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

ARGUS ®

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

February 12, 2018 Vol. 85, No. 19

Not for the Fainthearted: Our Monthly Survey IN THIS ISSUE of the Economy, Interest Rates, and Markets SECTION 1 ECONOMIC & MARKET COMMENTARY After a strong start to the year that carried across most of January, stocks struggled TECHNICAL TRENDS COMMENTARY at month’s end and were slammed early in February. In fact, stocks are now experiencing their first meaningful selloffs since the twin corrections around Brexit (-3.8%) and the SECTION 2 U.S. pre-election 2016 summer (-4.5%). The S&P 500 experienced a steeper selloff (- FOCUS STOCKS 11.2%) from December 2015 to February 2016 amid the trough in energy prices. The CHANGES IN RATING U.S. stock market did not experience a single sizable (5%) correction in 2017. GROWTH & VALUE STOCKS Why are stocks selling off now? Investors cannot point to the usual suspects. Un- UTILITYSCOPE like two years ago, when investors feared that weakness in energy prices signaled declin- STOCKS TO AVOID ing global demand, the global macro environment is at its strongest level in years; after SECTION 3 3.7% growth in 2017, the IMF forecast global GDP growth of 3.9% in 2018. The weak U.S. MACROECONOMIC DATA dollar is helping to lift commodity prices, whereas two years ago the strong dollar was ECONOMIC CALENDAR making oil cheap and most oil producers unprofitable. SPECIAL SITUATIONS & SCREENS Regardless of why stocks are selling off, we see no signs that this long-running bull MASTER LIST CHANGES market is at risk of falling into a bear market. The economic and earnings fundamentals RECENT ARGUS BUY UPGRADES remain compelling, as we detail below.

THE ECONOMY, INTEREST RATES, AND EARNINGS The preliminary 4Q17 GDP report showed an unexpected slowing in U.S. economic activity in the year’s final quarter. GDP growth of 2.6% slipped from 3.2% in the third quarter; economists had forecast 3.0% growth in 4Q17. The consumer roared in the 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 higher consumer demand but also the spike in energy prices. Exports grew at a healthy clip, but still only at half the pace of import growth. Government spending, which has been suppressed in recent years, grew at a rapid 3.0% pace, fueled by defense spending. One silver lining is that full-year 2017 GDP grew 2.3%, much better than the 1.5% growth recorded in 2016. After the slippage 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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A R G U S R E S E A R C H C O M P A N Y • 6 1 B R O A D W A Y • N E W Y O R K, N.Y. 1 0 0 0 6 ECONOMIC & MARKET COMMENTARY (CONT.) averaged less than 1% growth since 2013. Really bad 1Q MAJOR INDEX GDP reports are often associated with bad weather, and DATA AS OF FEBRUARY 2, 2018 this year, we have seen harsh weather, particularly in the Midwest and Northeast. On the upside, the recently en- Year-To-Date Return acted tax cuts should begin to benefit corporate profits and consumer wallets, which could help the overall trend. Growth Stocks (Wilshire Large Growth) 5.2% For all of 2018, and factoring in positive drivers that include global growth, domestic deregulation, and tax cuts, Nasdaq Composite 4.9% we now forecast GDP growth in the 2.3%-2.8% range; we S&P 500 3.4% had previously forecast midpoint GDP growth of 2.25%. Annual GDP growth for 2018 will depend in part on dodg- DJIA 3.3% ing a big winter falloff in 1Q18, as well as on the administration’s ability to drive fiscal stimulus from tax Value Stocks (Wilshire Large Value) 2.0% reform and infrastructure investment. Russell 2000 0.8% As the Fed continues pushing rates gradually higher, we expect some negative impact on economic activity in Lehman US Aggregate Bond Index -1.8%

2018 and particularly in 2019. Our first GDP forecast for -5% 0% 5% 10% 2019 shows growth slipping back into the low 2% range. But before we can model 2019 with any confidence, we SECTOR PERFORMANCE need to see how 2018 plays out. The yield curve, which spent much of 2017 in a generally flattening trend, has now completely changed the Year-To-Date Performance narrative. Long rates, which seemed stuck at the 2.5% mark, are now surging since breaking through that psychologi- Consumer Discretionary 7.2% cally important level. The Fed moved with painful slow- Health Care 5.3% ness early in this restrictive monetary cycle. But it hiked Financials 5.2% three times in 2017, and investors now know that the Fed Technology 4.4% means business. With the Fed expected to stay aggressive Industrials 3.0% on rate hikes in 2018, we see plenty more upside in bond Energy 0.6% yields – and downside in bond prices. Telecom 0.4% The short end of the curve continues to move higher; Materials 0.0% that has not changed. Over the past year, the 3-month bill Consumer Staples -0.7% yield has moved up 101 basis points, to about 1.48%. The Utilities -5.3% two-year note yield has also advanced 101 basis points in -10% -5% 0% 5% 10% the past year, to 2.16 %. As we move into the middle maturities, the rate of INTERNATIONAL EQUITY change is suddenly more aggressive. The five-year Trea- MARKET PERFORMANCE sury note currently yields 2.58%, up 30 basis points in just the past month and about 75 basis points from the prior Year-To-Date Return year. The 10-year yield, at 2.85%, is 44 basis points higher than it was in February 2017, after being just 12 basis points Russia 11.9% higher one month ago. And the 30-year yield, at 3.08%, is China 10.2% finally higher than it was a year ago. Brazil 10.0% During 2017, investors asked if the flattening yield DJ World Index 3.8% curve signaled heightened risk of recession. Although the S&P 500 3.4% slope is increasing, investors need to remain alert for signs India 3.0% of slowing activity. The Fed is actively pushing up rates; Japan 2.2% there is always the risk that it will push too hard. Still, as Mexico 2.1% we stated while the curve was flattening, we see limited Euro Zone 0.8% inflation or recession risks ahead in a well-balanced UK -3.1% economy. Canada -3.5% -10% -5% 0% 5% 10% 15% (continued on next page) Source: Dow Jones, Argus Research

- Section 1 - ECONOMIC & MARKET COMMENTARY (CONT.)

We had been looking for long-term rates to move up, While economically sensitive stocks continue to out- and that now appears to be happening. Too rapid a rise perform defensive and income-oriented groups in 2018, won’t be good for stocks, but the equity market can with- the leadership deck has been reshuffled. Technology had a stand several more Fed rate hikes as long as they are mea- fantastic 2017, as digital transformation – including cloud, sured and restrained. analytics and everything-as-a-service – moved from plan- The fourth-quarter earnings season is coming in ning stages to reality. In 2018, however, Technology is only strongly, as expected. At a time of declining bond and stock the fourth-best sector. The best performances in descend- prices, the trend in EPS growth is a reminder that the stock ing order have come from Consumer Discretionary, market, even as it wobbles, has firm underpinnings. Healthcare and Financials. Last month, we raised our forecast for S&P 500 earn- Particularly late in 2017, investors rotated into infla- ings from continuing operations for 2018 to $149.50 from tion beneficiaries with “wealth in the ground” – meaning a prior $145.25. The weak dollar remains a key EPS growth Energy and Materials. Those sectors are little changed this driver on a sector-wide basis. The rebound in energy prices year as investors seek to determine if they have come too is important obviously for energy earnings, but also for far too fast. The most defensive and income-oriented sec- related areas such as industrial. tors have fared the worst in 2018, with Utilities and Con- We have increased our 2019 EPS growth forecast to sumer Staples in the negative column and Telecom cling- $169 from $154. As weak dollar effects begin to recede, ing to breakeven. We do not expect 2018 to be the year of the gain next year should primarily be driven by global defensive rotation and would continue to underweight po- growth. We expect both the anticipation and the reality of sitions in those areas. tax cuts to drive higher consumer spending and business Despite the wild swoops in the market thus far in activity. 2018, for now sector leadership is pretty much intact from Our revised estimates imply EPS growth of 12.6% 2017. That may not be true a month from now, particularly for 2018 and 13.0% for 2019, respectively. We also expect if economic fundamentals show signs of deterioration. large corporations to return more value to shareholders in Assuming positive fundamentals remain intact, the current the form of higher dividends. We look for 7.6% dividend selling jag may be seen retrospectively as an opportunity growth in 2018, with additional mid- to high single-digit to buy into 2017 darlings that had a rough start in 2018. growth in 2019. Note that our month-end sector table does not capture the whipsaw selling of early February. In January, Tech- DOMESTIC AND GLOBAL MARKETS nology built on its market leadership to increase its sector Plainly, the late January and early February stock selling weight within the S&P 500 by 40 basis points, to 24.2%. have cut into what was a very strong start to the year. What That is not quite a peak reading, but close to it. Consumer is surprising, however, is how closely the start of 2018 Discretionary also expanded by 40 basis points, as mirrors the start of 2017. As was the case last winter, the homebuilders bounced back and retailers remained in Nasdaq and the Wilshire Large-Cap Growth lead among favor even after the holidays. Other sectors that gained major domestic indices. In the middle of the pack are the month-over-month include Financial Services and blue-chip S&P 500 and Dow Jones Industrial Average. And Healthcare. just like last February, the Russell 2000 is lagging the av- The sectors that continue to lose weight also include erage, as investors continue to avoid small-cap stocks. Telecom Services. At 1.9%, Telecom is now below 2.0% One thing that has changed is bond performance. A for the first time in our multiyear model. Real Estate, year ago the Lehman US aggregate bond index was frac- Telecom, and Utilities all lost 20 basis points of market tionally positive. As of early 2018, this index is down about weight in January. Given that all three are small sectors to 2% year-to-date. We think the Fed will enact three addi- begin with, those are significant declines and continue the tional rate hikes in 2018. If longer maturity yields con- downsizing pattern among defensive and rate-sensitive tinue their recent turn higher, this index could not only sectors that persisted in 2017. At present, we do not underperform in 2018 but could also sustain a negative expect the sector leadership map for 2018 to vary much performance for the full year. from 2017, though again, this assumes continued glo- Sector leadership in 2017 favored risk-on, economi- bal growth. cally sensitive names over defensive and income-oriented The U.S. enjoyed a strong stock market in 2017 but stocks. Thus far in 2018, risk-on, economically sensitive still lagged world stock performance. The same is true for stocks remain in the lead at the expense of defensive and 2018 to date, at least in the very early going. income-oriented names. We note that the top-performing Among international stock indices, the BRIC nations sectors in 2017 have been hit hard by the early February have the best aggregate performance, up just under 9% year- selling, but that no sector has been immune. to-date. Close behind are resources nations, which are up

- Section 1 - ECONOMIC & MARKET COMMENTARY (CONT.) about 6%. The DJ world index is up 3.8%, putting it slightly U.S. consumer may finally be taking a pause. In addition, ahead of 3.4% for the S&P 500 – which has retraced from apart from post-hurricane rebuilding, neither housing not a gain of 7%. automotive appear particularly robust. While the S&P 500 is underperforming the world, it The main correction driver may simply be profit-tak- is at least positive. The UK is down 3% and that has im- ing following a strong 2017 and an eye-popping January pacted the 1.5% gain in our mature markets basket. Canada 2018. Stock selloffs are nerve-wracking but necessary. is also down 3%; our Americas basket is up 3%, however, Market complacency such as that seen in 2017 saves in- thanks to strength in Brazil. vestors from short-term worries about wealth accumula- For the present at least, foreign investors have been tion. The lack of periodic selloffs, however, increases the turned off by the weak dollar, which is eroding their re- risk that the market will become toppy and prone to steeper turns on U.S. stocks. That is one of several reasons to as- falls. Corrections can be thought of as bad-tasting medi- sume that even if the U.S. has another good stock year, it cine that, like castor oil, can keep the market mechanism likely won’t match the global average gain. functioning smoothly. We continue to see good value in the U.S. stock mar- CONCLUSION ket. We also favor risk-on and economically sensitive stocks The stock selloff in early 2018 has several causes. The rise with good growth prospects over defensive and income- in bond yields has been interpreted as a preemptive strike oriented names that actually offer limited defense in an against inflation; and inflation has proven in the past to be environment of rising interest rates. a surefire stock rally killer. After several strong years, the Jim Kelleher, Director of Research

TECHNICAL TRENDS COMMENTARY

Volatility has returned with a vengeance. For its part, current correction really got going, the S&P 500 was hold- CME Group, a large options and futures market operator, ing a 5% plus gain. Then, in a single session on February reported that its January volumes were up 18%, year over 2, that gain was shaved to 3.3%. But in that same session, year, with equity index, energy and metals contracts all Energy went from a 5.4% YTD gain to a 0.2% YTD de- showing gains above 20%, and interest rate contracts up cline. Materials fell from a 4.5% YTD gain to a 0.3% YTD 15%, as investors speculated for, or hedged against, mar- decline. ket moves. Other sectors that declined more than 2% in that sell- When a stock sell-off is raging, even if just for a brief off include Technology and Industrials. span, every stock and every sector seems to be swept up in After the huge dip on February 5, defensive sectors, the general panic. There are, of course, degrees to which which did not have a lot of gain to give away, are firmly in any one sector participates. This sell-off has surprisingly the red year to date. Consumer Staples, Utilities, and Real taken aim at “wealth in the ground” sectors such as En- Estate were already in the red even before the market’s ergy and Materials. epic 4% correction on 2/5/18. This correction may take At its peak, the S&P 500 was up 7% for 2018 in the some time to play out; so far, we expect to recommend final week of January; remember that stocks also lost bargain buying when the selling stops. ground in the final trading days of that month. Before the Jim Kelleher, CFA, Director of Research FOCUS LIST

Focus List Stocks Focus List Stocks in this Report

PRICE PRICE AS OF AS OF TICKER 2/7/18 TICKER 2/7/18

Basic Materials Estee Lauder Companies Inc EL $137.22 Arconic Inc ARNC $25.28 Lockheed Martin Corp LMT 337.59 Newmont Mining Corp. NEM 37.63 Microsoft Corp MSFT 91.33

Consumer Discretionary Estee Lauder Companies Inc (EL) Carnival Corporation CCL 69.27 Current Rating: BUY Publication Date: 2/5/18 Darden Restaurants Inc DRI 94.38 International Game Tech PL IGT 28.05 HIGHLIGHTS *EL: Raising target by $16 to $158 Consumer Staples *Estee Lauder has invested heavily in its businesses in Anheuser-Busch In Bev SA/NV BUD 108.96 recent years and continues to benefit from strong demand for Estee Lauder Companies Inc EL 137.22 high-end beauty products. We also like the company's mix of Kroger Co KR 29.07 retail stores, e-commerce and 'travel retail' sales at major Monster Beverage Corp MNST 64.21 airports. Energy *We believe that Estee Lauder can reach its revised targets of 8%-9% local-currency revenue growth and Devon Energy Corp. DVN 38.38 double-digit earnings growth over the next three years. Royal Dutch Shell PLC RDS/A 65.73 *Reflecting management's guidance and the company's Financial history of positive earnings surprises, we are raising our FY18 Bank of America Corp BAC 31.20 EPS estimate from $4.20 to $4.42. For FY19, we are Capital One Financial Corp COF 98.44 increasing our estimate from $4.65 to $4.95. Charles Schwab Corp SCHW 52.86 *Our $158 target implies a multiple of 35.7-times our US Bancorp USB 54.62 revised FY18 earnings estimate, and a potential total return of 18% including the dividend. Healthcare AstraZeneca PLC AZN 34.30 ANALYSIS Celgene Corp CELG 96.25 INVESTMENT THESIS Humana Inc. HUM 269.12 We are maintaining our BUY-rating on Estee Lauder Vertex Pharmaceuticals Inc VRTX 159.27 Companies Inc. (NYSE: EL) and raising our target price from Industrials $142 to $158. The company continues to benefit from strong Cummins Inc (Ex. Cummins Engin CMI 174.83 demand for high-end beauty products, and about one-third of Lockheed Martin Corp LMT 337.59 its brands are posting double-digit revenue growth. We also Owens Corning Inc OC 87.59 like its mix of retail stores, e-commerce and 'travel retail' sales at major airports, and its efforts to invest in developing the Real Estate business. We believe that Estee Lauder can reach its targets of Vornado Realty Trust VNO 67.79 8%-9% local-currency revenue growth and double-digit earnings growth over the next three years. The company has Technology also steadily raised its dividend, which currently yields about Adobe Systems Inc ADBE 194.47 1.1%. Broadcom Limited AVGO 240.38 We are keeping our long-term rating at BUY. HP Inc HPQ 21.43 Lam Research Corp LRCX 178.34 RECENT DEVELOPMENTS Microsoft Corp MSFT 91.33 On February 2, Estee Lauder reported fiscal 2Q18 Utility 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. Aqua America Inc WTR 34.03 Management's guidance had called for earnings of NextEra Energy Inc NEE 149.56 $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 scale. estimate of $3.67 billion. In constant currency, net sales rose S&P's credit rating on Estee Lauder is an 14.0%, above the consensus estimate of 10.7%. Half the investment-grade A-. company's brands reported double-digit revenue growth and In 2Q18, the company's adjusted gross margin decreased organic revenue was up 12%. In constant dollars, the Skincare 40 basis points to 79.9%, while the adjusted operating margin category posted a 17% increase in revenue, reflecting rose 40 basis points to 20.9%. The Street had called for a double-digit gains for the La Mer and Estee Lauder brands, as gross margin of 79.9% and an adjusted operating margin of well as strong growth in Clinique. In constant currency, sales 20.9%. Cash and cash equivalents totaled $2.1 billion at the rose 10% in the Fragrance business, and were up 4% in the end of 2Q18. At the end of the quarter, Estee Lauder had $3.4 Hair Care segment. Driven by a double-digit increase in the billion in long-term debt and a long-term debt/capital ratio of Tom Ford brand and strong growth in namesake Estee Lauder 42.5%, up from 33.2% a year earlier. products, as well as acquisitions, Makeup sales rose 13% in In November 2017, the company raised its quarterly constant currency. dividend 12% from $0.34 to $0.38. The annualized dividend The 2Q adjusted gross margin fell 40 basis points to of $1.52 yields about 1.1%. The new dividend was paid on 79.9%, but matched the consensus estimate. However, December 15, 2017 to shareholders of record as of November reflecting carefully managed SG&A costs, the adjusted 30, 2017. Our dividend estimates are $1.48 for FY18 and operating margin rose 40 basis points to 20.9%. The $1.64 for FY19. consensus estimate had called for an adjusted operating margin of 20.9%. RISKS By geographic region, reported sales in the Americas rose Estee Lauder generates more than 60% of its revenue 5% to $1.3 billion, reflecting strong sales of Estee Lauder internationally and could thus be hurt by unfavorable currency fragrance and skin care products as well as double-digits gains effects. in sales of La Mer. Operating income rose 14% to $98 While Estee Lauder's products target affluent consumers million, driven by carefully managed expenses and solid sales and have thus been relatively resistant to economic weakness, of established brands. we think that sales would be hurt in the event of a deep In the Europe, Middle East and Africa (EMEA) region, recession. reported sales grew 20%, to $1.6 billion. Operating income Estee Lauder sells many of its products at airports and rose 12% to $463 million, due primarily to double-digit any decline in air travel could hurt results in the Travel Retail earnings growth in the Travel Retail business, partially offset segment, which contributes about 20% of the company's by lower earnings in the U.K., Germany and France. earnings. It also generates about 30% of sales in Western Asia/Pacific sales rose 33% to $874 million, reflecting Europe, and could be hurt by weakness in this region. double-digit growth in China, Hong Kong and Thailand. COMPANY DESCRIPTION Operating income rose 36% to $218 million, driven by strong Estee Lauder manufactures and markets skin care, revenue growth in China, Hong Kong, Thailand, Japan and makeup, fragrance and hair care products. The company's Taiwan. products are sold in over 150 countries and territories under a EARNINGS & GROWTH ANALYSIS range of brand names, including Estee Lauder, Aramis, In 3Q18, the company projects 12%-13% revenue growth Clinique, Origins, M.A.C., Bobbi Brown, La Mer, and Aveda. as reported and earnings of $1.02-$1.04 per share. Prior to the Estee Lauder also licenses fragrances and cosmetics under the earnings announcement, the consensus estimate had been brand names Tommy Hilfiger, Donna Karan, Michael Kors, $1.01 per share. and Coach. The company's sells its products through more Management now expects FY18 revenue to grow 12.5% than 30,000 retail locations, including upscale department -13.5%, up from a prior 10%-11% on a reported basis and stores, specialty retailers, high-end perfumeries, pharmacies, 10%-11% in constant currency, up from a previous forecast of and salons and spas. 8%-9%. It now projects full-year EPS of $4.27-$4.32, up from VALUATION prior guidance of $4.04-$4.12. The consensus EPS estimate In our view, EL shares are favorably valued at 30.5-times prior to the release was $4.20. Management often issues our revised FY18 EPS estimate, near the five-year average of conservative guidance, which it then surpasses. 31.0. We believe that Estee Lauder's above-peer-average Reflecting management's guidance and the company's growth rate, strong return on equity, and demonstrated record history of positive earnings surprises, we are raising our FY18 of cost cutting justify a higher multiple. Our revised $158 EPS estimate from $4.20 to $4.42. For FY19, we are target implies a multiple of 35.7-times our FY18 earnings increasing our estimate from $4.54 to $4.95. Our long-term estimate, and a potential total return of approximately 18% earnings growth rate forecast remains 14%. including the dividend. FINANCIAL STRENGTH & DIVIDEND On February 5 at midday, BUY-rated EL traded at Our financial strength rating for Estee Lauder is $136.44, up $2.05. (John Staszak, CFA, 2/5/18) Medium-High, the second-highest rank on our five-point

Section 2.2 FOCUS LIST

the year rose 8% to $51 billion. Lockheed Martin Corp (LMT) The company also provided 2018 guidance. Net sales are Current Rating: BUY Publication Date: 2/6/18 expected to increase 2% -- below trend due to an accounting HIGHLIGHTS rule change. Total business segment operating margin in 2018 *LMT: Raising target price to $385 is expected to be in the 10.3% to 10.5% range and cash from *LMT shares have outperformed the market over the past operations is expected to be greater than or equal to $3.0 quarter, rising 12% while the S&P 500 has advanced 5.1%. billion, after a $5 billion contribution to the pension program. *The company topped Street expectations with 4Q results Management expects EPS of $15.20-$15.50. We note that and is forecasting double-digit EPS - aided by a lower tax rate Lockheed has a history of lowering investor expectations early - in 2018. in the year and then boosting its outlook as the year *Management has a history of managing through progresses. challenges, and a GOP-controlled House, Senate and White EARNINGS & GROWTH ANALYSIS House should bode well for defense spending. *We believe that LMT shares are favorably valued at Lockheed Martin has four primary business segments: current levels. Our revised target of $385 assumes continued Aeronautics (approximately 40% of 2017 sales); Missiles and strong earnings based on increased U.S. and international Fire Control (15%); Rotary and Mission Systems (28%); and defense spending. Space Systems (18%). Except for Space Systems, all segments once again posted ANALYSIS revenue growth in 4Q. The Aeronautics division benefited from higher net sales in the F-35 and C-130 programs, offset INVESTMENT THESIS by a slight decline in C-5 deliveries, as the top line grew 12%. Our rating on Lockheed Martin Corp. (NYSE: LMT) is Rotary and Mission Systems, which includes the recently BUY. Lockheed has consistently surprised the Street in recent acquired Sikorsky operations, posted 14% revenue growth as years, regardless of whether defense spending is rising or increases for training and logistics programs were boosted by falling. In recent quarters, government spending has started to higher helicopter deliveries. In Missiles and Fire Control, accelerate again, which is expected to provide a boost to revenue rose 31% due to higher net sales for air and missile earnings. We have a favorable view of the company's focus on defense programs, tactical missile programs and fire control international revenue diversification (now 25% of sales), and programs. Space Systems' revenue declined 12% due to a expect increased geopolitical tension to benefit sales and reduction in launch-related events. earnings going forward. The shares face ongoing headline LMT finished the quarter with a backlog of $100 billion, risk, as the company's F-35 fighter jet program has been down $4 billion from the prior quarter. Within the pipeline, targeted by President Trump from time to time. But management anticipates delivering 90 F-35s this year, up from management has a history of navigating through challenges. 66 in 2017. In Missile and Fire Control, Lockheed participated The company is mindful of shareholder returns and has raised in a signing agreement with the U.S. and Romania that the dividend at a double-digit rate for the past 15 years while provides Romania with the opportunity to upgrade its air also aggressively buying back stock. The current yield of defense system, and also received an order of more than $900 2.25% is high for the industry. Our target price for this million for PAC-3 missiles for the U.S. and allied military blue-chip defense company is $385, raised from $340. The forces. shares are a suitable core holding in a diversified portfolio. On the expense side, the total business segment operating RECENT DEVELOPMENTS margin was 9.8% in 4Q17, up 50 basis points. Operating LMT shares have outperformed the market over the past margins increased Aeronautics, Rotary and Mission Systems quarter, rising 12% while the S&P 500 has advanced 5.1%. and Space. We look for continued strengthening of margins in Over the past year, the shares have also outperformed, gaining Rotary and Mission Systems as the Sikorsky operations are 36% compared to a 19% increase in the broad market. The fully integrated. Management is targeting overall margin shares have outperformed the industrial sector IYJ ETF over expansion in 2018. the past year, as well as over the longer five-year period. The Based on the solid sales growth, expectations for higher beta on LMT is 0.63. margins and a lower tax rate, we are raising our 2018 EPS On January 29, Lockheed reported 4Q17 earnings that forecast to $15.50 from $13.75. Our estimate is at the high end topped analyst expectations. Revenue increased a sequentially of management's guidance range and implies growth of about stronger 9%, to $15.1 billion. Segment operating profit rose 16% for the year. We look for further growth in 2019 and are 15% as the segment operating profit margin widened 50 basis implementing a preliminary EPS forecast of $18.00. Our points to 9.8%. On a per share basis, adjusted net earnings long-term EPS growth rate forecast remains 9%. from continuing operations jumped 32% to $4.30, above the FINANCIAL STRENGTH & DIVIDEND consensus of $4.07. For the full year, the company earned Our financial strength rating for Lockheed Martin is $13.33 per share on an adjusted basis, above the $13.15 high Medium. The company scores about average on our three end of the guidance range and up 8% year-over-year. Sales for main components of financial strength: debt levels (including

Section 2.3 FOCUS LIST the impact of unfunded pension assets), fixed-cost coverage, dividend discount model, taking into account our revised and profitability. estimates, points to a fair value of around $400 per share. The company has a stock buyback plan. At the end of the Blending our approaches, we arrive at a new target price of most recent quarter, shares outstanding were down 3.0% $385. year-over-year. On February 5, BUY-rated LMT closed at $336.46, down Lockheed pays a dividend. In September, it raised its $16.20. (John Eade, 2/5/18) 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 Microsoft Corp (MSFT) dividend forecasts are $8.40 for 2018 and $9.84 for 2019. Current Rating: BUY Publication Date: 2/6/18 Lockheed has increased its dividend at a double-digit pace for 15 consecutive years. HIGHLIGHTS *MSFT: Raising target price to $107 MANAGEMENT & RISKS *Given Microsoft's massive commercial user base and Marillyn Hewson is the chairman and CEO of Lockheed. long-term relationships, we believe that the company is well Bruce Tanner has served as CFO since 2007. positioned to grow commercial revenue as the process of Investors in LMT shares face risks. Lockheed is a key digital transformation continues both in the U.S. and supplier to the U.S. military and thus vulnerable to cuts in internationally. defense spending. Approximately three quarters of the *We see Azure cloud services, Dynamics 365, and Office company's current revenue comes from U.S. government 365 as primary growth drivers for Microsoft as the Consumer contracts. However, LMT and other defense contractors have side of the business remains steady. been expanding internationally to offset volatile Defense *We are raising our FY18 EPS forecast to $3.66 from spending trends, particularly on short-cycle programs. $3.39 and our FY19 forecast to $3.82 from $3.62. And in any event, with a Republican in the White House *MSFT shares have already had a strong run, but we and the House and Senate both controlled by the GOP, the think they could move higher as the company's commercial outlook for defense spending has brightened. and public cloud business drive growth. On a more micro basis, President Trump has focused his attention (and tweets) on Lockheed Martin's important F-35 ANALYSIS program. LMT management has gone to great lengths to INVESTMENT THESIS demonstrate that F-35 costs are falling and remain below We are reiterating our BUY rating on Microsoft Corp. government forecasts. (NGS: MSFT) and raising our target price to $107 from $95. COMPANY DESCRIPTION CEO Satya Nadella has pivoted Microsoft toward high-value Lockheed Martin provides advanced technology systems, commercial and cloud application businesses as the company products and services to the U.S. government and has shaken off past missteps in the wireless phone handset international defense customers. The company is organized market. According to industry tracker Gartner, Microsoft has a into four businesses: Aeronautics, Missiles and Fire Control roughly 7% market share in the public cloud, a distant second (MFC), Rotary and Mission Systems, and Space Systems. The to Amazon but still much greater than that of other shares are a component of the S&P 500. competitors. Given Microsoft's massive commercial user base and long-term relationships, we believe that the company is VALUATION well positioned to grow commercial revenue as the process of LMT shares appear attractively valued at current prices digital transformation continues to gain traction, both in the near $344, near the high end of their 52-week range of U.S. and internationally. The company's large consumer $251-$354. On a technical basis, the shares have been in a business is growing more slowly, though it may show better positive trend of higher highs and higher lows that dates to profitability in 2018. August 2011. MSFT shares have already had a strong run, but we think To value the stock on a fundamental basis, we use peer they could move higher as the company's commercial and and historical multiple comparisons, as well as a dividend public cloud business drive growth. Microsoft is also one of discount model. LMT shares are trading at 22-times projected the few tech companies in our coverage group that pays a 2018 earnings, near the top of the historical range of 15-24. growing dividend. On a price/sales basis, the shares are also trading near the top RECENT DEVELOPMENTS of the five-year range. But the dividend yield of about 2.25% is above the midpoint of the five-year range, signaling value. Microsoft reported fiscal 2Q18 results (for the quarter The shares are mixed compared to the peer group, with a high ended December 31 ) after the market close on January 31. P/E, in-line P/S ratio and higher-than-average yield. Given EPS topped the consensus forecast by $0.10 and sales topped management's history of topping expectations, we think the the consensus by almost $528 million. shares deserve to trade at above-peer-average multiples. Our Second-quarter revenue rose 12% to $28.9 billion.

Section 2.4 FOCUS LIST

Positive foreign exchange effects added 1% to revenue that improve productivity and security while also providing growth. Operating income rose 10% to $8.7 billion. The hybrid cloud and AI and 'intelligent edge' platforms. He has acquisition of LinkedIn in December 2016 again contributed refocused the company on investments in core productivity four percentage points to revenue growth. Excluding experiences and platform development. We think that this LinkedIn, revenue was driven by the Productivity and means business systems like the company's Azure cloud Business Processes and Intelligent Cloud segments, while the service, Dynamics 365, and SQL Server as well as the More Personal Computing segment posted 2% growth. The traditional stalwarts Windows and Office. He also plans to gross margin was flat with the prior year at 62%. The eliminate duplicative products. Other than the Surface company held adjusted operating expense growth to 3%, tablet/laptop, we think that Microsoft has given up on its excluding the impact of LinkedIn amortization expense. The mobile strategy. operating margin narrowed by 60 basis points to 30% as the In the Productivity and Business Processes division, company invested in cloud engineering, artificial intelligence, first-quarter revenue rose 25% from the prior year to $8.95 and increased sales capacity. Adjusted diluted EPS rose 20% billion; some 15 percentage points of this growth came from to $0.96. The company took a $13.8 billion charge related to the LinkedIn acquisition, though legacy product growth was the new tax law in 2Q18. The GAAP loss was $0.82 per share. also reasonably strong, with 10% growth in Office On December 8 , 2016, Microsoft completed its Commercial products, 12% growth in Office Consumer acquisition of professional social networking website Products, and 10% growth in Dynamics. Segment operating LinkedIn. Microsoft acquired LinkedIn for $196 per share, a income rose 9%, to $3.4 billion, including amortization 50% premium to the June 10, 2016 LNKD closing price. charges related to the LinkedIn acquisition. Excluding LinkedIn is Microsoft's largest-ever acquisition. The LinkedIn, pro forma operating income would have grown transaction was all-cash, with a total value of $26.2 billion, 11%. including LinkedIn's net cash. Jeff Weiner remains CEO of The Intelligent Cloud Division exhibited another quarter LinkedIn and reports to Microsoft CEO Satya Nadella. of strong growth, with total revenue rising 15% from the prior Microsoft expects the acquisition to become accretive in year to $7.8 billion. Within this division, Azure cloud revenue FY19, though excluding purchase accounting, it could be rose 99%. Server products and cloud services revenue rose accretive in FY18. Microsoft management believes that 18% as enterprise services rose 5%. Operating income rose LinkedIn will both expand its total addressable market and 24% to $2.8 billion. help it to leverage current trends in technology. In addition, it In the More Personal Computing segment, 2Q revenue believes that LinkedIn fits with Microsoft's industry rose 2% to $12.2 billion, driven by growth in the Gaming and positioning and goal of making people more productive. Search business. Microsoft released an update to its Xbox Microsoft thinks that it can make powerful use of the data gaming console, the Xbox One X, in November 2017. Xbox supplied by LinkedIn's more than 500 million members. Live active users continued to grow, rising 7% year-over-year Management believes that LinkedIn will be able to leverage in the December quarter. Microsoft's Windows OEM business Microsoft's sales force, channels, and enterprise customer base grew 4% in 2Q18, again topping the 0.7% increase in the to expand its core Talent Solutions business. The companies overall PC OEM market, according to industry tracker also believe that LinkedIn's current total addressable market of International Data Corp. Growth was again driven by the $115 billion will increase the TAM in Microsoft's Productivity business-oriented Windows Pro subsegment, with a gain of & Business Process segment by 58%, from $200 billion to 11%, while non-Pro subsegment revenue fell 5%. Segment $315 billion. Microsoft believes that its market share is operating income declined 2% to $2.5 billion. currently only 9% of the TAM, so its sees an opportunity to grow share. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating for Microsoft is High, the EARNINGS & GROWTH ANALYSIS top of our five-point scale. Microsoft took on $31 billion in We are raising our FY18 EPS forecast to $3.66 from incremental debt in 1H17 to finance the LinkedIn acquisition. $3.39 and our FY19 forecast to $3.82 from $3.62. Like many Total debt now stands at $85.8 billion, of which $12.5 billion companies, Microsoft has lowered its effective tax rate is current. Microsoft still has an extremely large cash and forecasts for FY18 and FY19. It also expects a flat gross short-term investment balance of $143 billion. Trailing margin and slightly higher operating expenses in FY18. Our 12-month free cash flow rose 20% in FY17 to $33 billion. EPS estimates imply 8.4% growth over the next two years, Microsoft is triple A-rated by the credit agencies and outlooks above our five-year growth rate forecast of 5.0%. are stable. Moody's raised its outlook to stable in December Mr. Nadella has outlined some first principles based on 2017. his vision for Microsoft as a productivity and platform Microsoft's quarterly dividend is $0.42 per share, or $1.68 company for the 'mobile-first, cloud-first world.' His ambition annually, for a yield of about 1.8%. Our FY18 dividend is for Microsoft to 'change the nature of work through digital estimate is $1.65 and our FY19 forecast is $1.69. Microsoft technology.' This means putting Microsoft at the center of bought back $4.6 billion of its stock in 1H18, $11.8 billion in business process transformation through Microsoft products FY17, and $16 billion in FY16.

Section 2.5 FOCUS LIST

RISKS Microsoft shares have risen 47% in the last year on a Investors in Microsoft face potential losses if the total-return basis, compared to a 23% increase for the S&P company's operating performance falls short of expectations. 500 and a 37% increase in the S&P Information Technology For example, Microsoft took a $7.5 billion write-off for Nokia Sector Index. With a trailing enterprise value/EBITDA Devices and Services (NDS), writing down 80% of the multiple of 16.1, MSFT trades near the peer median and above purchase price in a little more than a year following the the high end of its five-year historical average range of acquisition. The company has also taken additional large 9.9-11.9. Microsoft's forward enterprise value/EBITDA write-offs. Other risks include the migration of consumers multiple of 14.0 is 11% below the peer average, less than the away from the PC to mobile devices that do not use a average discount of 21% over the past two years. We are Microsoft-based operating system (e.g. Apple's iPad); the maintaining our BUY rating on Microsoft with a revised potential for a prolonged downturn in global software target price of $107. investment spending; the well-publicized security On February 5, BUY-rated MSFT closed at $88.00, down vulnerabilities in the company's products; the possible $3.78. (Joseph Bonner, CFA, 2/5/18) 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

Section 2.6 CHANGE IN RATING / INITIATION OF COVERAGE

other niches. Change in Rating / Initiation of Although profit margins are not yet industry competitive, we believe the company's profit potential can increase as new Coverage in this Report and existing businesses - including desktop CPU, notebook PRICE APU, server CPU, and GPU for multiple application, AS OF including professional graphics and blockchain - help AMD TICKER 2/7/18 scale its business. Our long-term rating is also BUY. We are Advanced Micro Devices Inc. AMD $11.65 setting a 12-month price target of $18. Mastercard Incorporated MA 169.28 RECENT DEVELOPMENTS AMD is up 28% year-to-date in 2018, compared with a Advanced Micro Devices Inc. (AMD) 9% gain for the Argus semiconductor peer group. In 2017, Current Rating: BUY Publication Date: 2/1/18 AMD declined 9% following a spectacular 2016. AMD shares rose 295% in 2016, compared with a 70% peer-group gain; HIGHLIGHTS the shares began 2016 below $3 and bottomed at $1.90, before *AMD: Upgrading to BUY on sustainable growth rallying to $11 by year-end. AMD shares rose 7% in 2015; prospects dropped 31% for 2014; rose 61% in 2013; declined 58% in *We are raising our rating on Advanced Micro Devices to 2012; declined 34% in 2011; and fell 15% in 2010. BUY from HOLD. For 4Q17, Advanced Micro Devices reported revenue of *In our view, recent quarterly results have demonstrated $1.48 billion, which was up 34% year-over-year and down the sustainability of AMD's return to consistent profitability 10% sequentially from seasonally strong 3Q17. Revenue was and top and bottom-line growth. above management's guidance of $1.34-$1.44 billion; and *Although profit margins are not yet industry above the $1.40 billion consensus estimate. Non-GAAP profit competitive, we believe the company's profit potential can for 4Q17 totaled $0.08 per diluted share, compared with a increase as new and existing businesses - including desktop non-GAAP loss of $0.01 a year earlier and non-GAAP profit CPU, notebook APU, server CPU, and GPU for multiple of $0.10 in 3Q17. The Street had been modeling non-GAAP application, including professional graphics and blockchain - EPS of $0.05 for the quarter. help AMD scale its business. For 4Q17, Computing & Graphics (C&G) revenue of *Our long-term rating is also BUY. We are setting a $958 million (65% of total) rose 60% annually and 17% 12-month price target of $18. sequentially. C&G operating profit expanded to $85 million in ANALYSIS 4Q17, versus $70 million in 3Q17 and a year-earlier loss of $21 million. C&G margin expanded to 8.9% in 4Q17 from INVESTMENT THESIS 8.5% in 3Q17. Profit growth partly reflects some mix We are raising our rating on Advanced Micro Devices improvement but mainly reflects better overhead absorption Inc. (NYSE: AMD) to BUY from HOLD. In our view, recent on rising revenue levels in the segment. quarterly results have demonstrated the sustainability of Growth at C&G was principally driven by Ryzen desktop AMD's return to consistent profitability and top- and processors and new offerings in the Radeon graphics product bottom-line growth. family. GPU growth reflected both OEM demand, Fourth-quarter sales and non-GAAP profitability were supplemented by growing demand for new opportunities well above expectations. Adoption of a new accounting including professional graphics and blockchain. We think standard governing revenue recognition complicates GPU and ASIC development in the blockchain space could be year-over-year comparisons, but the overarching trend is promising as companies moved beyond cryptocurrency and positive. into business-related niches including transaction Even as the company moves beyond its seasonally strong authentication, supply chain & parts tracking, and other. second half, the outlook appears favorable for additional Ryzen for desktop client (PC) is a stand-alone part. growth in 2018 and beyond. Top-line guidance for 1Q18 was Management stated that desktop Ryzen did 'incredibly well,' 25% ahead of consensus and signals the company's growing despite lower ASPs based on popular demand for the lower success in multiple markets. end Ryzen 3 chip. The company expects ASP trends to AMD is benefiting from its improving execution with improve based on growing OEM demand for cost-effective, high performance products. More broadly, the higher-performance Ryzen 5 and Ryzen 7 chips. company is well-positioned for the global digital The company launched its Ryzen-based offering for the transformation based on its presence in key markets such as notebook PC space during 4Q17. For the notebook market, client and server compute, graphics processing, consumer AMD is offering APUs (accelerated processing units) that gaming and electronics. AMD is also well positioned in combine Ryzen CPU and a Vega GPU in smaller format on a promising markets including cloud data center, AI & machine single die. learning, IoT, and blockchain as that technology moves EE&SC (Enterprise, Embedded and Semi-Custom) beyond cryptocurrency and into transaction authentication and

Section 2.7 CHANGE IN RATING / INITIATION OF COVERAGE revenue of $522 million (35% of total) increased 3% $1.24 billion pre-reporting consensus. Note that AMD has year-over-year while declining 37% sequentially as console adopted the revenue recognition standard ASC 606. This will makers Sony and Microsoft have concluded their holiday allow AMD to recognize revenue when it has inventory on season. Segment profit of $19 million declined 60% as the hand and a non-cancellable order; previously, revenue company spent to roll out its EPYC server CPU product recognition was triggered when product went out the door. family. While this will distort near-term year-over-year comparisons, With Sony and Microsoft in the fifth season for their the new standard will have no effect on full-year revenue. current generation consoles, the semi-custom part of the We are raising our 2018 non-GAAP profit forecast to business likely remains subdued. Any new console generation $0.37 per diluted share, from $0.27. We are implementing a could potentially entail VR, 3D and other advanced graphic preliminary 2019 non-GAAP EPS forecast of $0.55 per capabilities that would benefit AMD. diluted share. Our GAAP estimates are a profit of $0.22 per The real excitement in EE&SC is on the enterprise server diluted share for 2018 and a profit of $0.40 per diluted share side, where AMC's EPYC family finally appears able to for 2019. compete with Intel's Xeon juggernaut. Management stated that the company continues to record design wins and FINANCIAL STRENGTH & DIVIDEND qualifications for EPYC. The company's goal would appear to Our financial strength rating for AMD is Medium. AMD be exiting 2018 with single-digit percentage market share in has successfully re-profiled its debt, which is helping the server processors. While that may not sound like much, it company save on annual interest costs. would be more than any other company currently not named Cash was $1.19 billion at year-end 2017, reduced from Intel. year-end 2016 by use of cash in working capital (related to As with Ryzen and its APUs, EPYC seeks to beat the wafer purchases in anticipation of a strong 3Q17). Cash was competition partly on performance and partly on price. In $1.26 billion at the end of 2016, $785 million at year-end some SKUs, EPYC offers a 1P (one-socket) configuration 2015, $1.04 billion at the end of 2014, $1.19 billion at capable of handling as much I/O as 2P (two-socket) Intel year-end 2013, and $1.18 billion at year-end 2012. Cash & parts. securities totaled $1.9 billion at the end of 2011, $1.79 billion For 1Q18, AMD blew away expectations with a revenue at year-end 2010, and $2.67 billion at the end of 2009. forecast of $1.55 billon. The Street had been modeling an 'old Debt was $1.40 billion at year-end 2017. Debt was $1.44 AMD' revenue cutback to the $1.24 billion range. The current billion at the end of 2016, reduced from $2.24 billion at 2Q16. guidance is more than $300 million, or 25%, above Debt was $2.26 billion at year-end 2015, $2.21 billion at the pre-reporting expectations. end of 2014, $2.05 billion at year-end 2013, $2.04 billion at Although profit margins are not yet industry competitive, year-end 2012, $2.0 billion at the end of 2011, and $2.18 we believe the company's profit potential can increase as new billion at year-end 2010. As a result of the debt pay-downs and existing businesses - including desktop CPU, notebook (from Intel settlement proceeds) in 1Q10 and the transfer of APU, server CPU, and GPU for multiple application, debt obligations to GF, debt was reduced from $4.55 billion at including professional graphics and blockchain - help AMD the end of 2009 and peak debt of $5.86 billion at the end of scale its business. While the company provides only top-line 3Q09. guidance, based on recent gross margin and operating cost Net debt was $210 million at year-end 2017, rising from trends we believe AMD could more than double non-GAAP year-end 2016 on cash use for wafer purchases. Net debt was EPS in 2018 compared with 2017. $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 EARNINGS & GROWTH ANALYSIS billion at year-end 2014, and $871 million at the end of 2013. For 4Q17, Advanced Micro Devices reported revenue of Net debt at year-end 2012 was $859 million, compared to $1.48 billion, which was up 34% year-over-year and down $102 million at year-end 2011, $403 million at the end of 10% sequentially from seasonally strong 3Q17. Revenue was 2010, $1.88 billion at the end of 2009, and $3.89 billion at the above management's guidance of $1.34-$1.44 billion; and end of 2008. above the $1.40 billion consensus estimate. Non-GAAP profit Cash flow from operations was $63 million for 2017, for 4Q17 totaled $0.08 per diluted share, compared with compared with $90 million for 2016. Cash use from non-GAAP loss of $0.01 a year earlier and non-GAAP profit operations was $237 million for 2015; $98 million in 2014; of $0.10 in 3Q17. The Street had been modeling non-GAAP $148 million in 2013; and $338 million in 2012. Cash flow EPS of $0.05 for the quarter. from operations was $382 million in 2011. AMD had a cash For all of 2017, AMD posted revenue of $5.33 billion, up use from operations of $412 million in 2010, and generated 25% from $4.27 billion in 2015. On a non-GAAP basis, AMD cash flow from operations of $473 million in 2009. posted a profit of $0.17 per diluted share in 2017, compared to We do not expect AMD to pay a dividend in 2018 or a loss of $0.15 per share in 2016. 2019. Share repurchases are primarily used to offset dilution For 1Q18, AMD forecast revenue of $1.55 billon, which from stock-based compensation. would be up over 50% annually and was miles above the MANAGEMENT & RISKS

Section 2.8 CHANGE IN RATING / INITIATION OF COVERAGE

Dr. Lisa Su became CEO in October 2014. The CFO is development of the Internet of Things (IoT). Healthy Devinder Kumar, appointed to that role early in 2013. company and sector fundamentals are also positive. For We believe the IP monetization strategy, as well as individual companies, these include high cash levels, low success in EE&SC, could give CEO Su a longer leash than debt, and broad international business exposure. was given to prior CEOs. But the company is also battling In terms of performance, the sector rose 12.0% in 2016, structural decline in PCs, lending uncertainty to CEO tenure at above the market average, after rising 4.3% in 2015. It AMD. strongly outperformed in 2017, with a gain of 36.9%. AMD has been betting heavily on nontraditional Fundamentals for the Technology sector look reasonably businesses including embedded, micro-server, and balanced. By our calculations, the P/E ratio on projected 2018 semi-custom (gaming console). Simultaneously, AMD is earnings is 19.0, above the market multiple of 18.2. Earnings supporting both stand-alone CPU and GPU lines as well as its are expected to grow 19.5% in 2018 and 30.3% in 2017 APU line that combines compute and graphics processing on a following low single-digit growth in 2015-2016. The sector's single die. The new CEO must consider exiting some debt ratios are below the market average, as is the average businesses. Spinning off the ATMP Asian operations into the dividend yield. NFME JV is part of that plan. A long-running risk for AMD is that the decline in PC VALUATION demand is more structural than cyclical, and that AMD is AMD shares is trading at a P/E of 29.0-times on a exposed to industry niches that are feeling the structural two-year forward average basis, compared with 57-times for impact more sharply than its more diversified rival, Intel. In recent profitable years (2014 and 2017). Historical our view, tablets and smartphones will not displace PCs, comparable valuation for AMD indicates value slightly in the although they have clearly changed the industry dynamic. $20-plus range, in a fast accelerating trend. Our discounted AMD must demonstrate its ability to compete in all parts of free cash flow assumptions render a fair value in the $20 the compute value chain, including tablets and smartphones, range, also rising. Blending these approaches, we arrive at a and eventually as an ARM licensee as well. blended value in the low $20s per share, in a rising trend. An ongoing risk for AMD is the perception that the We are encouraged by progress in EE&SC, particularly exceptional executive turnover under CEO Read signals with EPYC, and the successful launch of Ryzen CPU for unusual turmoil in the executive suite. We believe that Wall desktop PCs and Ryzen APU for notebook PCs. We believe Street will give the new CEO a pass as long as the company the company's profit potential can increase as new and executes on its strategic priorities. existing businesses help AMD scale its business. We are AMD also faces the risk that the sharp sequential raising our rating to BUY and setting a 12-month price target step-down is more than a reflection of global softness and of $18. represents significant share loss. While AMD may have lost On January 31, BUY-rated AMD closed at $13.74, up some share, we think the company's ASP Fusion strategy and $0.87. (Jim Kelleher, CFA, 1/31/18) price-leader tactics will help it preserve most of its current share, though market share gains now look more difficult. Mastercard Incorporated (MA) COMPANY DESCRIPTION Current Rating: BUY Publication Date: 2/2/18 Advanced Micro Devices is the number-two player in x86-based microprocessors, behind Intel, and - with the 2008 HIGHLIGHTS acquisition of ATI - a top player in graphic processors. During *MA: Upgrading to BUY with $200 target 2009, Advanced Micro Devices spun off its foundry *Based on strong cyclical and secular trends in the operations into a joint venture called Global Foundries. In payment processing industry, we believe that MasterCard 2013, Advanced Micro Devices reported $5.3 billion in should trade above its historical average earnings multiple in revenue. In mid-2014, AMD underwent an internal the high 20s. reorganization, aligning businesses along functional lines and *On February 1, MasterCard reported adjusted 4Q17 creating a single internal infrastructure. operating earnings of $1.14 per share, up from $0.86 in 4Q16 and two cents above consensus. INDUSTRY *Management projects a 20% effective tax rate in 2018, Our rating on the Technology sector is Over-Weight. down from 27% in 2017, due to the recent cut in the U.S. Technology is showing clear investor momentum, topping the corporate tax rate. Based on the lower tax rate and prospects market in the year-to-date. At the same time, the average for strong revenue growth, we are raising our 2018 EPS two-year-forward EPS growth rate exceeds our broad-market estimate to $5.74 from $5.24, implying 25% growth from estimate and sector averages, which has kept technology 2017. We are also setting a 2019 forecast of $6.46, implying sector PEG valuations from becoming too rich. 13% growth next year. Over the long term, we expect the Tech sector to benefit *Our new 12-month price target of $200 implies a total from pervasive digitization across the economy, greater potential return of 17% from current levels. acceptance of transformative technologies, and the

Section 2.9 CHANGE IN RATING / INITIATION OF COVERAGE

ANALYSIS convenience/security and for the opportunity to take advantage of rewards programs. MasterCard also continues to INVESTMENT THESIS benefit from emerging market growth and expanded merchant We are upgrading MasterCard Inc. (NYSE: MA) to BUY acceptance. following 4Q17 earnings, which showed continued strong Along with the 4Q17 results, management offered 2018 purchase volumes and growth in cross-border volumes and financial guidance that included currency-neutral revenue processed transactions. Based on strong cyclical and secular growth in the mid-teens, and low double-digit growth in trends in the payment processing industry, we believe that operating expenses. Its three-year outlook (for the 2016-2018 MasterCard should trade above its historical average earnings period) calls for revenue growth of 13%-14%, an operating multiple in the high 20s. margin of at least 50%, and compound annual EPS growth in At the company's most recent Investor Day in September the mid-20s. 2017, management emphasized that it would drive growth by We look for 13% revenue growth in 2018, and believe capturing more payment flows through its consumer and that currency translation will be favorable for MasterCard, commercial cards and virtual cards; leveraging its recent which generates substantial revenue outside the U.S. We acquisition of VocaLink; targeting the affluent card market; expect expense growth of 11% in 2018, reflecting investments and increasing merchant acceptance. in digital initiatives and data processing, and efforts to take For 2016-2018, MasterCard projects annual revenue advantage of the opening of the Chinese card-processing growth in the low teens (in constant currency), an operating market. We expect these factors to result in a higher operating margin of at least 50%, and EPS growth in the mid-20% range margin. (above its earlier guidance of 20%). Management projects a 20% effective tax rate in 2018, We like MasterCard's overall growth story, particularly down from 27% in 2017, following the recent passage of the relative to the broad market, and are maintaining long-term Tax Cuts and Jobs Act. Based on the lower tax rate and BUY rating. We expect the company to continue to benefit prospects for stronger revenue growth, we are raising our from the cyclical and secular trends of higher global consumer 2018 EPS estimate to $5.74 from $5.24, implying 25% growth spending, and the shift from cash to charge cards. Our new from 2017. We are also setting a 2019 forecast of $6.46, 12-month price target of $200 implies a total return potential implying 13% growth next year. of 17%. FINANCIAL STRENGTH & DIVIDEND RECENT DEVELOPMENTS We rate MasterCard's financial strength as High, the MA shares have risen 64% over the past year, versus a highest point on our five-point scale. 24% gain for the broad market. In March 2014, MasterCard completed its first debt On February 1, MasterCard reported adjusted 4Q17 offering. The company sold $1.5 billion of 5- and 10-year operating earnings of $1.14 per share, up from $0.86 in 4Q16 notes at very attractive spreads over comparable Treasuries. and two cents above consensus. The 4Q17 results exclude Long-term debt at the end of 4Q was $5.4 billion, for a $0.92 of nonrecurring charges, mostly related to assessments debt/total capital ratio of 25%. for repatriation and the revaluation of deferred tax assets. Net We believe that MasterCard will continue to buy back revenue of $3.3 billion rose 20%, while currency-neutral stock and increase dividend payments given its strong free revenue rose 18%. cash flow. MasterCard reduced its average diluted share count Gross dollar volume rose 13% from the prior year, to $1.4 by 2% in 2017. In 4Q17, the company repurchased 6.9 million trillion, and switched transactions (formerly processed shares of common stock for $1 billion. As of February 1, transactions, or transactions that MasterCard has authorized, MasterCard had $5.0 billion remaining under its existing cleared or settled) rose 17% to 17.7 billion. authorizations. Adjusted operating expenses increased 17%, reflecting MasterCard recently announced a 13.6% increase in its spending on strategic initiatives and advertising/marketing, as quarterly dividend to $0.25 per share, or $1.00 annually, for a well as acquisition costs. The 4Q operating margin increased projected yield of about 0.6%. The first payment at the new to 51.0% from 49.8%. Net income rose 28%, to $1.21 billion. rate will be made on February 9, 2018 to holders of record as EPS rose a stronger 33%, helped by a 2.5% reduction in the of January 9. Our dividend estimates are $1.04 per share for share count. 2018 and $1.12 per share for 2019. For all of 2017, net revenues increased 16% to $12.5 billion, and EPS rose 21% to $4.58 from $3.77. MANAGEMENT & RISKS In April 2017, the company acquired a 92.4% interest in MasterCard's president and CEO, Ajay Banga, has been VocaLink, a leader in bank account-based payments in the with the company since 2009 and was previously the CEO of U.K., Singapore and Thailand, for $929 million. Citigroup Asia Pacific. Government regulation remains a risk for the company. In EARNINGS & GROWTH ANALYSIS particular, interchange fees are being reviewed in the U.S. Longer-term secular trends remain favorable and include under the Dodd-Frank Act as well as in other countries. the continued shift from cash to credit cards, both for While the secular shift from cash to electronic payments

Section 2.10 CHANGE IN RATING / INITIATION OF COVERAGE 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 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 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

Current Rating: BUY Publication Date: 2/2/18 Growth / Value Stocks in this Report HIGHLIGHTS *ABBV: Strong 4Q17; raising target to $145 PRICE *AbbVie delivered solid 4Q17 results on January 26, as AS OF TICKER 2/7/18 well as an upbeat outlook that included a substantial boost from lower tax rates. AbbVie Inc ABBV $111.20 *We expect the company to submit applications in 2018 Alphabet Inc GOOGL 1,084.43 both for new products and expanded indications of existing Amazon.Com Inc AMZN 1,442.84 drugs. Apple Inc AAPL 163.03 *AbbVie now expects 2018 adjusted EPS of $7.33-$7.43, AT&T, Inc. T 36.83 up from its prior forecast of $6.37-$6.57 and implying 43% growth at the midpoint of the range. Autozone Inc AZO 745.07 *Based on the company's updated guidance and strong Boeing Co BA 340.91 4Q17 performance, we are raising our 2018 adjusted EPS Boston Scientific Corp BSX 26.72 estimate to $7.25 from $6.63. We are also establishing a 2019 Brinker International Inc EAT 33.70 estimate of $8.35. CA Inc CA 33.70 Caterpillar Inc. CAT 156.41 ANALYSIS Check Point Software Teches Lt CHKP 101.44 INVESTMENT THESIS CME Group Inc CME 157.65 We are reaffirming our BUY rating on AbbVie Inc. Corning Inc GLW 29.80 (NYSE: ABBV) with a revised price target of $145, raised Danaher Corp DHR 97.05 from $120. ABBV delivered strong 4Q17 results as well as an Facebook Inc FB 185.31 upbeat outlook that included a substantial boost from lower Flextronics International Ltd FLEX 17.31 tax rates. We are also encouraged that the company is Harley-Davidson, Inc. HOG 48.62 developing new growth drivers (Imbruvica and Mavyret) to complement the current large contribution from Humira, and Hawaiian Holdings, Inc. HA 35.95 seeking expanded indications for existing drugs. Helmerich & Payne Inc HP 68.69 Hershey Company HSY 101.29 RECENT DEVELOPMENTS Ingersoll-Rand PLC IR 91.75 On January 26, AbbVie posted 4Q17 adjusted EPS of International Paper Co IP 59.57 $1.48, up 23.3% from the prior year and above the consensus Invesco Ltd IVZ 33.61 forecast of $1.45. Revenue rose 12.6% on an operational basis JetBlue Airways Corp JBLU 20.35 to $7.739 billion. While Humira and Imbruvica were the primary drivers of Lazard Ltd LAZ 56.80 top-line growth, revenue also benefited from the uptake of hep Lululemon Athletica Inc LULU 78.62 C drug Mavyret following its U.S. launch in August 2017. In McDonald's Corp MCD 165.18 all, hepatitis C drugs generated $510 million in worldwide 4Q Northrop Grumman Corp NOC 327.50 sales, an increase of 62.7% from the prior year. Humira sales Nucor Corp NUE 63.60 rose to $18.4 billion (+10.1% worldwide; +14.1% U.S.). Sales Parker-Hannifin Corp PH 186.92 of Imbruvica, a treatment for blood cancers, rose to $708 PayPal Holdings Inc PYPL 75.68 million (+38.7%). Praxair Inc PX 155.31 Fourth-quarter GAAP net income was $52 million or Progressive Corp. PGR 52.87 $0.03 per share, down from $1.391 billion or $0.85 per share Qualcomm Inc QCOM 64.40 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 Ralph Lauren Corp RL 106.73 charge includes a $4.5 billion impact from the taxation of Raytheon Co. RTN 201.13 repatriated overseas earnings. Sherwin-Williams Co SHW 405.00 The company also provided an upbeat 2018 outlook. It Tractor Supply Co TSCO 67.28 now expects full-year adjusted EPS of $7.33-$7.43, up from Union Pacific Corp UNP 131.15 its prior forecast of $6.37-$6.57. This guidance assumes United Parcel Service, Inc. UPS 112.71 strong operational performance as well as benefits from a Visa Inc V 119.97 lower effective tax rate. Wells Fargo & Co WFC 57.28 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 AbbVie Inc (ABBV) cash in capital projects in the U.S. It will also make a one-time

Section 2.12 GROWTH / VALUE STOCKS

$350 million contribution to charitable organizations in 2018, 2Q18 and will serve as the basis for a regulatory filing. and enhance nonexecutive compensation and other benefits. The settlement of the Humira patent dispute with Amgen AbbVie expects a non-GAAP tax rate of 9% in 2018, with a has improved investor sentiment toward ABBV. Under the gradual increase to 13% over the next five years due to terms of the settlement, Amgen must wait until January 2023 increased domestic income and investment. By comparison, to sell its biosimilar version of Humira in the U.S., though it the company had non-GAAP effective tax rates of 18.9% in will be able to sell the product in Europe by October 2018. 2017 and 20.2% in 2016. Amgen has acknowledged the validity of the Humira patents The 4Q adjusted gross margin was 79.0%, down 210 and will pay undisclosed royalties to AbbVie. basis points due to partnership accounting and currency Although the settlement removes one legal threat for hedges. The adjusted operating margin was 38.1%, up 90 AbbVie, we note that other biosimilar companies, including basis points. Boehringer Ingelheim, are challenging the Humira patents. For all of 2017, the company posted adjusted EPS of Boehringer has an approved biosimilar but has not begun sales $5.60, up 16.2% from 2016. GAAP net income came to in the U.S. due to the patent dispute; however, Amgen's $5.309 billion or $5.60 per share, compared to $5.953 billion acknowledgement of the validity of the Humira patents may or $4.82 per share a year earlier. The higher EPS on lower net undercut the cases of the challengers. (While Humira's income reflected the impact of stock buybacks over the last composition-of-matter patent expired in December 2016 in the year. Revenue rose 10.1% on an operational basis to $28.2 U.S. and will expire in 2018 in the EU, AbbVie has other billion. patents covering Humira's formulation, manufacturing process ABBV is seeking new growth drivers to complement and dosing schedule that in some cases extend out to 2027.) Humira, which accounted for 65% of 2017 revenue. It made The settlement with Amgen gives AbbVie additional time progress on that front in 4Q with help from newly launched to diversify away from Humira, which currently accounts for products and solid uptake of Imbruvica. Reflecting strong more than 60% of revenue. However, the settlement applies initial sales of Mavyret, the company expects revenue of $2.5 only in the U.S. as AbbVie is preparing for competition from billion from hepatitis C drugs in 2018. Imbruvica exceeded Humira biosimilars in Europe and other overseas markets by $2.5 billion in sales in 2017. Other pipeline developments are October. It expects overseas sales of Humira to peak at about summarized below: $6.2 billion in 2018, and then to plateau or decline. It is taking ABBV is seeking to expand the use of Imbruvica for proactive steps, such as negotiating with larger hospital different groups of hematology patients, either as a single customers in Southern Europe, in order to maintain volume agent or in combination with other drugs. Later this year, it and market positioning. We will be watching the impact of expects Phase 3 data for Imbruvica in combination with these negotiations on Humira sales and pricing. Gazyva as a first-line treatment for diffuse large B-cell By way of perspective, it is worth noting the competitive lymphoma. impact that biosimilars have had on Remicade, another The company expects to receive approval later this year anti-TNF drug, in the U.S. and overseas markets. In 4Q17, for Venclexta in combination with Rituxan as a treatment for Remicade sales fell 8.5% in the U.S. and 22.6% overseas. relapsed/refractory chronic lymphocytic leukemia (CLL). The filing is supported by the Murano trial, which showed EARNINGS & GROWTH ANALYSIS improvements in progression-free survival. This combination AbbVie now expects 2018 adjusted EPS of $7.33-$7.43, has the potential to be the new standard chemo-free treatment implying growth of 43% at the midpoint of the range. The option for patients with relapsed/refractory CLL. revised guidance assumes stronger operating performance and -- AbbVie also plans to submit an application for benefits from a lower U.S. tax rate. The new forecast is $1.78 Venclexta as a treatment for acute myeloid leukemia (AML), higher than adjusted 2017 EPS, and assumes a $0.95 setting up potential approval for this indication in late 2018 or incremental contribution from stronger operating performance early 2019. Venclexta has been approved for previously and an $0.83 contribution from lower taxes. The company treated CLL patients with the 17p deletion, which is a also expects 2018 revenue to rise about 13% to $32 billion. mutation of chromosome 17. Based on the company's updated guidance and strong -- Risankizumab, a psoriasis drug still under 4Q17 performance, we are raising our 2018 adjusted EPS development, has shown very strong results in several studies. estimate to $7.25 from $6.63. We are also establishing a 2019 The drug appears on track for a launch in 2019 and could be estimate of $8.35. used to treat patients who do not benefit from Humira. FINANCIAL STRENGTH ANALYSIS and DIVIDEND -- Elagolix, a potential blockbuster treatment for We rate AbbVie's financial strength as Medium, the endometriosis, was granted priority-review status by the FDA midpoint on our five-point scale. At the end of 3Q17, the in late October. A decision is expected in 2Q18. debt/total capitalization ratio was 85%, compared to 89% at -- The company is also studying Rova-T the end of 4Q16. Cash flow from operations was $7.376 (Rovalpituzumab tesirine) as a single agent and in billion in the first nine months of 2017, compared to $5.50 combination with Opdivo as a treatment for small-cell lung billion in the year-earlier period. We will update these cancer. Data from the Phase 3 Trinity study is expected in numbers when the company files its 10-K for 2017.

Section 2.13 GROWTH / VALUE STOCKS

ABBV pays an annualized dividend of $2.84. Our mobile, they will abandon search for other mobile apps. Bears dividend estimates are $2.96 for 2018 and $3.08 for 2019. have also argued that Alphabet will be less successful in monetizing mobile search advertising than it has been with RISKS desktop search. However, mobile search advertising appears AbbVie faces a range of risks. The development of new to be growing strongly, even as it generates lower margins drugs from clinical trials to final approval may take several than desktop. Meanwhile, the company's next-generation years and cost hundreds of millions of dollars, and many businesses, YouTube, Google Cloud, and Google Play, have drugs do not make it through this process. The company also all begun to generate significant revenue growth. faces risks related to the integration of acquired businesses. While the 2015 transition to the Alphabet holding COMPANY DESCRIPTION company structure has been a source of confusion for some, AbbVie, a research-based biopharmaceutical company, investors should not be fooled into thinking that the company was spun off from Abbott Laboratories in January 2013. The has changed in any fundamental way: it continues to be driven company is based in suburban Chicago. The shares are a by digital advertising revenue, with search advertising at its component of the S&P 500. core, and by its extraordinary positioning as the search engine leader in both desktop and mobile. The company's robust and VALUATION consistent advertising revenue growth is evidence that it ABBV shares trade at 15.4-times our 2018 EPS estimate, continues to successfully navigate this paradigm shift -- from above the average multiple of 14.7 for our coverage universe desktop to mobile. We think that the Alphabet reorganization of pharmaceutical stocks. We believe that this valuation is should help to develop the company's next generation of supported by continued strong sales of Humira and by the leaders, as well as new ideas, products, and businesses. company's ability to develop new growth drivers. We are As 2017's record fine in Europe suggests, Google may be reaffirming our BUY rating with a revised target price of a victim of its own astounding success in internet/mobile $145. search. The company has come to dominate search in Europe On February 1, BUY-rated ABBV closed at $116.34, up even more than in the U.S., weighing on competitors who, in $4.12. (David Toung, 2/1/18) 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 Alphabet Inc (GOOGL) outcome of other Google-related EC antitrust investigations is Current Rating: BUY Publication Date: 2/5/18 also uncertain. While the company can certainly afford the fine, the more important issue concerns the impact of the case HIGHLIGHTS on the company's future business practices and competitive *GOOGL: Boosting target price to $1,300 position. *Although Google took a nearly $10 billion tax We believe that GOOGL shares are attractively valued adjustment charge to reflect the impact of the new tax law, its given the company's rapidly expanding businesses. operating results were fairly steady in 4Q18. *The company's 'Other' segment, including the Google RECENT DEVELOPMENTS Cloud Platform, Google Play, and Hardware, posted 38% Alphabet reported fourth-quarter and full-year results on revenue growth, to $4.7 billion. February 1 after the market close. Adjusted EPS missed the *We are raising our 2018 EPS estimate to $50.60 from consensus forecast by about 4%. Advertising revenue, at 85% $49.45 and establishing a 2019 forecast of $61.05. Our of gross revenue, continues to drive results in the Google estimates imply 19% EPS growth on average over the next segment, and indeed for the company as a whole. Advertising two years. revenue rose 22%. *We believe that GOOGL shares are attractively valued Gross revenue rose 24% year-over-year to $32.3 billion. given the company's rapidly expanding businesses. Including traffic acquisition costs (TAC), non-GAAP net revenue rose 22% to $25.9 billion. Management again ANALYSIS highlighted strong growth in mobile and desktop search INVESTMENT THESIS revenue, along with significant contributions from YouTube We are maintaining our BUY rating on Alphabet Inc. and programmatic advertising sales. It also noted 'substantial (NGS: GOOGL) and raising our target price to $1,300 from growth' from Google Cloud, Google Play, and Hardware. $1,220. These businesses are included in the 'Other' segment, where We see Alphabet as one of the tech industry's leaders, revenue rose 38% from the prior year to $4.7 billion. along with Facebook, Apple and Amazon. These companies Traffic acquisition costs (TAC) rose 200 basis points have come to dominate new developments in mobile, public from the prior year to 24% of advertising revenue. The TAC cloud, and big data analytics, as well as emerging areas such ratio has been rising over the last year as Google has seen a as artificial intelligence and virtual/augmented reality. mix shift toward mobile search and programmatic advertising, The bear case on Alphabet has been that as users move to which carry higher TAC. CFO Ruth Porat has previously

Section 2.14 GROWTH / VALUE STOCKS noted management's strategic choice to keep Google focused on long-term dollar growth rather than margins. EARNINGS & GROWTH ANALYSIS Paid clicks rose a strong 43%. Cost per click (CPC) again We are raising our 2018 EPS estimate to $50.60 from declined, however, falling 14%. (Remember that 'paid clicks' $49.45 and establishing a 2019 forecast of $61.05. Our is a volume metric and that 'cost per click' is akin to average estimates imply 19% EPS growth on average over the next selling price. CPC has continued to decline as paid clicks have two years. Alphabet does not issue formal guidance. Our risen due to a variety of factors, including a mix shift from long-term earnings growth rate forecast is 17%. higher-yielding desktop search ads to lower-yielding mobile Search advertising, whether on Google sites or through its search and YouTube ads, and efforts to reduce lower-quality third-party Google Network (on desktop or mobile), remains a advertising inventory.) The 4Q non-GAAP operating margin crucial revenue driver, even as other businesses, like YouTube contracted by 320 basis points from the prior year to 36.8%. Google Play and Google Cloud Platform, the so-called 'second As forecast by management, the 4Q operating margin was wave' have ramped up. Investors may be concerned about the negatively impacted by launch and marketing expenses for the double-digit decline in CPC, while also being heartened by the company's new line of 'Made by Google' products as well as even stronger double-digit increase in paid clicks. However, by holiday seasonality. Non-GAAP EPS rose 24% to $11.58. advertising revenue growth has been remarkably consistent, The GAAP net loss was $4.35 per share, which included a rising at a high-teens rate over most of the last five years and $9.86 billion charge due to a one-time transition tax on accelerating to 20% in 2017. We think that Google has accumulated foreign subsidiary earnings and the deferred tax successfully made the transition to mobile search. impact of the new tax law. Management has noted that Google has indexed more than For all of 2017, non-GAAP net revenue rose 21% to 100 billion links within third-party applications - so much for $89.2 billion. Non-GAAP EPS increased 25% to $43.00. the idea that other applications would kill mobile search. With In December 2016 , Alphabet separated its Waymo more than 50% of search queries now on mobile, and the self-driving car business from its X incubator lab; Waymo success of the YouTube, Google Maps, and Google Play LLC now functions as an independent subsidiary. Waymo has mobile apps, Alphabet is certainly growing in the right begun to accelerate, passing 4 million real world miles driven direction. (with the last million in just six months versus 18 months for Aside from advertising, Google is looking to apply its its first million). Waymo has been road-testing its systems deep research into artificial intelligence across the company's (including with a human driver) in Phoenix, and plans to platforms and applications. Its three primary 'bets' for the launch the first autonomous vehicle commercial ride service future are YouTube, the Google Cloud Platform (GCP), and in Phoenix in 2018. It has also been conducting tests in more hardware. YouTube took some heat early in 2017 on press than 25 other cities. reports of advertising that appeared alongside noxious We think that Waymo is significantly ahead of most of its content. As usual, Google responded with technical solutions, competitors. Management has stressed the concept of 'safety using AI to prevent advertising from being matched with first' in its autonomous vehicle technology. The emerging inappropriate content. However, we see nothing in Google's autonomous vehicle (Waymo calls it 'self-driving,' others results to indicate a severe advertiser backlash. With GCP, 'driverless') car market has become more crowded than when Google has provided a continuous stream of improvements, as Google first began the project in 2009 (provoking laughter it does with most of its products. It has also moved to provide about the hubris of tech companies and the waste of discounts, competing on price against Amazon. In addition, it resources). Ride-hailing upstarts like Uber, old-line auto has made strategic acquisitions in the space, acquiring Kaggle, industry giants, and big tech companies like Amazon and Intel which focuses on AI, and AppBridge, a are now racing to develop the technologies needed to produce data-premises-to-cloud migration application. Google is a commercially viable autonomous vehicle (AV). We think generally thought to be in third place in the hyper-scale public that AV technology is clearly building momentum, though it cloud market, behind Amazon and Microsoft. Google is also is uncertain how quickly the technology will be broadly partnering with multinational giants, as in its deals with SAP commercialized and who will end up making the and Cisco to integrate business software systems into GCP. highest-value components of driverless vehicles: Silicon Management clearly views GCP as critical to the company's Valley tech companies like Google, traditional auto future. manufacturers, or component suppliers. Intel's agreement to Google's YouTube announced its new streaming pay $15.3 billion to acquire MobileEye, a key supplier of television channel service, called 'YouTubeTV,' on February autonomous vehicle sensor components, in August 2017, and 28, 2017. It had previously been referred to as 'Unplugged.' Delphi's agreement to acquire driverless tech company The new service, technically a virtual multichannel video Nutonomy on October 24 (for $50 million) reflect the serious program distribution service ('VMVPD'), becomes another interest of both major tech firms and auto industry players in formidable competitor in the over-the-top (OTT) streaming this emerging industry. The greatest hurdle for self-driving video market. This market already includes Hulu Live TV, technology may be to change the 50 different state motor Dish's Sling, Sony's PlayStation Vue, and AT&T's DirecTV vehicle laws in the U.S. Now, as well as a host of other OTT services like Netflix,

Section 2.15 GROWTH / VALUE STOCKS

Amazon Prime Video, and CBS All Access. We say The Snowden revelations of National Security 'formidable' because YouTube users already spend over a Administration spying on personal e-mails and billion hours a day watching its short-form content offerings; communications collected from internet service providers, it thus has a huge potential customer base. YouTube TV including Alphabet, have led a number of governments to recently got one more leg up with its debut on both the Roku explore the possibility of enacting legislation that would and Apple TV streaming devices. YouTubeTV charges a $35 ensure that data traffic remains stored within national per month subscription fee for an initial lineup of 40 channels, boundaries. China passed a new internet law in July, 2017 that including the major broadcast networks (CBS, NBC, ABC, mandated that all data from Chinese users be kept within its and FOX) as well as an assortment of cable channels like the national boundaries. As illogical as this idea sounds given the ESPN and FOX sports channels and nearly all of global nature of the worldwide web, the threat of such laws to NBC/Universal's Disney's and FOX's other cable channels. Alphabet's business is real. For example, Alphabet's capex and YouTube TV subscribers have access to the content on opex costs would increase substantially if it were required to YouTube's cheaper $9.95 per month content subscription maintain a data center in each country in which it operates service, YouTube Red. rather than using its current regional data center model. The Snowden revelations related to cooperation with U.S. FINANCIAL STRENGTH & DIVIDEND government agencies have also tarnished the reputation of Our financial strength rating for Alphabet is High, our Alphabet and other American internet technology companies, highest rating. The company's credit ratings are in the high which could make it harder for them to penetrate foreign A's, high-quality investment grade, with stable outlooks. markets. In response, Alphabet and its peers have begun to The company does not pay a dividend. Alphabet implement encryption systems intended to make user data repurchased $4.85 billion of its stock in 2017. The board also invulnerable even to government spy agencies, a move that reauthorized repurchases of up to $8.6 billion of Class C has been opposed by U.S. officials. capital stock in January 2018. As usual, actual repurchases are Alphabet's growth could slow if it is unable to acquire the made at the discretion of management. The share count rose technologies, talent, and customers that management believes less than 1% year-over-year in 2017. are necessary to sustain long-term performance. Other risks RISKS relate to the integration of acquisitions and the retention of Like Microsoft and Intel, Alphabet has begun to run into key personnel in the highly competitive internet technology serious antitrust issues in Europe. The European Commission sector. The company lost Regina Dugan, the head of Google's levied a record fine of 2.42 billion euros ($2.71 billion) Advanced Technologies and Products Group, to Facebook, in against Alphabet/Google in June 2017 for alleged antitrust April 2016 - another in a long line of senior executives who violations. While these issues will likely take years to play have moved on to other companies. These include Chief out, Alphabet could one day be subject to onerous regulation Business Officer Nikesh Aurora, who resigned in July 2014 to as a result of its market power, as well as to additional fines. become COO of Japanese telecom SoftBank; Sheryl Alphabet's internet advertising-based businesses are Sandberg, now the COO of Facebook; and Marissa Mayer, highly competitive and subject to rapid and disruptive who became CEO of Yahoo. We think the reorganization into technological change. Alphabet must keep up with, if not lead, Alphabet was, in part, designed to stem the brain drain to such changes to remain relevant. One recent change is the other companies by giving business unit leaders more rapid adoption of mobile connectivity, which has provided responsibility and freedom. Google competitor Facebook with a platform to challenge If Alphabet's financial results fall short of expectations in Google's hegemony in digital advertising. Mobile search, any given period, shareholders could quickly lose a significant particularly important to Alphabet, remains a vibrant business. portion of their investment. Indeed, momentum investors While mobile search queries are accelerating, mobile typically abandon a stock that is in decline, exacerbating the advertising typically carries a lower rate. Alphabet must find pullback. Investors should recognize that Alphabet's operating ways to profitably capitalize on emerging platforms in order to expenditures are driven by management's desire to capitalize sustain its growth. The company boosted R&D spending by on long-term growth opportunities - not by Wall Street's 19% in the first nine months of 2017, though this spending financial models or focus on quarterly results. Moreover, remained at about 15% of gross revenue. analysts have sometimes overestimated Alphabet's bottom The success of Alphabet's Android software for mobile line. Another risk for Alphabet is the growing complexity of devices has generated a raft of patent infringement suits from managing global operations, with foreign exchange risk and the likes of Oracle, Apple, and Microsoft, both directly against hedging becoming a greater factor in the company's results. Alphabet and indirectly against its handset manufacturing Management does not provide forecasts and instead partners, including Samsung and HTC. We think the discusses the business only in general terms which leads to a motivation for Alphabet's acquisition of Motorola in May large variances positive or negative between the analyst 2012 was to obtain its patent portfolio, thereby providing a consensus estimates and actual results. In addition, while the shield against patent lawsuits. Alphabet sold the loss-ridden first and fourth quarters are seasonally strong, the second and Motorola Mobility operations to Lenovo in October 2014. third quarters are seasonally slower - and the investment

Section 2.16 GROWTH / VALUE STOCKS community may underestimate or overestimate these seasonal GAAP EPS for 4Q17. effects. Large negative variances to consensus are likely to *The company's volume leverage is increasingly driving hurt GOOGL shares. margin expansion and EPS growth, led by Prime membership Finally, management may not be able to efficiently guide and growth in North American Retail sales and profits. the company's rapid growth. Competitive pressures are also *Further contributing to margin expansion, Amazon's likely to increase as Alphabet's rivals - Apple, Facebook, best-selling SKUs in 2017 were Amazon products, including Amazon, Yahoo, and Microsoft - continue their attempts to Fire TV Stick and Echo Dot. capture market share in the online advertising space, *AMZN has not been fully immune to the recent stock enterprise cloud computing, internet video and other correction while holding its value better than rival companies. competitive markets. Amazon is a true multi-industry disruptor and, in the age of cloud, an essential portfolio holding in most accounts. COMPANY DESCRIPTION Alphabet, formerly called Google, maintains the largest ANALYSIS online index of websites accessible through automated search technology and generates revenue through online advertising. INVESTMENT THESIS Google is now an operating segment of Alphabet. The BUY-rated Amazon.com (NGS: AMZN) reported company was founded in 1998 by Sergey Brin and Larry Page above-consensus revenue and GAAP EPS for 4Q17, as the and went public in 2004. company's volume leverage is increasingly driving margin Google's AdWords is an auction-based program that lets expansion and EPS growth. Fourth-quarter 2017 revenue of businesses display ads along with particular search results. $60.5 billion increased 38% annually while topping midpoint Google's AdSense program enables websites in the company's guidance and the Street consensus. GAAP EPS of $3.75 per network to serve targeted ads, based on search terms or web diluted share rose 143% and more than doubled the Street content, from AdWords advertisers. Most of the revenue GAAP consensus call of $1.85. generated through AdSense is shared with network partners. Amazon had a strong holiday season across the board, Alphabet also owns YouTube.com, the web-based video site, driving slightly better than average 38% sequential revenue and has expanded into mobile telephony with its Android growth (from 3Q17). Total North American retail grew 42%, smartphone operating system. About 54% of Alphabet's while AWS grew 47% year-over-year; NA retail profits more revenue is generated outside the United States. than doubled, while AWS profit growth tracked sales growth. On April 3, 2014, Alphabet's new nonvoting class C Although international operations remained unprofitable, total shares began trading under the ticker 'GOOG.' Alphabet's retail profits more than doubled year-over-year. publicly held class A shares switched to the ticker 'GOOGL.' Amazon's best-selling SKUs in 2017 were Amazon The effect of the new class C share issuance was a products, including Fire TV Stick and Echo Dot. Alexa has noneconomic 2-for-1 stock split. spawned perhaps the biggest developer community this side of the Apple Apps store; Alexa Skills store now offers over VALUATION 30,000 skills. Alphabet shares are up 37% in the last year, compared to Amazon is a true multi-industry disruptor and, in the age a 22% increase for the S&P 500 and a 37% gain for the S&P of cloud, an essential portfolio holding in most accounts. 500 Information Technology Sector Index. We believe that AMZN has not been fully immune to the recent stock the shares remain attractively valued given the company's correction while holding its value better than rival companies. rapidly expanding businesses. Alphabet's lagging With GAAP EPS now growing strongly and predictably, EV/EBITDA multiple of 20.5 is near the peer median. The AMZN valuations remain attractive even given the strong run forward EV/EBITDA multiple of 12.8 is 13% below the peer up in the stock. Our valuation analysis points to a fair value average, slightly less than the average discount of 14% over for AMZN above $1,550 per share. We are reiterating our the past two years. We are raising out target price on Google BUY rating on AMZN while raising our 12-month target price to $1,300, implying potential upside of 16% from current to $1,550 (from $1,250). levels. On February 2, BUY-rated GOOGL closed at $1119.20, RECENT DEVELOPMENTS down $62.39. (Joseph Bonner, CFA, 2/2/18) 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% Amazon.Com Inc (AMZN) gain for the S&P 500. AMZN rose 11% in 2016, compared Current Rating: BUY Publication Date: 2/6/18 with a 2% decline for internet service providers in Argus HIGHLIGHTS coverage. AMZN surged by 118% in 2015, and was down *AMZN: Volume, efficiency drive huge profit beat; BUY 22% in 2014. to $1,550 For 4Q17, Amazon posted revenue of $60.5 billion, *Amazon.com reported above-consensus revenue and which was up 38% year-over-year and a slightly stronger than

Section 2.17 GROWTH / VALUE STOCKS seasonal 38% on a sequential basis from 3Q17. Fourth-quarter about $1.25-$1.45 for 1Q18, compared with $1.48 for 1Q17. 2017 revenue was at the high end of guidance of $56.0-$60.5 Although Amazon has long thumbed its nose at Wall Street billion and exceeded the consensus estimate of $59.8 billion. analyst estimates, the significant beat against expectations has GAAP earnings of $3.75 per diluted share for 4Q17 were up many investors assuming Amazon is guiding cautiously for 143% year-over-year from $1.54 in 4Q16; GAAP EPS blew the current first quarter. away the consensus forecast of $1.85. With GAAP EPS now growing strongly and predictably, Amazon surprised the Street in 4Q17 by generating $2.1 AMZN valuations remain attractive even given the strong run billion in GAAP operating income, which was up 69% up in the stock. AMZN has not been fully immune to the year-over-year. North American Retail was the star in 4Q17, recent stock correction while holding its value better than rival delivering record profits that approximately doubled the companies. Amazon is a true multi-industry disruptor and, in year-earlier tally. the age of cloud, an essential portfolio holding in most North American retail of $37.3 billion (62% of total) was accounts. up 42% year-over-year; backing out $4.5 billion in physical store sales, nearly all from Whole Foods, NA sales would still EARNINGS & GROWTH ANALYSIS have risen 25%. NA operating profits exploded to $1.69 For 4Q17, Amazon posted revenue of $60.5 billion, billion, up 107% from 4Q16. NA retail margin improved to which was up 38% year-over-year and a slightly stronger than 4.5% in seasonally strong 4Q17, up 140 bps year-over-year seasonal 38% on a sequential basis from 3Q17. Fourth-quarter from 3.1% for 4Q16. 2017 revenue was at the high end of guidance of $56.0-$60.5 Amazon's best-selling SKUs in 2017 were Amazon billion and exceeded the consensus estimate of $59.8 billion. products, including Fire TV Stick and Echo Dot. Demand for Amazon in 4Q17 generated $2.1 billion in GAAP the two Alexa enabling devices, Echo and Echo Dot, has operating income, which was up 69% year-over-year and brought Alexa into homes and offices nationwide, which in principally driven by profit growth in North American Retail. turn has created a sub-industry of Alexa-based applications or GAAP earnings of $3.75 per diluted share for 4Q17 were up 'skills.' Alexa has spawned perhaps the biggest developer 143% year-over-year from $1.54 in 4Q16; GAAP EPS blew community this side of the Apple Apps store; Alexa Skills away the consensus forecast of $1.85. Store now offers over 30,000 skills. For all of 2017, Amazon.com posted revenue of $177.90 International retail revenue of $18.0 billion was up 29% billion, up 31% from $136.0 billion for 2016. GAAP EPS and came in above consensus. The overseas loss remains totaled $6.16 per diluted share in 2017, up 26% from $4.90 significant, amounting to $919 million in 4Q17, but narrowed per diluted share in 2016. slightly from $936 million for 3Q17. Amazon is less able to For 1Q18, Amazon.com guided for revenue of monetize Prime in overseas markets compared to the U.S., but $47.75-$50.75 billion, which at the midpoint signals sales CFO Brian Olsavsky noted that Prime International is starting growth in the 35% range. Based on operating income to gain more and more traction. The strategy to ramp Prime guidance in the $300 million-$1.0 billion range, Amazon is overseas matches the U.S. strategy of incrementally adding positioned to earn about $1.25-$1.45 for 1Q18, compared services, benefits, video content and devices. with $1.48 for 1Q17. AWS revenue of $5.1 billion grew 47% annually, while We are raising our GAAP EPS forecast for 2018 to $9.96 AWS operating profit of $1.35 billion improved 46% per diluted share, from a prior $9.03. We are implementing a year-over-year. AWS is now on track for annualized revenue 2019 GAAP EPS projection of $15.77 per diluted share. Our in the $20 billion range, up from the $18 billion annualized five-year earnings growth rate projection is 14%. range as recently as 3Q17. FINANCIAL STRENGTH & DIVIDEND Segment margin of 26.5% for 4Q17 contracted by 100 Our financial strength rating on Amazon is basis points year-over-year. Although AWS has faced fierce Medium-High, the second-highest rating on our five-point pricing in key markets such as IaaS and PaaS, margin scale. Amazon added debt to pay for the WFM merger, but contraction has begun to moderate, reflecting scale has strong cash flows that suggest the new higher debt level is efficiencies and volume leverage. AWS faced price hikes a manageable. year ago that suppressed revenue momentum in the early Cash was $31.0 billion at year-end 2017. Amazon had quarters of 2017. With no meaningful price hikes in December $25.98 billion of cash & marketable securities at the end of 2017, new customer growth is strong, and existing customers 2016 and $19.9 billion at year-end 2015. are stepping up their use of services. Management pushed Total debt was $24.7 billion at year-end 2017. Debt back against the suggested split-off of AWS from retail, increased from $7.68 billion at mid-year 2017, principally to noting that Amazon Retail is one of the biggest, if not the pay for acquiring Whole Foods. Total debt as of year-end biggest, customer for AWS services. 2016 was $7.69 billion. For 1Q18, Amazon.com guided for revenue of Amazon generates significant cash. Cash flow from $47.75-$50.75 billion, which at midpoint signals sales growth operations was $18.4 billion for 2017. Cash flow from in the 35% range. Based on operating income guidance in the operations for 2016 was $17.27 billion, compared to $11.92 $300 million-$1.0 billion range, Amazon is positioned to earn billion in 2015.

Section 2.18 GROWTH / VALUE STOCKS

The credit agencies rate Amazon's debt as investment would weigh on the company, we don't believe that simply grade. There is a substantial difference in agency ratings avoiding state taxes is an indispensable component of the between the Baa1 at Moody's and the very strong AA- at company's value proposition to consumers. S&P. Both agencies have stable outlooks. The company could also be hurt in the event of a Amazon does not pay and is unlikely to implement a significant security breach, theft of client information, or dividend. The company does not actively repurchase shares. outages at its Amazon Web Services unit. This is a risk for all e-commerce businesses, but may be heightened in the case of MANAGEMENT & RISKS a well-known consumer company like Amazon. Founder Jeff Bezos remains CEO of Amazon. Brian Olsavsky is CFO, and Jeffrey Wilke is chief executive officer COMPANY DESCRIPTION of Worldwide Consumer. Amazon.com is the leading U.S. eCommerce retailer and The addition of Whole Foods positions Amazon in a low among the top eCommerce sites globally. Amazon.com also margined business. Amazon has extensive experience in provides Amazon Web Services (AWS), which is the global operating efficiently in the low-margined online retail leader in cloud-based Infrastructure-as-a-Service (IaaS) business. We expect the company to pursue margin expansion platforms. The company's Prime membership platform is s a at WFM not from conservative pricing (AMZN is already key online retail differentiator, providing customers with free aggressively pricing WFM goods) but through increased shipping (after an annual fee) along with exclusive media efficiency and leverage from customer growth. content (music, video, audible books, etc.). The company's We give Amazon's management high marks for Kindle reader and Alexa-based Echo and Dot digital voice continually making their 'store' cheaper, easier and more assistants are category leaders. Amazon acquired Whole secure for shoppers. We think the security and convenience of Foods Market in August 2017. Amazon's site has given many former critics of e-commerce the confidence to shop online. Also, innovations like Amazon VALUATION Prime, Amazon Web Services and Kindle have made Amazon While the growth engine at Amazon is unmatched, the an internet powerhouse. stock has been difficult to time from a valuation perspective. The Whole Foods deal represents a modest but not Based on our historical comparables analysis and discounted immaterial risk to Amazon. The company has long used free cash flow valuation, we believe that Amazon's growth volume leverage to overcome the daunting margin challenges prospects are accelerating more rapidly than the share price, in retail. Amazon will now operate expensive stores in a thus creating a favorable entry point. business where margins are relentlessly compressing. On the On a historical comparables basis, AMZN trades at rich upside, the combination of significantly more natural and multiples, but these are well below historical multiples. The organic products available for delivery, along with Amazon's AMZN shares trade at an average two-year forward P/E of ability to run this business as a loss leader for years if 114-times on GAAP EPS; the trailing 3-year multiple necessary, may enable Amazon to improve the margin profile (2015-2017) is 229-times. The two-year forward relative P/E at WFM, while creating nightmares for legacy grocery of 6.7-times, though rich, is about one-half the trailing industry players. two-year relative P/E of 13.2-times. Our biggest concern is that Amazon is likely to face fierce AMZN trades at a 25.4- times EBITDA/Enterprise Value competition over the next several years as more companies multiple for 2018, at a modest premium to the trailing expand online sales and match Amazon's prices offline. These five-year (2013-2017) EBITDA/EV multiple of 23.9-times. competitive strategies may make it more difficult for the We believe this modest premium to historical EBITDA/EV is company to boost profits. We think that competitors will well earned, given overall growth in higher-end offerings such include everyone from giant brick-and-mortar retailer as Prime, superior growth in AWS, and exciting new Wal-Mart to internet upstarts and designers/manufacturers like opportunities such as Alexa and now Whole Foods Market. Under Armour or Black & Decker. Using our two- and three-stage discounted free cash flow Amazon typically receives payments from customers model, we calculate a value in the $2,000 range. Our blended before its obligations to suppliers are due. This is an important valuation model suggests a 12-month value for Amazon above enhancement to cash flow relative to many traditional $1,650. retailers, because Amazon has not needed to use increasing Appreciation to our 12-month target price of $1,550 amounts of short-term debt to support the company's growth. (raised from $1,350) implies a risk-adjusted return of 15%, One risk is that cash flow could be hurt if the company's wider greater than our forecast for the broad market. Given the assortments mean that it needs to carry more inventory and company's indisputable franchise leadership, its ability to can't turn it over quickly. leverage its vendor relationships in the retail space, and its Another risk is that the company may be forced to collect market dominance and superior growth in sales tax on an increasing number of purchases. Currently, infrastructure-as-a-service, we believe AMZN warrants Amazon collects taxes on about 50% of its revenue base. long-term accumulation in most equity accounts. While the potential need to collect taxes in additional states On February 6 at midday, BUY-rated AMZN traded at $1421.12, up $31.12. (Jim Kelleher, CFA, 2/6/18)

Section 2.19 GROWTH / VALUE STOCKS

Argus coverage was up 18%. AAPL is also running ahead of the XLK technology SPDR and all Argus-covered technology Apple Inc (AAPL) hardware names, which are up 22% and 12%, respectively. Current Rating: BUY Publication Date: 2/6/18 AAPL rose 10% in 2016, slightly lagging the 12% gain for the peer group. In 2015, AAPL fell 5% (after holding a 12% gain HIGHLIGHTS as of early November), its first down year in a decade, while *AAPL: iPhone units disappoint, but ASP drives revenue; the peer group declined 16%. AAPL shares rose 38% in 2014, reiterate BUY ahead of the peer group's 16% gain and the 11.4% capital *Apple grew revenue 13% year-over-year, led by record appreciation (13% total return) of the S&P 500. ASPs for iPhone. For fiscal 1Q18 (calendar 4Q17), Apple posted revenue *On the downside, iPhone unit sales missed expectations; of $88.3 billion, up 13% year-over-year, revenue growth was and Mac units declined. the highest since fiscal 4Q15. For this still hugely seasonal *On balance, we believe fiscal 1Q18 vindicates Apple's company, revenue came in above the top of management's strategy of being a premium vendor in the smartphone space. $84-$87 billion guidance range and bested the $86.2 billion *The current crop of phones appears to be driving an consensus call by over $2 billion. GAAP earnings totaled upgrade cycle worldwide, which we expect to carry through $3.89 per diluted share, up 16% year-over-year and up $1.82 into fiscal 2Q18. Although the unit outlook is disappointing, sequentially from 4Q17. Fourth-quarter EPS also came to ability to command premium pricing should power revenue $0.22, above the consensus call. growth and margin expansion going forward. Apple achieved more than $10 billion in annual revenue ANALYSIS growth in 1Q18, even though the recent quarter had 13 weeks while 1Q17 had 14 weeks. Apple's secret sauce, so to speak, is INVESTMENT THESIS composed equally of global scale and strong customer loyalty. BUY-rated Apple Inc. (NGS: AAPL) posted a mixed CEO Cook pointed out that Apple's current installed device performance for its fiscal 1Q18 (calendar 4Q17). Revenue base is 1.3 billion, an all-time high for the company's major grew 13% year-over-year, led by iPhone pricing; services products. Although both Mac and iPad have presence within remains a massive growth driver; and non-mature Asia is a that number, iPhone is plainly the major driver. More fast-growing opportunity. On the downside, iPhone unit sales impressive than the size of the installed base is its growth; the missed expectations; and Mac units declined. On balance, we base is up 30% in just two years. believe fiscal 1Q18 was a positive quarter for Apple, and one In past, we have compared Apple not to an innovator but that vindicates its strategy of being a premium vendor in the to a farmer, forever acquiring and cultivating more land. On smartphone space. Quarterly guidance for 2Q18 was that theme, Apple grew its acreage and yield in nearly every somewhat soft, although Apple beats its guidance fairly market. Revenue from Japan grew 26% annually and reached consistently. 8% of revenue, as the iPhone X met a strong reception in Apple's top-line growth is outpacing expense growth, affluent and tech-savvy Japan. Rest of Asia-Pacific, which leading to expanding margins. The legal battle with excludes Japan and China, posted 17% annual sales growth to Qualcomm rages on, but is likely a bigger deal for Qualcomm reach 8% of total sales, an all-time high. than for Apple. Following recovery in fiscal 4Q17, China Greater China (20% of revenue) grew 11% on top of delivered even stronger year-over-year growth in fiscal 1Q18. similar annual growth in fiscal 4Q17; this market is 'back' We regard this rebound as indicative of ongoing growth in the after multiple negative quarters. The mature markets of Chinese market. Asia outside Japan and China was among the Americas and Europe, which comprise a total 64% of revenue, fastest-growing markets for Apple. were up in low teens year-over-year. The current crop of phones appears to be driving an In the first full quarter, shipping iPhone 8/8 Plus and a upgrade cycle worldwide, which we expect to carry through nearly full quarter shipping iPhone X, Apple shipped 77.32 into fiscal 2Q18. Although the unit outlook is disappointing, million phones, which was down 1% annually. iPhone ability to command premium pricing should power revenue revenue of $61.6 billion, however, was up 13% and reached growth and margin expansion going forward. an all-time high level. Average selling price (ASP) per iPhone AAPL, particularly after the recent selloff, is well ahead was $796, up 15% annually and a stunning 29% annually; of the market and peers year-to-date and is particularly iPhone ASP was also an all-time record. inexpensive based on relative valuation. We believe that The iPhone X offers 3D sensing-enabled Face ID, Apple's positives are not fully reflected in the share price. We studio-quality lighting effects for the camera, and the ability to are reiterating our BUY rating with a target price of $210. play immersive augmented-reality games. The phone's A11 processor has a neural engine that has been in development for RECENT DEVELOPMENTS years, with a focus on machine learning. According to the AAPL is down 7% year-to-date in 2018, versus a slight industry analysis firm Canalys, IPhone X was the best-selling gain for peers. AAPL rose 46% in 2017; the peer group of smartphone in the December quarter, crowding out the next computing, storage & information-processing companies in two rivals - which were iPhone 8 and 8 Plus.

Section 2.20 GROWTH / VALUE STOCKS

In terms of other key product categories, iPad shipments For all of FY17, revenue of $229.26 billion rose 6% from of 13.2 million units were up 1% annually; sequential growth $215.6 billion in FY16. Apple earned $9.19 per share for the of 28% was actually pretty weak for the holiday quarter. Like year, up 10% from $8.28 in FY16. iPhone, however, iPad surprised with its ASP performance. For fiscal 2Q18, Apple disappointed with revenue Although we assumed iPad Mini would dominate in the guidance of $60-$62 billion, which at the midpoint would be quarter, acceptance of iPad Air drove 5% annual growth in up 15% annually. The Street was looking for sales in the $64 ASP to $455 in 1Q18 from $423 in 1Q17. ASP progress billion range; even with a typical $1-$2 billion beat against suggests strength in enterprise applications. top-of-range guidance, Apple would fall short of expectations. The biggest disappointment against our model came from Based on favorable gross margin and OpEx guidance, along the Mac. Unit sales for Apple's PCs were down 5% with lower tax rate, Apple should be able to hit 2Q18 EPS year-over-year, to 5.1 million - actually a sequential decline expectations in the $2.90 range, which would be consistent from 5.4 million in fiscal 4Q17. Mac ASPs were about flat with 35%-40% annual growth. annually at $1,349 per device. Total Mac revenue of $6.9 Primarily to reflect a lower tax rate, we are raising our billion declined 5%. Momentum from notebook refreshes fiscal 2018 earnings forecast to $12.14 per diluted share from introduced in June did not carry past the September quarter. $11.85. We are trimming our fiscal 2019 forecast to $13.28 Despite the setback, we expect the MacOS High Sierra per diluted share, from an initial $13.63. With no significant operating system to continue driving sales by making Mac adjustments, events or charges in any period, our GAAP and more capable and responsive. non-GAAP earnings estimates are identical. Our long-term Service revenue of $8.5 billion rose 18% annually and EPS growth rate forecast for AAPL is 13%. was flat sequentially. Apple is well on its way to meeting its goal of doubling services revenue from $24 billion in fiscal FINANCIAL STRENGTH & DIVIDEND 2016 to $48 billion by fiscal 2020. The products category Our financial strength rating on Apple is High, the top of grew 36% annually, to $5.52 billion, but will now dwindle to our five-point scale. a fraction of that level with the holiday season mainly behind Cash was $285.1 billion at 1Q18. Cash was $277.0 billion (Chinese New Year lies ahead). at the end of fiscal 2017, $237.6 billion at the end of fiscal For fiscal 2Q18, Apple disappointed with revenue 2016, $206 billion at the end of fiscal 2015, and $155.3 billion guidance of $60-$62 billion, which at the midpoint would be at the end of fiscal 2014. up 15% annually. The Street was looking for sales in the $64 Debt was $122.4 billion at 1Q18. Debt was $115.7 billion billion range; even with a typical $1-$2 billion beat against at the end of 4Q17, and $87.0 billion at the end of fiscal 2016. top-of-range guidance, Apple would fall short of expectations. In recent years, Apple has levered up in anticipation of more Based on favorable gross margin and OpEx guidance, along aggressive capital allocation. Debt was $64.5 billion at the end with lower tax rate, Apple should be able to hit EPS of fiscal 2015 and $32.3 billion at the end of fiscal 2014. The expectations in the $2.90 range, which would be consistent use of debt gives the company operating flexibility without with 35%-40% annual growth. the need to bring back cash from overseas at onerous tax rates. The current crop of phones appears to be driving an Cash flow from operations was $63.6 billion in fiscal upgrade cycle worldwide, which we expect to carry through 2017, $65.8 billion in fiscal 2016, and $81.3 billion in fiscal into fiscal 2Q18. Although the unit outlook is disappointing, 2015. Fiscal 2016 free cash flow was an estimated $53.1 ability to command premium pricing should power revenue billion, down from $70.0 billion in fiscal 2015. growth and margin expansion going forward. Management believes the Tax and Jobs Act will promote a more optimal capital structure for the company. We expect EARNINGS & GROWTH ANALYSIS details on these changes in April 2018. In April 2017, Apple For fiscal 1Q18 (calendar 4Q17), Apple posted revenue announced a $50 billion increase in its capital return program; of $88.3 billion, up 13% year-over-year, revenue growth was the company announced a similar $50 billion increment in the highest since fiscal 4Q15. For this still hugely seasonal April 2016. The company is committed to returning $300 company, revenue came in above the top of management's billion to shareholders by the end of March 2019, raised from $84-$87 billion guidance range and bested the $86.2 billion its previous target of $250 billion by the end of March 2018. consensus call by over $2 billion. Within the new capital allocation program, in April 2017 The 1Q18 GAAP gross margin of 38.4% expanded Apple hiked its quarterly dividend by 10.5%, to $0.63 per sequentially from 37.9% in 4Q17 but compressed slightly share. Prior hikes include 10% in April 2016, 11% in April from 38.5% a year earlier. The GAAP operating margin 2015, 8% in April 2014, and 15% in April 2013. Apple expanded sequentially to 29.8% in 1Q18 from 25.0% in 4Q17 declared its first quarterly dividend in April 2012. Our on volume leverage, and was flat with a year earlier. dividend forecasts are $2.60 for FY18 and $2.78 for FY19. GAAP earnings totaled $3.89 per diluted share, up 16% year-over-year and up $1.82 sequentially from 4Q17. MANAGEMENT & RISKS Fourth-quarter EPS also came to $0.22 above the consensus Timothy Cook has served as CEO since industry legend call. Steve Jobs passed away in 2011. Former Apple controller and former Xerox CFO Luca Maestri became CFO in September

Section 2.21 GROWTH / VALUE STOCKS

2013, succeeding Peter Oppenheimer. Phil Schiller is the head discounted free cash flow model renders a value north of $330 of worldwide marketing, and Jon Ivey is the chief of design. per share, in a slight rising trend and well above current Apple has a deep bench of executive, engineering and levels. Our blended fundamental valuation model points to a marketing talent. We think that it will continue to attract price above $290, also in a rising trend. Appreciation to our high-quality talent, both from an engineering perspective as 12-month target price of $210, along with the dividend yield well as in the corporate leadership ranks. of about 1.7%, implies a risk-adjusted total return exceeding While investors have criticized Apple for its closed our 12-month forecast for the broad market. ecosystem, that system does have the effect of prompting On February 6 at midday, BUY-rated AAPL traded at consumers to buy iPads and Macs for system compatibility. $160.66, up $4.17. (Jim Kelleher, CFA, 2/6/18) 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 AT&T, Inc. (T) out of the comfortable arms of Mother Apple. Current Rating: BUY Publication Date: 2/7/18 Despite its enormous revenue base, Apple continues to grow phone units and revenue at a double-digit pace. The HIGHLIGHTS shares are always at risk from the perception that growth *T: Reiterating BUY following mixed 4Q17 could slow as the law of large numbers catches up with Apple. *While revenue fell marginally and the adjusted operating The company has mitigated that risk, in our view, with very margin contracted in 4Q17, AT&T delivered strong postpaid aggressive shareholder return policies, which will likely wireless net additions. It also expects a lower effective tax rate remain paramount. Despite the company's growing largesse, to boost 2018 EPS by $0.45. we expect institutional investors to continue to demand more *AT&T has been busy with strategic acquisitions, aggressive dividend growth and a larger share repurchase completing a major deal with the First Responder Network as plan. it fights in court to save its planned purchase of Time Warner. *These deals should help the company to maintain its COMPANY DESCRIPTION industry position in terms of both spectrum and content as it Apple manufactures PCs, MP3 players, smartphones, prepares for new developments in the U.S. wireless market. tablet computers, software and peripherals for a worldwide *We are raising our 2018 EPS estimate to $3.52 from customer base. Its products include the Macintosh line of $3.01 and establishing a 2019 forecast of $3.65. AT&T's desktop and mobile PCs, the iPod MP3 line, the iPhone, the valuation metrics remain favorable. iPad, and various consumer products, including Apple TV. Apple also owns and operates iTunes, the world's largest ANALYSIS vendor of recorded music. Apple derives 40%-45% of its INVESTMENT THESIS revenue from the Americas, 20%-25% from Europe/MEA, We are maintaining our BUY rating on AT&T Inc. 12%-16% from Asia-Pacific, and 15%-18% from its own (NYSE: T) to a target price of $48. While revenue fell retail stores. marginally and the adjusted operating margin contracted in VALUATION 4Q17, AT&T delivered strong postpaid wireless net additions. AAPL trades at 12.9-times our FY18 EPS forecast and at It also expects a lower effective tax rate to boost 2018 EPS by 11.8-times our FY19 forecast; the two-year average P/E of $0.45. 12.3 is below the five-year (FY13-FY17) trailing multiple of AT&T has been busy with strategic acquisitions, 13.6. In a market that has reached record highs, Apple is completing a major deal with the First Responder Network as trading at a discount to historical relative multiples. During it fights in court to save its Time Warner acquisition. These the past five years, AAPL has traded at an average 16% deals should help the company to maintain its industry discount to the market multiple, or at a relative P/E of 0.84. position in terms of both spectrum and content as it prepares The stock currently trades at a 33% discount to the market on for new developments in the U.S. wireless market, including a two-year-average forward basis, or at a relative P/E of 0.67. mobile video, 5G, and the Internet of Things. Less net cash per share, AAPL trades at an average of At the same time, AT&T continues to face intense 9.7-times GAAP EPS for FY18 and FY19, or at about 53% of competition as the U.S. wireless industry has moved back to the market multiple - at a time when AAPL is poised to unlimited data plans after prodding first from T-Mobile and deliver 22% two-year average EPS growth and is the largest then from Sprint. The saturation of the U.S. market has led to single component of S&P 500 earnings. a price war and white-hot competition for both high-value AAPL also trades at discounts to the technology hardware postpaid and lower-value prepaid subscribers, with the peer group on EV/EBITDA and PEGY. We believe that a predictable impact of narrower margins. Although the significant premium to peers is justified given Apple's ability competitive environment has become quieter with the to expand globally and to generate healthy demand for its beginning of a new iPhone/smartphone refresh cycle, it products in every kind of economy. remains to be seen whether this will continue as the cycle Our more forward-looking two- and three-stage matures.

Section 2.22 GROWTH / VALUE STOCKS

We think that the competitive wireless environment in the market uncertainty about the deal. U.S. strengthens management's case for diversification into The DOJ's case hinges on the potential increase in satellite video and Mexico/South America - now with the AT&T's market power, relative competitors, as a result of the possible addition of premium branded content from Time merger. Time Warner has a portfolio of highly valued media Warner. Though the moves south of the border carry content, including sports broadcasts from the Turner cable significant risks, including greater exchange rate exposure, channels, hit television programming from premium cable AT&T sees opportunities in upgrading its Mexican wireless subscription service HBO, and movies from Warner Bros. The networks to 4G LTE as it integrates them into a common DOJ complaint alleges that a merger would harm the market North American calling area. in two ways. First, as we expected, the DOJ asserts that AT&T's valuation metrics remain favorable. AT&T would try to gouge competitors in the licensing of Time Warner's Turner channels (or withhold access RECENT DEVELOPMENTS altogether). The DOJ also asserts that the merger would result AT&T reported fourth-quarter results on January 31 after in fewer innovative offerings and higher bills for consumers. the market close. Revenue fell 0.4% year-over-year to $41.7 AT&T has repeatedly noted that the DOJ has not blocked billion, reflecting the long-term secular decline in legacy a 'vertical' merger of complementary (rather than competitive) wireline services, lower wireless service revenue (as businesses in more than 40 years - which would make the subscribers flock to cheaper unlimited data plans), and lower current case a radical departure from antitrust practice. The domestic video, partly offset by higher equipment sales and 2009 Comcast acquisition of NBC Universal - a deal stronger international results. Wireless service revenue remarkably similar to the AT&T/Time Warner merger - was declined 2.5% from 4Q16. The adjusted consolidated approved with conditions intended to curb anticompetitive operating margin fell 130 basis points from the prior year to behavior and has actually worked quite well over the years. 16.2%. However, adjusted EPS rose 18% to $0.78 from $0.66 We do not believe it would be in AT&T's interest to withhold in 4Q16. Adjusted EPS excluded $3.16 from a deferred tax the Time Warner channels from distribution on other services. liability remeasurement gain, due to the new tax law, and Withholding these channels from distribution would $0.19 in merger-related and amortization costs in 4Q17, and essentially mean lowering their advertising and distribution $0.17 for these costs in 4Q16. It also excluded $0.19 in revenue - something the company could ill afford. actuarial losses on benefit plans in 4Q17 and $0.10 for these We think that AT&T has a reasonable case, though costs in 4Q16, and $0.41 in asset write-offs and natural litigation is always risky, especially when the opponent is the disaster charges in 4Q17 and $0.05 for these costs in 4Q16, U.S. government. We believe that the DOJ is trying to fight among other smaller charges/gains. GAAP EPS rose to $3.08 yesterday's battle, as it does not consider the erosion of the from $0.39 a year earlier. cable bundle universe through cord cutting - a clear For all of 2017, revenue fell 2% to $160.55 billion. counterweight to any market power AT&T might gain. In our Adjusted EPS increased 7.4% to $3.05. view, the DOJ also fails to consider the evolution of cable AT&T gained a net 541,000 postpaid subscribers, distribution. Comcast, the industry leader, has already begun including 329,000 postpaid phone net adds, and a net 140,000 to open its platform to over-the-top digital streaming services lower-value prepaid phone subscribers in 4Q17. Postpaid net like Dish's Sling, Netflix, and YouTube, and has jumped into adds rose 4% while prepaid net adds fell 65.5%. The company wireless telecom services through a mobile virtual network also lost 529,000 lower-value reseller subscribers in 4Q17. operator deal, piggy-backing on Verizon's network. AT&T, along with Verizon, has been forced by competitors to We do not understand the DOJ's sudden allergy to tweak its wireless plans to add more unlimited data packages. negotiating conditions for approval, and its insistence on AT&T has created bundles of wireless plans with its DirecTV forcing AT&T to divest key assets like the Turner Channels or video offers in order to improve the value of its plans and DirecTV. The DOJ's position strikes us as ideological rather thereby boost subscriber loyalty. Postpaid churn was 1.12%, than practical, and has of course raised concerns about down 4 basis points from the prior year but up 5 basis points political interference given the contentious relationship sequentially. Phone-only postpaid ARPU declined 2.6% to between the White House and Time Warner's CNN. Whether $57.33, and phone-only postpaid ARPU plus EIP payments real or not, the specter of interference has only served to fell 1.9% from the prior year to $68.20 due to continued weaken the DOJ's case. subscriber migration to no-device subsidy and no-overage In December 2017 , AT&T raised its quarterly dividend plans. by 2% to $0.50 per share, or $2.00 annually, for a yield of On November 20, the U.S. Department of Justice filed about 5.3%. We are adjusting our dividend estimates to $2.00 suit in federal court to block AT&T's acquisition of Time for 2018 and $2.04 for 2019. AT&T has a five-year Warner on antitrust grounds. Far from backing down, AT&T compound annual dividend growth rate of 2%. has chosen to fight the U.S. government in court. The scheduled trial date is March 19, and a ruling is expected in EARNINGS & GROWTH ANALYSIS April or May. Time Warner's current share price remains 13% We are raising our 2018 EPS estimate to $3.52 from below AT&T's $107.50 offer price, which we believe reflects $3.01 and establishing a 2019 forecast of $3.65. Our 2018

Section 2.23 GROWTH / VALUE STOCKS estimate is above management's adjusted EPS forecast of We think the FirstNet deal is a positive for AT&T, $3.50, which includes a projected $0.45 boost from a lower particularly since it has had 100% buy-in from the individual effective tax rate. Our EPS estimates imply growth of about states. From AT&T's standpoint, greater network coverage is 10% on average over the next two years, above our long-term an obvious plus. FirstNet provides opportunities for AT&T to growth rate forecast of 5%. expand its service network footprint into geographic areas AT&T's strategic philosophy, like that of its cable with lower population density that may be uneconomical on a company peers, is now all about 'selling the bundle.' However, commercial basis alone. The addition of the 20MHz of in AT&T's case, the difference is that its bundle includes adjacent 700 MHz spectrum to the 40MHz of currently wireless as well as video, high-speed internet, and VoIP. The unused spectrum held by the company should also benefit company added 170,000 wireless bundle customers in 4Q17, network capacity, putting AT&T in a strong strategic position and has 700,000 wireless subscribers bundled with its as wireless data usage continues to explode. DirecTV satellite TV service. Management sees the service While the Time Warner acquisition is in litigation and bundle as a key future profit driver as well as a driver of therefore remains in doubt, we think acquiring a premium customer loyalty and lower churn. content provider like Time Warner would a plus for AT&T. It AT&T's has several strategic initiatives for 2018. would also take a particularly valuable piece off the -- Closing the Time Warner acquisition. This will, of entertainment industry M&A game board, preventing Time course, depend on successful litigation against the Department Warner's sale to another industry player. Time Warner is one of Justice. of the largest integrated media companies in the world, with -- Strengthening the network. This is also no surprise. industry-leading assets in film, TV, and videogame Like its wireless industry peers, AT&T is upgrading its production, as well as basic and premium cable channels. We network infrastructure to 5-G, a so-called 'gigabit network.' see this acquisition as a strategic move by AT&T to ensure The company is targeting $1 billion in incremental investment access to premium branded content not only for its DirecTV in 2018, mostly for network fiber deployment. This direct satellite video distribution business, but also for its investment will be funded in part by savings from the reduced nascent wireless video business. Management has been clear tax rate. that it sees mobile video as the future of the wireless business -- Launching DirecTV NOW 2.0, the next iteration of the as wireless bandwidth increases and as network technology company's nascent internet video streaming service. evolves from LTE to 5G. Verizon has taken a similar, though -- Creating a new platform for targeted advertising across more conservative approach, in a series of smaller its services. acquisitions, including AOL, the Huffington Post, and Yahoo. -- Boosting subscriber numbers and profitability in its AT&T management has justified the deal by projecting Mexican operations. accretion to both adjusted EPS and free cash flow per share in -- Lowering its cost structure. Management has noted that the first year after the closing. However, we expect adjusted 55% of the company's network operations are already results to ignore merger integration costs. AT&T looks for $1 virtualized. It expects to boost this to 75% by 2020 with, we billion in run-rate cost synergies within three years of the expect, concomitant cost savings. closing. Management also expects to rapidly delever after the In the Entertainment Group, 4Q revenue fell 3.5% to closing and to return to historically normal debt levels by 12.75 billion due to declines in legacy services and traditional 2022. TV subscribers. DirecTV lost 147,000 subscribers. However, subscriber gains at DIRECTV NOW offset losses at DirecTV FINANCIAL STRENGTH & DIVIDEND and Uverse, leading to 161,000 video net adds in 4Q17. Our financial strength rating on AT&T is Medium, the On March 30, 2017, AT&T announced an agreement with midpoint on our five-point scale. The Time Warner the federal First Responder Network Authority (FirstNet) to transaction will add more than $23 billion in debt to AT&T's build and operate a dedicated national wireless broadband balance sheet. Despite the increase in leverage, the company network for police, firefighters and emergency medical expects to maintain its investment-grade credit rating and to services. Emergency workers currently use commercial return to its target debt/EBITDA multiple of 1.8 by the end of wireless networks that can become clogged during the fourth year after the closing. AT&T's credit ratings are in emergencies. FirstNet will provide 20 MHz of national 700 the high B's, solidly investment grade. However, the ratings MHz low-band telecommunications spectrum, and agencies put the company on negative credit watch on success-based payments of $6.5 billion over the next five October 24, 2016, the day after the Time Warner acquisition years to support the buildout of the new network. Under the was announced. terms of the agreement, AT&T will spend $40 billion over the RISKS 25-year life of the agreement to build, operate and maintain The Time Warner acquisition, if it happens, will present the network, including upgrading to 5G. The FirstNet network significant integration risk as well as regulatory risk for will also integrate with AT&T's own network assets. In AT&T. Time Warner will be run as a separate subsidiary of addition, AT&T will be able to use/resell unused time on the AT&T. However, the combined company will still have to FirstNet network. integrate two very different corporate cultures: the relatively

Section 2.24 GROWTH / VALUE STOCKS staid culture of AT&T, a regulated telecom, and the more AT&T is highly regulated on the federal, state and local free-wheeling, entertainment-oriented culture of Time Warner. levels. As a regulated entity, it is vulnerable to changes in If the DOJ is successful in blocking the acquisition, the regulatory philosophy that could put it at a disadvantage market could interpret this as a negative for AT&T. relative to other industry players. We think this risk may have AT&T faces a number of traditional and newer lessened with the change in administration in Washington. competitors, as the telecom industry continues to evolve from a voice-centered to a wireless data and fixed broadband data COMPANY DESCRIPTION model. In addition, the U.S. wireless industry is essentially at AT&T provides telecommunications and entertainment saturation which has led to increased competitive intensity to services to consumers in the U.S. and Latin America and to win subscribers and narrower margins. These trends have businesses worldwide. SBC acquired the old AT&T in been partially offset by the rapid adoption of smartphones, November 2005 and took the AT&T name shortly thereafter. which come with higher-priced data plans, and by other data The combined company acquired BellSouth Corp. in devices like tablets that generally carry lower-priced plans December 2006 and spun out its Directories business in May though smartphones and tablets are also now beginning to 2012. The company acquired Mexican wireless telecoms close in on saturation. AT&T has diversified its handset Iusacell and Nextel Mexico in January 2015, and direct portfolio from an over-reliance on Apple's iPhone broadcast satellite video operator DirecTV in July 2015. (notwithstanding its blockbuster status), into Android, VALUATION Windows Phone and other smartphones. On the wireline side, AT&T shares have lost 7% in the last year, compared to a cable companies are fierce competitors for video and total return of 16% for the S&P 500 and a loss of 1% for the broadband internet services, and have also made large inroads S&P 500 Telecommunication Services Index. AT&T is with VoIP and into communications for small and trading near the middle of its five-year average range for medium-sized business customers. trailing enterprise value/EBITDA (7.5 versus a range of Following its spinoff from Deutsche Telekom and 6.9-8.0). Close rival Verizon has a multiple of 7.3. AT&T's acquisition of regional wireless telecom MetroPCS, a forward enterprise value/EBITDA multiple of 6.4 is 8% below resurgent T-Mobile has been particularly effective in the peer average, greater than the average discount of 4% over challenging the larger wireless industry incumbents with the last two years. We are maintaining our BUY rating on discounts and inventive new service plans. Sprint joined the AT&T to a target price of $48. fray in 2015 with cut rate plans of its own, and has gone even On February 6, BUY-rated T closed at $36.83, up $0.20. further by offering a promotion for a year of free service. (Joseph Bonner, CFA, 2/6/18) 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 Autozone Inc (AZO) equipment installment plans will also shift revenue out of Current Rating: BUY Publication Date: 2/2/18 service and into the equipment line in the short term, while increasing risks related to long-term accounts receivable. HIGHLIGHTS Management has pledged to value receivables conservatively *AZO: Boosting target to $875 on lower tax rate and may be able to reduce this risk by factoring. *We expect AutoZone to benefit from solid industry Through its recent moves into Mexico and elsewhere in fundamentals, which include an aging vehicle fleet, low Latin America, AT&T will be entering foreign markets that gasoline prices, and increasing miles driven per car. may not have the same demand dynamics as its home U.S. *We are raising our FY18 EPS estimate to $53 from $47. market. Mexico has, at least initially, been a capex drain on The main driver is the reduction in our full-year tax rate AT&T as it upgrades wireless networks to the 4G LTE estimate to 27% from 34%, standard of its U.S. network. Issues such as corruption and *We are also boosting our FY19 EPS estimate to $59.75 organized crime are also more prevalent in these markets than from $51.50, representing a 13% increase from our FY18 in the U.S., and could entangle AT&T. In addition, the estimate. We look for approximately 4% sales growth and a company's foreign exchange risk will increase. small reduction in shares outstanding. AutoZone will also Another risk is that the market continues to shift rapidly benefit from the lower tax rate for the entire year. to new communications formats, such as VoIP, Wi-Max and *At a multiple of 16-times our forward-four-quarter EPS wireless/IP integration. The danger is that AT&T will be estimate of $55.40, AZO shares would be worth unable to adapt quickly enough to keep pace with the new approximately $886 in one year. technology. AT&T also has a large retiree population and ANALYSIS correspondingly large pension and benefit obligations. Retiree INVESTMENT THESIS benefit plans could become more of a burden in the future. We are reiterating our BUY rating on AutoZone Inc. The company is acting to minimize the risk of future OPEB (NYSE: AZO) and raising our target price to $875 from $675, payments through its pension plan trust preferred equity plan. reflecting the increase in our FY18 and FY19 earnings

Section 2.25 GROWTH / VALUE STOCKS estimates due to a lower tax rate. We have also raised our very low levels of profitability. It is a risk for the stock forward-four-quarter EPS estimate, which is important to our because some investors are reluctant to invest anywhere that valuation, to $55.40 from $47.00. We expect AutoZone to Amazon might be a competitor. Another very long-term risk benefit from solid industry fundamentals, which include an could be the potential for sales of many engine and exhaust aging vehicle fleet, low gasoline prices, and increasing miles parts to decline as electric cars become a bigger segment of driven per car. the U.S. market. The average age of an American car is approaching 12 years and there are a growing number of cars that are more RECENT DEVELOPMENTS than seven years old. If vehicles are driven approximately AutoZone reported first-quarter sales and earnings on 12,500 miles per year, a car would have 87,500 miles after December 5. Sales and EPS were stronger than we expected. seven years. These stats continue to point to a fleet of vehicles SG&A was slightly higher than we modeled because of that are no longer under warranty and in need of extra hurricane-related expenses. While the storms helped sales, maintenance. costs and store damage reduced 1Q EPS by about $0.07 in a Miles driven increased by 3.5% in 2015, which AZO said quarter where the company earned $10.00 per share. was the largest increase in more than a decade. Miles driven Sales rose 4.9% to $2.59 billion versus our estimate of was up 1% in 2016 and up about 1.5% in the first half of $2.54 billion. Domestic comparable sales increased by 2.3%, 2017. The price of unleaded gasoline is still relatively low, at compared with the Bloomberg consensus call for a 0.9% gain. about $2.48 per gallon. It is up slightly on a year-over-year Management said that commercial sales accelerated as AZO basis, but down over the last month as hurricane-related gained market share. disruptions have eased. Gross margin, at 52.8%, was up by 10 basis points and 20 Collectively these indicators point to a U.S. vehicle fleet basis points above our estimate. Profitability was helped by that should need repairs as a result of age and use. Relatively higher merchandise margins, offset by 'shrink' or loss of low gas prices should enable drivers to put even more miles inventory. SG&A was 10 basis points higher than we on their mature vehicles. Low prices at the gas pump should modeled, mostly as a result of hurricane costs and occupancy also leave consumers with a little extra discretionary income costs growing faster than sales. SG&A dollars were $897 that can be spent on repairs. million, about $20 million above our estimate. Going forward, Near-term sales of auto parts have recently been management is optimistic that supply-chain costs will be well pressured by strong U.S. new-car sales, but in the longer term, controlled over the remainder of the year. Some wage pressure growth in the overall fleet of cars should be beneficial to is likely to remain. AZO. There has been a bit of noise from a mild winter and The operating margin was in line with our estimate and from a delay in tax returns, but we would expect those two very healthy at 18.1%. The net result was that fiscal 1Q net issues to be largely resolved as we head into FY18. income came to $281 million, above our estimate of $278 We expect the company to focus on improving inventory million. EPS came to $10.00, above our estimate of $9.86. availability to drive sales. We expect this to be accomplished A longer term issue getting a lot of attention is that by having more inventory in individual stores, by adding more Amazon appears to be encroaching on the profitable turf of large-format 'Hub' and 'Mega Hub' stores to significantly the auto parts stores - and the grocery stores - and the improve product availability and by increasing the number of appliance stores. While we think AZO and its peers have a lot replenishment deliveries to individual stores. going for them, we wouldn't dismiss Amazon's disruptive Despite the added cost of more inventories, deliveries, power. AutoZone has stressed the value of its in-store service and warehousing, management expects the initiative to deliver and the ability to help customers diagnose their problem and significant internal rates of return. This expectation could be make sure they have exactly the right part for the year and challenged if the softness in comp sales continues. model of the customer's vehicle. AZO also believes that its We expect management to add services for commercial in-stock position and its proximity within eight miles of 80% customers to more stores and to improve recently-launched of the U.S. population are advantages. AZO has the potential commercial programs as they mature. We also expect AZO to to gain market share in a very fragmented commercial market. offer a wider assortment of parts through its programs. Another concern in the marketplace is the potential for The auto parts sector is relatively insulated from internet electric vehicles to take share from vehicles with internal competition because of in-store service, relationships with combustion engines. While a noticeable erosion could take 10 parts suppliers and established delivery to commercial - 15 years it could still weigh on the shares. While our customers. We also expect AZO to improve its own online intuition is that electric cars will need fewer parts than cars offering. with an internal combustion engine, that is really hard to know AMZN has reportedly inked some deals with some major at this point. Electric cars will still, presumably need tires, makers of auto parts. While it will be tough for AMZN to rims, wipers, belts, wires, connectors, shocks, brakes, match the customer service and immediate-availability that the bearings, floor mats, cleaning supplies and, of course, air parts stores offer, a greater presence by Amazon is an ongoing fresheners. risk because the online giant has been willing to operate at EARNINGS & GROWTH ANALYSIS

Section 2.26 GROWTH / VALUE STOCKS

We are raising our FY18 EPS estimate to $53 from $47. price. The main driver is the reduction in our full-year tax rate Total debt, which includes both long-term and short-term estimate to 27% from 34%, with a rate of 25% from January 1 debt as well as capital leases, was $5 billion at the end of through the end of the fiscal year. The reduction is based on 1Q18, about the same as a year earlier. The 1Q balance sheet the new federal tax law. We have also reduced our interest lists no short-term debt, but we think it is important to note expense estimate based on 1Q debt levels. In addition, we that the company had $1 billion of outstanding commercial made a small increase in our 2Q sales forecast because of paper which it classified as long-term debt. We would frigid weather on the East Coast, and note that 1Q earnings normally regard CP as short-term debt.The company's were slightly higher than we modeled. Our operating margin rationale for classifying this debt as long term is it has $1.99 estimate is about 10 basis points higher at 19.2%. billion of borrowing capacity under its $2 billion revolving We are raising our FY19 EPS estimate to $59.75 from credit facility, which now matures in 2022. If the amount of $51.50, representing a 13% increase from our FY18 estimate. CP and debt maturing in less than one year was less than the We are modeling approximately 4% sales growth and a small available balance on the revolver, the company would show reduction in shares outstanding. Our model assumes a no short-term debt. The company said that the calculation of 20-basis-point increase in the operating margin, with an short-term debt is based on guidance from its auditor. We improvement in the expense rate offsetting a slight reduction understand the rationale and the disclosure in the financial in the gross margin, and a lower tax rate for the entire year. statements is clear. The total amount of debt is the same either Our five-year growth rate for AutoZone is 10%. We are way, but all things considered, we would prefer to see the modeling continuing repurchase activity. Our growth rate commercial paper and the near-term debt maturity classified assumes domestic square footage growth of approximately 3% under short-term debt - debt maturing in less than a year. -4% with comp-store sales also growing approximately 3%, Like most of the other retailers in our universe, AZO has though somewhat slower in the near term. We expect comp operating leases. The company owns about half of its 39.7 growth to be bolstered by the company's plan to add and million square feet of store space, which is a fairly high enhance commercial programs and improve its in-stock percentage. Argus treats the operating lease payments as fixed position. We also expect modest international expansion, obligations. If we add the estimated $1.5 billion present value initiatives to grow the IMC business, a better e-commerce of operating leases to the balance sheet, debt is about 130% of presence which could add incremental sales and ongoing share capital. repurchases. We are modeling repurchases at $1 billion or At the end of 1Q18, the adjusted four-quarter trailing slightly more which could represent more than 4% of the debt/EBITDAR ratio was 2.5 , flat with the prior year. The current market cap. company has targeted a ratio at or below 2.5. AZO uses a At the end of fiscal 1Q18, AutoZone had 6,049 stores, multiple of 6 to capitalize leases. We normally use a factor of including 5,480 AutoZone stores in the U.S., 529 in Mexico, 8 which would put adjusted debt slightly higher at 14 in Brazil and 26 IMC branches. As industry sales have approximately 2.75-times EBITDAR. The company told us grown, the company's broad geographic presence has enabled that the factor of 6-times is based on the cost of its actual it to gain market share. leases. AutoZone had cash and equivalents of $258 million at the FINANCIAL STRENGTH end of 1Q18, compared to $293 million at the end of 1Q18. We rate the financial strength of AutoZone as Medium, From a historical perspective, AutoZone repurchased 1.9 the midpoint on our five-point scale. The company has million of shares for about $1.5 billion in FY16, 2.0 million significant debt and it is in a very competitive sector, but the shares of its common stock for $1.3 billion in FY15 and it company has excellent consistency, producing solid margins repurchased 2.2 million shares of common stock for $1.1 and positive EPS in every year that it has been a public billion in FY14. In fact, the company has purchased over $1 company, going back to 1991. The company also generated billion of shares in each of the last seven years. positive free cash flow in 2000 and in every fiscal year since. AutoZone repurchased $400 million of shares in fiscal AZO's debt is rated Baa1 with a stable outlook from 1Q16, $150 million in 2Q, $533 million in 3Q, and $370 Moody's and BBB with a stable outlook from Standard & million in 4Q. The company repurchased $560 million of its Poor's. These are investment-grade ratings. The company's stock in the first half of FY17 and $284 million in 3Q17 and short-term ratings are A-2 from S&P and P-2 from Moody's. $227 million in the fourth quarter. AZO repurchased $353 These are below the top tier, but they should allow the million in 1Q18. The remaining authorization was $471 company to access the commercial paper market. million at the end of 1Q. At the end of 1Q18, the company's total debt/total On a trailing four-quarter basis, AutoZone's return on capitalization ratio was 144% (reflecting a stockholders' invested capital (ROIC) was 29.6% at the end of 1Q, down deficit of $1.5 billion). The company has been solidly slightly from 31.3% in the prior-year period. This is a very profitable over the last 20 years. The stockholders deficit is a healthy number that is bolstered by strong margins and by the result of the company repurchasing $18 billion of its stock shareholders deficit reducing total capital. over the last 18 years at prices that were far above the IPO AZO shares do not carry a dividend, and given the

Section 2.27 GROWTH / VALUE STOCKS company's current share buyback plans, and plans to open 2% in 2016. These statistics are reported with a lag. stores, we do not expect one to be implemented in FY18 or The products sold by auto parts stores generally fall into FY19. three categories: Failure, which includes belts, hoses, fuel pumps and alternators; Maintenance, which includes RISKS antifreeze, brake fluid, brake pads, spark plugs and windshield The two long-term concerns regarding Auto Zone and the wipers; and Discretionary items, such as air fresheners, other auto parts stores are competition from Amazon and the decorative floor mats, stereos and washes and cleaning possibility of a decline in business as electric cars gain a supplies. The failure and maintenance categories represent bigger share of the road over the next 10 - 20 years. 84% of total sales. While Amazon is adding inventory and may be a viable An additional risk is that some manufacturers won't make competitor for the do-it-yourself customer who is very diagnostic tools or part designs available to aftermarket part knowledgeable, most DIYers can probably benefit from the makers or repair chains. We once owned a European car that assistance they get at a parts store. And pro customers can had to receive all major repairs at the dealership because none benefit from parts-store delivery networks that are currently of the local mechanics wanted to spend the high amount for faster than Amazon can offer. the manufacturer's diagnostic software. The countercyclical nature of the auto parts industry The auto parts sector has generally been more sheltered suggests that when new auto sales are strong, sales at parts from internet competition. It is likely that online competition retailers will typically be weak, as the need for repairs or at least the cost of building and upgrading internal declines. On the other hand, although DIY sales have fallen capabilities could weigh on profitability. Shares of AZO and due to the increasing complexity of new vehicles, we other parts stores recently declined following a press report recognize that repair and maintenance work by DIYers will that Amazon was making agreements with some major makers often increase during periods of economic hardship. of auto parts. Most aftermarket parts retailers experienced solid sales Earnings could be crimped if the company is fulfilling growth after the great recession as tight lending conditions, more online orders with shipping that is free to customers. slow wage growth and fragile consumer balance sheets Another risk is that companies are likely to be faced with provided an incentive to keep cars on the road. We expect the more threats from computer hackers and upgrading systems DIY side to face the most pressure because the increasing could be a bigger use of cash. complexity of new vehicles is making it harder and harder for A growing concern is that Amazon is attempting to consumers to work on their own cars. increase its share of the auto parts market. A longer-term risk The sector generally benefits from an older fleet of is that sales at parts stores could be hurt by an increase in the American cars, which needs more repairs. More than 75% of number of electric cars. the U.S. auto fleet is more than six years old, according to data recently cited by competitor Genuine Parts. The average COMPANY DESCRIPTION age is 11.7 years. The average annual repair cost is just over AutoZone Inc. was founded in 1979 and is based in $800 per year for cars that are 6-12 years old, according to Memphis, Tennessee. The company is a leading retailer and a GPC. leading distributor of automotive replacement parts and Auto parts retailers also benefit if consumers are driving accessories with almost $11 billion of FY17 sales through more miles. While higher gas prices could crimp driving and almost 5,500 stores in the United States and Puerto Rico and the need for auto parts, miles driven were up 2.8% in 2016 more than 500 in Mexico. Each AutoZone store carries an bolstered by low and stable gasoline prices. And it appears extensive product line for cars, sport utility vehicles, vans and that they rose approximately 1.25% in calendar 2017, helped light trucks, including new and remanufactured automotive by relatively low gasoline prices. Gas prices remain low at hard parts, maintenance items, accessories, and nonautomotive approximately $2.60 a gallon. products. Weather is another factor. The company doesn't benefit if Over 80% of stores also have a commercial sales program the weather is so mild that parts aren't being used or worn out, that provides commercial credit and prompt delivery of parts but they don't want such harsh weather that people stay home. and other products to local, regional and national repair The company also doesn't want the economy to be so bad that garages, dealers, service stations, and public sector accounts. people can't afford to make DIY repairs and companies are IMC branches carry an extensive line of original equipment laying off workers, but neither do they want consumers to be import replacement parts. AutoZone also sells ALLDATA flush enough to buy a new car, although their used vehicle diagnostic and repair software through alldata.com. would probably still remain in the auto fleet and be in need of The company has more than 6,000 total stores and offers repairs. national brand and private-label products. According to During 2015, the number of registered vehicles grew by management, more than 50% of the sales mix is private label. 2.1% to 258 million vehicles and the scrappage rate was the The margins on these private-label products are higher than on lowest in more than a decade, according to AAP. We'd branded products because AZO is able to benefit from direct estimate that vehicle registrations increased by approximately sourcing.

Section 2.28 GROWTH / VALUE STOCKS

VALUATION aerospace and defense company in our coverage universe, and AutoZone shares have risen about 7% over the last year. we believe that it has superior prospects due to its significant We believe that concerns about competition from Amazon and backlog and strong presence in the growing commercial softness in comparable sales have weighed on the share price. aerospace industry. In the near term, the company is managing We believe that the company can gain share in the market and shifts in customer demand in order to prepare for stronger and compete with Amazon, and we expect comps to improve as more profitable growth in 2018 and beyond. At the same time, the company moves past the lull in repairs that resulted from the management team is clearly focused on delivering strong two mild winters. shareholder returns and continues to boost the dividend and The shares trade at 14-times our FY18 EPS forecast and repurchase stock. We note that the shares are susceptible to at 13-times our FY19 forecast. AZO is trading at 17.5-times headlines or presidential tweets about defense spending or trailing earnings. The five-year average is 17.6, with a range trade with China. We would view any headline-related of 11.5-22.0. The company's closest peers are trading at pullbacks as buying opportunities. Our dividend discount approximately 22-times trailing earnings. We believe the model renders a fair value above $420 per share. Blending our shares are attractively valued at a discount to peers based on valuation approaches, we see value up to $395 per share, our the company's record and prospects for earnings growth. One new target price, up from a prior $290. The BA shares are a issue is that AZO has more exposure to the retail DIY market. suitable core holding in a diversified portfolio. While this is beneficial to margins, the DIY market is more RECENT DEVELOPMENTS vulnerable to competition from Amazon than the commercial market. BA shares have been strong performers over the past At a multiple of 16-times our EPS estimate of $55.40 for quarter, gaining 40% compared to an increase of 10% for the the next four quarters, the shares would be worth S&P 500. Over the past 12 months, the shares have also approximately $886 in one year. This multiple is up from the outperformed, rising 120% compared to a 24% advance for 15 that we used in our previous note based on the solid sales the broad market. BA shares have also outperformed the performance in 1Q. industrial sector ETF IYJ over the past one-, five- and Using a simple discounted earnings model with our FY18 ten-year periods. The beta on BA is 1.29. and FY19 estimates and the assumption that EPS will grow at On January 31, Boeing reported quarterly earnings that 10% for the next three years puts the value of the shares at once again topped expectations. The company posted $850. This is based on EPS of about $80 and a terminal consolidated revenue of $25.4 billion, up a sequentially multiple of 16, which puts the value of the shares at about stronger 9% from the prior-year period. Non-GAAP core $1,280 in four years. We then discount to the present at 8.5%. operating earnings rose 30% as the operating margin increased We are raising our one-year price objective to $875 from 160 basis points to 10.5%. Non-GAAP core earnings were $675. $3.06 per share, ahead of the consensus forecast of $2.89. On February 1, BUY-rated AZO closed at $764.38, down For the full year, the company earned $10.30 per share, $1.06. (Christopher Graja, CFA, 2/1/18) 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 Boeing Co (BA) guidance for 2018. The company expects revenue of $96-$98 Current Rating: BUY Publication Date: 2/1/18 billion (up 2%-4%), and EPS of $13.80-$14.00. This forecast HIGHLIGHTS implies 13% growth from 2017, at the midpoint of the range, *BA: Raising target price to $395 after including the impact of the lower tax rate on an *BA shares have been strong performers over the past apples-to-apples basis in both periods. Management is also quarter, gaining 40% compared to an increase of 10% for the forecasting that operating cash flow will grow 13% to 415 S&P 500. billion. Management forecasts full-year deliveries of 810-815 *Boeing's 4Q results once again topped consensus, and aircraft in 2017. we look for solid growth over the next two years. *We note that the shares are susceptible to headlines or EARNINGS & GROWTH ANALYSIS presidential tweets about defense spending or trade with Boeing organizes its operations into two manufacturing China. We would view any headline-related pullbacks as businesses: Commercial Airplanes, which includes key buying opportunities. products such as the single-aisle 737MAX, the 787 *Management recently increased the dividend by 20%, Dreamliner series, and the 777X (the largest twin-engine jet in signaling confidence in its outlook. the world, with first scheduled deliveries in 2020); and Defense, Space and Security, which manufactures products ANALYSIS such as the F-18 Hornet, the AH-64 Apache helicopter, P-8 Poseidon aircraft, and the KC-46 Tanker. Boeing also has a INVESTMENT THESIS Capital segment, which provides aircraft financing, and a BUY-rated Boeing Co. (NYSE: BA) is the largest Global Services business, which 'captures value over the life

Section 2.29 GROWTH / VALUE STOCKS cycle' of the company's products. scores above-average on our key criteria of debt levels, In the Commercial Airplanes segment, revenues were up fixed-cost coverage and profitability. The company has A 8% year-over-year in 4Q, to $15.5 billion. The operating ratings from the major credit rating agencies. margin increased 320 basis points to 11.5%. The company Boeing has a share repurchase program. At the end of 4Q, delivered 209 commercial airplanes in the quarter, up from shares outstanding were down 4% year-over-year. 202 in 3Q and 185 a year earlier. It booked 414 net orders for The company also pays a dividend, which it raised by commercial airplanes, resulting in a backlog of $421 billion, 20% in December. The quarterly payout is $1.71, or $6.84 up from $412 billion at the end of the previous quarter. The annually, for a yield of about 2.0%. We think the dividend is backlog includes orders for more than 5,800 aircraft secure and expect it to grow. Our dividend estimates are $6.84 (approximately 75% of the backlog is for 737s and 10%-12% for 2018 and $7.80 for 2019. is for 787s), representing about seven years of production. Management has been adjusting the product mix to meet MANAGEMENT & RISKS changing demand. Last year, 737 production increased from Boeing recently named Dennis Muilenburg, 53, as its new 42 airplanes per month to 47, and the expectation is for 52 per CEO, succeeding James McNerney. Mr. Muilenburg month this year and 57 per month in 2019. Last year, previously served as Boeing's vice chairman and chief management also lowered production of the higher-priced 777 operating officer. Gregory Smith serves as CFO. model to 5 per month. The production rate for 787s is Investors in BA shares face numerous risks. expected to increase from 12 to 14 airplanes per month in BA was in the headlines early in the Trump presidency, 2019; Boeing expects to deliver the first 787-10 to launch related to stories about defense spending and jobs. The customer Singapore Airlines in March. headline events underscore Boeing's delicate situation. The The Defense, Space and Security segment reported 4Q company is among the largest U.S. exporters and employs tens revenue of $5.5 billion, up 5% from the prior year due to of thousands of people, and aggressive tariffs and other trade higher weapons deliveries. The operating margin rose 10 basis barriers could cost the company future orders. That said, we points to 10.0%. The segment backlog rose by $4 billion to expect that Boeing management - and the entire aerospace & $50 billion at the end of the quarter. International orders defense industry -- will ultimately work closely with the represented about 40% of the total. Looking ahead, we Trump economic team on these issues. forecast low-single-digit sales growth this year and stable to The company is also vulnerable to a cyclical downturn in slightly higher margins. the commercial aviation market, though the geographic The new Global Services segment reported 4Q revenue of diversification of its product portfolio provides some stability. $4.0 billion, up 17%. The operating margin contracted 120 Much of the company's backlog consists of orders from basis points to 15.4%. During the quarter, Global Services rapidly growing international customers. The current deferral was awarded a contract for F-15 Qatar Sustainment. It also rate is approximately 2% of the backlog, below the historical signed an agreement with All Nippon for the 787 landing gear average of 6%. Meanwhile, demand trends remain favorable exchange program, and was selected for P-8I Poseidon for Boeing as customers continue to upgrade to more training in India. Global Services began flight testing on the technologically advanced aircraft with improved fuel first 737-800 Boeing Converted Freighter and received an efficiency. In addition, airline profitability has improved due order from GECAS for seven conversions. Digital Solutions to lower fuel costs, and air traffic trends remain generally approached an annual revenue run rate of $1 billion in the positive; through November 2017, passenger traffic has grown quarter. Looking ahead, we estimate mid-single-digit sales an impressive 7%, above the 10-year average of 5.5%, and growth and mid-teens margins in this segment. cargo traffic has turned positive, rising 9%. Based on these At Boeing Capital, the net portfolio balance was $3.0 trends, Boeing management now projects demand for 41,000 billion at the end of 4Q, down $300 million from the new commercial aircraft over the next 20 years, which it beginning of the quarter. Boeing Capital reported expects to meet with three key products: its single-aisle fourth-quarter revenue of $73 million, down from $87 million 737MAX; the 787 Dreamliner series; and the 777X, the in the same period a year earlier, and operating income of $27 largest twin-engine jet in the world, with first scheduled million, up from $23 million a year earlier. deliveries in 2020. The service business represents Turning to our estimates, and factoring in expectations for opportunity as well. Boeing estimates the services market at low single-digit top-line growth, better margins, lower taxes, $2.6 trillion over the next 10 years. and continued share buybacks, we are raising our 2018 EPS Fixed costs are high in the airline manufacturing industry, estimate from $11.00 to $13.90. Based on expectations for and from time to time the company takes charges if it further top-line growth in 2019, we are implementing a determines that investments are not generating the expected preliminary forecast of $15.30 per share. return or that more investment is needed. Like most military contractors, Boeing also faces risks FINANCIAL STRENGTH & DIVIDEND related to the cancellation or curtailment of new and existing Our financial strength rating on Boeing is Medium-High, Defense Department contracts. However, Boeing has seen the second-highest rank on our five-point scale. The company solid support for its Defense, Space and Security programs,

Section 2.30 GROWTH / VALUE STOCKS and management continues to anticipate modest defense expansion into higher-growth markets, and success in spending growth over the next five years. boosting margins. Boeing also faces risks associated with its pension obligations. ANALYSIS

COMPANY DESCRIPTION INVESTMENT THESIS Boeing manufactures commercial jetliners and military We are reaffirming our BUY rating on Boston Scientific aircraft as well as rotorcraft, electronic and defense systems, Corp. (NYSE: BSX) and our price target of $32. BSX missiles, satellites, launch vehicles, and advanced information continues to deliver solid sales growth, with fourth-quarter and communication systems. The company was founded in and full-year organic revenue up in all three segments and 1916 and is based in Chicago. The shares are a component of across all regions. At the same time, the company is facing the Dow Jones Industrial Average and the S&P 500. remediation costs for its Lotus heart valve, which was recalled in Europe in February. Management reiterated its goal for a VALUATION relaunch of the Lotus in Europe and an initial launch in the We think that BA shares are attractively valued at current U.S in 2019. Despite this setback, we believe that BSX has prices near $358, near the high end of the 52-week range of compelling long-term growth opportunities, driven by strength $160-$361. The shares have been in a bullish pattern of higher in the Medsurg and Cardiovascular segments. highs and higher lows since falling to support at $126 in September 2016. RECENT DEVELOPMENTS To value the stock on a fundamental basis, we use peer We are monitoring the company's efforts to resolve issues and historical multiple comparisons, along with a dividend surrounding its Lotus heart valve device. This device, which discount model. BA shares are trading at 25.7-times projected essentially replaces the aortic valve in a catheter-based 2018 earnings, near the high end of the historical range of minimally invasive procedure, was recalled in European 12-26. On a price/sales basis, the shares are trading at the high markets in February 2017 due to a problem with the release of end of the five-year range of 0.7-2.4. The dividend yield of the valve from the catheter. Its U.S. marketing application was about 2.0% is near the midpoint of the five-year range. also delayed. Nevertheless, we believe that the Lotus valve Compared to the peer group, valuations are mixed: high on has a large addressable market and the potential to be a P/E, but below average on price/sales and dividend yield. Our significant revenue driver over time. dividend discount model renders a fair value above $420. We note that BSX shares fell sharply in late November Blending our approaches, we arrive at a revised target price of after the company announced delays in its planned $395. reintroduction of the Lotus in Europe and its launch in the On February 1 at midday, BUY-rated BA traded at U.S. Management is now targeting a relaunch in Europe and $360.29, up $5.92. (John Eade, 2/1/18) 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 Boston Scientific Corp (BSX) a one-time $861 million charge related to recent changes in Current Rating: BUY Publication Date: 2/6/18 the U.S. tax code, down from GAAP earnings of $124 million HIGHLIGHTS or $0.09 per share in 4Q16. Net sales rose to $2.41 billion, up *BSX: Reaffirming BUY with $32 target 9.9% on a reported basis and 8.1% operationally, above the *BSX continues to deliver solid sales growth, with consensus forecast and management's guidance. fourth-quarter and full-year organic revenue up in all three On an organic basis, which excludes acquisitions and segments and across all regions. At the same time, the divestitures as well as the impact of currency translation, sales company is facing remediation costs for its Lotus heart valve, rose 6.8% in the fourth quarter. Organic sales rose in all which was recalled in Europe in February. segments, with growth of 11.2% in MedSurg (which includes *On February 1, the company posted better-than-expected endoscopy, neuromodulation, and urology devices); 4.9% in 4Q17 sales of $2.41 billion. Adjusted EPS rose to $0.34, in Cardiovascular (which includes cardiology, structural heart line with consensus and up from $0.30 a year earlier. and peripheral devices); and 3.2% in Rhythm Management *Management projects adjusted 2018 EPS of (which consists of electrophysiology and cardiac rhythm $1.35-$1.39, with organic revenue growth of 5%-6%. We are management products). By geographic region, 4Q organic reaffirming our 2018 adjusted EPS estimate of $1.38 and revenue rose 7.5% in the U.S., 4.4% in Europe, 7.8% in establishing a 2019 estimate of $1.52. AMEA (Asia-Pacific, Middle East and Africa), and 12.9% in *BSX trades at 19.7-times our adjusted 2018 EPS other emerging markets. estimate, compared to an average multiple of 17.6 for our The fourth-quarter adjusted gross margin was 72.6%, flat coverage universe of med-tech stocks. We believe this with the prior year, and the adjusted operating margin was premium is warranted based on the company's growth 25.6%, up 190 basis points. Margin growth was driven mainly opportunities through new product launches and acquisitions, by operational improvement in the Rhythm Management and

Section 2.31 GROWTH / VALUE STOCKS

MedSurg segments, and by an 80-basis-point reduction in COMPANY DESCRIPTION SG&A spending to 35.7% of revenue. Based in Marlborough, Massachusetts, Boston Scientific For all of 2017, BSX posted adjusted EPS of $1.26, up is a developer, manufacturer and marketer of medical devices from $1.11 in 2016, and GAAP EPS of $0.08, down from used in a range of interventional medical specialties, including $0.25 a year earlier. Net sales for fiscal 2017 were $9.05 interventional cardiology, peripheral interventions, vascular billion, up 7.9% on a reported basis and 7.8% operationally. surgery, electrophysiology, oncology, endoscopy, urology, The adjusted gross margin for the full year rose 10 basis gynecology and neuromodulation. points to 72.1%, and the operating margin rose 90 basis points to 25%. SG&A spending fell 50 basis points from the prior VALUATION year to 35.6% of revenue. BSX trades at 19.7-times our adjusted 2018 EPS estimate, In the transcatheter aortic valve replacement market compared to an average multiple of 17.6 for our coverage (TAVR), Edwards Lifescience and Medtronic are the leading universe of med-tech stocks. We believe this premium is players. The TAVR market is expected to grow to $5 billion warranted based on the company's growth opportunities worldwide by 2021, according to Edwards. The TAVR through new product launches and acquisitions, expansion devices, which are implanted through a catheter, eliminate the into higher-growth markets, and success in boosting margins. need for surgical replacement of the aortic valve. Although the Our target price is $32. Lotus valve has strong clinical data showing its benefits to On February 6 at midday, BUY-rated BSX traded at patients, BSX will be playing catch-up as it seeks U.S. $26.35, down $0.05. (Deborah Ciervo, CFA, 2/6/18) marketing approval and works to relaunch the product in Europe. In January 2018, Boston Scientific announced a $90 Brinker International Inc (EAT) million investment and an acquisition option agreement with Current Rating: HOLD Publication Date: 2/2/18 Millipede Inc., a privately held cardiology device maker. In HIGHLIGHTS May 2017, BSX completed its $435 million acquisition of *EAT: Earnings top estimates but comps disappoint Symetis SA, a privately held Swiss company specializing in *While Brinker has traditionally relied on structural heart products. The acquisition will enable BSX to above-peer-average increases in same-store sales to drive expand its offerings in the TAVR market. In October, it earnings growth, it has seen weaker comps in recent quarters. acquired Apama Medical, Inc., which is developing a *In addition, management now appears to be relying single-shot RF balloon catheter system for more efficient Afib mainly on stock buybacks, as well as delayed G&A spending treatment. and other cost-reduction efforts, to drive growth in EPS. EARNINGS & GROWTH ANALYSIS *We are concerned that Brinker will need to boost G&A Management projects 1Q18 adjusted EPS of $0.30-$0.32 spending in the coming quarters, and that competitors' and organic revenue growth of 5%-6%. For the full year, it promotions will require it to lower menu prices. We believe expects adjusted EPS of $1.35-$1.39, with organic revenue this could weigh on earnings going forward. growth of 5%-6%. The revenue growth projections exclude *For investors seeking to invest in a restaurant company contributions of about 80 basis points in 1Q18 and 30 basis with stronger growth prospects, we recommend the shares of points in FY18 from the Symetis acquisition. BUY-rated McDonald's Corp. (MCD). We are reaffirming our 2018 EPS estimate of $1.38 and ANALYSIS establishing a 2019 estimate of $1.52. INVESTMENT THESIS RISKS We are maintaining our HOLD rating on Brinker Boston Scientific faces regulatory and technological risks. International Inc. (NYSE: EAT). While Brinker has The company is developing new products to fill its product traditionally relied on above-peer-average increases in pipeline, which is also benefiting from acquisitions. However, same-store sales to drive earnings growth, it has seen weaker these products must complete clinical trials and clear comps in recent quarters. In addition, management now regulatory hurdles before reaching the market. appears to be relying mainly on stock buybacks, as well as BSX's cardiac rhythm management products face delayed G&A spending and other cost-reduction efforts, to competition from industry leader Medtronic and from the St. drive growth in EPS. We are concerned that the company will Jude Medical business now owned by Abbott. Its coronary need to boost G&A spending in the coming quarters, and that stents also face challenges from Abbott and Medtronic. competitors' promotions will require it to lower menu prices. We note that product pricing and customer demand We believe this could weigh on earnings going forward. If depend on the reimbursement policies set by government comp sales recover more than we anticipate or food costs agencies and managed care companies. Governments in moderate significantly, we would consider returning the stock Europe and Japan, in particular, have imposed significant to our BUY list. For investors seeking to invest in a restaurant price cuts on medical devices. company with stronger growth prospects, we recommend the

Section 2.32 GROWTH / VALUE STOCKS shares of BUY-rated McDonald's Corp. (MCD). revenue to be up 0.5%-1.5%. It also looks for the FY18 Based on potential benefits from additional refranchising, restaurant-level margin to decline 25-40 basis points. The our long-term rating remains BUY. company continues to buy back stock and has authorized an additional $250 million in share buybacks, bringing the total RECENT DEVELOPMENTS available authorization to $365 million. It expects a year-end On January 30, Brinker reported results for fiscal 2Q18 share count of 47-49 million. (ended December 27 ). Second-quarter revenue fell 0.6% from Reflecting management's current guidance, we are raising the prior year to $766 million. The decline reflected 1.6% our FY18 EPS estimate from $3.40 to $3.50. For FY19, we lower comps at domestic Chili's, offset in part by 1.8% higher are increasing our estimate from $3.50 to $3.70. Both same-store sales at Maggiano's. Revenue came in $8 million estimates are above consensus. below the consensus estimate. Excluding special items, EPS rose 22.5% from the prior year to $0.87 and topped the FINANCIAL STRENGTH & DIVIDEND consensus estimate by $0.16. We rate Brinker's financial strength as Medium, the Reflecting a 4.4% decline in restaurant traffic, offset in midpoint on our five-point scale. Over the past 12 months, the part by a 0.6% contribution from a more favorable product shareholders' deficit fell by $3 million to $1.4 billion, and mix and a 2.3% contribution from improved pricing, long-term debt fell from $9.6 billion to $8.3 billion. Interest second-quarter same-store sales at company-owned Chili's in expense rose from $13.6 million to $14.3 million. The credit the U.S. fell 1.5%. We believe the disappointing comps also agencies rate Brinker's debt as investment grade. reflected aggressive promotions by quick-service restaurants Brinker has raised its quarterly dividend from $0.34 to and overall weakness in the casual dining industry. The $0.38 per share, or $1.52 annually, for a yield of about 4.2%. consensus estimate had called for comps to increase 20 basis Our dividend estimates are $1.52 for FY18 and $1.72 for points. FY19. Maggiano's saw comps increase 180 basis points, as a 1.1% pricing increase and a 1.1% improvement in product RISKS mix were partially offset by a 0.4% decline in restaurant Like all restaurant companies, Brinker faces the risk that traffic. The consensus estimate had called for comps to higher food and beverage costs may reduce earnings. The decline 0.4%. company's results could also be affected by issues related to Systemwide comps were down 1.0%, below the food contamination at restaurants or increased public consensus call for a 10-basis-point increase. Domestic perceptions of disease risk. franchise comps fell 160 basis points from the prior year, COMPANY DESCRIPTION while international franchise comps increased 0.1%. G&A fell Brinker International, based in Dallas, Texas, is a leading to $33.1 million from $33.5 million, but held steady as a casual restaurant operator. The company owns or franchises percentage of revenue, at 4.3%. The consensus estimate had more than 1,600 restaurants under the Chili's Grill & Bar and called for G&A of 4.6% of revenue. Reflecting higher Maggiano's Little Italy brand names. Brinker also holds a restaurant labor costs, offset in part by a lower cost of sales, minority investment in Romano's Macaroni Grill. The shares the restaurant-level margin fell 20 basis points to 14.9%, are included in the S&P MidCap 400. below the consensus estimate of 12.9%. Shares outstanding fell to 46.4 million at the end of the quarter, down 8.1% from VALUATION the prior year. Interest expense rose from $13.6 million to EAT shares trade at 10.3-times our revised FY18 EPS $14.3 million. estimate and at 9.9-times our new FY19 estimate, versus a As discussed in a previous note, for all of FY17, revenue three-year historical range of 5-18. Based on prospects for decreased 3.3% to $3.1 billion, while earnings fell to $3.29 continued weak same-store sales and management's current from $3.58 in FY16. guidance, we believe that the shares are fairly valued. If comp sales recover more than we anticipate or food costs moderate EARNINGS & GROWTH ANALYSIS significantly, we would consider returning the stock to our In fiscal 2Q18, the restaurant-level margin missed our BUY list. estimate by 10 basis points, and fell 20 basis points to 14.9%. On February 1, HOLD-rated EAT closed at $36.94, up The margin deterioration reflected higher restaurant labor $0.60. (John Staszak, CFA, 2/1/18) 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 CA Inc (CA) over time. To further lower the cost of sales, management is Current Rating: BUY Publication Date: 2/7/18 spending $20 million on new fryers, which are expected to add 100 basis points to the restaurant-level margin. HIGHLIGHTS For FY18, reflecting the positive impact of tax reform, *CA: Better bookings trend; reiterating BUY and $40 management now projects EPS of $3.42-$3.52. It expects target same-store sales to be flat to 1.5% higher and full-year *CA Inc. posted 3% GAAP revenue growth in fiscal

Section 2.33 GROWTH / VALUE STOCKS

1Q18, the strongest quarterly top-line comparison (on a $1.09 billion, which was up 9% year-over-year (7% in year-over-year basis) in six years. constant currency) and 6% sequentially. Revenue topped the *CA's mainframe solutions business has benefited from $1.07 billion consensus forecast; management does not IBM's release of the (relatively) new z14 mainframe; although provide quarterly top-line guidance. Adjusted earnings of mainframe revenue was flat, earnings rose in the high single $0.75 per diluted share advanced 20% from the prior year and digits. were up $0.12 from fiscal 2Q18. The consensus had called for *In the enterprise space, CA has issued an extensive list 2Q18 non-GAAP earnings of $0.60 per diluted share. of new offerings and product enhancements. Across its By business segment, Enterprise Solutions (ES) revenue portfolio, CA is positioning itself 'as the preeminent partner of $461 million (42% of total) was up 19% on a GAAP basis for customers to build a Modern Software Factory.' and 16% in constant currency. ES revenue growth was driven *On revenue, bookings and profit growth, fiscal 3Q18 mainly by the Automic and Veracode acquisitions. CA demonstrated that CA is stabilizing its Mainframe Solutions incurred higher costs to support the strong top-line growth, business and growing its Enterprise business. causing ES profits to fall and margins to contract. The fiscal 3Q segment margin of 11.0% declined from 14.4% a year ANALYSIS earlier, but widened from 10.0% in 2Q18. The year-over-year INVESTMENT THESIS margin contraction had a positive side as it was driven by BUY-rated CA Inc. (NGS: CA) posted 3% GAAP higher commission costs related to an increase in sales. revenue growth in fiscal 1Q18, the strongest quarterly top-line Mainframe Solutions (MS) revenue of $552 million (51% comparison (on a year-over-year basis) in six years. of total) was up 1% on a GAAP basis and flat in constant Non-GAAP EPS rose a healthy 20% from the prior year, the currency. MS segment operating income advanced 8% first double-digit gain since 3Q14. year-over-year, while supporting rich margins of 65.0%; the CA has benefited in its mainframe solutions business margin growth was driven by a decrease in corporate from IBM's release of the (relatively) new z14 mainframe; overhead. CA has a dominant position in mainframe software although mainframe revenue was flat, earnings rose in the alongside IBM, which produces z systems (mainframe) and high single digits. In the enterprise space, CA has issued an supporting software. extensive list of new offerings and product enhancements. The (relatively) new z14 mainframe from IBM appears to Across its portfolio, CA is positioning itself 'as the preeminent be driving higher levels of activity in this business, which partner for customers to build a Modern Software Factory.' rarely posts a positive revenue comparison. Software Enterprise revenue was up a sharp 19% annually, although development will typically lag a new mainframe launch by profits declined on costs for new business development. one or more quarters. Given that IBM is recording strong After multiple quarters in which weak contract renewals system shipments for the z14, CA is confident about the caused overall bookings to decline significantly from the prior strength of the new hardware cycle. year, CA experienced a rebound in bookings in 3Q18 and a Services revenue (7% of total) increased 11% annually book-to-bill ratio above 1.0. Software bookings were (9% in constant currency) mainly driven by service revenue particularly strong; international bookings led on a regional from the Automic and Veracode acquisitions. This business, basis. In November 2017, the company had forecast a more which has typically operated at a loss, posted a positive 2.0% 'normalized' renewal opportunity in the second half of fiscal operating margin in 3Q18, aided by a decrease in personnel 2018; even so, 3Q18 bookings exceeded our expectations. costs. On revenue, bookings and profit growth, fiscal 3Q18 After multiple quarters in which weak contract renewals demonstrated that CA is stabilizing its Mainframe Solutions caused overall bookings to decline significantly from the prior business and growing its Enterprise business. We see room for year, CA experienced a rebound in bookings in 3Q18 and a further earnings growth in FY18, leading to a promising book-to-bill ratio in excess of 1.0. In the seasonally strongest FY19. We are reiterating our BUY rating on CA to a bookings quarter, total bookings of $1.13 billion, though 12-month target price of $40. down 10% annually, broke the weak first-half trend and increased 56% sequentially. The book-to-bill ratio was 1.03. RECENT DEVELOPMENTS Software bookings were particularly strong, with 61% CA shares are flat year-to-date in 2018, versus a 3% gain annual growth; that offset a 21% contraction in subscription & for peers. The shares rose 5% in 2017, while the peer group of maintenance bookings. In November 2017, the company had information processing, storage & computing services forecast a more 'normalized' renewal opportunity in the second companies in Argus coverage was up 17%. CA rose 11% in half of fiscal 2018; even so, 3Q18 bookings exceeded our 2016, approximately in line with the 12% gain for the peer expectations. group. CA shares declined 6% in 2015, better than the 16% The company reiterated its fiscal 2018 outlook calling for average decline for the peers. Since our launch of coverage on 5% GAAP revenue growth (4% in constant currency). Based July 8, 2013, CA shares are up about 20%, while providing an on more favorable tax guidance, CA boosted its non-GAAP above-market yield ranging from 3.0% to as much as 3.8%. EPS forecast, though GAAP earnings will be negatively For fiscal 3Q18 (calendar 4Q17), CA reported revenue of impacted by transitory effects of the new tax law.

Section 2.34 GROWTH / VALUE STOCKS

On revenue, bookings and profit growth, fiscal 3Q18 the dividend and share buybacks. demonstrated that CA is stabilizing its Mainframe Solutions business and growing its Enterprise business. We see room for MANAGEMENT & RISKS further earnings growth in FY18, leading to a promising Michael Gregoire has been CEO since January 2013. FY19. Kiernan McGrath has been appointed interim CFO, replacing Richard Beckert, who retired on July 26, 2016. Adam Elster, EARNINGS & GROWTH ANALYSIS formerly head of Global Sales, is now president of Global For fiscal 3Q18 (calendar 4Q17), CA reported revenue of Field Operations. $1.09 billion, which was up 9% year-over-year (7% in Amit Chatterjee became head of Enterprise in May 2014. constant currency) and 6% sequentially. Revenue topped the The July 2013 hiring of chief marketing officer Lauren $1.07 billion consensus forecast; management does not Flaherty, previously with Juniper and IBM, should aid in CA's provide quarterly top-line guidance. goal of revitalizing the CA brand and leveraging increased Adjusted earnings of $0.75 per diluted share advanced investment in R&D. The company has added Otto Berkes as 20% from the prior year and were up $0.12 from fiscal 2Q18. its chief technology officer, and Ayman Sayed as chief The consensus had modeled 2Q18 non-GAAP earnings of product officer. $0.60 per diluted share. CA faces risks from general weakness in the economy, For all of fiscal 2017, revenue of $4.04 billion was which could lead many customers to postpone or cancel approximately flat on a GAAP basis (up 1% in constant software upgrades. It also competes with some of the world's currency), compared to $4.03 billion in FY16. Full-year largest technology firms, including Oracle, IBM, and non-GAAP EPS came to $2.51, up 3% from $2.44 in FY16. Microsoft, and must continue to invest in new product This was the first year of revenue growth since FY12 and the development. first year of EPS growth since FY14. The company reiterated its fiscal 2018 outlook calling for COMPANY DESCRIPTION 5% GAAP revenue growth at the midpoint of the range (4% in CA Inc., a provider of enterprise information technology constant currency), to $4.22-$4.425 billion. Based on more management software, has three main business segments: favorable tax guidance, CA boosted its non-GAAP EPS Mainframe Solutions, Enterprise Solutions, and Services. outlook. It now projects 2018 non-GAAP EPS of $2.54-$2.60, CA's core business strengths are in IT management and up from a prior $2.42-$2.48. However, GAAP earnings will security products, and its largest clients include financial be negatively impacted by the transitory effects of the new tax services firms and government agencies. law. INDUSTRY Given the change in the effective tax rate as well as the We have raised our rating on the Technology sector to strong 3Q18 results, we are raising our FY18 non-GAAP Over-Weight from Market-Weight. Technology is showing earnings forecast to $2.58 per diluted share from $2.44. We clear investor momentum, topping the market in the are also boosting our FY19 forecast to $2.65 per diluted share year-to-date and trailing one-month and three-month periods. from $2.53. Our five-year EPS growth rate forecast is 8%. At the same time, the average two-year-forward EPS growth FINANCIAL STRENGTH & DIVIDEND rate exceeds our broad-market estimate and sector averages. Our financial strength rating on CA is Medium-High, the This has kept technology sector valuations from becoming too second-highest rank on our five-point scale. CA issued $750 rich, and resulted in PEG ratios that are below the median for million in new debt at favorable interest rates in 4Q17. The all sectors. company is adding to liquidity as it steps up its M&A activity. Over the long term, we expect the Tech sector to benefit Cash & equivalents and investments were $2.97 billion at from pervasive digitization across the economy, greater the end of 3Q18. Cash was $2.77 billion at the end of FY17, acceptance of transformative technologies, and the $2.81 billion at the end of FY16, and $2.80 billion at the end development of the Internet of Things (IoT). Healthy of FY15. company and sector fundamentals are also positive. For Debt was $2.79 billion at the end of 3Q18. Debt was individual companies, these include high cash levels, low $2.79 billion at the end of FY17, $1.95 billion at the end of debt, and broad international business exposure. FY16, and $1.26 billion at the end of FY15. CA's debt is rated In terms of performance, the sector rose 12.0% in 2016, investment grade by Moody's and S&P; both have stable above the market average, after rising 4.3% in 2015. The outlooks. sector is outperforming thus far in 2017, with a gain of 23.7%. CA pays a quarterly dividend of $0.255 per share, or Fundamentals for the Technology sector look reasonably $1.02 annually, for a yield of about 3.0%. The company has balanced. By our calculations, the P/E ratio on projected 2018 not changed the dividend since 2011. Our dividend estimates earnings is 17.5, above the market multiple of 17.1. Earnings are $1.02 for both FY18 and FY19. The dividend appears are expected to grow 14.8% in 2018 and 29.3% in 2017 secure and sustainable. In FY13- FY17, cash flow from following low single-digit growth in 2015-2016. The sector's operations covered the dividend by a factor of 2.0-3.0. debt ratios are below the market average, as is the average Management has said that cash flow is adequate to fund both dividend yield.

Section 2.35 GROWTH / VALUE STOCKS

strong growth ahead. Our target price, based on our multipart VALUATION valuation model, is now $185, raised from $155. CA shares are trading at 13.0-times our FY18 EPS forecast and at 12.7-times our FY19 forecast, compared to a RECENT DEVELOPMENTS five-year (FY13-FY17) average P/E of 11.0. Lower historical CAT shares have shown strength relative to the market P/E's date to the years in which CA's revenue was contracting, over the past quarter, rising 20% compared to a 9.8% gain in not growing as it is now. Within the software space, CA trades the S&P 500. Over the past year, the shares are up 70%, while at a discount to peers based on price/book, price/sales, and the market has advanced 24%. The shares have outperformed price/cash flow. the industry ETF IYJ over the past 12 months but have Our two- and three-stage dividend discount models point underperformed over the past five years. The beta on CAT is to a fair value for CA in the low $50s, in a stable trend. The 1.60. free cash flow yield is above the peer group average, On January 25, Caterpillar reported 4Q17 results that suggesting that the company could increase dividends and were up sharply from the prior year and ahead of consensus stock buybacks. We are not looking for a dividend hike, but forecasts. Sales of $12.9 billion rose a sequentially stronger we expect the company to continue its measured share 35% year-over-year, while operating margins improved 630 repurchase program while also investing in niche acquisitions. basis points to 12.8%, driven by volume gains and the We calculate a blended fair value for CA in the mid-$40s, company's aggressive restructuring program. Adjusted EPS of in a rising trend. Appreciation to our 12-month price target of $2.16 rose 160% from the prior year and topped the consensus $40, combined with the dividend yield of about 3.0%, implies forecast of $1.79. For the full year, CAT earned $6.88 per a potential risk-adjusted return in excess of our forecast return share, well ahead of management's guidance of $6.25. for the S&P 500, and is thus consistent with a BUY rating. Along with the 4Q results, Caterpillar provided guidance On February 6, BUY-rated CA closed at $33.70, up for 2018. The company projects adjusted EPS of $8.25-$9.25, $0.14. (Jim Kelleher, CFA, 2/6/18) including a 24% tax rate. Management noted that 'after four challenging years,' the company is beginning 2018 with 'strong sales momentum' Caterpillar Inc. (CAT) resulting from strong order rates, lean dealer inventories, and Current Rating: BUY Publication Date: 2/1/18 an increasing backlog. Caterpillar is preparing its factories and suppliers to be ready for continued growth. HIGHLIGHTS *CAT: Raising target price to $185 EARNINGS & GROWTH ANALYSIS *CAT shares have shown strength relative to the market Caterpillar has four primary segments: Construction over the past quarter, rising 20% compared to a 9.8% gain in Industries (approximately 40% of 4Q sales), Resource the S&P 500. Industries (17%), Energy & Transportation (36%) and *In its latest earnings report, management was optimistic Financial Products (6%). Fourth-quarter results and segment about the outlook. outlooks are summarized below. *We are boosting our 2018 adjusted EPS estimate to In Construction Industries, sales soared 47% -- ahead of $9.20 from $8.30 and expect continued growth in 2019. the 37% gain in 3Q -- due to higher volume and pricing. *Despite the recent share price advance from cycle lows, Operating profit grew 151% as the operating margin jumped the shares appear to offer value, and we see strong growth to 15.9% from 9.3%. Sales were higher across all regions. The ahead. recovery in this segment is underway. In Resource Industries, sales jumped 53% on higher ANALYSIS volume, and the segment once again rebounded from an INVESTMENT THESIS operating loss last year. The segment operating margin was Our rating on Caterpillar Inc. (NYSE: CAT) is BUY, as 9.5%. This segment is driven by trends in the mining sector. operating results continue to improve. Valuations also remain Commodity prices have bounced off multiyear lows in recent attractive, despite recent gains in the share price. This months, which is a positive sign. Demand for parts remains well-managed firm has a strong balance sheet and a focus on solid. We think the mining sector has moved past a trough, as returning capital to shareholders. The business is highly dealers are adding to inventories. But commodity prices will cyclical, and various commodity and currency trends are now need to stay at current levels. turning in the company's favor. Meanwhile, management has In the Energy & Transportation segment, operating profit been aggressively cutting costs. In recent conference calls, increased 38%. This was driven in part by a 22% increase in management has highlighted positive developments in its end sales, which accelerated from 12% growth in the prior quarter. markets. Moreover, on a macro basis, key commodity prices Sales increased in all businesses: Industrial, Oil and Gas, have begun to firm, which could lead to better results over the Power Generation and Transportation. The operating margin next several quarters. Despite the recent share price advance rose 210 basis points to 18.7%. Stable-to-higher oil prices from cycle lows, the shares appear to offer value, and we see should continue to support drilling and well-servicing in North America, improving the growth profile.

Section 2.36 GROWTH / VALUE STOCKS

In the Financial Products division, operating profit rose 3.6% in 2018. 6% due in part to an increase in rates in North America and Caterpillar's results are also sensitive to trends in the higher earning assets in EAME and Asia/Pacific. The dollar. Looking ahead, we think the greenback is fairly valued allowance for credit losses at the end of the year was 1.33% of and likely to move in a trading range, particularly if the finance receivables, compared to 1.29% at the end of 2016. Federal Reserve continues to slowly to raise short-term rates. Against the backdrop of challenging global markets in A stable or falling dollar would be a positive development for 2014-2016, management took steps to cut costs. In 2017 the Industrial sector and Caterpillar. restructuring costs totaled $1.256 billion due to the The company also has an underfunded pension plan. consolidation of manufacturing facilities in Europe and the U.S. Other costs are also likely to rise as business picks up. COMPANY DESCRIPTION Total worldwide employment rose 10% in 2017, to 116,700. Caterpillar is the world's leading manufacturer of Based on expectations for stable-to-higher commodity construction and mining equipment, diesel and natural gas prices, a favorable pricing environment, and higher volume, engines, industrial gas turbines, and diesel-electric aided by management's restructuring activities, we are raising locomotives. The company was founded in 1925. It is a our 2018 diluted adjusted EPS estimate to $9.20 from $8.30. component of the Dow Jones Industrial Average and the S&P Our estimate is near the high end of management's guidance 500 Index. range. We look for another recovery year in 2019, and are VALUATION implementing a preliminary EPS forecast of $10.55. We think that CAT shares are attractively valued at FINANCIAL STRENGTH & DIVIDEND current prices near $163. Caterpillar shares have traded We rate Caterpillar's financial strength as Medium-High, between $90 and $173 over the past 52 weeks, and are the second-highest point on our five-point scale. The company currently near the high end of the range. From a technical receives above-average scores on our key financial tests of standpoint, the shares had been in a bearish pattern of lower leverage, fixed-cost coverage, cash flow generation, and highs and lower lows that dated to the peak commodity-price profitability. period of June-July 2014. However, since bottoming below At the end of 2017, CAT's debt/capitalization ratio, $60 in late January 2016, they have been in a bullish pattern excluding the Financial Products division, was 57%. of higher highs and higher lows. Caterpillar had cash and equivalents of $8.2 billion at the end The shares tend to experience volatile swings to the of the year. We keep a close eye on inventories at CAT. In downside, and then recover. For example, on four occasions 4Q, inventories were up 16% from the end of 2016 and in the past 15 years, CAT shares have fallen at least 35% in a accounted for 13% of total assets, in line with recent trends. period of six months. On average during these downturns, the CAT pays a dividend. The current rate is $0.78 per shares have fallen 52% over a period of 14 months. The most quarter or $3.12 annually, for a yield of about 1.8%. The recent downswing lasted 22 months and saw the shares fall company has paid dividends since 1933. Our dividend 50%. The shares have now recovered well above the estimates are $3.24 for 2018 and $3.50 for 2019. preceding high of $110. Caterpillar also has a share repurchase plan. On the fundamentals, CAT shares are trading at 17.8-times our 2018 EPS forecast, compared to a 15-year RISKS annual average range of 13-25. On other metrics, the shares Caterpillar is undergoing a change in the executive suite, are trading at a trailing price/book multiple of 7.1, near the as Chairman and CEO Doug Oberhelman has retired after high end of the historical range of 2.5-7.5; and at a price/sales serving in those roles since 2010. The new CEO is Jim multiple of 2.1, at the high end of the range of 0.8-2.1. Umpleby, formerly a Caterpillar group president with Compared to the peer group, the shares offer a higher yield responsibility for Energy & Transportation. Mr. Umpleby has and a lower P/E. Our dividend discount model points to a fair worked for Caterpillar for 35 years. The new chairman is value above $200. Dave Calhoun, a Caterpillar board member and a senior Despite their recent run, the shares appear to offer value, managing director at Blackstone Group. and we see strong earnings growth ahead. We are raising our Caterpillar has a history of providing transparent results price target to $185. to investors. On January 31, BUY-rated CAT closed at $162.78, down The company faces a range of operational and financial $0.98. (John Eade, 1/31/18) risks, and its performance could be hurt by rising interest rates, unfavorable exchange rate movements, declining commodity prices, and weakness in the construction and Check Point Software Teches Lt (CHKP) mining industries. Current Rating: BUY Publication Date: 2/1/18 Caterpillar generates more than 50% of its revenue overseas and its results are typically linked to global economic HIGHLIGHTS trends, which are improving. Worldwide, we estimate that *CHKP: Mixed 4Q17; reiterating $124 target global GDP is rebounding from a 3.1% growth rate in 2016 to *Checkpoint posted 4Q sales and earnings in line with

Section 2.37 GROWTH / VALUE STOCKS management's guidance, while continuing to work on a both 4Q17 and 4Q16. GAAP EPS rose 11% to $1.46. turnaround of its U.S. business after a sales force Transactions above the $50,000 level accounted for 75% reorganization. Management expects two more quarters of of total order value, similar to 4Q16. Some 110 customers had sales execution issues in the U.S. transactions greater than $1 million in the fourth quarter, up *We are raising our 2018 EPS estimate to $5.83 from 11% from 4Q16. $5.78 and establishing a 2019 forecast of $6.54. For the full year, revenue rose 7% to $1.855 billion. *Our 2018 estimate is in the upper half of the company's Non-GAAP EPS rose 13% to $5.33 in 2017 from $4.72 in guidance range of $5.50-$5.90. Our long-term earnings 2016. growth rate forecast is 10%. *Due to the company's transition to a subscription-based EARNINGS & GROWTH ANALYSIS business model, more revenue is shifting into deferred We are raising our 2018 EPS estimate to $5.83 from revenue - leading to slower growth in reported revenue. $5.78 and establishing a 2019 forecast of $6.54. Management has noted that due to the company's transition to a ANALYSIS subscription-based business model, more revenue is shifting into deferred revenue. Our 2018 estimate is in the upper half INVESTMENT THESIS of the company's guidance range of $5.50-$5.90. Our We are maintaining our BUY rating on Check Point long-term earnings growth rate forecast is 10%. Software Technologies Ltd. (NGS: CHKP to a target price of To address the emerging IT security landscape, $124. We see Check Point as one of the few players in Checkpoint began significantly expanding its product internet security with both the technology and the development, sales, and marketing teams more than a year management stability needed to take advantage of an ago. The company has also been hiring additional 'feet on the increasingly toxic malware threat environment. We also street' in a sales force expansion. While this has led to some believe that Check Point's focus on unified advanced threat short-term sales execution issues in the U.S., management protection architecture and mobile services addresses the expects these to dissipate over the next few quarters as the needs of most companies, not just for the perimeter defense of new reps become more productive. Further, Checkpoint has IT networks but also for the detection and neutralization of strengthened its technological edge through the introduction advanced threats, including 'zero-day' attacks and the of new software and appliances designed to meet advanced emerging threat of 'ransomware.' cyber threats. R&D spending increased to more than 10% of We also note that Checkpoint has been accelerating revenue in 2017, up from 9.2% in 2015. Still, despite investment in new technologies through tuck-in acquisitions continued reports of new and more dangerous cyberattacks, and new product development in order to expand its lead in Checkpoint believes that most enterprises' internet security network security technology. Management also expects U.S. systems are at least two generations behind the attackers and sales to improve by the end of 2Q18 as execution issues are unequipped to handle next-generation cyber-security threats. resolved. Management sees this as an extraordinary market opportunity. RECENT DEVELOPMENTS In 2018, the company remains focused on expanding security Check Point reported fourth-quarter and full-year results applications related to cloud computing; mobile, including the for 2017 on January 31. Fourth-quarter revenue rose 4% emerging Internet of Things; and as usual, threat prevention. year-over-year to $506 million, just above the $505 million The company announced a new consolidated security midpoint of management's guidance range but below the architecture called Check Point Infinity on April 20, 2017 consensus of $508.5 million. Deferred revenue rose 11% to during its user conference. The company calls Check Point $1.187 billion. Management attributed the relatively weak Infinity 'the first consolidated security (platform) across sales to continued execution issues in the U.S. and expects networks, cloud and mobile, providing the highest level of these effects to continue in the near term. The sales execution threat prevention against both known and unknown targeted issues arose as the company reorganized its sales force and attacks.' However, we know that other security software placed new reps in key positions. It typically takes new reps a companies, including Symantec and Palo Alto (both under few quarters to ramp up productivity. On the positive side, Argus coverage), have been emphasizing integrated security Security Subscriptions revenue rose 18% as the company platforms for some time. Still, we think that Checkpoint's solid revised its product offerings. technology base, along with its focus on threat prevention and The 4Q non-GAAP operating margin expanded by 300 remediation management rather than simply on detection, basis points to 57.7%. However, management mentioned on provide a coherent value proposition to clients. Checkpoint the call that it expects full-year margins in the 53%-54% also introduced a host of other new security range. Non-GAAP EPS rose 8% year-over-year to $1.58, well applications/updates at its user conference. The company above management's guidance of $1.30-$1.40 and the refreshed its security appliance lines, and Check Point vSEC consensus of $1.51. Non-GAAP EPS excluded a $0.13 impact Cloud security updated its portfolio of private/public cloud from stock-based compensation in 4Q17 and 4Q16 and $0.02 security applications. Other introductions were a new for the amortization of intangibles and acquisition expenses in SandBlast mobile firewall and Check Point Anti-Ransomware

Section 2.38 GROWTH / VALUE STOCKS to address a growing security threat. Another downturn in global software investment Checkpoint has pinpointed two major threats to cyber spending would likely translate into a significant drop in the security. They are, first, attacks by next-generation malware CHKP share price. In addition, rapid technological changes that can be programmed and remotely controlled, and that can and shifts in the industry's competitive structure could affect disguise itself by morphing within a system; and, second, the the company's growth prospects. As with many enterprise vulnerability caused by the increase in mobile computing and technology companies, Checkpoint's results are seasonal, with the Internet of Things. Checkpoint has initiated its 'one step a large portion of revenue falling into the fourth (December) ahead' program to stay ahead of the curve on cyber threats. In quarter and a corresponding falloff in the first (March) 2015, it launched Mobile Threat Prevention security solutions quarter. The market could misread this revenue seasonality. with its trademarked SandBlast technology. Sandblast, an Check Point, which is headquartered in Israel, could also advanced sandbox solution that restricts files with unknown be adversely affected by geopolitical turmoil in the Middle malware, is combined with Checkpoint's proprietary East. CPU-level threat emulation technology. COMPANY DESCRIPTION FINANCIAL STRENGTH Check Point Software Technologies Ltd. creates and Our financial strength rating for Check Point is High, the markets internet security products for enterprises and high-end top of our five-point scale. Trailing 12-month free cash flow networks, internet service providers, small and medium-sized rose 16% to $1.04 billion. Management expects 2018 free businesses, and consumers. The company's perimeter security cash flow to be 'in line' with 2017, i.e., a little over $1 billion. products include virtual private network and firewall products, Check Point repurchases about $250 million of common security management products, and ZoneAlarm security suites stock per quarter. It bought back 9.5 million shares for $995 for consumers and small businesses. Check Point's revenue million in 2017. The share count has fallen 3% over the last base consists of subscription and perpetual software licenses, year. The company does not pay a dividend. product sales, subscription-based fees for updates, and maintenance and consulting fees. Incorporated in 1993, Check MANAGEMENT & RISKS Point has a global workforce and maintains headquarters in Risks to Check Point's growth include downturns in Tel Aviv, Israel. About 51% of the company's revenue is software investment spending; increased competition, derived from outside the U.S. including Microsoft's entry into IT security; and the company's ability to execute its business plans. Volatility in VALUATION CHKP shares may be affected by the company's ability to CHKP shares are trading below the midpoint of their meet financial expectations. 52-week range of $98-$119. The shares have risen 4% in the The market for software security is intensely competitive, last year, well below the 32% return for the Nasdaq and the with many large players (Cisco, Juniper, IBM, Microsoft, and 41% gain for the Nasdaq Computer Index. Checkpoint's Symantec) and smaller startups like Palo Alto Networks and enterprise value to trailing 12-month EBITDA multiple of 14 FireEye that offer competing solutions to Check Point. Cisco is near the peer median. The forward enterprise stepped up its security offerings with its acquisition of value/EBITDA multiple of 11.9 is 24% below the peer cyber-security firm Sourcefire for $2.7 billion in 2013. The average, greater than the average discount of 16% over the software security market is fast-changing, which requires past two years. As Checkpoint is a market leader, we believe it Check Point to continually update and upgrade its product deserves to trade at a premium. We are maintaining our BUY offerings to remain ahead of the curve. It is of utmost rating on CHKP with a target price of $124. importance to clients that the company's security software On January 31, BUY-rated CHKP closed at $103.41, solutions be designed to be both highly secure, i.e., without down $1.00. (Joseph Bonner, CFA, 1/31/18) 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 CME Group Inc (CME) elsewhere. Current Rating: BUY Publication Date: 2/1/18 Check Point carries significant client concentration risk. Most of its sales are through third-party distributors. In 2016, HIGHLIGHTS about 52% of the company's sales were generated by its top *CME: Lifting target to $174 as tax cuts boost outlook ten distributors; the top two distributors accounted for about *On February 1, CME reported adjusted 4Q17 earnings 37% of sales. of $1.12 per share, down from $1.14 in the prior-year period Check Point faces integration risk from recent and but $0.03 above consensus. potential future acquisitions. We judge the risk to be modest *After generally sluggish trading volume in 2017, since the company tends to acquire intellectual property that management noted that average daily trading volume has risen complements its existing technologies. The downside risk is 15% thus far in 2018. that the company could overpay for intellectual property or *Management projects an effective tax rate of 24.5% in find it less useful than expected. 2018, down from 35.0% in 2017. It also expects relatively flat

Section 2.39 GROWTH / VALUE STOCKS operating expenses this year. contract volumes with help from product additions. We *With operating margins near record highs, we believe believe that the revenue growth outlook remains healthy for that CME shares should trade at a premium to historic most CME products, which include derivative contracts valuation levels. related to interest rates, equities, foreign exchange, energy, agricultural commodities, and metals. We expect contract ANALYSIS volume to remain near recent highs as investors speculate or INVESTMENT THESIS hedge positions based on geopolitical developments, currency Our rating on CME Group Inc. (NGS: CME) remains volatility, and prospects for additional interest rate hikes. BUY following the company's 4Q results. Our target price is Indeed, 2018 volumes have started off much stronger than the $174, raised from $142 to reflect the expected earnings benefit 2017 run rate. We look for 8% revenue growth in 2018, up from a lower tax rate. CME Group is a futures and derivatives from 1% in 2017. exchange and clearing company offering risk management After surpassing $100 million in each quarter of 2016, products across six major asset classes. market data fees fell below that mark in all but the fourth Continued market volatility in most of these asset classes quarter of 2017. We expect some rebound in this line in 2018 should drive high contract volume, particularly in equity, as the company implements price increases in the second interest rate, energy and commodity products. Geopolitical quarter. developments that lead to portfolio repositioning, as well as Management projects relatively flat operating expenses in hedging and speculative activities, should also continue to 2018 as it continues to tightly manage costs. Compensation result in elevated trading volumes. Contract volume eased a costs have been well controlled at around 15%-16% of bit to 15.9 million in 4Q, although the company referenced a revenues. 15% improvement in volume through the end of January. We Management has guided toward an effective tax rate of expect revenue leverage in 2018 as the company holds 24.5% for 2018, down from 35.0% in 2017, following the operating expenses largely flat with 2017. recent passage of the Tax Cuts and Jobs Act. Reflecting this With operating margins near record highs, we believe that lower rate, we are raising our 2018 EPS estimate to $6.20 CME shares should trade at a premium to historic valuation from $5.37. We are also initiating a 2019 forecast of $6.68. levels. Our long-term EPS growth rate forecast is 8%.

RECENT DEVELOPMENTS FINANCIAL STRENGTH & DIVIDEND Over the past year, CME shares have risen 28%, versus a Our financial strength rating on CME Group is High, the 24% increase in the broad market. highest point on our five-point scale. The company scores On February 1, CME reported adjusted 4Q17 earnings of above average on important financial criteria such as debt $1.12 per share, down from $1.14 in the prior-year period but levels, interest coverage, and profitability. $0.03 ahead of consensus. The adjusted results exclude a net CME had $1.9 billion in cash and cash equivalents and $7.51 per share of nonrecurring gains, mainly related to a $2.2 billion in debt as of December 31, 2017. The reduction in deferred tax liabilities following the passage of debt/shareholders' equity ratio at that time was 10.0%. The the new tax law. operating income/interest coverage ratio was a robust 18.5 in Fourth-quarter revenue declined 1.4% to $900 million, 4Q17 and the operating margin was a healthy 60%. with lower clearing outweighing higher market data revenue. In March 2017, the company raised its quarterly dividend Average daily contract volume fell 2.5% to 15.9 million. by 10% to $0.66, or $2.64 annually, for a yield of about 1.7%. Adjusted operating expenses rose less than 1%, as higher The company has a strong record of increasing its payout. The compensation costs were offset by lower professional fees and payout ratio on projected 2018 earnings is 48%. Management outside services, while adjusted net income declined 1.1% to is committed to returning excess capital to shareholders, and $383.0 million. we expect a payout ratio in the low to mid-50s over the next For all of 2017, revenues rose 1.4%, while adjusted EPS several years. Our dividend estimates are $3.00 for 2018 and climbed to $4.77 from $4.53. $3.20 for 2019. The company also occasionally pays an annual special EARNINGS & GROWTH ANALYSIS dividend based on operating results, potential merger and Revenue growth for CME is mainly driven by increases acquisition activity, and other forms of capital return, in average daily contract volume (ADV), a measure of the including regular dividends and share buybacks. It paid a average number of contracts traded and/or cleared in a day, $3.25 per share special dividend in January 2017. and by growth in the rate per contract (RPC), the average transaction and clearing fee generated from a contract. MANAGEMENT & RISKS Average contract volume was down 2.5% in 4Q, with Terry Duffy became chairman and CEO at the end of weakness in interest rate and equity products partly offset by 2016 following the retirement of Phupinder Gill. Mr. Duffy strength in foreign exchange products. Despite sluggish had been president of CME Group since 2012. Bryan Durkin, trading activity in 2017, CME was able to grow overall previously chief commercial officer, was named president as part of the transition.

Section 2.40 GROWTH / VALUE STOCKS

Management's growth strategy focuses on new product year-over-year. development, new customer acquisition, and global *Despite the currency headwind, the Display business expansion. In our view, management has done a good job of continues to benefit from less onerous price declines. launching new products that respond to regulatory changes. It Environmental is being helped by global growth positively also provides helpful financial guidance to the investment impacting the North American trucking industry. community. *Corning has returned over $9.0 billion to shareholders Price competition is a key risk for CME. Key exchange via buybacks and dividends within a larger plan to return competitors include Intercontinental Exchange, Hong Kong $12.5 billion by 2019. Exchanges and Clearing, and the Eurex Group. The *Although GLW is ahead of peers and the market over company's clearing operations also face increasingly stiff the past 12 months, we believe the shares remain attractively competition due to the implementation of Dodd-Frank. Many valued given a multiyear period of underperformance and exchanges, such as ICE, have their own clearing houses. growth prospects ahead. Other clearing houses include Depository Trust & Clearing Corp. ANALYSIS New regulations and regulatory uncertainty also pose INVESTMENT THESIS risks for CME. The company is subject to regulation by the BUY-rated Corning Inc. (NYSE: GLW) posted solid CFTC in the U.S. as well as by overseas regulators. Other results for 4Q17, led by now familiar strength in Gorilla Glass risks include market weakness in Europe, cyber security and Optical Communications. Despite the currency headwind threats, and legal and counterparty risks. related to yen strength, the Display business continues to COMPANY DESCRIPTION benefit from less onerous price declines. Among the smaller CME Group is a futures and derivatives exchange and units, Environmental is being helped by global growth clearing company. It operates exchanges such as the Chicago positively impacting the trucking industry, while Life Mercantile Exchange (CME), Chicago Board of Trade Sciences grew in high single digits for 4Q17. (CBOT), New York Mercantile Exchange (NYMEX), Corning's leadership priorities through 2019 are to focus Commodity Exchange (COMEX) and the Kansas City Board the portfolio of assets and utilize financial strength. This of Trade (KCBT). In addition, CME offers a range of market includes enhancing five market access portfolios while data and information services. CME shares are a component deploying $26-$30 billion in cash through 2019. The company of the S&P 500. has generally maintained its strategy across the market access portfolios, while tweaking its goals. Corning is expanding the VALUATION opportunity set in automotive, environmental and life CME shares have traded in a range of $115-$158 over the sciences. past 52 weeks, and are currently at the high end of that range. In a generally rising environment for technology shares, We approach valuation from a few angles. CME's P/E GLW topped $32.60 late in 2017 before backing down amid ratio of 25.0-times our revised 2018 EPS estimate is above the profit-taking in technology shares. Given a multiyear period midpoint of the historical range of 9-27. However, based on of underperformance, we believe the shares remain favorable operating metrics and a healthy industry attractively valued. The tighter focus on core operations, environment, we believe that the shares merit a higher leadership in optical and Gorilla, signs of improving growth in multiple. Compared to the peer group, CME shares trade at a the smaller businesses, and stabilizing trends in display premium P/E, which we think is warranted based on the highlight GLW's positive prospects. We are reiterating our company's above-peer-average (and generally expanding) BUY rating to a 12-month target price of $36. operating margins above 60%. Our target price of $174, raised from $142, implies a multiple of 28-times our 2018 EPS RECENT DEVELOPMENTS estimate. A recurring annual dividend adds to the total return GLW shares are up 1% year-to-date, versus a 2% gain for potential. the peer group of Argus-covered Communications Equipment On February 1 at midday, BUY-rated CME traded at companies. That follows a strong 2017 for GLW, in which the $157.92, up $4.44. (Stephen Biggar, 2/1/18) 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 Corning Inc (GLW) 2013. Current Rating: BUY Publication Date: 2/1/18 For 4Q17, Corning reported core (non-GAAP, HIGHLIGHTS currency-adjusted) revenue of $2.74 billion, which was up 7% *GLW: Solid finish to 2017; reiterating BUY annually; and above the $2.65 billion consensus forecast. *Corning posted solid results for 4Q17. Core revenue and Non-GAAP EPS of $0.49 per diluted share for 4Q17 was EPS were impacted by unfavorable currency movements and down 2% year-over-year and was $0.02 above consensus investments in future growth, and non-GAAP EPS dipped 2% expectations.

Section 2.41 GROWTH / VALUE STOCKS

More so than many technology companies, Corning uses Display prices have declined less in every year since the year-end quarter to advance and refine its business model 2014, and were in high single digit in 2017. For 2018, and financial structure for the years ahead. Corning's strategy Corning expects mid-single-digit price declines, with three and priorities are generally intact from earlier in the year, factors driving the positive trend. Glass supply is balanced although there have been slight emphasis shifts in several with demand, and in some places tight. Corning's Gen 10.5 market access platforms, including Environmental and Life plant supports expected growth of large-sized TVs and Sciences. The opportunity set in Automotive has also been produces in cooperation with a major customer. Below gen expanded. 10.5, demand continues to grow and capacity additions are not Broadly speaking, Corning's leadership priorities through keeping up. 2019 are to focus the portfolio of assets and to utilize financial The second factor is that competitors are unprofitable at strength. This includes enhancing five market access current prices, and will have to slow their price declines to portfolios while deploying $26-$30 billion in cash through survive. Finally, customers recognize that LCD manufacturing 2019. requires investments that must be paid for with rational glass In terms of focusing the portfolio across the company's pricing. Also for 2018, Corning forecasts LCD market glass five market access platforms, Corning believes Optical volume to grow mid-single-digits, mainly tracking higher Communications can be a $5 billion annual revenue business average TV screen size. Corning expects its volumes to grow by 2020. In the mobile consumer electronics platform, the faster than the market in 2018. goal is to double sales in coming years, led by Gorilla Glass. In 2017, Optical Communications (OC) reclaimed the In automotive, Corning seeks to build a $500 million GPF mantle as Corning's largest business by revenue contribution. (gasoline particulate filter) while pushing into display and OC revenue of $928 million for 4Q17 was up 13% annually tough window glass. In Display, the goal remains stabilizing and at its highest level since 3Q01 (immediately before this returns while winning in new display categories. And in Life business was cut in half by the internet implosion and 9/11). Sciences, Corning seeks to build out its pharmaceutical OC segment profits of $84 million, however, backed down packaging business while growing faster than markets served. 6% annually and also sequentially from $111 million in 3Q17 In terms of utilizing financial strength, Corning plans to as the company invested to support growth in 2018 and return $12.5 billion to shareholders through 2019 via share beyond. Corning added new fiber and cable capacity and new buybacks and a dividend increase of at least 10% annually. products for Saudi Telecom. During 2017, OC sales to carrier The company will also invest approximately $10 billion in the customers (77% of OC revenue) rose 20%, while sales to business in order to enhance growth and sustain leadership. enterprise and data center customers were up 13%. Within its Strategy and Capital Allocation Framework, since For 2018, Corning is modeling low double-digit revenue October 2015 Corning has returned over $9 billion to growth excluding any contribution from the pending shareholders while investing $4.5 billion in R&D, capital acquisition of 3M's communications market division; this spending, and M&A. Corning will also maintain a ratio of business will add $200 million in annual sales, be neutral to target debt/EBITDA of about 2.0. 2028 core earnings, and be accretive thereafter. Management During 4Q17, on a core basis, Corning posted expects OC profitability to rise through the course of 2018 as double-digit annual growth in three businesses - Optical the division ramps to meet committed customer demand. Communications, Environmental, and Specialty Materials - Management has pledged to attain $5 billion in annual sales and high single-digit growth in Life Sciences. Only the for its optical communications market-access platform by display business declined annually. Operating profit improved 2020. in double digits in Environmental, Life Sciences, and For 4Q17, Specialty Materials (SM) again posted all-time Specialty Materials. high revenue and profits. Sales of $393 million increased 17% At the segment level and on a core basis, Display annually, while profits of $73 million increased 12%. SM technology core revenue of $847 million was down 6% operating margin was 18.6%, down from 19.3% a year earlier. annually. Display net profit of $221 million declined 20% Full-year 2017 sales growth for SM rose 25%, and annual annually; margin compressed to 26.1% in 4Q17 from 30.5% a profits rose 32%. year earlier. SM sales and profit growth in 4Q17 was driven by strong Display volumes were up slightly on a sequential basis, in shipments of Gorilla Glass 5th generation tough cover glass to line with market growth and ahead of internal expectations. support multiple new smartphone launches. Although the Volume growth in this business has historically been driven holiday season is over, positive trends should continue and by larger screen sizes, which is helping offset the shrinking management forecasts further growth for 2018; as always, the pace of notebook and (in particular) desktop PC sales. magnitude of growth is dependent on new OEM product Corning's display business confronts a relentless launches and consumer acceptance. reduction in display glass pricing, although downtrend Corning's two smaller businesses, Environmental and Life moderated in the past year. Display pricing in 4Q17continued Sciences, surprised with high-single- to low-double-digit its moderating trend, declining less on a sequential basis than growth in 4Q17. Environmental revenue (11% of total) in 3Q17. improved 19%, representing the best quarterly growth for the

Section 2.42 GROWTH / VALUE STOCKS

2017 year, as the North American heavy duty diesel market non-operating expense of about $200 million; Core equity continues to improve. Environmental segment profits grew income of $200 million; and core tax rate is forecast at 20% 33%. -22%. Life sciences revenue (8% of total) rose 9% in 4Q17, Principally on the higher tax rate, we are reducing our while core profits were up 18%. For 2018, revenue for both 2018 core earnings forecast to $1.82 per diluted share, from Environmental and Life Sciences is expected up in $1.98. We are initiating a 2019 core EPS forecast of $1.93 per high-single-digits for the year. diluted share. Our long-term earnings growth rate forecast is The display glass business is primarily conducted in 10%. Japanese yen, not dollars, and is influenced by movements in the yen and the Korean Won (KRW). Corning employs FINANCIAL STRENGTH & DIVIDEND translation hedges to add more certainty to earnings and cash Our financial strength rating for Corning is flow while protecting against adverse currency swings. Hedge Medium-High, the second-highest rank on our five-point contracts settled in any quarter substantially offset the change scale. The Dow Corning transaction added $4.8 billion to the in Display earnings and cash flow related to currency balance sheet. Corning also reduced cash with aggressive movements. Corning is adjusting its constant currency rates buybacks. In October 2015, Corning announced a new capital for 2018-2020 to yen 107 and KRW 1,175 to align with the allocation plan. The plan proposed returning $10 billion to company's economic exposure. shareholders and investing $10 billion in the business into For 2018, Corning is modeling core sales growth of 7%, 2020. Following the Dow Corning deal close, Corning raised to about $11 billion. Core gross margin for the year is forecast its shareholder return target to more than $12.5 billion by sequentially stable with the 41.3% level from 2017; core 2019. operating costs should be about $2.2 billion; and the core tax Cash & investments were $4.3 billion at year-end 2017. rate is forecast at 20%-22%. According to our model, that Cash & investments were $5.2 billion at year-end 2016, down supports mid- to upper-single-digit percentage EPS growth, from $7.1 billion at the end of 2Q16 following a $2 billion despite ongoing investments in the business and the declining accelerated stock repurchase executed in summer 2016. price trend in display glass. Before the infusion from the Dow Corning transaction, cash In a generally rising environment for technology shares, was $3.54 billion at the end of 1Q16. Cash at the end of 1Q16 GLW topped $32.60 late in 2017 before backing down amid was reduced by more than $2 billion in share repurchases profit-taking in technology shares. Given a multiyear period under the revised capital allocation plan. Cash & investments of underperformance, we believe the shares remain were $4.6 billion at the end of 2015, $6.1 billion at the end of attractively valued. The tighter focus on core operations, 2014, and $5.23 billion at the end of 2013. leadership in optical and Gorilla, signs of improving growth in Debt was $5.13 billion at year-end 2017. Debt was $3.90 the smaller businesses, and stabilizing trends in display billion at year-end 2016. Debt/cap was 23.5 % at 3Q17. highlight GLW's positive prospects. We are reiterating our Debt/cap was 20.0 % at year-end 2016, down from 22.1% at BUY rating to a 12-month target price of $36. 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. EARNINGS & GROWTH ANALYSIS Net debt was $811 million at year-end 2017. Net cash For 4Q17, Corning reported core (non-GAAP, was $1.39 billion at year-end 2016, reduced from $2.95 currency-adjusted) revenue of $2.74 billion, which was up 7% billion at the end of 2Q16. Net cash was $118 million at the annually; and above the $2.65 billion consensus forecast. Core end of 2015, $2.42 billion at the end of 2014, and $1.96 or non-GAAP gross margin was 41.0% for 4Q17 versus billion at the end of 2013. 42.0% for 3Q17 and 40.0% a year earlier. Cash flow from operations was $2.00 billion for 2017. The core operating margin was 18.7% for 4Q17, down Cash flow from operations was $2.50 billion in 2016, $2.81 from 20.4% for 3Q17 and 23.1% a year earlier. Non-GAAP billion in 2015, $4.71 billion in 2014, and $2.8 billion in EPS of $0.49 per diluted share for 4Q17 was down 2% 2013; 2014 included a $1.4 billion currency hedge gain. year-over-year and was $0.02 above consensus expectations. In October 2015, within its multiyear capital allocation Corning posted a GAAP loss of $1.45 per share, reflecting a plan, Corning's board authorized a new $4 billion buyback one-time $1.4 billion tax charge. program. The company executed an accelerated $1.25 billion For all of 2017, Corning's core revenue of $10.51 billion buyback in 4Q15, spent $750 million to repurchase shares in increased 8% from $9.71 billion for 2016. Non-GAAP core 1Q16, and spent $810 million to buy shares in 2Q16. On earnings totaled $1.72 per diluted share for 2017, up 10% 7/27/16, Corning announced and then executed an additional from $1.57 per diluted share for 2016. accelerated $2 billion buyback. The buyback will largely Corning provides directional rather than explicit offset the EPS impact from the loss of Dow Corning equity guidance. For 2018, Corning is modeling core sales growth of earnings. 7% to about $11 billion. Core gross margin for the year is Corning has pledged to raise the dividend by at least 10% forecast sequentially stable with the 41.3% level from 2017; annually through 2019. In February 2017, it raised its core operating costs should be about $2.2 billion; net quarterly dividend 14.8% to $0.155. Corning previously

Section 2.43 GROWTH / VALUE STOCKS raised its dividend to $0.135 per common share in February two-year-forward EPS growth rate exceeds our broad-market 2016, to $0.12 per share in December 2015, to $0.10 in April estimate and sector averages, which has kept technology 2013, and to $0.09 in October 2012. Corning had paid a sector PEG valuations from becoming too rich. quarterly dividend for much of its 150-year history before Over the long term, we expect the Tech sector to benefit suspending the payment in July 2001. from pervasive digitization across the economy, greater Reflecting management's capital allocation guidance and acceptance of transformative technologies, and the the February 2017 hike, our annual dividend forecasts are development of the Internet of Things (IoT). Healthy $0.70 for 2018 and $0.78 for 2019. company and sector fundamentals are also positive. For individual companies, these include high cash levels, low MANAGEMENT & RISKS debt, and broad international business exposure. Wendell Weeks is the highly regarded chairman and CEO In terms of performance, the sector rose 12.0% in 2016, of Corning. CFO Jim Flaws retired in November 2015 after above the market average, after rising 4.3% in 2015. It more than 40 years with the company. Tony Tripeny is CFO. strongly outperformed in 2017, with a gain of 36.9%. Corning's division leaders report directly to CEO Weeks. Fundamentals for the Technology sector look reasonably The entire executive team is well regarded by investors and balanced. By our calculations, the P/E ratio on projected 2018 industry participants. James Clappin is president of Corning earnings is 19.0, above the market multiple of 18.2. Earnings Glass Technologies. Richard Eglan is VP and general are expected to grow 19.5% in 2018 and 30.3% in 2017 manager of the Life Sciences business. Mark Beck leads the following low single-digit growth in 2015-2016. The sector's Environmental Technologies segment. debt ratios are below the market average, as is the average Corning's exit from Dow Corning makes strategic sense. dividend yield. The deal allows Corning to end exposure to a noncore business, while significantly enhancing balance sheet cash for VALUATION future strategic actions. GLW is trading at 17.8-times our 2018 non-GAAP core We also believe the buyout of SCP was a sound move. EPS estimate and at 16.8-times our 2019 forecast; the Corning will now have more direct exposure to the coming five-year (2013-2017) historical average P/E is 14.0. In a wave of low-cost Chinese display glass producers. However, rising market, relative P/E of 0.94-times remains reasonably Corning is experiencing strong demand in its role as market close with historical relative P/E multiples in the 0.82 range. leader. GLW trades at a discount to peers on absolute P/E, relative A key risk is the uneven demand for flat-panel televisions P/E and on EV/EBITDA. Overall comparable historical from quarter to quarter. The company has managed through valuation points to a fair value near $30, in a rising trend such a period and now expects improving demand. Lesser though below current prices. risks include the threat of competitive inroads; Nippon Our discounted free cash flow model now renders a value Electric Glass is now producing bulk quantities of for GLW in the high-$60s, in a rising trend. Corning's major generation-5 glass. For the telecom business, risks include a capital expenditures (glass tanks) have largely been further contraction in carrier capital spending after some completed, supporting ongoing cash flow strength. modest signs of recovery. On a blended basis, we calculate a fair value in the upper Both in display and telecom, demand risks are mitigated $50s, in a rising trend. Appreciation to our 12-month target by Corning's proprietary technology, low-cost operations, and price of $36 along with the indicated dividend yield of about well-established relationships with leading customers. While 1.9%, implies a risk-adjusted total return of about 15%, which global demand for LCD sets may soften for a few quarters, we exceeds our forecast for the broad market and is thus do not anticipate a multiyear collapse in global demand, as consistent with a BUY rating. occurred in telecom in 2000-2002. On January 31, BUY-rated GLW closed at $31.22, down $1.11. (Jim Kelleher, CFA, 1/31/18) COMPANY DESCRIPTION Corning Inc. is the leading global supplier of precision glass for liquid crystal displays, and a leader in the Danaher Corp (DHR) manufacture and sale of optical fiber and cable. It participates Current Rating: BUY Publication Date: 2/1/18 in the environmental business, with a focus on emission substrates for gasoline and diesel engines, and is also active in HIGHLIGHTS the life sciences business. Specialty Materials operations *DHR: Raising target price to $115 produce Gorilla Glass, the fast-growing, tough-cover glass *DHR shares have performed in line with the market over used in smartphones and tablets. the past quarter, rising 10%. *On January 30, the company reported 4Q results that INDUSTRY rose from the prior year and topped analyst expectations. Our rating on the Technology sector is Over-Weight. *Management has a history of double-digit dividend Technology is showing clear investor momentum, topping the growth, and we expect an increase in the payout in the next market in the year-to-date. At the same time, the average few weeks.

Section 2.44 GROWTH / VALUE STOCKS

*Our target price of $115 assumes a P/E of 23-times our In 2017, Danaher deployed nearly $400 million of capital on 2019 earnings estimate, within the normal historical range. 10 strategic bolt-on acquisitions. CEO Thomas Joyce commented on the 4Q conference call that he remains ANALYSIS encouraged by recent larger acquisitions (Cepheid, INVESTMENT THESIS Phenomenex, Pall) and that Danaher is well-positioned 'for a Our rating on Danaher Corp. (NYSE: DHR) is BUY. This more significant capital deployment in 2018.' On the 3Q call, leading blue-chip industrial company appears poised to he noted that Danaher values the high gross margins in the deliver mid-single-digit core sales growth, which, along with consumable portions of its markets. acquisitions and margin expansion, has the potential to drive EARNINGS & GROWTH ANALYSIS low double-digit earnings growth over time. Danaher typically Danaher operates four business segments: Life Sciences pursues acquisitions in niche markets with little competition, (31% of sales), which provides filtration, separation and and drives improvement in operational efficiency and product purification technologies to the pharma/biotech, government, quality through its 'Danaher Business System.' We believe the clinical and hospital research businesses; Diagnostics (31%), coming years will present a favorable environment for which provides pathology support services, molecular acquisitions, and expect Danaher to continue to streamline diagnostics, blood sample testing and other services; Dental operations and boost margins at acquired companies. The (15%) and Environmental & Applied Solutions (22%). Each is company recently completed the transformative acquisition of expected to contribute to revenue and earnings growth. Pall Corp., and has now separated into two independent Fourth-quarter results and outlooks by segment are companies. The new Danaher is focused on Med-Tech summarized below. businesses. Since the split, management has gotten back to The Life Sciences segment has about 13% of a $40 making new deals and the outlook is positive. Our revised billion market. Danaher's 2015 acquisition of Pall Corp. has target price of $115, raised from $100, implies a multiple of spurred growth in this business. In the Life Sciences segment, 23-times our 2019 EPS estimate, still within the normal core revenue rose a sequentially stronger 7.5% in 4Q. The historical range for this well-managed company. We think the core operating margin increased 305 basis points to 20% as DHR shares are a suitable core holding in a diversified management more deeply integrated the operations acquired portfolio. through the Pall transaction. Management noted strong growth RECENT DEVELOPMENTS in Western Europe and in China, as the government invests in DHR shares have performed in line with the market over healthcare. For 2018, we look for mid-single-digit sales the past quarter, rising 10%. Over the past year, the shares growth, driven by new products, along with further margin have underperformed the market (21% versus 24%), as well as expansion. the industry ETF IYJ (27%). Over longer periods - 5 and 10 Diagnostics has about a 14% share of a $35 billion years - DHR has outperformed the market and the industry by market supporting hospital labs, reference labs and hospital wide margins. The beta on DHR shares is 0.98. critical care facilities. In 4Q, core revenue rose 6.0%, while The company is emerging from a transformative period. overall revenue rose 13.5% due to the Cepheid acquisition. On July 5, 2016, Danaher split into two companies, the The core operating margin rose 105 basis points. Management ongoing Danaher and the new Fortive (NYSE: FTV). Fortive commented that China was again a growth market in the is an industrial growth company comprised of Danaher's fourth quarter. For 2018, we look for mid-single-digit sales former Professional Instrumentation and Industrial growth and margin improvement in this segment as Technologies businesses. Danaher is now more focused on management applies the Danaher Business System to the medical technology. acquired Cepheid assets. On January 30, the company reported 4Q results that rose Core sales in the Dental segment declined 0.5%, with from the prior year and topped analyst expectations. For the growth in specialty consumables and implants offset by quarter, overall revenue, including acquisitions, grew 11%, persistent weakness in traditional consumables. The core and organic revenue grew a sequentially stronger 5.5% to $5.1 operating margin declined 100 basis points to 13.1%. billion. The operating profit margin rose 105 basis points on a Management is focused on profit improvement in this group. core basis to 18.6%, and adjusted diluted EPS increased 13% We look for flat revenue but better margins in 2018. to $1.19. This was above the high end of management's The Environmental & Applied Solutions segment has two guidance range and the consensus forecast of $1.16. For the major businesses: Water Quality and Product Identification. full year, the company earned $4.03 per share, up 12% over Both of these businesses are experiencing increased demand, the prior year. as municipalities and businesses focus on water monitoring Along with the 4Q results, management provided and disposal, and corporations focus on brand consistency and guidance for 2018. Management's EPS target range for 2018 product safety. Revenue in the Environmental and Applied is $4.25-$4.35. For the first quarter, management expects EPS Solutions segment rose 6.0% on a core basis, driven by solid of $0.90-$0.93. sales of water quality platforms and coding equipment. The The company employs a growth-by-acquisition strategy. core operating margin declined 50 basis points to 23.1% due

Section 2.45 GROWTH / VALUE STOCKS to acquisition integration expenses. For 2018, we look for low Danaher is a diversified Med-Tech company with global single-digit sales growth and for margins to stabilize. operations. It recently spun off its industrial growth businesses Turning to our estimates, we are raising our 2018 EPS into a new company called Fortive. DHR shares are a estimate to $4.38 from $4.36, just above management's component of the S&P 500. guidance range, based on expectations for mid-single-digit sales growth and margin improvement. We are also expecting VALUATION growth in 2019 and are establishing a preliminary EPS DHR shares appear attractively valued at current prices estimate of $4.78. Our five-year earnings growth rate forecast near $100, near the high end of their 52-week range of is 12%. $78-$104. On a technical basis, the shares have been in a long-term positive trend of higher highs and higher lows that FINANCIAL STRENGTH & DIVIDEND dates to August 2010. Our financial strength rating on DHR is Medium-High, To value the stock on a fundamental basis, we use peer the second-highest rank on our five-point scale. The company and historical multiple comparisons, as well as a dividend receives above-average marks on our four main criteria of discount model. DHR shares are trading at 23-times projected debt levels, fixed-cost coverage, cash flow generation, and 2018 earnings, near the high end of the historical range of profitability. Danaher stands out among the peer group for its 17-24. On a price/sales basis, the shares are trading near the consistently high free cash flow conversion ratio. The top of the five-year range. The dividend yield of about 0.6% is company has a 26-year record of generating more free cash at the low end of the five-year range. Compared to the peer flow than net income, for a ratio greater than 100%. group, the DHR shares are priced at a premium. We think Danaher has a share buyback program, though shares these multiples are justified given the company's growth outstanding were up 1.1% year-over-year at the end of 3Q. record and clean balance sheet. Reflecting the company's Danaher pays a quarterly dividend. In February 2017, the strong free cash flow growth, our DCF model points to a company raised its quarterly payout by 12% to $0.14 per value for DHR near $120 per share. We are reiterating our share, or $0.56 annually, for a yield of about 0.6%. Our BUY rating. Our revised target price of $115, raised from dividend estimates are $0.64 for 2018 and $0.74 for 2019. $100, implies a multiple of 23-times our 2019 EPS estimate, still within the normal historical range for this well-managed MANAGEMENT & RISKS company. In our view, Danaher is one of the best-run industrial On January 31, BUY-rated DHR closed at $101.28, down conglomerates, consistently identifying acquisition targets in $0.32. (John Eade, 1/31/18) 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 Facebook Inc (FB) since 2001. CEO Joyce is a 25-year veteran of Danaher. Current Rating: BUY Publication Date: 2/2/18 Management's long-term strategy of growing through acquisitions has resulted in mid-teens annualized EPS growth HIGHLIGHTS over the past five years. In keeping with its long experience in *FB: Raising target price by $22 to $237 business development, the company has generally paid fair *Facebook's strong 4Q17 was overshadowed by prices for acquisitions and has generated the returns that it management's proactive steps to enhance user interaction, expected. In this way, DHR has been able to minimize possibly at the expense of short-term company profit. write-downs of goodwill and intangibles. *Facebook for the first time reported a 5% decline in time There are risks to owning DHR shares. spent on the site and a 700,000 decline daily active users in A global company, Danaher's results are typically linked the U.S. and Canada in 4Q17. to global economic trends, which are not always positive. In *While the decline in user metrics could give some 4Q, China and India led the way for growth, while conditions investors pause, we believe that making user engagement improved in the US and Western Europe. Global GDP growth more relevant could actually increase the value of time spent is expected to reach 3.6% in 2018, up from 3.5% growth in on its sites, thereby increasing advertising rates and revenue. 2017. *We are raising our 2018 EPS estimate to $8.61 from DHR is also sensitive to trends in the dollar. A stable or $7.38 and establishing a 2019 forecast of $10.45. falling dollar would be a positive development for the Industrial sector and Danaher. ANALYSIS The bear case against Danaher always includes the point INVESTMENT THESIS that the company faces integration risks emanating from its We are maintaining our BUY rating on Facebook Inc. growth-by-acquisition strategy. A step-back in bottom-line (NGM: FB) and raising our target price to $237. Facebook's growth earlier in 2017 led to a brief period of strong 4Q17 was overshadowed by management's proactive underperformance. steps to enhance user interaction, possibly at the expense of COMPANY DESCRIPTION short-term company profit. While the decline in user metrics

Section 2.46 GROWTH / VALUE STOCKS could give some investors pause, we believe that making user daily active users (DAU's) so even a small decline is engagement more relevant could actually increase the value of magnified. CFO Dave Wehner pointed out that the company time spent on its sites, thereby increasing advertising rates and had for the first time actually lost 700,000 DAU's in the U.S. revenue. and Canada in 4Q17. He stressed that management did not We think that Facebook is well positioned to take identify the loss as the beginning of a trend though DAU's advantage of the ongoing movement of audiences and could 'fluctuate' going forward due to the high penetration advertisers to mobile digital video. Facebook also continues to rates in the U.S. and Canada. post double-digit growth in its user base and average revenue per user, a remarkable feat for a company this size. EARNINGS & GROWTH ANALYSIS In our view, Facebook's valuation metrics do not We are raising our 2018 EPS estimate to $8.61 from adequately reflect the company's status as an industry leader. $7.38 and establishing a 2019 forecast of $10.45. Our estimates imply 22% average annual earnings growth over the RECENT DEVELOPMENTS next two years. Our long-term earnings growth rate forecast is Facebook posted strong 4Q17 and full-year results after 24%. the close on January 31, beating the consensus EPS estimate CEO Mark Zuckerberg's visionary goal for Facebook has by $0.13 and consensus revenue forecast by $424 million. morphed just a little from the original idea - to 'connect Fourth-quarter revenue rose 47% year-over-year to $13 everyone in the world.' His goal is now to 'give people the billion. Growth slowed from 51% in 4Q16 but was on par power to build community and bring the world closer with 3Q17. Revenue benefited from a $329 million foreign together.' Mr. Zuckerberg's original vision underpinned the exchange tailwind in 4Q17 which contributed about three 2014 acquisition of the WhatsApp message service, Facebook percentage points to growth. Advertising revenue, the Messenger, and the Facebook Lite and Free Basics services company's core earnings driver, rose 48% from the prior year. (which have been rolled out in India and other developing Total costs rose 32% and the operating margin rose by five markets). The company now has more than 1 billion percentage points to 57%. GAAP diluted EPS rose 19% to WhatsApp daily active users, and has rolled out VoIP and $1.44. The new tax law caused the company to take an video calling using this service. Facebook Messenger reached extraordinary tax charge of $2.27 billion in 4Q17. Excluding 1 billion monthly users in 2Q16. Instagram Stories now has the tax charge, non-GAAP EPS rose 83% to $2.21. 250 million daily actives. WhatsApp, Instagram and Facebook For all of 2017, revenue rose 47% to $40.65 billion. Messenger, are what management calls its 'next-generation' Non-GAAP EPS increased 65% to $6.97 from $4.23 in 2016. services. As these services have reached critical mass, the time Over the past year, Facebook became embroiled in has come for monetization. Facebook is in the process of political controversy over the false and divisive content placed testing advertising formats, and though management is on Facebook during the 2016 presidential campaign by typically cautious, it is not a stretch to see these services accounts linked to the Russian government. Further, Facebook powering future revenue growth as advertising on the has come in for criticism from third parties, former executives, company's main Newsfeed application has reached saturation. and even its own research as often making users feel worse The controversies over the past year have led Facebook to about themselves. CEO Mark Zuckerberg has made tinker with its critical user Newsfeed platform and this throws addressing these related issues the company's top priority in another layer of uncertainty on top of ongoing risks related to 2018 and reiterated on the quarterly call that the initiatives to the deceleration of ad loads on the main Facebook site. For address these issues will impact the company's profitability now, however, the value of the company's advertising going forward. Mr. Zuckerberg' thesis is that Facebook has a continues to move robustly higher. The average price per ad responsibility to make users' engagement more valuable increased 43% in 4Q17 and the number of ad impressions rose through meaningful interactions rather than simply increasing 4%. Fourth-quarter average revenue per user (ARPU) rose the amount of time users spend on the platform passively 28% year-over-year to $6.18. watching entertainment. The company is implementing Facebook's key growth drivers are increasing changes in its user Newsfeed as a first step in addressing its membership, member engagement, advertising loads (the issues around content. Facebook will de-emphasize number of ads it places), and ad prices. Facebook claimed 2.1 advertising and news in favor of personal interactions. billion monthly active users as of the end of 2017, up 14.5% Facebook is using artificial intelligence to quickly take down from 2016 - including 57 million in 4Q alone. These figures false or offensive content while also promoting more do not include users of Instagram, WhatsApp or Oculus. The trustworthy news sources like national newspapers. The increase reflects strong membership growth in India, Brazil, company recognizes that changes to the Newsfeed could lead and Indonesia - all key markets for the company. As noted in to a decline in the amount of time users spend on Facebook Recent Developments, the company actually lost 700,000 and/or in the number of active users. Indeed, Mr. Zuckerberg DAU's in the US & Canada in 4Q17 for the first time. While noted that the company estimated that its changes to the one data point does not make a trend, we will be keeping a Newsfeed decrease time spent on Facebook by 5% or 50 watchful eye on these metrics to ensure that Facebook is not million hours per day. We note that Facebook has 1.4 billion trading high value developed economy subscribers for much

Section 2.47 GROWTH / VALUE STOCKS lower value emerging economy subs. latest development in VR technology, in 2018. The Oculus Go Under Mr. Zuckerberg, Facebook has three operating is expected to be an untethered VR headset, i.e. mobile. The priorities: capitalizing on the shift of computing/internet to company also realizes that it needs to invest in the buildout of mobile devices, growing the number of marketers that use the virtual reality ecosystem, particularly games, in order for Facebook's advertising products, and making its advertising VR to become a more popular mass market device. Oculus has more relevant and effective. The underlying goal is always to also begun to line up content programming partners, including increase member engagement with the site. This is why Netflix, 20th Century Fox, and Lionsgate for streaming Facebook's push into video has become almost as critical as its movies and TV; and Microsoft for video games such as shift to a mobile communications platform. Mr. Zuckerberg 'Minecraft.' believes that video will be key to fueling Facebook's next Over the next ten years, Facebook plans to focus on three growth stage and is one of the primary investment areas broad technological areas. The first of these is virtual outlined for 2018.Management first identified reality/augmented reality (VR/AR), as exemplified by Oculus member-generated short-form video as a key opportunity to VR. Second, the company will focus on internet connectivity - boost engagement. It has more recently also begun to move with the goal of connecting more than 4 billion potential into long-form professionally produced video with the 'Watch' Facebook users who currently have no access to mobile tab. For advertisers, the company has invested heavily in broadband, who are too poor to afford a handset, or who are ad-technology to measure reach, engagement, and sales simply unaware that Facebook exists. Facebook's introduction conversion. An unintended consequence has been the use of of its Free Basics service in developing countries; its Facebook Live video to record some grisly scenes of violence. development of more efficient antennae for mobile broadband; Facebook is working to remedy this live video issue. While and its experiments with drones, solar powered planes, Facebook currently relies on human checkers to flag satellites, and laser beams are part of the connectivity objectionable content, the company plans to apply AI initiative. The company's third focus area is artificial technology across its product portfolio, including News Feed, intelligence, which has already begun to underpin new search, advertising, security, and spam filtering. applications. China remains the one gaping hole in Mr. Zuckerberg's Mr. Zuckerberg's vision is certainly grand, even if every plan to 'connect the world.' Facebook, along with Twitter, idea or product does not perform as expected. Of course, the have been blocked in China since 2009 after accusations that company's goals are not simply altruistic; their purpose is to ethnic protesters had used the site as a platform for organizing keep the Facebook user base and user engagement growing. protests. Mr. Zuckerberg now characterizes a China reentry as a 'long-term' goal, which we take to mean about 10 years. In FINANCIAL STRENGTH & DIVIDEND the meantime, Chinese domestic social network champions We rate Facebook's financial strength as High, the highest WeChat, Weibo, and QQ have come to dominate the Chinese rating on our five-point scale. market. The company had cash, equivalents and marketable Management has often mentioned the gap between the securities of $41.7 billion at the end of 2017, and no debt. It media time consumers spend on mobile and the small generated $17.5 billion in free cash flow in 2017, up 50% percentage of ad budgets spent on mobile advertising. We year-over-year. believe that Facebook is well positioned to close this gap over Facebook does not intend to pay a dividend in the near time. The company is also pursuing growth opportunities term. Facebook's board authorized a $6 billion share among small and medium-sized businesses, and has 65 million repurchase program beginning in 2017. The company monthly active business pages. However, this opportunity repurchased $2 billion in stock in 2017 and remains includes the one-third of U.S. SMB's that have no web committed to further repurchases to offset expected share presence at all, and the even larger proportion that have no dilution from stock option grants. Share count rose 1% in mobile presence. While setting up a Facebook page is fairly 2017. easy, the company has introduced tools to simplify the process MANAGEMENT & RISKS of becoming a Facebook advertiser. Facebook is almost entirely dependent on advertising While Facebook (and its investors) are relying on revenue, which has grown to about 98% of total revenue. The Instagram, WhatsApp, and Facebook Messenger to drive secular trend of advertisers devoting more and more of their growth as the Facebook site matures, the company's foray into advertising dollars to internet-based advertising has generally virtual and augmented reality is seen as a more long-range softened the impact of cyclical swings in the online opportunity. Virtual reality is not expected to have an impact advertising market; however, this trend may not continue on Facebook's revenue in the near term. The company indefinitely. launched both the Samsung-produced Oculus mobile 'Gear Facebook is the repository of a vast amount of personal VR' headset in late 2015 and its own Oculus 'Rift' headset in information on its members and their habits. It will thus need early 2016 after some delays. While somewhat promising, to tread very carefully in how it uses and monetizes this these were just the initial commercial launches of this new information, and is vulnerable to member and regulatory technology. Facebook expects to launch the Oculus Go, its backlash of perceived misuse of members' private

Section 2.48 GROWTH / VALUE STOCKS information. Even inadvertent leaks of personal member website. The site enables users to communicate with friends information could generate headline risk, legal liability, and and family by posting to the site; commenting on others' posts; regulatory scrutiny. Facebook may also be subject to attacks sharing photographs, website links, and videos; messaging from individuals or organizations attempting to steal member and playing games. Facebook also partners with application information. developers to add functionality to the site, and allows users to Mobile is a critical growth engine for Facebook and the pay for virtual goods and services through its Payments company derives 88% of its advertising revenue from mobile function. In recent years, the company has acquired applications. Management has also warned that it is willing to photo-sharing and social networking site Instagram, sacrifice short-term margin expansion for long-term messaging service WhatsApp, and virtual reality developer membership growth and increased member engagement. Oculus VR. Facebook derives about 55% of its revenue from Investors could find themselves in the position of waiting for outside the U.S. and Canada. Facebook went public on May profitability that may never come. 18, 2012. Competition in the internet space is intense and Facebook is up against a number of larger companies with greater VALUATION resources, including Google, Microsoft, and Apple. As Facebook shares have risen 46% in the last year, Facebook expands internationally, it must manage its entry compared to a 24% increase for the S&P 500 and a 40% into new markets, where it may have limited understanding of increase for the S&P Information Technology Index. the local culture. It also faces pressure from 'national Facebook's EV/EBITDA multiple of 22.6 is near the peer champion' competitors, especially in China from which it is median. The forward enterprise value/EBITDA multiple of legally banned. Government regulation and the possible 15.3 is 14% below the peer average, compared to an average censorship of site content could also become much more premium of 9% over the past two years. We are maintaining burdensome in coming years in both the U.S. and international our BUY rating on Facebook and raising our target price to markets. The Snowden revelations involving the use of $237, up from $215. American internet company data by the NSA could make On February 1, BUY-rated FB closed at $193.09, up Facebook's penetration of foreign markets much more $6.20. (Joseph Bonner, CFA, 2/1/18) difficult, and result in restrictions or outright bans by foreign governments. Facebook has expanded its role from simple interpersonal Flextronics International Ltd (FLEX) communications, i.e., timeline posts, to become a broad-based Current Rating: BUY Publication Date: 1/31/18 news media outlet. However, this expansion has been fraught HIGHLIGHTS with allegations of bias. It has also raised concerns about the *FLEX: Diverse business model offsets legacy weakness company's role in disseminating fake news, in which bad *Flex Ltd. was able to offset weakness in traditional EMS actors game Facebook's news algorithms to plant false news services in fiscal 3Q18 with strong sales and earnings in its stories or propaganda. Management is now in an 'arms race' nontraditional businesses. with individuals trying to use its service to distribute fake *During the quarter, profits from legacy news. The Russian government's usage of the company's technology-related businesses, including Communications, advertising systems has brought this issue into a harsher light. Enterprise Compute and Consumer were down in the double Like any start-up, Facebook must successfully manage its digits. explosive growth trajectory. It must also ensure 24/7 system *However, both Industrial & Emerging (IEI) and High reliability in the face of increasingly toxic computer network Reliability Solutions (HRS), set new quarterly records for attacks from sources who would like nothing more than the revenue and adjusted operating profit. headlines from a successful attack on a high-profile target like *Flex is on track for a positive revenue growth for the Facebook. March 2018 fiscal year. We also look for strong EPS growth Goodwill and intangible assets are a significant 24% of in FY19. total assets. Though Facebook does not have a history of write-downs, such assets are always subject to reappraisal. ANALYSIS Moreover, since they are such a significant part of the INVESTMENT THESIS company's assets, any write-down could be a serious negative BUY-rated Flex Ltd. (NGS: FLEX) - formerly for FB shares. Flextronics International Ltd. - was able to offset weakness in More than most internet start-ups, Facebook is identified traditional EMS services, and particularly in communications with its founder, chairman and CEO Mark Zuckerberg, and equipment, with strength at nontraditional customers in 3Q18. his possible loss would undoubtedly be a major blow to the That weakness slammed rivals Sanmina and Celestica, two company. companies with higher legacy concentration, during the COMPANY DESCRIPTION current earnings season. The diversity of Flex's model and end Facebook operates the world's largest social networking markets has prevented heavy concentration in the

Section 2.49 GROWTH / VALUE STOCKS communications space, where growth has slowed ahead of the performance between legacy businesses linked to anticipated 5G spending splurge in 2019 and beyond. communications and enterprise computing on the one hand; For fiscal 3Q18, Flex posted revenue of $6.75 billion, and focus businesses that provide higher growth and margin which was up 10% annually; non-GAAP EPS of $0.31 opportunities in areas including industrial, aerospace-defense, declined 8% year-over-year, reflecting lower margins and a medical devices, appliances, automotive, renewable energy, doubling in the tax rate. Flex continues to shift its portfolio and automotive. In short, legacy end markets weakened in the toward 'sketch-to-scale' solutions for customers in quarter, causing margin compression. Focus business areas high-value-added markets, including industrial, automotive, grew, leading to segment margin expansion and preventing a clean energy, and other nontraditional areas. steeper EPS decline in a challenging legacy environment. During the quarter, profits in legacy technology-related Given this mix shift and change in focus at Flex, the businesses, including Communications, Enterprise Compute company was able to dodge the weakness reported by industry and Consumer, were down in the double digits. Profits in rivals Sanmina and Celestica. Hurt by weak communications Industrial & Emerging (IEI) and High Reliability Solutions customer demand and inability to absorb overhead costs, (HRS), however, grew sharply, offsetting the legacy loss. Sanmina posted a 33% decline in non-GAAP EPS for its fiscal Both IEI and HRS set new quarterly records for revenue and 1Q18 (calendar 4Q17). Although Celestica was not impacted adjusted operating profits. as deeply, the Canadian company too reported challenging Flex has historically benefited from the diversity of its comps as its legacy customers cut demand in the period. customer base, as well as from its unmatched ability to meet During the fiscal third quarter (calendar 4Q17), legacy the global design, manufacturing, and logistics needs of even communications and compute end markets were challenging; the world's largest companies. Disengagement from former and top-line challenges were reflected in profits. Although major customers (Lenovo, in the personal devices space, and Flex's personal devices business posted double-digit revenue bankrupt SunEdison, in solar panels) has begun to improve growth in a seasonally strong quarter, this unit, too, revenue comps. experienced margin pressure as smartphones continued to After three years (FY15-FY17) of flat to lower top-line move into the commodity category. comparisons, Flex is on track for a positive revenue growth For 3Q18, Consumer Technology Group (CTG) revenue for the March 2018 fiscal year, along with a slight of $2.06 billion (30% of total) was up 11% annually and 17% year-over-year decline in non-GAAP EPS. We are modeling sequentially in a seasonally strong holiday quarter. The CTG continued top-line growth in FY19; given expected operating margin remains challenged, coming in at 1.9% in improvements in operating efficiency and revenue mix, we 3Q18 - down from 3.2% a year earlier. The CTG operating look for margin expansion and positive EPS growth in fiscal margin missed the 2%-4% target range. Beyond anticipated 2019. FLEX remains attractive on historical comparable and margin pressure attributable to elevated costs for the Nike discounted free cash flow valuation, and in relation to its partnership, most parts of this business experienced sequential slow- to no-growth peer group. We are reiterating our BUY improvement in profits. rating to a 12-month target price of $23. CTG has recovered from its 1Q17 low, which included most of the costs associated with closure of the RECENT DEVELOPMENTS Lenovo-Motorola China operations. With the Lenovo FLEX is up 2% year-to-date in 2018, compared with a wind-down out of the way and with Flex better managing 5% peer group decline. FLEX shares appreciated 25% in Nike costs, we look for CTG margins to recover to 2017, ahead of the 4% gain for the peer group of management's target range in coming quarters. Argus-covered electronic manufacturing services (EMS) Flex's largest business, Communications & Enterprise companies. FLEX shares rose 28% in 2016, in line with peers. Compute, posted a 6% annual sales decline to $1.98 billion FLEX appreciated less than 1% in 2015, while the peer group (29% of revenue). The CEC operating margin of 2.5% was at was down 3%; and in 2014 finished with a 44% gain while the low end of the 2.5%-3.5% target range, and operating outpacing the 31% gain for the peer group. profit declined 19% year-over-year for a second consecutive For fiscal 3Q18 (calendar 4Q17), Flex reported revenue quarter. Margin pressure in CEC reflected both lower of $6.75 billion, which was up 10% annually and 8% overhead absorption on decreased volume and costs related to sequentially; above the high end of management's $6.3-$6.7 building the cloud data center business. billion guidance range; and comfortably above the $6.50 Flex's Industrial & Emerging Industries (IEI) and High billion consensus forecast. Non-GAAP earnings totaled $0.31 Reliability Solutions (HRS) units, however, set new quarterly per diluted share, which was down 8% year-over-year though records for revenue and adjusted operating profits. Industrial up $0.04 sequentially; toward the high end of management's & Emerging Industries (IEI) group revenue of $1.49 billion $0.28-$0.32 guidance range; and one cent above the (22% of total) increased 31% annually and 3% sequentially. consensus estimate. Flex posted a non-GAAP tax rate of 13% The IEI operating margin expanded sequentially to 4.1% in in 3Q18; at the 7% tax rate from 3Q17, Flex would have 3Q18 from 3.5% in 2Q18; margin edged back into the low earned $0.33 per diluted share. end of the target range of 4%-6%. Impacts from the For Flex Ltd., fiscal 3Q18 reflected diverging bankruptcy at SunEdison, at one time IEI's largest customer,

Section 2.50 GROWTH / VALUE STOCKS continue to recede. IEI is now encountering costs related to For all of FY17, sales of $23.9 billion declined 2% from ramping up substantial new business. While positive for the the $24.4 billion recorded in FY16. On a non-GAAP basis, long term, this investment could weigh on IEI margins in Flextronics earned $1.17 per diluted share in FY17, up 14% coming quarters. from $1.03 per share in FY16. For the long term, IEI is building a much more diversified Flex forecast fiscal 4Q18 revenue of $6.1-$6.5 billion, energy business, with a particular focus on its NEXTracker which at the midpoint would be up 7% annually. Management technology (which positions solar panels to take advantage of is modeling $200-$230 million in non-GAAP operating the movement of the sun). Since acquiring the business, IEI income, along with $35-$40 million in net interest expense has doubled the number of NEXTracker customers and and a 10%-15% tax rate. Non-GAAP EPS guidance of countries in which this business operates. Other IEI new $0.28-$0.32 at the midpoint of the range implies low-teens customers and projects should help this business sustain 4% annual EPS growth. Both midpoints were ahead of the -6% operating margins in the coming quarters. prereporting consensus. High Reliability Systems (HRS) revenue of $1.22 billion We are raising our non-GAAP earnings forecast for the was up 20 year-over-year and 6% sequentially. The HRS March 2018 fiscal year to $1.13 per diluted share from a prior operating margin expanded to 8.2% in 3Q18 from 7.9% in $1.12. Despite expectations for a higher blended tax rate and 2Q18; the margin remained well above the midpoint of the 6% higher interest costs, we are also increasing our non-GAAP -9% target range, as the group continues its solid operational forecast for FY19 to $1.38 per diluted share from $1.37. On a execution. Flex is making investments to ramp up programs, GAAP basis, our forecasts are $1.08 for FY18 and $1.06 for particularly in the automotive and medical groups. FY19. Our long-term earnings growth rate forecast is 10%. For fiscal 4Q18, Flex forecast an annual sales decline of 5%-10% in its Communications & Enterprise Compute group. FINANCIAL STRENGTH & DIVIDEND The other three units are all forecast to grow annually: CTG Our financial strength rating for FLEX remains by 5%-10%, IEI by 15%-25%, and HRS by 10%-20%. In all, Medium-High, the second-highest rank on our five-point Flex forecast fiscal 4Q18 revenue of $6.1-$6.5 billion, which scale. In our view, the company's cash management during its at midpoint would be up 7% annually. Non-GAAP EPS transition to higher-margin businesses has been solid. guidance of $0.28-$0.32, at the midpoint, implies low-teens Debt was $2.95 billion at the end of 3Q18. Debt was EPS growth. Both midpoints were ahead of the prereporting $2.874 billion at the end of FY17, $2.77 billion at the end of consensus. FY16 and $2.08 billion at the end of FY15.Debt/cap was After three years (FY15-FY17) of flat to down top-line 49.7% at the close of 3Q18. Debt/cap was 52.0 % at the close comparisons, Flex is on track for a positive revenue of FY17, 51.6% at the end of FY16, and 46.5% at year-end comparison for the March 2018 fiscal year, along with a slight FY15. year-over-year decline in non-GAAP EPS. We are modeling Cash & equivalents were $1.29 billion at the end of continued top-line growth in FY19; given expected 3Q18. Cash was reduced from year-end FY17 by higher improvements in operating efficiency and revenue mix, we capital spending and purchases of niche assets. Cash & also look for margin expansion and positive EPS growth. equivalents were $1.83 billion at the end of FY17, $1.61 billion at year-end FY16, reduced from $2.33 billion at the EARNINGS & GROWTH ANALYSIS end of 1Q16 by the cost of acquiring MCi as well as by capital For fiscal 3Q18 (calendar 4Q17), Flex reported revenue allocation. of $6.75 billion, which was up 10% annually and 8% Cash flow from operations was $1.15 billion in FY17, sequentially; above the high end of management's $6.3-$6.7 $1.14 billion in FY16, and $794 million in FY15. Free cash billion guidance range; and comfortably above the $6.5 billion flow was $600 million in FY17, $626 million in FY16, and consensus forecast. $554 million in FY15. Non-GAAP gross margins were sequentially stable at Flex spent $180 million to repurchase shares in the first 6.7% in 3Q18 compared with 2Q18, while narrowing from nine months of the fiscal 2018 year. Since launching its 7.1% a year earlier. Despite the gross margin contraction, the capital return program in 2011, Flex has spent more than $2.5 non-GAAP operating margin expanded to 3.3% for 3Q18 billion on buybacks, reducing its share count by over 34%. from 3.0% in 2Q18 while contracting from 3.6% a year We do not expect Flex to pay a common dividend in earlier. FY18 or FY19. Non-GAAP earnings totaled $0.31 per diluted share, which was down 8% year-over-year though up $0.04 MANAGEMENT & RISKS sequentially; toward the high end of management's Mike McNamara has served as CEO since January 2006. $0.28-$0.32 guidance range; and one cent above the Christopher Collier became CFO in May 2013. Francois consensus estimate. Flex posted a non-GAAP tax rate of 13% Barbier is president of Global Operations and Components, in 3Q18; at the 7% tax rate from 3Q17, Flex would have and Paul Humphries is president of High Reliability Solutions. earned $0.33 per diluted share, or one cent below year-earlier The chief risk for globally diversified Flex is that its earnings. operations will need substantial restructuring in the event of a global economic crisis. We think the company has in the past

Section 2.51 GROWTH / VALUE STOCKS shown a willingness to act decisively in response to dynamic slightly above its historical relative P/E of 0.66. Based on situations, and we believe that it has the financial solvency to historical price-based comparisons, FLEX shares now trade survive. above calculated fair value; we believe the premium is Flex faces risks related to the integration of assets, though warranted given top-line growth and the margin expansion it is adept at integrating smaller acquisitions. Flex is also at now underway. risk from its vertical manufacturing strategy, which includes Flex now trades at slight premiums to peers; we believe ownership of significant component assets. The company is a the premiums are warranted given little to no growth among leader in non-EMS adjacencies, such as plastic and metal EMS rivals. Our discounted free cash flow model indicates a enclosures, PCB fabrication, and power modules. We believe fair value in the high $30s, in a stable trend. Our blended that risks in these noncore businesses are offset by their higher valuation model indicates a fair value in the low $30s, in a margins. positive trend. Appreciation to our 12-month target price of $23 implies COMPANY DESCRIPTION a risk-adjusted return in excess of our forecast for the broad Flex is the largest global provider of electronic market. Based on valuation and the company's accelerating manufacturing services (EMS) and related competencies. In fundamentals, we believe that FLEX shares warrant both near- addition to its core printed circuit board (PCB) assembly and and long-term BUY ratings. systems assembly businesses, the company provides design, On January 31 at midday, BUY-rated FLEX traded at logistics, components, enclosures and PCB manufacturing. $18.05, down $0.18. (Jim Kelleher, CFA, 1/31/18) Flex has expanded its customer base from OEM companies in traditional electronics and technology to nontraditional niches, such as consumer, medical and instrumentation, Harley-Davidson, Inc. (HOG) aerospace-defense and automotive. In FY17, revenue was Current Rating: BUY Publication Date: 2/5/18 $23.9 billion, down 2% from $24.4 billion in FY16. HIGHLIGHTS INDUSTRY *HOG: Maintaining BUY on strong 4Q and cost-cutting Our rating on the Technology sector is Over-Weight. initiatives Technology is showing clear investor momentum, topping the *In an effort to lower costs, Harley will shift operations at market in the year-to-date. At the same time, the average its Kansas City, Missouri factory to its plant in York, two-year-forward EPS growth rate exceeds our broad-market Pennsylvania. We believe that this consolidation will enable estimate and sector averages, which has kept technology the company to improve production efficiency both for legacy sector PEG valuations from becoming too rich. models and the 100 new 'high impact' models that it plans to Over the long term, we expect the Tech sector to benefit introduce over the next 10 years. from pervasive digitization across the economy, greater *On January 30, Harley reported 4Q17 adjusted EPS of acceptance of transformative technologies, and the $0.48, up from $0.27 a year earlier. The results matched our development of the Internet of Things (IoT). Healthy estimate and topped the consensus of $0.46. company and sector fundamentals are also positive. For *We are lowering our 2018 adjusted EPS estimate from individual companies, these include high cash levels, low $3.77 to $3.50 and setting a 2019 estimate of $3.77. Our debt, and broad international business exposure. estimates assume higher costs as the company consolidates its In terms of performance, the sector rose 12.0% in 2016, plants, partly offset by benefits from a lower effective tax rate. above the market average, after rising 4.3% in 2015. It *HOG shares are trading below historical and peer strongly outperformed in 2017, with a gain of 36.9%. average P/E, price/sales, and price/book multiples; however, Fundamentals for the Technology sector look reasonably we believe that higher valuations are warranted. Our target balanced. By our calculations, the P/E ratio on projected 2018 price of $53, combined with the dividend, implies a potential earnings is 19.0, above the market multiple of 18.2. Earnings total return of 15% from current levels. are expected to grow 19.5% in 2018 and 30.3% in 2017 following low single-digit growth in 2015-2016. The sector's ANALYSIS debt ratios are below the market average, as is the average INVESTMENT THESIS dividend yield. We are maintaining our BUY rating on Harley-Davidson VALUATION Inc. (NYSE: HOG) following the company's FLEX shares are trading at 16.1-times our FY18 better-than-expected 4Q17 earnings. Our target price is $53. non-GAAP EPS forecast and at 13.2-times our FY19 forecast, Despite industrywide pricing pressures, the company is versus a five-year (FY13-FY17) average multiple of 10.1. gaining market share and strengthening its product mix. It Although at a two-year forward P/E of 14.7, the shares trade continues to reduce its inventory of older motorcycles and has at a premium to historical P/E, Flex has now returned to top- begun an ambitious effort to launch 100 new models by 2027. and bottom-line growth. In an appreciated market, FLEX is We have been impressed with the first of these new models, trading at a relative P/E of 0.72 for FY18 and FY19, only and believe that they live up to the company's reputation for

Section 2.52 GROWTH / VALUE STOCKS solid, powerful motorcycles. Although the new models and company was able to maintain its No.1 spot in the 601+cc styles will not entirely replace personal customization, they category, as well as its leading market share in the U.S., should enable most buyers to get the look, sound, and feel that Canada, Japan, Australia and India. As noted above, Harley is they want directly from the sales floor, without costly also broadening its product line, with 100 new models slated upgrades. We note that Harley is also designing an electric to be introduced by 2027. We believe that this wider range of motorcycle that should appeal to a new group of customers. models will help to attract customers who might otherwise HOG shares are trading below historical and peer average prefer to purchase a 'fully custom' motorcycle. Nevertheless, P/E, price/sales, and price/book multiples; however, we Harley is likely to face pressure from continued weak believe that higher valuations are warranted based on the industrywide pricing as well as from higher production costs company's rising market share, improved product mix, and as it adds new models. We note that the company is also potential to attract new customers. Our target price of $53, planning to launch its first electric motorcycle within the next combined with the dividend, implies a potential total return of 18 months. 15% from current levels. *We are lowering our 2018 adjusted EPS estimate from $3.77 to $3.50 and setting a 2019 estimate of $3.77. Our RECENT DEVELOPMENTS estimates assume higher costs as the company consolidates its HOG shares have underperformed over the past quarter, plants, partly offset by benefits from a lower effective tax rate. 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 FINANCIAL STRENGTH & DIVIDEND gain of 23% for the index. The beta on HOG is 0.96. Our financial strength rating on Harley-Davidson is On January 30, Harley reported 4Q17 adjusted EPS of Medium-High, the second-highest point on our five-point $0.48, up from $0.27 a year earlier. The results matched our scale. Harley's debt is rated A3/stable by Moody's, A/stable by estimate and topped the consensus of $0.46. Fourth-quarter Fitch, and A-/stable by Standard & Poor's. net income came to $8.3 million on consolidated revenue of At the end of 4Q17, the debt/capitalization ratio was $1.23 billion, compared to net income of $47.2 million on 79.1%, compared to 78.0% at the end of 4Q16. Long-term revenue of $1.11 billion in 4Q16. Revenue rose due to higher debt at the end of 2017 stood at $4.59 billion, down from shipments, while the new tax cut law impacted earnings by $4.67 billion a year earlier. The company generated $1.01 $53.1 million. Harley motorcycle unit sales fell 9.6% billion in cash from operating activities in 2017, compared to worldwide and 11.1% in the U.S., while overall industry sales $765.5 million in 2016. For 2017, Harley-Davidson's effective fell 6.5%. The gross margin rose to 30.9% from 30.7% a year tax rate was 39.6%, up from 32.4% in 2016, reflecting the earlier, reflecting the increase in shipments of motorcycles and write-down of deferred tax assets following the passage of the related products. 2017 Tax Cuts and Jobs Act. However, due to the new law, At Harley-Davidson Financial Services (HDFS), revenue Harley expects a significantly lower effective tax rate of rose 2.4% to $182 million and operating profit rose 5.9%. 23.5%-25.0% in 2018. For all of 2017, diluted EPS fell to $3.02 from $3.83 in The company pays a quarterly dividend of $0.365 per 2016. Net income was $521.8 million on consolidated revenue share, or $1.46 annually, for a yield of about 3.1%. Our of $5.65 billion, versus net income of $692.2 million on dividend estimates are $1.52 for 2018 and $1.54 for 2019. consolidated revenue of $6.00 billion a year earlier. In 2017, The company repurchased 8.7 million shares for $456.1 Harley motorcycle unit sales fell 6.7% worldwide, 8.5% in the million in 2017. At the end of the year, it had 10.6 million U.S., and 3.9% in international markets. shares remaining on its buyback authorization. In an effort to lower costs, on January 25, the board approved a plan to shift operations at the company's Kansas RISKS City, Missouri factory to its plant in York, Pennsylvania. The Knowing that it cannot rely solely on its traditional move is expected to cost $170-$200 million through 2019 and clientele, predominantly white male baby boomers, Harley has is expected to save $65-$75 million per year after 2020. We been working hard to appeal to women, minorities, and believe that this consolidation will enable the company to younger Gen X and Millennial consumers, as demonstrated by improve production efficiency both for legacy models and the its plan to launch 100 new 'high-impact' models over the next 100 new 'high impact' models that it plans to introduce over 10 years. Although the company will need time to roll out the next 10 years. these new motorcycles, and will face higher production costs Along with the 4Q release, management issued shipment in the near term, we expect the wide variety of new models to and margin guidance for 2018. It expects full-year shipments better address customer preferences and believe that they of 231,000-236,000 motorcycles, down from 241,498 in 2017. could be a game-changer for the company. Harley currently It also projects 1Q shipments of 60,000-65,000 motorcycles. It plans to launch 14 new high-impact models in 2018 and plans expects full-year operating margins of 9.5%-10.5% and to launch its first electric motorcycle within 18 months. capital spending of $250-$270 million. Harley-Davidson and its peers are highly sensitive to economic weakness, which can limit consumer credit and EARNINGS & GROWTH ANALYSIS have an outsized impact on discretionary spending. The Although Harley's U.S. motorcycle sales fell in 2017, the company also faces risks from aggressive price competition.

Section 2.53 GROWTH / VALUE STOCKS

Motorcycle manufacturers are also subject to regulatory potential total return of 15% from current levels. We believe changes (such as new engine emissions standards) over which that the recent pullback in the stock provides investors with a they have limited control. favorable entry point. On February 2, BUY-rated HOG closed at $47.50, down COMPANY DESCRIPTION $1.18. (David Coleman, 2/2/18) Founded in 1903 and based in Milwaukee, Harley-Davidson became a public company in 1986. The Motorcycle segment designs, manufactures and sells Hawaiian Holdings, Inc. (HA) heavyweight Harley-Davidson motorcycles (engine Current Rating: HOLD Publication Date: 2/6/18 displacement of 651+ cubic centimeters), as well as motorcycle parts, accessories, general merchandise, and HIGHLIGHTS related services. The company plans to launch 100 new *HA: Maintaining HOLD on heightened competition motorcycle models over the next 10 years in an effort to *With both United Continental and Southwest Airlines attract new riders, and has also begun to manufacture smaller entering the West Coast-to-Hawaii market and a competitor 500-750 cubic centimeter motorcycles. Harley-Davidson expanding aggressively in the intra-island market, we expect Financial Services (HDFS) provides wholesale and retail HA's yields to deteriorate. financing and insurance to Harley-Davidson dealers and their *We note that Southwest has typically reduced fares by retail customers in the United States, Canada and other 15%-25% when entering new markets. international markets. The company's products are sold to *In addition, Hawaiian Holdings' costs have recently been retail customers through a network of independent dealers. rising at a 6%-7% pace. Given these challenges and the absence of positive catalysts, we believe that a HOLD rating INDUSTRY remains appropriate. We have raised our rating on the Consumer Discretionary *If the company is able to offset the impact of new sector to Over-Weight from Market-Weight. The sector has competition and hold the line on costs, we would consider shown solid market momentum, reflecting investor returning the stock to our BUY list. expectations for strong durable goods demand in the wake of tax cuts. At the same time, Consumer Discretionary stocks ANALYSIS have been out of favor for multiple quarters, and appear INVESTMENT THESIS undervalued relative to peers. The sector accounts for 12.1% of the S&P 500. We think We are maintaining our HOLD rating on Hawaiian investors should consider allocating 13%-14% of their Holdings Inc. (NGS: HA) on concerns about increased diversified portfolios to the group. Over the past five years, competition and rising costs. With both United Continental the weighting has ranged from 8% to 13%. The sector (UAL, not covered by Argus) and Southwest Airlines (LUV: underperformed in 2016, with a gain of 4.3%, after BUY) entering the West Coast-to-Hawaii market and a outperforming in 2015, with a gain of 8.4%. It slightly competitor expanding aggressively in the intra-island market, outperformed in 2017, with a gain of 21.2%. we expect HA's yields to deteriorate. Southwest management Consumer Discretionary earnings are expected to increase believes that passenger fares to Hawaii are too high, and has 8.7% in 2018 and 3.6% in 2017 after rising 9.4% in 2016 and typically reduced fares by 15%-25% when entering new 9.9% in 2015. On valuation, the 2018 projected P/E ratio is markets. In addition, Hawaiian Holdings' costs have recently 20.3, above the market multiple of 18.2. The sector's debt been rising at a 6%-7% pace. Given these challenges and the ratios are high, with an average debt-to-cap ratio of 52%. absence of positive catalysts, we believe that a HOLD rating Yields are below average at 1.0%. remains appropriate. If the company is able to offset the impact of new competition and hold the line on costs, we VALUATION would consider returning the stock to our BUY list. HOG shares are trading toward the low end of their RECENT DEVELOPMENTS. 52-week range of $45.52-$63.40. They are trading at On January 29, HA reported 4Q17 EPS that topped the 13.8-times our 2018 EPS estimate and 12.8-times our 2019 consensus estimate by $0.02, reflecting lower-than-expected estimate, compared to a five-year historical range of fuel costs, a 5% decline in total operating expenses, and a 10.3-21.3. The 2018 peer average P/E is 23.3. The price/sales nearly 3% decline in the share count. Fourth-quarter adjusted ratio is 1.5, near the low end of the five-year range of 1.3-2.7 net income fell $11.3 million year-over-year to $57.5 million. and below the peer average of 1.9. The price/book ratio of 4.4 Passenger revenue grew 7.8% to $596.8 million, and other is below the midpoint of the historical range of 3.4-5.8 and revenue rose 13% to $89.7 million. Total revenue grew more below the peer average of 4.6. Despite Harley's current than 8.5% year-over-year to $686.5 million. Total operating challenges, we believe that the shares merit higher multiples expenses fell 5.0%. Aircraft fuel costs, including taxes and based on the company's forward-looking restructuring plan, delivery, rose 29% to $124 million. Interest expense dropped improved product mix, and potential to attract new customers. from $8.2 million to $7.6 million. The share count fell by 1.6 Our target price of $53, combined with the dividend, implies a million to 52.3 million.

Section 2.54 GROWTH / VALUE STOCKS

In 2017, revenue increased 10% year-over-year to $2.7 Holdings and its subsidiary, Hawaiian Airlines, since 2005. In billion, while earnings rose to $5.64 per share from $5.21 in 2011, he began to expand the carrier's route network beyond 2016. inter-island flights with service from Hawaii to Asia and the In the first quarter, management expects costs per West Coast. available seat mile (CASM ) to rise 3.5%-6.5%. For the full Airline financials, labor negotiations, ticket prices, and year, management expects CASM, less fuel and special items, fuel costs all represent potential catalysts for share price to be down 0.5% to up 2.5%. %. It expects available seat movement. In addition, the risk of a major terrorist attack or miles to increase 5%-8% and economic fuel cost per gallon of health scare that reduces airline travel is ever-present. $1.97-$2.07. The company faces stiff competition from other low-cost As discussed in a previous note, on January 8, 2018, airlines and from legacy carriers that have cut ticket prices Hawaiian Holdings announced that it had flown a record 11.5 over the past several years. million passengers in 2017, up 4.1% from the prior year. In times of high oil prices, fuel costs represent more than In March 2017, Hawaiian Airlines pilots ratified a new a third of an airline's costs. Hawaiian Holdings' earnings and 63-month labor contract, ending a long-running dispute. The share price could suffer if oil prices increase significantly. new contract provides for salary increases of 36%-86% over the term of the agreement and retroactive pay dating back to COMPANY DESCRIPTION September 15, 2015. It also includes improved work rules and Hawaiian Holdings, through its subsidiary Hawaiian maintains pilots' existing healthcare benefits. Airlines, is a leading carrier for inter-island flights, which account for about a quarter of revenue. The airline also has the EARNINGS & GROWTH ANALYSIS largest share of flights between Hawaii and the West Coast, Although the company is working to control costs, it will which account for half of revenue. face higher labor costs following recent contract agreements with its pilots, dispatchers, and machinists. On the positive INDUSTRY side, it is upgrading its fleet to boost efficiency. It recently Our rating on the Industrial sector is Market-Weight. took delivery of its 24th A330-200. The company plans to Industrial stocks have been lagging the market, reflecting the lease two A321 neos beginning in 1Q18 and to retire its stronger U.S. dollar and concerns about trade restrictions. In remaining fleet of 767s by the end of 2018. addition, Industrial sector EPS growth is below the market We are maintaining our 2018 EPS estimate of $4.50, average, while the two-year-forward P/E is above both the below the consensus estimate of $4.54. Our 2018 estimate five-year historical average and the market average. assumes slower revenue growth as the company competes The Industrial sector accounts for 10.1% of S&P 500 against Southwest and United Continental in the West market capitalization. Over the past five years, the weighting Coast-to-Hawaii market. For 2019, we are setting an estimate has ranged from 9% to 12%. We think that investors should of $4.90. Our five-year earnings growth rate forecast remains allocate 9%-11% of their diversified portfolios to the group. 5%. The sector includes industries such as transportation, aerospace & defense, heavy machinery and electrical FINANCIAL STRENGTH & DIVIDEND equipment. Our financial strength rating on Hawaiian Holdings is The sector outperformed the market in 2016, with a gain Medium-Low. The company scores below average on our of 16.1%, after underperforming in 2015, with a loss of 4.7%. three main financial strength criteria of debt levels, interest It also underperformed in 2017, with a gain of 18.5%. coverage and profitability. The company's debt is rated By our calculations, the 2018 P/E ratio is 18.8, slightly B1/stable by Moody's, BB-/stable by S&P, and B+/positive by above the market multiple. Earnings are now expected to rise Fitch. 9.2% in 2018 and 10.3% in 2017 after declining 3.3% in The company ended 4Q17 with $460 million in cash and 2016. The sector's debt/cap ratio of 50% is above the market investment securities, down from $694 million at the end of average. The yield of 1.4% is below the market average of 4Q16. At the end of 4Q17, the company had $571 million of 1.8%. outstanding debt and capital lease obligations, compared to $565 million at the end of 4Q16. It repurchased $100 million VALUATION of its stock in 2017 and has reauthorized another $100 million HA shares fell on January 29 after the company issued in buybacks through May 2019. Given the company's strong disappointing fourth-quarter earnings. The shares appear fairly free cash flow, we expect continued debt retirement and stock valued at current prices near $37, toward the low end of their buybacks going forward. 52-week range of $32-$59. In November 2017, Hawaiian initiated a $0.12 per share On the fundamentals, the shares are trading at 8.1-times quarterly dividend. The current yield is about 1.3%. Our our 2018 estimate. The five-year historical P/E range is dividend estimates are $0.52 for 2018 and $0.60 for 2019. 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 MANAGEMENT & RISKS historical range. The price/cash flow ratio is 6.9, above the Mark B. Dunkerley has been the CEO of Hawaiian peer average of 5.9 and just below the midpoint of the

Section 2.55 GROWTH / VALUE STOCKS five-year range of 0.9-14.1. Given management's projections narrower than the consensus loss estimate of $0.13. for higher costs and heightened competition, we think the The narrower net loss was primarily attributable to higher shares are fairly valued. As such, our rating remains HOLD. revenue in the U.S. Land segment. The segment posted a 75% On February 5, HOLD-rated HA closed at $35.60, down increase in sales and benefited from higher rig utilization. $1.80. (John Staszak, CFA, 2/5/18) 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 Helmerich & Payne Inc (HP) these segments below. Current Rating: BUY Publication Date: 2/1/18 The U.S. Land segment posted an operating profit of $24.8 million in fiscal 1Q18, compared to an operating loss of HIGHLIGHTS $30.9 million in fiscal 1Q17. The swing to an operating profit *HP: Boosting target to $87 was primarily attributable to higher drill rig sales, which rose *Our revised target reflects the recent improvement in 75%. The division also benefited from lower average rig crude oil prices and the decision by OPEC to maintain expenses. Rig utilization averaged 57% in 1Q18, up from 31% production at current levels through the end of 2018. in the year-earlier period. As of January 25, 2018, Helmerich *On January 25, Helmerich & Payne reported an adjusted & Payne's U.S. Land division had approximately 206 fiscal 1Q18 net loss of $2.54 million or $0.02 per share, contracted rigs (109 term contract and 97 spot contract) compared to an adjusted net loss of $43.2 million or $0.41 per generating revenue. This compares to 197 contracted rigs at share in the prior-year quarter. The net loss was in line with the end of September 2017. our loss estimate but narrower than the consensus loss The Offshore drilling segment reported operating income estimate of $0.13. of $8.73 million, up from $6.78 million in the prior-year *We are reaffirming our FY18 EPS estimate of 0.32, as period. The improvement reflected an 18% gain in the average we expect continued improvement in rig utilization, rig rig margin and a 14% increase in rig revenue per day. margins and overall sales this year. The current FY18 The International Land segment reported an operating consensus estimate calls for a profit of $0.03 per share. profit of $3.53 million in 1Q18, up from $825,000 in 1Q17, * We are raising our FY19 EPS estimate to $0.60 from reflecting lower rig expense and higher utilization. $0.45 to reflect our expectations for positive industry As of January 26, 2018, the total active U.S. rig count, as fundamentals and modestly higher crude oil prices next year. calculated by Baker Hughes, was 947, up 33% from the prior The FY19 consensus is $0.74. year. This compares to a peak rig count of 1,609 in October ANALYSIS 2014. As discussed in past notes, on June 2, 2017, HP INVESTMENT THESIS completed the acquisition of MOTIVE Drilling Technologies, We are reaffirming our BUY rating on Helmerich & a software company that uses cognitive computing to improve Payne Inc. (NYSE: HP) and raising our price target to $87 results in directional drilling. The company has drilled from $65. Our revised target reflects the recent improvement extensively in all major U.S. shale plays using this in crude oil prices and the decision by OPEC to maintain technology. production at current levels through the end of 2018. Looking ahead, we expect drilling activity by E&P companies to EARNINGS & GROWTH ANALYSIS continue to increase, though at a slightly slower pace than in In its January 25 earnings release, HP management said recent quarters. We also expect new drilling to be that it was encouraged by an improving macroeconomic concentrated in regions with relatively low production costs, environment for oil and by prospects for increased drill rig such as the Permian basin and the Bakken and Eagle Ford activity this year. shales, where HP is better-positioned relative to peers. Our In fiscal 2Q18, management expects average rig revenue revised target of $87, combined with the dividend, implies a in the U.S. Land segment to be flat with or slightly higher than total potential return of 25% from current levels. in 1Q18, with average rig expense of about $13,900 per day. In the Offshore segment, it expects revenue days to decrease RECENT DEVELOPMENTS 2% sequentially in 2Q18, with an average rig margin of HP shares have outperformed thus far in 2018, rising $11,500. Management contracts are expected to generate $4 11.9% while the S&P 500 Energy index has increased 3.4%. million in operating income. In the International Land However, the shares have underperformed over the past year, segment, the company expects revenue days to decrease from climbing 1.7% while the Energy index has increased 3.3%. the prior quarter by about 4%, with an average rig margin of On January 25, Helmerich & Payne reported an adjusted $8,000. fiscal 1Q18 net loss (for the period ended December 31, 2017) We are reaffirming our FY18 EPS estimate of 0.32, as we of $2.54 million or $0.02 per share, compared to an adjusted expect continued improvement in rig utilization, rig margins net loss of $43.2 million or $0.41 per share in the prior-year and overall sales this year. The current FY18 consensus quarter. The net loss was in line with our loss estimate but estimate calls for a profit of $0.03 per share. Our full-year

Section 2.56 GROWTH / VALUE STOCKS revenue forecast is now $2.27 billion, up 2% from our prior By our calculations, the projected P/E ratio on 2018 estimate. earnings is 25.0, above the market multiple of 18.5. We are raising our FY19 EPS estimate to $0.60 from We forecast that West Texas Intermediate crude oil $0.45 to reflect our expectations for positive industry (WTI) will average $56 per barrel in 2018, up from $50 in fundamentals and modestly higher crude oil prices next year. 2017 and $43 in 2016 but well below the average price of $93 The FY19 consensus is $0.74. 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 FINANCIAL STRENGTH & DIVIDEND barrel. We rate HP's financial strength as Medium-High, the Our 2018 forecast for the average wellhead price of second-highest rating on our five-point scale. The company's Henry Hub natural gas is $2.90 per MMbtu with a range of debt is rated BBB+/stable by Standard & Poor's. $2.75-$3.05, compared to $3.00 per MMbtu in 2017. At the end of fiscal 1Q18, HP's total debt/capitalization ratio was 9.7%, down from 9.9% a year earlier. The total VALUATION debt/cap ratio remains well below the peer average and has HP shares have traded between $42.16 and $75.02 over averaged 7.5% over the past five years. the past 52 weeks and are currently in the upper half of that Helmerich & Payne had total debt of $493.17 million at range. P/E multiples are not useful for valuation purposes the end of 1Q18, compared to $492.11 million at the end of given our low EPS estimates for both FY18 and FY19. The 1Q17. The company has access to $300 million in liquidity shares are trading at a trailing price/book multiple of 1.8, under its revolving credit facility. above the midpoint of the historical range of 1.2-2.1; at a HP had cash and cash equivalents of $384 million at the price/sales multiple of 4.0, above the high end of the range of end of 1Q18, compared to $826 million at the end of 1Q17. 1.8-3.4; and at a price/cash flow multiple of 22.5, above the Cash from operating activities totaled $72.2 million in 1Q17, high end of the range of 6.3-11.2. compared to $70.7 million a year earlier. Looking ahead, we expect increased drilling to be HP pays a quarterly dividend of $0.70, or $2.80 annually. concentrated in regions with relatively low production costs, Our FY18 and FY19 dividend estimates are $2.82 per share. such as the Permian basin and the Bakken and Eagle Ford The shares currently yield about 3.8%, above the peer average shales, where HP is well positioned relative to peers. We also of 3.4%. We believe that the dividend remains secure given expect the company to benefit from higher oil prices and the company's relatively low debt and ample liquidity. increased rig utilization in 2018. We are reaffirming our BUY rating with a revised target price of $87. MANAGEMENT & RISKS On January 31, BUY-rated HP closed at $72.03, down HP is subject to fluctuations in demand associated with $0.68. (Bill Selesky, 1/31/18) 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. Hershey Company (HSY) However, this risk is lower for HP than for some competitors, Current Rating: BUY Publication Date: 2/6/18 as its fleet is larger, newer, and more land-based. HIGHLIGHTS COMPANY DESCRIPTION *HSY: Maintaining BUY; lowering target to $120 Helmerich & Payne, Inc. is a contract drilling company. *Hershey reported disappointing 4Q results on February As of January 26, 2017, the company's fleet included 350 land 1, as net sales fell 1.6%. Non-GAAP earnings came to $1.03 rigs in the U.S., 38 international land rigs, and nine offshore per share, missing our estimate by $0.06. platform rigs. The company was founded in 1920 and is based *Looking ahead, we expect new CEO Michele Buck to be in Tulsa, Oklahoma. aggressive in controlling costs and in introducing new INDUSTRY products. We have raised our rating on the Energy sector to *We are raising our 2018 EPS estimate to $5.38 from Over-Weight from Market-Weight. Investors remain skeptical $5.29 and initiating a 2019 forecast of $5.56. about the sector despite prospects for significant earnings *We believe that the recent selloff in HSY offers acceleration in 2018-2019. We also expect Energy stocks to investors a favorable entry point. benefit as OPEC continues to limit production in order to ANALYSIS 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 INVESTMENT THESIS 14%. We think that investors should consider allocating 6% We are maintaining our BUY rating on Hershey Co. -8% of their diversified portfolios to the Energy group. The (NYSE: HSY) with a target price of $120, reduced from $125. sector includes the major integrated firms, as well as This financially strong company has a focus on shareholder exploration & production, refining, and oilfield & drilling returns, with a stock buyback program and a record of services companies. increased dividend payments. The shares yield a relatively

Section 2.57 GROWTH / VALUE STOCKS high 2.5%. The company reported disappointing 4Q adjusted scale. Moody's rates Hershey's long-term debt as A1. Standard EPS on February 1, but provided positive guidance for 2018. & Poor's has an A rating with a negative outlook. We believe that the stock remains attractive based on most Debt was $2.92 billion at the end of 2017, compared to standard metrics and that the recent selloff offers investors a $2.98 billion at the end of 2016. Cash and equivalents totaled favorable entry point. Our revised target of $120, combined $380 million, up from $297 million a year earlier. with the dividend, implies a potential total return of 22% from Hershey purchased $300.3 million of its common stock in current levels. the first nine months of 2017 but did not repurchase any shares in the fourth quarter. In October 2017, the board RECENT DEVELOPMENTS approved an additional $100 million buyback authorization, HSY shares have outperformed over the past three which will begin after the current authorization is completed. months, rising 5.9% compared to an increase of 1.4% for the HSY pays a dividend. In September 2017, it raised its S&P 500. The stock has underperformed over the past year, quarterly dividend by 6% to $0.656 per share, or $2.62 however, falling 3.4% compared to a gain of 23.1% for the annually, for a yield of about 2.5%. Our dividend estimates S&P 500. are $2.69 (reduced from $2.70) for 2018 and $2.82 for 2019. In an effort to expand into the salty snack market, in December 2017, Hershey agreed to acquire Amplify Snack MANAGEMENT & RISKS Brands for $1.6 billion including debt. The company expects Michele Buck became the company's new CEO on March the acquisition to boost 2018 sales by 5%. 1, 2017 following the retirement of John Bilbrey. On February 1, Hershey posted 4Q17 revenue of $1.94 As a snack and confectionary company, Hershey is billion, down 1.6% from 4Q16, with a slight benefit from subject to input cost inflation, which has been high in recent currency translation. The decline reflected shipment timing years. The company requires large amounts of sugar, and a difficult comparison with 4Q16, which benefited from sweetener, peanuts, cocoa, dairy products, and plastic the launch of the Cookie Layer Crunch Bar. packaging. North American earnings fell 0.9% to $1.67 billion, as Health concerns related to diabetes are always a concern, lower volume outweighed higher realized prices and positive and producers of confectionary products have been a frequent currency translation. target of critics. We note that after years of growth, the Fourth-quarter net sales in the International and Other number of diabetes cases in the U.S. appears to have segment declined 5.4% to $65.0 million, reflecting lower stabilized. volume. The segment loss narrowed to $15 million from $16.7 Hershey is also facing additional international million a year earlier. competition following Kraft's acquisition of Cadbury. At the Fourth-quarter reported net income rose to $181.1 million same time, the company has relatively less exposure to or $0.85 per diluted share from $116.9 million or $0.55 per exchange rate movements given that most of its business is share a year earlier. Non-GAAP earnings came to $1.03 per still based in the U.S. share, missing our estimate by $0.06. The adjusted gross margin contracted by 180 basis points to 42.7%, as higher COMPANY DESCRIPTION freight and distribution costs and an unfavorable product mix Hershey Co. produces and markets chocolate and other more than offset the impact of supply-chain improvements confections, as well as chocolate-related grocery products. Its and other cost-savings initiatives. major brands include Hershey's, Jolly Rancher, Kit Kat, For all of 2017, adjusted net income came to $1.02 billion Heath, Twizzlers, Reese's, Ice Breakers and SkinnyPop. or $4.76 per share, up from $948.5 million or $4.41 per share Hershey has expanded into new categories and markets in in 2016. recent years with the acquisitions of Brookside, Krave, Shanghai Golden Monkey, Ripple Brand Collective, and EARNINGS & GROWTH ANALYSIS Amplify Snack Brands. The company's largest shareholder is Along with the 4Q results, the company issued 2018 the Hershey Trust Company. guidance. It expects adjusted EPS to increase 12%-14% to $5.33-$5.43, including gains from the Amplify acquisition and INDUSTRY the impact of a lower tax rate. It expects reported net sales to Our rating on the Consumer Staples sector is increase 5%-7%, and organic net sales to increase Under-Weight. Investors are voting with their feet in this approximately 2%. It also looks for an adjusted gross margin sector, recently reducing the sector's weighting in the S&P in line with 2017, a largely neutral impact from currency 500 to a multiyear low. We note that consumers who shifted translation, and an effective tax rate of 20%-22%. to generic products when money was tighter are simply not We are raising our 2018 EPS estimate to $5.38 from returning to familiar brand names. The sector accounts for $5.29 and initiating a 2019 forecast of $5.56. 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 FINANCIAL STRENGTH & DIVIDEND diversified portfolios to this group. The sector includes Our financial strength rating for Hershey is industries such as food, beverages, household products and Medium-High, the second-highest point on our five-point grocery stores. The sector underperformed in 2016, with a

Section 2.58 GROWTH / VALUE STOCKS gain of 2.6%, but outperformed in 2015, with a gain of 3.8%. repurchase program. The stock appears favorably valued It underperformed in 2017, with a gain of 10.5%. relative to peers based on P/E and price/sales. We are According to our models, the projected P/E ratio on 2018 reiterating our BUY rating and raising our target price to earnings is 19.3, ahead of the market multiple of 18.2. Sector $105. We think the shares are a suitable core holding in a earnings are expected to increase 8.6% in 2018 and 7.0% in diversified portfolio. 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 RECENT DEVELOPMENTS with the market average. Yields of 2.6% on average are higher IR shares have outperformed over the last quarter, gaining than the market's yield of about 1.8%. 5% while the S&P 500 has risen 2.2%. Over the past year, the shares have underperformed, advancing 13% while the market VALUATION has gained 15.6%. IR shares have also underperformed the We think that HSY shares are attractively valued at recent industry ETF IYJ over the past year but have outperformed prices near $102, near the low end of their 52-week range of over the past 5- and 10-year periods. The beta on IR shares is $101-$116. 1.24. On the fundamentals, the metrics point to value. The On January 31, the company reported 4Q EPS that rose stock trades at 19.1-times our 2018 non-GAAP EPS forecast, more than 20% but fell just shy of Street expectations. below the peer average of 20.7 and the five-year historical Fourth-quarter revenue grew 6% on an organic basis to $3.7 range of 20.5-29.3. Peers include, but are not limited to, billion. Bookings advanced a stronger 5% to $3.6 billion. The Kellogg (K), Tyson Foods (TSN), Hormel Foods (HRL), adjusted operating margin rose 20 basis points to 11.1%. General Mills (GES) and Campbell Soup (CPB). The Adjusted EPS increased 21% to $1.02, compared to the price/sales multiple of 2.9 is above the peer average of 2.0 and consensus forecast of $1.03. For the full year, the company near the midpoint of the historical range of 2.5-3.4. The earned $4.51 per share, once cent above management's target. price/cash flow multiple of 18.5 is above the peer average of On a conference call to discuss 4Q results, management 15.2 but in the lower half of the historical range of 14.8-29.1. established guidance for 2018. It expects adjusted EPS from We are maintaining our BUY rating. Our revised target continuing operations of $5.00-$5.20, and organic revenue price of $120, combined with the dividend, implies a potential growth of 3.0%-3.5%. total return of 22% from current levels. On February 5, BUY-rated HSY closed at $100.17, down EARNINGS & GROWTH ANALYSIS $2.80. (David Coleman, 2/5/18) 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 Ingersoll-Rand PLC (IR) Thermo King. The Industrial segment provides a diverse Current Rating: BUY Publication Date: 2/6/18 range of products and services, including compressed air HIGHLIGHTS systems, power tools, and golf carts. Fourth-quarter results *IR: Raising target price to $105 and outlooks by segment are summarized below. *IR shares have outperformed over the last quarter, In the Climate segment, revenue rose a solid 6% gaining 5% while the S&P 500 has risen 2.2%. year-over-year on an organic basis. The operating margin was *Over the past year, the shares have underperformed, 12.6%, down 100 basis points from the prior year. Bookings advancing 13% while the market has gained 15.6%. rose 7% organically. In the Residential HVAC business, sales *On January 31, the company reported 4Q EPS that rose and bookings picked up to low-teens and high-single digit more than 20% but fell just shy of Street expectations. rates. In Transportation Refrigeration, the company noted *Management recently increased the dividend by 12.5%, improvement in revenue but a decline in bookings due to signaling confidence in its outlook. weakness in North America trailer and marine. Commercial HVAC reported that organic revenue growth was up in the ANALYSIS mid-single digits, while bookings rose at higher rates; margins INVESTMENT THESIS declined as the company targeted underpenetrated markets in Our rating on Ingersoll-Rand plc (NYSE: IR) is BUY. China, but this initiative is expected to be accretive to EPS in Going forward, we expect IR to benefit from improving 2018 and beyond. economic conditions and strength in U.S. construction Revenue in the Industrial segment rose 5% on an organic markets, and look for the Climate segment to continue to basis, above the long-term trend. Bookings increased 12%, deliver mid-single-digit growth, driven by strength in the U.S., signaling even better growth ahead. The segment adjusted Europe - and more recently Latin America and China. We also operating margin rose 220 basis points from the prior year to expect the company to benefit from recent acquisitions. 12.9%. This business, which has been exposed to challenging Management has been focused on rewarding shareholders; it macro trends in commodities and energy, appears on the road recently boosted the dividend by 12.5% and has a share to recovery. Management has been focusing on cost-cutting and expects continued margin improvement in 2018. In a sign

Section 2.59 GROWTH / VALUE STOCKS that energy markets are recovering, bookings in Compression weak construction activity. The acquisition of Trane, the sales Technologies increased in the mid-teens. Bookings in of Bobcat and Dresser-Rand, and the expansion of the Industrial Products and Club Car were both higher. We Security Technologies product portfolio have also helped to continue to look for solid growth in 2018. create a more diversified business. Turning to our estimates, based on bookings and margin IR generates substantial revenue overseas and its results trends, as well as expectations of a lower tax rate, we are are typically linked to global economic trends. Worldwide, we raising our 2018 estimate to $5.19 from $5.17. Our estimate is estimate that global GDP advanced at a 3.1% rate in 2016; we just above the low end of management's guidance range and and the IMF look for growth of 3.7% in 2017 and 3.9% in implies growth of 15% for the year. We look for continued 2018. growth in 2019 and are implementing a preliminary EPS Ingersoll Rand is also sensitive to trends in the dollar. estimate of $5.81. Our five-year earnings growth rate forecast Looking ahead, we think the greenback is fairly valued and in remains 10%. a trading range, particularly if the Federal Reserve continues to move slowly to raise short-term rates. A stable or falling FINANCIAL STRENGTH & DIVIDEND dollar would be a positive development for the Industrial Our financial strength rating on IR is Medium-High. The sector and Ingersoll-Rand. company receives above-average scores on our key financial strength criteria of debt levels, fixed-cost coverage, cash flow COMPANY DESCRIPTION conversion and profitability. Ingersoll-Rand is a diversified large-cap industrial IR had $1.5 billion in cash and cash equivalents at the end company headquartered in Ireland. The company's two of 4Q17, down from $1.7 billion at the end of 2016. Total operating divisions are Climate and Industrial. debt was $4.0 billion or 36% of total capital. Operating income covered net interest expense by a factor of 8.5 last VALUATION year. The company's free cash flow to net income ratio was an We think that IR shares are favorably valued at current impressive 118%. prices near $90, above the midpoint of their 52-week range of The company has a share repurchase plan. $77-$96. On a technical basis, the shares, after establishing a Ingersoll-Rand pays a dividend. In August, it increased its triple-bottom near $49 in January-February 2016, have payout by 12.5% to $0.45 per quarter, or $1.80 annually, for a embarked on a bullish pattern of higher highs and higher lows. yield of about 1.9%. We think the dividend is secure and To value the stock on a fundamental basis, we use a peer likely to grow. Our dividend forecasts are $1.94 for 2018 and and historical comparison model, as well as a dividend $2.14 for 2019. discount model. IR shares are trading at 17.4-times our 2018 estimate, just above midpoint of the historical range of 12-21. MANAGEMENT & RISKS On a price/sales basis, the shares are trading near the midpoint Mike Lamach has been the company's CEO since early of the five-year range. The dividend yield of 1.9% is above 2010, and previously served as chief operating officer. Susan the midpoint of the five-year range. Compared to the peer Carter has been the CFO since September 2013. group, IR's multiples generally point to undervaluation. Our The company's strategy is to deliver reliable, dividend discount model renders fair value near $120. energy-efficient and environmentally friendly products in Blending our approaches, we arrive at a revised target price of growing markets. The company's businesses are typically $105. among the top 2 in each industry. On February 5, BUY-rated IR closed at $90.53, down Investors in IR shares face risks. $4.71. (John Eade, 2/5/18) 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 International Paper Co (IP) contracts to U.S. companies that have reincorporated abroad. Current Rating: BUY Publication Date: 2/5/18 The Homeland Security Act of 2002, for example, prohibits such companies from receiving contracts from the Department HIGHLIGHTS of Homeland Security. Further restrictions may also be *IP: Boosting target by $8 to $70 imposed by state and local governments. *Despite rising input costs, International Paper has been The company continues to grow both organically and able to pass along price increases, increase production, reduce through acquisitions. In January 2018 it acquired ICS Cool planned maintenance outages, and improve manufacturing Energy, a privately owned temperature control and HVAC efficiency. solutions and services company that specializes in temporary *On February 1, the company reported 4Q17 non-GAAP rental of energy efficient chillers for commercial and net income of $530 million or $1.27 per diluted share, up from industrial buildings across Europe. Acquisitions such as these $279 million or $0.67 per share in 4Q16. EPS topped the acquisitions pose integration risks. consensus of $1.19 and our estimate of $1.18. Ingersoll-Rand has reduced its exposure to *We are increasing our 2018 EPS estimate from $4.35 to heavy-equipment sales cycles, providing some protection from $4.70, which assumes further acquisition-related synergies

Section 2.60 GROWTH / VALUE STOCKS along with higher production and pricing. We are also setting billion in pension plan liabilities by approximately 9%. a 2019 estimate of $5.15. On September 22, IP announced plans to convert its #15 *On valuation, IP is trading at 13.2-times our 2018 EPS paper machine at Riverdale Mill from uncoated freesheet to forecast, below the midpoint of the five-year annual range of high-quality whitetop linerboard and containerboard. The 7.8-21.2 and the average multiple of 17.7 for close conversion, which is expected to be completed by 2019, will competitors. add 450,000 tons of annual capacity and provide the ability to shift manufacturing among different containerboard products. ANALYSIS IP will invest $300 million in the project.

INVESTMENT THESIS EARNINGS & GROWTH ANALYSIS We are maintaining our BUY rating on International We expect IP to generate $200 million in Paper Co. (NYSE: IP) and raising our target price to $70 from acquisition-related synergies in 2018. We are boosting our $62. We believe that IP's purchase of assets from 2018 EPS estimate from $4.35 to $4.70, which assumes Weyerhaeuser will continue to strengthen its product line and further acquisition synergies along with increased production expand its customer base. The company has also acquired a and higher pricing. We are initiating a 2019 estimate of $5.15. newsprint mill in Spain from Holmen Paper, which it will Assuming further global economic recovery, we believe that convert to produce recycled container board, and has sold a IP will continue to leverage its geographically diverse revenue range of underperforming assets. In addition, it is buying back base to generate stronger earnings and cash flow. stock and has a steady record of increasing its dividend, with a 3% increase in November 2017. The company has also FINANCIAL STRENGTH & DIVIDEND implemented effective cost-cutting measures while integrating We rate International Paper's financial strength as acquisitions; in all, it expects acquisition-related synergies of Medium, the midpoint on our five-point scale. IP's debt is $200 million in 2018, which should help to offset rising input rated Baa2/stable by Moody's and BBB/stable by Standard & costs. On valuation, IP is trading at 13.2-times our 2018 EPS Poor's. Fitch no longer rates IP's debt. forecast, below the midpoint of the five-year annual range of At the end of 4Q17, IP's debt/capitalization ratio was 7.8-21.2 and the average multiple of 17.7 for close 63%, down from 72% at the end of 4Q16 but above the peer competitors. The dividend yield of about 3.1% is above the average of 48%. IP had cash and equivalents of $1.02 billion peer average of 2.3%, indicating value. Our target price of $70 at the end of 2017, compared to $1.03 billion at the end of implies a multiple of 14.9-times our 2018 EPS estimate, near 2016, and debt of $11.2 billion, compared to $11.3 billion a the midpoint of the five-year range and below the peer year earlier. average. We believe that the recent decline in share price In November 2017, the company raised its quarterly offers investors an attractive entry point. 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 RECENT DEVELOPMENTS estimates are $1.92 for 2018 and $1.98 for 2019. IP shares have outperformed the S&P 500 over the past We expect IP to continue to repurchase stock three months, rising 8.8% while the index has gained 6.7%. opportunistically, and to announce a new buyback They have gained 17.3% over the past year, compared to a authorization when its current program is completed. gain of 20.2% for the index. The beta on the stock is 1.5. On February 1, the company reported 4Q17 non-GAAP MANAGEMENT & RISKS net income of $530 million or $1.27 per diluted share, up from Mark S. Sutton became IP's CEO on November 1, 2014 $279 million or $0.67 per share in 4Q16. EPS topped the and chairman of the board on January 1, 2015. Mr. Sutton was consensus of $1.19 and our estimate of $1.18. Non-GAAP previously the company's chief operating officer. He earnings excluded a provisional net tax benefit of $1.2 billion succeeded John Faraci, who had served as CEO and chairman ($2.93 per diluted share) related to the passage of the Tax since November 2003. Glenn Landau, formerly senior vice Cuts and Jobs Act of 2017. Fourth-quarter revenue rose to president of Finance, recently succeeded Carol Roberts as the $5.71 billion from $5.38 billion in 4Q16, but fell short of the company's CFO. IP has a deep bench of executive talent, and consensus forecast. The year-over-year increase in revenue we expect future management changes to be smooth. reflected higher realized prices, and record volume in North Executive bonuses are tied to free cash flow, return on American Industrial Packaging and Global Cellulose Fiber. investment, and total shareholder return, which we consider For the full year, IP posted adjusted EPS of $3.60, up appropriate. from $3.36 in 2016. Revenue was $22.9 billion, up from Investors owning shares in International Paper face a $21.1 billion a year earlier. range of risks. In addition to the industry-wide issues of On September 26, 2017, International Paper agreed to competition, operational efficiency, environmental compliance purchase a group annuity contract from Prudential Insurance and potential litigation, the firm has significant debt. Pulp and and transfer to Prudential future pension benefit obligations paper prices can also be highly volatile. and annuity administration for approximately 45,000 participating employees. The agreement will reduce IP's $14 COMPANY DESCRIPTION

Section 2.61 GROWTH / VALUE STOCKS

International Paper is a global producer of renewable appreciation ($14.9 billion), and currency translation ($2.5 fiber-based packaging, pulp and paper products with billion). The addition of Source, a European-based ETF manufacturing operations in North America, Latin America, provider with $26 billion in total AUM (in-house and Europe, North Africa, India and Russia. It produces externally managed), also boosted 3Q results. corrugated packaging products; pulp for diapers, tissue and The company agreed in late September to acquire the other personal hygiene products; and printing and writing ETF business of Guggenheim Investments, with $36.7 billion papers. The company was founded in 1898 and is based in of assets under management. The transaction is expected to Memphis, Tennessee. close in 2Q18. We view the acquisition favorably, based both on price (which is 4% of AUM) and the range of ETFs being VALUATION acquired (which include smart-beta and index funds). We think that IP shares are attractively valued at current Invesco is among the largest independent investment prices near $62. Over the past 52 weeks, the shares have management firms, with a large retail equity business that we traded between $49 and $67. believe is well positioned to benefit from improving equity On the fundamentals, IP is trading at 13.2-times our 2018 market values. AUM is leveraged toward equities, with 46% EPS forecast, below the midpoint of the five-year annual in stocks and 24% in bonds. We believe that recent strength in range of 7.8-21.2 and the average multiple of 17.7 for close equity market values bodes well for profitability. competitors such as Westrock Co. (WRK), Packaging Corp. IVZ trades below industry-average levels for P/E and of America (PKG), Avery Dennison (AVY) and Sonoco price/book. As management focuses on cost controls and Products (SON). The price/sales ratio is 1.1, near the top of boosts operating margins toward the level of the industry the five-year range of 0.6-1.2 but below the peer average of leaders, we expect earnings and valuation multiples to 1.3. The price/book ratio is 3.9, in the middle of the five-year increase. 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%, RECENT DEVELOPMENTS indicating value. Our target price of $70 implies a multiple of Over the past year, IVZ shares have risen 25%, similar to 14.9-times our 2018 EPS estimate, near the midpoint of the the broad market. five-year range and below the peer average. On January 31, Invesco reported adjusted 4Q17 adjusted On February 5 at midday, BUY-rated IP traded at $62.23, EPS of $0.73, up from $0.59 in the prior-year quarter and up $0.06. (David Coleman, 2/5/18) 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 Invesco Ltd (IVZ) performance fees, and the acquisition of Source. Average Current Rating: BUY Publication Date: 1/31/18 AUM rose 15% to $930.3 billion. Adjusted operating expenses rose 15%, which the HIGHLIGHTS company attributed in part to higher marketing expenses *IVZ: Favorable AUM trends continue in 4Q related to the Source acquisition. Adjusted net income rose *On January 31, Invesco reported adjusted 4Q17 adjusted 25% to $299.18 million. EPS of $0.73, up from $0.59 in the prior-year quarter and For all of 2017, net revenues rose 11% to $3.7 billion, above the consensus of $0.70. while adjusted EPS climbed to $2.70 from $2.23. *Average assets under management rose 15% from the In September 2017, Invesco agreed to acquire the ETF prior year. Net inflows were light at $2.7 million, but AUM business of Guggenheim Investments, with $36.7 billion of benefited from a strong quarter for market appreciation and assets under management, for $1.5 billion in cash. The positive currency translation. company noted that the acquisition would expand its active, *In late September 2017, Invesco agreed to acquire the passive and alternative investment capabilities. ETF business of Guggenheim Investments, with $36.7 billion In August 2017, Invesco acquired Source, an independent of assets under management. specialist ETF provider in Europe with $26 billion in equity, *IVZ trades at 11.6-times our 2018 EPS estimate, below fixed-income, and commodity ETF assets, including smart the industry average multiple of 15.0. Our target price of $41 beta and active ETFs. The purchase was made using available implies a multiple of 13.2-times our forward four-quarter EPS cash. estimate, closer to the industry average. EARNINGS & GROWTH ANALYSIS ANALYSIS Invesco reported average assets under management of INVESTMENT THESIS $930.3 billion in 4Q17, up 15% from the prior year, aided by We are reaffirming our BUY rating on Invesco Ltd. the integration of Source, which was acquired in August. We (NYSE: IVZ) following the company's fourth-quarter results. look for a 9% rise in average AUM in 2018, aided by healthy AUM trends showing 15% growth were favorable in 4Q, with equity markets and the acquisition of Guggenheim's ETF a combination of net inflows ($2.7 billion), market business. Management has guided toward organic AUM growth of 3%-5%, including dividend reinvestment, and

Section 2.62 GROWTH / VALUE STOCKS expects additional growth to come through acquisitions. Investors in IVZ shares face numerous risks, including Long-term net inflows in 4Q were $4.4 billion, down from the fact that most of the company's revenues are tied to the $5.2 billion in 3Q, though a strong quarter for market value of assets under management. appreciation added $14.9 billion. The Source acquisition Management is under constant pressure to provide the boosted assets by $26 billion in 3Q. right products to meet investors' evolving needs. As the Most of the company's actively managed funds have industry consolidates, management will face more pressure to performed in the top half of their peer group range over the have the right products to maintain market share. past five years - generally a good sign that the company has The company's results are also dependent on product the ability to attract and retain investment assets. performance, and a prolonged downturn in investment results The net revenue yield (investment revenues divided by could hurt sales, earnings and the share price. AUM) has generally been declining due to lower fees in a competitive asset management environment; however, COMPANY DESCRIPTION margins have benefited from the company's increased scale. Invesco is an independent global investment manager; it Growth in employee compensation costs has been better provides a variety of investment alternatives to high-net-worth contained in recent quarters, benefiting from a business and retail investors, as well as to institutions worldwide. optimization program. However, headcount continues to Headquartered in Atlanta and incorporated in Bermuda, it increase to support growth initiatives. The company had 7,030 offers investors equity, fixed-income and alternative employees as of December 31, up from 6,790 a year earlier. investment funds. IVZ shares are a component of the S&P The business optimization program (announced in 4Q15) 500. focused on making support functions more efficient. IVZ The company's first operations date back to England and recorded a 4Q charge of $16.2 million for this program, Wales in 1935, and the original Invesco was founded in the including $12.2 million for staff severance costs. IVZ noted United States in 1978. After a series of smaller mergers in the that the initiative delivered $43 million in run-rate expense 1980s, the company merged with AIM in 1997 to form savings in 2017. AMVESCAP, and was then rebranded as Invesco in 2007. Management projects a 20%-21% effective tax rate in Current subsidiaries, brought in through acquisitions, include 2018, down from the 27% paid in 2017, following the recent ETF leader PowerShares, among others. passage of the Tax Cuts and Jobs Act. Largely reflecting the VALUATION lower effective tax rate, we are raising our 2018 EPS estimate IVZ shares appear attractive at current prices in the to $3.11 from $2.96. We are also setting a 2019 forecast of mid-$30s. Over the past 12 months, the shares have traded in $3.40. a range of $29-$38. IVZ trades at 11.6-times our revised 2018 Over the long term, we expect strong investment results earnings estimate, compared to an industry average of 15.0. to lead to fund inflows and higher performance fees, and The shares also appear inexpensive on a price/book basis, project long-term earnings growth of 8%. with a multiple of 1.8, and carry a dividend yield of about FINANCIAL STRENGTH & DIVIDEND 3.2%, above the average for large-cap financials. Our financial strength rating for Invesco is Medium, the Our target price of $41 implies a multiple of 13.2-times midpoint on our five-point scale. The company scores well on our 2018 EPS estimate, closer to the industry average. Invesco our three-point test of debt levels, fixed-cost coverage, and has lower operating margins than some peers, such as profitability. In 4Q17, the adjusted operating margin was a BlackRock, but continues to benefit from consistent robust 39.7%. Cash and cash equivalents totaled $2.0 billion profitability, a strong industry position, and a clean balance at the end of 4Q17, and long-term debt totaled $2.1 billion sheet. (excluding debt of consolidated investment products). On January 31 at midday, BUY-rated IVZ traded at In 1Q17, the company raised its quarterly dividend by $36.22, down $0.46. (Stephen Biggar, 1/31/18) 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. JetBlue Airways Corp (JBLU) In 4Q16, the company repurchased $150 million of its Current Rating: HOLD Publication Date: 2/1/18 common stock, or 4.8 million shares, at a weighted-average HIGHLIGHTS price of $31.43 per share. Invesco did not repurchase any *JBLU: Solid 4Q results; maintaining HOLD shares in 2017, which it attributed to the acquisition of Source *JBLU shares have had a strong run over the past five and the pending acquisition of Guggenheim's ETF business. years, with a return of 235%. EPS rose strongly from 2012 to MANAGEMENT & RISKS 2016, reflecting impressive traffic and capacity growth and Martin Flanagan, 57, has been president and CEO of the impact of low fuel prices. Invesco since 2005, and has worked to improve the firm's *However, we expect rising fuel costs and other expenses operational efficiency and position it for growth. Prior to to cause some investors to avoid the shares going forward. joining Invesco, Mr. Flanagan worked for Templeton Funds. *We are maintaining our 2018 estimate of $2.16 and

Section 2.63 GROWTH / VALUE STOCKS setting an estimate of $2.30 per share for 2019. We expect CASM excluding fuel to rise 1.0% in 2018, at *We will look to put this well-managed airline back on the high end of management's forecast for 1% lower to 1% the BUY list on signs of improved investor sentiment or a higher CASM. We look for cost-cutting initiatives to continue significant nonfundamental pullback in the share price. to benefit results over the next 12-18 months We are maintaining our 2018 estimate of $2.16 based on INVESTMENT THESIS our expectations for solid revenue growth. For 2019, we are We are maintaining our HOLD rating on JetBlue Airways setting an estimate of $2.30 per share. Corp. (NGS: JBLU). JBLU shares have had a strong run over the last five years, with a return of 235%. Earnings rose FINANCIAL STRENGTH strongly in 2012-2016, driven by impressive traffic and Our financial strength rating on JetBlue is Medium, the capacity growth, as well as by low fuel prices. However, we midpoint on our five-point scale. The company ended 4Q17 expect rising fuel costs and other expenses to cause some with $695 million in cash and investment securities, down investors to avoid the shares going forward. We will look to from $1.06 billion at the end of 4Q16. Total debt of $1.20 put this well-managed airline back on the BUY list on signs of billion at the end of 4Q17 was down from $1.38 billion at the improved investor sentiment or a significant nonfundamental end of 2016. pullback in the share price. JBLU does not pay a dividend, and we do not expect it to initiate one in the near term. RECENT DEVELOPMENTS The company's long-term debt is rated Ba3/stable by On January 25, JetBlue reported fourth-quarter results. Moody's, BB-/stable by S&P, and BB-/stable by Fitch. The Net income fell to $170 million or $0.32 per diluted share company has a debt/cap ratio of 24%, below its 30%-40% from $274 million or $0.50 per share a year earlier. The target range. consensus estimate had called for earnings of $0.34 per share. The decrease reflected an 8.1 % increase in CASM. MANAGEMENT & RISKS Management had expected CASM to rise 5.0%-7.0% in the Robin Hayes took the reins as JetBlue's CEO in February fourth quarter. 2015, succeeding David Barger. Mr. Hayes previously served In the fourth quarter, revenue rose 7.0% to $1.76 billion, as the company's president. above the consensus estimate of $1.75 billion. Passenger Investors in the JBLU shares face risks. Airline revenue grew 5.9% to $1.56 billion, while 'Other' revenue financials, labor negotiations, fare and traffic rates, and fuel grew 16.9%. Revenue passenger miles rose 3.1% to 11.5 costs all represent potential catalysts for share price billion on a capacity increase of 5.1%. Management had movement. In addition, the risk of a major terrorist attack or projected 4.5%-5.5% higher capacity. The fourth-quarter load health scare is ever-present. factor was 83.1%, down 160 basis points from the prior-year JetBlue faces tough competition from other low-cost period. The yield per passenger mile rose 2.8% to $0.136. carriers, as well as from legacy airlines that have slashed fares Passenger revenue per available seat mile (PRASM) increased in recent years. The company's biggest challenge is to expand 80 basis points from the prior year to $0.113, while operating its route structure while sustaining margin and earnings revenue per available seat mile (RASM) increased 180 basis growth. The company hopes that its new and retrofitted Mint points to $0.127. planes and associated in-flight service will help it to maintain Fourth-quarter operating expenses rose 16.5% from the ticket prices amid increased competition. prior year to $1.57 billion, reflecting rising aircraft fuel costs JBLU's internal operations have not always kept pace and an increase in salaries, wages and benefits. Operating with capacity. As it is based in New York City, the airline also income fell 36% to $189 million, and the pretax operating faces the risk of delays caused by significant traffic margin decreased to 10.8% from 18.0% in 4Q16. congestion in the area or by major storms. Given JBLU's In 2017, revenue increased 5.8% to $7.0 billion, but relatively high aircraft utilization rate, a major delay could earnings declined from $2.19 to $1.76 per share. have a domino effect, hurting the entire network. Along with the 4Q results, management provided 2018 We note that JetBlue employees, unlike those of many guidance. It expects CASM excluding fuel to be 1.0% lower airlines, are not unionized. As a result, the company has been to 1.0% higher in 2018. It also looks for capacity to increase able to design a competitive pay structure that responds well 6.5%-8.5%. to market changes, incorporating profit-sharing and RASM is expected to be up 2.5%-5.5% year-over-year in stock-based compensation. the first quarter of 2018. Management expects CASM ex-fuel to be up 2.0%-4.0% COMPANY DESCRIPTION in the first quarter. It also expects capacity to increase 3.5% JetBlue Airways is a low-cost airline based at New York's -5.5%. JFK Airport. The airline operates a fleet of Airbus A320s and Embraer E190s, and runs an average of 1000 daily flights to EARNINGS & GROWTH ANALYSIS 101 destinations. JetBlue posted revenues of $7.0 billion in For 2018, we expect an 8.5% increase in revenue to $7.6 2017. billion on 8% higher capacity and slightly higher yields.

Section 2.64 GROWTH / VALUE STOCKS

INDUSTRY a still favorable macro environment, we expect advisory Our rating on the Industrial sector is Market-Weight. revenues at Lazard to rebound. Industrial sector EPS growth is below the market average, *We look for Lazard to gain share relative to large and while the two-year-forward P/E is above both the five-year mid-sized advisors, leading to above-industry-average revenue historical average and the market average. growth. The Industrial sector accounts for 10.3% of S&P 500 market capitalization. Over the past five years, the weighting ANALYSIS has ranged from 9% to 12%. We think that investors should INVESTMENT THESIS allocate 9%-11% of their diversified portfolios to the group. We are reiterating our BUY rating on Lazard Ltd. The sector includes industries such as transportation, (NYSE: LAZ) and raising our target price to $62 from $53. aerospace & defense, heavy machinery and electrical The company is operating in a healthy environment for both equipment. advisory fees and assets under management. It also has a The sector outperformed the market in 2016, with a gain favorable pipeline of deal activity and is advising on major of 16.1%, after underperforming in 2015, with a loss of 4.7%. transactions that should result in continued strong advisory It underperformed in 2017, with a gain of 18.5%. fees. By our calculations, the 2018 P/E ratio is 18.8, slightly Lazard has benefited from a generally healthy M&A above the market multiple. Earnings are now expected to rise market that reflects a low cost of capital, CEO optimism, 9.2% in 2018 and 10.3% in 2017 after declining 3.3% in rising shareholder activism, and efforts by companies to boost 2016. The sector's debt/cap ratio of 50% is above the market revenue through both domestic and cross-border transactions. average. The yield of 1.4% is below the market average of The usage of repatriated cash, as part of the recent Tax Cuts 1.8%. and Jobs Act, could also spur increased M&A activity as VALUATION companies look to expand. The company is also gaining share relative to large and JBLU shares fell 45% from late September 2015 to a mid-sized advisors. It ranks fifth in trailing 12-month financial near-term low of $14.76 on June 27, 2016; they then rose to a advisory revenues, below only Goldman Sachs, JPMorgan, high near $23 in early January before trading lower through Morgan Stanley and Bank of America. most of February and March. The shares rose on October 24 In our view, Lazard remains a compelling secular growth following stronger-than-expected 3Q earnings, but fell sharply story with a clean balance sheet and a focused business model. the next day. They are currently trading near $21. We believe that Lazard's P/E has room to expand as To value the stock on a fundamental basis, we use peer operating margins and market share improve. Our revised and historical multiple comparisons. JBLU shares are trading target price of $62 implies a 15-times multiple on forecasted at 9.7-times our 2018 EPS estimate, toward the low end of the 2018 EPS. The dividend yields about 2.8%, adding a historical range of 7-25 and below the peer average of 15.3. significant recurring income component to the total return, They are trading at a price/sales multiple of 1.1, in the upper and is amply covered by cash flow. Special dividends the last half of the five-year range of 0.3-1.3 but below the peer several years have also added a solid return component. 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 RECENT DEVELOPMENTS average of 3.2. Based on prospects for moderate earnings Over the past year, LAZ shares are up 28%, compared to growth, we see limited near-term upside for JBLU. Our rating a 15% gain for the broad market. remains HOLD. On February 1, Lazard reported adjusted 4Q17 earnings On February 1 at midday, HOLD-rated JBLU traded at of $1.12 per share, down from $1.13 in the prior year but well $20.93, up $0.07. (John Staszak, CFA, 2/1/18) 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 Lazard Ltd (LAZ) net income was down 1% to $148.1 million. Current Rating: BUY Publication Date: 2/7/18 The financial advisory segment was hurt by lower HIGHLIGHTS strategic advisory and restructuring revenue, while greater *LAZ: Raising target to $62 following 4Q EPS asset management fees reflected higher AUM. Average AUM *On February 1, Lazard reported adjusted 4Q17 earnings rose 22% to $244 billion in 4Q17. of $1.12 per share, down from $1.13 in the prior year but well For all of 2017, revenues were up 13% to $2.65 billion, above the consensus of $0.90. while adjusted EPS climbed to $3.78 from $3.09. *Advisory revenues softened in 4Q under strong EARNINGS & GROWTH ANALYSIS prior-year comparisons, but a solid gain in asset management We believe the market environment for Lazard's broader fees was helped by a 16% year-over-year increase in average advisory practice - which includes restructuring and strategic AUM. advisory - remains robust, and note that the company *The backlog of advisory deals remains healthy, and with

Section 2.65 GROWTH / VALUE STOCKS continues to gain advisory market share relative to peers. In 2017, Lazard repurchased 7.0 million shares of Lazard's broad and deep coverage - by geography and industry common stock for about $309 million. In October 2017, the - distinguishes it from boutiques, while its focus on advisory board authorized additional share repurchases of up to $200 distinguishes it from large banks. million through the end of 2019. Share buybacks primarily During the fourth quarter, the company advised on a offset dilution from share issuances and have not range of major M&A transactions: Level 3 Communications meaningfully reduced the diluted share count. on its $34 billion sale to CenturyLink; Gilead's $11.9 billion acquisition of Kite Pharma; Paysafe's 3.0 billion British Pound MANAGEMENT & RISKS recommended sale to a consortium of funds managed or Lazard is led by Chairman and CEO Kenneth M. Jacobs, advised by Blackstone and CVC; Express Scripts' $3.6 billion who has been in those roles since 2009. acquisition of eviCore healthcare; and Anheuser-Busch While Lazard has diversified its revenue in recent years, InBev's $3.2 billion transition of its 54.5% stake in Coca-Cola revenue is still highly dependent on fees earned from advising Beverages Africa to The Coca-Cola Company. We believe the clients on financial transactions and fees earned on assets pipeline of capital advisory, sovereign advisory, restructuring, under management. Lazard also earns fees if its investment and debt advisory deals remains healthy. funds exceed return hurdles, but these typically account for Advisory revenues should continue at a relatively high only 5%-10% of asset management revenues. Thus, Lazard's pace, as current transactions begin to close. The top-five deals revenues can be volatile and tough to predict from quarter to on which the company is advising totaled more than $175 quarter. billion at the end of 4Q. In 2018, we look for a 3% rise in Advisory revenues are dependent on levels of CEO advisory revenue, which includes difficult comparisons with a confidence as well as stock valuations and conditions in the strong 2017. financing markets. Large companies are currently flush with The asset management business has also been performing cash, financing markets are functioning well, and interest rates well. Average AUM was up 16% in 2017 to $227 billion, with remain at historically low levels. recent results benefiting from market appreciation and healthy With regard to risks related to financial regulatory reform, inflows. We are projecting 9% growth in asset management we note that Lazard does not have a proprietary trading desk revenues in 2018, leading to 5% growth in overall revenues. or commit its own capital to private equity or real estate funds. Compensation was 53.8% of revenue in 4Q17, down As a result, the Volcker Rule has no direct impact on the from 54.9% the prior year. The company expects to achieve a company. compensation ratio in the mid- to high 50% range on both an COMPANY DESCRIPTION awarded and adjusted basis. Noncompensation expense was Lazard Ltd., one of the world's leading financial advisory 18.5% of revenue in 4Q17, up from 16.8% a year earlier; the and asset management firms, provides advice on mergers and company's goal is to keep this ratio between 16% and 20%. acquisitions, strategic matters, restructuring and capital Management is guiding toward an effective tax rate in the structure, capital raising and corporate finance, as well as mid-20s in 2018, following recent passage of the Tax Cuts asset management services to corporations, partnerships, and Jobs Act. Aided by the lower rate, as well as recent institutions, governments, and individuals. momentum in the asset management business, we are raising our 2018 forecast to $4.13 from $3.76. We are initiating a VALUATION 2019 EPS forecast of $4.39. Lazard derives about 52% of its revenues from corporate advisory and the balance from institutional asset management. FINANCIAL STRENGTH & DIVIDEND The asset management piece is tough to benchmark. While Our financial strength rating for Lazard is High. The Lazard has been able to consistently grow assets in recent company has a low long-term debt/cap ratio and high years, the average 2018 P/E for large publicly traded liquidity. Lazard acts mainly as an advisor; it does not provide traditional active asset managers has been hurt by outflows to financing for transactions or otherwise commit its own capital passive index strategies. In comparisons with advisory firms, in order to complete transactions. Lazard trades well below Greenhill (GHL), with a multiple of In April 2017, Lazard announced an 8% increase in its 17-times the 2018 consensus. Moelis (MC), a pure-play quarterly dividend to $0.41 per share, or $1.64 annually, for a advisor that went public in April 2014, trades at about yield of about 2.8%. We estimate regular dividends of $1.70 20-times the 2018 consensus. Advisory revenues for Greenhill in 2018 and $1.78 in 2019, representing a payout ratio in the and Moelis are a fraction of those for Lazard, and the growth low-40s for both years. The company declared a special $1.30 rates for those companies will be faster in an improving M&A per share common stock dividend in January 2018, special market (assuming they don't lose market share). $1.20 per share common stock dividends in January 2017 and Assuming a continued healthy M&A environment and February 2016, and a special $1.00 per share dividend in stable to rising assets under management, we believe that LAZ February 2015. Special dividends have provided a healthy shares should trade closer to 15-times our 2018 estimate, boost to total return. The extra yield on the early 2018 special closer to the peer average for advisory firms. Our target price dividend was about 3.0%. of $62 (raised from $53) implies a multiple of 15-times our

Section 2.66 GROWTH / VALUE STOCKS

2018 estimate. maintain industry-leading store productivity. However, On February 6, BUY-rated LAZ closed at $56.80, up management must continue to restore the product quality and $0.14. (Stephen Biggar, 2/6/18) performance, merchandise availability, and image that are essential to a premium brand. We believe that the company's in-store service remains top-notch. Lululemon Athletica Inc (LULU) A risk is from both competition and substitution. A whole Current Rating: HOLD Publication Date: 2/6/18 range of competitors from Under Armour to Nordstrom are making competing products. Another risk is that some HIGHLIGHTS retailers are seeing customers switching to 'jeans' that *LULU: CEO fails to meet conduct standards, resigns incorporate more advanced materials and construction to *After the close of trading on February 5, lululemon improve their comfort and fit. announced that CEO Laurent Potdevin was resigning. Lulu While our analysis currently suggests that the shares are said in a press release said that it 'expects all employees to fairly valued, we would consider raising our recommendation exemplify the highest levels of integrity and respect for one if it appears that the company can further improve the another, and Mr. Potdevin fell short of these standards.' efficiency of its design, production and supply chain with *Glenn Murphy will have an expanded role as Executive incremental increases to operating margin. Chairman. Mr. Murphy is a proven executive who we met during his tenure as CEO of GAP. In addition to running the RECENT DEVELOPMENTS huge specialty retailer whose Athleta brand competes with After the close of trading on February 5, lululemon lululemon, he was CEO of Shoppers Drug Mart and a senior announced that CEO Laurent Potdevin was resigning for executive at Loblaw Companies, which is the biggest grocery failing to meet the company's standards of conduct. The chain in Canada. company's press release was vague, but it said that it 'expects *For FY19, we are raising our full-year estimate to $3.00 all employees to exemplify the highest levels of integrity and per share from $2.65 per share. This reflects about 11% sales respect for one another, and Mr. Potdevin fell short of these growth, up from 9.5%% previously and an improvement in standards of conduct.' our estimate of operating margin to approximately 19% from Glenn Murphy now has an expanded role as Executive 18.3% previously. Chairman. Mr. Murphy is a proven executive who we met *We are lowering our FY19 tax rate estimate to 27% during his tenure as CEO of GAP. In addition to running the from 31%. Our sales forecast is $2.9 billion, which is close to huge specialty retailer whose Athleta brand competes with consensus. Our estimate of operating income is $558 million lululemon, he was CEO of Shoppers Drug Mart and a senior versus consensus of $566 million and our estimate of net executive at Loblaw Companies, which is the biggest grocery income is $408 million versus the current consensus of $403 chain in Canada. million. Consensus EPS is $3.02 per share. The company also announced that three of lululemon's top managers will take on additional responsibilities, reporting ANALYSIS to Mr. Murphy; Executive VP, Americas Celeste Burgoyne, INVESTMENT THESIS will oversee the global business, including stores and Our rating on lululemon athletica inc. (NGS: LULU) e-commerce, and brand marketing; COO Stuart Haselden will remains HOLD, as the shares are trading close to our fair have responsibility for all operations related to finance, supply value estimate. chain, people, and technology; and Sr. VP of Merchandising Lululemon has been recovering from quality-control Sun Choe will guide all aspects of product development, issues, merchandising missteps, supply-chain challenges, and design, and merchandising. concerns about management turnover. It appears that demand The company also confirmed the earnings guidance it is returning and the flow of merchandising is generally provided on January 8, as discussed below. improving. On December 6 , lululemon reported third-quarter EPS of We believe that the company remains poised for several $0.43, which was down from the prior year's GAAP EPS of years of double-digit earnings growth, driven by an increase $0.50 per share. The GAAP result includes about $0.13 per in retail square footage, the expansion of its e-commerce and share of restructuring costs related to the previously-discussed international businesses, the development of new products, plan under which the company closed 48 of the company's 55 and the addition of features and fabrics to enhance existing ivivva stores. Through the third quarter, the company had product lines. The company's grassroots marketing, in-store largely completed the $45 - $50 million of restructuring, asset events, product innovation and controlled distribution also impairment and lease-termination costs. This is at the low end provide a competitive advantage that enhances LULU's of the company's initial guidance of $50 - $60 million. The product offering at a time when competition from online company plans to run ivivva primarily as an e-commerce sellers is compressing margins on all but the most unique business with just the few remaining brick-and-mortar stores. merchandise. On an apples-to-apples basis, the 3Q result exceeded The shares may benefit from the company's ability to expectations. The company earned $0.56 per share on an

Section 2.67 GROWTH / VALUE STOCKS adjusted basis, which was above the adjusted $0.47 the because our estimate of impairments was too high and actual company earned in the prior year. The result also exceeded the sales were higher than we expected. GAAP operating income $0.52 per share non-GAAP consensus and the top of dollars were $17 million higher than we modeled with $9 management's non-GAAP guidance, which was also $0.52. million being a result of lower impairments. The remainder of Our estimate was on a GAAP basis and in the middle of the the outperformance is from better-than-expected gross margin company's GAAP guidance of $0.33- $0.35. We will discuss dollars offset by $4 million from higher SG&A. the deviations from our estimates, but one significant factor is Below the operating line, the tax rate of 32% was 20 basis that we modeled 3Q impairments at $30 million, or $0.17 per points below our estimate. share, and they came in at $22 million, or $0.13 per share. Total inventory was 9% higher than in the prior-year Fiscal third-quarter revenue rose 14% to $619 million, quarter, but we don't see any markdown risk as inventory which topped the StreetAccount consensus of $610 million growth is less than the projected growth in sales. Going and our estimate of $608.5 million. forward management expects inventories to grow in line with Total comparable sales, including direct-to-customer and sales expectations. in-store sales, increased 7% on a constant-dollar basis. This Cash generated from operations came to $131 million in was better than the StreetAccount consensus of 5.3% growth. the first three quarters, up from $99 million a year earlier. Square footage was up 4% year-over-year. The company closed a net 33 stores in the quarter with 17 openings offset by EARNINGS & GROWTH ANALYSIS 50 stores closed. We are raising our FY18 diluted EPS estimate to $2.27 Sales in company operated stores increased by 8% to per share from $2.10 per share, which includes approximately $425 million. The StreetAccount consensus was $431.5 $0.25 per share of expense to restructure ivivva. Our estimate million. Comparable-sales in company-operated stores were is on a GAAP basis. Nine cents of this increase is a result of up 1% in the quarter on a constant-dollar basis. Store comps 3Q earnings coming in above our estimate with $0.04 of the were up 2% in dollars. Traffic was down, but conversion outperformance coming from lower-than-expected improved as a higher percentage of store visitors made restructuring and the rest coming from better sales and gross purchases. The visitors who made purchases also made larger margin than we expected. The remaining $0.08 of the increase purchases. is from raising our 4Q GAAP estimate to $1.25 per share from Direct-to-consumer revenue jumped 26% to $131 million. $1.17. This is based on the company's post-holiday guidance The StreetAccount consensus was $121.6 million. Direct of $1.24-$1.26 per share, which is up by $0.05 from guidance revenue was up 25% on a constant dollar basis. Management issued at the end of 3Q. There are a few notable changes to has seen increases in traffic, conversion and the average dollar our estimate. The first is that we expect stronger sales than we value of transactions. Direct represented approximately 21.2% had modeled. The sales increase to nearly $910 million of total revenue in 3Q, which was up 210 basis points reflects stronger comp-store and direct-to-customer growth year-over-year. than we had modeled offset by slightly lower square footage. The 2Q gross margin increased by 90 basis points to 52% We are also raising our estimate of operating margin. One of sales. Most of the benefit came from higher product important clarification is that our estimate and the guidance margins. Gross margin was hurt by approximately 20 basis reflect a tax rate of 30.4%. Lulu expects to incur a significant points related to repositioning ivivva. There was a drag of 4Q repatriation tax on foreign earnings. about 20 basis point from unfavorable exchange rates, and 20 For FY19, we are raising our full-year estimate to $3.00 basis points of drag from occupancy and depreciation costs. per share from $2.65 per share. This reflects about 11% sales The StreetAccount consensus was 51.2%. Our estimate was growth, up from 9.5%% previously and an improvement in 50.9%. our estimate of operating margin to approximately 19% from SG&A dollars of $215 million rose 16% year-over-year 18.3% previously. About 40 basis points of this increase is on a GAAP basis. The company had higher store labor costs, from our expectation for gross margin improvement. This technology spending and digital marketing. SG&A increased estimate does not include any restructuring costs, but we are by 70 basis points to 34.8% of sales. The StreetAccount reducing our estimate of the tax rate to 27% from 31%. Our consensus was 34.8%. Our estimate was 34.7%. LULU also sales forecast is $2.9 billion, which is close to consensus. Our had $21 million in asset impairments on a separate line of the estimate of operating income is $558 million versus consensus income statement. We had modeled $30 million of of $566 million and our estimate of net income is $408 million impairments. versus the current consensus of $403 million. Consensus EPS Adjusted income from operations, which excludes is $3.02 per share. We suspect that there is a fair amount of impairments and restructuring costs was $74.14 million, little uncertainty on the tax rate. changed in dollars. The adjusted operating margin was 17.4%, We are maintaining our five-year compound annual EPS which was up 30 basis points from the prior year and 80 basis growth rate forecast of 20%. We will reevaluate this after the points better than the StreetAccount consensus. GAAP 4Q call. We still see significant growth opportunities in the operating margin decreased by 330 basis points to 13.8% of domestic, international and men's businesses. Sector-wide sales. The result was better than the 11.3% we modeled demand appears strong, but LULU's leadership position is

Section 2.68 GROWTH / VALUE STOCKS being challenged by growing competition and the potential for into its core products. Lululemon also largely controls its competitors to seek new, lower priced distribution channels as distribution through its own stores, websites and a very small Under Armour did in choosing to sell merchandise through wholesale channel that helps to build brand awareness. Kohl's. On the plus side, controlled distribution provides In our view, the company has the potential to open insulation from retailers, such as department stores, slashing additional stores in the U.S. and internationally. The prices to drive store traffic and it also gives lulu a double challenge, of course, isn't to simply open stores. The challenge margin from being both the manufacturer and the retailer. The is to open highly productive stores, and the company has an company says that it reinvests some of this margin in the innovative process that is helping it to achieve sales of over quality of its products. Management believes that the quality $1,100 per square foot in the first year a store is open, and technical attributes of its products, as well as its store compared with an old target of about $750 per square foot. environment and connections to local communities are major The more mature Canadian stores, with sales of approximately differentiators against competitors who are trying to gain $2,800 per square foot, are approximately 40% more business by offering lower prices. Following the Luon fabric productive than the U.S. stores. This implies potential for problems, the company stepped up its technical standards and further gains in the U.S. stores as they build a loyal customer testing and hired a new CEO, CFO, a new head of product base in their trade areas. The average store has sales of about operations, a new head of logistics and a new chief product $1,500 per square foot. officer. Lululemon typically looks for street and mall locations Going forward, we expect the company to devote more that are close to yoga studios and fitness centers. Initially, the resources to developing localized assortments that will make company will enter a new market with a showroom that is individual stores more productive. The company's operating roughly 700-1,000 square feet in a less expensive location. margin is very high compared to that of pure retailers, These showrooms operate on a limited schedule to enable the although investments in the business and supply-chain issues manager to build relationships in the community by visiting took the operating margin to approximately 18% in FY17. the best yoga instructors, running coaches and trainers in the The company could probably grow faster in the near term area. Lululemon tries to find the professionals who share the with an exclusive retail partner, but that could compromise company's values as part of its word-of-mouth marketing. The long-term growth and control of the brand, which we view as manager will hold trunk shows, in addition to running the being important. It could also further strain the supply chain. showroom, to build awareness and reach customers. The Managing stores, distribution, inventories, and building a web company intends to expand its showroom presence in Europe presence has become very sophisticated work and it could be a and Asia. We estimate that showrooms have recently challenge for a small company to leverage these costs. That generated sales per store of approximately $500,000 per year. said, we like the company's process for opening new stores Once a store is open, the staff members - called educators and believe it is the right strategy for maintaining the integrity - try to maintain a connection with customers by hosting of the brand and the unique store experience, which aids its weekly yoga classes. The stores have community bulletin ability to charge premium prices. boards designed to position the store as a hub of information Over the next several years we expect substantial earnings for core customers. Stores also have a community coordinator growth to be driven by store openings in the U.S. and whose job is to build a marketing plan with connections to internationally. The ivivva concept is now poised to grow as important athletic and charity events in the area. an online product rather than through square footage. The The company's product development is also very company may try to add square footage to lulu locations when connected with influential professionals, or ambassadors, who it has leases up for renewal, but the company is likely to like the brand. The designers regularly meet with athletes and maintain its stores at approximately 2,700-3,000 square feet. practitioners in local markets and they also work in stores to Lulu is also aiming to raise eCommerce to well over 20% of get direct feedback from guests. sales from approximately 16.5% in FY14 and 17.9% in FY15 It takes the company approximately nine months to get and about 19.5% in FY16 and FY17. This means that even products from design to market but it can get a select number with significant store openings, the company is expecting of products to market in as little as two months. Shortening eCommerce to grow faster than retail. We also believe that the cycle times is an ongoing goal for retailers and apparel makers eCommerce business has an operating margin that is 3%-5% because it allows them to have a better read on styles and higher than retail. Growth of eCommerce may divert sales and shopper demand before they commit to a major order. This reduce store comps. It isn't a problem to divert sales to a highlights the fact that LULU is both a manufacturer and a higher margin channel; we just want to consider the retailer. We like the vertical integration in the current market possibility when modeling comparable sales. The company is because the company has the structure and expertise to working to integrate its online and store point of sale systems; develop unique proprietary merchandise. A differentiated this should help inventory management and product product offering is important amid the prevalence of internet availability. Lulu recently completed a mobile phone price comparisons. The company is constantly testing new application to help users find yoga studios. This is a way to products and incorporating the most promising innovations build customer relationships and help the company's product

Section 2.69 GROWTH / VALUE STOCKS ambassadors. The company does have fixed obligations in the form of Lulu is planning to grow sales by providing merchandise operating leases. Treating the approximately $400 million for more sports and activities. Running has grown to about present value of these leases as debt shows that adjusted debt 20% of the business and the men's business has significant was approximately 22% of capital at the end of 3Q18. This is upside. The company is expanding its offering of polo shirts relatively low. Retailers in the Argus universe average for men. The core men's customer is approximately 35 years approximately 50%. old. The company sees the age range broadening. More men One of the reasons the company doesn't have our highest are buying the products for themselves, and tend to view financial strength assessment is because it sells discretionary LULU as a premium brand rather than a women's brand. The products, it has a significant number of larger competitors and company also noted that men, unlike women, are more likely because the company is still refining its supply chain and to buy multiple units of products they like. quality control. Lulu's categories include running, swim suits and leisure The company's lease-adjusted debt (using rental expenses gear. That said, yoga-inspired products for women are likely multiplied by 8) was approximately 1.8-times EBIT plus rent to remain the dominant component of the business, with new and depreciation in FY17 (a lower multiple indicates higher categories being used to drive incremental traffic and help the strength), up slightly from 1.56-times EBIT plus rent and company to explore new directions for the business. depreciation in FY16, 1.6-times at the end of FY15, but up The company also seems intent on developing ways to from 1.4-times at the end of FY14 and 1.3-times at the end of make its products more supportive and comfortable. It is FY13. We'd normally equate a multiple of 2.0 with a working to develop lighter fabrics and anti-chafe technology, Medium-High Argus rating and investment-grade standing as well as fabrics that don't retain odors as some polyester from one of the rating agencies. fabrics do. Lulu has a $150 million credit facility that may be drawn We expect the company to open more country-specific in either U.S. dollars, Canadian dollars or euro. At the end of web sites with international fulfillment from distribution 3H18, there was $149 million of available borrowing capacity centers in Hong Kong and Holland. We believe that LULU under the facility. reaches customers in more than 80 countries through a Lululemon does not pay a cash dividend. It did not pay combination of stores, showrooms and e-commerce. one in FY18 and we do not expect it to initiate one in FY19 We expect the company to open stores in international given its plans to open more stores and expand its product markets only when e-commerce and showrooms show signs of offerings. success, although management may accelerate the process We don't have expectations for a significant slightly. The company is also working to ensure that it has share-repurchase plan as the company has the opportunity to created an effective ambassador network, trained employees, earn high returns on capital by opening new stores and and built sufficient infrastructure. To support international supporting overall growth by investing in e-commerce, expansion, the company is hiring more executives with customer service and logistics. LULU did initiate a $450 experience outside North America. The company recently million buyback plan in June of 2014. In the 3Q17 earnings opened stores in Chengdu, Taipei and Munich. release, LULU announced a new repurchase program for $100 Management has said that the German market may be million, which it completed in 3Q18. In the 3Q18 release, the attractive, as the climate is conducive to the layering of company announced a new $200 million repurchase plan. products. In addition, the population is sports-oriented and yoga is popular. Other areas for European expansion could be RISKS Switzerland and the Netherlands. Management has also noted Lululemon faces competition from much larger that it is seeing tourists from throughout Southeast Asia companies such as Nike, Reebok, Adidas and the Gap's buying in bulk in Hong Kong. Athleta, which have attempted to replicate its success selling women's athletic apparel. Under Armour, is more focused on FINANCIAL STRENGTH & DIVIDEND men, team and competitive sports, but UA's management also Our financial strength rating for lululemon is has strong ambitions of winning more female customers and it Medium-High, the second-highest rating on our five-point is expanding its distribution. Lucy Activewear focuses on scale. workout clothes for women that aim to be functional, stylish The company ended the third quarter with no debt and and flattering. approximately $650 million of cash and equivalents. Lulu's success and the tremendous sales productivity of Lulu posted a healthy operating margin of about 18% in more than $2,000/SF has also drawn the attention of Victoria's both FY16 and FY17 though those levels were lower than Secret, Express, Macy's, J.C. Penney, Nordstrom, Dick's, the 20.9% in FY15, 24.6% in FY14, 28.2% in FY13 and 28.7% in entrepreneurial actress Kate Hudson's Fabletics, and FY12. We expect the adjusted operating margin to be down in long-respected outdoor brands such as Patagonia. Even New FY18 because of restructuring costs on the ivivva business, Balance, whose shoes seem to emphasize fit over glitz, has a but we expect operating margin to rebound to about 19% in line of athleisure gear for women. FY19. While the company's growth, sales productivity and

Section 2.70 GROWTH / VALUE STOCKS margins are likely to attract more entrants into the category, best-in-class e-commerce systems and applications can be an we like lulu's focused position as a provider of functional, ongoing use of cash, especially when competing against larger high-end apparel for affluent, educated enthusiasts. companies with deeper pockets. The company could see sales slip if yoga becomes less Maintaining staff and systems for financial management popular or if active wear becomes less popular attire for can also be a challenge for small companies, although the mainstream pursuits. We are hearing that denim is regaining company's image and growth potential may make it easier to lost ground against active wear because innovative new jeans attract talent. Like other companies with an e-commerce are being designed with lycra and other fabrics to make them presence, lulu must work to safeguard its customers' more comfortable. information. While lulu's merchandise has loyal shoppers, some may Lulu relies on grass roots marketing through local fitness treat it as a discretionary purchase especially when economic practitioners who become brand ambassadors. We like this conditions are difficult. The company posted extraordinary strategy. A risk is that as the company grows it may be hard to growth during the recession but few companies remain build enough of these relationships or that competitors may be immune through multiple business cycles. In the year ended able to be able to build their brand image more quickly February 1, 2009, comparable-store sales were flat after rising through more aggressive use of mass media or celebrity 34% the prior year. In the year ended January 31, 2010, endorsements. comps increased 8% before rebounding to 37% growth the The company requires its manufacturers to sign a code of following year. conduct regarding manufacturing quality, working conditions Another challenge is that yoga is still a relatively small and social concerns. We think this is extremely important and activity. The company is expanding its addressable market, there could be risks if the company's procedures disappoint its but yoga is where it possesses its greatest edge. Running core customers. Scrutiny has risen, especially since the factory apparel is a very mature and crowded market. tragedies in Bangladesh. While competition is undoubtedly a risk, we saw during The company discontinued operations in Japan and it the recession that affluent shoppers remained very loyal to could be difficult to overcome cultural and language their favorite brands even if it meant trading down within the differences as well as regulatory issues and local preferences brand or buying fewer items. The core lululemon customer is as it attempts to grow internationally. Yoga practitioners may a highly educated woman, who is 32 years old and makes not wear the same styles and women outside a small number $85,000 or more per year. We believe that lulu's appeal is of affluent countries may be reluctant or unable to pay $150 - largely related to the fit and functionality of its merchandise, $200 for tights and a top. It is also possible that the company as well as the personality of the brand, rather than being won't have the same success in grass roots marketing that it purely based on fashion. For this reason the company needs to has had in the U.S. and Canada. avoid product defects like the problem with overly sheer yoga The company doesn't own patents or intellectual property tights that management disclosed in March of 2013. rights in the technology, fabrics or processes underlying its Still, some yoga purists may scoff at paying premium products. The company also has a relatively high prices for merchandise that is used in a historically austere concentration of products coming from a small number of practice. suppliers, with about 60% of products coming from five Overseas suppliers and international store locations make manufacturers in FY17. No one supplier represents more than the company vulnerable to foreign exchange risk from the 30% of sales. Competitors may be able to sell products with Canadian dollar and higher labor costs, particularly in China. performance characteristics that are similar to lulu's. Larger The company also has exposure to higher raw materials costs, competitors may be able to do so at lower prices. The particularly for cotton and for petroleum-based products that company's tee shirts start at about $50. Wal-Mart offers tees are used in synthetic materials. Defending intellectual made from 'technical' materials for about $10. That said, property is another challenge, but one management is willing people who are passionate about an activity may pay for to take on. While loyal customers will recognize the feel, fit premium apparel if they have the means. and construction of premium merchandise, others may be Management turnover is a concern with the February, looking for the look and the logo. 2018 resignation of CEO Laurent Potdevin for 'falling short' Rapid expansion is another challenge. The company must of the company's standards of conduct. Mr. Potdevin replaced find the right retail locations, maintain merchandise quality Christine Day as CEO in December 2013. J. Crew executive and appeal to a broader range of customers while maintaining Stuart Haselden replaced John Currie as CFO on February 2, the connection and loyalty with core shoppers as well as the 2014. Mr. Currie retired after serving as the company's CFO scarcity required to be a luxury-type brand. Opening retail since 2007. locations can be a way to build awareness and increase sales, Dennis Wilson, the company's founder stepped down as but retailers must be mindful of signing long leases in a world chairman of the board prior to the June 2014 annual meeting. that is gravitating to online shopping. We believe that lulu's Media reports said that at the 2014 meeting, Mr. Wilson voted active, upscale customers are probably very connected as against Michael Casey's bid for reelection to the board. The demonstrated by high e-commerce growth. Maintaining Wall Street Journal said that 'the unusual -- and unusually

Section 2.71 GROWTH / VALUE STOCKS public -- spat between founder and board brings an In the current environment, we believe that investors are unwelcome disruption as Lululemon struggles to recover from concerned that some retailers have too many retail locations 2013's recall of sheer yoga pants and related supply chain and that they face price competition from Amazon and other problems.' retailers. We believe that lululemon's innovative product line, small retail footprint, impressive store productivity and COMPANY DESCRIPTION controlled distribution could help the company to trade at a Founded in 1998, lululemon athletica is based in premium valuation relative to peers. We believe that the Vancouver, Canada, though it is incorporated in Delaware and shares are currently trading at close to fair value. We would its financial results are reported in U.S. dollars. The company consider raising our recommendation to BUY based on designs and sells athletic apparel, and markets its valuation. An offset is that competition is increasing from a yoga-inspired clothing under the lululemon athletica and range of sources. ivivva athletica brand names. It also sells fitness pants, shorts, On February 6, at midday, HOLD-rated LULU traded at tops and jackets designed for running and other sports. As of $77.82, up $0.41. (Christopher Graja, CFA, 2/6/18) 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 McDonald's Corp (MCD) FY17 were $2.3 billion. Current Rating: BUY Publication Date: 1/31/18 The fiscal year ends on the Sunday closest to January 31. HIGHLIGHTS VALUATION *MCD: Strong comps across the board; turnaround LULU shares have risen approximately 15% over the last continues year. We believe that the ratio of reward to risk is balanced. *Our continued optimism reflects our improved revenue The shares are trading at 35-times trailing earnings, above expectations for 2018, driven in part by the launch of new the five-year average of 31, even though operating margin will promotional offers, including $1 soft drinks and the Big Mac end FY18 at about 17%, down from almost 29% at the end of Trio. In addition, we expect revenue to benefit from the FY12. We believe that some of the premium is because increasing adoption of the company's mobile order and pay investors are anticipating an earnings boost from lower taxes system. that is not yet manifest in trailing earnings. *We also believe that income-oriented investors will be LULU trades at approximately 34-times our FY18 attracted to MCD's 2.3% dividend yield and record of annual estimate and 26-times our FY19 estimate. The shares are dividend increases. currently at 26-times consensus estimates for the next four *We are raising our 2018 EPS estimate from $7.16 to quarters. The five-year range is 20-to 37-times. $7.80 and setting an estimate of $8.50 per share for 2019. Our The trailing multiple of 35 compares to a median of 21 long-term earnings growth rate forecast is 10%. for a universe of apparel and footwear tracked by Bloomberg. *Our target price of $190 implies a multiple of 24.4-times In many ways, this comparison is an unfair one for LULU our revised 2018 estimate, and a potential total return, because its trailing operating margin of 17.2 is above the including the dividend, of 13% from current levels. peer-group median of 12. Lulu also has substantially more opportunity to open stores than mature members of this group, ANALYSIS such as Gap. INVESTMENT THESIS If EPS grows 20% annually from our FY19 estimate, it would be approximately $5.20 in about four years. If the We are maintaining our BUY rating and $190 price target shares trade at a terminal multiple of 16, they would be worth on McDonald's Corp. (NYSE: MCD). Our optimism reflect approximately $83 in four years. Discounted to the present at the launch of new promotional offers, including $1 soft drinks 9%, they would be worth approximately $60. At a terminal and the Big Mac Trio. In addition, we expect revenue to multiple of 18, the shares would be worth about $95 in 4 years benefit from the increasing adoption of the company's mobile and about $67 discounted at 9% order and pay system and from the renewed emphasis on Is a multiple of 16-times reasonable? It implies an value menus. We also believe that income-oriented investors additional five years of relatively strong 8% growth at a 9% will be attracted to MCD's 2.3% dividend yield and long cost of equity and then steady state growth at 3.25% with a history of annual dividend increases. payout of 75% of earnings and an 8% cost of equity. We Based on the company's ongoing turnaround efforts and could argue about the nuances, but we believe this is a prospects for growth in China, our long-term rating remains reasonable scenario. An 18 terminal multiple could be BUY. achieved with a 50 basis point lower cost of equity in each RECENT DEVELOPMENTS period. This is plausible for a company with strong margins On January 30, McDonald's posted 4Q17 earnings of and no debt, but given the level of competition it does not $1.71 per share, up from $1.44 in the same period a year offer a big enough margin of safety to justify a BUY earlier and $0.12 above consensus. The EPS growth reflected recommendation.

Section 2.72 GROWTH / VALUE STOCKS higher same-store sales in all segments and the impact of long-term earnings growth rate forecast is 10%. share buybacks. Fourth-quarter revenue of $5.34 billion fell 11% from the prior year (down 15% in constant currency), but FINANCIAL STRENGTH & DIVIDEND topped the consensus estimate by $110 million. Our financial strength rating for McDonald's remains Overall same-store sales rose 5.5%, well above the Medium-High, the second-highest rank on our five-point consensus forecast calling for 4.9% growth. In the U.S., scale. We are encouraged by the company's efforts to same-store sales increased 4.5%. This was better than the refranchise stores, as these locations require no capital consensus estimate, which called for a 4.3% increase. expenditures and improve free cash flow. Long-term debt rose Same-store sales rose 6.0% in International Lead Markets from $25.9 billion in 4Q16 to just under $28.4 billion in (above the consensus estimate of 4.9% growth), 4.0% in 3Q17. The shareholders' deficit rose from $2.2 billion in 4Q16 High-Growth Markets (above the consensus of 3.4%), and to approximately $3.5 billion. Operating income covered 8.0% in Foundational Markets (above the consensus of 7.5%). interest expense by a factor of 9.1 in 4Q17. SG&A rose 70 basis points as a percentage of revenue to In the fourth-quarter earnings release, McDonald's raised 11.6%, above the consensus estimate of 11.5%. Operating its quarterly dividend from $0.94 to $1.01 per share, or $4.04 income of $2.14 billion topped the consensus estimate of annually. The new dividend will be paid on March 15, 2017 to $2.12 billion. The operating margin rose to 40.1% in 4Q17 shareholders of record as of March 1. The current yield is from 32.7% in 4Q16, reflecting the higher-than-expected about 2.3%. The company has raised its dividend every year comps and lower SG&A, offset in part by higher labor since 1976. Our dividend estimates are $4.04 for 2018 and expense. The operating margin missed the consensus forecast $4.40 for 2019. by 40 basis points. Interest expense rose 6%, to $235.1 RISKS million. In 2017, MCD spent $7.7 billion on dividends and A key risk to our estimates and target price is the cost of share repurchases, and the share count fell to 803 million from beef. We estimate that a 7%-9% increase in beef prices would 830 million a year earlier. reduce annual EPS by a penny. Since 65% of the company's In 2017, revenue fell 7% to $22.8 billion and EPS rose to revenue is generated outside the U.S., unfavorable foreign $6.64 from $5.77 in 2016. Full-year same-store sales rose currency movements have a significant impact on earnings. 5.3%. In the press release, management said it will spend $2.4 COMPANY DESCRIPTION billion in 2018 to invest in technology to improve 'the McDonald's is the world's largest restaurant chain, with customer experience' and open 1,000 new restaurants. more than 37,000 fast-food restaurants in 119 countries. The Investors reacted negatively to the news of company is a member of the Dow Jones Industrial Average higher-than-expected capital expenditures but we expect these and the S&P 500. With a market capitalization of $140 billion, initiatives to result in market share gains. MCD is generally considered a large-cap growth stock. As discussed in a previous note, on January 9, McDonald's announced that it had sold the majority of its VALUATION mainland China and Hong Kong businesses to a consortium On January 30, MCD shares fell 3% despite strong led by government-backed CITC and Caryle, a private equity fourth-quarter results as investors appeared to worry about firm, for $2.1 billion. The new owners will operate as a management's plans to spend $2.5 billion on technology McDonald's master franchise for the next 20 years. CITC will upgrades and store openings. However, we believe this have a 52% stake; Caryle will have 28% and McDonald's spending will enable MCD to gain market share and benefit 20%. long-term earnings growth. We continue to believe that the current MCD share price inadequately reflects the benefits of EARNINGS & GROWTH ANALYSIS management's turnaround plan. MCD shares are trading at Following a 7% decrease in 2017, we now expect 2018 22.1-times our revised 2018 EPS estimate and at 20.3-times revenue to decline 7.8% to $21.0 billion. Our 2018 revenue our new 2019 estimate. Based on our expectations for gains forecast assumes a 4.0% increase in comp sales (up from a from restaurant refranchising, as well as benefits from new prior forecast of 3.8% growth), offset by refranchising and promotional offerings and the company's mobile and order foreign exchange headwinds. We expect the adjusted pay system, we believe that a higher multiple is warranted. operating margin to rise from 41.9% in 2017 to 42.5% in Our target price of $190 implies a multiple of 24.4-times our 2018, driven by the higher margins available from revised 2018 estimate, and a potential total return, including refranchised restaurants. Lower commodity prices and the dividend, of 13% from current levels. stepped-up efforts to reduce operating costs should also On January 31 at midday, BUY-rated MCD traded at benefit margins, though increases in the minimum wage in $171.41, down $1.07. (John Staszak, CFA, 1/31/18) 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 Northrop Grumman Corp (NOC) $7.16 to $7.80 and setting an estimate of $8.50 for 2019. Our Current Rating: BUY Publication Date: 2/5/18

Section 2.73 GROWTH / VALUE STOCKS

HIGHLIGHTS The company grows through acquisitions as well as *NOC: Raising target by $40 to $375 organically. In September 2017, Northrop announced plans to *NOC shares have outperformed the market over the past acquire Orbital ATK (OA: HOLD) for $9.2 billion. Northrop quarter, rising 19% while the S&P 500 has advanced 10%. Grumman plans to establish Orbital ATK as a new, fourth *The company recently reported 4Q earnings that topped business segment after the deal closes, which is expected in expectations. the first half of 2018. On a pro forma 2017 basis, Northrop *Management also boosted the dividend by 10% in Grumman expects the business to have sales of $29.5-$30 response to the recent reduction in the U.S. corporate tax rate. billion based on current guidance. It expects the transaction to *Given Northrop's consistent record of positive earnings be accretive to EPS and free cash flow per share in the first surprises and prospects for growth in 2017-2018, we think full year after the closing, and to generate annual pretax cost that the stock merits a premium valuation. savings of $150 million by 2020. Management plans to update its guidance following the closing. ANALYSIS EARNINGS & GROWTH ANALYSIS INVESTMENT THESIS Northrop Grumman has three reporting segments: BUY-rated Northrop Grumman Corp. (NYSE: NOC) is a Aerospace Systems (42% of 4Q sales), which includes leading global defense contractor with a focus on aerospace military aircraft and space systems; Mission Systems (42%), and, increasingly, electronic programs, including such as control rooms and cyber solutions; and Technology cybersecurity. The company's balance sheet is clean, and Services (17%), such as logistics, systems security and fraud management has a history of meeting and beating analyst detection. We provide business updates and outlooks for these expectations. The shares are susceptible to headlines about segments below. cuts in defense spending and budget ceilings. However, we In Aerospace Systems, 4Q revenue rose 5% believe that recent defense spending developments bode well year-over-year, driven by higher volume in the F/A-18, F-35 for the industry for at least the next two years. Management is and E-2D manned aircraft programs, as well as in autonomous aggressively raising the dividend, with a clear focus on systems programs (Triton, Global Hawk) and space programs. delivering returns to shareholders. The company is in line to The segment operating margin narrowed from 11.4% to make an accretive acquisition, and EPS estimates appear 10.5%. Looking ahead, we expect mid- to high single-digit poised to rise. Our target price is now $375, raised from $335. sales growth in 2018, driven by growth in manned aircraft, The shares are a suitable core holding for a diversified autonomous systems and space programs. We expect segment portfolio. margins to remain near 10% as the sales mix shifts slightly RECENT DEVELOPMENTS toward lower-margin development contracts. NOC shares have outperformed the market over the past Mission Systems saw 6% growth in 4Q revenue, quarter, rising 19% while the S&P 500 has advanced 10%. reflecting higher volume in Sensors and Processing programs. Over the past year, the shares have also outperformed, gaining Cyber sales were lower. The operating margin dipped 170 52% compared to the market's advance of 24%. The shares basis points to 12.0%. Margins in this group are expected to have outperformed the industrial sector ETF IYJ over the past recover to the 13.0% range in 2018 and to be the highest of all 1-, 5- and 10-year periods. The beta on NOC is 0.70. segments. We are modeling 2018 sales of $11.5 billion, On January 25, Northrop reported 4Q17 EPS that were implying low single-digit growth. down from the prior year but above management's guidance Technology Services recorded a 1% decrease in 4Q and the consensus estimate. Revenue increased 4% to $6.6 revenue, reflecting lower volume in System Modernization billion. Segment operating income fell 7%, as the operating and Services, offset by growth in Global Logistics and margin narrowed by 60 basis points to 10.9%. Adjusted EPS Modernization programs. The segment operating margin fell to $2.82 from $2.96 a year earlier, but topped the increased to 10.5%. This segment is expected to be the consensus forecast of $2.74. company's least profitable, with a full-year margin of For all of 2017, the company earned $13.28 per share, approximately 10% in 2018. We look for 2018 sales of $4.5 above management's guidance range of $12.90-$13.10. billion, down about 5% from the prior year. Along with the 4Q results, management established Turning to our estimates, based on expected sales and guidance for 2018. It expects revenue to grow 5% to $27.0 margin trends, as well as a lower tax rate, we are raising our billion; the segment operating margin to narrow to the 2018 EPS forecast to $15.30 from $13.75, though this is likely mid-11% range; free cash flow to total $2.0-$2.3 billion; and to change after the Orbital ATK deal closes. We look for adjusted EPS to increase from $13.28 in 2017 to additional growth in 2019 and are implementing a preliminary $15.00-$15.25 in 2018. EPS estimate of $17.60. Our five-year EPS growth rate The company also declared a 10% increase in its forecast is 10%. quarterly dividend to $1.10 per share. Management indicated FINANCIAL STRENGTH & DIVIDEND that the increase was prompted by the recent reduction in the Our financial strength ranking for Northrop Grumman is U.S. corporate tax rate. Medium, the midpoint on our five-point scale. The company

Section 2.74 GROWTH / VALUE STOCKS receives average scores on our three main financial strength discount model. NOC shares are trading at 22-times our 2018 criteria: debt levels, fixed-cost coverage, and profitability. estimate, near the high end of the historical range of 12-23. The company had $11.2 billion in cash and equivalents at On a price/sales basis, the shares are trading above the the end of 4Q17. Total debt was $14.4 billion at the end of the midpoint of the five-year range. The dividend yield of about quarter and the total debt/total capital ratio was 67%, above 1.3% is at the low end of the five-year range. NOC's multiples the peer group average. The company has issued $8.25 billion are generally in line with or slightly above industry averages. in new debt to finance the Orbital ATK acquisition. Interest But given the company's consistent record of positive earnings rates range from 2.08% for three-year notes to 4.03% for surprises and prospects for growth in 2018-2019, we think 30-year notes. Operating income covered interest expense by that the stock merits a premium valuation. Our revised a factor of 9 in 4Q17. dividend discount model points to a value above $420 per Northrop has a share buyback program. At the end of 4Q, share. Blending our valuation approaches, we arrive at a new the share count was down 2.7% year-over-year. target price of $370. Northrop pays a dividend. The company typically reviews On February 2, BUY-rated NOC closed at $336.79, down the dividend in May. In December 2017, it raised the quarterly $6.07. (John Eade, 2/2/18) 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 Nucor Corp (NUE) for 2019. Current Rating: BUY Publication Date: 2/5/18 MANAGEMENT & RISKS HIGHLIGHTS Wes Bush has been the CEO of Northrop Grumman since *NUE: Reiterating BUY and $70 target 2010. Kathy J. Warden is the new President and COO, as of *Nucor delivered solid 2017 results and issued a positive January 2018. Ken Bedingfield, previously the national client outlook for 2018. leader of the U.S. aerospace and defense audit practice at *Nucor shares have risen 15.2% over the past three KPMG, is the CFO. months, compared to an increase of 9.8% for the S&P 500. Investors in NOC shares face risks. Northrop Grumman is *NUE appears favorably valued at 12.9-times our 2018 a key supplier to the U.S. military and thus vulnerable to cuts EPS estimate and at 12.2-times our 2019 forecast, compared in defense spending. About 80% of the company's current to a five-year annual range of 15-37. backlog comes from U.S. government contracts. However, *Our target price of $70, combined with the dividend, NOC and other defense contractors have been expanding implies a potential return of 13% from current levels. internationally to offset volatile U.S. defense spending trends, particularly on short-cycle programs. ANALYSIS And in any event, with a Republican in the White House INVESTMENT THESIS and the House and Senate both controlled by the GOP, the We are maintaining our BUY rating on Nucor Corp. outlook for defense spending has brightened. (NYSE: NUE) with a target price of $70. Nucor delivered In 2015, Northrop was selected by the U.S. Air Force to solid 2017 results and issued a positive outlook for 2018. The build the Long-Range Strike Bomber. This program is company has grown through both internal expansion and expected to result in 80-100 aircraft, at a cost of $500-$550 acquisitions. Looking ahead, we expect NUE shares to benefit million each, over the next 15-20 years. Northrop won the from the Trump administration's efforts to limit the dumping contract by beating out rival Boeing Co. (BA: BUY), which of imported steel, as well as from gradually improving steel had teamed with Lockheed Martin Inc. (LMT: BUY). Boeing market fundamentals. Our long-term rating also remains BUY. and Lockheed have protested the decision, and Northrop is awaiting the results of a review of the contract award process. RECENT DEVELOPMENTS Nucor shares have risen 15.2% over the past three COMPANY DESCRIPTION months, compared to an increase of 9.8% for the S&P 500. Northrop Grumman is a leading global defense The shares have gained 14.7% over the past year, compared to contractor, providing systems integration, defense electronics, an increase of 24.1% for the index. information technology, and advanced aircraft and space On January 30, Nucor reported 4Q17 adjusted net technology. The shares are a component of the S&P 500. earnings of $208.7 million or $0.65 per diluted share, VALUATION compared to $153.2 million or $0.50 per share in 4Q16. NOC shares appear attractively valued at current prices in Fourth-quarter consolidated net revenue rose 29% the lower half of the 52-week range of $229-$349. On a year-over-year to $5.09 billion. The average sales price per technical basis, the shares have been in a positive trend of ton increased 14% year-over-year, and total steel mill higher highs and higher lows since August 2011. shipments increased 18%. To value the stock on a fundamental basis, we use peer The average scrap and scrap-substitute cost in the fourth and historical multiple comparisons, as well as a dividend quarter was $317 per ton, up 34% from 4Q16. Capacity

Section 2.75 GROWTH / VALUE STOCKS utilization at the company's steel mills was 81%, compared to Both ratings are investment grade. Nucor is the only North 72% a year earlier. Total fourth-quarter energy costs were American steel producer with investment-grade credit ratings. down about $1 per ton from the prior year. Nucor ended 2017 with $999.1 million in cash and cash For all of 2017, Nucor's consolidated net sales increased equivalents and short-term investments. Its $1.5 billion 25% to $20.25 billion, total tons shipped to outside customers revolving credit facility remains undrawn. rose 9%, and the average sales price per ton rose 15%. Net At the end of 2017, the company's debt/capitalization earnings totaled $1.15 billion or $3.58 per diluted share, up ratio was 29.5% down from 34.6% in the year-earlier period. from $806.4 million or $2.48 per share in 2016. The company pays a quarterly dividend of $0.38, or $1.52 Nucor has a growth-by-acquisition strategy. On annually, for a yield of about 2.3%. The company has paid September 1, 2017, it completed the acquisition of St. Louis uninterrupted quarterly dividends for more than 45 years. Our Cold Drawn, a manufacturer of cold-drawn rounds, hexagons, dividend estimates are $1.52 for 2018 and $1.53 for 2019. squares and special sections that serves the U.S. and Mexican automotive and industrial markets. In January 2017, Nucor RISKS purchased Southland Tube, a manufacturer of hollow The steel industry is extremely cyclical and highly structural section steel tubing, for $130 million. Nucor also competitive. It may also be affected by excess global capacity, acquired Republic Conduit, a North American manufacturer which has limited price increases during periods of economic of steel electrical conduit, for $335 million. growth and led to price decreases during periods of The company has also grown organically, investing $2.1 contraction. In addition, the industry faces competition in billion in capital projects since 3Q16. In September 2016, it many markets from producers of aluminum, cement, announced plans for a new specialty cold mill complex in composites, glass, plastics and wood. Steel producers also Arkansas. The plant will expand the company's ability to face risks associated with commodity prices, interest and produce advanced high-strength, motor-lamination and exchange rates, asbestos liability, and environmental issues. high-strength, low-alloy steel products. The $230 million On the positive side, we expect Nucor and other domestic facility is expected to begin operations in the second half of steel producers to benefit from new trade legislation that 2018. In May 2017, Nucor announced that it would invest would limit the negative impact of low-cost imported steel. $176 million to build a hot band galvanizing and pickling line COMPANY DESCRIPTION at its sheet mill in Ghent, Kentucky. The new line will have an Founded in 1940 and based in Charlotte, North Carolina, annual capacity of 500,000 tons, and is expected to take two Nucor Corp. is a manufacturer of steel and steel products and years to construct. Nucor and JFE Steel have also begun work North America's largest steel recycler. The company's three on a new galvanizing facility in Mexico, which is expected to main operating units are Steel Mills, Steel Products, and Raw open in the second half of 2019. In November 2017, Nucor Materials. announced that it would build a full-range merchant bar The Steel Mills segment produces hot-rolled steel quality mill at its existing steel mill in Bourbonnais, Illinois. products, including angles, rounds, flats, channels, sheet, The project will take approximately two years to complete at a wide-flange beams, and cold-rolled steel products. Steel cost of $180 million. Also in November, Nucor announced Products provides steel joists and joist girders, steel deck, that it would spend $250 million to build a rebar micro mill in fabricated concrete-reinforcing steel, cold-finished steel, steel Sedalia, Missouri fasteners, steel grating, and metal and wire mesh. The Raw EARNINGS & GROWTH ANALYSIS Materials segment produces direct-reduced iron (DRI); Management expects first-quarter earnings to be up from brokers ferrous and nonferrous metals, pig iron, hot briquetted 4Q17, excluding the impact of tax benefits in 4Q. The iron, and DRI; and processes ferrous and nonferrous scrap company expects stronger results in its raw materials business products. The company also has international steel trading and in steel mill products, offset by the impact of higher scrap operations. prices and weather-related disruptions at certain sheet mills. INDUSTRY Although Nucor continues to face pressure from illegal Our recommended weighting for the Basic Materials steel imports, we expect it to benefit over time from the sector is Over-Weight, based on stabilizing commodity prices administration's actions to limit the dumping of imported steel and signs that the global economy will avoid recession. The as well as from recent acquisitions and gradual improvement sector accounts for 2.9% of the S&P 500, and includes in the nonresidential construction, automotive, energy, heavy industries such as chemicals, paper, metals and mining. Over equipment and agricultural markets. We are increasing our the past five years, the weighting has ranged from 2.5% to 2018 EPS estimate to $4.99 from $4.52. We are initiating a 4%. We think investors should consider allocating about 4% 2019 EPS estimate of $5.25. of their diversified portfolios to stocks in this sector. The FINANCIAL STRENGTH & DIVIDEND sector outperformed in 2016, with a gain of 14.1%, and We rate Nucor's financial strength as Medium, the underperformed in 2015, with a loss of 10.4%. It is midpoint on our five-point scale. The company's debt is rated performing largely in line with the market thus far in 2017, A-/stable by Standard & Poor's and Baa1/stable by Moody's. with a gain of 10.5%.

Section 2.76 GROWTH / VALUE STOCKS

The P/E ratio on projected 2018 EPS is 17.0, close to the see better revenue and earnings growth ahead. We also have a market multiple. The sector's debt ratios appear sound, as favorable view of the 2017 acquisition of filtration company many in the group have deleveraged over the past three years. CLARCOR. The shares have moved higher over the past year, Yields of 2.0% are close to the market average. The Street but we see the potential for further strong performance. Our consensus calls for earnings growth of 35.6% in 2017 and 12-month target price is $210. 15.7% in 2018. RECENT DEVELOPMENTS VALUATION PH shares have underperformed the market over the past Nucor shares have traded between $51 and $70 over the quarter, with a flat performance versus an increase of 4.0% for past 52 weeks and are currently in the upper half of the range. the S&P 500. The shares have also underperformed the The shares are trading at 12.9-times our 2018 EPS estimate average industrial stock, as the Industrial ETF IYJ has risen and at 12.2-times our 2019 forecast, compared to a five-year 4.6% in the past quarter. The shares have outperformed over annual range of 15-37. The shares are trading at a the past year with a gain of 24%, versus an 18% advance for price/EBITDA ratio of 7.9, below the midpoint of the the market and a 20.6% gain for the sector. The stock's five-year range of 6.0-11.4 but above the peer average of 6.8. long-term performance record, over multiple market cycles, is The current price/sales multiple is 1.0, compared to a five-year solid as well. The beta on PH shares is 1.25. historical range of 0.6-1.4 and a peer average of 0.7. The On February 1, PH reported fiscal second-quarter price/book multiple is 2.3, above the midpoint of the five-year earnings that easily topped the consensus estimate. Adjusted range of 1.5-2.8 and the peer average of 2.0. EPS rose 13% to $2.15, and beat the consensus by $0.08. We continue to view Nucor as a best-in-class steel Revenue rose a solid 10% on an organic basis (26% including manufacturer with a strong balance sheet. We also expect the acquisitions) to $3.4 billion. The overall segment operating company to benefit from favorable government action on steel margin increased 20 basis points to 14.9%. For the first half, imports, recent acquisitions, and gradual improvement in the company has earned $4.39 per share. nonresidential construction. Our target price of $70, combined Along with the 2Q results, management raised its with the dividend, implies a potential return of 13% from guidance for FY18. It now expects full-year adjusted EPS of current levels. $9.65-$10.05, up from $9.10-$9.70. On February 5 at midday, BUY-rated NUE traded at The company has scheduled an Analyst Day to review its $64.18, down $0.08. (David Coleman, 2/5/18) strategy and outlook for March 7, 2018.

EARNINGS & GROWTH ANALYSIS Parker-Hannifin has three primary segments: Diversified Parker-Hannifin Corp (PH) Industrial North America (46% of 2Q sales), Diversified Current Rating: BUY Publication Date: 2/6/18 Industrial International (37%), and Aerospace Systems (17%). HIGHLIGHTS Second-quarter results and outlooks by segment are *PH: Recent weakness offers buying opportunity summarized below. *PH shares have underperformed the market over the past In the Industrial North America segment, revenues rose a quarter, with a flat performance versus an increase of 4.0% for sequentially stronger 12.7% on an organic basis (40% the S&P 500. including the impact of the $4.3 billion CLARCOR *On February 1, the company reported fiscal 2Q18 EPS acquisition, completed in February 2017). The adjusted that topped analyst expectations and raised its full-year segment operating margin declined 150 basis points to 15.1% guidance. as the new business is being integrated. Orders were up an *Based on our expectations for margin improvement and impressive 15%. Looking ahead to the balance of FY18, we growth in new orders, we are once again boosting our EPS expect 20% growth in sales, including contributions from the estimates for FY18 and FY19. acquisition. We also anticipate slightly lower margins *The shares have moved higher over the past year, but we year-over-year in the 17.0%-17.4% range. see the potential for further strong performance. Revenue in the Diversified Industrial International segment rose 10.7%, while the adjusted operating margin ANALYSIS widened by 110 basis points to 14.2%. Orders rose 13%. INVESTMENT THESIS Looking ahead to the balance of FY18, we now expect a Our rating on Parker-Hannifin Corp. (NYSE: PH) is mid-teens increase in sales, with improved margins in the BUY. In our view, the company is on track to achieve its 15.1%-15.5% range. long-term goals of raising margins and growing earnings. In Aerospace Systems, organic revenue reversed course Over time, we expect it to generate high single-digit EPS and rose 0.8%. The adjusted operating margin widened 250 growth, driven by 2%-4% revenue growth, margin basis points to 16.0% and orders rose a sequentially stronger improvement, and share buybacks. Near-term trends, which 8% compared to the prior-year quarter. We look for low had been a problem, appear to have turned a corner, and we 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 GROWTH / VALUE STOCKS

By markets, management is upbeat on the aerospace, construction machinery, trucks and automotive, among others) agriculture, construction, distribution, forestry, general is mitigated by its wide range of motion-control customers, industrial, heavy-duty truck, lawn and turf, mining, oil and which span virtually every industry and are serviced by its gas, refrigeration and air-conditioning, semiconductor and worldwide distribution network. telecom. Neutral markets are automotive, power generation, PH generates substantial revenue overseas and its results rail and life sciences. are typically linked to global economic trends. Worldwide, we Management is keeping a close eye on costs. The estimate that global GDP rose 3.1% in 2016. We and the IMF second-quarter segment operating margin rose 20 basis points look for stronger growth of 3.7% in 2017 and 3.9% in 2018. from the prior year to 14.9%. Management's target range for Parker-Hannifin is also sensitive to trends in the dollar. the year is 16.1%-16.5%. Looking ahead, we think the greenback is fairly valued and in Turning to our estimates, based on our expectations for a trading range, particularly if the Federal Reserve continues margin improvement and the recent increase in orders, as well to move slowly to raise short-term rates. A stable or falling as expectations for a lower tax rate (28% this year and 23% dollar would be a positive development for the Industrial next year) we are boosting our FY18 EPS forecast to $9.90 sector and Parker-Hannifin. from $9.49. Our estimate implies growth of 22% this year. We are also boosting our FY19 forecast to $11.30 from $10.67, COMPANY DESCRIPTION implying growth of 14% as margins continue to recover, Parker-Hannifin manufactures motion and control revenue improves and the lower tax rate settles in. Our technologies and systems that are used to control fluids, gas, long-term earnings growth rate forecast for PH is 9%. or air in hydraulic, pneumatic and vacuum applications. It sells its more than 800,000 products to aerospace, commercial FINANCIAL STRENGTH & DIVIDEND and industrial customers, which use them to move materials Our financial strength rating on Parker-Hannifin is and operate machines and vehicles. PH shares are a Medium-High, the second-highest rank on our five-point component of the S&P 500. scale. The company receives above-average scores on our three main financial strength criteria of debt levels, fixed-cost VALUATION coverage and profitability. PH shares appear attractively valued at current prices near The company had $884 million in cash and marketable $183, above the midpoint of their 52-week range of securities at the end of the fiscal year. Total debt was $6 $145-$212. From a technical standpoint, the shares have been billion or 53% of total capital. Pretax income covered net in a bullish trend of higher highs and higher lows since interest expense by a factor of 8 last year. Management has reaching a low of $83 in January 2016. said that it is committed to maintaining a high To value the stock on a fundamental basis, we use peer investment-grade rating and plans to pay down the debt it has and historical multiple comparisons, as well as a dividend taken on to buy CLARCOR. discount model. PH shares are trading at 16.3-times our FY19 The company's priorities for the use of cash are EPS estimate, just above the midpoint of the historical range dividends, acquisitions, and share buybacks - in that order. of 10-20. On price/sales, the shares are at the top of their Parker pays a dividend and targets a payout ratio of 30%. five-year range. The dividend yield of about 1.3% is near the The current dividend rate is $2.64 annually, for a yield of midpoint of the five-year range. Compared to the peer group, about 1.3%. The company has increased its annual dividends PH multiples are mixed, but generally suggest fair valuation. per share paid to shareholders for 61 consecutive years. Our Our dividend discount model, incorporating our revised dividend forecasts are $2.64 for FY18 and $2.76 for FY19. estimates, points to a fair value of $220 per share. Blending our valuation approaches, our target price remains $210. MANAGEMENT & RISKS On February 5, BUY-rated PH closed at $182.00, down Tom Williams became the company's CEO in 2015. He $8.64. (John Eade, 2/5/18) 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. PayPal Holdings Inc (PYPL) Suever is the CFO. Current Rating: BUY Publication Date: 2/1/18 Management continues to focus on its 'New Win' Strategy. The plan focuses on engaging team members, HIGHLIGHTS providing a premier customer experience, and generating *PYPL: Raising target to $92 on continued strong profitable growth. With this strategy, management is targeting payment volumes sales growth of 150 basis points above the industry rate, 17% *On January 31, PayPal reported adjusted 4Q17 EPS of operating margins, and a compound annual growth rate of 8% $0.55, up from $0.42 a year earlier and above the $0.52 by the end of fiscal 2020. consensus. Parker Hannifin is a virtual pure-play on the industrial *Management provided revenue growth guidance for economy. PH's exposure to specific market niches (aerospace, 2018 in a range of 15%-17%, including a 1% benefit from refrigeration, air conditioning, telecom, semiconductors, favorable FX but also a 3%-5% reduction from the sale of

Section 2.78 GROWTH / VALUE STOCKS

$6.4 billion of consumer receivables to Synchrony Financial P/E of 40, above the multiples of 30 for Visa and MasterCard, (expected to close in 3Q18). but merited, in our view, based on PayPal's stronger growth *We view the Synchrony deal favorably as it will free prospects. The shares also trade at a PEG ratio of 1.7, below cash flow for other uses, reduce credit risk, and improve the multiples of both Visa and MasterCard. operating margins, which should in turn result in a higher valuation. RECENT DEVELOPMENTS *The company also announced an extension of its Over the past year, PYPL shares have risen 116%, versus agreement with eBay to feature PayPal at checkout on the a gain of 24% for the broad market. eBay Marketplace through July 2023. However, eBay On January 31, PayPal reported adjusted 4Q17 EPS of announced separately that PayPal would no longer be its $0.55, up from $0.42 a year earlier and above the $0.52 primary payments processor, with customers also having an consensus. Revenues rose 24% to $3.71 billion (also 24% on option to use a competitor processor. We believe weakness in an FX-adjusted basis) and adjusted net income rose 31% to PYPL shares is likely related to this news, but do not see $670 million. considerable fallout on revenue growth prospects. Total 4Q payment volume rose 32% from the prior year *Our revised target price of $92 implies a projected 2018 to $131.4 billion, and was primarily responsible for the P/E of 40, above the multiples of 30 for Visa and MasterCard, revenue gain. The number of active PayPal accounts was 227 but merited, in our view, based on PayPal's stronger growth million at December 31, 2017, up 15% from a year earlier, prospects. The shares also trade at PEG ratio of 1.7, below the while the number of payment transactions was 2.20 billion, up multiples of both Visa and MasterCard. 25%. For all of 2017, net revenues increased 20% to $13.1 ANALYSIS billion, while adjusted EPS climbed to $1.91 from $1.49. In November 2017, PayPal announced an agreement INVESTMENT THESIS under which Synchrony Financial would acquire about $6.8 We are maintaining our BUY rating on PayPal Holdings billion of PYPL's consumer receivables. The deal, which is Inc. (NYSE: PYPL) following 4Q earnings, while boosting expected to close in 3Q18, would also extend an existing our target price to $92 from $87. Payment volumes remained co-brand consumer credit card program, with Synchrony strong, with several metrics accelerating from 3Q. We also becoming the exclusive issuer of PayPal's online consumer view the recent Synchrony deal favorably as it will free cash financing program for 10 years. The company said the flow for other uses, reduce credit risk, and improve operating receivables were being sold at par value. margins, which should in turn result in a higher valuation. In July 2017, PayPal acquired TIO Networks, a bill PayPal management noted that cash proceeds from the deal payment processor that serves telecom, wireless, cable, and would be reinvested in its core business, used for M&A, or utility bill issuers in North America, for $238 million. returned to shareholders. On July 17, 2015, eBay Inc. completed the spinoff of PayPal, which was spun off from eBay in July 2015, is PayPal, distributing one share of PayPal stock for each share taking advantage of the changing payments landscape, and we of eBay. believe that several trends favor the company's growth. These include greater adoption of mobile devices for payments, and EARNINGS & GROWTH ANALYSIS the technological integration of different payment types and We expect revenue growth at PayPal to benefit from channels. With 227 million active accounts, PayPal is a leader higher consumer spending, increased merchant acceptance of in innovative payment mechanisms and has strong brand the company's services, growth in the number of mobile recognition. devices using mobile payment apps, and an increase in Unlike MasterCard and Visa, PayPal's network enables average transactions per active account (the latter increased to account holders to both pay and be paid for merchandise or 33.6, on an annualized basis, in 4Q17, up 8% from 31.1 a year services. PayPal is accepted at more than 75 of the top 100 earlier). Another encouraging sign is the expansion of active retailers in the U.S., and we expect even greater penetration in accounts, which grew 15% year-over-year in 4Q to 227 the next year. Total payment volume rose 32% to $131.4 million. This was also up 9 million sequentially, the fastest billion in 4Q17 (the strongest rate of growth for PayPal since pace since the company's spinoff from eBay. In addition, its IPO), and the number of payment transactions rose 25% to PayPal should benefit from trends that have boosted growth $2.0 billion. for credit card processors, such as the increasing use of digital In our view, the company has several strengths that put it payments over checks and cash for both convenience and ahead of the competition as it seeks to grow payment volumes. security. We expect further market share gains as the company These include a strong international presence, with 100 leverages its platforms globally and takes advantage of its million non-U.S. users in more than 200 countries. The strong brand recognition and rapid growth in merchant company also provides merchants with end-to-end payment acceptance. authorization and settlement capabilities, as well as instant Person-to-person volume growth, which includes the access to funds. popular social payment app Venmo, is also strong, rising 50% Our revised target price of $92 implies a projected 2018 in 4Q to $27 billion, and now accounting for 20% of total

Section 2.79 GROWTH / VALUE STOCKS payment volume. on behalf of consumers and merchants worldwide. It accepts The company has noted that the sale of its consumer payments from merchant websites, mobile devices and credit receivables portfolio to Synchrony will reduce revenues applications, and at offline retail locations through its PayPal, in 2018 by 3%-5%, assuming a July 1 close. PayPal Credit, Venmo and Braintree products. We look for revenue growth of 17% in 2018, down from PayPal processes transactions in more than 200 markets 21% in 2017. We see a similar organic growth rate as 2017, and in more than 100 currencies, and allows customers to although the Synchrony sale will weigh on overall revenue withdraw funds from bank accounts in 56 currencies and hold growth. We note a continuing decline in net revenue as a balances in PayPal accounts in 25 currencies. percentage of total payment volume (known as the 'take rate') as the company adds larger merchants, which tend to have VALUATION lower take rates. However, operating margins should also PayPal trades at 34.5-times our 2018 EPS estimate. The benefit as the company leverages its network scale. shares have a 52-week trading range of $39-$86. The company has been transparent with its 2018 financial We expect PayPal to show steady growth in payment goals, which include revenue growth guidance of 14%-16% volumes as it adds merchants, signs additional partnerships, on an FX-neutral basis (15%-17% at current spot rates), increases the number of transactions per customer, and including the Synchrony sale. Adjusted EPS guidance is benefits from greater global spending. PayPal competes in the $2.24-$2.30. PayPal also has a three-year outlook, which calls payments space with American Express, Discover, Visa and for FX-neutral revenue growth of 16%-17% per year, stable to MasterCard, as well as with other mobile payment services growing operating margins, and free cash flow growth in line such as ApplePay. Unlike Visa and MasterCard, PayPal with revenue gains. currently offers forms of credit to its customers, although a We are maintaining our 2018 EPS estimate of $2.30, recent agreement to sell its receivables portfolio to Synchrony implying 20% growth, while initiating a 2019 forecast of Financial would remove this element of credit risk. The deal $2.77, or 21% growth. should also free cash flow for other uses and improve operating margins, allowing for a higher valuation. FINANCIAL STRENGTH & DIVIDEND To value the stock, we believe that processing pure-plays Our financial strength rating on PayPal is Medium-High. Visa and MasterCard still offer the best peer comparisons. Balance sheet metrics are favorable, with cash and short-term PayPal is a smaller player in the payments market, though it investments as of December 31, 2017 of $5.70 billion and no also has a strong brand and a record of innovation. As such, long-term debt. The company has a limited operating history we expect it to post above-industry-average earnings growth as a public company. for many years, and believe that it merits a premium multiple. Free cash flow is expected to be reinvested in the Our 12-month target price of $92 (raised from $87) implies a business and used for acquisitions and buybacks. Along with multiple of 40-times our 2018 EPS estimate, above the 1Q17 earnings, the company announced a $5 billion share multiples of about 28 for Visa and MasterCard. PYPL shares buyback plan, a considerable increase from a $2 billion also trade at a more favorable PEG ratio of 1.7, versus 2.0 for repurchase program authorized in 4Q15. During 2017, PayPal Visa and MasterCard. repurchased 19.7 million common shares for $1.0 billion. The On February 1 at midday, BUY-rated PYPL traded at company does not expect to pay a regular cash dividend. $80.00, down $5.32. (Stephen Biggar, 2/1/18)

MANAGEMENT & RISKS PayPal is led by president and CEO Dan Schulman, who Praxair Inc (PX) joined the company in 2014 from American Express. In Current Rating: BUY Publication Date: 2/6/18 August 2015, John Rainey joined PayPal as chief financial officer. He was previously with United Continental Holdings. HIGHLIGHTS PayPal faces considerable competition in the payments *PX: Increasing target price by $4 to $175 market from well-established brands, including Apple's *We believe that Praxair is well positioned to deliver ApplePay, Visa's Checkout, MasterCard's MasterPass, and stronger EPS growth based on its mix of high-growth American Express's Later Pay services, as well as other digital businesses, which have generated above-industry-average products from Facebook and Google. Customers generally margins, earnings, and returns on invested capital. have a range of payment options in addition to PayPal at the *On January 25, Praxair reported 4Q17 adjusted net point of sale, and the company must compete on convenience income of $441 million or $1.52 per diluted share, up from and transaction price. The company must also respond quickly $406 million or $1.41 per share in the prior-year quarter. EPS to changing customer preferences, including the increasing topped our estimate of $1.48 and the consensus estimate of demand for mobile payment services. $1.47. *The higher earnings reflected higher volume (+7%), COMPANY DESCRIPTION positive price/mix (+1%), favorable currency translation Spun off from eBay in July 2015, PayPal is a technology (+3%), and positive cost pass-throughs (+1%). Fourth-quarter platform company that enables digital and mobile payments revenue came to $2.953 billion, up 12% from the prior year.

Section 2.80 GROWTH / VALUE STOCKS

*We are raising our 2018 EPS estimate to $6.66 from contribution from favorable pricing and product mix. The $6.31, reflecting management's 1Q18 guidance, which was volume growth was driven by strength in the electronics, $0.04 above our forecast, and our expectations for increased metals and chemicals end-markets. Operating profit rose to volume and positive pricing this year. The 2018 consensus $90 million from $78 million a year earlier. forecast is $6.62. Praxair Surface Technologies posted fourth-quarter sales of $159 million, up from $149 million in 4Q16, as growth in ANALYSIS aerospace end markets was partially offset by weaker sales to INVESTMENT THESIS utility customers. Operating profit of $27 million was in line We are reaffirming our BUY rating on Praxair Inc. with prior-year results. (NYSE: PX) and raising our price target by $4 to $175. We On June 1, Praxair and Linde AG (Xetra: LIN) agreed to believe that Praxair remains well positioned to deliver combine in an all-stock merger-of-equals transaction. Based stronger EPS growth based on its mix of high-growth on 2016 reported results, the combined company will have pro businesses, which have generated above-industry-average forma revenues of approximately $29 billion, excluding margins, earnings, and returns on invested capital. Results in potential divestitures and other adjustments, and a market cap the last three quarters have surprised to the upside. In of more than $70 billion. The merger is expected to generate addition, we see the merger with Linde AG as a significant $1.2 billion in annual synergies within three years of the positive, as we expect the combined company's greater scale closing. and geographic reach to benefit earnings over time. In all, we The transaction will be structured as an exchange offer expect Praxair to outperform peers as it works to complete the under German law for Linde shareholders and as a merger merger in 2H18. under Delaware law for Praxair shareholders. Under the terms of the agreement, Linde shareholders will receive 1.54 shares RECENT DEVELOPMENTS of the new holding company for each Linde share, and Praxair PX shares have outperformed since the beginning of shareholders will receive one share in the new company for 2018, falling 2.8% while the S&P 500 Basic Materials index each Praxair share. Assuming 100% participation in the has dropped 3.4%. Over the past year, they have risen 29.1%, exchange offer, Linde shareholders and Praxair shareholders while the Materials index has climbed 12.2%. will each own approximately 50% of the combined company. On January 25, Praxair reported 4Q17 adjusted net The companies expect the transaction to close in the second income of $441 million or $1.52 per diluted share, up from half of 2018, subject to customary closing conditions and $406 million or $1.41 per share in the prior-year quarter. EPS regulatory approval. topped our estimate of $1.48 and the consensus estimate of For all of 2017, Praxair reported adjusted net income of $1.47. $1.690 billion or $5.85 per diluted share, up from $1.576 The higher earnings reflected higher volumes (+7%), billion or $5.48 per share in 2016. positive price/mix (+1%), favorable currency translation (+3%), and positive cost pass-throughs (+1%). Fourth-quarter EARNINGS & GROWTH ANALYSIS revenue came to $2.953 billion, up 12% from the prior year. Praxair management has discontinued its full-year EPS In North America, fourth-quarter sales rose 10% to guidance due to the pending merger with Linde. However, it $1.542 million, reflecting higher volume and pricing and has projected 1Q18 EPS of $1.53-$1.58, implying growth of positive currency translation. In particular, the company 15% at the midpoint of the range. The 1Q18 consensus prior benefited from higher volume to electronics, downstream to the earnings release was $1.54. energy, chemicals, and manufacturing customers. Operating We are raising our 2018 EPS estimate to $6.66 from profit rose to $396 million from $359 million a year earlier. $6.31, reflecting management's 1Q18 guidance, which was In Europe, fourth-quarter sales rose 17% from the prior $0.04 above our forecast, and our expectations for increased year to $412 million and volume rose 5%, reflecting the volume and positive pricing this year. The 2018 consensus acquisition of a carbon dioxide business serving food and forecast is $6.62. beverage customers. Management noted particular strength in We are also initiating a 2019 EPS estimate of $7.41, Spain, Germany and Italy. Operating profit came to $80 implying 12% growth from our 2018 estimate. The 2019 million, up from $71 million a year earlier. consensus is $7.20. In South America, fourth-quarter sales rose 5% from the FINANCIAL STRENGTH & DIVIDEND prior year to $370 million. Praxair continues to expect margin We rate Praxair's financial strength as Medium, the pressure in South America in 2018 due to weak industrial midpoint on our five-point scale. The company's debt is rated production. The 4Q operating margin fell to 16.2% from A2/stable by Moody's and A/under review by Standard & 18.2% in the prior-year quarter. Operating profit fell to $60 Poor's. million from $64 million. At the end of 4Q17, PX's debt/capitalization ratio was In Asia, revenue rose 19% to $470 million, reflecting 58.0%, down from 63.6% at the end of 4Q16. The company's 11% volume growth, a 4% benefit from currency translation, a debt/cap ratio is modestly higher than that of most peers. Its 1% contribution from cost pass-throughs, and a 3% average ratio over the past five years is 60.1%.

Section 2.81 GROWTH / VALUE STOCKS

Total debt came to $9.0 billion at the end of 4Q17, 2018 EPS estimate and 20.3-times our 2019 estimate, including $1.217 billion of short-term borrowings and $7.783 compared to a 23-year average annual range of 17-23. They billion of long-term borrowings. This compares to total debt are also trading above the high end of their historical average of $9.515 billion at the end of 4Q16. range for price/book (7.4 versus a range of 4.1-5.5), Praxair had cash and equivalents of $617 million at the price/sales (3.9 versus a range of 2.0-2.7), and price/EBITDA end of 4Q17, compared to $524 million a year earlier. (14.6 versus a range of 7.7-10.1), and at a slight premium to Praxair did not repurchase any stock in 4Q17, though it peers. Despite these relatively high valuation metrics, we has $1.1 billion remaining on its existing authorization. In believe that increased demand for industrial gases and the July 2015, it said that it would initiate a new $1.5 billion upcoming merger with Linde AG have strengthened the authorization following the completion of its current program. company's prospects and we expect continued upside for PX In conjunction with its 4Q17 earnings release, Praxair shares. Our revised target price of $175, combined with the announced a 5% increase in its quarterly dividend to $0.8250 dividend, implies a total potential return of 19% from current per share or $3.30 annually, for a projected yield of about levels. 2.2%. The company has raised its dividend annually for the On February 6 at midday, BUY-rated PX traded at last 25 years. The first payment at the new rate will be made $153.00, up $2.68. (Bill Selesky, 2/6/18) 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. Progressive Corp. (PGR) Current Rating: HOLD Publication Date: 1/31/18 RISKS Risks facing Praxair include inflation in raw material and HIGHLIGHTS commodity costs, plant outages, liability lawsuits, regulatory *PGR: Fully valued following 4Q results changes, and exchange rate volatility. The company also faces *On January 24, Progressive reported 4Q17 operating a range of country-specific risks. EPS of $0.98, above the consensus estimate of $0.77 and our estimate of $0.63. Operating EPS rose 57% year-over-year, COMPANY DESCRIPTION boosted by premium growth, margin improvement, and tax Praxair Inc. is an industrial gases company with benefits. Excluding those benefits, EPS rose 28% to $0.81 per operations in North and South America, Asia and Europe. Its share. primary products are atmospheric gases (oxygen, nitrogen, *Progressive generates a high ROE and has shown steady argon and rare gases) and process gases (carbon dioxide, growth in premium revenue. helium, hydrogen, electronic gases, specialty gases and *We are raising our 2018 estimate to $3.49 from $2.86, acetylene). Praxair serves customers in approximately 25 which assumes greater increases in net premiums and lower industries. The company was founded in 1907 and is costs than we previously projected. Additionally, we expect headquartered in Danbury, Connecticut. less severe natural disasters and benefits from lower tax rates. INDUSTRY We are establishing a 2019 estimate of $3.75. Our recommended weighting for the Basic Materials *PGR shares trade at 15.4-times our 2018 EPS estimate, sector is Over-Weight, based on stabilizing commodity prices below the midpoint of the historical range of 14.3-23.5 and in and signs that the global economy will avoid recession. The line with the peer median. They are also trading at a sector accounts for 3.0% of the S&P 500, and includes price/book multiple of 3.4, at the high end of the five-year industries such as chemicals, paper, metals and mining. Over historical range of 2.0-3.5 and above the median of 1.5 for the past five years, the weighting has ranged from 2.5% to peers. 5%. We think investors should consider allocating about 4% ANALYSIS of their diversified portfolios to stocks in this sector. The sector outperformed in 2016, with a gain of 14.1%, and INVESTMENT THESIS underperformed in 2015, with a loss of 10.4%. It slightly Our rating on Progressive Corp. (NYSE: PGR) is HOLD. outperformed in 2017, with a gain of 21.4%. Progressive is a well-managed company with a clean balance The P/E ratio on projected 2018 EPS is 18.0, close to the sheet. The company targets the value segment of the market multiple. The sector's debt ratios appear sound, as Property-Casualty insurance market and spends aggressively many in the group have deleveraged in recent years. Yields of on marketing in order to gain market share. However, 1.5% are below the market average. The Street consensus earnings growth has been uneven in recent quarters, and calls for earnings growth of 35.7% in 2017 and 16.1% in valuations are high on a historical basis and relative to peers. 2018. The shares are a suitable core holding for long-term investors, but we will look for more stable earnings growth or lower VALUATION valuations to move them back onto the BUY list. Praxair shares are trading in the upper half of their 52-week range of $115.53-$166.95, and at 22.6-times our RECENT DEVELOPMENTS

Section 2.82 GROWTH / VALUE STOCKS

PGR shares have outperformed over the past quarter, Direct, was 92.4, a decrease of 30 basis points. Commercial rising 9.9% versus a 9.7% gain for the S&P 500. They have Lines combined ratio increased to 93.8 from 90.8 in 4Q16, also outperformed over the past year, with a gain of 40.8%, while the property business reported a ratio of 97.3, up from compared to a 23.0% increase for the index. The beta on PGR 73.3. is 0.86, in line with the peer average. -- Sales growth has been strongest in the property On January 24, Progressive reported 4Q17 operating EPS business, which reported a gain of 20%, helped by the of $0.98, above the consensus estimate of $0.77 and our company's aggressive advertising and push into home estimate of $0.63. Operating EPS rose 57% year-over-year, insurance. Separately, auto insurance has been improving. boosted by premium growth, margin improvement, and tax Progressive's innovative Snapshot program provides new tools benefits. Excluding those benefits, EPS rose 28% to $0.81 per designed to boost profitability. Snapshot monitors driver share, perhaps a better comparison to year-over-year results. behavior and has been popular with customers, as it can The combined ratio was 91.4%, an improvement from 92.6% reduce their premiums. Perhaps for the same reasons, it has last year. The 4Q combined ratio benefited from $17 million been less embraced by insurance agents. The company is also in favorable reserve development and the company did not growing via acquisitions. report any catastrophe losses. Revenue rose 16% to $7.2 CEO Tricia Griffith has helped push the company into the billion and beat the consensus by $20 million. home insurance business. By bundling car and home In 4Q17, the company reported 17% year-over-year insurance, the company has been able to boost customer growth in net premiums earned (the money the company loyalty and reduce switching costs. We see home insurance as keeps), to $6.8 billion. Net premiums written, or new policies an area for growth and believe that PGR has the potential to signed, rose 22%, to $6.8 billion. Policies in force, or gain share through improved marketing. insurance contracts outstanding, rose 12% year-over-year in -- Progressive's $27 billion investment portfolio returned the Personal Auto segment. In Commercial Lines, policies an annualized 2.0% in the fourth quarter. This is low by rose 6%, but the segment accounts for only about 4% of historical standards and reflects the current low interest rate policies. Progressive appears to be generating much of its environment; some 85% of the investment portfolio is in revenue growth through price hikes. fixed-income securities or cash. Book value of $15.96 per share was up from $13.72 a To generate our EPS estimates for the insurance industry, year earlier. we typically focus on returns on equity, which are more The trailing 12-month return on average shareholders' predictable than catastrophe losses and net favorable equity, using net income as the numerator, was an impressive prior-year development. Progressive's ROE (17.3% in 4Q17) 17.3% in 4Q, compared to a peer average of 6.3%. is among the highest in the industry. However, ROE has fallen For all of 2017, EPS came to $2.72 per share, a rise of from 19% in 2014. 55% from 2016. Net income rose 54% to $1.6 billion and We are raising our 2018 estimate to $3.49 from $2.86, revenue rose 14% to $26.8 billion. which assumes greater increases in net premiums and lower costs than we previously projected. Additionally, we expect EARNINGS & GROWTH ANALYSIS less severe natural disasters and benefits from lower tax rates. We like the fact that Progressive generates a high ROE We are establishing a 2019 estimate of $3.75. Our long-term and has shown steady growth in premium revenue. The operating earnings growth rate estimate is 8%. company's positive investment results allow PGR to maintain higher loss reserves - which lessen the impact of volatile FINANCIAL STRENGTH & DIVIDEND catastrophe losses. We also like the growth in policies in force Our financial strength rating for Progressive is and book value. The auto insurance business generates Medium-High, the second-highest level on our five-point consistent quarterly earnings (as the number of car crashes is scale. The company scores highly on our three main criteria of largely steady from quarter to quarter) and has posted strong debt levels, fixed-cost coverage and profitability. results amid rising car sales. The business is marked by steady As of the end of 4Q17, Progressive had debt of $3.3 earnings and strong prospects. We have also recently seen billion, up from $3.1 billion at the end of 4Q16, and greater increases in premiums, which have led to higher shareholders' equity of $9.3 billion, up from $8.0 billion. The margins. The combined ratio has also improved - indicating debt-to-total-capitalization ratio was 26%, down from 28% at lower loss frequency. Our concerns for the stock include the end of 4Q16 but above the peer average of 20%. Total earnings growth and the current high valuation. assets were $38.7 billion, up from $33.4 billion a year earlier. Key fourth-quarter trends for PGR are summarized Operating income covered interest expense by a factor of below: 15.5, up from 8.3 last year, and well above the peer average of -- The combined ratio was 91.4 in 4Q16, down 120 basis 1.4. The profit margin was 6.9%, up from 6.1% last year and points. In 4Q17, the company's largest business, Personal above the peer average of 4.6%. Adjusted ROE for the quarter Lines - Agency, recorded an average GAAP combined ratio of was 17.3%, up from 13.5% a year earlier and well above the 89.3, a decrease of 510 basis points from a year earlier. The peer average of 6.3%. combined ratio for the third-largest segment, Personal Lines - Progressive pays a dividend with a unique policy. The

Section 2.83 GROWTH / VALUE STOCKS annual variable dividend is determined by a formula that is Current Rating: BUY Publication Date: 2/7/18 based on after-tax underwriting income, and a subjective HIGHLIGHTS 'gainshare factor,' a measure of the core insurance business. *QCOM: Executing amid Broadcom bid, Apple war; This is announced early in the calendar year for the previous reiterating BUY to $75 year. For example, on December 8, the December earnings *Qualcomm reported stronger-than-expected results for release stated that the annual variable dividend for 2017 its fiscal 1Q18 (calendar 4Q17). would be $1.12 per share, payable on February 9 to holders of *Qualcomm is executing despite trying to buy NXP, record on February 2. By comparison, the annual variable fending off acquisition by Broadcom, and fighting an IP war dividends in the previous four years were $0.68, $0.28, $0.41, with Apple and $0.69. From time to time, Progressive also pays a special *While revenue and earnings may seem like a sideshow, dividend, most recently in 2013. We think the core dividend Qualcomm's operating progress is instrumental to all these will be $1.26 in 2018 and $1.29 in 2019. struggles. The company did not repurchase shares during the *Even with the many impediments in Qualcomm's path, quarter. The company has 24.2 million shares remaining on its operating momentum shows that Qualcomm is being 25.0 million share repurchase authorization announced in undervalued by Broadcom, can carry on without Apple (as it 2014. has done for about a year), and would be a good landing spot MANAGEMENT & RISKS for NXP. Tricia Griffith, 52, became CEO in July 2016. Ms. ANALYSIS Griffith previously served as chief operating officer. She joined the firm as a claims representative in 1988. INVESTMENT THESIS The shareholder base includes Vanguard and BlackRock BUY-rated Qualcomm Inc. (NGS: QCOM) reported (which each own about 7% of shares outstanding) and State stronger-than-expected results for its fiscal 1Q18 (calendar Street (4%). 4Q17), while guiding cautiously for fiscal 2Q18. Revenue of Progressive faces macroeconomic risks related to the $6.07 billion was up 1%, the first positive annual revenue economy and volatile equity markets on the company's comparison since 1Q17; sales also topped consensus while balance sheet, capital levels, credit ratings, revenues and coming in above the (broad) guidance midpoint. Non-GAAP income. Low interest rates are a challenge to investment EPS of $0.98 per diluted share were down 17% annually but returns, though recent Fed rate hikes should help. exceeded consensus by $0.07. The company also faces competitive threats from rivals Qualcomm's EPS reports may seem incidental given the such as Geico, Allstate and State Farm. Progressive focuses multiple dramas in which it is engaged. These include fending on insurance markets in Florida, New Jersey, New York and off a bid from Broadcom, now sweetened; engaging in a Michigan. grueling legal battle with Apple, which may cut QCOM modems out of future iPhones; and trying to close the NXP COMPANY DESCRIPTION acquisition, which NXPI activists are calling Qualcomm's bid Progressive Corp., based in Mayfield Village, Ohio, is a too low. Qualcomm's also has incurred past and future fines leading property & casualty insurance company. The company totaling $3.9 billion since 2015, including from EU, China, sells through independent agencies and its own direct-sales Taiwan and Korea; only the EU fine is still in front of the website. The shares are included in the S&P 500 index. company, however. VALUATION While revenue and earnings may seem like a sideshow, We think that PGR shares are fairly valued at current Qualcomm's operating progress is instrumental to all these prices near $54. Over the past 52 weeks, the shares have struggles. Operating momentum, even with the many traded in a range of $37-$58. impediments in Qualcomm's path, shows that Qualcomm is PGR shares are trading at a price/book multiple of 3.4, at being undervalued by Broadcom, can carry on without Apple the high end of the five-year historical range of 2.0-3.5 and (as it has done for about a year), and would be a good landing above the median of 1.5 for peers. The shares trade at spot for NXP. Qualcomm settled past royalty disputes and set 15.4-times our 2018 EPS estimate, below the midpoint of the 5G royalty terms with one of its largest licensees, Samsung; historical range of 14.3-23.5 and in line with the peer median. this suggests Qualcomm is doubling down on the efficacy and The shares are a suitable core holding for long-term investors, fairness of its licensing & royalty model, despite Apple's but we will look for more stable earnings growth or lower protests. This settlement also undercuts a key Broadcom valuations before moving them back to the BUY list. argument -- that Qualcomm can no longer get its customers to On January 31 at midday, HOLD-rated PGR traded at agree to its licensing terms. $53.88, up $0.39. (Jacob Kilstein, CFA, 1/31/18) 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 Qualcomm Inc (QCOM) maker is building up a huge pile of licensing revenue due to

Section 2.84 GROWTH / VALUE STOCKS

Qualcomm. Whether the court decides on Qualcomm's terms revenue during QCOM's fiscal 1Q18, as it did in 2H17. QTL or Apple's, past royalties due could amount to about $2 billion revenue is derived on a three-month lag basis, and thus fiscal from 2017 alone (based on existing royalty rates). 1Q18 revenue represents the calendar third quarter from July QCOM shares are subject to many cross-currents having through September 2017. QTL 1Q18 revenue totaled $1.30 nothing to do with operations, but that actually makes the billion and was down 28% year-over-year, while growing focus on fundamentals more important. Despite the absence of sequentially by 1%. substantial Apple licensing revenue, and potential loss of QTL margin, which formerly ran in the mid-80s, is now Apple parts revenue (which would not be onerous), in the 60%-70% range on lost volume leverage and overhead Qualcomm was able to post higher sales in 1Q18 and is on absorption. QTL EBIT for 1Q18 of $887 million was down track for flattish sales in 2Q18. 42% annually; QTL margin of 68.3% for 1Q18 narrowed Weakness in QCOM shares has created a deep-value from 84.6% for 1Q17, which was the penultimate quarter opportunity, though we caution that the risk of owning the before the Apple dispute turned nasty. shares has increased. Investors willing to take on a range of Qualcomm is involved in several separate dramas, all of risks but also potential benefits may be inclined to initiate or which could impact the company deeply going forward. But add to positions in QCOM shares. We are reiterating our BUY Qualcomm also had good news to share. Qualcomm rating to a 12-month target price of $75. announced several developments central to its relationship with Samsung, the largest volume smartphone vendor in the RECENT DEVELOPMENTS world. Qualcomm has amended and renewed its technology QCOM shares are down about 2% in 2018, compared to a licensing deal with Samsung through 2023, which includes flat performance for peers. QCOM declined 2% in 2017, device-level royalties consistent with Qualcomm's long-term compared to a 31% simple average gain for the peer group of model. communications and information processing semiconductor Samsung is withdrawing its opposition to Qualcomm's companies in Argus coverage. QCOM was up 30% in 2016, appeal of the order (fine) imposed by the Korean Fair Trade versus 60% for peers, and declined 33% in 2015, lagging the Commission. Qualcomm also announced a multi-year 9% gain for the peer group. strategic agreement with Samsung in various technology areas For fiscal 1Q18 (calendar 4Q17), Qualcomm reported across a range of mobile devices. The agreement encompasses revenue of $6.07 billion, which was up 1% annually; revenue 5G and other technologies. was within the $5.5-$6.3 billion guidance range and topped The central dramas facing Qualcomm include Broadcom's the $5.93 billion consensus. Non-GAAP EPS of $0.98 unsolicited bid; Qualcomm's long quest to purchase NXP; and declined 17% from the prior year while exceeding the high the bruising Apple legal battle. Qualcomm's also has incurred end of the $0.85-$0.95 guidance range and the $0.91 past and future fines totaling $3.9 billion since 2015, consensus forecast. including from EU, China, Taiwan and Korea; only the EU As in fiscal 2017, revenue was impacted by payments fine is still in front of the company, while Qualcomm is withheld by an unnamed licensee (not related to Apple). battling the EU fine. Separately, Apple has compelled its contract manufacturing CEO Steve Mollenkopf updated investors on the Apple partners (such as Foxconn) to withhold payments. dispute, stating that Qualcomm 'continues to move closer to a On a segment basis in 1Q18, Qualcomm CDMA number of key legal milestones later this year and early next Technology (QCT) revenue of $4.65 billion was up 13% year.' In numerous global jurisdictions, hearings are scheduled year-over-year and flat sequentially. QCT EBIT of $955 to determine whether Qualcomm is entitled to injunctive relief million was up 32% year-over-year and generated a 20.5% and exclusion orders. And Qualcomm's cases against Apple EBIT margin, versus 17.7% in 1Q17. contract manufacturers should move to resolution in the same QCT shipped about 237 million chipsets in 1Q18, at the time frame. While Qualcomm would like to patch things up high end of the guidance range. Chipset shipments include with Apple, the CEO stated, it wants to be paid fairly for its both thin mobile modems as well as Snapdragon IP. system-on-a-chip (SoC) apps processors. Qualcomm does not Apple has signaled an increasing likelihood that it will break out the number of modems versus SoCs in any quarter. stop using Qualcomm modems in its iPhones. We use the Based on both revenue per device and the high level of following assumptions for Apple's contribution to QCT earnings, as well as comments from management regarding revenue: 230 million iPhones shipped per year; 50% modem favorable mix, we believe that shipments of Snapdragon SoCs market share split evenly with Intel; and $11 per chip grew more than 15% annually in the quarter while modems wholesale price. That suggests QCT's annual Apple revenue were about flat year-over-year. Apple has engaged a second of about $1.2-$1.3 billion. This money could be lost modem vendor (Intel) for the iPhone; a flat annual comparison altogether, although it may entail Apple using a weaker is better than the mid-teens declines in recent quarters. product from Intel. The QTL ( Qualcomm Technology Licensing) business is More money is at stake for QTL, but Apple will not be obviously most impacted by the Apple legal battle. An able to fully wiggle out of paying Qualcomm. Using our additional non-compliant licensee withheld significant annual iPhones shipped data, a wholesale list under $500 and

Section 2.85 GROWTH / VALUE STOCKS a 2.5% net royalty (including royalty rebates), we believe that NXP and (presumably) has some settlement with Apple, QTL's royalties on the iPhone would be in the $2.0-$2.5 Qualcomm believes it can earn $6.75-$7.50 per diluted share billion range in any year; this is according to the pre-lawsuit in non-GAAP FY19 EPS. terms that prevailed for all iPhones up through iPhone 6S and Street estimates are well below that level, given that so 6S Plus. many uncertainties are baked into that target number. And Apple will not be able to fully stop paying for licensing Qualcomm did not help its case with below-consensus rights, although it is seeking to pay much less. Apple seeks to current-quarter guidance. For 2Q18, Qualcomm forecast end Qualcomm's practice of charging a percentage rate based revenue of $4.8-$5.6 billion, which at the $5.2 billion on wholesale device price; Apple believes what it pays midpoint would be flat to down 2% year-over-year. Qualcomm should reflect only Qualcomm's IP and should Non-GAAP EPS was forecast at $0.65-$0.75, compared with have no relationship to the cost of an iPhone. The imminence the $1.34 earned in 2Q17 - the last 'normal' quarter before of meaningful legal outcomes in the next 9-12 months Apple & its contract manufacturers began withholding increases the incentive on both sides to settle before the court revenue. settles for them. QCOM shares are subject to many cross-currents having There are new and recent developments in the Broadcom nothing to do with operations, but that actually makes the saga as well. Qualcomm rebuffed the initial Broadcom bid, focus on fundamentals more important. Despite the absence of calling it too low and based on pressures on operations related substantial Apple licensing revenue, and potential loss of to Apple and partners withholding revenue due to Qualcomm. Apple parts revenue (which would not be onerous), On 2/4/18, Broadcom raised its offer for QCOM to $121 Qualcomm was able to post higher sales in 1Q18 and is on billion, or about $82 per share - 17% higher than the original track for flattish sales in 2Q18. bid offered in November. Broadcom called its offer price Weakness in QCOM shares has created a deep-value 'final.' opportunity, though we caution that the risk of owning the Broadcom has alleged that Qualcomm is no longer shares has increased. Investors willing to take on a range of capable of maintaining its chipset business (QCT) and its risks but also potential benefits may be inclined to initiate or licensing business (QTL) under one roof. According to add to positions in QCOM shares. Broadcom, QTL is trapped in endless licensing disputes with companies (Apple, Blackberry) and governments (EU, EARNINGS & GROWTH ANALYSIS Taiwan, Korea, China); Qualcomm would be best served by For fiscal 1Q18 (calendar 4Q17), Qualcomm reported spinning off the asset and focusing on chip technology. revenue of $6.07 billion, which was up 1% annually; revenue Qualcomm's successful renegotiation with the world's largest was within the $5.5-$6.3 billion guidance range and topped smartphone vendor (Samsung) takes some of the juice out of the $5.93 billion consensus. that argument. Some investors are concluding that Broadcom The GAAP gross margin expanded sequentially to 56.1% gave its 'final' offer with no expectation that Qualcomm would in 1Q18 from 55.1% in 4Q17, while narrowing from 59.3% a take it, creating an easier path for Broadcom to walk away year earlier. The decline reflected lost volume leverage on from the deal. lower high-margined QTL revenue. The non-GAAP operating We do not expect Qualcomm to accept $82 per share. margin expanded sequentially to 27.5% in 1Q18 from 26.5% That is partly because Qualcomm expects to acquire NXP and in 4Q17 and declined from 34.6% a year earlier. vastly expand its available market opportunity. Non-GAAP EPS of $0.98 declined 17% from the prior In mid-January, Qualcomm won EU and South Korean year while exceeding the high end of the $0.85-$0.95 regulatory approval to buy NXP; ironically, both jurisdictions guidance range and the $0.91 consensus forecast. are seeking to fine Qualcomm for violating FRAND (fair and For all of fiscal 2017, Qualcomm had sales of $22.9 reasonable) terms in its licensing contracts. NXP will likely be billion, down 7% from $24.0 billion in fiscal 2016. required to divest its credit card security-chip business; but Non-GAAP EPS totaled $4.28 in fiscal 2017, down 4% from that would still leave its embedded processing business, which $4.45 in fiscal 2016. is the largest player in automotive electronics. Chinese For 2Q18, Qualcomm forecast revenue of $4.8-$5.6 regulators have yet to approve the deal. billion, which at the $5.2 billion midpoint would be flat to Qualcomm will also likely need to sweeten its bid, which down 2% year-over-year. Non-GAAP EPS was forecast at remains at the original $110 per share over a year since the $0.65-$0.75, compared with the $1.34 earned in 2Q17 - the deal was first proposed. Qualcomm may have been awaiting last 'normal' quarter before Apple & its contract manufacturers early regulatory decisions before offering a new takeout price. began withholding revenue. Based on NXP's huge presence in automotive embedded We are modeling a more extended period of missing QTL products along with new markets entered by Qualcomm - royalties and, as a result, tighter QTL margins. We have including device niches such as front end and WiFi, and reduced our FY18 non-GAAP earnings forecast to $3.65 per verticals such as healthcare, IoT, and others - Qualcomm diluted share, from $4.07. We have reduced our preliminary believes it can expand its addressable market to $150 billion fiscal 2019 non-GAAP EPS projection to $4.02 per diluted by 2020, from $23 billion in 2015. Assuming Qualcomm buys share from an initial $4.46.

Section 2.86 GROWTH / VALUE STOCKS

We are not incorporating NXP into non-GAAP estimates is president of QCT. for FY18 or FY19; in our view, Qualcomm will need to offer The suit and countersuit with Apple significantly better terms. Our estimates are also not indicative of industry increases risks for Qualcomm; in an unsuccessful outcome, or Qualcomm fundamentals and reflect our expectations that Qualcomm could end up paying a large legal bill and fine resolution of major litigation with Apple, the unnamed while also losing a major customer. However, the legal licensee, and regulatory authorities will take place over an sparring may not ultimately influence Apple's business extended period of time. decisions, particularly if this spat is resolved quickly. Apple Our long-term EPS growth rate forecast is 10%. currently has only one other qualified baseband supplier - Intel. Despite its huge fabrication infrastructure, Intel has been FINANCIAL STRENGTH & DIVIDEND outsourcing baseband production and may not be ready to Our financial strength rating for Qualcomm is High, the supply chips for over 200 million phones. top of our five-point scale. The NXP deal would represent a An ongoing risk for Qualcomm is that the KFTC and strain for any company. Qualcomm could potentially fund FTC investigations, along with an ongoing EU investigation, nearly all of the deal with offshore cash should it choose to do will materially impact results. Regarding the FTC so; however, we expect QCOM to access credit markets to pay investigation, Qualcomm has in the past won court decisions for a significant part of the acquisition. Qualcomm added related to allegations that its marketing practices violated approximately $10 billion in debt in 3Q17 in anticipation of FRAND. For the EU investigation, the language regarding the NXP deal close. We will monitor our financial strength use of rebates and incentives for silicon sales smacks of a ranking as final deal details begin to emerge. smaller vendor objecting to volume discounts for larger Note that Qualcomm's withholding of $1 billion due vendors (Apple and Samsung, for example). In Korea, we Apple under the cooperation agreement has increased cash by expect Qualcomm to pay a fine and renegotiate royalty rates that amount while increasing other current liabilities by that with Samsung and LG; the amount of the fine may be amount. The launch of the RF 365 JV with TDK has bulked negotiable. up assets, as this JV is consolidated on Qualcomm's financial The acquisition of NXP is expensive, though it will be statements. worth the price if it future-proofs the company against the Cash was $39.9 billion at 1Q18. Cash was $39.8 billion at inevitable decline in the smartphone market. Qualcomm is in a the end of fiscal 2017, $32.4 billion at the end of fiscal 2016, nearly unique position of being able to finance the deal largely $30.9 billion at the end of fiscal 2015, and $32.0 billion at the with offshore cash should it choose to do so. Overall, we see end of fiscal 2014. risks and opportunities being evenly balanced or perhaps Cash flow from operations was $4.79 billion in FY17, favoring opportunities in this acquisition. reduced from $7.40 billion in fiscal 2016. Cash flow from The company's previously announced realignment plan operations was $5.5 billion in fiscal 2015, and free cash flow carries multiple risks, but was a necessary response to a was $4.5 billion. Cash flow from operations was $8.9 billion changing market. Instead of just cutting heads, Qualcomm has in fiscal 2014, while free cash flow (non-GAAP) was $8.1 also changed the board, aligned executive compensation to billion. performance, and cut share-based compensation. While it will Debt was $22.8 billion at 1Q18. Debt was $21.9 billion at take time for the plan to be judged on its successes and the end of FY17, $11.8 billion at the end of FY16 and $10.9 failures, we think it is a needed step given the current billion at the end of FY15. To pay for a major increase in its environment. capital-return program, early in FY15 Qualcomm announced The NDRC settlement should allow Qualcomm to reduce plans to access the credit markets. Previously, Qualcomm had underreporting and noncompliance in its royalty & licensing not had any debt since FY12. business in China. Qualcomm's capital allocation strategy targets a return of Qualcomm and Intel formerly controlled discrete parts of at least 75% of free cash flow to shareholders. Qualcomm has the technology industry. But the two giants - now with almost returned a cumulative $57.5 billion to shareholders since identical market caps - compete squarely with one another in 2007. Qualcomm repurchased $3.9 billion of its stock in multiple markets. We believe this competition is healthy for FY16, after repurchasing $11.3 billion in FY15. It both companies, and do not look for either to gain a repurchased $4.55 billion of its stock in FY14, $4.61 billion in meaningful advantage over the other on an aggregate basis. FY13, and $1.3 billion in FY12. The cumulative return to shareholders between FY03 and FY16 was about $54 billion. COMPANY DESCRIPTION On 3/7/17, Qualcomm announced a hike in its quarterly Qualcomm is a designer and manufacturer of advanced dividend to $0.57 per common share from $0.53. Our annual semiconductors for mobile phones and commercial wireless dividend estimates are $2.40 for FY18 and $2.54 for FY19. applications. Qualcomm provides integrated solutions, including processors, GPS, WiFi, basebands and other MANAGEMENT & RISKS applications, for smartphones, tablets, and mobile PCs. Steve Mollenkopf has served as CEO since 2014. Former Qualcomm has extended its leadership in the 3G CDMA CEO Paul Jacobs is executive chairman of the board. George wireless standard into the 4G LTE niche. It derives substantial Davis is CFO and Derek Abele is president. Christiano Amon

Section 2.87 GROWTH / VALUE STOCKS royalty and licensing revenue from its extensive Ralph Lauren Corp (RL) intellectual-property portfolio for 3G and 4G technologies. Current Rating: HOLD Publication Date: 2/6/18 INDUSTRY HIGHLIGHTS Our rating on the Technology sector is Over-Weight. *RL: Raising EPS estimates but maintaining HOLD Technology is showing clear investor momentum, topping the *On February 1, Ralph Lauren posted fiscal 3Q18 market in the year-to-date. At the same time, the average adjusted EPS of $2.03, up from $1.86 a year earlier and above two-year-forward EPS growth rate exceeds our broad-market the consensus of $1.87. Net revenue was $1.6 billion, down estimate and sector averages, which has kept technology 4% year-over-year but in line with the company's guidance. sector PEG valuations from becoming too rich. * We are raising our FY18 diluted EPS estimate to $5.83 Over the long term, we expect the Tech sector to benefit from $5.62 and our FY19 estimate to $5.87 from $5.65. from pervasive digitization across the economy, greater *Although management is taking steps to improve results, acceptance of transformative technologies, and the we believe that RL shares adequately reflect our expectations development of the Internet of Things (IoT). Healthy for continued weak apparel sales in the near term. As such, company and sector fundamentals are also positive. For our rating remains HOLD. individual companies, these include high cash levels, low *We would consider raising our rating on signs of debt, and broad international business exposure. stabilizing revenues and a return to sustainable EPS growth. In terms of performance, the sector rose 12.0% in 2016, above the market average, after rising 4.3% in 2015. It ANALYSIS strongly outperformed in 2017, with a gain of 36.9%. Fundamentals for the Technology sector look reasonably INVESTMENT THESIS balanced. By our calculations, the P/E ratio on projected 2018 Despite margin improvement in fiscal 3Q18, we expect earnings is 19.0, above the market multiple of 18.2. Earnings HOLD-rated Ralph Lauren Corp. (NYSE: RL) to face are expected to grow 19.5% in 2018 and 30.3% in 2017 near-term earnings pressure from internet competition, weak following low single-digit growth in 2015-2016. The sector's consumer spending at brick-and-mortar stores, and continued debt ratios are below the market average, as is the average store closings. dividend yield. In June 2016, Ralph Lauren announced a restructuring plan, called the Way Forward, to drive growth by streamlining VALUATION operations and focusing on core brands. The strategy calls for QCOM shares are trading at 16.9-times our FY18 eliminating underperforming stores and department store non-GAAP EPS forecast and at 15.3-times our FY19 distribution points, launching new marketing initiatives, projection, compared to an average P/E of 13.7 for restructuring the company's global e-commerce platform, and FY13-FY17. The shares, which historically traded at a 15% reducing supply-chain lead times. Together with fewer discount to the market P/E, now trade at an average 12% shipments, a reduction in surplus inventory, and fewer discount for FY17-FY18. promotional markdowns, these initiatives have helped to Our historical comparables model signals value in the expand margins; however, revenues continue to suffer. North low-$60s, in line with current levels and down from past American sales, which account for more than half of total peaks on the reduced QTL contribution. Discounted free cash revenue, declined 11% in the fiscal third quarter. On the flow modeling signals value above $80, also in declining trend positive side, the company continues to tweak its product and on reduced royalty cash flows but still above current levels. marketing mix and to expand its digital and international Outside of disputes with major OEMs, revenue and EPS presence, particularly in China. We believe that these efforts continue to recover across the broad base of customers based are gaining traction and expect the company's results to show on technology leadership at QCT and growth in the total improvement in fiscal 2H19. If costs continue to moderate, addressable market and reported devices. The potential revenue stabilizes, and results in North America and Europe acquisition of NXP argues for a longer-term appraisal of the improve, we would consider an upgrade. On the other hand, value that Qualcomm can generate in the coming decades. we could lower our rating in the event of continued weak Legal issues remain a wild card. revenue. Appreciation to our 12-month target price of $75, along with the annualized dividend yield of about 3.5%, implies a RECENT DEVELOPMENTS risk-adjusted return exceeding our benchmark forecast. We Ralph Lauren shares have outperformed over the last 12 are reiterating our BUY rating on QCOM, while reminding months, gaining 42% compared to a 16% increase in the S&P investors of the multiple risk (and opportunity) now in the 500. Over the last three months, the shares have surged nearly shares. 20%, outpacing the index's 2.3% gain. On February 6, BUY-rated QCOM closed at $64.40, up On February 1, Ralph Lauren reported fiscal 3Q18 $2.67. (Jim Kelleher, CFA, 2/6/18) 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 GROWTH / VALUE STOCKS

6% in constant currency, but in line with management's driver in Asia. The company is targeting Greater China guidance. revenue of approximately $0.5 billion in five years, driven by The adjusted gross margin rose 250 basis points to expanded distribution and higher comp sales. 60.7%, and the operating margin rose 40 basis points to Along with the 3Q earnings release, management 13.2%. The improvement was driven by fewer promotional reiterated its FY18 constant-currency revenue guidance, and discounts, as well by a better channel and geographic mix again raised the low end of its operating margin guidance. It (i.e., a larger portion of revenue coming from higher-margin continues to expect an 8%-9% decline in revenue, but now international and retail business). Favorable currency effects looks for an operating margin of 10.0%-10.5%, up from its also boosted the gross margin by 50 basis points. Adjusted prior forecast of 9.5%-10.5%. It also expects currency operating expenses were nearly flat at $780 million, as a 27% translation to boost operating margins by 30 basis points. increase in marketing spending offset the impact of store Management expects to restore revenue growth and further closures and other savings. SG&A as a percentage of revenue improve operating margins in FY19. It is targeting a mid-teens dropped by 211 basis points from the prior year, to 47%. operating margin by FY20. Interest expense rose to $4.8 million from $3.6 million a year We are raising our FY18 diluted EPS estimate to $5.83 earlier. from $5.62 and our FY19 estimate to $5.87 from $5.65. The third quarter share count was 81.7 million, down from 83.3 million a year earlier. Management does not plan to FINANCIAL STRENGTH & DIVIDEND repurchase shares in FY18, but will review its plans going Our financial strength rating on Ralph Lauren is High. forward. The company ended 3Q18 with $2.04 billion in cash and Ralph Lauren opened 15 stand-alone stores and 10 short-term investments, up from $1.4 billion a year earlier. concessions in the third quarter, and closed 3 stand-alone Total debt was $589 million at the end of 3Q18, flat with stores and 4 concessions. At the end of 3Q18, it had 481 the prior year. Total liabilities were approximately $2.8 stand-alone stores and 628 concessions globally. It expects a billion, up from $2.4 billion. Inventories fell 16% from the small net increase in both stand-alone stores and concessions prior year to $825 million. by year-end, with most of the expansion in Asia. The company pays a quarterly dividend of $0.50 per Patrice Louvet became the company's new president and share, or $2.00 annually, for a yield of about 1.9%. Our CEO in July 2017, replacing interim CEO Jane Nielsen. Mr. dividend estimates are $2.00 for FY18 and $2.20 for FY19. Louvet was previously the group president of Procter & RISKS Gamble's Global Beauty division, and has more than 25 years Ralph Lauren faces risks from slower consumer spending, of experience in the consumer products industry. especially at brick-and-mortar stores, as well as from higher EARNINGS & GROWTH ANALYSIS input, manufacturing, and labor costs. Management has Ralph Lauren has three geographic segments. limited discounts in recent quarters, but has noted that higher Third-quarter segment results are summarized below. revenue may not fully offset cost inflation. RL also faces Revenue in North America fell 11% to $886 million in currency risk, as changes in exchange rates impact reported the third quarter, reflecting sales declines in both the sales and earnings in international operations as well as wholesale and retail channels due to the discontinuation of spending by foreign tourists in the U.S. The company hedges less profitable brands and distribution points, reduced inventory purchases to reduce the impact of currency promotions, reduced shipments, and weaker consumer fluctuations. demand. Comparable sales fell 10%, with a 3% decline in COMPANY DESCRIPTION sales at brick-and-mortar stores and a 27% decrease in Ralph Lauren, based in New York, designs, markets and e-commerce sales. The adjusted operating margin rose by 160 distributes premium apparel, accessories and fragrances, and basis points. North America accounts for approximately 54% home products. The company's brands include Polo by Ralph of the company's net revenues. Lauren, Ralph Lauren Purple Label, Ralph Lauren Collection, In Europe, 3Q revenue came to $378 million, up 8% on a Black Label, Blue Label, Lauren by Ralph Lauren, RRL, reported basis but flat in constant currency. Comparable sales RLX, Rugby, Ralph Lauren Childrenswear, Chaps (at Kohl's), fell 8%, with a 9% decline at brick-and-mortar stores and a and Club Monaco. 1% decline in e-commerce sales, primarily due to fewer promotions. Wholesale revenue was flat on a reported basis VALUATION and up 8% in constant currency. Retail sales fell 8% in RL shares are trading at 18.1-times our FY18 EPS constant currency, reflecting lower tourist spending. Europe estimate, within the range of 17-20 for other luxury apparel represents about 23% of net revenues. manufacturers; however, the company's earnings and revenues In Asia, fiscal 3Q revenue rose to $251 million, up 7% on remain weak. At current levels, we believe that the shares a reported basis and in constant currency, driven by both the adequately reflect our expectations for continued weak wholesale and retail channels. Asia accounted for 15% of apparel sales in the near term. As such, our rating remains 3Q18 net revenue. China is expected to be the major growth HOLD. We would consider raising our rating on signs of

Section 2.89 GROWTH / VALUE STOCKS stabilizing revenues and a return to sustainable EPS growth. for 2018. The company projects sales growth of 4%, based on On February 6 at midday, HOLD-rated RL traded at the strong bookings trend and EPS of $9.55-$9.75 for 2018. $106.32, up $0.88. (Deborah Ciervo, CFA, 2/6/18) Management expects a tax rate for the year of 19%, down from 25% in 2017. CEO Thomas Kennedy noted during the call that the Raytheon Co. (RTN) company continues to see a strong global demand for its Current Rating: BUY Publication Date: 2/2/18 innovative solutions. HIGHLIGHTS EARNINGS & GROWTH ANALYSIS *RTN: Boosting target by $25 to $225 RTN has five primary business segments: Integrated *RTN shares have outperformed the market over the past Defense Systems (23% of 4Q sales); Intelligence, Information quarter with a gain of 16% while the S&P 500 has advanced and Services (23%); Missile Systems (31%); Space and 10%. Airborne Systems (24%); and Forcepoint (2%). Fourth-quarter *Raytheon recently posted 4Q results that were up from results and trends by segment are summarized below. the prior year and above consensus expectations. In Integrated Defense Systems (IDS), which provides *Management has raised its outlook based on solid sales air-and-missile defense systems and naval combat and ship growth and a lower tax rate. electronic systems, net sales rose 6% year-over-year, *Our target price of $225 implies premium valuations - reflecting higher sales on an international early warning radar which we believe that Raytheon merits given its program that started in 1Q17. The segment operating margin well-positioned portfolio of businesses and its growth outlook. widened to 16.3% from 15.9%, due to operating leverage. Management commented that the increase in operating income ANALYSIS was primarily driven by higher volume and favorable changes INVESTMENT THESIS within the sector program. For 2018, we look for sales to Our rating on Raytheon Co. (NYSE: RTN) is BUY. We increase at a mid-single-digit pace, and margins to fluctuate expect management's focus on its international and near 16.5%. cybersecurity businesses to generate stronger growth over the In Intelligence, Information, and Services (IIS), which next three to five years. RTN's business mix appears favorable provides services to intelligence customers, revenue rose 4%, compared to that of most defense industry peers, and given while operating income dipped 3% as the operating margin rising geopolitical threats, we like its emphasis on advanced fell to 7.4% from 7.9%. During the quarter, IIS booked almost missile defense, electronic warfare, counter-insurgency and $1 billion of new business, including deals in support of counter-terrorism systems. The company is also generating Warfighter Field Operations Customer Support program, the strong cash flow and aggressively returning cash to US Air Force and a number of classified accounts. shareholders through increased dividends and share buybacks. Management expects a low single-digit top-line decline this Our target price of $225, raised from $200, implies premium year with stable margins around 7.7%. valuations - which we believe that Raytheon merits given its In Missile Systems, which develops missile and combat well-positioned portfolio of businesses and its growth outlook. systems, net sales increased 15% year-over-year due to higher The shares are a suitable core holding for a diversified sales on the Paveway and Excalibur programs. Operating portfolio. income increased 7%, as the operating margin increased to 13.8%. The segment has benefited from strong sales of RECENT DEVELOPMENTS AIM-9X Sidewinder short-range air-to-air missiles; Paveway RTN shares have outperformed the market over the past laser-guided bombs; and Tube-launched, Optically-Tracked, quarter with a gain of 16% while the S&P 500 has advanced Wireless-Guided (TOW) missiles. In 2018, we expect sales to 10%. Over the past year, the shares have also outperformed, grow at a mid-single-digit rate, while margins increase slightly rising 44% compared to the market's advance of 24%. The above last year's 13.2%. shares have outperformed the industrial sector IYJ ETF over In Space and Airborne Systems (SAS), which serves the the past 1-, 5- and 10-year periods. The beta on RTN is 0.75. satellite and space markets, net sales increased 4%, and On January 25, Raytheon posted quarterly results that margins increased 9 basis points to 14.5%. In 2018, once again topped expectations. Net sales rose 8.0% to $6.8 management expects sales to grow at a high-single-digit rate, billion. Income from continuing operations increased 1.1%, while margins decrease slightly from last year. though the total operating margin narrowed 10 basis points. Finally, in Forcepoint, net sales rose 9% from the prior EPS from continuing operations rose 9% to $2.03. Total year to $156 million. Operating income totaled a loss of $8 bookings came to $8.5 billion, up 12.6% from the prior year. million, down sharply due to investments in sales and For the full year, on an operating basis, Raytheon earned marketing. $7.64, just below the high end of its guidance range of The total company backlog at the end of FY17 was $38.2 $7.55-$7.65. Sales rose 5% to $25.3 billion. billion, up approximately $1.5 billion from FY16. Along with the results, management provided guidance Turning to our estimates, based on the sales improvement

Section 2.90 GROWTH / VALUE STOCKS and expectations of lower taxes, we are raising our 2018 to employees. RTN shares are a component of the S&P 500. $9.70 from $8.50. We look for another year of double-digit growth in 2019 and are establishing a preliminary EPS VALUATION forecast of $11.15. Our five-year earnings growth rate forecast We think that RTN shares are attractively valued at is 10%. current prices near $210. The shares are trading near the top of their 52-week range of $146-$123. On a technical basis, FINANCIAL STRENGTH & DIVIDEND they have been in a bullish trend of higher highs and higher Our financial strength rating for Raytheon is lows dating back to September 2011. Medium-High, the second-highest rank on our five-point To value the stock on a fundamental basis, we use peer scale. The company receives above-average scores on our and historical multiple comparisons, as well as a dividend three main financial strength criteria of debt levels, fixed-cost discount model. RTN shares are trading at 20.5-times coverage and profitability. projected 2018 earnings, at the high end of the historical range Raytheon has a stock buyback program. At the end of 4Q, of 12-21. On a price/sales basis, the shares are also trading the share count was down 1.5% year-over-year. close to the top of the five-year range. The dividend yield of Raytheon pays a quarterly dividend. In March 2017, the 1.5% is below the midpoint of the five-year range. RTN's board increased the dividend by 8.9% to $0.7975 per share, or multiples are in line with or slightly above industry averages. $3.19 annually, for a yield of about 1.5%. The dividend But we think that RTN merits a premium valuation, as we appears secure and we expect it to grow. We look for payouts expect management's focus on international and cybersecurity of $3.50 in 2018 and $3.90 in 2019. businesses to pay off over time. Our dividend discount model renders fair value for RTN above $230. Blending our MANAGEMENT & RISKS valuation approaches, we arrive at a 12-month target price of Thomas Kennedy is the Chairman and CEO of Raytheon. $225. Mr. Kennedy has been with Raytheon for more than 30 years, On February 2 at midday, BUY-rated RTN traded at and previously served as COO. Anthony O'Brien became the $209.49, down $1.36. (John Eade and Marisa Janeczek, company's CFO in March 2015. Mr. O'Brien joined Raytheon 2/2/18) in 1986 and most recently served as CFO of the Integrated Defense Systems business. Raytheon management sees a potential increase in Sherwin-Williams Co (SHW) demand for its products as foreign governments respond to Current Rating: BUY Publication Date: 2/5/18 increased global threats. In addition, Raytheon continues to see opportunities in the cyber protection market, driven by HIGHLIGHTS evolving threat levels. In 2Q15, it signed an agreement with *SHW: Posts better-than-expected 4Q17; maintaining Vista Equity Partners to form Raytheon/Websense, a jointly BUY owned cyber security company that is now called Forcepoint. *On January 25, Sherwin-Williams reported an adjusted Going forward, Raytheon also plans to invest in emerging 4Q17 net profit of $306.8 million or $3.16 per diluted share, areas such as next-generation radar, high-energy lasers, and up from $211.0 million or $2.34 per share in the prior-year hypersonics. quarter. The 4Q earnings beat our estimate of $2.12 and the Investors in RTN shares face risks. As a key supplier to consensus forecast of $3.12. the U.S. military, Raytheon is likely to be impacted by defense *The higher year-over-year net profit reflected the spending pressures over the next decade, especially in its acquisition of the Valspar Corp. on June 1, 2017 and higher short-cycle businesses. Most of the company's sales come paint volume in the Americas Group. Valspar increased net from U.S. government contracts, and new or renegotiated sales in the fourth-quarter by approximately $1 billion. contracts may be on the chopping block in the coming years. Consolidated net sales rose 43% in 4Q to $3.98 billion, That said, Raytheon has a diverse product base, which including Valspar sales. effectively reduces its dependence on any single platform; in *Together with its 4Q17 earnings report, management fact, no single program provides more than 5% of total sales. provided a 2018 EPS outlook of $18.80-$19.30 per diluted It also has one of the largest international sales programs in share, which includes costs related to the acquisition of the defense peer group (approximately 32% of sales in 2017), Valspar of approximately $3.45 per diluted share. The which adds stability to revenues. company indicated that it will no longer provide quarterly And in any event, with a Republican in the White House EPS guidance going forward. The consensus estimate prior to and the House and Senate both controlled by the GOP, the the earnings release was $18.69. outlook for defense spending has brightened. *We are raising our 2018 EPS estimate to $19.37 from $18.33, reflecting positive profit trends from the recently COMPANY DESCRIPTION completed 4Q17, as well expected strong industry Raytheon's operations encompass a wide range of fundamentals and improving results in the Consumer Brands government- and defense-related activities. The company is segment. The consensus for 2018 is $19.09. based in Waltham, Massachusetts and has about 63,000

Section 2.91 GROWTH / VALUE STOCKS

ANALYSIS were weak in most product categories and market segments and the division also experienced higher raw material costs. INVESTMENT THESIS Management noted again that strong sales to professional We believe that BUY-rated Sherwin-Williams Company customers may have reduced demand in the do-it-yourself (NYSE: SHW) is well positioned as the U.S. housing recovery market. The company looks for slowly improving results in matures, home owners seek to improve the value of existing the Consumer segment in 2018. homes, and contractors build new homes. In addition, we In the Performance Coatings Group, revenue rose 160% expect the company to benefit from the recently completed to $1.22 billion, while operating profit increased 81% to Valspar acquisition, which should increase its product $119.4 million. The higher sales reflected a full quarter portfolio and help it to expand internationally. contribution from Valspar, higher paint sales, and higher We look for continued EPS growth in 2018, reflecting selling prices. The improvement in earnings was driven by strong industry fundamentals, ongoing cost reduction Valspar contributions and positive currency translation synergies and positive pricing momentum. We expect effects, which increased profit by 9.6% in the quarter. improvement in the Consumer Brands Group. Our rating As noted in previous reports, Sherwin-Williams remains BUY with a price target of $476. completed its acquisition of Valspar on June 1. Under the RECENT DEVELOPMENTS terms of the agreement, Valspar shareholders received $113 SHW shares have underperformed since the beginning of per share in cash. Sherwin-Williams continues to project $320 2018, falling 1.7% while the S&P 500 Basic Materials Index million of annual run-rate synergies within three years of the has risen 0.1%. However, they have outperformed over the closing. past year, climbing 32.8% while the Materials Index has Finally, on October 3, 2017, Sherwin-Williams provided increased 15.8%. its strategic outlook to the financial community in a NYC On January 25, Sherwin-Williams reported an adjusted analyst meeting, highlighting how its recent acquisition of 4Q17 net profit of $306.8 million or $3.16 per diluted share, Valspar Corp. will accelerate earnings growth and dividend up from $211.0 million or $2.34 per share in the prior-year payments through the end of the decade. Expanding sales to quarter. The 4Q earnings beat our estimate of $2.12 and the new markets outside of North America (industrial and consensus forecast of $3.12. residential), along with cost and revenue synergies, should The higher year-over-year net profit reflected the reach about $400 million by 2020, contributing to wider profit acquisition of the Valspar Corp. on June 1, 2017 and higher margins and higher profit rates. Altogether, SHW anticipates paint volume in the Americas Group. Valspar increased net spending $3.9 billion on debt reduction, $1.9 billion on sales in the fourth-quarter by approximately $1 billion. dividends, $1.6 billion in capital expenditures and $1.2 billion Consolidated net sales rose 43% in 4Q to $3.980 billion, on acquisitions through 2020. On the profit side, the company including Valspar sales. expects earnings to rise by 12% a year through 2020. The consolidated gross margin contracted by 470 basis For all of 2017, the company reported adjusted net points to 45.2% of sales due to a change in the classification income of $1.772 billion or $15.04 per diluted share, of revenue, while SG&A expense rose 27% to $1.32 billion in compared to adjusted net income of $1.133 billion or $12.41 the quarter. As a percent of sales, the total dropped to 33.3% per diluted share in 2016. from 37.3% in 4Q16 due to improved operating efficiency. EARNINGS & GROWTH ANALYSIS Foreign exchange increased profit by $6.3 million in the Along with its 4Q17 earnings report, management quarter and $8.7 million for the full year. provided a 2018 EPS outlook of $18.80-$19.30 per diluted As a result of the recent Valspar acquisition and share, which includes costs related to the acquisition of integration, Sherwin-Williams has changed its reporting Valspar of approximately $3.45 per diluted share. The structure. The company now has three reporting segments: the company indicated that it will no longer provide quarterly Americas Group, the Consumer Brands Group, and the EPS guidance going forward. The consensus estimate prior to Performance Coatings Group. Fourth-quarter results by the earnings release was $18.69. segment are discussed below. We are increasing our 2018 EPS estimate to $19.37 from In the Americas Group, revenue rose 9% from the prior $18.33 to partially reflect positive profit trends from the year to $2.19 billion, while operating profit rose 22% to $406 recently completed 4Q17, as well as our forecast calling for million, reflecting higher architectural paint sales across all strong industry fundamentals and improving results in the end markets and higher prices. The segment profit margin Consumer Brands segment. The consensus for 2018 is $19.09. improved to 19.4% from 19.1% a year earlier. We expect this At the same time, we are introducing a 2019 EPS estimate segment to perform well this year, as professional customers of $22.20 per share. Our estimate implies growth of about continue to report large project backlogs. 15% from our 2018 estimate. Our estimate assumes positive In the Consumer Brands Group, revenue grew 89% from industry fundamentals, higher product pricing and ongoing the prior year to $572 million, while operating profit fell 54% cost benefit synergies from the recent Valspar acquisition. The to $23.6 million. The increase in revenue was primarily the current 2019 consensus is $21.88. result of the inclusion of Valspar. However, Consumer sales

Section 2.92 GROWTH / VALUE STOCKS

FINANCIAL STRENGTH & DIVIDEND The shares are trading at 20.8-times our 2018 EPS We rate Sherwin-Williams' financial strength as Medium, forecast and at 18.2-times our 2019 forecast, compared to a the midpoint on our five-point scale. The company's debt is six-year annual average range of 24-34. The projected 2018 rated BBB/stable by Standard & Poor's and Baa3/stable by P/E is also slightly below the peer average of 28.1. Moody's. Fitch rates company debt at BBB/stable. Following The shares are also trading at a trailing price/book the Valspar acquisition, SHW's debt ratings were lowered by multiple of 10.6, below the low end of the historical range of the credit agencies, due primarily to higher overall debt. 11.8-20.7; at a price/sales multiple of 2.6, above the high end At the end of 4Q17, SHW's total debt/capitalization ratio of the range of 1.8-2.4; and at a price/cash flow multiple of was 74.0%, up from 51.0% a year earlier. The total debt/cap 24.3, above the high end of the range of 16.4-23.2. The ratio is above the peer average. Over the past five years, the price/EBITDA multiple is 22.0, above the high end of the debt/cap ratio has averaged 61.7%. range of 14.6-19.4. Outstanding debt totaled $10.52 billion at the end of Looking ahead, we expect the company to benefit from 4Q17, up from $1.95 billion at the end of 4Q16. The increase continued positive housing market fundamentals and look for reflected debt issuance to help fund the Valspar acquisition. strong earnings growth in 2018. We believe that SHW is Sherwin-Williams had cash and cash equivalents of $204 favorably valued given the company's current prospects, million at the end of 4Q17, compared to $890 million a year including synergies from Valspar, and are reiterating our BUY earlier. rating with a target price of $476. The company suspended share buybacks from March On February 5 at midday, BUY-rated SHW traded at 2016 to June 2017 as it pursued the Valspar acquisition. With $404.51, up $1.38. (Bill Selesky, 2/5/17) 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 Tractor Supply Co (TSCO) buy any shares in 4Q17. Current Rating: HOLD Publication Date: 2/5/18 The annualized dividend of $3.40 yields about 0.8%. The HIGHLIGHTS company raised its dividend by just 1.2% in 2017 due to the *TSCO: Maintaining HOLD following 4Q17 results Valspar acquisition, down from its substantial 25% increase in *On January 31, Tractor Supply reported fourth-quarter 2016. We expect dividend growth to pick up now that the adjusted diluted EPS of $0.91, down from $0.94 a year earlier merger has been completed. Our dividend forecasts are $3.56 but in line with the consensus estimate. Fourth-quarter for 2018 and $3.60 for 2019. revenue rose 1.9% to $1.95 billion and comp sales rose 4%, MANAGEMENT & RISKS up from 3.1% growth in 4Q16. John Morikis succeeded Christopher Connor as the *For 2018, management projects EPS of $3.95-$4.15, company's CEO on January 1, 2016, following more than nine revenue of $7.69-$7.77 billion, comparable-store sales growth years as president and COO (he retains the title of president). of 2.0%-3.0%, and capital expenditures of $260-$300 million. Mr. Morikis joined Sherwin-Williams in 1984 as a *Management also projects a decrease in the company's management trainee, and has held many key positions in his effective tax rate to 23.0%-23.5% in 2018 from about 37% in 31+ years with the company. 2017 due to the new tax law. SHW investors face risks related to the highly cyclical *We are raising our 2018 EPS estimate to $3.96 from nature of the company's end markets, particularly $3.59 and establishing a 2019 estimate of $4.46. Our five-year construction, housing and manufacturing. The company also earnings growth rate estimate is 12%. faces risks related to the integration of its many acquisitions. ANALYSIS COMPANY DESCRIPTION INVESTMENT THESIS Sherwin-Williams is the largest U.S. producer of paint, We are maintaining our HOLD rating on Tractor Supply coatings and related products, which it sells to professional, Co. (NGS: TSCO). Despite 2.7% growth in same-store sales industrial, commercial and retail customers. The company and 7.1% revenue growth in 2017, TSCO's revenue growth operates over 4,100 retail stores and supplies coatings directly slowed from 8.9% in 2016 - the fourth consecutive year of to retailers, distributors, industrial & commercial customers decelerating growth. We expect growth in SG&A expense to and other industry professionals. The company completed its continue to outpace sales growth in 2018 due to higher freight, acquisition of Valspar on 6/1/17. wage and incentive costs, leading to a further decrease in VALUATION operating margins. In 2017, Tractor Supply added 101 new Sherwin-Williams shares have traded between $301.51 stores, slightly ahead of its target of 100; going forward, we and $435.15 over the past 52 weeks and are currently in the expect it to add fewer new stores than previously planned, upper half of that range, which we believe reflects the recent resulting in slower earnings growth. We are also concerned completion of the Valspar acquisition and strengthening that weak pricing for agricultural commodities will pressure trends in the U.S. housing market. Tractor Supply's customer base. If margins expand and

Section 2.93 GROWTH / VALUE STOCKS same-store sales improve more than we anticipate, we would 34.3%. consider returning the stock to our BUY list. Based on management's guidance and the company's Our long-term rating remains BUY. Management projects 2017 results, we are raising our 2018 EPS estimate to $3.96 a decrease in the company's effective tax rate to 23.0%-23.5% from $3.59 and establishing a 2019 estimate of $4.46. Our in 2018 from about 37% in 2017 due to the new tax law, and five-year earnings growth rate estimate is 12%. plans to reinvest the savings in long-term growth initiatives. We also note that Tractor Supply has few competitors with FINANCIAL STRENGTH & DIVIDEND similar product lines, and that it typically focuses on markets Our financial strength rating for TSCO is Medium-High, that are too small for Lowe's and Home Depot. the second-highest rank on our five-point scale. The total debt/capitalization ratio was 23% at the end of 2017. RECENT DEVELOPMENTS Operating income of $686 million easily covered interest On January 31, Tractor Supply reported fourth-quarter expense of $14 million. and full-year results for 2017. Fourth-quarter revenue rose In June 2017, the company raised its quarterly dividend 1.9% to $1.95 billion. Comparable sales rose 4%, up from by 12.5% to $0.27, or $1.08 annually, for a yield of about 3.1% growth in 4Q16. Comp sales were driven by a 2.7% 1.5%. Our dividend estimates are $1.14 for 2018 and $1.24 increase in comparable-store transactions and a 1.3% increase for 2019. in the average ticket. The increase in the comp-store transaction count reflected strong sales of 'consumable, usable MANAGEMENT & RISKS and edible' products as well as seasonal items. Adjusted The company is less subject to changing consumer trends diluted EPS fell to $0.91 from $0.94 a year earlier, but than most retailers given the nature of its product line, but is matched the consensus estimate. Net income was $109.7 still vulnerable to overall shifts in the farm, garden supply, million, down 11.2% from the prior year. We note that the and animal care markets. As such, the company would likely company faced more difficult sales and net income experience lower sales from any extended or severe changes comparisons in 4Q17 due to a 53rd week in 2016. in those markets (such as widespread animal disease or The 4Q17 gross margin rose by 3.5% to $668.6 million, prolonged drought conditions). reflecting fewer promotions and strength in seasonal products, Tractor Supply is expanding both the number of its stores partly offset by higher freight costs. SG&A expense, and its geographic reach. The company could experience including depreciation and amortization, was 24.8% of sales, much lower-than-anticipated returns from new operations if up from 23.6% a year earlier. Interest expense rose to $3.75 its product mix is not properly tailored to new markets. million from $1.1 million. TSCO shares are likely to move with the overall retail For all of 2017, Tractor Supply reported revenue of $7.26 sector, but with greater-than-average volatility due to the billion, up 7.1% from the prior year. Adjusted diluted EPS company's size. rose to $3.33, up from $3.27 a year earlier and ahead of both COMPANY DESCRIPTION management's guidance and the consensus forecast. Net Tractor Supply Co. offers a broad range of items for the income was $422.6 million, down from $437.1 million in farming, ranching and gardening markets, as well as for small 2016. enterprises. The company sells maintenance supplies, For 2018, management projects EPS of $3.95-$4.15, clothing, animal care supplies, hardware and lawn products, revenue of $7.69-$7.77 billion, comparable-store sales growth garden products, and truck and trailer products. The of 2.0%-3.0%, and capital expenditures of $260-$300 million. company's stores are geared toward the needs of rural It also expects to reduce shares outstanding by 2.5%-3.5% in America. Formed in 1982 from the assets of a catalog 2018 through stock buybacks. company that had been selling farm supplies since 1938, In 2017, the company opened 101 new Tractor Supply Tractor Supply is converting its older stores to larger formats stores, just ahead of its target of 100 openings but down from (17,000-19,000 square feet) and opening new smaller-format 113 in 2016. It also opened 25 new Petsense stores and closed stores and distribution centers beyond its core Southern and nine Del's stores. It expects to open 80 new Tractor Supply Midwestern markets. With a market capitalization of and 20 new Petsense stores in 2018. approximately $7.5 billion, TSCO is generally classified as a Tractor Supply continues to integrate its physical stores mid-cap growth company. with its e-commerce business. Management noted that customers have responded positively to its 'Buy Online, Pick VALUATION Up in Store' program, which was rolled out in 2Q17, and to its TSCO shares are trading at 18.0-times our 2018 EPS Neighbor's Club program, which now has about 7 million estimate, below the five-year average of 21.7. However, we members. remain concerned about the company's margins, rising SG&A costs, and weaker sales growth, and expect it to add fewer EARNINGS & GROWTH ANALYSIS new stores than previously planned. We expect these factors The company's operating margin fell in all four quarters to result in less rapid earnings growth and a lower P/E of 2017, declining to 9.5% for the full year from 10.2% in multiple. As such, our rating remains HOLD. If margins 2016. The 2017 gross margin was virtually unchanged at

Section 2.94 GROWTH / VALUE STOCKS expand and same-store sales improve more than we anticipate, $2.0 billion was up 4%, as the operating ratio rose 60 basis we would consider returning the stock to our BUY list. points to 62.6%, due largely to higher fuel costs. Diluted EPS On February 2, HOLD-rated TSCO closed at $67.88, of $1.53 increased 10% year-over-year, benefiting from share down $3.56. (Deborah Ciervo, CFA, 2/2/18) repurchases. For the full year, the company earned $5.80 per share. Union Pacific does not give specific guidance. During the Union Pacific Corp (UNP) post-earnings conference call and Q&A session, management Current Rating: BUY Publication Date: 2/1/18 noted that its volume growth was below peers and its expenses were rising. But management remained committed to its HIGHLIGHTS long-term expense reduction goals, and we have confidence *UNP: Raising target by $25 to $155 they will reach them. *UNP shares have outperformed the market over the past Management also offers a volume outlook by segment for quarter, with a gain of 16% compared to an increase of 9.8% the year ahead. On the positive side, management expects the for the S&P 500. food, plastics, ethanol exports and construction products *Management has signaled confidence in its outlook with markets to perform well. In the all-important coal segment, the a recent double-digit dividend hike; the company is also company sees strong demand for exports but notes that low aggressively buying back stock. natural gas prices remain a challenge. Lower automotive sales *The company is expected to benefit from tax reform and are expected to be a challenge. A stable-to-weaker dollar we have raised our 2018 EPS estimate from $6.53 to $7.53. could help shipments in the export grain, minerals, and metals *Compared to the peer group, UNP's multiples are mixed, segments. but generally point to undervaluation. We think this comparison is important because UNP stock has outperformed EARNINGS & GROWTH ANALYSIS peers in past periods. UNP has six primary segments: Agricultural Products (18% of freight revenues), Industrial Products (21%), Coal ANALYSIS (13%), Chemicals (18%) , Automotive (10%), and Intermodal INVESTMENT THESIS (19%). Our rating on Union Pacific Corp. (NYSE: UNP) is BUY Agricultural segment revenue declined for the second and our target price is $155, raised from $130. UNP shares are quarter in a row after rising four quarters in a row. Revenue in recovery mode as the energy markets recover. In general, was down 4% as volume dropped 7%. Grain and grain we see strengthening underlying demand for the rail industry, product exports were weak due to high global inventories. and note that overall volume trends are finally turning Management noted growth in ethanol exports and imported positive. Over the long term, we remain upbeat about North beer. Looking ahead, we anticipate flat volume in this segment American railroad companies based on strength in the in 2018 as the grain market remains challenging. consumer sector and solid demand for finished goods, as well In Automotive, revenue declined 1%, as volume dropped as fuel prices that remain well below 2013-2014 levels. In 4%. Management noted continued soft vehicle demand. addition, UNP's industry-low operating ratio helps to boost the Shipments of auto parts, which account for 45% of segment bottom line. Lastly, management is focused on returning volume, were down 1%. The fourth quarter saw a bit of a capital to shareholders and has a history of buying back stock boost from the replacement of vehicles following Hurricane and raising the dividend. Compared to the peer group, UNP's Harvey, but the outlook remains muted into 2018. multiples are mixed, but generally point to undervaluation. Revenues in the Chemical segment rose 7%, as pricing We think this comparison is important because UNP stock has improved 2% and volume rose 5%. Petroleum products outperformed peers in past periods. The shares are a suitable volume recovered and jumped 15%. Plastics volume dropped core holding in a diversified portfolio. 4%, while Fertilizer rose 6%. We look for low single-digit sales growth in 2018, driven by improved pricing. RECENT DEVELOPMENTS Coal revenue declined 5% as volume fell 3%. Union UNP shares have outperformed the market over the past Pacific's coal business has now cycled past the trough of the quarter, with a gain of 16% compared to an increase of 9.8% coal market, though conditions remain challenging. Looking for the S&P 500. Over the past year, the shares have also ahead, we believe that coal inventories are normalizing, which outperformed, rising 26%, versus an increase of 24% for the is positive, but potential weakness in natural gas prices (below index. The shares have performed in line with the Industrial $3 per mcf) could pose a threat. sector ETF IYJ over the trailing 1- and 5-year periods. The In Industrial Products, revenue jumped 28% as the oil beta on UNP is 1.06. patch recovers. Volume was up 17% while pricing was strong On January 25, UNP reported4Q17 earnings that fell a -- up 10%. Rising oil prices have led to higher shipments of penny shy of consensus expectations. Operating revenue rose drilling materials. This is one of the segments we expect to 5% (in line with the gain in 3Q) to $5.5 billion, as volume drive performance in 2018. rose 1% (versus a 1% decline in 3Q). Operating income of Finally, in the Intermodal segment (where standard

Section 2.95 GROWTH / VALUE STOCKS shipping containers are transported without any handling of Corp. In April 2016, CP terminated its offer to acquire their contents), revenue rose 4% on flat volume and a 4% Norfolk Southern Corp. (NYSE: NSC), a freight railroad increase in pricing. Management commented that parcel operating mostly in Eastern and Midwestern states in the U.S. shipments increased for the holiday season. We look for Railroads are also highly sensitive to the macroeconomic mid-single-digit growth in this business for 2018. environment, and are subject to risk from fluctuating fuel The operating ratio (expenses/revenues) is widely used by prices, fuel hedges, bad weather, strikes and other labor railroads to assess efficiency; a declining operating ratio actions. Union Pacific's main rival in the Western United signals rising margins and is positive. In 4Q, Union Pacific's States is BNSF Corp., which is owned by the deep-pocketed operating ratio rose 60 basis points to 62.6%. Fuel expense, Berkshire Hathaway. which had been declining for several quarters but hit an UNP also faces risks related to government regulation, inflection point in 1Q17, rose 27% in 4Q, while compensation and may incur extraordinary costs related to positive train and benefit costs and the cost of purchased services and control systems, the transportation of flammable liquids, and materials rose 4-6% year-over-year. Management has targeted braking standards. a 60% operating ratio by 2019 and a 55% ratio in subsequent The company has a pension plan, which is not fully years; the company plans to take out $300-$350 million in funded. costs in 2018. Turning to our estimates, based on strength in the COMPANY DESCRIPTION Industrial and Intermodal segments, as well as a lower Union Pacific provides rail transportation services in expected tax rate (between 17%-18%), we are raising our North America. It has approximately 32,000 route miles and 2018 EPS estimate to $7.53. We anticipate another year of transports agricultural goods, automotive products, chemicals, growth in 2019 and are implementing a preliminary EPS coal, industrial products and other commodities between ports estimate of $8.44. Our long-term growth rate forecast is 10%. on the West Coast and Eastern gateways, as well to Mexico. Union Pacific was founded in 1862 and is based in Omaha, FINANCIAL STRENGTH & DIVIDEND Nebraska. The stock is a component of the S&P 500. Our financial strength rating on Union Pacific is Medium-High, the second-highest rank on our five-point VALUATION scale. The company generally scores above average on our We think that UNP shares offer value at current prices financial strength tests of debt levels, fixed-cost coverage and near $135, toward the high end of their 52-week range of profitability, though we note some recent slippage. The $101-$143. From a technical standpoint, the shares appear to company ended 2017 with $1.3 billion in cash and be in a bullish pattern of higher highs and higher lows that equivalents, level with the end of 2016. Total debt was $17 dates to January 2016. Prior to this, the shares had been in a billion and accounted for 40% of total capital. Full-year bearish pattern of lower highs and lower lows that dated to EBITDA covered interest expense by a factor of 14. February 2015. UNP has a share buyback program. Shares outstanding To value the stock on a fundamental basis, we look at were down almost 4% year-over-year at the end of the quarter. historical P/E ratios and peer group valuations, and also use a The company also pays a dividend. In 4Q17, management dividend discount model. UNP shares are currently trading at raised the dividend by 10%. The current annualized dividend 18-times our 2018 EPS estimate, just above midpoint of the of $2.66 yields about 1.9%. The company has paid a dividend historical range of 12-23. They are trading at a price/sales for 119 consecutive years. Management's target payout ratio is multiple of 5, toward the high end of the range of 2.1-5.2; but 35%. Our dividend estimates are $2.66 for 2018 and $2.94 for the dividend yield of 1.9% is above the midpoint of the 2018. five-year range. Compared to the peer group, UNP's multiples are mixed, but generally point to undervaluation. We think MANAGEMENT & RISKS this comparison is important because UNP stock has Lance M. Fritz has been the company's president, CEO outperformed peers in past periods. Based on our dividend and chairman since 2015. Mr. Fritz joined Union Pacific in discount model, we see fair value for UNP at more than $170 2000 and previously served as COO. Robert Knight has per share. We are maintaining our BUY rating and raising our served as CFO since 2004 and has worked at UNP since 1980. price target to $155 on this well-managed company. UNP remains focused on improving its operating ratio, On January 31, BUY-rated UNP closed at $133.50, down and while management stated that it is always looking for $1.86. (John Eade, 1/31/18) 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 United Parcel Service, Inc. (UPS) operating ratio of 60% by the end of 2019. Current Rating: BUY Publication Date: 2/5/18 Investors in UNP face risks. Railroads may face a period of industry consolidation, and pricing dynamics may change. HIGHLIGHTS In January 2017, the former CEO of Canadian Pacific retired *UPS: Recent sell-off offers buying opportunity early and, collaborating with an activist investor, joined CSX *UPS shares have underperformed the S&P 500 over the

Section 2.96 GROWTH / VALUE STOCKS past quarter, with a decline of 1% compared to an 8% increase Chain and Freight (17%). Fourth-quarter results and outlooks in the broad market. by segment are summarized below. *On February 1, UPS reported 1Q results that were in line In the U.S. Domestic Package segment, revenue rose 8%, with analyst expectations but did not show much earnings driven by a 3% increase in price. Segment operating margin power despite impressive e-commerce-fueled top-line growth. declined 150 basis points to 12.2%, however, as 'shipments *The company is expected to benefit from lower taxes surged beyond network capacity during Cyber-periods.' For and secular e-commerce growth; we estimate 20% EPS 2018, UPS management projects revenue growth of 5%-6% growth in 2018. with margins under pressure due to lower pension discount *The shares are trading near the low end of the historical rates, increased roll-out of Saturday services and network average P/E range, and in our view offer value at current expansion. levels. Revenue in the International segment was up 13% on a constant-currency basis in 4Q, and the operating margin was ANALYSIS 20.2%, down 100 basis points. For 2018, management INVESTMENT THESIS projects revenue growth of 7%-9%. Operating profits are BUY-rated United Parcel Service Inc. (NYSE: UPS) expected to rise at a faster rate due to operating leverage. remains seemingly well positioned to benefit from a number In the Supply Chain and Freight segment, 4Q sales rose of positive trends, including improving consumer confidence 21%, while the operating margin rose 160 basis points to and the continued growth of e-commerce. UPS provides 8.3%. For 2018, management projects core revenue growth of shipping, logistics and return services for internet retailers, 6%-8% as conditions in the freight sector are improving. whose sales are growing three- to four-times faster than those Profits are expected to improve through the balance of the of brick-and-mortar stores. After several years of year. streamlining, we believe that UPS can leverage the solid Turning to our forecasts, based on the positive revenue volume growth that is taking place in the U.S. domestic trends, expectations for margin pressure in US Domestic and market. The company's EPS growth over the next two years is lower taxes, we are raising our 2018 EPS estimate to $7.20 expected to be driven by 3%-5% top-line growth, margin from $6.50. Our estimate is above the midpoint of improvement, and share buybacks. The shares are trading near management's guidance range and implies growth of 20%. We the low end of the historical average P/E range, and in our look for further growth in 2019 and are implementing a view offer value at current levels. Our target price, based on preliminary EPS estimate of $7.90. Our five-year EPS growth our blended valuation approach, is $145. rate remains 8%.

RECENT DEVELOPMENTS FINANCIAL STRENGTH & DIVIDEND UPS shares have underperformed the S&P 500 over the Our financial strength rating on UPS is Medium. The past quarter, with a decline of 1% compared to an 8% increase company receives average marks on our three key criteria in the broad market. Over the past year, the shares have (debt levels are high, but fixed-cost coverage and profitability underperformed, rising 10% versus a 22% gain for the broad are above average). index. Industry rival FedEx Corp. (FDX: BUY) has sharply UPS has a share buyback program. Shares outstanding outperformed UPS over the past one-, five- and 10-year were down 0.5% year-over-year at the end of the quarter. periods, as has the Industrial ETF IYJ. The current beta on UPS pays a dividend. In 1Q17, the company boosted its UPS shares is 0.81. quarterly payout by 6% to $0.83 per share, or $3.32 annually. On February 1, UPS reported 1Q results that were in line The current yield is about 2.6%. For more than four decades, with analyst expectations but did not show much earnings UPS has either increased or maintained its dividend. Since power despite impressive e-commerce-fueled top-line growth. 2000, its dividend has more than quadrupled. We think the Revenue rose a strong 11% on an organic basis to $18.8 dividend is secure and that it will continue to grow. Our billion. But operating income increased 3% as the operating dividend estimates are $3.50 for 2018 and $3.70 for 2019. margin narrowed 90 basis points to 12.2%. Adjusted earnings MANAGEMENT & RISKS per share came to $1.67, up 2% and a penny ahead of the The CEO of UPS is David P. Abney, who took over in Street's forecast of $1.66. For the full year, the company 2014. He is the 11th CEO in the company's 107-year history. earned $6.02 per share, above the midpoint of management's He was previously the company's COO and began his career guidance range of $5.85-$6.10. at UPS as a part-time package loader in college in 1974. On a conference call to discuss results, management Richard Peretz took over as CFO in 2015. Mr. Peretz has provided earnings guidance for 2018. The company expects worked at UPS since 1981 and most recently served as EPS of $7.03-$7.37. corporate controller and treasurer. EARNINGS & GROWTH ANALYSIS Management held an Investor Conference to review UPS has three primary segments: U.S. Domestic Package long-term plans through 2019 on February 21, 2017. (63% of 4Q sales); International Package (20%); and Supply The company is targeting 4%-6% revenue growth through 2019, driven in part by plans to expand U.S. delivery and

Section 2.97 GROWTH / VALUE STOCKS 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 Visa Inc (V) efficiency to support further B2B and B2C growth. Current Rating: BUY Publication Date: 2/2/18 In addition, the company forecasts adjusted EPS growth of 5%-10%. The board plans to spend $1-$1.8 billion per year HIGHLIGHTS on share buybacks. Finally, capex is expected to increase 6% *V: Raising target to $140 and boosting EPS estimates -7% per year. *On February 1, Visa reported adjusted EPS of $1.08 for Investors in UPS face numerous risks. These include fiscal 1Q18 (ended December 31) , up from $0.86 a year uneven economic growth in both the U.S. and in international earlier and ahead of the $0.99 consensus. Payment volume markets, labor negotiations, and even exposure to the and processed transactions remained strong, rising 10% and struggling U.S. Postal Service. In recent years, overcapacity in 12%, respectively. the air freight market has put pressure on yields across the *The company recently announced a new $7.5 billion industry. And UPS customer Amazon.com (AMZN: BUY) is share repurchase program and an 8% increase in its quarterly taking steps to deliver more of its packages on its own, though dividend. we note that UPS' fleet of more than 580 planes is a strong *Management projects an effective tax rate of 23% in competitive advantage. FY18, down from its prior forecast of 29%. Primarily UPS also has pension plan risk. The company is reflecting this lower rate, we are raising our FY18 EPS addressing its pension risk by transitioning to a 401-k plan in estimate to $4.38 from $4.05 and our FY19 forecast to $4.96 2023. from $4.57. UPS also faces political risks, as President Trump may *Visa shares trade at 27.5-times our forward four-quarter propose policies that lead to the revision of some international EPS estimate of $4.48, slightly below peer MasterCard at trade agreements. On a recent conference call, management 29.7-times. We think that Visa merits a higher multiple than said that participating countries typically saw a 20% increase MasterCard based on its higher operating margins. in trade following the ratification of new trade agreements. If ANALYSIS the new administration dismantles or scales back existing trade deals, or fail to pass new agreements, UPS's results INVESTMENT THESIS could be negatively impacted. We are maintaining our BUY rating on Visa Inc. (NYSE: V) following fiscal 1Q18 earnings that came in above COMPANY DESCRIPTION consensus and our estimate. We are also raising our target The world's largest package-delivery company, United price to $140 from $111 and boosting our FY18 EPS forecast Parcel Service (UPS) provides a wide range of transportation, to reflect our lower tax rate assumptions. distribution and logistics services. The company has three We expect several factors to impact Visa's revenue main business segments: U.S. Domestic; International; and profile. We look for cross-border fees to increase, driven by Supply Chain & Freight. The shares are a component of the renewed currency volatility, while several recent deals, S&P 500. including Costco and USAA, should benefit results in the first VALUATION part of FY18. The UPS shares appear attractively valued at current We believe that the Visa Europe acquisition, completed in prices near $116, at the midpoint of their 52-week range of June 2016, makes sense from several angles. The combination $102-$135. From a technical standpoint, the shares appear to provides scale advantages and marketing synergies, and be in a long-term bullish pattern of higher highs and higher should boost the combined company's net revenue yield and lows that dates to November 2012. operating margins over time. To value the stock on a fundamental basis, we use peer We believe that tailwinds for Visa are both cyclical and and historical multiple comparisons, as well as a dividend structural in nature, and include improving global economic discount model. The shares are trading at 16.3-times our 2018 conditions, particularly in Europe, which should boost EPS estimate, near the bottom of the historical range of 16-23. payment volumes, as well as the continued transition from On a price/sales basis, the shares are trading above the cash to plastic for convenience, safety and rewards program midpoint of the five-year range. The dividend yield of about benefits. We also note that the market for payment processors 2.6% is above the midpoint of the five-year range. Compared is far from saturated given that 85% of the world's retail to peers, the stock's valuation multiples are mixed, but transactions are still done with cash and checks. generally below industry averages. Our dividend discount We expect Visa's core earnings (excluding benefits from model renders a fair value north of $150 per share. Blending a lower tax rate) to grow an average of 15% annually over the our valuation approaches, we arrive at our 12-month target next two fiscal years. Even in the absence of P/E multiple price of $145. expansion, we believe that Visa shares are a compelling On February 2, BUY-rated UPS closed at $116.47, down investment. $3.04. (John Eade, 2/2/18) RECENT DEVELOPMENTS Section 2.98 GROWTH / VALUE STOCKS

Visa shares have risen 53% over the past year, compared Reflecting the stronger-than-expected 1Q results and a to a 24% gain for the broad market. lower effective tax rate, we are raising our FY18 EPS estimate On February 1, Visa reported adjusted EPS of $1.08 for to $4.38 from $4.05. We are also boosting our FY19 forecast fiscal 1Q18 (ended December 31) , up from $0.86 a year to $4.96 from $4.57. Our estimates imply growth of 26% in earlier and ahead of the $0.99 consensus. FY18 (including benefits from the lower tax rate) and 13% in First-quarter net revenue totaled $4.86 billion, up 9% FY19. from the prior year, benefiting from strong gains in service FINANCIAL STRENGTH AND DIVIDEND fees, data processing fees, and international transaction fees. We rate Visa's financial strength as Medium-High, the Payment volume in 1Q, on a constant-dollar basis, rose second-highest rank on our five-point scale. 10% year-over-year, to $1.93 trillion, while total processed In September 2017, Visa issued $2.5 billion in fixed-rate transactions rose 12%, to 30.5 billion. senior notes, with maturities ranging from 5 to 30 years and Adjusted operating expenses rose 13%. The adjusted interest rates from 2.15% to 3.65%. It used most of the operating margin was 68%, down from 69% a year earlier. proceeds to redeem $1.75 billion of senior notes scheduled to On the 1Q18 conference call, management updated its mature in December 2017 . In December 2015, Visa issued FY18 guidance. It expects net revenue to increase in the high $16 billion in fixed-rate senior notes, with maturities ranging single digits on a nominal basis, with a 0.5%-1.0% positive from 2 to 30 years and interest rates from 1.20% to 4.30%. currency impact. It looks for client incentives to be 21.5% The proceeds were used primarily to fund the upfront cash -22.5% of gross revenues, up from 19.5% in FY17. portion of the Visa Europe acquisition. As of December 31, Management projects an adjusted operating margin in the high 2017, the company had long-term debt of $16.6 billion and a 60s and an adjusted tax rate of 23%, down from its forecast of debt/equity ratio of 50%, but with high operating margins in 29% prior to the recent cut in the tax rate. the mid-60s. In June 2016, Visa acquired Visa Europe in a transaction The company has raised its dividend substantially over valued at 18.5 billion euros. The company noted that there are the last several years from an admittedly low base. On more than 500 million active Visa cards in Europe, with 1.5 February 1, it announced an 8% increase in its quarterly trillion euros in payment volumes and 18 billion annual payout to $0.21, or $0.84 annually, for a projected yield of transactions. The agreement called for an upfront cash about 0.7%. Our dividend estimates are $0.80 for FY18 and payment of 12.2 billion euros, preferred stock valued at 5.3 $0.92 for FY19. billion euros, and an additional 1.0 billion euros (plus 4% The company split its stock 4-for-1 in March 2015. interest) payable on the third anniversary of the closing. Visa repurchased 15.5 million common shares in 1Q18 for $1.7 billion, at an average price of $110.67 per share. The EARNINGS & GROWTH ANALYSIS board also authorized a new $7.5 billion share repurchase The company's primary sources of revenue are services, program. Visa currently has $9.1 billion available for share derived mainly from payment volume on Visa-branded cards; repurchases. The company had suspended buyback activity in data processing fees, from the number of transactions 4Q15 during discussions to acquire Visa Europe. We look for processed; and international transaction fees on cross-border a 2%-3% decline in the average share count in both FY18 and transactions. Transaction volumes have benefited from both FY19. economic growth and the increased use of cards rather than cash. Mobile payments are also expected to be a revenue MANAGEMENT & RISKS driver. In the online segment, the company has noted that Alfred F. Kelly became the company's CEO in December more than 10 million individuals have signed on to Visa 2016 after Charles W. Scharf resigned for personal reasons. Checkout. Mr. Kelly had joined Visa's board in 2014 as an independent In fiscal 1Q18, payment volume and transactions director. processed remained strong, which we believe reflects Management is transparent with investors, in our view, continued strong retail sales and card usage as well as solid providing a range of financial projections for the business, growth in Europe. We expect nominal dollar revenues to grow including revenue growth, operating margins, tax rate, at an 8% pace in FY18, down from 25% in FY17, which earnings growth, and free cash flow. included the Visa Europe acquisition. We look for a further Visa faces risks from regulation, including rules capping 8% increase in FY19. A weaker dollar is finally providing a interchange reimbursement rates, as well as from economic slight revenue tailwind, a reversal after several years of variables that could impact service revenues, data processing currency headwinds. fees, and cross-border transaction fees. Geopolitical factors, Meanwhile, client incentives (a revenue offset) are which could result in business disruption, are also a risk. expected to increase from prior-year levels, as new deals come with higher incentives. Expense growth overall should be in COMPANY DESCRIPTION the mid-single digits, allowing for continued operating margin Visa Inc. operates the world's largest electronic payments improvement. We look for an operating margin of 67% in network, providing processing services and payment product FY18 and 68% in FY19. platforms, including credit, debit, prepaid and commercial payments under the brands Visa, Visa Electron, Interlink and

Section 2.99 GROWTH / VALUE STOCKS

PLUS. Visa/PLUS is one of the world's largest ATM recovers from that scandal, with lending volumes relatively networks, offering cash access in local currency in more than muted, and efficiency measures not yet providing tangible 200 countries and territories. benefits. The Consent Order requires several changes to board VALUATION governance, including: separating the roles of chairman and Visa shares trade at 27.5-times our forward four-quarter CEO and amending the company's by-laws to require an EPS estimate of $4.48, slightly below peer MasterCard at independent chair; electing six new independent directors in 29.7-times. We think that Visa merits a higher multiple than 2017 as five directors retired, and planned refreshment of an MasterCard given its higher operating margins. Visa is a additional four directors in 2018; enhancing the overall large-cap name with consistent low to mid-teens earnings capabilities and experience represented on the board, growth prospects. We believe the Visa Europe acquisition, including financial services, risk management, cyber, which re-connects the global Visa franchise, will provide technology, regulatory, human capital management, finance, long-term benefits from global branding and cost synergies. accounting, and consumer and social responsibility; reviewing We are raising our 12-month target price to $140, up from a the board's committee structure and leadership, amending prior $122, implying a multiple of 31-times our forward committee charters to enhance risk oversight, and refreshing four-quarter estimate. We believe that Visa's low double-digit the chairs of certain key committees, including the Risk earnings growth rate makes for a compelling story even Committee and Governance and Nominating Committee; and without P/E multiple expansion. conducting a board self-evaluation in 2017. On February 2 at midday, BUY-rated V traded at Risk management measures include: centralizing critical $122.22, down $3.50. (Stephen Biggar, 2/2/18) control functions (including Human Resources, Finance, and Technology) to improve enterprise visibility, consistency and control; centralizing all risk management functions to Wells Fargo & Co (WFC) accelerate the design and implementation of an integrated Current Rating: HOLD Publication Date: 2/5/18 operating model for risk management; developing and HIGHLIGHTS executing comprehensive plans that addressed compliance and *WFC: Fed's Consent Order to limit asset growth operational risk management programs, organizations, *On February 2, Wells entered into a Consent Order with processes, technology and controls; hiring external talent for the Federal Reserve Board of Governors related to governance critical risk management leadership roles, such as a chief oversight, and compliance and operational risk management operational risk officer, chief compliance officer and head of program, stemming from sales practice issues announced in regulatory relations; and forming new centralized enterprise the fall of 2016. functions dedicated to key risk control areas. *As part of the order effective 2Q18, the company's total Wells has been trying to put the issue behind it now for assets will be capped at the 2017 year-end level of $2.0 about 18 months. At its 2017 Investor Day on May 11, trillion, a cap that will remain in effect until enhanced plans management provided an update on its efforts to restore for governance and risk management are adopted and customer trust in the wake of fraudulent sales practices. These finalized, to the satisfaction of the Fed. efforts include better communications with customers, *Wells expects a $300-$400 million negative after-tax regulators and industry groups; stronger internal controls; and impact on net income for 2018 related to the action. We are a new employee compensation structure. At the same time, lowering our 2018 EPS estimate to $4.88 from $5.00 to reflect management noted that the company was seeing a reduction in the asset cap and what we expect will be some additional branch interactions and new account openings as well as customer fallout. diminished customer loyalty. *However, on historical P/E and price/book multiples, The company has terminated more than 5,000 employees WFC current discount valuation appears to factor in the connected with the fraudulent practices. In addition, it has company's current challenges. made amends to customers that experienced late charges or other penalties connected with the fake accounts, and paid ANALYSIS $185 million in settlement charges to the Consumer Financial Protection Bureau, the Office of the Comptroller of the INVESTMENT THESIS Currency, and the county and city of Los Angeles. It has also We are maintaining our HOLD rating on Wells Fargo & eliminated product sales goals within the retail franchise, and Co. (NYSE: WFC) following news that the company has hired an outside firm to analyze deposit and credit card entered into a Consent Order with the Federal Reserve's Board accounts opened between 2011 and 2015. of Governors that places a cap on total assets at the $2 trillion In response to reduced branch activity and customer level of the end of 2017, as the company implements various losses, the company is targeting $2 billion in expense savings enhanced risk management practices. The Order relates to a by the end of 2018, mainly in marketing, finance, human sales practice scandal that was uncovered in late 2016. Wells resources and operations/technology, as well as reductions in has continued to face sluggish revenue growth trends as it consulting and third-party expenses. At the 2017 Investor

Section 2.100 GROWTH / VALUE STOCKS

Day, management also announced an additional $2 billion in Consent Order referenced above. savings that it expects to achieve by the end of 2019, driven Net charge-offs and loss provisions reached parity in by operational consolidation, improved processes, and the 3Q17, but this reversed in 4Q with $100 million being outsourcing of certain functions. released into earnings. About $400 million was released into WFC shares are trading in line with historical P/E and earnings for all of 2017, which we believe shows weak price/book multiples, which we believe is fair given the earnings quality. While the net charge-off percentage has company's current challenges - including sluggish revenue declined in recent quarters, we would prefer to see a closer growth relative to peers. approximation of loss provisions at this stage of the credit cycle. RECENT DEVELOPMENTS Wells is attempting to get better control of expenses, and WFC shares have risen 5% over the past year, versus 20% has noted that the efficiency ratio (noninterest expenses to for the broad market. revenues) is currently too high. The company is targeting On January 12, WFC reported 4Q17 earnings of $0.97 efficiency initiatives to lower expenses by $2 billion annually per share, down from $1.03 in the prior-year period and below by the end of 2018, and plans to reinvest the savings in the the $1.07 consensus forecast. Results in the current quarter business. It looks for an additional $2 billion in annual exclude a $0.67 per share benefit from the Tax Cuts and Jobs expense reductions by the end of 2019, which are expected to Act (reduction to net deferred income taxes), $0.11 from the flow directly to earnings. sale of an insurance unit, and a charge for litigation accruals Management guided toward a 19% effective tax rate in of $0.59. Revenue increased 2% to $22.05 billion. 2018, down from a high-20% rate in 2017, due to the recently Average earning assets rose 0.2%, but with the net passed Tax Cuts and Jobs Act. To reflect the asset cap at 2017 interest margin narrowing to 2.84% from 2.87% a year earlier, year-end levels, as well as expected additional customer net interest income declined 0.7%. Credit quality improved, fallout, we are lowering our 2018 EPS estimate to $4.88 from with net charge-offs at 0.31% of average loans, down from $5.00. We are also lowering our 2019 EPS forecast to $5.39 0.37% a year earlier. With a loss provision of $651 million, from $5.50. versus net charge-offs of $751 million, $100 million of reserves were released into earnings. FINANCIAL STRENGTH & DIVIDEND Noninterest income rose 6%, as a decline in services Our financial strength rating on Wells Fargo is High. changes and mortgage banking income was offset by higher At December 31 , 2017, Wells Fargo estimated that its gains from equity investments and other income (versus Tier 1 common ratio was 11.9% under Basel III (advanced expense). approach, fully phased-in). The 4Q efficiency ratio was 61.5% (excluding the In June 2017, the Fed did not object to the company's litigation expense), compared to 61.2% a year earlier. 2017 capital plan, which included an increase in the common For all of 2017, revenues were flat at $88.1 billion, while stock dividend from $0.38 to $0.39 per share as of 3Q17, and EPS declined 4% to $3.90 from $4.06. 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 EARNINGS & GROWTH ANALYSIS 3.5%-4.0% range prior to the financial crisis. Our dividend Commercial loans, which on average yielded about estimates are $1.68 for 2018 and $1.84 for 2019. 3.68% (up from 3.45% a year earlier as prime rate increases In 4Q17, the company repurchased 51.4 million shares of were passed through), declined 0.2% in 4Q, while consumer its common stock. We look for a 3% decline in the average loans, which on average yielded 5.10% (up from 5.01% a year share count in 2018. earlier), declined 2.5%. Meanwhile, funding costs were only slightly lower in 4Q17 at 2.84% versus 2.87% a year earlier MANAGEMENT & RISKS on higher deposit and long-term debt rates. We believe that The new CEO of Wells Fargo is Tim Sloan, formerly the the consumer segment continues to face fallout from the 2016 company's president and COO. Mr. Sloan replaces John G. sales scandal. However, we expect commercial lending Stumpf, who resigned in October 2016 following revelations growth to remain a bright spot and to result in higher net of fraudulent sales practices at the retail bank. Mr. Sloan is a interest income in 2018. Overall, we expect net interest 29-year veteran of Wells Fargo, having spent much of his income growth of 6% in 2018 as interest rate increases are career in wholesale and commercial banking. passed through. While Wells Fargo is a diversified financial services Noninterest income was hurt in 2017 by declines in company, its focus on the low-margin mortgage business is a service charges and weak mortgage banking volume. While concern. Wells Fargo views the mortgage as the gateway to a other banks have been hurt by a decline in mortgage broader consumer relationship, and its earnings growth originations as interest rates rise, WFC's 29% decline in this strategy has always been focused on revenue growth, driven line item was greater than that of other banks, also indicating in part by cross-selling, or selling multiple products to each customer fallout from the sales scandal. Overall, we now customer. However, these sales practices have been sharply project flat revenues in 2018, versus flat revenues also from curtailed in the wake of a 2016 scandal. There is also the risk 2016 to 2017, as assets are capped following the Fed's that demand for WFC products may slow - at least on the

Section 2.101 GROWTH / VALUE STOCKS 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 $59.12, down $4.95. (Stephen Biggar, 2/5/18)

Section 2.102 UTILITY SCOPE

earnings growth. Duke is now benefiting from positive Utility Scope Stocks in this Report changes in its regulated electric utility rate structures, an improving economy in its Carolina and Florida service areas, PRICE and moderate kilowatt-hour sales growth. In our view, these AS OF factors make DUK shares a sound long-term holding for TICKER 2/7/18 investors seeking moderate share price appreciation and a solid dividend. We think the current annualized payout of Duke Energy Corp DUK $74.49 $3.56 per share is secure and expect annual dividend growth El Paso Electric Co EE 49.50 of 2.5%-3.0% over the next several years. The current yield is Public Serv Enterprise Grp In PEG 47.63 about 4.6%. In our view, these factors should combine to generate total returns to shareholders of 5%-6% annually over Duke Energy Corp (DUK) the next 4-5 years. Current Rating: HOLD Publication Date: 1/31/18 RECENT DEVELOPMENTS HIGHLIGHTS Over the past three months, DUK shares have fallen 12%, *DUK: Lowering EPS estimates and reiterating HOLD compared to a gain of 10% for the S&P 500. Over the past 52 *We are lowering 2017 EPS estimate to $4.57 from $4.65 weeks, the shares have gained 1%, compared to an increase of and our 2018 EPS estimate to $4.78 from $4.85. In both years, 24% for the index. The five-year track record shows an we look for higher depreciation and amortization expense as increase of 13% for DUK, versus a gain of 91% for the S&P well as higher interest costs related to the financing of Duke 500. The beta on DUK is 0.03. Energy's Piedmont Natural Gas acquisition. Duke will report fourth-quarter and full-year results on *Despite the company's solid fundamentals, including a February 20, 2018. favorable regulatory environment and an expanding rate base, we see an unexciting total return potential for DUK over the EARNINGS & GROWTH ANALYSIS next 12 months. Based on Duke's nine-month results, we think that the *Due to the company's infrastructure improvement company remains on track to achieve its 2017 adjusted program, we expect above-average rate base growth over the earnings guidance of $4.50-$4.60 per share. next several years and view the company's sale of We are lowering 2017 EPS estimate to $4.57 from $4.65 nonregulated generating assets in the Midwest as a strong and our 2018 EPS estimate to $4.78 from $4.85. In both years positive. we look for higher depreciation and amortization expense as *The annualized dividend of $3.56 yields about 4.6%, well as higher interest costs related to the financing of Duke and may appeal to income-oriented investors. Energy's Piedmont Natural Gas acquisition. In addition, the expected absence of earnings from the earlier sale of Duke ANALYSIS Energy's International Energy segment and a continuation well into 2018 of lower investment tax credits in the solar INVESTMENT THESIS portfolio are expected to have a noticeable effect in supporting Our rating on Duke Energy Corp. (NYSE: DUK) is our revised EPS estimates. HOLD, based primarily on valuation. DUK shares trade at On the other hand, our long-term BUY rating takes into 16.2-times our revised 2018 EPS estimate of $4.78, near the account management's current EPS guidance, generally average multiple for comparable electric utilities and the favorable regulation in North and South Carolina, clearer five-year historical average of 14.9. Despite the company's earnings visibility and the company's infrastructure solid fundamentals, including a favorable regulatory improvement program, we believe these positives will support environment and an expanding rate base, we see an unexciting our five-year EPS growth forecast of 5%. We note that total return potential for DUK over the next 12 months. kilowatt-hour sales have improved in nearly all service At the same time, we are maintaining our long-term BUY territories, with sales now growing at a relatively strong rate rating. We expect above-average rate base growth over the of 1.1%-1.2% annually. next several years and view the company's recent sale of Our long-term BUY rating reflects our assumption of nonregulated generating assets in the Midwest as a strong lower O&M expenses and benefits from the refinancing of positive. Other positive fundamentals include the company's high-cost debt. In addition, we look for Duke to benefit from improving balance sheet and well-managed effective management execution, as well as from continued nuclear-generating assets. The 2012 addition of Progress improvement in its service area economies. The company Energy has also generated significant cost synergies, and we should benefit from future rate case filings in North and South expect the same with the October 2016 addition of Piedmont Carolina, cost-savings programs, and infrastructure Natural Gas Co. improvements. Using 2017 as a base year, our five-year The expected rise in Duke's construction spending for earnings growth rate estimate for Duke Energy is 5%. new power plants, infrastructure improvements and alternative energy projects should have little, if any, impact on long-term FINANCIAL STRENGTH & DIVIDEND

Section 2.103 UTILITY SCOPE

Our financial strength rating for Duke Energy is Medium, in the U.S., has a market cap of approximately $58.8 billion, the midpoint on our five-point scale. The company's debt is with total assets of more than $120 billion. Its regulated utility investment grade. At the end of 3Q17, common stock operations serve approximately 7.4 million electric customers comprised 52% of Duke Energy's permanent capitalization, in six states in the Southeast and Midwest. The company's and long-term debt, 48%. nonregulated Commercial Renewables segment owns a Long-term debt totaled $48.929 billion at the end of growing portfolio of renewable energy assets in the U.S. In 3Q17, compared to $45.576 billion at the end of 2016. October 2016, Duke acquired Piedmont Natural Gas Co. Earnings covered interest on long-term debt by a factor of 3.3 Including Piedmont, the company now has approximately 1.4 in 3Q17. Cash and cash equivalents were $282.2 million at the million natural gas customers. end of 3Q17, compared to $392.3 million at the end of 2016. Operating cash flow totaled $5.011 billion in the first nine INDUSTRY months of 2017, compared to $5.611 billion in the same Our rating on the Utility sector is Under-Weight. The period in 2016. sector outperformed the S&P 500 in 2016, with a gain of While the company's plant construction and upgrade 12.2%, after underperforming in 2015, with a loss of 8.4%. It schedule will require some external financing, we expect underperformed in 2017, with a gain of 8.3%. relatively little pressure on the balance sheet. Indeed, the The sector accounts for 3.1% of the S&P 500. Over the company's overall financial position has steadily improved. past five years, the weighting has ranged from 3.0% to 5.0%. Additional positive factors are the efficiency of the company's We think the sector should account for at most 2%-3% of nuclear generating units, which are among the highest-rated in diversified portfolios. The sector includes the electric, gas and the industry; focused cost controls; high-quality earnings; and water utility industries. balanced regulation. By our calculations (using 2018 EPS), the sector In July 2017, Duke Energy raised its quarterly dividend price/earnings multiple is 18.6, a record high level and above by 4.1% to $0.89. The annualized rate is now $3.56. Based on the market average of 18.2. Earnings are expected to rise 5.7% trailing 12-month adjusted EPS, the dividend payout ratio is in 2018 and 5.9% in 2017 after rising 21.5% in 2016 and about 71%. We expect the company to increase its dividend falling 14.9% in 2015. The sector's debt-to-cap ratio is about 4.5%-to-5.0% annually over the next four to five years. Our 55%, above the market average. This represents a risk, given dividend payout estimates are $3.49 for 2017 and $3.56 for the current state of the credit markets, particularly if corporate 2018. bond rates rise. The sector dividend yield of 2.8% is above the market average of 1.8%. MANAGEMENT & RISKS Lynn J. Good is president and CEO of Duke Energy and VALUATION the vice chairman of the board. Prior to assuming her current Over the past 52 weeks, DUK shares have traded between role in July 2013, Ms. Good served as EVP and CFO. $76 and $92. The shares currently trade at 16.2-times our Steven K. Young is EVP and CFO, and is responsible for revised 2018 EPS estimate of $4.78, above the average for the controller's office, treasury, risk management, as well as comparable electric utilities and the company's five-year corporate strategy and development. Mr. Young joined Duke historical average of 14.4. DUK also trades at a premium to Power in 1980 as a financial assistant. peers based on price/sales and price/book. Based on these In general, Duke Energy management is committed to metrics, we believe a HOLD rating is appropriate. electric and gas service expansion strategies in its regulated At the same time, we are maintaining our long-term BUY service territories. In terms of its nonregulated operations, rating. We view the company's visible forward earnings management decided to lower the company's profile in the stream and attractive integrated structure, along with competitive energy business due to relatively low power management's demonstrated execution ability, as compelling prices. Note, too, that management will enter into the outside reasons for investors to maintain their current positions. purchase of energy assets only after thorough due diligence. Added benefits are the company's growing dividend, generally In our view, the company's platform for growth is solid, and positive relations with regulators, geographic diversity, and we are confident in management's ability to provide well-run electric generation and gas distribution facilities. In shareholders with increased value over the long term. addition, the company continues to add new customers despite Key risks for stocks in our electric utility universe include some remaining economic weakness in its service areas. It has commodity price fluctuations, the effect of adverse weather also generated significant cost synergies from its 2012 merger conditions on revenue, regulatory issues (especially with Progress Energy and we expect the same with the recent construction cost recovery) and potential environmental and acquisition of Piedmont Natural Gas. We believe these factors safety liabilities. In addition, the capital-intensive nature of the should combine to generate total annual returns for DUK utility industry creates ongoing liquidity risk that must be shareholders of 5%-6% over the next four to five years. actively managed by each company. The annualized dividend of $3.56 per share yields about 4.6%, and may appeal to income-oriented investors. COMPANY DESCRIPTION On January 31 at midday, HOLD-rated DUK traded at Duke Energy, the largest electric power holding company $77.71, up $0.05. (Gary Hovis, 1/31/18)

Section 2.104 UTILITY SCOPE

and attractive integrated structure are also positives. In addition, the company should benefit from a favorable El Paso Electric Co (EE) regulatory environment. We expect these positives to result in Current Rating: HOLD Publication Date: 2/2/18 above-average EPS and dividend growth over time, and are maintaining our long-term BUY rating. HIGHLIGHTS *EE: Lowering 2018 EPS estimate; reiterating HOLD RECENT DEVELOPMENTS *El Paso Electric operates in a geographic region that has Over the past three months, EE shares have fallen 8%, seen strong economic growth relative to the national average, compared to a gain of 9% for the S&P 500. Over the past 52 and has benefited from an improving service-area housing weeks, the shares have risen 13%, compared to a gain of 24% market and above-peer-average kilowatt-hour sales to for the index. The five-year track record shows an increase of residential customers. 52% for EE and 89% for the S&P 500. The beta on EE shares *EE shares currently trade at 19.3-times our revised 2018 is 0.31. EPS estimate, a premium to the average multiple for comparable electric utilities with fully regulated operations. It EARNINGS & GROWTH ANALYSIS also trades at a small premium to peers based on price/cash The company's earnings guidance for 2017 falls within a flow and price/book multiples. range of $2.30 to $2.50 per share. It is expected to release 4Q *El Paso operates in a geographic region that has seen and full-year 2017 financial results on February 27. strong economic growth relative to the national average, and Over the last five years, El Paso has seen has benefited from an improving service-area housing market above-industry-average growth in both retail and commercial and above-peer-average kilowatt-hour sales to residential kilowatt-hour sales. Most of this growth has been in the customers. residential customer segment, and although per customer *In our view, the company's strong fundamentals should usage has been falling due to conservation measures, it combine to generate total returns of 5%-6% annually over the remains well above the industry average. In all, we believe next four to five years. Even so, the dividend yield of about that economic growth in El Paso's service territory will remain 2.6% is below the peer average of 3.4%. strong for the foreseeable future and expect it to result in above-industry-average customer and load growth. Over the ANALYSIS last 10 years, EE's service territory has grown faster than the regulated utility industry average. Customer growth was 1.7% INVESTMENT THESIS in 3Q17 and has averaged about 1.4% annually (above the We are reiterating our HOLD rating on El Paso Electric industry average of 0.5%). Co. (NYSE: EE). EE currently trades at 19.3-times our revised Our 2017 earnings estimate is $2.47 per share. While the 2018 EPS estimate, a premium to the average multiple for rate case approval in Texas benefited earnings in 2016, the comparable electric utilities with fully regulated operations. It company still faces uncertainty surrounding the also trades at a small premium to peers based on price/cash reimbursement of expenses related to the company's Montana flow and price/book multiples. Power Station and Eastside Operations Center. With the latter We believe that the company has adequate liquidity in mind, we are lowering our 2018 EPS estimate to $2.66 through its current cash balance, cash from operations and from $2.75. credit facility to meet all anticipated cash requirements through 2018. FINANCIAL STRENGTH & DIVIDEND We note that utilities as a group are heavily debt-financed Our financial strength rating for El Paso Electric is and that aggregate interest charges are likely to rise in the Medium-Low, the second-lowest rank on our five-point scale, event of future Fed rate hikes. In addition, in a rising interest down from Medium. Moody's rates the company's debt rate environment, equity investors seeking income often move investment grade. El Paso has maintained a strong balance away from utility shares and turn to the bond market, as sheet and cash position to support investments in utility fixed-income rates begin to rise. Even so, we think that EE, infrastructure. with its strong finances and solid management execution, will The company continues to maintain a strong capital help support the EE share price. structure with common stock equity representing 44% of El In our view, these positives should combine to generate Paso's capitalization at the end of 3Q17. At the end of 3Q17, total returns of 5%-6% annually over the next four to five El Paso had $7.060 million in cash and cash equivalents. years. Based on current projections, we believe the company will El Paso Electric operates in a geographic region that has have adequate liquidity through its current cash balances, cash seen strong economic growth relative to the national average, from operations and available borrowings under the and has benefited from an improving service-area housing company's revolving credit facility to meet all expected cash market and above-peer-average kilowatt-hour sales to requirements through December 31, 2018. residential customers. We believe that El Paso's solid financial Cash flows from operations for the nine months ended strength, limited risk profile, visible forward earnings stream, 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 water utility industries. contributing to the increase in cash flows from operations By our calculations (using 2018 EPS), the sector were the change in net over-collection and under-collection of price/earnings multiple is 18.6, a record high level and above fuel revenues and the collection of back surcharges. the market average of 18.2. Earnings are expected to rise 5.7% EE pays a quarterly dividend of $0.335, or $1.34 on an in 2018 and 5.9% in 2017 after rising 21.5% in 2016 and annualized basis, for a yield of 2.4%. Our 2017 dividend falling 14.9% in 2015. The sector's debt-to-cap ratio is about estimate is $1.30 per share and for 2018, we are looking at 55%, above the market average. This represents a risk, given $1.38. Management has targeted a 55%-65% payout ratio over the current state of the credit markets, particularly if corporate the next three years with increases beginning in 2018. bond rates rise. The sector dividend yield of 2.8% is above the market average of 1.8%. MANAGEMENT & RISKS Management is committed to electric service expansion VALUATION strategies in the company's regulated service territories. We Over the past 52 weeks, HOLD-rated EE shares have think the company's platform for growth is solid, and we are traded between $45 and $61, and are currently near the low confident in management's ability to provide EE shareholders end of this range. Despite the company's positive with increased value over the long term. fundamentals, including a strong financial position and a Management projects heavy capital expenditures of $1.1 growing service territory economy, we see an unexciting total billion through 2021 (including early estimates for a 320 return potential for EE shares over the next 12 months. The megawatt combined cycle generating plant to be completed in shares currently trade at 19.3-times our revised 2018 EPS 2023), as the company develops additional generating estimate of $2.66, near the low end of their five-year trading capacity and upgrades transmission and distribution range, above the peer average of 18.2 and lastly, above their infrastructure. five-year historical average P/E of 14.6. As well, the dividend El Paso Electric is regulated in Texas and New Mexico, yield of 2.6% is below the peer average of 3.4%. Thus, we and is also regulated by FERC. Over the next decade, the believe a HOLD rating is appropriate. company will face regulations in Texas and New Mexico that At the same time, we are maintaining our long-term BUY require El Paso to boost sales of energy from renewable rating. We view the company's visible forward earnings sources. These incremental costs are expected to be recovered stream and attractive integrated structure, along with through base rates and renewable energy credits. management's demonstrated execution ability, as compelling Key risks for stocks in our electric utility universe include reasons for investors to maintain their current positions. commodity price risk, adverse weather conditions, regulatory Added benefits are the company's growing dividend, generally risk (especially when it involves construction cost recovery), positive relations with regulators, and well-run electric and potential environmental and safety liabilities. The generation facilities. The company also has a strong balance capital-intensive nature of the utility industry also creates sheet and continues to add new customers in a growing ongoing liquidity risk that must be actively managed by each service area economy. company. We would probably lower our earnings estimates on Looking ahead, we expect El Paso Electric to benefit El Paso if the economy weakens. Finally, we note that nuclear from its list of strong fundamentals and look for total annual power issues pose risks for the company because of its 15.8% returns to shareholders of 5%-6% over the next 4-to-5 years. stake in the Palo Verde nuclear plant in Arizona. As well, the annualized dividend of $1.34 per share yields about 2.6% and, in a market downturn, may appeal to COMPANY DESCRIPTION income-oriented investors. El Paso Electric is a regional electric utility providing On February 2 at midday, HOLD-rated EE traded at generation, transmission and distribution service to $51.30, down $0.15. (Gary Hovis, 2/2/18) 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 Public Serv Enterprise Grp In (PEG) Cruces, New Mexico. El Paso Electric has a net generating Current Rating: BUY Publication Date: 2/6/18 capability of 2,080 MW. HIGHLIGHTS INDUSTRY *PEG: Raising 2018 EPS estimate; reaffirming BUY Our rating on the Utility sector is Under-Weight. The *We view the company's increased spending on electric sector outperformed the S&P 500 in 2016, with a gain of transmission and gas pipeline projects as a strong plus, as 12.2%, after underperforming in 2015, with a loss of 8.4%. It these facilities are more likely to provide higher returns on underperformed in 2017, with a gain of 8.3%. equity than those earned on distribution and generation assets. The sector accounts for 3.1% of the S&P 500. Over the *We are maintaining our 2017 EPS estimate of $2.91, but past five years, the weighting has ranged from 3.0% to 5.0%. are raising our 2018 estimate to $3.11 from $2.98. We think the sector should account for at most 2%-3% of *Our revised 2018 estimate reflects the continued diversified portfolios. The sector includes the electric, gas and expansion of the company's electric and gas transmission and

Section 2.106 UTILITY SCOPE distribution facilities, as well as its favorable natural gas 2018 estimate reflects the continued expansion of the supply position. company's electric and gas transmission and distribution *PEG trades at 16-times our revised 2018 EPS estimate, facilities, as well as its favorable natural gas supply position. below the average multiple for electric and gas utilities with In addition, the company is beginning to benefit from a both regulated and nonregulated assets. turnaround in nonregulated wholesale power prices and lower energy supply costs as well as from declining O&M expenses. ANALYSIS At the same time, our revised estimate assumes some pressure INVESTMENT THESIS from rising depreciation and higher property taxes, both Our target price on BUY-rated Public Service Enterprise related to the infrastructure buildout program, as well as from Group Inc. (NYSE: PEG) is $56, based on the company's customer conservation efforts. growing network of transmission assets and its well-managed FINANCIAL STRENGTH & DIVIDEND regulated utility subsidiary, Public Service Electric & Gas Co. Our financial strength rating on Public Service Enterprise (PSE&G). We view the company's increased spending on is Medium-High, the second-highest rank on our five-point electric transmission and gas pipeline projects as a strong plus, scale. The company's bond ratings are investment grade. as these facilities are more likely to provide higher returns on Public Service remains focused on balance sheet equity than those earned on distribution and generation assets. improvement, growth in cash flow, and strong cost controls. We expect above-average growth in the company's rate While total debt has increased as a result of its infrastructure base from infrastructure investments, as well as higher buildout program, the overall cost of financing has declined profitability in its nonregulated operations. In addition, we due to refinancing activity and lower interest rates. The continue to expect annual dividend growth of 4.0%-5.0% over company ended 3Q17 with a relatively low long-term the next several years. The shares currently offer a solid debt/capital ratio of 48%, well below the sector average of dividend yield of about 3.4%. 55%. EBITDA covered interest expense by a factor of 6.8 in Utilities as a group are heavily debt-financed and 3Q17, slightly below the industry average near 7.0. The 3Q17 aggregate interest charges are likely to rise. In addition, in a profit margin was 14.4%, compared to 13.9% in 3Q16. rising interest rate environment, equity investors seeking Operating cash flow fell to $2.734 billion in 3Q17 from income more often than not move away from utility industry $2.761 billion in 3Q16.Increasing shareholder value remains a shares and turn to the bond market, as fixed-income rates priority, and the company has paid dividends without begin to rise. Even so, we think Public Service, with its strong interruption since 1907. The annualized dividend is currently finances and solid management execution, will outperform $1.72 per share, for a yield of about 3.4%. Our dividend other utilities in a rising interest rate environment. estimates are $1.72 for 2017 and $1.78 for 2018. We expect The company should continue to benefit from strong cost dividend increases of close to 5% annually over the next 3-4 controls, solid cash flow from operations, a strong years. management team, and what we view as a favorable regulatory environment at both the state and federal levels. In MANAGEMENT & RISKS addition, our positive assessment reflects the company's Ralph Izzo was elected chairman and CEO of Public efficiently operated nuclear generation units, focus on balance Service Enterprise Group in April 2007. He became the sheet improvement, and expanding economic activity in its company's president and chief operating officer and a member service area. We believe that the company's core business of the board of directors in October 2006. He previously strategy complements its well-balanced asset portfolio, and served as president and chief operating officer of PSE&G. that its regulated electric and gas business is well positioned On September 23, 2015, Daniel J. Cregg, formerly VP of for growth beyond 2018. Finance for PSE&G, was named executive vice president and CFO. During his 24-year career with the company, Mr. Cregg RECENT DEVELOPMENTS has held senior financial positions at both PSE&G and PSEG Over the past three months, PEG shares have fallen 1%, Power. compared to an increase of 7% for the S&P 500. Over the past Overall, we believe that Public Service Enterprise is 52 weeks, the shares have risen 14%, compared to an advance committed to electric and gas service expansion strategies in of 20% for the S&P 500. The five-year track record shows an its regulated service territory and that it is keeping O&M increase of 59% for PEG, versus a gain of 91% for the S&P expenses in check. In addition, we think the company's 500. The beta on PEG shares is 0.23. platform for growth is solid, and we are confident in EARNINGS & GROWTH ANALYSIS management's ability to provide shareholders with increased Management's 2017 operating earnings guidance is value over the long term. $2.80-$3.00 per share. The company will report fourth-quarter The company's regulated utility operations are subject to and full-year results for 2017 on February 23, cooler-than-normal conditions during the summer We are maintaining our 2017 EPS estimate of $2.91, but air-conditioning season, and the gas distribution business are raising our 2018 estimate to $3.11 from $2.98. Our revised 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 On February 5, BUY-rated PEG closed at $48.84, down possibility that regulators will lower the company's allowed $1.20. (Gary Hovis, 2/5/18) 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 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 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.

Section 2.108 STOCKS TO AVOID

There are no companies updated in the Stocks to Avoid category this week.

Section 2.109 2.8% N/A

-0.3% N/A

-1.1% N/A

-0.1% 0.9% N/A

-0.4% 1.7%

1.3% 0.1% 0.6% 0.7% N/A

2.0% 0.7% 0.9% 0.4% N/A

0.2% 1.8%

2.1% 2.4% 1.2% 1.7% 0.4% 1.7% 1.7% N/A

0.6% 0.7% 0.2% 1.4% 0.6% 0.8% 0.2% 0.8% 0.1% N/A

-0.1%

Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18

0.5%

0.1% 0.4% 0.5% 0.1% 0.4% 0.1% N/A

-0.2% -0.4%

-6.8% -3.3%

3.2%

-0.8% -0.9% 0.5%

-0.1%

ay-17 Jun-17 Jul-17

1.6%

0.0% 6.4%

0.3% 0.5% 0.3% 0.6% 0.0% 0.0% 0.4% N/A N/A

-0.1% 0.0% -0.7% -0.1% -0.2% -0.1% -0.2% -0.2%

22.8% 0.3% 9.6% 11.7% 0.1% 10.2% 6.2%

0.2% 0.7% 0.2%

-1.8%

-0.8% -0.3% -0.3%

-0.2%

-0.1%

0.1% 0.3% 0.0%

-0.3% -0.3% -0.2%

19.8%

0.2% 0.2% 1.1% 0.0% 0.2%

-0.2%

-1.7%

14 21 11 20 0 13 13 8 22 9 33 24 15

599 615 638 590 606 619 564 559 639 599 689 625 N/A

90.3 86.5 86.5 87 87.7 83.9 80.5 87.7 84.4 90.5 88.9 84.3 86.3 98.5 96.3 96.9 97 97.1 95.1 93.4 96.8 95.1 100.7 98.5 95.9 95.7

55.6 57.6 56.6 55.3 55.5 56.7 56.5 59.3 60.2 58.5 58.2 59.3 59.1 60.5 61.7 57.3 58.9 57.5 60.9 60.4 62 61.9 61 64.3 65.2 64.5 60.7 62.9 59.2 61.9 60.6 60.7 56.5 57.9 60.9 61.5 61.1 57.8 N/A 51.2 57.3 57.1 58.7 59.3 63.6 59.5 59.5 64.3 65.4 65.6 67.8 65.7

24.1 35.3 31.6 22.8 35.5 26.9 23.2 22.1 25.8 28.8 24.3 27.9 22.2

98.8 99.1 99.2 99.4 98.9 98.8 N/A N/A N/A N/A N/A N/A N/A

0.6% 0.3% 0.5% 0.2% 0.4% 0.6% 0.3% 0.4% 0.0% 1.3% 0.5% 0.6% N/A

0.2% 1.0% 0.3% 0.3% 0.1% 0.5% 0.3% 0.2% 0.1% 0.3% 0.2% 1.0% 0.3% 0.8% 0.4% N/A 0.8%

6.6% 6.6% 6.3% 6.1% 6.0% 5.9% 5.8% 5.3% 5.3% 5.3% 5.3% N/A N/A

0.3% 1.4% 2.4% 0.4% 0.8% 1.0%

0.3% 0.3% 0.2% 2.0% 2.2% 1.8% 1.7% 1.5% 1.4% 1.4% 1.4% 1.7% 1.6% 1.8% 1.7% N/A 1.9% 1.9% 1.6% 1.6% 1.5% 1.5% 1.4% 1.3% 1.4% 1.4% 1.5% 1.5% N/A 0.6% 0.1% 1.0% 0.3% 0.6% 0.3%

4.8% 4.7% 4.5% 4.4% 4.3% 4.3% 4.3% 4.4% 4.2% 4.1% 4.1% 4.1% 4.1%

0.9% 0.5% 0.3% 0.1% 0.2% 0.0% 0.3% 0.2% 0.5% 0.4% 0.3% 0.4% N/A

6.2% 4.0% 6.8% 5.1% 5.5% 3.1% 6.5% 4.4% 3.8% 4.3% 2.5% 4.5% N/A 6.6% 6.3% 6.3% 6.0% 5.9% 5.6% 5.6% 5.3% 5.1% 5.0% 4.6% 4.7% N/A

111.6 116.1 124.9 119.4 117.6 117.3 120 120.4 120.6 126.2 128.6 123.1 125.4

1,236 1,288 1,189 1,154 1,129 1,217 1,185 1,172 1,159 1,261 1,299 1,192 N/A 1,300 1,219 1,260 1,228 1,168 1,275 1,230 1,272 1,225 1,316 1,303 1,300 N/A

5,690 5,470 5,700 5,560 5,620 5,510 5,440 5,350 5,370 5,500 5,780 5,570 N/A

17.34 17.32 16.72 16.97 16.7 16.59 16.69 16.03 18.47 17.98 17.4 17.76 17.07

-0.3%

112.8 112.77 111.39 111.49 110.78 112.39 110.26 109.98 112.51 113.64 112.54 112.69 109.19

75.7% 75.8% 75.9% 76.6% 76.6% 76.6% 76.4% 76.0% 76.1% 77.4% 77.2% 77.9% N/A

19.0%

Jan-17 Feb-17 Mar-17 Apr-17 M

192.04 190.62 185.88 181.73 179.77 174.78 182.64 180.86 183.09 187.56 189.17 193.86 197.38 $5,994 $5,967 $5,816 $5,711 $5,658 $5,927 $6,336 $6,760 $6,432 $6,817 $6,735 $7,207 $7,079 $52.81 $54.01 $50.60 $49.33 $48.32 $46.04 $50.17 $47.23 $51.67 $54.38 $57.40 $60.42 $64.73

18,000 21,000 10,000 10,000 4,000 14,000 -4,000 39,000 6,000 20,000 30,000 21,000 15,000 45,934 36,957 43,310 36,602 33,092 31,105 28,307 33,825 32,346 29,831 35,038 32,423 44,653

$21.81 $21.85 $21.89 $21.94 $21.98 $22.02 $22.06 $22.11 $22.20 $22.18 $22.23 $22.31 $22.34

1.0798 1.0576 1.0652 1.0895 1.1244 1.1426 1.1842 1.191 1.1814 1.1646 1.1904 1.2005 1.2414

259,000 200,000 73,000 175,000 155,000 239,000 190,000 221,000 14,000 271,000 216,000 160,000 200,000

-$48.775 -$44.507 -$44.812 -$48.147 -$47.883 -$45.686 -$45.162 -$44.306 -$44.890 -$48.900 -$50.500 N/A N/A

127.3877 125.5928 125.0647 124.146 123.6594 122.0436 120.3736 119.0583 117.9287 120.0495 120.2745 119.9565 117.2182

$1,212.80 $1,255.60 $1,244.85 $1,266.45 $1,266.20 $1,242.25 $1,267.55 $1,311.75 $1,283.10 $1,270.15 $1,280.20 $1,291.00 $1,345.05

U.S. MACROECONOMIC DATA SHEET U.S. MACROECONOMIC DATA SHEET

U.S. MACROECONOMIC DATA SHEET

U.S. MACROECONOMIC DATA SHEET U.S. MACROECONOMIC DATA SHEET

Consumer Confidence, Conference Board Consumer Expectations, U Michigan Consumer Sentiment Index, U Michigan Leading Economic Indicators CRB Futures Index LME Copper (USD/Metric Tonne) Crude Oil, WTI Housing Starts (000) Housing Permits (000) New Home Sales (000) Existing Home Sales Construction Expenditures Personal Consumption Expenditures Retail Sales Automotive & Lt. Truck Sales, Mlns (SAAR) Consumer Credit Industrial Production Capacity Utilization ISM - Purchasing Managers Index ISM - Production Index ISM - Non-Manufacturing Index Chicago-Area Purchasing Managers Index Durable Goods Orders Factory Orders Philadelphia Fed BOS Richmond Fed Manufacturing, Shipments Business Inventories PCE Deflator (YOY%) Core PCE Deflator (YOY%) Consumer Price Index %change Producer Price Index Import Price Index Export Price Index Spot Gold, London PM Fixing Nonfarm Payrolls, Monthly Change Manufacturing Payrolls, Monthly Change Challenger, Gray & Christmas Job Cuts Unemployment Rate Average Hourly Earnings Personal Income M-1 % Change (MOM%) M-2 % Change (MOM%) M-2, seasonally adjusted (yoy%) U.S. $ -- Trade Weighted Index (Broad) USD/Yen USD/EUR U.S. Trade Deficit (blns$)

a/o February 4, 2018 ECONOMIC TRADING CALENDAR

Release: Consumer Prices Release: ConsumerLeading Economic Prices, Indicators Ex-F&E Release: RetailExisting Sales Home Sales Date: 2/14/2018 Date: 2/14/20183/22/2007 Date: 2/14/20183/23/2007 Month: January Month: JanuaryFebruary Month: JanuaryFebruary Previous Report: 0.1% Previous Report: 0.3%0.1% Previous Report: 0.4%6.46 mln. Argus Estimate: 0.2% Argus Estimate: 0.3%0.0% Argus Estimate: 0.2%6.50 mln. Street Estimate: 0.3% Street Estimate: 0.2%0.0% Street Estimate: 0.2%6.35 mln.

0.6% 0.4% 2%

0.3% 0.2% 1%

0.0% 0.0% 0%

Source: Bureau of Labor Statistics Source: Bureau of Labor Statistics -0.3% Source: US Department of Commerce -0.2% -1% Jan-17 Apr-17 Jul-17 Oct-17 Jan-17 Apr-17 Jul-17 Oct-17 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17

Release: Retail Sales; ex-autos Release: EmpireLeading Economic State Index Indicators Release: ProducerExisting Home Prices Sales FD Date: 2/14/2018 Date: 2/15/20183/22/2007 Date: 2/15/20183/23/2007 Month: January Month: February Month: JanuaryFebruary Previous Report: 0.4% Previous Report: 17.70.1% Previous Report: -0.1%6.46 mln. Argus Estimate: 0.2% Argus Estimate: NA0.0% Argus Estimate: 0.3%6.50 mln. Street Estimate: 0.5% Street Estimate: 17.70.0% Street Estimate: 0.3%6.35 mln.

2% 30 1.0%

1% 20 0.5%

0% 10 0.0%

Source: US Department of Commerce Source: Federal Reserve Bank NY Source: Bureau of Labor Statistics -1% 0 -0.5% Jan-17 Apr-17 Jul-17 Oct-17 Feb-17 May-17 Aug-17 Nov-17 Jan-17 Apr-17 Jul-17 Oct-17

Release: Producer Prices FD-Ex-F&E Release: IndustrialLeading Economic Production Indicators Release: CapacityExisting HomeUtilization Sales Date: 2/15/2018 Date: 2/15/20183/22/2007 Date: 2/15/20183/23/2007 Month: January Month: JanuaryFebruary Month: JanuaryFebruary Previous Report: -0.1% Previous Report: 0.9%0.1% Previous Report: 77.9%6.46 mln. Argus Estimate: 0.2% Argus Estimate: 0.5%0.0% Argus Estimate: 78.0%6.50 mln. Street Estimate: 0.2% Street Estimate: 0.3%0.0% Street Estimate: 78.1%6.35 mln. 0.6% 2% 78%

0.3% 1% 77%

0.0% 0% 76%

Source: Federal Reserve BOG Source: Bureau of Labor Statistics Source: Federal Reserve BOG -0.3% -1% 75% Jan-17 Apr-17 Jul-17 Oct-17 Jan-17 Apr-17 Jul-17 Oct-17 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17

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

- Section 3 - ECONOMIC TRADING CALENDAR (CONT.)

Release: Import Prices Release: LeadingHousing Economic Starts Indicators Release: ExistingU. of Michigan Home Sentiment Sales Date: 2/16/2018 Date: 3/22/20072/16/2018 Date: 3/23/20072/16/2018 Month: January Month: FebruaryJanuary Month: February Previous Report: 0.1% Previous Report: 0.1%1,192 K Previous Report: 6.4695.7 mln. Argus Estimate: 0.0% Argus Estimate: 0.0%1,200 K Argus Estimate: 6.50NA mln. Street Estimate: 0.6% Street Estimate: 0.0%1,210 K Street Estimate: 6.35NA mln.

1% 1,300 K 105

100 0% 1,200 K

Source: Bureau of Labor Statistics Source: Department of Commerce Source: University of Michigan -1% 1,100 K 90 Jan-17 Apr-17 Jul-17 Oct-17 Jan-17 Apr-17 Jul-17 Oct-17 Feb-17 May-17 Aug-17 Nov-17

Previous Week's Releases Previous Argus Street Date Release Month Report Estimate Estimate Actual 5-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 Actual 21-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

- Section 3 - SPECIAL SITUATIONS & SCREENS

ARGUS RESEARCH RATING DISTRIBUTION MASTER LIST CHANGES

Rating Date 1000 Stock From To Change 900 919 Advanced Micro Devices Inc. AMD HOLD BUY 2/1/18 800 Mastercard Incorporated MA HOLD BUY 2/2/18 700 RECENT BUY UPGRADES 600 500 523 Stock Raised to BUY 400 Symbol On this date 300 Advanced Micro Devices Inc. AMD 2/1/18 Mastercard Incorporated MA 2/2/18 200 184 100 0 BUY HOLD SELL

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

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

A HOLD-rated stock is expected to perform in line with the S&P 500.

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

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