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Research Highlights

A weekly summary of our Best Ideas and developments within our coverage universe

U.K. Capacity Auction Postpartum: EDF's Moat Shines


31 January 2015 6 February 2015

2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc.
Reproduction or transcription by any means, in whole or part, without the prior written consent of Morningstar, Inc., is prohibited.

Contents

Research Highlights ...................................................................................................3


U.K. Capacity Auction Postpartum: EDF's Moat Shines
AWS-3 Auction Demonstrates the Limits of Wireless Carrier Moats
Hong Kong Exchanges and Clearing: an Update on Shanghai Hong Kong Stock Connect
Best Ideas ..................................................................................................................7
Highlighted Stocks ...................................................................................................10
Apollo Global Management LLC APO
Petroleo Brasileiro SA Petrobras PBR
Gap Inc. GPS
All market data as of Feb. 5, 2015.

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Research Highlights

U.K. Capacity Auction Postpartum: EDF's Moat Shines


The U.K. government recently approved the results of its inaugural electric capacity auction.
These results confirmed the key analysis presented in our Utilities Observer, "Europe's Power
Plates Are Spinning," published in October 2014. The market power and cost advantage
supporting a moat for Electricite de France's generation in the U.K. drove outperformance in the
auction and brings significant incremental cash flow for EDF's investors. EDF secured
EUR 318 million in new pretax margin for 2018 and won a 25% share of awarded contracts
while only one competing new build gas plant cleared the auction, confirming our analysis.
Among European diversified utilities, we think EDF offers the best combination of valuation,
yield, and dividend stability, with modest growth during the next three to five years for patient
investors in the downtrodden space. Other diversifieds have more upside to power prices and
similar competitive advantages, but none has EDF's cash-flow consistency and near-term
visibility to support a narrow economic moat and a strong dividend with a 5.1% current yield.
EDF stands head and shoulders above peers in upside potential from new European capacity
markets, as the inaugural U.K. capacity auction clearly demonstrated. EDF also could realize
significant incremental value from newbuild nuclear in the U.K.
Key Takeaways
Capacity results: As we detailed in the Utilities Observer, "Europe's Power Plates Are
Spinning," the advent of capacity markets can lift all European generators' finances.
The U.K. results and application to moats in the sector highlights EDF's
superior position.

EDF is trading at a 15% discount to our EUR 28 per share fair value estimate. The
firm's narrow moat and more-regulated cash flows provide more stability than its
diversified European peers. Upside to new nuclear development and new European
capacity markets also trump peers', demonstrated in the first U.K. auction results.

Risks to EDF's equity include U.K. retail margin erosion, French government policy
changes, legal threats to Hinckley Point, and value-dilutive asset swapping. We don't
think any are severe enough to force a dividend cut anytime soon.

For further information, please contact:


Mark Barnett | +1 312-696-6603 | mark.barnett@morningstar.com

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Research Highlights

AWS-3 Auction Demonstrates the Limits of Wireless Carrier Moats


The AWS-3 auction clearly demonstrated the moat-limiting impact that government control of
spectrum has on the wireless industry (which we explored in detail in our "Technology
Observer: All Wireless Spectrum Isn't Created Equal: Some Holdings Protect Moats, but
Overvaluation Will Ultimately Limit Returns," published Nov. 18, 2014). We believe auction
prices are difficult to justify in light of current industry conditions. We view this outcome as the
result of one bidder (DISH Network) attempting to increase spectrum scarcity to drive up the
value of its existing holdings, set against the belief among existing carriers that certain licenses
are strategic necessities at almost any price.
After parsing the winning bids, we believe Verizon was the relative winner, generally limiting its
bidding to strategically critical markets, given its existing AWS-1 holdings and fixed-line assets.
T-Mobile also came out looking good, in our view, limiting its bids to a small number of licenses
and saving itself for low-frequency opportunities next year. We're leaving our fair value
estimates unchanged for both. We suspect that AT&T has destroyed value with its bidding
strategy, apparently determined to claim at least 20 MHz of spectrum in all major markets
regardless of cost. We've lowered our AT&T fair value estimate to $32 per share from $34 as a
result. However, AT&T's ability to secure spectrum at a high cost without completely destroying
the economics of its business reflects its scale advantage.
We continue to believe DISH Network faces a challenging road in finding an economical use for
its spectrum holdings. Its previous spectrum plays were savvy, in our view, buying up licenses
on the cheap and using elbow grease to increase their value. Buying spectrum at auction,
especially at high prices, is another matter entirely. We don't believe DISH can credibly threaten
to enter the wireless business, and we suspect that the existing carriers will now turn their
attention to the broadcast auction.
(continued on next page)

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Research Highlights

We can't deny that the values achieved in the AWS-3 auction raise the probability that one of
the carriers will look to acquire DISH's spectrum. We've raised our DISH fair value estimate to
$50 per share from $40. However, we still believe DISH faces a tough hurdle with the buildout
requirements on its AWS-4 holdings. A heavy dose of leverage now adds to the time pressures
the firm may face in the near future. We suggest investors avoid DISH shares at current prices
and instead wait for spectrum values (and DISH's share price) to retreat and/or see how the
firm's wireless strategy shakes out.
For further information, please contact:
Michael Hodel, CFA | +1 312-696-6578 | michael.hodel@morningstar.com

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Research Highlights

Hong Kong Exchanges and Clearing: an Update on Shanghai Hong Kong Stock
Connect
Shanghai-Hong Kong Stock Connect launched on Nov. 17, 2014. While trading volume on the
scheme is much lower than anticipated because of compliance issues, we believe it is a longterm positive for wide moat-rated Hong Kong Exchanges and Clearing. The scope of the
scheme can be expanded by increasing the quota under the scheme and widening the
tradeable universe of investment products, and a link with the Shenzhen Stock Exchange is also
likely. Hong Kong Exchanges and Clearing will benefit from higher trading and clearing revenue,
but the upside, in our view, is priced into the current share price.
Key Takeaways
We believe the low trading volume is attributable to low participation by institutional funds,
as a result of compliance issues and a lack of investment education for retail investors. The
latter is also hampered by attractive returns offered by non-listed investment products in
mainland China, along with an implicit guarantee on the principal as the government steps
in to prevent a default situation.

Trading volume should increase over the longer term as mainland investors' market
knowledge matures, returns on trust products decline, the investable universe widens and
more investment products are included in the scheme.

Shanghai-Hong Kong Stock Connect is a first step in the liberalization of the mainland
Chinese market, in our opinion. The next phases of liberalization would see an expansion in
the quota set at the launch of the scheme, an expansion into companies with smaller
capitalization and a possible link to the Shenzhen Stock Exchange.

We believe Hong Kong Exchanges and Clearing is overvalued. Shanghai Hong Kong Stock
Connect is off to a slow start and contribution to earnings is low. While the underlying
trading volume on the exchange improved in the second half of fiscal 2014, we believe an
improvement over the longer term is priced into the current share price.

For further information, please contact:


Michael Wu | +852 2973-4688 | michael.wu@morningstar.com

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Best Ideas

Fair
Value

Price/
Fair
Value

Market
Cap

Economic
Moat
Rating

Uncertainty
Rating

Morningstar
Rating

0.78

5.67

None

High

QQQQ

40

0.79

167.96

Narrow

Medium

QQQQ

2,175

0.69

80.12

Narrow

Medium

QQQQ

62

0.77

15.19

Narrow

Medium

QQQQ

36

0.48

0.74

Narrow

High

QQQQQ

Rohr,
Daniel

400

0.93

173.63

Wide

High

QQQ

Hottovy,
R.J.

19

0.74

10.26

Narrow

High

QQQQ

Han, Brian

48

0.86

17.58

Narrow

Medium

QQQQ

Weishaar,
Bridget

36.25

48

0.76

58.38

None

High

QQQQ

Whiston,
David

338.00

430

0.79

7.94

Narrow

Medium

QQQQ

Gorham,
Philip

147.94

169

0.88

9.82

Wide

High

QQQ

Katz,
Jaime

1,044.60

1,822

0.57

54.69

Narrow

High

QQQQQ

Wasiolek,
Dan

527.50

550

0.96

3.73

Narrow

Medium

QQQ

403.20

565

0.71

22.44

Wide

High

QQQQ

19

0.93

275.84

Wide

High

QQQ

Price

Analyst

Basic Materials
Alumina Ltd
2.02
(AWC)
BHP Billiton
31.55
Ltd (BHP)
BHP Billiton
1,505.00
PLC (BLT)
Nucor Corp
47.63
(NUE)
Rayonier
Advanced
17.29
Materials Inc.
(RYAM)
Consumer Cyclical
Amazon.com
373.89
Inc (AMZN)
Crown Resorts
14.09
Ltd (CWN)
Fiat Chrysler
Automobiles
41.50
NV (FCAU)
Gap Inc (GPS)
General
Motors Co
(GM)
Kingfisher PLC
(KGF)
Priceline
Group Inc
(PCLN)
REXAM PLC
(REX)
Swatch Group
AG (UHR)

Taylor,
Mark
Taylor,
Mark
Taylor,
Mark
Lane,
Andrew

Wenning,
Todd
Swinand,
Paul

Consumer Defensive
Ambev SA
(ABEV3)

17.60

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Gorham,
Philip

Best Ideas

Price

Fair
Value

Price/
Fair
Value

Market
Cap

Economic
Moat
Rating

Uncertainty
Rating

Morningstar
Rating

BG Group PLC
(BG.)

934.90

1,400

0.67

31.92

Narrow

Medium

QQQQQ

BP PLC (BP)

41.38

54

0.77

126.29

Narrow

Medium

QQQQ

26.66

46

0.58

11.01

Narrow

High

QQQQQ

Hanson,
Mark

13.80

22

0.63

10.23

Narrow

High

QQQQ

Meats,
David

7.11

21

0.34

46.37

None

Very High

QQQQQ

Good,
Allen

8.10

18

0.45

7.92

Narrow

High

QQQQQ

Taylor,
Mark

24.55

40

0.61

9.47

Narrow

High

QQQQ

Ellis,
Stephen

34.90

39

0.89

96.53

Wide

Medium

QQQQ

Ellis, David

4.88

0.65

36.85

Narrow

High

QQQQ

Puls,
Timothy

15.97

18

0.89

167.95

Narrow

High

QQQ

Sinegal,
Jim

75.78

93

0.81

42.13

Narrow

Medium

QQQQ

Werner,
Dan

38.93

45

0.87

16.77

Narrow

Medium

QQQQ

Warren,
Greggory

75.81

94

0.81

54.11

Narrow

High

QQQQ

Davis, Erin

Analyst

Energy

Cabot Oil &


Gas Corp
(COG)
Encana Corp
(ECA)
Petroleo
Brasileiro SA
Petrobras
(PBR)
Santos Ltd
(STO)
Financial Services
Apollo Global
Management
LLC (APO)
Australia and
New Zealand
Banking Group
Ltd (ANZ)
Banco
Santander
Brasil SA/Brazil
(BSBR)
Bank of
America
Corporation
(BAC)
Capital One
Financial Corp
(COF)
Invesco Ltd
(IVZ)
Lloyds Banking
Group PLC
(LLOY)

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Good,
Allen
Simko,
Stephen

Best Ideas

Price/
Fair
Value

Market
Cap

Economic
Moat
Rating

Uncertainty
Rating

Morningstar
Rating

Price

Fair
Value

274.67

330

0.83

72.80

Wide

Low

QQQQ

Waterhouse,
Michael

71.36

84

0.85

38.68

Wide

Low

QQQQ

Andersen,
Karen

52.45

57

0.92

10.88

Narrow

Medium

QQQ

87.90

95

0.93

33.52

Wide

Medium

QQQ

194.51

220

0.88

27.62

Narrow

High

QQQ

85.00

91

0.93

112.27

Wide

Medium

QQQ

43.64

53

0.82

4.01

None

High

QQQQ

54.50

53

1.03

6.11

Narrow

High

QQQ

63.69

75

0.85

105.06

Wide

Medium

QQQQ

21.00

28

0.75

8.18

None

High

QQQQ

37.03

41

0.90

31.83

Wide

Medium

QQQ

Analyst

Health Care
Actavis PLC
(ACT)
Baxter
International
Inc (BAX)
Catamaran
Corp (CTRX)
Elekta AB
(EKTA B)
Illumina Inc
(ILMN)
Sanofi (SAN)

Lekraj,
Vishnu
Morozov,
Alex
Waterhouse,
Michael
Conover,
Damien

Industrials
AGCO Corp
(AGCO)
MSCI Inc
(MSCI)
Technology
Qualcomm Inc
(QCOM)
Utilities
Calpine Corp
(CPN)
Exelon Corp
(EXC)

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Webb,
Kwame
Wahlstrom,
Peter
Colello,
Brian
Bischof,
Andrew
Miller,
Travis

Highlighted Stocks

Apollo Global Management LLC APO


Morningstar
Rating
QQQQ

Industry
Asset Management

Market Cap Market Fair


(USD Bil.) Price Value
9.47
24.55 40

Price/Fair
Value
0.61

Fair Value
Uncertainty
High

Economic
Moat Rating
Narrow

In our opinion, Apollo remains deeply undervalued, as investors do not appreciate the healthy
secular tailwinds toward increased allocations to alternative asset managers by institutional
investors, the higher levels of profitability versus traditional asset managers, and Apollo's
opportunity to potentially nearly triple credit AUM to $250 billion from $108 billion today.
Analyst Note as of 05 Feb 2015:
Apollo's fourth-quarter results were mixed, as it lapped a strong incentive fee performance from
2013, which caused significant year-over-year declines in economic net income. However, we
plan to maintain our $40 fair value estimate and narrow moat rating, as we consider Apollo's
2015 outlook to be healthier. We believe the current dislocation in the energy markets and the
continued challenges with credit, particularly European credit, play to Apollo's strengths, and
Apollo should be able to take advantage of solid investing opportunities going forward. In our
opinion, Apollo remains deeply undervalued, as investors do not appreciate the healthy secular
tailwinds toward increased allocations to alternative asset managers by institutional investors,
the higher levels of profitability versus traditional asset managers, and Apollo's opportunity to
potentially nearly triple credit AUM to $250 billion from $108 billion today.
Apollo's quarterly results were generally weak. Total economic net income was $93.8 million
versus $444.0 million last year, thanks primarily to a decline in incentive fee income, particularly
within private equity. Apollo's private equity funds were up less than 1% during the quarter.
Total AUM declined to $159.8 billion from $163.9 billion over the same time frame due to
$5.7 billion in realizations that was only somewhat offset by capital inflows. We anticipate
better performance on this front, as we expect Apollo to raise new energy and credit funds in
2015 to supplement its $33 billion in uncalled capital commitments. Distributable net income
was $1.4 billion for 2014 versus $1.8 billion in 2013, thanks again to lower incentive income.
(continued on next page)

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

10

Highlighted Stocks

Valuation as of 06 Oct 2014:


We're maintaining our fair value estimate at $40 per unit. Our fair value estimate implies a 2015
price/economic net income multiple (the industry's preferred metric) of 13 times and a dividend
yield of 6.0%. On a distributable earnings basis, which is our preferred metric because it
removes the effects of unrealized incentive income and is closer to cash earnings, we value
Apollo at 14 times our 2015 forecast. We're fans of the attractive nature of the alternative
asset manager business model versus traditional asset managers. The alternative asset
manager model includes higher profitability and secular tailwinds (increasing allocations from
institutions), and we could see multiple expansion over time as investors obtain greater levels
of comfort with the lumpier, but recurring, nature of performance fees over long time horizons.
That said, we expect that the industry's use of the partnership rather than the traditional
corporate structure means that the alternative asset managers will still trade at a discount to
their traditional peers, probably because of potential tax ramifications, thanks to the industry's
use of K-1s, which create tax complexity, and the carried interest tax issue. We also assume
that carried interest tax reform eventually passes in some fashion and our long-term tax rate is
35%, but we do not see any near-term threats to the industry at this stage.
We expect results to weaken from 2013 levels, as Apollo will find it impossible, in our view, to
replicate the success both of 2013's LyondellBasell profits and the close of its Fund VIII.
Accordingly, we expect fee-earning AUM levels around $133 billion in 2014, economic net
income of about $1.1 billion (distributable income is similar), and earnings per unit of $2.66.
Beyond 2014, we expect modest earnings and AUM growth driven mainly by healthy markets,
Apollo's strong reputation, and continued solid fund performance. That said, if Apollo and
Athene continued to make aggressive acquisitions of credit-related AUM, our forecasts could
prove conservative. In 2017, we project total AUM at $201 billion, economic net income of
$2.0 billion, distributable earnings of $1.8 billion, and economic net income per unit of
about $4.92.
Analyst:
Stephen Ellis | +1 312-384-4851 | stephen.ellis@morningstar.com

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

11

Highlighted Stocks

Petroleo Brasileiro SA Petrobras PBR


Morningstar
Rating
QQQQQ

Market Cap Market


Industry
(USD Bil.) Price
Oil & Gas Integrated 46.37
7.11

Fair
Value
21

Price/Fair
Value
0.34

Fair Value
Uncertainty
Very High

Economic
Moat Rating
None

Though expensive based on its forward multiple, Petrobras trades at a steep discount to our
discounted cash flow-derived fair value estimate. While fraught with risks, Petrobras' shares are
compelling below our Consider Buying price, as improving upstream operations in 2014 and the
eventual waning of downstream losses mean the worst is probably over. However, the
uncertainty surrounding the corruption investigation will likely act as a headwind to near-term
share price appreciation. As a result, we are increasing our uncertainty rating to very high
from high.
Analyst Note as of 04 Feb 2015:
Petrobras announced Wednesday the departure of CEO Maria das Gracas Foster and five
executive board members, confirming press reports from the day before. While she had
reportedly offered her resignation to Brazilian president Dilma Rousseff several times in the past
few months, it was not accepted. The inability to finalize an impairment charge related to the
corruption scandal and issue audited results may have been the final straw, however.
We initially were impressed by Foster when she took the reins in 2012 and slashed unrealistic
production targets and focused on cutting costs and investment levels. However, her tenure
since has been marred by continued government influence, downstream losses, and most
recently the corruption scandal, which resulted in a cratering stock price.
We think her resignation could be a step in the right direction to restore market confidence. But
whether it does ultimately depends on her successor and his or her ability to deliver audited
financial statements. Our preference is for a respected industry veteran, but with the
government making the decision, the new CEO is just as likely to be a politically connected
bureaucrat. We'd find the latter a disappointment and doubt it would be well received by the
market. If the government is serious about moving beyond the corruption scandal and past
operational issues, we suggest it go with the former.
(continued on next page)

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

12

Highlighted Stocks

We are not changing our fair value estimate because of this announcement but continue to
update our forecast based on recently issued guidance. Our moat rating is unchanged. As
demonstrated by today's announcement, Petrobras will continue to command its share of
headlines, positive and negative. However, we still see the shares as materially undervalued
based on improving operating performance.
Valuation as of 18 Nov 2014:
We are lowering our fair value estimate to $21 per ADR from $23 after updating our forecasts
with lower oil prices and a weaker domestic currency. Our fair value estimate implies an
enterprise value/EBITDA multiple of 7.3 times our 2015 EBITDA forecast of $36 billion. Though
expensive based on its forward multiple, Petrobras trades at a steep discount to our discounted
cash flow-derived fair value estimate. While fraught with risks, Petrobras' shares are compelling
below our Consider Buying price, as improving upstream operations in 2014 and the eventual
waning of downstream losses mean the worst is probably over. However, the uncertainty
surrounding the corruption investigation will likely act as a headwind to near-term share price
appreciation. As a result, we are increasing our uncertainty rating to very high from high.
After slightly lower domestic oil production in 2013, we expect steady growth of 3%-5% in
2014-16, slightly below management's guidance of 4%-6%. The latest guidance for 2014
production growth is 5.5%-6%, a decrease from 7.5%. Domestic natural gas volumes should
see growth as well, as infrastructure is added to send gas onshore. We think Petrobras' latest
long-term production forecast is more realistic compared with earlier years, but we continue to
risk its targets to arrive at our forecast.
We forecast the refining segment could actually be profitable over the next couple of years if
lower prices hold and the domestic currency strengthens from current levels. Otherwise losses
through are likely to persist for several more years given the gap between domestic and
international prices. While lower oil prices benefits the downstream segment, they reduce
upstream earnings and vice versa, with gains or losses in one segment largely offsetting
the other.
(continued on next page)

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

13

Highlighted Stocks

In our discounted cash flow model, our benchmark Brent oil prices are based on Nymex futures
contracts for 2014-16. For oil, we use $103 per barrel in 2014, $82 in 2015, and $86 in 2016.
Our long-term oil price forecast for 2017-18 is $100. Our DCF valuation uses a cost of equity
of 12%.
Analyst:
Allen Good, CFA | +1 312-384-3867 | allen.good@morningstar.com

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

14

Highlighted Stocks

Gap Inc. GPS


Morningstar
Rating
QQQQ

Industry
Retail Apparel &
Specialty

Market Cap Market


(USD Bil.)
Price

Fair
Value

Price/Fair
Value

Fair Value
Uncertainty

Economic
Moat Rating

17.58

48

0.86

Medium

Narrow

41.50

We are maintaining our narrow moat, positive moat trend rating, but are closely monitoring our
standard stewardship rating in light of what we perceive to be strong strategic and fast-paced
organizational and operational changes. Further prudent capital decisions by new Gap
leadership could result in an increase to this stewardship rating. With the stock trading 14%
below our fair value estimate, Gap remains one of our favorite ideas in the consumer cyclical
space with what we perceive to be an underappreciated margin expansion story driven by rapid
response initiatives and an undervalued asset in the Athleta brand.
Analyst Note as of 29 Jan 2015:
On the heels of the announcement of two senior executive leadership changes and the closure
of Piperlime all in the space of about two months, Gap management announced today that it
has appointed Scott Key as senior vice president and general manager of Customer Experience
and will be eliminating the Creative Director role of Gap, resulting in Rebekka Bay's departure.
We think this announcement is further evidence of management's commitment to right the
fashion and marketing problems of the Gap brand and that management will exercise little
patience in the process. We are maintaining our narrow moat, positive moat trend rating, but
are closely monitoring our standard stewardship rating in light of what we perceive to be strong
strategic and fast-paced organizational and operational changes. Further prudent capital
decisions by new Gap leadership could result in an increase to this stewardship rating. With the
stock trading 14% below our fair value estimate, Gap remains one of our favorite ideas in the
consumer cyclical space with what we perceive to be an underappreciated margin expansion
story driven by rapid response initiatives and an undervalued asset in the Athleta brand.
We think both of the organizational changes announced today are strategically sound. Scott
Key's new position unites the e-commerce and marketing organization which we believe will
provide a more consistent message and customer experience across channels. Furthermore,
we have seen little in the way of product improvement at Gap and agree that it is time for a
(continued on next page)

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

15

Highlighted Stocks

fresh creative vision. Overall, we think that new management has brought an excitement and
focus on execution that was needed as new technologies and innovations are rolled out and
believe that Art Peck and his team are the right people for the job.
Valuation as of 25 Nov 2014:
We are maintaining our fair value estimate of $48 as we see weakness in the core Gap brand
pressuring near-term performance and the transition to a new CEO to increasing short-term
volatility. That said, we continue to like the long-term story and we see operating margin
expansion as the main driver of valuation as Gap has invested heavily in technology and supply
chain systems which we believe can narrow the margin disparity between Gap and its global
fast-fashion competitors. In our model, we think Gap can reach an operating margin of 15.4% in
five years from 13.3% currently. This is still well below the high-teens margins of fast-fashion
competitors. This reflects our belief that the company is successfully executing on its
responsive supply chain, omnichannel, and seamless inventory initiatives as evidenced by its
work on fabric platforming, reserve in store, and order in store.
In 2014, we are modeling 1% revenue growth and expect the operating margin to decline to
12.5% from 13.3% in 2013. We think poor merchandising (product was too spring-forward) and
heavy inventory levels weighed on first-half results. In our opinion, products at the core Gap
brand remain uninspiring and the new ad campaign from Wieden+Kennedy appears to be
failing to resonate with consumers. We expect discounting to weigh on 2014 margins.
However, we are encouraged that Banana Republic is showing some signs of a turnaround with
improved marketing and more contemporary merchandising. Ultimately we see full year top-line
growth driven by a 1% decline in comparable sales and a 3% increase in store count.
Over the next five years, we expect 3% average annual revenue growth driven by 1%
comparable sales growth on average and 3% new store growth weighted toward factory
stores, Asia expansion, and franchises. We think operating margins will expand from 13.3% in
2013 to 15.4% in 2018 (7% average annual operating income growth) on improved
responsiveness and supply chain management. We note that this is still below average high
teen margins at H&M and Inditex.
Analyst:
Bridget Weishaar | +1 312-384-5485 | bridget.weishaar@morningstar.com

Morningstar Equity Research Highlights | 31 January 2015 06 February 2015


2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original
distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written
permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

16