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Wedgewood Partners 3Q17 – The Bull Market in Everything; GOOGL, FAST, QCOM, PYPL, TSCO

Wedgewood Partners 3Q17 Letter: The Bull Market in Everything, October 2017

Review and Outlook

  • Gained 4.8% during 3Q17 vs. Russell 1000 Growth Index of 5.9% and S&P 500 of 4.5%
  • Significant driver of market’s advance has come from the remarkable run of technology companies, with Russell 1000 Growth averaging a roughly 37% weighting in Information Technology
    • Frustrated that far too many of our invested growth companies have not participated in the market’s relentless valuation march to new all-time highs
  • Stock market continues to march higher in truly historic fashion; 3Q17 represented the 19th positive quarter over the past 20; last negative quarter was 2 years ago when market suffered a -6.6% decline in 3Q15 (last double-digit correction was 6 years ago in 2011)
  • Since 1990, lowest 10 VIX readings out of the past lowest 20 have occurred just since this past May; current rally in the market without at least a -3% correction is the 2nd longest in stock market history
  • Great Bull Market of 2009-2017 continues to rack up new records or close in on historical records in terms of gain, duration, and lack of volatility

Alphabet

  • Continues to extend its lead, evidenced in its over 20% constant currency revenue growth for the June quarter, while generating 15% adjusted operating income growth
  • Traffic acquisition costs rose during the past few quarters but expect to moderate
  • One of the strongest balance sheets in Corporate America, with nearly $100bn in net cash and investments
  • On pace to generate $25bn/year in FCF along with a de minimis payout ratio
  • Expect the Company to eventually begin returning to shareholders which should benefit existing shareholders, as a new class of income-oriented investors is brought into the ownership fold
  • Though multiple has expanded quite a bit, still remains attractive particularly given its financial strength and continued high-teens revenue and profitability growth

Fastenal

  • ISM’s Purchasing Managers Index just hit a 6-year high in September, with the component of the index representing actual production hitting its highest level in 13 years
  • Fastenal’s results have moved from declining revenues and operating margins to double-digit % revenue growth and improving operating margins
  • Valuations are still near 2009’s recessionary lows; persistent noise about potential disruption to the industry from Amazon has weighed on the stock to some degree (Amazon is actually Fastenal’s largest vending customer)
  • Continue to view Fastenal as a high-quality growth business, benefitting from continuing long-term renaissance in US manufacturing and energy production, while gaining share in this highly fragmented industry from a variety of competitors who are unable to offer the services Fastenal provides

Qualcomm

  • Stock continues to be in lawsuit purgatory; a judge says AAPL doesn’t have to pay Qualcomm even though AAPL admits they owe Qualcomm at least $4 per phone; FTC says Qualcomm is violating antitrust even though the head of FTC admits Qualcomm isn’t violating antitrust
  • Apple is adamant about letting a judge decide on a fair price and Qualcomm is just as adamant that they will once again go to great lengths to defend what they believe is fair market price for their technology
  • Main position in holding the stock throughout this turmoil is that we cannot conceive that a US court would rule that a US company’s patent estate can be rendered virtually worthless
  • At current valuation, market has priced in either an onerous settlement with Apple or an onerous settlement that for all practical purposes emasculates Qualcomm’s cash-cow royalty business
    • Believe either extreme is unlikely and risk/reward for stock is significantly asymmetric to the upside, particularly in a world where NVidia and Broadcom sport market caps of over $100 billion, both on lower revenues and profits than Qualcomm
  • Believe that the market is giving little benefit for the earnings accretion of the planned year-end closing of their $47+bn acquisition of NXP Semiconductor

PayPal

  • Constant currency revenue growth, operating earnings, and EPS continue to grow at high-teens rates as core payment services gain relevance with a growing base of more than 15 million merchants and over 200 million users
  • Large-scale, two-sided platform is a unique value proposition to the payments industry, where competitors typically focus on either merchants or customers, but rarely integrate both at scale
  • Core value proposition is its ability to offer a turn-key payments platform that includes payment acceptance, processing, fraud detection, and an increasing array of financial services traditionally offered by banks, to merchants of any size
  • In the very early stages of adding substantial value to banks, via their recently signed partnership agreements with Visa and MasterCard
  • Disciplined value chain that is focused on procuring the natural operating leverage inherent to payments and prudently reinvesting it into large and growing addressable markets
  • Over the next few years, expect PayPal to monetize credit receivables portfolio and think it will begin to specify their strategy around their exclusivity agreement with eBay, which expires in few years
  • While PayPal sports one of the richest earnings multiples in the portfolio, think it has a multi-year potential for double-digit revenue and profit growth, which is rare for a business of PayPal’s size

Tractor Supply Company

  • Amazon’s retail business has been wildly successful in building revenues over the past 20 years and this has led them to a low-single-digit share of US retail
  • However, US retail market is a monstrous, and growing, multi-trillion-dollar opportunity, which leaves trillions of dollars of addressable market for everyone who is not Amazon
  • Tractor Supply’s strategy to remain relevant to their customers in the face of Amazon is a natural evolution for accompany that established its value proposition around the sides of Home Depot, Lowe’s, and Wal-Mart – which incidentally has roughly 5-6x domestic sales of Amazon
  • Believe Tractor Supply brings stores, service, and on-the-ground inventory to an underserved, rural customer base
  • Can continue to grow its store base over time while generating healthy, flat to improving returns, leading to mid-to-high-single-digit revenue growth and double-digit EPS growth

Image Source: Wedgewood Partners

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