7.90. Our five-year EPS growth

rate remains 8%.


Our financial strength rating on UPS is Medium. The

company receives average marks on our three key criteria

(debt levels are high, but fixed-cost coverage and profitability

are above average).

UPS has a share buyback program. Shares outstanding

were down 0.5% year-over-year at the end of the quarter.

UPS pays a dividend. In 1Q17, the company boosted its

quarterly payout by 6% to $0.83 per share, or $3.32 annually.

The current yield is about 2.6%. For more than four decades,

UPS has either increased or maintained its dividend. Since

2000, its dividend has more than quadrupled. We think the

dividend is secure and that it will continue to grow. Our


MANAGEMENT & RISKS

The CEO of UPS is David P. Abney, who took over in

2014. He is the 11th CEO in the company's 107-year history.

He was previously the company's COO and began his career

at UPS as a part-time package loader in college in 1974.

Richard Peretz took over as CFO in 2015. Mr. Peretz has

worked at UPS since 1981 and most recently served as

corporate controller and treasurer.

Management held an Investor Conference to review

long-term plans through 2019 on February 21, 2017.

The company is targeting 4%-6% revenue growth through

2019, driven in part by plans to expand U.S. delivery and

Section 2.97


pick-up schedules to include six days per week for ground

shipments. Management is also constructing 17 major facility

projects (over 5 million square feet) to create capacity and

efficiency to support further B2B and B2C growth.

In addition, the company forecasts adjusted EPS growth

of 5%-10%. The board plans to spend $1-$1.8 billion per year

on share buybacks. Finally, capex is expected to increase 6%

-7% per year.

Investors in UPS face numerous risks. These include

uneven economic growth in both the U.S. and in international

markets, labor negotiations, and even exposure to the

struggling U.S. Postal Service. In recent years, overcapacity in

the air freight market has put pressure on yields across the

industry. And UPS customer Amazon.com (AMZN: BUY) is

taking steps to deliver more of its packages on its own, though

we note that UPS' fleet of more than 580 planes is a strong

competitive advantage.

UPS also has pension plan risk. The company is

addressing its pension risk by transitioning to a 401-k plan in

2023.

UPS also faces political risks, as President Trump may

propose policies that lead to the revision of some international

trade agreements. On a recent conference call, management

said that participating countries typically saw a 20% increase

in trade following the ratification of new trade agreements. If

the new administration dismantles or scales back existing

trade deals, or fail to pass new agreements, UPS's results

could be negatively impacted.

COMPANY DESCRIPTION

The world's largest package-delivery company, United

Parcel Service (UPS) provides a wide range of transportation,

distribution and logistics services. The company has three

main business segments: U.S. Domestic; International; and

Supply Chain & Freight. The shares are a component of the

S&P 500.

VALUATION

The UPS shares appear attractively valued at current

prices near $116, at the midpoint of their 52-week range of

$102-$135. From a technical standpoint, the shares appear to

be in a long-term bullish pattern of higher highs and higher

lows that dates to November 2012.



discount model. The shares are trading at 16.3-times our 2018

EPS estimate, near the bottom of the historical range of 16-23.

On a price/sales basis, the shares are trading above the

midpoint of the five-year range. The dividend yield of about

2.6% is above the midpoint of the five-year range. Compared

to peers, the stock's valuation multiples are mixed, but

generally below industry averages. Our dividend discount

model renders a fair value north of $150 per share. Blending

our valuation approaches, we arrive at our 12-month target

price of $145.

On February 2, BUY-rated UPS closed at $116.47, down

$3.04. (John Eade, 2/2/18)

Visa Inc (V)


HIGHLIGHTS

*V: Raising target to $140 and boosting EPS estimates

*On February 1, Visa reported adjusted EPS of $1.08 for

fiscal 1Q18 (ended December 31), up from $0.86 a year

earlier and ahead of the $0.99 consensus. Payment volume

and processed transactions remained strong, rising 10% and

12%, respectively.

*The company recently announced a new $7.5 billion

share repurchase program and an 8% increase in its quarterly

dividend.

*Management projects an effective tax rate of 23% in

FY18, down from its prior forecast of 29%. Primarily

reflecting this lower rate, we are raising our FY18 EPS

estimate to $4.38 from $4.05 and our FY19 forecast to $4.96

from $4.57.

*Visa shares trade at 27.5-times our forward four-quarter

EPS estimate of $4.48, slightly below peer MasterCard at

29.7-times. We think that Visa merits a higher multiple than

MasterCard based on its higher operating margins.

ANALYSIS

INVESTMENT THESIS

We are maintaining our BUY rating on Visa Inc. (NYSE:

V) following fiscal 1Q18 earnings that came in above

consensus and our estimate. We are also raising our target

price to $140 from $111 and boosting our FY18 EPS forecast

to reflect our lower tax rate assumptions.

We expect several factors to impact Visa's revenue

profile. We look for cross-border fees to increase, driven by

renewed currency volatility, while several recent deals,

including Costco and USAA, should benefit results in the first

part of FY18.

We believe that the Visa Europe acquisition, completed in

June 2016, makes sense from several angles. The combination

provides scale advantages and marketing synergies, and

should boost the combined company's net revenue yield and

operating margins over time.

We believe that tailwinds for Visa are both cyclical and

structural in nature, and include improving global economic

conditions, particularly in Europe, which should boost

payment volumes, as well as the continued transition from

cash to plastic for convenience, safety and rewards program

benefits. We also note that the market for payment processors

is far from saturated given that 85% of the world's retail

transactions are still done with cash and checks.

We expect Visa's core earnings (excluding benefits from

a lower tax rate) to grow an average of 15% annually over the

next two fiscal years. Even in the absence of P/E multiple

expansion, we believe that Visa shares are a compelling

investment.

RECENT DEVELOPMENTS

Section 2.98


Visa shares have risen 53% over the past year, compared

to a 24% gain for the broad market.

On February 1, Visa reported adjusted EPS of $1.08 for

fiscal 1Q18 (ended December 31), up from $0.86 a year

earlier and ahead of the $0.99 consensus.

First-quarter net revenue totaled $4.86 billion, up 9%

from the prior year, benefiting from strong gains in service

fees, data processing fees, and international transaction fees.

Payment volume in 1Q, on a constant-dollar basis, rose

10% year-over-year, to $1.93 trillion, while total processed

transactions rose 12%, to 30.5 billion.

Adjusted operating expenses rose 13%. The adjusted

operating margin was 68%, down from 69% a year earlier.

On the 1Q18 conference call, management updated its

FY18 guidance. It expects net revenue to increase in the high

single digits on a nominal basis, with a 0.5%-1.0% positive

currency impact. It looks for client incentives to be 21.5%

-22.5% of gross revenues, up from 19.5% in FY17.

Management projects an adjusted operating margin in the high

60s and an adjusted tax rate of 23%, down from its forecast of

29% prior to the recent cut in the tax rate.

In June 2016, Visa acquired Visa Europe in a transaction

valued at 18.5 billion euros. The company noted that there are

more than 500 million active Visa cards in Europe, with 1.5

trillion euros in payment volumes and 18 billion annual

transactions. The agreement called for an upfront cash

payment of 12.2 billion euros, preferred stock valued at 5.3

billion euros, and an additional 1.0 billion euros (plus 4%

interest) payable on the third anniversary of the closing.


The company's primary sources of revenue are services,

derived mainly from payment volume on Visa-branded cards;

data processing fees, from the number of transactions

processed; and international transaction fees on cross-border

transactions. Transaction volumes have benefited from both

economic growth and the increased use of cards rather than

cash. Mobile payments are also expected to be a revenue

driver. In the online segment, the company has noted that

more than 10 million individuals have signed on to Visa

Checkout.

In fiscal 1Q18, payment volume and transactions

processed remained strong, which we believe reflects

continued strong retail sales and card usage as well as solid

growth in Europe. We expect nominal dollar revenues to grow

at an 8% pace in FY18, down from 25% in FY17, which

included the Visa Europe acquisition. We look for a further

8% increase in FY19. A weaker dollar is finally providing a

slight revenue tailwind, a reversal after several years of

currency headwinds.

Meanwhile, client incentives (a revenue offset) are

expected to increase from prior-year levels, as new deals come

with higher incentives. Expense growth overall should be in

the mid-single digits, allowing for continued operating margin

improvement. We look for an operating margin of 67% in

FY18 and 68% in FY19.

Reflecting the stronger-than-expected 1Q results and a

lower effective tax rate, we are raising our FY18 EPS estimate

to $4.38 from $4.05. We are also boosting our FY19 forecast

to $4.96 from $4.57. Our estimates imply growth of 26% in

FY18 (including benefits from the lower tax rate) and 13% in

FY19.

FINANCIAL STRENGTH AND DIVIDEND

We rate Visa's financial strength as Medium-High, the

second-highest rank on our five-point scale.

In September 2017, Visa issued $2.5 billion in fixed-rate

senior notes, with maturities ranging from 5 to 30 years and

interest rates from 2.15% to 3.65%. It used most of the

proceeds to redeem $1.75 billion of senior notes scheduled to

mature in December 2017. In December 2015, Visa issued

$16 billion in fixed-rate senior notes, with maturities ranging

from 2 to 30 years and interest rates from 1.20% to 4.30%.

The proceeds were used primarily to fund the upfront cash

portion of the Visa Europe acquisition. As of December 31,

2017, the company had long-term debt of $16.6 billion and a

debt/equity ratio of 50%, but with high operating margins in

the mid-60s.

The company has raised its dividend substantially over

the last several years from an admittedly low base. On

February 1, it announced an 8% increase in its quarterly

payout to $0.21, or $0.84 annually, for a projected yield of

about 0.7%. Our dividend estimates are $0.80 for FY18 and

$0.92 for FY19.

The company split its stock 4-for-1 in March 2015.

Visa repurchased 15.5 million common shares in 1Q18

for $1.7 billion, at an average price of $110.67 per share. The

board also authorized a new $7.5 billion share repurchase

program. Visa currently has $9.1 billion available for share

repurchases. The company had suspended buyback activity in

4Q15 during discussions to acquire Visa Europe. We look for

a 2%-3% decline in the average share count in both FY18 and

FY19.

MANAGEMENT & RISKS

Alfred F. Kelly became the company's CEO in December

2016 after Charles W. Scharf resigned for personal reasons.

Mr. Kelly had joined Visa's board in 2014 as an independent

director.

Management is transparent with investors, in our view,

providing a range of financial projections for the business,

including revenue growth, operating margins, tax rate,

earnings growth, and free cash flow.

Visa faces risks from regulation, including rules capping

interchange reimbursement rates, as well as from economic

variables that could impact service revenues, data processing

fees, and cross-border transaction fees. Geopolitical factors,

which could result in business disruption, are also a risk.

COMPANY DESCRIPTION

Visa Inc. operates the world's largest electronic payments

network, providing processing services and payment product

platforms, including credit, debit, prepaid and commercial

payments under the brands Visa, Visa Electron, Interlink and

Section 2.99


PLUS. Visa/PLUS is one of the world's largest ATM

networks, offering cash access in local currency in more than

200 countries and territories.

VALUATION

Visa shares trade at 27.5-times our forward four-quarter

EPS estimate of $4.48, slightly below peer MasterCard at

29.7-times. We think that Visa merits a higher multiple than

MasterCard given its higher operating margins. Visa is a

large-cap name with consistent low to mid-teens earnings

growth prospects. We believe the Visa Europe acquisition,

which re-connects the global Visa franchise, will provide

long-term benefits from global branding and cost synergies.

We are raising our 12-month target price to $140, up from a

prior $122, implying a multiple of 31-times our forward

four-quarter estimate. We believe that Visa's low double-digit

earnings growth rate makes for a compelling story even

without P/E multiple expansion.

On February 2 at midday, BUY-rated V traded at


Wells Fargo & Co (WFC)


HIGHLIGHTS

*WFC: Fed's Consent Order to limit asset growth

*On February 2, Wells entered into a Consent Order with

the Federal Reserve Board of Governors related to governance

oversight, and compliance and operational risk management

program, stemming from sales practice issues announced in

the fall of 2016.

*As part of the order effective 2Q18, the company's total

assets will be capped at the 2017 year-end level of $2.0

trillion, a cap that will remain in effect until enhanced plans

for governance and risk management are adopted and

finalized, to the satisfaction of the Fed.

*Wells expects a $300-$400 million negative after-tax

impact on net income for 2018 related to the action. We are

lowering our 2018 EPS estimate to $4.88 from $5.00 to reflect

the asset cap and what we expect will be some additional

customer fallout.

*However, on historical P/E and price/book multiples,

WFC current discount valuation appears to factor in the

company's current challenges.

ANALYSIS

INVESTMENT THESIS

We are maintaining our HOLD rating on Wells Fargo &

Co. (NYSE: WFC) following news that the company has

entered into a Consent Order with the Federal Reserve's Board

of Governors that places a cap on total assets at the $2 trillion

level of the end of 2017, as the company implements various

enhanced risk management practices. The Order relates to a

sales practice scandal that was uncovered in late 2016. Wells

has continued to face sluggish revenue growth trends as it

recovers from that scandal, with lending volumes relatively

muted, and efficiency measures not yet providing tangible

benefits.

The Consent Order requires several changes to board

governance, including: separating the roles of chairman and

CEO and amending the company's by-laws to require an

independent chair; electing six new independent directors in

2017 as five directors retired, and planned refreshment of an

additional four directors in 2018; enhancing the overall

capabilities and experience represented on the board,

including financial services, risk management, cyber,

technology, regulatory, human capital management, finance,

accounting, and consumer and social responsibility; reviewing

the board's committee structure and leadership, amending

committee charters to enhance risk oversight, and refreshing

the chairs of certain key committees, including the Risk

Committee and Governance and Nominating Committee; and

conducting a board self-evaluation in 2017.

Risk management measures include: centralizing critical

control functions (including Human Resources, Finance, and

Technology) to improve enterprise visibility, consistency and

control; centralizing all risk management functions to

accelerate the design and implementation of an integrated

operating model for risk management; developing and

executing comprehensive plans that addressed compliance and

operational risk management programs, organizations,

processes, technology and controls; hiring external talent for

critical risk management leadership roles, such as a chief

operational risk officer, chief compliance officer and head of

regulatory relations; and forming new centralized enterprise

functions dedicated to key risk control areas.

Wells has been trying to put the issue behind it now for

about 18 months. At its 2017 Investor Day on May 11,

management provided an update on its efforts to restore

customer trust in the wake of fraudulent sales practices. These

efforts include better communications with customers,

regulators and industry groups; stronger internal controls; and

a new employee compensation structure. At the same time,

management noted that the company was seeing a reduction in

branch interactions and new account openings as well as

diminished customer loyalty.

The company has terminated more than 5,000 employees

connected with the fraudulent practices. In addition, it has

made amends to customers that experienced late charges or

other penalties connected with the fake accounts, and paid

$185 million in settlement charges to the Consumer Financial

Protection Bureau, the Office of the Comptroller of the

Currency, and the county and city of Los Angeles. It has also

eliminated product sales goals within the retail franchise, and

hired an outside firm to analyze deposit and credit card

accounts opened between 2011 and 2015.

In response to reduced branch activity and customer

losses, the company is targeting $2 billion in expense savings

by the end of 2018, mainly in marketing, finance, human

resources and operations/technology, as well as reductions in

consulting and third-party expenses. At the 2017 Investor

Section 2.100


Day, management also announced an additional $2 billion in

savings that it expects to achieve by the end of 2019, driven

by operational consolidation, improved processes, and the

outsourcing of certain functions.

WFC shares are trading in line with historical P/E and

price/book multiples, which we believe is fair given the

company's current challenges - including sluggish revenue

growth relative to peers.

RECENT DEVELOPMENTS

WFC shares have risen 5% over the past year, versus 20%

for the broad market.

On January 12, WFC reported 4Q17 earnings of $0.97

per share, down from $1.03 in the prior-year period and below

the $1.07 consensus forecast. Results in the current quarter

exclude a $0.67 per share benefit from the Tax Cuts and Jobs

Act (reduction to net deferred income taxes), $0.11 from the

sale of an insurance unit, and a charge for litigation accruals

of $0.59. Revenue increased 2% to $22.05 billion.

Average earning assets rose 0.2%, but with the net

interest margin narrowing to 2.84% from 2.87% a year earlier,

net interest income declined 0.7%. Credit quality improved,

with net charge-offs at 0.31% of average loans, down from

0.37% a year earlier. With a loss provision of $651 million,

versus net charge-offs of $751 million, $100 million of

reserves were released into earnings.

Noninterest income rose 6%, as a decline in services

changes and mortgage banking income was offset by higher

gains from equity investments and other income (versus

expense).

The 4Q efficiency ratio was 61.5% (excluding the

litigation expense), compared to 61.2% a year earlier.

For all of 2017, revenues were flat at $88.1 billion, while

EPS declined 4% to $3.90 from $4.06.


Commercial loans, which on average yielded about

3.68% (up from 3.45% a year earlier as prime rate increases

were passed through), declined 0.2% in 4Q, while consumer

loans, which on average yielded 5.10% (up from 5.01% a year

earlier), declined 2.5%. Meanwhile, funding costs were only

slightly lower in 4Q17 at 2.84% versus 2.87% a year earlier

on higher deposit and long-term debt rates. We believe that

the consumer segment continues to face fallout from the 2016

sales scandal. However, we expect commercial lending

growth to remain a bright spot and to result in higher net

interest income in 2018. Overall, we expect net interest

income growth of 6% in 2018 as interest rate increases are

passed through.

Noninterest income was hurt in 2017 by declines in

service charges and weak mortgage banking volume. While

other banks have been hurt by a decline in mortgage

originations as interest rates rise, WFC's 29% decline in this

line item was greater than that of other banks, also indicating

customer fallout from the sales scandal. Overall, we now

project flat revenues in 2018, versus flat revenues also from

2016 to 2017, as assets are capped following the Fed's

Consent Order referenced above.

Net charge-offs and loss provisions reached parity in

3Q17, but this reversed in 4Q with $100 million being

released into earnings. About $400 million was released into

earnings for all of 2017, which we believe shows weak

earnings quality. While the net charge-off percentage has

declined in recent quarters, we would prefer to see a closer

approximation of loss provisions at this stage of the credit

cycle.

Wells is attempting to get better control of expenses, and

has noted that the efficiency ratio (noninterest expenses to

revenues) is currently too high. The company is targeting

efficiency initiatives to lower expenses by $2 billion annually

by the end of 2018, and plans to reinvest the savings in the

business. It looks for an additional $2 billion in annual

expense reductions by the end of 2019, which are expected to

flow directly to earnings.

Management guided toward a 19% effective tax rate in

2018, down from a high-20% rate in 2017, due to the recently

passed Tax Cuts and Jobs Act. To reflect the asset cap at 2017

year-end levels, as well as expected additional customer

fallout, we are lowering our 2018 EPS estimate to $4.88 from

$5.00. We are also lowering our 2019 EPS forecast to $5.39

from $5.50.


Our financial strength rating on Wells Fargo is High.

At December 31, 2017, Wells Fargo estimated that its

Tier 1 common ratio was 11.9% under Basel III (advanced

approach, fully phased-in).

In June 2017, the Fed did not object to the company's

2017 capital plan, which included an increase in the common

stock dividend from $0.38 to $0.39 per share as of 3Q17, and

the repurchase of up to $11.5 billion of common stock. The

stock's yield under the new dividend is about 2.5%, below the

3.5%-4.0% range prior to the financial crisis. Our dividend


In 4Q17, the company repurchased 51.4 million shares of

its common stock. We look for a 3% decline in the average

share count in 2018.

MANAGEMENT & RISKS

The new CEO of Wells Fargo is Tim Sloan, formerly the

company's president and COO. Mr. Sloan replaces John G.

Stumpf, who resigned in October 2016 following revelations

of fraudulent sales practices at the retail bank. Mr. Sloan is a

29-year veteran of Wells Fargo, having spent much of his

career in wholesale and commercial banking.

While Wells Fargo is a diversified financial services

company, its focus on the low-margin mortgage business is a

concern. Wells Fargo views the mortgage as the gateway to a

broader consumer relationship, and its earnings growth

strategy has always been focused on revenue growth, driven

in part by cross-selling, or selling multiple products to each

customer. However, these sales practices have been sharply

curtailed in the wake of a 2016 scandal. There is also the risk

that demand for WFC products may slow - at least on the

Section 2.101


consumer side. In addition, Wells Fargo focuses exclusively

on the U.S. - a mature and intensely competitive market.

Wells Fargo is primarily a retail and commercial banking

and consumer finance firm. While the company has added to

its trust and investment management business in recent years

via internal growth and acquisitions, market-sensitive

revenues have remained a relatively small part of the

company's mix. In general, we favor financial institutions that

are more heavily linked to fee revenues than to spread

revenues.

Wells Fargo is among the largest mortgage originators

and servicers in the United States. It has direct exposure to

about $320 billion of consumer mortgage loans, of which

about $42 billion are second liens.

With regard to the Volcker Rule, Wells has relatively less

exposure on the capital markets side than other large-cap

banks since it is not a big proprietary trader or investor in

private equity and real estate. However, the company is a

major owner and trader of derivatives used to hedge interest

risk, so there could be some negative impact there. The

biggest negative impacts on the company have been in

consumer banking due to lower fees on debit cards and

overdraft accounts, and higher FDIC fees.

COMPANY DESCRIPTION

Wells Fargo is one of the largest diversified financial

services firms in the United States, with a nationwide network

of several thousand branches and more than 15,000 financial

advisors. Wells Fargo provides a full range of consumer

banking, commercial banking, and investment banking

services. The company nearly doubled its assets with the

acquisition of the former Wachovia. Wells Fargo originates

roughly one of every four residential mortgages in the United

States.

VALUATION

The shares have traded in a range of $49-$64 over the

past year, and are currently near the middle of that range.

The stock trades at 1.6-times tangible book value and at

12.1-times our revised 2018 EPS estimate, closer to its

historical average multiples. We view these valuations as fair

given the company's current challenges, which include

sluggish revenue growth as it recovers from a 2016 sales

scandal. Our rating remains HOLD.

On February 5 at midday, HOLD-rated WFC traded at


Section 2.102

UTILITY SCOPE

Utility Scope Stocks in this Report

PRICE

AS OFTICKER 2/7/18

Duke Energy Corp DUK $74.49

El Paso Electric Co EE 49.50

Public Serv Enterprise Grp In PEG 47.63

Duke Energy Corp (DUK)


HIGHLIGHTS

*DUK: Lowering EPS estimates and reiterating HOLD

*We are lowering 2017 EPS estimate to $4.57 from $4.65

and our 2018 EPS estimate to $4.78 from $4.85. In both years,

we look for higher depreciation and amortization expense as

well as higher interest costs related to the financing of Duke

Energy's Piedmont Natural Gas acquisition.

*Despite the company's solid fundamentals, including a

favorable regulatory environment and an expanding rate base,

we see an unexciting total return potential for DUK over the

next 12 months.

*Due to the company's infrastructure improvement

program, we expect above-average rate base growth over the

next several years and view the company's sale of

nonregulated generating assets in the Midwest as a strong

positive.

*The annualized dividend of $3.56 yields about 4.6%,

and may appeal to income-oriented investors.

ANALYSIS

INVESTMENT THESIS

Our rating on Duke Energy Corp. (NYSE: DUK) is

HOLD, based primarily on valuation. DUK shares trade at

16.2-times our revised 2018 EPS estimate of $4.78, near the

average multiple for comparable electric utilities and the

five-year historical average of 14.9. Despite the company's

solid fundamentals, including a favorable regulatory

environment and an expanding rate base, we see an unexciting

total return potential for DUK over the next 12 months.

At the same time, we are maintaining our long-term BUY

rating. We expect above-average rate base growth over the

next several years and view the company's recent sale of

nonregulated generating assets in the Midwest as a strong

positive. Other positive fundamentals include the company's

i m p r o v i n g b a l a n c e s h e e t a n d w e l l - m a n a g e d

nuclear-generating assets. The 2012 addition of Progress

Energy has also generated significant cost synergies, and we

expect the same with the October 2016 addition of Piedmont

Natural Gas Co.

The expected rise in Duke's construction spending for

new power plants, infrastructure improvements and alternative

energy projects should have little, if any, impact on long-term

earnings growth. Duke is now benefiting from positive

changes in its regulated electric utility rate structures, an

improving economy in its Carolina and Florida service areas,

and moderate kilowatt-hour sales growth. In our view, these

factors make DUK shares a sound long-term holding for

investors seeking moderate share price appreciation and a

solid dividend. We think the current annualized payout of

$3.56 per share is secure and expect annual dividend growth

of 2.5%-3.0% over the next several years. The current yield is

about 4.6%. In our view, these factors should combine to

generate total returns to shareholders of 5%-6% annually over

the next 4-5 years.

RECENT DEVELOPMENTS

Over the past three months, DUK shares have fallen 12%,

compared to a gain of 10% for the S&P 500. Over the past 52

weeks, the shares have gained 1%, compared to an increase of

24% for the index. The five-year track record shows an

increase of 13% for DUK, versus a gain of 91% for the S&P

500. The beta on DUK is 0.03.

Duke will report fourth-quarter and full-year results on

February 20, 2018.


Based on Duke's nine-month results, we think that the

company remains on track to achieve its 2017 adjusted

earnings guidance of $4.50-$4.60 per share.

We are lowering 2017 EPS estimate to $4.57 from $4.65

and our 2018 EPS estimate to $4.78 from $4.85. In both years

we look for higher depreciation and amortization expense as

well as higher interest costs related to the financing of Duke

Energy's Piedmont Natural Gas acquisition. In addition, the

expected absence of earnings from the earlier sale of Duke

Energy's International Energy segment and a continuation

well into 2018 of lower investment tax credits in the solar

portfolio are expected to have a noticeable effect in supporting

our revised EPS estimates.

On the other hand, our long-term BUY rating takes into

account management's current EPS guidance, generally

favorable regulation in North and South Carolina, clearer

earnings visibility and the company's infrastructure

improvement program, we believe these positives will support

our five-year EPS growth forecast of 5%. We note that

kilowatt-hour sales have improved in nearly all service

territories, with sales now growing at a relatively strong rate

of 1.1%-1.2% annually.

Our long-term BUY rating reflects our assumption of

lower O&M expenses and benefits from the refinancing of

high-cost debt. In addition, we look for Duke to benefit from

effective management execution, as well as from continued

improvement in its service area economies. The company

should benefit from future rate case filings in North and South

Carolina, cost-savings programs, and infrastructure

improvements. Using 2017 as a base year, our five-year

earnings growth rate estimate for Duke Energy is 5%.


Section 2.103

UTILITY SCOPE

Our financial strength rating for Duke Energy is Medium,

the midpoint on our five-point scale. The company's debt is

investment grade. At the end of 3Q17, common stock

comprised 52% of Duke Energy's permanent capitalization,

and long-term debt, 48%.

Long-term debt totaled $48.929 billion at the end of

3Q17, compared to $45.576 billion at the end of 2016.

Earnings covered interest on long-term debt by a factor of 3.3

in 3Q17. Cash and cash equivalents were $282.2 million at the

end of 3Q17, compared to $392.3 million at the end of 2016.

Operating cash flow totaled $5.011 billion in the first nine

months of 2017, compared to $5.611 billion in the same

period in 2016.

While the company's plant construction and upgrade

schedule will require some external financing, we expect

relatively little pressure on the balance sheet. Indeed, the

company's overall financial position has steadily improved.

Additional positive factors are the efficiency of the company's

nuclear generating units, which are among the highest-rated in

the industry; focused cost controls; high-quality earnings; and

balanced regulation.

In July 2017, Duke Energy raised its quarterly dividend

by 4.1% to $0.89. The annualized rate is now $3.56. Based on

trailing 12-month adjusted EPS, the dividend payout ratio is

about 71%. We expect the company to increase its dividend

4.5%-to-5.0% annually over the next four to five years. Our

dividend payout estimates are $3.49 for 2017 and $3.56 for

2018.

MANAGEMENT & RISKS

Lynn J. Good is president and CEO of Duke Energy and

the vice chairman of the board. Prior to assuming her current

role in July 2013, Ms. Good served as EVP and CFO.

Steven K. Young is EVP and CFO, and is responsible for

the controller's office, treasury, risk management, as well as

corporate strategy and development. Mr. Young joined Duke

Power in 1980 as a financial assistant.

In general, Duke Energy management is committed to

electric and gas service expansion strategies in its regulated

service territories. In terms of its nonregulated operations,

management decided to lower the company's profile in the

competitive energy business due to relatively low power

prices. Note, too, that management will enter into the outside

purchase of energy assets only after thorough due diligence.

In our view, the company's platform for growth is solid, and

we are confident in management's ability to provide

shareholders with increased value over the long term.

Key risks for stocks in our electric utility universe include

commodity price fluctuations, the effect of adverse weather

conditions on revenue, regulatory issues (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

Duke Energy, the largest electric power holding company

in the U.S., has a market cap of approximately $58.8 billion,

with total assets of more than $120 billion. Its regulated utility

operations serve approximately 7.4 million electric customers

in six states in the Southeast and Midwest. The company's

nonregulated Commercial Renewables segment owns a

growing portfolio of renewable energy assets in the U.S. In

October 2016, Duke acquired Piedmont Natural Gas Co.

Including Piedmont, the company now has approximately 1.4

million natural gas customers.

INDUSTRY

Our rating on the Utility sector is Under-Weight. The

sector outperformed the S&P 500 in 2016, with a gain of

12.2%, after underperforming in 2015, with a loss of 8.4%. It

underperformed in 2017, with a gain of 8.3%.

The sector accounts for 3.1% of the S&P 500. Over the

past five years, the weighting has ranged from 3.0% to 5.0%.

We think the sector should account for at most 2%-3% of

diversified portfolios. The sector includes the electric, gas and

water utility industries.

By our calculations (using 2018 EPS), the sector

price/earnings multiple is 18.6, a record high level and above

the market average of 18.2. Earnings are expected to rise 5.7%

in 2018 and 5.9% in 2017 after rising 21.5% in 2016 and

falling 14.9% in 2015. 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 2.8% is above the

market average of 1.8%.

VALUATION

Over the past 52 weeks, DUK shares have traded between

$76 and $92. The shares currently trade at 16.2-times our

revised 2018 EPS estimate of $4.78, above the average for

comparable electric utilities and the company's five-year

historical average of 14.4. DUK also trades at a premium to

peers based on price/sales and price/book. Based on these

metrics, we believe a HOLD rating is appropriate.


rating. We view the company's visible forward earnings

stream and attractive integrated structure, along with

management's demonstrated execution ability, as compelling

reasons for investors to maintain their current positions.

Added benefits are the company's growing dividend, generally

positive relations with regulators, geographic diversity, and

well-run electric generation and gas distribution facilities. In

addition, the company continues to add new customers despite

some remaining economic weakness in its service areas. It has

also generated significant cost synergies from its 2012 merger

with Progress Energy and we expect the same with the recent

acquisition of Piedmont Natural Gas. We believe these factors

should combine to generate total annual returns for DUK

shareholders of 5%-6% over the next four to five years.

The annualized dividend of $3.56 per share yields about

4.6%, and may appeal to income-oriented investors.

On January 31 at midday, HOLD-rated DUK traded at

$77.71, up $0.05. (Gary Hovis, 1/31/18)

Section 2.104

UTILITY SCOPE

El Paso Electric Co (EE)


HIGHLIGHTS

*EE: Lowering 2018 EPS estimate; reiterating HOLD

*El Paso Electric operates in a geographic region that has

seen strong economic growth relative to the national average,

and has benefited from an improving service-area housing

market and above-peer-average kilowatt-hour sales to

residential customers.

*EE shares currently trade at 19.3-times our revised 2018

EPS estimate, a premium to the average multiple for

comparable electric utilities with fully regulated operations. It

also trades at a small premium to peers based on price/cash

flow and price/book multiples.

*El Paso operates in a geographic region that has seen

strong economic growth relative to the national average, and

has benefited from an improving service-area housing market

and above-peer-average kilowatt-hour sales to residential

customers.

*In our view, the company's strong fundamentals should

combine to generate total returns of 5%-6% annually over the

next four to five years. Even so, the dividend yield of about

2.6% is below the peer average of 3.4%.

ANALYSIS

INVESTMENT THESIS

We are reiterating our HOLD rating on El Paso Electric

Co. (NYSE: EE). EE currently trades at 19.3-times our revised

2018 EPS estimate, a premium to the average multiple for

comparable electric utilities with fully regulated operations. It

also trades at a small premium to peers based on price/cash

flow and price/book multiples.

We believe that the company has adequate liquidity

through its current cash balance, cash from operations and

credit facility to meet all anticipated cash requirements

through 2018.

We note that utilities as a group are heavily debt-financed

and that aggregate interest charges are likely to rise in the

event of future Fed rate hikes. In addition, in a rising interest

rate environment, equity investors seeking income often move

away from utility shares and turn to the bond market, as

fixed-income rates begin to rise. Even so, we think that EE,

with its strong finances and solid management execution, will

help support the EE share price.

In our view, these positives should combine to generate

total returns of 5%-6% annually over the next four to five

years.

El Paso Electric operates in a geographic region that has

seen strong economic growth relative to the national average,

and has benefited from an improving service-area housing

market and above-peer-average kilowatt-hour sales to

residential customers. We believe that El Paso's solid financial

strength, limited risk profile, visible forward earnings stream,

and attractive integrated structure are also positives. In

addition, the company should benefit from a favorable

regulatory environment. We expect these positives to result in

above-average EPS and dividend growth over time, and are

maintaining our long-term BUY rating.

RECENT DEVELOPMENTS

Over the past three months, EE shares have fallen 8%,

compared to a gain of 9% for the S&P 500. Over the past 52

weeks, the shares have risen 13%, compared to a gain of 24%

for the index. The five-year track record shows an increase of

52% for EE and 89% for the S&P 500. The beta on EE shares

is 0.31.


The company's earnings guidance for 2017 falls within a

range of $2.30 to $2.50 per share. It is expected to release 4Q

and full-year 2017 financial results on February 27.

Over the last five 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 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. Over the

last 10 years, EE's service territory has grown faster than the

regulated utility industry average. Customer growth was 1.7%

in 3Q17 and has averaged about 1.4% annually (above the

industry average of 0.5%).

Our 2017 earnings estimate is $2.47 per share. While the

rate case approval in Texas benefited earnings in 2016, the

company still faces uncertainty surrounding the

reimbursement of expenses related to the company's Montana

Power Station and Eastside Operations Center. With the latter

in mind, we are lowering our 2018 EPS estimate to $2.66

from $2.75.


Our financial strength rating for El Paso Electric is

Medium-Low, the second-lowest rank on our five-point scale,

down from Medium. Moody's rates the company's debt

investment grade. El Paso has maintained a strong balance

sheet and cash position to support investments in utility

infrastructure.

The company continues to maintain a strong capital

structure with common stock equity representing 44% of El

Paso's capitalization at the end of 3Q17. At the end of 3Q17,

El Paso had $7.060 million in cash and cash equivalents.

Based on current projections, we believe the company will

have adequate liquidity through its current cash balances, cash

from operations and available borrowings under the

company's revolving credit facility to meet all expected cash

requirements through December 31, 2018.

Cash flows from operations for the nine months ended

September 30, 2017 were $218.7 million, compared to $176.8

Section 2.105

UTILITY SCOPE

million for the same period in 2016. The primary factors

contributing to the increase in cash flows from operations

were the change in net over-collection and under-collection of

fuel revenues and the collection of back surcharges.

EE pays a quarterly dividend of $0.335, or $1.34 on an

annualized basis, for a yield of 2.4%. Our 2017 dividend

estimate is $1.30 per share and for 2018, we are looking at

$1.38. Management has targeted a 55%-65% payout ratio over

the next three years with increases beginning in 2018.

MANAGEMENT & RISKS

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.

Management projects heavy capital expenditures of $1.1

billion through 2021 (including early estimates for a 320

megawatt combined cycle generating plant to be completed in

2023), as the company develops additional generating

capacity and upgrades transmission and distribution

infrastructure.

El Paso Electric is regulated in Texas and New Mexico,

and is also regulated by FERC. Over the next decade, the

company will face regulations in Texas and New Mexico that

require El Paso to boost sales of energy from renewable

sources. These incremental costs are expected to be recovered

through base rates and renewable energy credits.

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 the company because of its 15.8%

stake in the Palo Verde nuclear plant in Arizona.

COMPANY DESCRIPTION

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







We think the sector should account for at most 2%-3% of












VALUATION

Over the past 52 weeks, HOLD-rated EE shares have

traded between $45 and $61, and are currently near the low

end of this range. Despite the company's positive

fundamentals, including a strong financial position and a

growing service territory economy, we see an unexciting total

return potential for EE shares over the next 12 months. The

shares currently trade at 19.3-times our revised 2018 EPS

estimate of $2.66, near the low end of their five-year trading

range, above the peer average of 18.2 and lastly, above their

five-year historical average P/E of 14.6. As well, the dividend

yield of 2.6% is below the peer average of 3.4%. Thus, we

believe a HOLD rating is appropriate.


rating. We view the company's visible forward earnings

stream and attractive integrated structure, along with

management's demonstrated execution ability, as compelling

reasons for investors to maintain their current positions.

Added benefits are the company's growing dividend, generally

positive relations with regulators, and well-run electric

generation facilities. The company also has a strong balance

sheet and continues to add new customers in a growing

service area economy.

Looking ahead, we expect El Paso Electric to benefit

from its list of strong fundamentals and look for total annual

returns to shareholders of 5%-6% over the next 4-to-5 years.

As well, the annualized dividend of $1.34 per share yields

about 2.6% and, in a market downturn, may appeal to

income-oriented investors.

On February 2 at midday, HOLD-rated EE traded at

$51.30, down $0.15. (Gary Hovis, 2/2/18)

Public Serv Enterprise Grp In (PEG)


HIGHLIGHTS

*PEG: Raising 2018 EPS estimate; reaffirming BUY

*We view the company's increased spending on electric

transmission and gas pipeline projects as a strong plus, as

these facilities are more likely to provide higher returns on

equity than those earned on distribution and generation assets.

*We are maintaining our 2017 EPS estimate of $2.91, but

are raising our 2018 estimate to $3.11 from $2.98.

*Our revised 2018 estimate reflects the continued

expansion of the company's electric and gas transmission and

Section 2.106

UTILITY SCOPE

distribution facilities, as well as its favorable natural gas

supply position.

*PEG trades at 16-times our revised 2018 EPS estimate,

below the average multiple for electric and gas utilities with

both regulated and nonregulated assets.

ANALYSIS

INVESTMENT THESIS

Our target price on BUY-rated Public Service Enterprise

Group Inc. (NYSE: PEG) is $56, based on the company's

growing network of transmission assets and its well-managed

regulated utility subsidiary, Public Service Electric & Gas Co.

(PSE&G). We view the company's increased spending on

electric transmission and gas pipeline projects as a strong plus,

as these facilities are more likely to provide higher returns on

equity than those earned on distribution and generation assets.

We expect above-average growth in the company's rate

base from infrastructure investments, as well as higher

profitability in its nonregulated operations. In addition, we

continue to expect annual dividend growth of 4.0%-5.0% over

the next several years. The shares currently offer a solid

dividend yield of about 3.4%.

Utilities as a group are heavily debt-financed and

aggregate interest charges are likely to rise. In addition, in a

rising interest rate environment, equity investors seeking

income more often than not move away from utility industry

shares and turn to the bond market, as fixed-income rates

begin to rise. Even so, we think Public Service, with its strong

finances and solid management execution, will outperform

other utilities in a rising interest rate environment.

The company should continue to benefit from strong cost

controls, solid cash flow from operations, a strong

management team, and what we view as a favorable

regulatory environment at both the state and federal levels. In

addition, our positive assessment reflects the company's

efficiently operated nuclear generation units, focus on balance

sheet improvement, and expanding economic activity in its

service area. We believe that the company's core business

strategy complements its well-balanced asset portfolio, and

that its regulated electric and gas business is well positioned

for growth beyond 2018.

RECENT DEVELOPMENTS

Over the past three months, PEG shares have fallen 1%,

compared to an increase of 7% for the S&P 500. Over the past

52 weeks, the shares have risen 14%, compared to an advance

of 20% for the S&P 500. The five-year track record shows an

increase of 59% for PEG, versus a gain of 91% for the S&P

500. The beta on PEG shares is 0.23.


Management's 2017 operating earnings guidance is

$2.80-$3.00 per share. The company will report fourth-quarter

and full-year results for 2017 on February 23,

We are maintaining our 2017 EPS estimate of $2.91, but

are raising our 2018 estimate to $3.11 from $2.98. Our revised

2018 estimate reflects the continued expansion of the

company's electric and gas transmission and distribution

facilities, as well as its favorable natural gas supply position.

In addition, the company is beginning to benefit from a

turnaround in nonregulated wholesale power prices and lower

energy supply costs as well as from declining O&M expenses.

At the same time, our revised estimate assumes some pressure

from rising depreciation and higher property taxes, both

related to the infrastructure buildout program, as well as from

customer conservation efforts.


Our financial strength rating on Public Service Enterprise

is Medium-High, the second-highest rank on our five-point

scale. The company's bond ratings are investment grade.

Public Service remains focused on balance sheet

improvement, growth in cash flow, and strong cost controls.

While total debt has increased as a result of its infrastructure

buildout program, the overall cost of financing has declined

due to refinancing activity and lower interest rates. The

company ended 3Q17 with a relatively low long-term

debt/capital ratio of 48%, well below the sector average of

55%. EBITDA covered interest expense by a factor of 6.8 in

3Q17, slightly below the industry average near 7.0. The 3Q17

profit margin was 14.4%, compared to 13.9% in 3Q16.

Operating cash flow fell to $2.734 billion in 3Q17 from

$2.761 billion in 3Q16.Increasing shareholder value remains a

priority, and the company has paid dividends without

interruption since 1907. The annualized dividend is currently

$1.72 per share, for a yield of about 3.4%. Our dividend

estimates are $1.72 for 2017 and $1.78 for 2018. We expect

dividend increases of close to 5% annually over the next 3-4

years.

MANAGEMENT & RISKS

Ralph Izzo was elected chairman and CEO of Public

Service Enterprise Group in April 2007. He became the

company's president and chief operating officer and a member

of the board of directors in October 2006. He previously

served as president and chief operating officer of PSE&G.

On September 23, 2015, Daniel J. Cregg, formerly VP of

Finance for PSE&G, was named executive vice president and

CFO. During his 24-year career with the company, Mr. Cregg

has held senior financial positions at both PSE&G and PSEG

Power.

Overall, we believe that Public Service Enterprise is

committed to electric and gas service expansion strategies in

its regulated service territory and that it is keeping O&M

expenses in check. In addition, we think the company's

platform for growth is solid, and we are confident in

management's ability to provide shareholders with increased

value over the long term.

The company's regulated utility operations are subject to

cooler-than-normal conditions during the summer

air-conditioning season, and the gas distribution business

faces the possibility of warmer-than-normal temperatures

during the winter heating season. Although utility regulation

Section 2.107

UTILITY SCOPE

in New Jersey is generally balanced, there is always the

possibility that regulators will lower the company's allowed

return on common equity. The company's earnings could also

come under pressure in the event of a downturn in the U.S.

economy.

COMPANY DESCRIPTION

Public Service Enterprise Group is a combination electric

and gas utility holding company, with regulated operations

serving a large part of New Jersey, and nonregulated

operations serving electricity markets primarily in the

Mid-Atlantic and Northeast. It has two primary wholly owned

subsidiaries: PSE&G (a regulated utility), and nonregulated

PSEG Power (nuclear, solar and fossil-fuel-powered electric

generating operations). At the end of 2016, the company

operated a portfolio of 13,850 megawatts of installed

generating capacity.

INDUSTRY







We think the sector should account for at most 2%- 3% of












VALUATION

PEG trades at 16-times our revised 2018 EPS estimate of

$3.11, below the average multiple for electric and gas utilities

with both regulated and nonregulated assets. The stock also

trades at a discount to peers based on price/cash flow and

price/book.

Other favorable factors are the company's experienced

management team, strong operating efficiencies, limited risk

profile, solid cost controls, and generally positive relations

with regulators. The company also has a strong balance sheet

and continues to add new customers in an improving service

area economy. Overall, we believe that the company is

committed to optimizing the value of its regulated and

nonregulated assets.

We believe that Public Service has the potential to

generate total annual returns for shareholders of 5%-6% over

the next four to five years. Our target price of $56, along with

the dividend, implies a potential total return of about 15%

from current levels.

On February 5, BUY-rated PEG closed at $48.84, down

$1.20. (Gary Hovis, 2/5/18)

Section 2.108

STOCKS TO AVOID

There are no companies updated in the Stocks to

Avoid category this week.

Section 2.109

U.S

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Nov-17

Dec-17

Jan-18

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CR

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125.5928

125.0647

124.146

123.6594

122.0436

120.3736

119.0583

117.9287

120.0495

120.2745

119.9565

117.2182

US

D/Y

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112. 77

111. 39

111. 49

110. 78

112. 39

110. 26

109. 98

112. 51

113. 64

112. 54

112. 69

109. 19

US

D/E

UR

1. 0798

1. 0576

1. 0652

1. 0895

1. 1244

1. 1426

1. 1842

1. 191

1. 1814

1. 1646

1. 1904

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1. 2414

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-$44. 306

-$44. 890

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-$50. 500

N/ A

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Feb

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201

8

ECONOMIC TRADING CALENDARECONOMIC TRADING CALENDARECONOMIC TRADING CALENDARECONOMIC TRADING CALENDARECONOMIC TRADING CALENDAR

- Section 3 -

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

Release:Date:Month:Previous Report:Argus Estimate:Street Estimate:

Leading Economic Indicators3/22/2007February0.1%0.0%0.0%


Existing Home Sales3/23/2007February6.46 mln.6.50 mln.6.35 mln.


Consumer Prices2/14/2018January0.1%0.2%0.3%


Consumer Prices, Ex-F&E2/14/2018January0.3%0.3%0.2%


Retail Sales2/14/2018January0.4%0.2%0.2%







Retail Sales; ex-autos2/14/2018January0.4%0.2%0.5%


Empire State Index2/15/2018February17.7NA17.7


Producer Prices FD2/15/2018January-0.1%0.3%0.3%







Producer Prices FD-Ex-F&E2/15/2018January-0.1%0.2%0.2%


Industrial Production2/15/2018January0.9%0.5%0.3%


Capacity Utilization2/15/2018January77.9%78.0%78.1%


-0.3%

0.0%

0.3%

0.6%

Jan-17 Apr-17 Jul-17 Oct-17

Source: Bureau of Labor Statistics

-0.2%

0.0%

0.2%

0.4%



-1%

0%

1%

2%

Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17

Source: US Department of Commerce

-1%

0%

1%

2%


Source: US Department of Commerce0

10

20

30

Feb-17 May-17 Aug-17 Nov-17

Source: Federal Reserve Bank NY

-0.5%

0.0%

0.5%

1.0%



-0.3%

0.0%

0.3%

0.6%


Source: Bureau of Labor Statistics-1%

0%

1%

2%


Source: Federal Reserve BOG75%

76%

77%

78%

Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17

Source: Federal Reserve BOG

ECONOMIC TRADING CALENDAR (CONT.)

- Section 3 -






Import Prices2/16/2018January0.1%0.0%0.6%


Housing Starts2/16/2018January1,192 K1,200 K1,210 K


U. of Michigan Sentiment2/16/2018February95.7NANA


-1%

0%

1%


Source: Bureau of Labor Statistics1,100 K

1,200 K

1,300 K


Source: Department of Commerce90

95

100

105

Feb-17 May-17 Aug-17 Nov-17

Source: University of Michigan

Previous Week's Releases Previous Argus Street

Date Release Month Report Estimate Estimate Actual5-Feb ISM-NonManufacturing January 56.00 56.00 56.70 59.90

6-Feb U.S. Trade Balance December -$50.5B -$50.0B -$52.0B NA

7-Feb Consumer Credit December $27.95B $25B $20B NA\

Next Week's Re eases Previous Argus Street

Date Release Month Report Estimate Estimate Actual21-Feb Existing Home Sales January 5.57 mln 5.5 mln NA NA

FOMC Minutes Released NA NA NA NA NA

22-Feb Leading Economic Indicators January 0.6% 0.3% NA NA

* Preliminary** Final^Final

Argus Research Co. (ARC) is an independent investment research provider whose parent company, Argus Investors’ Counsel, Inc. (AIC), is registered with theU.S. Securities and Exchange Commission. Argus Investors’ Counsel is a subsidiary of The Argus Research Group, Inc. Neither The Argus Research Group norany affiliate is a member of the FINRA or the SIPC. Argus Research is not a registered broker dealer and does not have investment banking operations. TheArgus trademark, service mark and logo are the intellectual property of The Argus Research Group, Inc. The information contained in this research report isproduced and copyrighted by Argus Research Co., and any unauthorized use, duplication, redistribution or disclosure is prohibited by law and can result inprosecution. The content of this report may be derived from Argus research reports, notes, or analyses. The opinions and information contained herein havebeen obtained or derived from sources believed to be reliable, but Argus makes no representation as to their timeliness, accuracy or completeness or for theirfitness for any particular purpose. This report is not an offer to sell or a solicitation of an offer to buy any security. The information and material presented in thisreport are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of anyspecific person who may receive this report. Investing in any security or investment strategies discussed may not be suitable for you and it is recommended thatyou consult an independent investment advisor. Nothing in this report constitutes individual investment, legal or tax advice. Argus may issue or may haveissued other reports that are inconsistent with or may reach different conclusions than those represented in this report, and all opinions are reflective ofjudgments made on the original date of publication. Argus is under no obligation to ensure that other reports are brought to the attention of any recipient of thisreport. Argus shall accept no liability for any loss arising from the use of this report, nor shall Argus treat all recipients of this report as customers simply byvirtue of their receipt of this material. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as anindication or guarantee of future performance. Argus has provided independent research since 1934. Argus officers, employees, agents and/or affiliates mayhave positions in stocks discussed in this report. No Argus officers, employees, agents and/or affiliates may serve as officers or directors of covered companies,or may own more than one percent of a covered company’s stock. Argus Investors’ Counsel (AIC), a portfolio management business based in Stamford,Connecticut, is a customer of Argus Research Co. (ARC), based in New York. Argus Investors’ Counsel pays Argus Research Co. for research usedin the management of the AIC core equity strategy and model portfolio and UIT products, and has the same access to Argus Research Co. reports asother customers. However, clients and prospective clients should note that Argus Investors’ Counsel and Argus Research Co., as units of The ArgusResearch Group, have certain employees in common, including those with both research and portfolio management responsibilities, and that ArgusResearch Co. employees participate in the management and marketing of the AIC core equity strategy and UIT and model portfolio products.

SPECIAL SITUATIONS & SCREENS

ARGUS RESEARCH RATING DISTRIBUTION

ARGUS RATING SYSTEMArgus uses three ratings for stocks: BUY, HOLD and SELL. Stocksare rated relative to a benchmark, the S&P 500.

A BUY-rated stock is expected to outperform the S&P 500 on arisk-adjusted basis over a 12-month period. To make this determi-nation, Argus Analysts set target prices, use beta as the measureof risk, and compare risk-adjusted stock returns to the S&P 500forecasts set by the Argus Market Strategist.

A HOLD-rated stock is expected to perform in line with theS&P 500.

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

BUY HOLD SELL0

100

200

300

400

500

600

700

800

900

1000

523

919

184

RECENT BUY UPGRADES

MASTER LIST CHANGES

Rating DateStock From To Change

Advanced Micro Devices Inc. AMD HOLD BUY 2/1/18Mastercard Incorporated MA HOLD BUY 2/2/18

Stock Raised to BUYSymbol On this date

Advanced Micro Devices Inc. AMD 2/1/18Mastercard Incorporated MA 2/2/18

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