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Wedgewood Partners 1Q17 Letter – Review/Outlook, AAPL, V, CLB, EW, ESRX, LKQ, MJN, PCLN, QCOM, SLB, TSCO

Wedgewood Partners 1Q17 Letter: Happy 8th Anniversary Mr. Market, April 2017

Review and Outlook

  • Gained 6.0% during 1Q17 compared to Russell 1000 Growth Index of 8.9%; S&P 500 gained 6.1% during the quarter
  • Top first quarter performance contributors included Priceline, Apple, Mead Johnson, TreeHouse Foods, and Visa
  • Top first quarter detractors included Schlumberger, Qualcomm, Berkshire Hathaway, Core Labs, and Tractor Supply Company
  • Trimmed positions in Apple, increased positions in Alphabet, TJX, PayPal, Qualcomm, and Tractor Supply, sold Mead Johnson and Express Scripts, and bought Edwards Lifesciences
  • The Great Bull Market of 2009-2017 continues to increase its rank in the pantheon of the great bull markets of all-time
    • March marked the 96th month of this Ruthian bull market
    • S&P 500 gained 260% since March 2009 bear market lows (Nasdaq 360%, Nasdaq 100 420%)
    • The other notable historic attribute has been the lack of downside volatility: last episode of volatility of any length occurred all the way back in fall of 2011
  • Wedgewood’s relative performance struggled since 2013 – since 2013:
    • While S&P 500 is up about 30%, stocks like Facebook, Amazon, and Microsoft have gained approximately 160%, 125%, 75%, respectively; biotech stocks surged 190% from 2013 through mid-2015
    • Our reticence to invest in these mentioned stocks over the past few years has been a combination of either challenging profitability or excessive valuation – we have invested in Amgen, Genentech, Gilead Sciences, Microsoft, Amazon, and came close to investing in Facebook on few occasions
  • Conservative, valuation-sensitive, defense-first investment philosophy was designed for all market conditions, both bull and bear markets
    • However, in a world of literally unlimited liquidity at an undemanding cost of capital, our investment strategy has been hand-cuffed
    • Expansion of central bank balance sheets, pre-Lehman, from $5 trillion to ~$20 trillion over the past decade has increased investor desire to chase yield in the stock market and to assume a risk-tolerance rarely seen
  • Since the stock market peak in late February, market has changed its tune on the “Trump trade”
    • Market expected sweeping, immediate legislative change from Trump and the Republican-controlled Congress but failure to replace and repeal ObamaCare cannot be expressed any other way than a defeat for Trump (and Wall Street too)
    • Prospects for legislation being enacted on healthcare, tax reform, and infrastructure before this year’s congressional August recess seems to grow slimmer by the day

Apple

  • Company’s iPhone franchise continues to dominate profitability share within the smartphone OEM market, after Samsung incurred sizable losses from a product recall
  • Continues its long history of maintaining a focused hardware portfolio while aggressively innovating its in-house software and services capabilities which enables the narrow hardware portfolio to act much wider
    • Revenue from software and services grew almost 20% to over $24B in 2016
    • Apple’s software and services revenue stream has a very attractive profitability profile that should help offset the financial ebbs and flows inherent in the Company’s well-established hardware product cycles
  • Exited the most recent quarter with a fortress-like balance sheet, a byproduct of their FCF generation of about $50B or more in each of the last 3 fiscal years
    • With pent-up demand for upcoming iPhone 8, FCF may challenge the previous fiscal high of nearly $70B generated in 2015

Core Labs

  • Oil service stocks corrected from recent January highs during the first quarter
  • Profit-taking was not too surprising after sharp stock price advances over the past year
    • An unusually weak seasonal refinery pause (winter maintenance)
    • Unusually large build-up of OPEC inventories before the commencement date of agreed-upon supply cuts
  • Our thesis continues to play out as expected: supply/demand continues to come into balance after the recent depression
    • Service activity is robust in North America; pricing inflation has snapped back after recent deflation; international spending remains at depressed levels
    • Net, net, OFS industry remains in the early innings of our expectation of a multi-year recovery
  • Think CLB is at the leading edge of a multi-year rebound in E&P capex spending cycle
    • Revenues are derived from providing high-return, niche products and services for E&P companies
    • Majority of revenues from Reservoir Description business which is focused on studying fluid and core samples from oil or gas field; this business tends to be much less cyclical compared to most of the industry
    • More activity driven business, Production Enhancement, grew 15% sequentially and has begun to see benefits of increased E&P spending
  • Expect Production Enhancement business to lead the return to growth in the short term while Reservoir Description business should drive growth longer-term, particularly as international E&P spending begins rebounding later this year and into 2018
  • Further Reading: David Einhorn’s Short Thesis on Core Laboratories

Edwards Lifesciences

  • Established a new position in Edwards Lifesciences in the first quarter
  • Pioneer in heart valve surgery, with nearly 90% of revenues tied to heart valve replacement, by virtue of its best in class portfolio of IP, backed by a relatively lengthy history of clinical data and successful outcomes
  • Heart disease is the world’s leading killer and incidence grows with age, meaning that aging of populations across the developed world is directly leading to a rise in the occurrence of heart problems
  • Over half of business is tied to the rapidly-growing TAVR, or Transcatheter Aortic Valve Replacement, category
    • View TAVR as clearly superior to traditional open-heart surgery
    • 2016 saw a surge in procedures as TAVR was approved for patients for whom surgery is an intermediate risk and clinical trials are underway to seek approval for low-risk patients as well
  • Clear market leader in the TAVR segment of the market and expect its TAVR solutions to continue to gain significant share industry-wide over time as the procedure spreads into the low-risk patient population and as industry invests in patient and physician education to expand the overall valve-replacement population
  • Valuation looks attractive in relation to peers and the broader market
    • Earnings slightly underperformed versus expectations
    • Temporary issue with France running out of money in its budget for TAVR reimbursement
  • Y-o-y growth of 30% globally and nearly 40% in the US – very attractive growth
  • Longer-term, attractive growth opportunity as aging populations lead to increasing heart disease and as TAVR takes share within the valve-replacement market

Express Scripts (Exited)

  • Company will be challenged to grow operating income beyond mid-to-low single digits as the market has matured over the past few years
  • There are multiple service providers Anthem believes are capable of taking on 250 million or more claims per year with minimal disruption – tacit evidence that rivals and substitutes have gained enough traction and scale to compete away excess economics
  • Remains the last independent, large scale PBM, which allows them to better align with customers but that novelty can be quickly copied by increasingly larger rivals
  • With a slower rate of earnings growth than we are willing to accept, decided to liquidate position

LKQ Corporation (Exited)

  • Continues to evolve away from what we were expecting in our original thesis
  • When initially purchased, derived substantial majority of its revenues from procuring and distributing aftermarket, and recycled/refurbished collision parts for automobiles
    • Attracted to the collision side of the business because it enjoys substantial financial and distributive support from P&C insurance industry which has a vested interest in driving a higher utilization of LKQ’s low cost, high-quality replacement parts
    • Prior to pro-competitive legislation enacted by EU in 2010, European collision aftermarket for automobiles was virtually non-existent; quite optimistic on expansion in European collision aftermarket
  • Over the past 3 years, continued to move away from the collision business, mostly through acquisition of mechanical aftermarket parts distributors in both Europe and US
    • This shift required quite a bit of capital – having accrued over $3B in debt on less than $1B of EBITDA
  • Has amassed unique scale and fulfillment capabilities in their US collision business but would prefer to invest in companies that allocate towards defending and growing their core competencies

Mead Johnson (Exited)

  • Exited after we determined the growth and competitive positioning of the business would be challenged for the next several years; also, Company reached an agreement to be acquired by the European CPG firm, Reckitt Benckiser
  • Substantial portion of growth is derived from China where a confluence of factors have blunted the competitive advantage
    • Barriers to entry have fallen: has a well-established position in traditional distribution channels but emerging e-commerce channel has facilitated a booming “gray” market
    • China has become much less hospitable from a competitive standpoint

Priceline Group

  • Top contributor as they continue to execute their strategy of connecting the supply of heavily fragmented, independent hospitality providers with demand from the Company’s rapidly expanding user base
  • Online travel agency market in the US has matured but there remains a sizable addressable international market in which Priceline continues to aggressively reinvest in organic growth opportunities
  • Priceline’s Booking.com site has amassed listings on over 500,000 alternative properties
  • Believe value proposition of renting a private residence is still substantially different from traditional hospitality services and represents an incremental revenue opportunity for Booking.com
  • Multiple on the stock has expanded over the past few quarter but continue to view Priceline’s valuation as one of the more attractive multiples in our universe

Qualcomm

  • Worst relative performer during the quarter
  • Suffered sharp profit-taking following Apple’s lawsuit filed in February
  • FTC alleged that Qualcomm used its unfair supplier of smartphone modems to demand higher patent payments; Apple was specifically called out for allegedly entering into an exclusivity deal with Qualcomm in order to avoid its onerous terms
  • While we own both Apple and Qualcomm, we come down on the side that Qualcomm deserves to charge its current IP royalty rates given that they have been the mobile industry’s de facto R&D arm
  • In our view, stock fell too sharply and embeds a far too onerous settlement with AAPL – on the share price weakness, added to our position in mid-to-late February

Schlumberger

  • Schlumberger is less focused on North America, relative to rest of OFS industry and more focused on international E&P clients (particularly national oil companies)
  • Portfolio of vertically integrated assets increasingly allows the Company to become more entrenched with their NOC clients – increasingly, Company is managing entire oilfields in exchange for performance incentives that result from increased production

Tractor Supply Company

  • One of the largest detractors from 1Q17 performance
  • Both the Q4 spike and Q1 decline can be attributed to political and energy-related noise, with the stock correctly viewed as a potential beneficiary from a possible reduction in corporate tax rates and a recovery in US energy production
  • Would be perfectly happy to see a lower tax rate but that is not a tenet of our long-term thesis
  • See clear indications that US production activity has moved positively and expect exposure to energy-producing regions to benefit from recovery for the foreseeable future

Visa

  • Constant-dollar payment volume growth and cross border volume growth continued accelerating across several key markets as Visa has gained share, which helped Company post adjusted EPS growth of 23%
  • Recent acquisition of Visa Europe should provide Company with continued opportunities for growth (both cost savings and revenue)
  • Several European markets have card payment share that remains significantly under-penetrated relative to cash when compared to the US – shift towards e-commerce should continue to aid Visa’s value proposition
  • Maintains a conservative balance sheet, with substantial amount of offshore cash, and valuation continues to be attractive, especially relative to high-teen growth profile for the next several years
Image Source: Wedgewood Partners 1Q17 Letter, Compustat, FactSet, IBES, S&P, JP Morgan
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