Argus Market Digest€¦ · Good Morning. This is the Market Digest for Monday, August 28, 2017,...

MARKET DIGEST

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MONDAY, AUGUST 28, 2017AUGUST 25, DJIA 21,813.67

UP 30.27

Good Morning. This is the Market Digest for Monday, August 28, 2017, with analysis of the financial markets and comments onKimco Realty Corp., Air Products & Chemicals Inc., Broadcom Ltd., Brocade Communications Systems Inc., ColfaxCorp., Equifax Inc., Splunk Inc., Stryker Corp., Time Warner Inc., Under Armour Inc., New Jersey Resources Corp. andOGE Energy Corp.

IN THIS ISSUE:* Change in Rating: Kimco Realty Corp.: Downgrading to HOLD on weak near-term outlook (Jacob Kilstein)

* Growth Stock: Air Products & Chemicals Inc.: Boosting target by $6 to $165 (Bill Selesky)

* Growth Stock: Broadcom Ltd.: Exceptional growth continues; reiterating target of $275 (Jim Kelleher)

* Growth Stock: Brocade Communications Systems Inc.: Final regulatory approval advances acquisition outlook(Jim Kelleher)

* Growth Stock: Colfax Corp.: Recent weakness offers buying opportunity (John Eade)

* Growth Stock: Equifax Inc.: Maintaining BUY as margins expand (Jasper Hellweg)

* Growth Stock: Splunk Inc.: Solid growth prospects for tech startup (Joseph Bonner)

* Growth Stock: Stryker Corp.: Selloff overdone; reaffirming $160 target (David Toung)

* Growth Stock: Time Warner Inc.: Mixed 2Q17; reiterating BUY (Joseph Bonner)

* Growth Stock: Under Armour Inc.: Stock fully valued; maintaining HOLD (John Staszak)

* UtilityScope: New Jersey Resources Corp.: Raising target price by $3 to $49 (Gary Hovis)

* UtilityScope: OGE Energy Corp.: Despite strong 2Q17 EPS, reiterating HOLD on valuation (Gary Hovis)

MARKET REVIEW:In light late-summer trading volume, stocks closed mixed on Friday, with the Dow Jones Industrial Average rising 0.1%,

the S&P 500 adding 0.2%, but the Nasdaq Composite declining 0.1%. For the week, however, stocks broke a two-week losingstreak, with gains of 0.8% for the Nasdaq, 0.7% for the S&P 500 and 0.6% for the Dow. Year-to-date gains are now 16.4% forthe Nasdaq, 10.4% for the Dow and 9.1% for the S&P 500.

The 10-year Treasury yield ended the week at 2.17%, down from 2.20% the prior week. Yields have been in retreat sincemid-July and are now near their lows for the year. At an annual Jackson Hole, WY, conference, comments by Federal ReserveChair Janet Yellen focused more on regulation than interest rate policy. Investors are now more concentrated on the Fed’s balancesheet unwinding, expected to begin in September, rather than the next interest rate hike, where expectations have been pushed to2018. Lower U.S. yields, subdued inflation readings, and stronger European currencies due to an expected moderation inquantitative easing by the European Central Bank, have also taken a toll on the U.S. Dollar (DXY), which continued its descentlast week, finishing down 1.0%. The DXY has now fallen 9.6% year-to-date, and could provide an unexpected benefit to the profitsof U.S. multinationals.

Meanwhile, the USD returns of almost all major countries have benefitted from strong gains in their currencies.Generally, the superior returns of foreign markets have come from currency appreciation - in many cases the local currency stockreturns have been modest or even negative. Despite double-digit gains, U.S. stocks have lagged the global benchmarks over thepast year and year to date. For asset allocation purposes, we continue to prefer emerging over developed markets, as stronger globalgrowth boosts trade and emerging market earnings, and U.S. interest rates remain low. We also see opportunities in Swiss, German,U.K. and Australian markets, all with strong PMIs, EPS and still-competitive currencies, even after recent rises.

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1934 - DJIA: 104.04

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MARKET DIGEST

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Looking at Argus market indicators, our technical composite had a strong week as NYSE breadth bounced back froma late July/early August slump on a recovery in stocks above their 150-day moving average and good gains in net advance/declines(both issue and volume). The CBOE trading index was little changed as improving S&P VIX and NYSE TRIN (which comparesadvancing/declining stock issues and trading volume) was offset by weakness in Nasdaq TRIN. Our strategic composite also foundsupport above the 2Q lows, with market internals improving on relative strength in small-caps, Energy and Materials sectors, aswell as selling in Consumer Staples. External indicators had a small gain on relative strength in emerging vs. developed marketstocks, with some weakness in international vs. U.S. Treasuries. Composite technicals still remain in neutral/negative territory,while composite strategic indicators are neutral.

In this week’s busy economic calendar, international trade in goods for July will be released on Monday. Tuesday bringsthe S&P Corelogic Case-Shiller home price index for June and consumer confidence for August. On Wednesday, the ADPEmployment Report for August and the second estimate for 2Q GDP will be released. Thursday will bring personal income andoutlays and the pending home sales index for July, as well as the Chicago PMI for August. On Friday, construction spending forJuly will be announced, as well as motor vehicle sales, the PMI manufacturing index, the ISM manufacturing index, and non-farmpayrolls for August.

Last week, Argus analysts upgraded NetApp Inc. (NTAP), Estee Lauder Companies (EL), and Vornado Realty Trust(VNO) to BUY from HOLD, and downgraded Mylan N.V. (MYL) and Domino’s Pizza (DPZ) to HOLD from BUY. They alsoinitiated coverage of Baker Hughes a GE Company (BHGE), formed from the merger of Baker Hughes Inc. and General Electric’soil and gas business in July 2017, with a BUY rating. The average stock in the Argus universe gained 1.0% last week. The largestpercentage gainers were Abercrombie & Fitch (ANF; SELL; +30.0%), Tesaro Inc. (TSRO; BUY; +15.9%) and Chicago Bridge& Iron (CBI; HOLD; +12.4%), while the largest percentage decliners were Foot Locker (FL; HOLD; -24.8%), Ethan AllenInteriors (ETH; HOLD; -7.5%), and Deere & Co. (DE; BUY; -6.6%). (Stephen Biggar)

MARKET DIGEST

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KIMCO REALTY CORP. (NYSE: KIM, $19.85) ..................................................................... HOLD

KIM: Downgrading to HOLD on weak near-term outlook

* Our downgrade reflects the 15% run-up in the KIM stock price since June, ongoing challenges in the retail sector,and Amazon’s purchase of major tenant Whole Foods, which may reduce margins going forward.

* We note that KIM shares fell 5% on June 16 following the announcement of the Amazon/Whole Foods deal, and4% on August 24 when Amazon announced price cuts at Whole Foods stores. We believe that the shares couldfall further as Amazon continues to make changes at Whole Foods.

* We are also concerned about the impact of rising interest rates, which have made bond yields more attractive thanthe yields of Kimco and other REITs.

* KIM shares are trading at 12.9-times our 2017 AFFO estimate, below the peer median of 13.3 and toward the lowend of the five-year range of 11.6-21.6; however, we believe that the low valuation is appropriate given thecompany’s current challenges.

ANALYSISINVESTMENT THESISWe are lowering our rating on Kimco Realty Corp. (NYSE: KIM) to HOLD from BUY, reflecting the 15% run-up in

the stock price since June, ongoing challenges in the retail sector, and Amazon’s purchase of major tenant Whole Foods, whichmay reduce margins going forward. In our view, the Amazon/Whole Foods deal, as well as the 2016 bankruptcy of SportsAuthority (another major Kimco tenant) highlight the increased threat to traditional retailers from online competition, and, in thecase of Whole Foods, show that even grocery stores are not immune. We are also concerned about the impact of rising interestrates, which have made bond yields more attractive than the yields of Kimco and other REITs. Although we have a favorable viewof Kimco’s transformation into a pure-play U.S. retail REIT and its focus on redeveloping high-quality shopping centers, we seelimited upside for KIM in the near term. The shares are trading at 12.9-times our 2017 AFFO estimate, below the peer medianof 13.3 and toward the low end of the five-year range of 11.6-21.6; however, we believe that the low valuation is appropriate giventhe company’s current challenges.

RECENT DEVELOPMENTSKIM shares have outperformed the market over the last three months, rising 8% compared to a gain of 1% for the S&P

500. The shares have underperformed over the past year, however, falling 33% versus a 12% increase for the index. The beta onKIM shares is 0.87, slightly above the peer average of 0.82.

On July 26, Kimco reported 2Q17 FFO of $175 million or $0.41 per share, above our estimate and the consensus forecastof $0.38. FFO per share rose 11% from 2Q16, driven by higher operating income and a $24 million cash distribution from aninvestment in Albertsons. (FFO, a metric similar to EPS, consists of net income plus depreciation, amortization, and the impactof transactions.) AFFO, which excludes nonrecurring items, rose 3% to $161 million, reflecting higher base rents, lowerimpairment costs, and gains on asset sales, which reduce FFO. On a per share basis, AFFO rose to $0.38, up 3% from 2Q16. Rentalrevenue rose 2% to $293 million. NOI rose 0.3%, down from 3.1% in 2Q16 and 2.2% in 1Q17, due to the impact of the SportsAuthority bankruptcy.

Management reiterated its 2017 FFO and AFFO per share guidance of $1.50-$1.54, which accounts for $22 million or$0.05-$0.07 per share from asset sales in 2016. Management raised its asset sales guidance to $300-$400 million from $250-$300million, which CIO Ross Cooper attributed to high demand for quality grocer-anchored properties. The company expects NOIgrowth of 2%-3% this year, which accounts for the lost rent on vacant Sports Authority stores following last year’s bankruptcyand a credit loss reserve to account for additional potential bankruptcies this year. The company reported NOI growth of 2.8%in 2016 and is targeting growth of 4.0% in 2020.

Amazon recently completed its purchase of Whole Foods for $13.7 billion. Shares of grocery-anchored retailers fell whenthe deal was announced on June 16, as investors felt traditional grocery stores would be upended by Amazon’s ability to cut costsand expertise in online delivery. KIM shares declined 5% following the announcement, as Whole Foods is one of its top ten largesttenants, accounting for about 1% of annualized rent and total square footage. On August 24, Amazon also announced that it wouldcut prices at Whole Foods stores, which sent KIM stock down an additional 4%. We believe that KIM shares could fall furtheras Amazon continues to make changes at Whole Foods.

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EARNINGS & GROWTH ANALYSISKey 2Q operating metrics for Kimco are summarized below.Occupancy: Companywide occupancy was 95.5%, down 40 basis points from the prior year.Leasing: Kimco signed 390 leases, renewals, and options, for a total of 2.0 million square feet, in 2Q. Property leasing

spreads in the U.S. rose 11%, with rental rates for new leases rising 17%, and rates on lease renewals or options rising 8%. Thecompany’s leasing spreads are in line with the peer average.

Acquisitions: During the quarter, Kimco acquired a parcel next to its shopping center in Augusta, Georgia, for $700,000.After the end of the quarter, it purchased a shopping center in Portland, Oregon, for $132 million. It also acquired an anchor parcelin Reno, Nevada, for $24 million.

Dispositions: In 2Q, Kimco sold interests in nine shopping centers and two land parcels for $156 million. In 2016, it sold65 shopping centers for $983 million, including 34 centers in Canada. The company has sold $3 billion in properties over the lastthree years in an effort to focus on larger U.S. cities.

Development/redevelopment: Kimco has an $800 million pipeline, including $580 million in active projects. It also hasa $2 billion “shadow pipeline,” or backlog. The company intends to boost spending on redevelopment and development projectsfrom $135 million in 2016 to $235 million annually in 2018-2020.

We expect the repositioning away from Canada and toward high-quality assets in major U.S. cities to benefit KIM overtime. Asset sales have weighed on earnings, but management has said that most of the sales are now complete.

We are maintaining our 2017 AFFO estimate of $1.54 per share. Our estimate assumes 3% growth from 2016, as thecompany moves past the impact of recent asset sales. However, we are lowering our 2018 estimate to $1.60 per share from $1.63,reflecting our expectations for challenges in the retail sector, including grocery stores, over the next year. We expect revenue toincrease 1% in 2017 to $1.18 billion, up from our previous estimate of $1.17 billion, and to rise 4% in 2018, to $1.22 billion.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for KIM is Medium, the midpoint on our five-point scale, as its financial health metrics are

in line with peers. KIM’s total debt/cap ratio was 49% at the end of 2Q17, unchanged from the end of 2Q16. The net debt/adjustedEBITDA ratio was 6.2, up from 5.7 in 2Q16. At the end of the quarter, KIM had $5.4 billion in debt, $143 million in cash and$1.6 billion available on its revolving credit facility. EBITDA covered interest expense by a factor of 3.9 during the second quarter,up from 1.9 a year earlier. Management is working to raise the company’s S&P credit rating from BBB+ to A. Moody’s rates KIM’sdebt at Baa1.

KIM pays a quarterly dividend of $0.27 per share, or $1.08 annually, for a yield of about 5.5%. Our dividend estimatesare $1.08 for 2017 and $1.14 for 2018. We think the dividend is secure given a forecast FFO payout ratio in the high 60% range.However, the relatively high yield could be a negative for the stock if the Fed raises interest rates too quickly.

MANAGEMENT & RISKSConor Flynn became CEO in January 2016 after serving as the company’s president and chief information officer since

2014. In February, he noted that Kimco focused on the “sweet spot” of retail, i.e., stores offering name-brand clothing at discountprices, such as TJ Maxx and Nordstrom Rack. He also said that the company was seeing strong growth in grocery stores, whichmay benefit from higher traffic due to low gas prices.

Kimco’s top tenants are TJX Companies (4% of annualized base rent), followed by Home Depot (3%), Ahold Delhaize(a Dutch food retailer), Bed Bath & Beyond, Albertson’s, Ross Stores, Wal-Mart, Kohl’s and PetSmart (2% each). The company’sdiversification is a strength, as tenant bankruptcy is a risk in a weak economy. This risk was highlighted by the March 2016bankruptcy of Sports Authority, which accounted for 1% of Kimco’s rent and square footage.

Leases will expire on 3% of the company’s square footage in 2017, including month-to-month leases, and on 9% of squarefootage in 2018. The average in-place minimum rent for tenants with leases expiring in 2017 is $18.33 per square foot.

COMPANY DESCRIPTIONKimco is a real estate investment trust (REIT), specializing in the acquisition, development and management of open-

air shopping centers. As of June 30, Kimco owned equity interests in 510 shopping center properties in the United States. Theshares are included in the S&P 500.

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INDUSTRYReal Estate has now been assigned its own sector within the Global Industry Classification System, or GICS, which

designates sectors for the S&P and MSCI indices. MSCI and S&P, which manage the GICS, believe that Real Estate and REITsrepresent a unique and sufficiently large asset class to merit a separate sector designation. Real Estate previously accounted forabout 20% of the Financial sector; the new Real Estate sector accounts for about 3% of the S&P 500.

Our rating on the Real Estate sector is Market-Weight. We believe that concerns about rising interest rates are now largelypriced into the REIT sector, which may be able to translate these increases into higher rental rates. Real estate PEG ratios also signalattractive valuations.

VALUATIONKIM shares have traded between $17 and $31 over the last 52 weeks and are currently toward the low end of this range.

The shares are trading at 12.9-times our 2017 AFFO per share forecast, below the peer median of 13.3 and toward the low endof the five-year range of 11.6-21.6. We believe that this relatively low valuation is appropriate given the stock’s strong recent run-up and continued challenges in the retail sector. We are also concerned about management’s plans for increased asset sales thisyear and about the negative impact of rising interest rates on Kimco and other REITs. As such, our rating is now HOLD.

On August 25, HOLD-rated KIM closed at $19.85, up $0.25. (Jacob Kilstein, CFA, 8/25/17)

MARKET DIGEST

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AIR PRODUCTS & CHEMICALS INC. (NYSE: APD, $146.01) ................................................ BUY

APD: Boosting target by $6 to $165

* Despite relatively high valuation multiples, we believe that increased demand for industrial gases, recent assetsales, and restructuring actions have strengthened the company’s prospects, and see continued upside for APDshares.

* On August 1, Air Products reported adjusted fiscal 3Q17 earnings from continuing operations of $363 million or$1.65 per diluted share, down from $420 million or $1.92 per share a year earlier. However, EPS topped ourestimate of $1.56 and the consensus forecast of $1.59.

* Along with its third-quarter earnings release, Air Products raised its full-year adjusted EPS forecast to $6.20-$6.25from $6.00-6.25, reflecting the impact of stronger demand.

* We are raising our 2017 EPS estimate to $6.23, near the midpoint of the revised guidance range, from $6.13. The2017 consensus forecast is $6.21.

ANALYSISINVESTMENT THESISWe are reiterating our BUY rating on Air Products & Chemicals Inc. (NYSE: APD) and raising our target price to $165

from $159. We look for strong volume growth going forward and believe that APD will be able to more than offset negativecurrency effects with increased energy cost pass-throughs. We expect these factors to result in above-peer-average earnings inthe coming quarters. APD also expects to have about $8 billion in cash over the next three years that it will be able to use fordividend increases, stock buybacks, or acquisitions. Our revised target price of $165, combined with the dividend yield, impliesa total potential return of 16% from current levels.

RECENT DEVELOPMENTSAPD shares have underperformed since the beginning of 2017, rising 1.0% while the S&P 500 Basic Materials index

has risen 8.8%. Over the past year, they have decreased 6.4%, while the Materials index has climbed 10.7%.On August 1, Air Products reported adjusted fiscal 3Q17 earnings from continuing operations of $363 million or $1.65

per diluted share, down from $420 million or $1.92 per share in the prior-year quarter. However, EPS topped our estimate of $1.56and the consensus forecast of $1.59.

The year-over-year decline in earnings reflected lower LNG activity, flat pricing, increased maintenance and unfavorablecurrency effects, which partially offset higher volumes and favorable energy cost pass-throughs. The adjusted EBITDA marginfell 120 basis points from the prior year to 34.0%.

In Industrial Gases Americas, revenue increased 12% from the prior year to $930 million, primarily reflecting higherenergy cost pass-throughs, which rose 9%. Volume rose 3% on higher North American activity, while weakness persisted in LatinAmerica. Operating income of $236 million rose 1% from the prior year, while the operating margin fell 270 basis points to 25.4%.

Industrial Gases EMEA posted sales of $452 million, up 5% year-over-year, as higher volume and higher energy costpass-throughs were partly offset by lower pricing and negative currency effects. Operating income fell 10% to $94 million andthe operating margin dropped 350 basis points to 20.8%.

In Industrial Gases Asia, sales rose 20% to $538 million, as volume growth was partly offset by negative currency effects.Pricing made a 2% positive contribution. Operating income rose 26% to $149 million, and the operating margin rose 130 basispoints to 27.7%.

Activist investor Pershing Square Capital Management recently sold its remaining 1.78% stake in APD. The companyinitially took a 9.65% position in the company in May 2015.

EARNINGS & GROWTH ANALYSISAlong with its third-quarter earnings release, Air Products raised its full-year adjusted EPS forecast to $6.20-$6.25 from

$6.00-6.25, reflecting the impact of stronger demand. It projects 4Q adjusted EPS of $1.65-$1.70. It looks for full-year capex of$1 billion.

We are raising our 2017 EPS estimate to $6.23, near the midpoint of the revised guidance range, from $6.13. We havealso raised our revenue forecast by 0.6%, to $8.108 billion, based on our expectations for slightly higher pricing and moderatingcurrency headwinds over the remainder of the year. The 2017 consensus forecast is $6.21.

We are boosting our 2018 EPS estimate to $6.92 from $6.88, which assumes improved industrial gas demand andmoderating currency effects. We are raising our revenue forecast by 2.2% to $8.457 billion. The 2018 consensus forecast is $6.87.

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FINANCIAL STRENGTH & DIVIDENDWe rate APD’s financial strength as Medium-High, the second-highest rank on our five-point scale. The company’s debt

is rated A2/stable by Moody’s and A/stable by Standard & Poor’s.At the end of 3Q17, the total debt/cap ratio was 29.2%, down from 44.2% at the end of 3Q16. The debt/cap ratio is below

those of close peers and has averaged 42.6% over the past five years.Air Products had cash and equivalents of $2.33 billion at the end of 3Q17, up from $515 million at the end of 3Q16. It

has an undrawn $2.690 billion credit line.At the end of 3Q17, total debt was $3.926 billion, down from $5.684 billion at the end of 3Q16.Air Products repurchased $462 million of its stock in FY13, but made no repurchases in FY14, FY15, or FY16. It has

$485 million remaining on its current buyback authorization.In early 2017, the company raised its quarterly dividend by 10% to $0.95 per share, or $3.80 annually. The current yield

is about 2.6%. This increase represents the company’s 35th consecutive annual dividend increase. Our dividend estimates are$3.71 for FY17 and $3.86 for FY18.

MANAGEMENT & RISKSSeifi Ghasemi became APD’s new chairman, president and CEO in July 2014, succeeding John E. McGlade. Mr.

Ghasemi became a member of the Air Products board in September 2013. He was previously chairman and CEO of RockwoodHoldings, a provider of inorganic specialty chemicals and advanced materials. Prior to joining Rockwood, Mr. Ghasemi waschairman and CEO of GKN Sinter Metals. He also held senior management positions at BOC Group, which is now part of LindeAG.

APD faces risks from industry capacity additions, commodity price and volume pressures, and higher energy costs. Italso faces a range of legal, environmental and operational risks.

COMPANY DESCRIPTIONAir Products is a leading producer of industrial gases. It provides atmospheric and process gases and related equipment

to refining and petrochemical, metals, electronics, and food and beverage companies. Air Products is also the world’s leadingsupplier of liquefied natural gas process technology and equipment. The company had fiscal 2016 sales of $9.52 billion.

INDUSTRYOur recommended weighting for the Basic Materials sector is Over-Weight, based on stabilizing commodity prices and

signs that the global economy will avoid recession. The sector accounts for 2.9% of the S&P 500, and includes industries suchas chemicals, paper, metals and mining. Over the past five years, the weighting has ranged from 2.5% to 4%. We think investorsshould consider allocating about 4% of their diversified portfolios to stocks in this sector. The sector outperformed in 2016, witha gain of 14.1%, and underperformed in 2015, with a loss of 10.4%. It is outperforming thus far in 2017, with a gain of 10.6%.

The P/E ratio on projected 2018 EPS is 16.7, close to the market multiple. The sector’s debt ratios appear sound, as manyin the group have deleveraged over the past three years. Yields of 2.0% are close to the market average. The Street consensus callsfor earnings growth of 35.8% in 2017 and 14.0% in 2018.

VALUATIONAPD shares have traded between $129.00 and $150.45 over the past 12 months and are currently in the upper half of this

range. The shares are trading at 23.4-times our FY17 EPS forecast and at 21.1-times our FY18 forecast, compared to a 22-yearannual average range of 16-23. They are also trading at a trailing price/book multiple of 3.4, near the high end of the historicalrange of 2.6-3.7; at a price/sales multiple of 3.8, above the high end of the historical range of 1.7-2.3; and at a price/cash flowmultiple of 18.7, above the high end of the range of 8.9-12.7. The price/EBITDA multiple is 13.6, compared to a range of 7.4-10.2.

Despite these relatively high valuation multiples, we believe that increased demand for industrial gases, recent asset sales,and restructuring actions have strengthened the company’s prospects, and see continued upside for APD shares. Our revised targetprice of $165, combined with the dividend yield, implies a total potential return of 16% from current levels.

On August 25, BUY-rated APD closed at $146.01, up 0.78. (Bill Selesky, 8/25/17)

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BROADCOM LTD. (NGS: AVGO, $245.59) ............................................................................. BUY

AVGO: Exceptional growth continues; reiterating target of $275

* Broadcom Ltd. delivered strong growth and above-consensus results for fiscal 3Q17, including 18% revenuegrowth and 42% EPS growth.

* The company is anticipating robust results in 4Q17, as higher content per device offsets somewhat less thannormal seasonal strength in wireless.

* Broadcom’s proposed acquisition of Brocade received final regulatory clearance from Chinese authorities inAugust 2017. We expect this deal to close in Broadcom Ltd.’s fiscal 4Q17 and to begin contributing approximately$1.4 billion in annual revenue from SAN (storage area network) operations in FY18.

* We continue to regard Broadcom Ltd. as the most successfully diversified semiconductor play in Argus technologycoverage, and results in the quarter underscored the company’s many strengths.

ANALYSISINVESTMENT THESISBUY-rated Broadcom Ltd. (NGS: AVGO) continues to exceed expectations, delivering strong growth and above-

consensus results for fiscal 3Q17. The rollout of iPhone 8 will be protracted, which, while potentially stealing some revenue from4Q17, should prevent a steep sequential falloff in 1Q18. Accordingly, fiscal 4Q17 guidance lagged the “wow” factor thatBroadcom has been delivering, causing a 3% selloff in the shares.

We continue to regard Broadcom Ltd. as the most successfully diversified semiconductor play in Argus technologycoverage, and results in the quarter underscored the company’s many strengths. Revenue of $4.47 billion increased 18% year-over-year, topping guidance and Street expectations in the $4.45 billion area. Broadcom is sufficiently diverse that the higher inputcosts impacting rival companies’ gross margins were not material to the company, leading to gross margin expansion year-over-year. Non-GAAP EPS advanced 42% in 3Q17, again growing much faster than earnings for the market or for peers.

The company is anticipating robust results in 4Q17, as higher content per device offsets somewhat less than normalseasonal strength in wireless. Apple demand is increasing ahead of the ramp of new iPhone models, while Samsung’s new Note8 model should be broadly available in mid-September.

AVGO shares have appreciated sharply in 2017. Broadcom’s exceptional growth and operating execution, however,have prevented valuations from spiking out of sight. AVGO is not trading much above its own historical valuation metrics, withtwo-year forward relative P/Es only slightly above its trailing five-year average. Valuation against peers does not signalovervaluation, and the stock is particularly attractive on our forward-looking discounted free cash flow valuation. We reiterateour BUY rating on AVGO shares to a 12-month target price of $275.

RECENT DEVELOPMENTSAVGO is up 41% in 2017; the peer group of communications & computing semiconductor companies under Argus

coverage is up 16%, while the SOX is up 20%. AVGO shares rose 21% in 2016, compared to a 70% simple average gain for thepeer group (market-cap weighted gain of 30%). AVGO rose 44% in 2015; surged 90% in 2014, from $56 to $100; and advanced67% in 2013, besting the 22% gain for the peer group.

For fiscal 3Q17 (ended 7/31/17), Broadcom Ltd. reported revenue of $4.47 billion, which was up 18% year-over-yearand 6% sequentially. Revenue was toward the top of management’ guidance of $4.375-$4.525 billion and was above theprereporting consensus of $4.45 billion.

Non-GAAP EPS of $4.10 per diluted share for 3Q17 rose 42% year-over-year, while increasing by $0.41 on a sequentialbasis from 2Q17. Non-GAAP EPS exceeded the prereporting consensus forecast of $4.03, which was based on line-item guidancerather than explicit guidance from management.

Broadcom Ltd. has anniversaried the February 2016 acquisition of the former Broadcom Corp., and analysis of recentresults against year-earlier periods is now fully comparable. The Broadcom acquisition effectively doubled revenue and addedsignificantly to revenue from end markets, most notably wired infrastructure.

Key Wired Infrastructure end markets include connected home (settop & cable modem, broadband access) and enterprise& data center (fiber optics, switching ASSPs, PHY). The two most important wireless end markets are RF Filters, a legacybusiness, and wireless connectivity (WiFi & Bluetooth), which came over with Broadcom Corp.

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The Enterprise Storage business includes custom Flash controllers, server & storage connectivity including HBAs andEthernet products, and hard disk drive (HDD) components. The company also derives approximately 5% of revenue from diverseindustrial applications and from other, which includes IP licensing.

For 3Q17, Wired Infrastructure revenue of $2.21 billion (49% of total) was up 7% annually and 5% sequentially. On theconnected home front, Wired Infrastructure demand was driven by seasonal strength in settop boxes. More important, BroadcomLtd. experienced “robust demand,” according to CEO Hock Tan, from data center customers for merchant and custom siliconproducts. Optical and broadband access products underperformed expectations, based on weakening trends from Chineseoperators.

Wireless Communications revenue of $1.28 billion advanced 27% annually and 12% sequentially, slightly better thanpre-reporting expectations. Growth was driven, as expected, by the start of the ramp from a large North American smartphonecustomer (Apple) that started transitioning to its new platform. The company in May warned that this new-product ramp will bemore stretched out than normal.

Although the cycle is stretched out compared to past iPhone generations, Broadcom has significantly more content inthe new device than in current devices. Taking these factors into consideration, the sequential surge in fiscal 4Q17 could besomewhat more muted than the historical norm on a percentage basis, while still being very vigorous on a dollar basis. As anadditional upside, fiscal 1Q18 wireless revenues will likely be sequentially stable with 4Q17 rather than experiencing the normalsequential plunge.

Enterprise storage revenue of $735 million (16% of total) was up 39% annually and 3% sequentially. Storage growthwas led by HDDs, while server & storage connectivity (Fibre Channel HBAs and Ethernet Connectivity) held up well. HDDdemand is showing signs of tapering off, but that should be offset by continued strength in FC HBAs. Industrial & Other revenue(5% of total) increased 22% year-over-year in 3Q17 and was up 6% sequentially. This diverse business benefited for a secondconsecutive quarter from a large increase in IP licensing revenue; the underlying industrial business was healthy in its own right.

Broadcom has agreed to acquire Brocade, and that deal received final regulatory clearance from Chinese authorities inAugust 2017. Brocade will divest all switching & routing assets in advance of the deal and will contribute approximate $1.4 billionin annual revenue from SAN (storage area network) operations. We expect this deal to close late in Broadcom Ltd.’s fiscal 4Q17and to begin contributing to revenue in FY18.

CEO Tan was uncommonly candid in discussing the longer-term outlook for the company. Although fiscal 2017 revenuewill likely rise more than 30%, Broadcom Ltd. believes its longer-term top-line growth will be more moderate, based on its strongmarket share positions in key franchises and maturity of some key markets.

The company believes its top line can exceed growth in global GDP, however, as the company increases content indevices, in the data center and in communications infrastructure. On balance, we believe this supports mid-single to high-single-digit annual revenue growth on an organic basis for FY18 and beyond. This does not include, of course, revenue impacts fromacquired businesses; and Broadcom Ltd. is highly acquisitive.

For the current quarter, Brocade is modeling sequential declines in three of four businesses. But sequential accelerationin wireless, led by the iPhone ramp and Samsung and other handset OEM business, should compensate for quarter over quarterdeclines in all other businesses. On that basis, Broadcom is guiding for overall sequential revenue growth of approximately 7%.

For 4Q17, Broadcom guided for revenue of $4.725-$4.875 billion, which at the guidance midpoint would be up 16% year-over-year. Line-item guidance pointed toward non-GAAP EPS of about $4.43, which would be up over 25% annually.

Based on the strong growth outlook for Broadcom Ltd.’s diverse end markets, we are again raising non-GAAP EPSexpectations for FY17 and FY18. Although AVGO has had a strong run, operating fundamentals growth is out in front of share-price appreciation. Fast-rising EPS and cash flows have prevented valuations from spiking, and the shares remain attractivelyvalued.

EARNINGS & GROWTH ANALYSISFor fiscal 3Q17 (ended 7/31/17), Broadcom Ltd. reported revenue of $4.47 billion, which was up 18% year-over-year

and up 6% sequentially. Revenue was toward the top of management’ guidance of $4.375-$4.525 billion and was above theprereporting consensus of $4.45 billion.

Non-GAAP EPS of $4.10 per diluted share for 3Q17 rose 42% year-over-year while increasing by $0.41 on a sequentialbasis from 2Q17. Non-GAAP EPS exceeded the prereporting consensus forecast of $4.03, which was based on line-item guidancerather than explicit guidance from management.

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For 4Q17, Broadcom guided for revenue of $4.8 billion, +/- $75 million, which would indicate a range of $4.725-$4.875billion. On an annual basis, revenue at the guidance midpoint would be up 16% year-over-year. On a non-GAAP basis, grossmargin is forecast at 63%, +/- 1%, and operating costs are forecast at $780 million. That points to non-GAAP EPS of about $4.43,which would be up 28% year-over-year.

We are raising our fiscal 2017 non-GAAP earnings estimate to $15.86 per diluted share from $15.84. We also raisingour fiscal 2018 non-GAAP EPS estimate to $17.51 per diluted share from a preliminary $17.30. Our GAAP forecasts are $4.10for 2017 and $5.53 for 2018. Our long-term annualized EPS growth rate forecast is 11%.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on Broadcom Ltd. is Medium-High, raised from Medium in May 2017. The company’s cash,

debt and net debt changed significantly between 2Q16 and 3Q16, during which time Avago acquired Broadcom Corp. andrebranded itself Broadcom Ltd. The company has subsequently increased cash generation, and debt service is manageable. During3Q17, cash & investments increased by nearly $1 billion while net debt was essentially flat.

Cash & investments were $5.45 billion as of the end of 3Q17. Cash & investments were $3.10 billion as of the end ofFY16, $1.82 billion at the end of FY15, $1.60 billion at the end of FY14, $958 million at the end of FY13, and $1.08 billion atthe end of FY12.

Total debt was $13.57 billion at 2Q17. Total debt was $13.64 billion at the end of FY16, reduced from $15.0 billion asof the end of 2Q16. Prior to the closing of the Broadcom Corp. deal, debt was $4.41 billion at the end of 1Q16. Debt was $4.42billion at the close of FY15, down from $5.51 billion at the end of FY14. Debt was minimal prior to the purchase of LSI Logic;debt was zero at the end of FY13, $3 million at the end of FY12, and $6 million at year-end FY11.

Debt-to-cap was 37.4% at 3Q17. Debt-to-cap was 38.4% at the end of FY16, compared with 48.1% as of the end of fiscal2015.

Net debt was $8.12 billion at 3Q17, down from $9 billion at mid-year and $10.03 billion at 1Q17. Net debt was $10.54billion at the end of FY16, reduced from $12.98 billion at the end of 2Q16. Prior to the Broadcom Corp. acquisition, net debt was$2.60 billion at the end of FY15, down from $3.90 billion at the end of FY14. Prior to the purchase of LSI Logic, net cash was$985 million at the end of FY13 and $1.08 billion at the end of FY12.

We look for the new Broadcom Ltd. to generate annual cash flow from operations in the $4-$5 billion range. Cash flowfrom operations was $3.541 billion in FY16, $2.32 billion in FY15, $1.18 billion in FY14, $722 million in FY13, and $693 millionin FY12.

Free cash flow was $2.94 billion in FY16, $1.73 billion in FY15, $1.22 billion in FY14, $766 million in FY13, and $486million in FY12.

In December 2016, Broadcom Ltd. raised its quarterly dividend to $1.02 per common share. In terms of dividend history,in June 2016 Broadcom Ltd. announced a quarterly dividend of $0.50. In March 2016, then-Avago raised its dividend by 9% to$0.49. In September 2015, Avago raised its quarterly dividend to $0.44 from $0.40. We estimate that the annual dividend will costthe company $700 million in FY16 and $790 million in FY17. In FY15, cash flow covered the dividend by a factor of 5.6, andfree cash flow covered the dividend by a factor of 4.2. We are modeling similar to higher coverage ratios for FY17 and FY18.

Our dividend estimates are $4.08 for FY17 and FY18.MANAGEMENT & RISKSAvago’s CEO is Hock E. Tan. CFO Anthony Maslowski has taken a medical leave of absence, and Thomas Krause has

now become full-time CFO after serving as interim CFO. Other key officers include Boon Chye Ooi, SVP of Global Operations;and Broadcom founder Henry Samueli, who is chief technology officer as well as a board member. The Broadcom holdovers aremainly at the division level.

Avago already has more debt than cash as a result of past acquisitions. It has now completed one of the largest Technologysector acquisitions ever. We believe that Avago’s deep experience in acquiring and integrating significant acquisitions will enableit to combine with the larger Broadcom without major operational disruptions or reduced profitability.

Avago is at risk from the diversity of its business lines, which increased further once Broadcom was acquired. Avago’sleadership and market share strength in Analog III-V and in mixed-signal CMOS enable the company to command premium pricesfor its products. We believe that the combined company will not hesitate to exit or sell unprofitable or low-return product lines,thus enabling it to maintain its profit margins.

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COMPANY DESCRIPTIONBroadcom Ltd., based in Singapore and formerly known as Avago Technologies Ltd., is a top-five global fabless

semiconductor company with leading franchises in wired and wireless communications, enterprise data center and storage,industrial, and other end markets. Since going public in 2009, Avago has grown via acquisitions, including Agere, LSI Logic, andEmulex. In January 2016, the former Avago acquired Broadcom for $37 billion and changed its name to Broadcom Ltd.

INDUSTRYWe have raised our rating on the Technology sector to Over-Weight from Market-Weight. Technology is showing clear

investor momentum, topping the market in the year-to-date and trailing one-month and three-month periods. At the same time,the average two-year-forward EPS growth rate exceeds our broad-market estimate and sector averages. This has kept technologysector valuations from becoming too rich, and resulted in PEG ratios that are below the median for all sectors.

Over the long term, we expect the Tech sector to benefit from pervasive digitization across the economy, greateracceptance of transformative technologies, and the development of the Internet of Things (IoT). Healthy company and sectorfundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad internationalbusiness exposure.

In terms of performance, the sector rose 12.0% in 2016, above the market average, after rising 4.3% in 2015. The sectoris outperforming thus far in 2017, with a gain of 17.9%.

Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2018earnings is 16.8, above the market multiple of 16.6. Earnings are expected to grow 14.7% in 2018 and 28.6% in 2017 followinglow single-digit growth in 2015-2016. The sector’s debt ratios are below the market average, as is the average dividend yield.

VALUATIONAVGO stock trades at 14.8-times its two-year-forward P/E, compared with an historical five-year (FY12-FY16) trailing

P/E of 13.0-times. More important, with the overall stock market at all-time highs, AVGO’s relative P/E is only slightly aboveits trailing five-year average. AVGO trades at a relative P/E of 0.82-times our two-year-forward non-GAAP EPS and our S&P500 earnings estimates, compared with an historical five-year (FY12-FY16) trailing relative P/E of 0.81. Relative P/E thussupports valuation right around the current price.

Comparative analysis, based on historical multiples and current expectations, suggests a value for the stock in the mid-$260s range, in a rising trend. Peer group analysis shows AVGO trading in line with peers on trailing 12-month P/Es but at ameaningful discount to peers on PEG ratio.

Discounted free cash flow analysis points to a value above $400, also in a rising trend. DFCF valuation has held up despitea higher share count from the Broadcom purchase. Cash flow generation has begun to improve and should accelerate further asthe company integrates high-quality assets and achieves volume leverage and greater synergies across its operations.

Our blended valuation analysis indicates a fair value for AVGO above $325, up from the $29s. Our revised calculatedfair value estimate remains well above the current stock price.

Appreciation to our 12-month target of $275 implies a potential risk-adjusted total return, including the 1.7% (indicated)dividend yield, of 13%, in excess of our forecast for the broad market. On that basis, we are reiterating our BUY rating.

On August 25, BUY-rated AVGO closed at $245.59, down $9.46. (Jim Kelleher, CFA, 8/25/17)

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BROCADE COMMUNICATIONS SYSTEMS INC. (NGS: BRCD, $12.30) HOLD

BRCD: Final regulatory approval advances acquisition outlook

* Brocade Communications posted a weak quarterly performance in fiscal 3Q17, which was met with investorindifference as the company moved closer to its acquisition by Broadcom.

* During August, China’s Ministry of Commerce (MOFCOM) tentatively signed off on the deal, on the condition thatBroadcom set up a firewall related to sensitive competitive data.

* Despite little incentive for purchasing managers to buy SAN switching revenue held up in 3Q17. IP Networking,which is to be divested, suffered from lack of the usual seasonal surge from government agencies ahead of thefiscal year-end.

* We downgraded BRCD in November 2016 as deal speculation mounted, and regard the shares as fairly valuedat current levels. In the unlikely event that the deal falls through, we believe that BRCD shares could retreat to the$9-$10 range.

ANALYSISINVESTMENT THESISHOLD-rated Brocade Communications Systems Inc. (NGS: BRCD) posted another weak quarterly performance in fiscal

3Q17, which was again met with investor indifference as the company moved closer to its acquisition by Broadcom Inc. DuringAugust, China’s Ministry of Commerce (MOFCOM) tentatively signed off on the deal, on the condition that Broadcom set upa firewall related to sensitive competitive data for Cisco’s fibre channel switch business (Brocade is a Cisco supplier, whereasBroadcom is a Cisco competitor).

Broadcom, which agreed in November 2016 to acquire Brocade for $5.5 billion, is interested primarily in Brocade’s SANswitching business. Brocade has struck deals to divest its IP and wireless networking units, with those divestitures conditionalon Broadcom buying Brocade. In February 2017, Arris International plc agreed to acquire Ruckus Wireless and the ICX campusswitch business for $800 million. In March 2017, Extreme Networks agreed to acquire Brocade’s data center network business,including routing and switching gear, for $55 million.

We downgraded BRCD in November 2016 as deal speculation mounted, and regard the shares as fairly valued at currentlevels. In the unlikely event that the deal falls through, we believe that BRCD shares could retreat to the $9-$10 range, where theytraded prior to the emergence of deal rumors. We are reiterating our HOLD rating.

RECENT DEVELOPMENTSBRCD is down 1% year-to-date in 2017, compared to a 9% gain for the Argus Information Processing & Storage peer

group. BRCD rose 36% in 2016, while the “old” storage peer group rose 41%. BRCD declined 23% in 2015, compared to a 27%decline for the peer group. BRCD shares advanced 33% in 2014, rose 66% in 2013, and rose 3% in 2012.

Argus no longer tracks a storage peer group within our technology hardware & cloud universe. The formerly discreteData Storage peer group has been folded into the Information Processing & Storage group. Over the past two years, three of thesix companies that had been in the Data Storage peer group – SanDisk, QLogic, and EMC – were acquired. Brocade is slated tobe acquired during Broadcom’s fiscal 4Q17, or by the end of October 2017. Array maker NetApp is now included in theInformation Processing & Storage peer group, while Micron is now part of the Semiconductor peer group.

For fiscal 3Q17, Brocade reported revenue of $549 million, which was down 7% year-over-year and down less than 1%sequentially; revenue was below the $584 million consensus forecast. Non-GAAP earnings of $0.16 per diluted share declined23% year-over-year; non-GAAP earnings matched the consensus forecast. Since the Broadcom merger offer, Brocade hasdispensed with quarterly conference calls and no longer provides forward guidance.

Since the November 2016 announced acquisition by Broadcom, Brocade has been waiting to be acquired. The originaltargeted close date of July 2017 is now past. A key final regulatory hurdle has now been cleared, increasing the likelihood thatthe deal can close by the end of Broadcom’s October 2017 fiscal year. Similar to earlier regulatory clearances won from the EU,Japan, and the U.S. Federal Trade Commission (FTC), the regulatory clearance from China comes with strings attached.

On 8/23/17, the Ministry of Commerce of the People’s Republic of China (MOFCOM) issued an English-language pressrelease updating its regulatory status in relation to the proposed acquisition. MOFCOM announced it approved Broadcom Ltd.’sstock right acquisition of Brocade communications with conditions. MOFCOM noted that both Broadcom and Broadcom “take

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a lead in fiber channel storage.” Brocade is dominant in SAN switching, with a 70%-80% global market share. Broadcom alsoparticipates in SAN switching, which it integrates with its Fiber Channel Host Bus Adaptor (HBA) products; as owner of theformer Emulex, Broadcom has about a 40%-45% share in FC HBAs.

MOFCOM is concerned that, post-acquisition, Broadcom may use its new hegemony in SAN switching “to weaken thetechnological interoperability of FC HBA” with third parties who are producing HBA products. MOFCOM is also concerned thatBroadcom might misuse confidential business information from those third parties; might seek to “bundle” sales of its own HBAs,presumably with SAN switches; and therefore eliminate or restrict competition in the FC HBA market.

MOFCOM further noted that Broadcom would be able to gain access to confidential information from its maincompetitor in SAN switches. That’s because Cisco Systems and Brocade both rely on ASICs (application-specific integratedcircuits) provided by Broadcom that are at the heart of both Cisco and Brocade SAN switches.

Considering all of the above, MOFCOM “decided to approve this case with conditions.” Those conditions, thoughunspecified in the MOFCOM note, are similar to earlier concessions made to European and U.S. regulators, we believe.

In July 2017, the U.S. FTC stated it would allow the deal to go forward provided that Broadcom does not inhibitcompetition in the market for SAN switches. For any SAN-related Cisco products, Broadcom will build a “firewall” between thetechnological (research, development, engineering, & manufacturing) team and any of its sales & marketing or go-to-marketteams.

Further, in May Broadcom won approval from EU regulators by guaranteeing interoperability for acquired SANproducts. That is, the acquired SAN switches will be designed to work on competitors’ networks and with related products, suchas HBAs, made by competitors.

Neither Broadcom nor Brocade has commented since the MOFCOM ruling, which constitutes the final meaningfulregulatory hurdle in the way of deal close. From Broadcom’s perspective, the pending deal close clears the way for two keydivestitures of Brocade businesses, both conditioned on Broadcom buying Brocade.

In February 2017, Arris International plc agreed to acquire Ruckus Wireless and the ICX campus switch business for$800 million. In March 2017, Extreme Networks agreed to acquire Brocade’s data center network business, including routing andswitching gear, for $55 million. As of the close of fiscal 3Q17, Brocade had $1.18 billion in cash, $1.53 billion in debt, and netdebt of $355 million. Assuming realization of about $855 million in asset-sale proceeds, Brocade would bring to Broadcom about$500 million in net cash.

In its dwindling time as a stand-alone company, Brocade is being hurt by a reticence by buyers to commit meaningfullyto new product purchases. In such circumstances, purchasing managers tend to move to the sidelines while waiting to see whichproducts from the to-be-acquired company are deemed redundant, non-core, or otherwise unwanted by the acquiring company.

Brocade is also standing still from a technological perspective, at a time when all-flash is reshaping the storage hardwareuniverse and cloud is reshaping the data management universe. Again based on precedent, the acquiring company likely advisedthe to-be-acquired company to shut down all speculative ventures in these developing markets. Chances are high that the twocompanies are on separate development paths, and that any acquired technology not on the acquiring company’s trajectory willbe discontinued. The acquirer would much rather have the cash on the to-be-acquired company’s balance sheet than half-finishedwork that will be discarded.

Against this daunting background, the business to be acquired by Broadcom held its own, relatively speaking, in thequarter. Brocade’s SAN product revenue of $275 million (50% of total for 3Q17) declined 3% annually and 3% sequentially. SANservice revenue (10% of total) was down 1% annually. A significant percentage of Brocade’s SAN revenue comes from SANswitches that are sold to large OEMs, who incorporate them into integrated storage solutions.

For the businesses to be divested immediately before acquisition, IP Networking product revenue of $176 million for3Q17 was down 16% annually and up 3% sequentially. Normally, IP Networking has a seasonally strong 3Q17, reflecting end-of-fiscal-year “budge flush” buying at major government agencies.

Unlike SAN switches that are sold to technology OEMs, Brocade’s IP networking gear is sold to carrier, data center andenterprise customers, including Public (government) customers. Disruption in business-as-usual in Washington during Brocade’sfiscal 3Q17 appears to have impacted the normal seasonal pattern. This business appears less stable going forward.

We downgraded BRCD in November 2016 as deal speculation mounted, and regard the shares as fairly valued at currentlevels. In the unlikely event that the deal falls through, we believe that BRCD shares could retreat to the $9-$10 range, where theytraded prior to the emergence of deal rumors. We are reiterating our HOLD rating.

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EARNINGS & GROWTH ANALYSISFor fiscal 3Q17, Brocade reported revenue of $549 million, which was down 7% year-over-year and down less than 1%

sequentially; revenue was below the $584 million consensus forecast. Non-GAAP earnings of $0.16 per diluted share declined23% year-over-year; non-GAAP earnings matched the consensus forecast. Since the Broadcom merger offer, Brocade hasdispensed with quarterly conference calls and no longer provides forward guidance.

For all of FY16, Brocade generated revenue of $2.35 billion, up 4% from $2.26 billion in FY15. Non-GAAP earningstotaled $1.04 per diluted share, up 3% from $1.01 per share in FY15.

Given the forthcoming acquisition, Brocade is no longer furnishing quarterly or annual revenue or EPS guidance.We are lowering our non-GAAP FY17 earnings estimate to $0.61 per diluted share from $0.65 and our FY18 forecast

to $0.71 from $0.78. Our GAAP forecasts are $0.01 for FY17 and $0.39 for FY18. We expect our FY18 estimates to be moot.Our long-term annualized EPS growth rate forecast is 10%.FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for Brocade is Medium. Brocade completed the acquisition of Ruckus on 5/27/16;

announced it was being acquired by Broadcom in November 2016; and announced proposed asset sales in February and March2017.

Debt was $1.53 billion at the end of 3Q17. Debt was $1.58 billion at the end of FY16, up from $802 million at 2Q16.Debt was $796 million at the end of 2015, $596 million at the end of FY14, and $599 million at the end of FY13.

The total debt/cap ratio was 37.8% at the end of 3Q17, 38.3% at the end of FY16, and 24.1% at the end of 2Q16. Totaldebt/cap was 25.2% at the end of 4Q15, 19.8% at the close of FY14, and 20.3% at the end of FY13.

Cash & equivalents were $1.18 billion at the end of 3Q17. Cash & equivalents were $1.26 billion at the end of FY16,down from $1.43 billion at the end of 2Q16. Cash & equivalents were $1.44 billion at the end of FY15, $1.26 billion at the endof FY14, and $987 million at the end of FY13.

As of the close of fiscal 3Q17, based on $1.18 billion in cash and $1.53 billion in debt, Brocade had net debt of $355million. Assuming realization of about $855 million in asset-sale proceeds, Brocade would bring to Broadcom about $500 millionin net cash.

Cash flow from operations was $412 million in FY16, $448 million in FY15, $542 million in FY14, and $451 millionin FY13.

Brocade has historically been active in repurchasing shares, buying back $180 million in shares in 1H16. Companiesawaiting acquisition have been known to suspend buybacks; but Brocade may continue on a limited basis in order to reduce shareinflation related to the Ruckus purchase.

On 5/21/15, Brocade announced a 29% hike in the quarterly dividend, to $0.045 per share. The company first establisheda quarterly dividend of $0.035 per share in May 2014. Our dividend estimates are $0.18 per share for both FY17 and FY18.

MANAGEMENT & RISKSLloyd Carney became Brocade’s CEO in January 2013. Dan Fairfax has served as CFO since 2011. Jeff Lindholm is SVP

of Worldwide Sales and Ken Cheng serves in the CTO role.BRCD shares rose 47% in less than a week in fall 2016, as takeover speculation was subsequently followed by the

Broadcom announcement on 11/2/16. We still see some risk that the deal could fall through if regulators disapprove or requiredisposition of assets that Broadcom would prefer to keep.

BRCD shares may contain a lingering acquisition premium related to past efforts to sell the company to private equitybuyers or strategic buyers such as Oracle, IBM, Cisco, or H-P. Possible deals with buyers such as Blackstone have reportedlyfoundered on price. Brocade’s inability to find a buyer after seeking to be taken out for years suggests that the board may beovervaluing Brocade relative to its peer group.

Brocade also has risk related to its sizable exposure to the federal government in its Ethernet business. Other risks includeBrocade’s dependence on large customers such as EMC, IBM, and Hewlett-Packard. Brocade currently faces competitive threatsfrom Dell EMC and NetApp, as well as from smaller, flash-based companies.

COMPANY DESCRIPTIONBrocade Communications Inc. is a leading provider of fiber channel fabric switches, directors, and routers for storage

area networks. Brocade’s acquisitions of SBS and Silverback added to its storage switching capabilities; the acquisition ofFoundry Networks created the company’s IP Networking business; and the 2016 acquisition of Ruckus provided a wireless accessbusiness. In November 2016, Brocade agreed to be acquired by Broadcom Ltd.

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INDUSTRYWe have raised our rating on the Technology sector to Over-Weight from Market-Weight. Technology is showing clear

investor momentum, topping the market in the year-to-date and trailing one-month and three-month periods. At the same time,the average two-year-forward EPS growth rate exceeds our broad-market estimate and sector averages. This has kept technologysector valuations from becoming too rich, and resulted in PEG ratios that are below the median for all sectors.

Over the long term, we expect the Tech sector to benefit from pervasive digitization across the economy, greateracceptance of transformative technologies, and the development of the Internet of Things (IoT). Healthy company and sectorfundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad internationalbusiness exposure.


Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2018earnings is 16.8, above the market multiple of 16.6. Earnings are expected to grow 14.7% in 2018 and 28.6% in 2017 followinglow single-digit growth in 2015-2016. The sector’s debt ratios are below the market average, as is the average dividend yield.

VALUATIONBRCD shares are trading at 20.3-times our non-GAAP EPS projection for FY17 and at 17.5-times our forecast for FY18;

the two-year average forward P/E of 18.9 is now well above the average historical P/E of 9.4 over the past five years (FY12-FY16).Historical comparable valuation based on price/sales and price/cash flow suggest value in the $7 range, in a declining trend andwell below current prices.

DFCF valuation suggests a value above current levels in the $11 range, and our blended fair value estimate for BRCDis $9.00 per share; both are in a declining trend. This estimate implies a risk-adjusted retreat of more than 10% from current levels,which would normally be consistent with a SELL rating. However, the proposed takeout price of $12.75, slightly above the current$12.33, is providing a sturdy floor.

We downgraded the stock in November 2016 as deal speculation mounted and regard BRCD as fairly valued at currentlevels. We still see some risk the deal could fall through, which would send BRCD shares sharply lower, but that risk appears tobe receding. We are reiterating our HOLD rating on Brocade.

On August 25, HOLD-rated BRCD closed at $12.30, up $0.11. (Jim Kelleher, CFA, 8/25/17)

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COLFAX CORP. (NYSE: CFX, $39.08) ................................................................................... BUY

CFX: Recent weakness offers buying opportunity

* CFX shares have underperformed the market over the past quarter, slipping 2.5%, while the S&P 500 has risen1.2%.

* The shares of this mid-cap industrial company, which focuses on power generation, energy and infrastructure, arebenefiting in part from expectations that the Trump administration will increase spending on infrastructure projects.

* On the income statement, margins are improving. We also look for sales to grow once again in 2018.

* Despite the recent rally, CFX shares are trading 45% below their all-time high and appear favorably valued basedon historical price/sales multiples.

ANALYSISINVESTMENT THESISOur rating on Colfax Corp. (NYSE: CFX) is BUY. Over the long term, we see Colfax, a well-managed mid-cap company

with a focus on power generation, energy and infrastructure, as an emerging leader in the Industrial sector. Colfax has a historyof growing via M&A, and management integrates acquired businesses through the “Colfax Business System,” which focuses onthe continuous improvement of acquired companies and is modeled on the highly successful Danaher Business System. In recentquarters, earnings have been weak due to the company’s exposure to the energy and mining industries, and to unfavorable currencyeffects. But the company recently touched an inflection point, as margins have begun to rise and orders are improving. We seethe improvement in orders as a catalyst that could lead to positive EPS surprises and further stock momentum. Our target priceis $50.

RECENT DEVELOPMENTSCFX shares have underperformed the market over the past quarter, slipping 2.5%, while the S&P 500 has risen 1.2%.

They have outperformed over the past year, gaining 27% versus a 12% advance for the index. Despite the recent rally, the sharesare still trading more than 45% below the all-time highs established in 2014. The beta on CFX is 1.37.

Colfax recently reported 2Q17 earnings that were higher versus the prior year and in line with Street expectations.Revenue of $966 million reversed the recent trend and rose 1% on an organic basis, while the adjusted operating margin rose 40basis points to 9.5%. Adjusted net income per share increased 5% to $0.43. For the first half, the company has earned $0.78 pershare.

Along with the 2Q results, management once again raised its 2017 adjusted EPS guidance range, to $1.65-$1.75 from$1.60-$1.70, implying growth of up to 12%.

The company has a growth-by-acquisition strategy. In 2Q, Colfax announced the acquisitions of TBI, a leader in robotictorch technology, and HKS, which specializes in advanced welding process analytics.

EARNINGS & GROWTH ANALYSISColfax has two primary segments: Fabrication Technology (51% of 2Q sales) and Gas and Fluid Handling (49%).

Second-quarter results and management’s business segment forecasts are summarized below.In the Fabrication Technology segment, organic revenue reversed a down trend and is now positive — +2.3% in the

quarter. The adjusted operating margin was 12.3%, up from 11.5% due to cost-reduction efforts. Management said that mostregions showed sequential improvement. In 2017, we continue to look for improvement to revenue comparisons along with furthermargin gains.

Gas and Fluid Handling segment revenue was down 5.8% on an organic basis – an improvement from the 9% declinein 1Q, and management expects a positive comparison in 3Q. The adjusted operating margin increased 60 basis points to 9.3%,reflecting structural cost savings. Orders rose 66% organically to $458 million; this was the fourth quarter in a row of strong ordersgrowth. We continue to look for a better performance in 2017 and then for growth in 2018, as orders turn into revenue.

Management is focusing on margins in a difficult top-line environment, and has targeted $50 million of restructuringsavings in 2017 after achieving $50 million in savings in 2016. Management’s goal is for mid-teens segment margins. In 2Q, theadjusted operating margin rose to 9.5% from 9.1% in the prior-year quarter.

Turning to our estimates, we are maintaining our 2017 EPS forecast of $1.74, which is at the high end of management’sguidance range and assumes continued margin improvement. We also look for revenue trends to continue to strengthen in 2017,and are now forecasting 1% revenue growth. We are raising our 2018 EPS forecast from $2.00 to $2.05, which assumes low single-digit top-line growth.

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FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on Colfax is Medium, the midpoint on our five-point scale. The company receives average

scores on our three main financial strength criteria of debt levels, fixed-cost coverage, and profitability.Colfax’s total debt/equity ratio at the end of last year was 29%. Second-quarter operating income covered interest expense

by a factor of 12. The operating margin is typically near 10% — and is likely on its way toward 15%.Colfax uses its cash mainly for acquisitions. It has never paid a dividend, and has no plans to do so in the near term.Colfax has a share buyback program.MANAGEMENT & RISKSMatt Trerotola is the CEO of Colfax. He replaced Steven Simms, the former president and CEO, who announced his

retirement in 2015. Mr. Trerotola is a former executive vice president at DuPont, and also has experience at Danaher andMcKinsey. Christopher Hix is the new CFO. He joined the company on July 1, 2016. His most recent post was with OM GroupInc.

At an Investor Day in December 2015, management outlined its 3-5 year financial goals, including top-line growth inline with global GDP growth plus 1.25%; mid-teens operating margins; and free cash flow growth able to drive an activeacquisition program.

Colfax’s growth strategy has depended heavily on acquisitions, which carry integration risk. Colfax may also face risksfrom any underestimated liabilities of acquired companies. Since the beginning of 2012, the company has spent nearly $5.1 billionon acquisitions.

We note that corporate insiders continue to hold almost 20% of CFX shares, which could lead to further dilution in theevent of stock sales.

Colfax is a global company, and its results are typically linked to global economic trends. Worldwide, a strong dollarand slumping commodity prices have posed a challenge to global economic growth, particularly in emerging markets. However,we expect the global GDP picture to brighten slightly this year, and commodity prices have begun to recover. We estimate thatglobal GDP advanced 3.1% in 2016, and we (and the IMF) look for a pick up to 3.5% in 2017.

Colfax is also sensitive to trends in the dollar. Looking ahead, we think the greenback is fully valued and near a top,particularly if the Fed moves slowly to raise rates. A stable or falling dollar would be a positive development for the Industrialsector and Colfax.

Colfax is also affected by trends in the oil patch. We look for WTI crude to range between $45 and $60 per barrel in 2017,up slightly from our range for 2016.

COMPANY DESCRIPTIONColfax Corp. provides gas and fluid-handling and fabrication technology products and services to customers under the

Howden, Colfax Fluid Handling, and ESAB brand names. The company’s businesses are divided into two reportable segments,Gas & Fluid Handling and Fabrication Technology.

VALUATIONWe think that CFX shares are attractively valued at current prices near $40, near the high end of their 52-week range of

$24-$42. From a technical perspective, the shares had been in a bearish pattern of lower highs and lower lows that dated to June2014, when they were priced near $75. However, since January 2016, CFX shares have been in a bullish pattern of higher highsand higher lows.

On a fundamental basis, the shares are trading at 19-times our 2018 EPS estimate, above the midpoint of the historicalrange of 11-24, reflecting depressed earning. On other metrics, such as price/sales, they are trading toward the low end of the five-year range (at 1.4 versus a range of 0.9-2.3). We see the recent improvement in orders as a catalyst that could lead to positive EPSsurprises and further stock momentum. We are maintaining our 12-month target price of $50, or about 1.7-times projected 2018sales, as earnings recover.

On August 25, BUY-rated CFX closed at $39.08, up $1.34. (John Eade, 8/25/17)

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EQUIFAX INC. (NYSE: EFX, $140.70) ................................................................................... BUY

EFX: Maintaining BUY as margins expand

* EFX shares have outperformed over the past quarter, rising 3.2% compared to a 1.3% increase for the S&P 500.

* The second quarter of 2017 marked the 42nd straight quarter that the company has either met or exceededconsensus EPS forecasts.

* We are lowering our 2017 adjusted EPS forecast to $6.10 from $6.15, reflecting current weakness in the GCSsegment, on an 8.8% increase in revenue. Our EPS estimate implies 10.5% growth from the $5.52 recorded in2016. In 2018, we look for EPS to increase by 13.1%, to $6.90, on another 8.8% advance in revenue. Our five-year earnings growth rate forecast is 12%.

* On valuation, we believe that EFX shares are attractively priced at 20-times our 2018 EPS estimate, below themidpoint of the five-year range of 15-26.

ANALYSISINVESTMENT THESISWe are maintaining our BUY rating on Equifax Inc. (NYSE: EFX), a global provider of information solutions for

businesses, governments and consumers. The company has posted strong EPS growth over the past five years, helped by a solidbusiness strategy and improving economic conditions, and has consistently met or exceeded consensus earnings forecasts. It hasalso boosted its dividend at a double-digit rate over the past seven years. Looking ahead, we expect Equifax to post compoundannual EPS growth of 12.0% over the next five years. On valuation, we believe that EFX shares are attractively priced at 20-timesour 2018 EPS estimate, below the midpoint of the five-year range of 15-26. The shares are also trading at a PEG ratio of 1.9, belowthe average multiple of 2.4 for a peer group of professional services companies. Our target price is $166.

RECENT DEVELOPMENTSEFX shares have outperformed over the past quarter, rising 3.2% compared to a 1.3% increase for the S&P 500. However,

they have underperformed over the past year, gaining 6.7% compared to a 12.2% gain for the index. Over the past five years, EFX’s207% return has far outpaced the 74% increase in the S&P. The beta on EFX is 1.04.

On July 26, Equifax posted 2Q17 adjusted EPS of $1.60, up from $1.43 in the year-earlier period and $0.03 aboveconsensus. Revenue rose 5.6% to $857 million, or about 7% on a local-currency basis, boosted by solid gains in its U.S. InformationSolutions (USIS), International, and Workforce Solutions segments, partly offset by a decline in the Global Consumer Solutions(GCS) segment. Operating margins widened in all segments, leading to a company-wide operating margin of 30.8%, up from27.8% a year earlier. The adjusted EBITDA margin also rose to 39.1% from 36.6% in the prior-year-period. Adjusted resultsexclude the tax impact of stock-based compensation and acquisition-related amortization expenses.

The second quarter of 2017 marked the 42nd straight quarter that the company has either met or exceeded consensus EPSforecasts.

Along with the 2Q results, management provided third-quarter and full-year guidance. It projects third-quarter revenuegrowth of 6%-7%, to $853-$861 million, assuming current exchange rates, and adjusted EPS growth of 4%-7%, to $1.50-$1.54.These estimates also assume continued mortgage-market headwinds, which are expected to lower revenue growth by 300 basispoints and adjusted EPS growth by 500 basis points. For the full year, management expects revenues of $3.395-$3.425 billion,up at the low end from a prior $3.375-$3.425 billion and representing 9% constant-currency growth at the midpoint of the range.It also raised its EPS estimate to $6.02-$6.10 from a prior $5.96-$6.10. The full-year estimates are within management’s long-term growth targets of 7%-10% for revenue and 11%-14% for adjusted EPS.

In February 2016, Equifax acquired Veda Group Ltd., a provider of credit information and analytical services in Australiaand New Zealand, for US$1.9 billion, which was funded mostly through new debt issuance. Through Veda, Equifax plans toexpand elsewhere in the Asia-Pacific region.

In 1Q17, Equifax launched its InstaTouch mobile solution, which enables users to verify identities and to securely pre-populate personal and payment information into applications. Management expects significant growth for InstaTouch in thesecond half of 2017 and 2018.

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EARNINGS & GROWTH ANALYSISOver the past five years, EFX has posted compound annual growth of 9.8% in revenue, 16.7% in net income, and 16.7%

in adjusted EPS.Equifax organizes its business into four segments: USIS (36% of 2Q17 revenues), International (27%), Workforce

Solutions (23%), and GCS (12%).Second-quarter revenue in USIS rose to $332 million from $308 million a year earlier, largely driven by mortgage

solutions, marketing and analytic services, and identity and fraud services. In the International segment, revenue rose to $231million from $219 million, driven by the launch of new products and expanded operations in Europe, Latin America, Canada, andthe Asia-Pacific region. In Workforce Solutions, revenue rose to $195 million from $177 million in 2Q16 as growth in verificationservices more than offset a decline in employer services. The worst performing segment, GCS, saw revenue fall to $99 millionfrom $107 million, largely due to a significant shift in annual customer delivery.

We expect 2017 revenue to benefit from a full-year contribution from the Veda Group and solid demand in other foreignmarkets. We also look for strong gains in the Workforce Solutions segment, driven by increasing demand for EFX’s employmentverification and employer services offerings. We expect increased demand for mortgage-related products to offset lower overallmortgage market volume (management expects volume to decline 10%-15% in 3Q17, with further significant declines in 4Q17).We also look for wider margins, as cost cuts help to leverage increased revenue.

We are lowering our 2017 adjusted EPS forecast to $6.10 from $6.15, reflecting current weakness in the GCS segment,on an 8.8% increase in revenue. Our EPS estimate implies 10.5% growth from the $5.52 recorded in 2016. In 2018, we look forEPS to increase by 13.1%, to $6.90, on another 8.8% advance in revenue. Our five-year earnings growth rate forecast is 12%.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on Equifax is Medium, the second-highest rank on our five-point scale. Over the four

quarters ending June 30, 2017, it posted an operating margin of 28.3%, below the average of 33.6% for its professional servicespeers. It also posted an adjusted ROE of 21.3% over that period, below the peer average of 54.6%. Its long-term debt/equity ratioof 67.5% at June 30 was well below the average of 182.9% for the professional services industry.

Equifax pays a dividend. In March 2017, it raised its quarterly payout by 18.2% to $0.39 per share, or $1.56 annually,for a yield of about 1.1%. This marked the seventh straight year of double-digit dividend increases. Our dividend forecasts are$1.56 for 2017 and $1.76 for 2018.

Equifax has not repurchased any shares since its acquisition of Veda in February 2016; however, on the 2Q conferencecall, management signaled that it plans to resume buybacks in 3Q. It will also consider new acquisitions.

MANAGEMENT & RISKSRichard Smith has served as chairman and CEO of Equifax since late 2005, and previously held executive positions at

General Electric. John Gamble, Jr. has been vice president and CFO since May 2014. He was previously executive vice presidentand CFO of Lexmark International.

Equifax’s credit reporting solutions face competition from Experian and TransUnion. Other competitors in this areainclude LifeLock, a national provider of personal identity theft-protection products, and Credit Karma, which offers free creditscores. In the commercial segment, its primary competitors are again Experian, as well as Dun & Bradstreet and Cortera, and inemployment verification services, it faces competition from Verify Jobs and First Advantage. The company also faces risks fromgovernment regulation and from unfavorable currency effects, as international operations account for 27% of revenue. In addition,the company has substantial goodwill on its books ($4.06 billion at the end of 2Q17), which could lead to significant write-downs.

COMPANY DESCRIPTIONEquifax is a global provider of information and credit reporting solutions for businesses, governments and consumers.

Founded in 1899 and based in Atlanta, the company has approximately 9,500 employees.INDUSTRY

We have raised our rating on the Technology sector to Over-Weight from Market-Weight. Technology is showing clear investormomentum, topping the market in the year-to-date and trailing one-month and three-month periods. At the same time, the averagetwo-year-forward EPS growth rate exceeds our broad-market estimate and sector averages. This has kept technology sectorvaluations from becoming too rich, and resulted in PEG ratios that are below the median for all sectors.

Over the long term, we expect the Tech sector to benefit from pervasive digitization across the economy, greateracceptance of transformative technologies, and the development of the Internet of Things (IoT). Company and sectorfundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad internationalbusiness exposure.

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Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2018earnings is 16.8, above the market multiple of 16.6. Earnings are expected to grow 14.7% in 2018 and 28.6% in 2017 followinglow single-digit growth in 2015-

VALUATIONWe believe the EFX shares are attractively valued at current prices near $140. Over the past year, the shares have traded

in a range of $110-$147. From a technical standpoint, the shares have risen in a long-term bullish pattern of higher highs and higherlows since 2011.

On the fundamentals, the shares are trading at 20-times our 2018 EPS estimate, below the midpoint of the five-year rangeof 15-26. They are also trading at a PEG ratio of 1.9, below the average multiple of 2.4 for a peer group of professional servicescompanies. Our target of $166 implies a projected 2018 P/E of 24, still below the high end of the five-year historical range.

On August 25, BUY-rated EFX closed at $140.70, up $0.32. (Jasper Hellweg, 8/25/17)

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SPLUNK INC. (NGM: SPLK, $65.39) ................................................................................... HOLD

SPLK: Solid growth prospects for tech startup

* We are maintaining our HOLD rating on Splunk, an early-stage data analytics company. Although its original focuswas IT operations management, Splunk has expanded into adjacent product areas such as IT network security.

* We are maintaining our FY18 non-GAAP EPS estimate of $0.64 and our FY19 forecast of $0.95. Our forecastsimply average non-GAAP EPS growth of 54% over the next two years.

* Splunk shares appear fairly valued at current levels, making a near-term HOLD rating appropriate. However, webelieve that the shares could quickly command a higher premium if revenue accelerates, or even slows moregradually than investors expect.

* We also believe that Splunk could become an acquisition target for a larger enterprise software firm.

ANALYSISINVESTMENT THESISWe are maintaining our HOLD rating on Splunk Inc. (NGM: SPLK), an early-stage data analytics company. Although

its original focus was IT operations management, Splunk has expanded into adjacent product areas such as IT network security.We see Splunk as an early-stage data analytics company with a strong technology base. Given Splunk’s presence in a fast-growingmarket, we believe that much of its success will depend on execution — especially management’s ability to ramp up software salesand capture market share without squeezing margins or running up losses. Although its original focus was IT operationsmanagement, Splunk has expanded, often driven by customer requests, into adjacent product areas such as IT network security.At the same time, revenue has slowed from the super-fast growth seen several years ago.

Splunk shares appear fairly valued at current levels, making a near-term HOLD rating appropriate. SPLK shares havebeen stuck in a trading range between $50 and $60 over the last year and a half. However, we believe that the shares could quicklycommand a higher premium if revenue accelerates, or even slows more gradually than investors expect. In addition, although weare loath to play M&A roulette, we believe that Splunk is exactly the kind of company that could become an acquisition targetfor a larger enterprise software firm. Our long-term rating is BUY.

RECENT DEVELOPMENTSSplunk reported fiscal 2Q18 results on August 24 after the close, and raised its FY18 revenue forecast for a third time,

this time to $1.450 billion from $1.195 billion. Its initial forecast was $1.175 billion. The market reaction to Splunk’s results andhigher revenue forecast was remarkably positive, driving SPLK shares up more than 8% on August 25.

Second-quarter revenue rose 32% from the prior year to $303.4 million and non-GAAP operating income rose to $14.7million from $8.2 million in 2Q17. The GAAP operating loss narrowed slightly, to $82.1 million. The primary exclusion fromnon-GAAP operating income was $92.4 million in stock-based compensation expense (SBC) in 2Q18, compared to $88.9 millionin 2Q17. SBC came to 33% of revenue, down from 40% in FY17. However, SBC was also four times cash flow from operationsin 2Q17. We think these levels are high relative to peers. Non-GAAP EPS rose to $0.08 in 2Q18 from $0.05 a year earlier, whilethe GAAP loss narrowed to $0.60 from $0.65 per share. We believe that investors generally value Splunk on non-GAAP results.

Splunk will hold its annual user conference, called “.conf2017,” on September 26-28 in Washington DC.EARNINGS & GROWTH ANALYSISWe are maintaining our FY18 non-GAAP EPS estimate of $0.64 and our FY19 forecast of $0.95. Our forecasts imply

average non-GAAP EPS growth of 54% over the next two years. Our long-term EPS growth rate forecast is 48%.As Splunk has expanded, revenue growth has slowed from the 60%-plus rate seen a few years ago to a projected 27%-

28% in FY18 (ending in January); however, we believe that the company still has significant room for growth in the rapidlyexpanding enterprise analytics software industry. Of course, much will depend on the company’s ability to provide technologythat enables clients to efficiently index, analyze, and form actionable insights from an ever-increasing mountain of data. Splunkwill also need strong execution to expand its customer base, upsell additional products to existing customers, and boost its averageselling price (ASP). Management expects to expand its enterprise customer base from the current 14,000 to 20,000 in 2020. It tookanother step in that direction in 2Q18, adding 500 new enterprise customers but will need to boost that closer to 600 over timeto meet its target of 20,000. Splunk plans to hire more sales reps and to focus on demand-generation activities to reach its goals.Management also plans to increase ASP to $80,000 by 2020. In FY17, the company added 2,200 new customers and boosted ASP

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to $69,000. Customers will judge Splunk’s software technology on such factors as performance and support, scalability andflexibility, ease of deployment and use, total cost of ownership, and time to value. Management estimates that the company’s totaladdressable market is $55 billion. Tech industry tracker IDC expects worldwide big data and business analytics software revenueto grow at a 50% compound annual rate in 2015-2019, reaching $187 billion at the end of this period.

Splunk’s core Enterprise software was initially developed as an IT “break/fix” tool, enabling customers to rapidlydiscover and remediate system problems and breakdowns. The company developed its proprietary software to intercept,categorize, and examine IT system log files, including machine-to-machine communications, in an unformatted, system-agnosticway without relying on a database format. Since inception, the use of the software has rapidly expanded from IT systemsmanagement to broader categories of business operations management and business intelligence, including “big data” generatedby websites, applications, networks, cloud applications, mobile devices and the Internet of Things. New uses have often beencustomer-driven, as customers and developers imagine new ways to apply Splunk technology to solve business intelligenceproblems. The key for Splunk is to find repeatable, broadly applicable solutions that can be sold across its customer base. Theseinclude the Splunk Enterprise Security and Splunk User Behavior Analytics premium applications, which use machine learningand advanced correlation to detect and analyze advanced cyber threats. We note that as internet security attacks have evolved fromsimple virus insertion to more toxic advanced threats, including network intrusion and data theft, the combination of Splunk’ssoftware with a partner like Palo Alto Networks can provide customers with a more robust defense. According to management,security-related applications account for 40% of revenue.

Splunk offers an array of products anchored by its core Splunk Enterprise software, which may be purchased throughan on-site license, as a cloud service, or as a virtual machine through Amazon Web Services. For Splunk Enterprise, customerspay a license fee based on the estimated daily data indexing capacity that they require. For Splunk Cloud, customers pay an annualsubscription fee based on the volume of data indexed per day and the length of the data retention period. Cloud-based revenueaccounts for less than 10% of total revenue, but we think that it is a key growth area. Cloud-based revenue again doubled fromthe prior year in 2Q18, to $21.3 million. Management’s goal is to transition to a 75% subscription service model by 2020. Thecompany provides Splunk Light for the SMB segment.

To fuel its go-to-market strategy, Splunk is expanding its field sales force while also adding indirect channel systemintegrator partners. It is also expanding strategic relationships, like that with Amazon Web Services, in which Splunk Enterprisecan be integrated into other systems. While Splunk is platform-agnostic, i.e., equally compatible with AWS, Microsoft Azure orGoogle Cloud, the use of services other than AWS is generally customer driven. Given Splunk’s close partnership with AWS,growth in the company’s business on rival cloud services could become a tricky issue for management. At some point, the companymay need to choose between its relationship with AWS and opportunities for broader distribution through other partners.

We see international expansion as another important growth opportunity for Splunk, as most of its European and AsiaPacific sales currently come from system integration resellers. The company is also looking to extend its technology into otheradjacent areas, as it has already done with enterprise security and IT service monitoring. Finally, Splunk is working to developits ecosystem of customers, partners, and, just as importantly, application developers who can build customized applications onthe Splunk Enterprise platform.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on Splunk is High, the highest point on our five-point scale. The company had cash and cash

equivalents plus current investments of $1.1 billion at the end of 2Q18, flat with the end of FY17. In 2Q18, trailing 12-month freecash flow rose 56% from the prior year to $173 million. Splunk has no debt. It also has an undrawn $25 million revolving bankloan. Total liabilities were $936 million at the end of 2Q18. Deferred revenue rose 39% to $649 million.

As an early-stage tech company, Splunk does not pay or intend to pay a dividend.MANAGEMENT & RISKSDoug Merritt has served as CEO since November 2015, when he replaced Godfrey Sullivan, who became the company’s

nonexecutive chairman. Mr. Merritt joined Splunk in 2014 as senior vice president of Field Operations. He previously held seniorexecutive positions at tech giants Cisco and SAP, and also served as CEO of Baynote, a technology startup.

The company’s key software product, Splunk Enterprise, generates nearly all of its revenue and cash flow, and any bugsin the software or implementation difficulties could hurt Splunk’s financial outlook.

Splunk also has client concentration risk. As of January 31, 2017, one channel partner represented 28% and a secondchannel partner represented 16% of total revenue. Relationships with channel partners are critical for Splunk, as channel salesrepresent nearly all of the company’s non-U.S. revenue. The company’s business is also seasonal, with fourth-quarter salesrepresenting a much larger portion (32%) of annual sales than any other quarter. Not surprisingly, 1Q is the lightest revenue quarterof the year, with 20% of annual revenue.

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As a tech startup, Splunk has a relatively short operating history that has been marked by consistent GAAPunprofitability. Market sentiment about GAAP unprofitability tends to move through cycles, and investors could in the future reactnegatively to results that are currently viewed as acceptable. Splunk’s high valuation as a technology startup could also lead toa sharp selloff in the stock if the company reports inconsistent results or fails to meet investor expectations.

The company also operates in a relatively new market — enterprise machine data. It is uncertain how quickly this marketwill grow, how much share Splunk will be able to capture, and how well it will be able to manage its explosive revenue growth.In particular, it must effectively manage the transition from its current high-growth phase to a period of slower growth, while alsobuilding its product portfolio and field sales force.

Splunk also competes with more established software companies with vastly greater resources. Tech giants Oracle, BMCSoftware, CA Technologies, Hewlett Packard Enterprise, IBM, Intel, Microsoft, Dell Software, and VMware all have competingbusiness lines or have expressed interest in machine data and business analytics. Larger competitors may also be able to offerbundles of services that could be more attractive to clients. Further, although Splunk’s partnership with Amazon Web Servicescurrently benefits both parties, AWS could decide to compete directly with Splunk or make the terms of the partnership moreonerous.

The company will likely continue to invest heavily in R&D and in expanded marketing efforts, which may not producethe desired returns. In addition, as a provider of cloud data management services, Splunk transmits and stores large amounts ofcustomer data; it thus runs the risk of a data breach due to its own errors or negligence or those of third parties. Splunk also relieson systems integrators and other third-party partners to help implement its solutions and to ensure that they work properly withclients’ IT systems. If these third parties fail to implement properly or turn to other vendors, Splunk’s sales could be affected.

The company also faces integration risk from recent acquisitions, as well as risks related to patents and intellectualproperty. In particular, adverse rulings in patent infringement cases could force the company to pay confiscatory license fees,design patent workarounds, or abandon certain technologies. These additional technical and legal costs could have a negativeimpact on the company’s results.

COMPANY DESCRIPTIONSplunk is a provider of machine data analytics software that enables clients to make more informed business decisions.

Splunk’s software gives clients increased visibility into IT infrastructure and security, operations management, applicationsmanagement, compliance, and business and web analytics. Its products also enable enterprises to search, monitor, and analyzebig data sets from emerging technology applications. Splunk generates 24% of its revenue outside the U.S. It went public on April18, 2012 at $17 per share.

VALUATIONOur valuation methodology is multistage, including peer analysis, a multiple-analysis matrix applied to our proprietary

forecasts, and discounted cash flow modeling. SPLK shares have traded between $50 and $69 over the past year, and are currentlynear the high end of this range. The shares are up 29% year-to-date, above the 23% gain of the Russell 1000 Technology Indexand the increase of 24% of the Nasdaq Computer index. This includes the 8.5% gain after the release of fiscal 2Q18 results.

The trailing EV/revenue multiple of 7.5 is well below the low end of the five-year historical average range of 11.8-17.4.On a forward basis, the EV/revenue multiple of 5.8 is 1% below the peer average, less than the historical average premium of 8%.Our DCF analysis indicates a fair value for SPLK of $54 per share, below current levels but still consistent with a HOLD rating.

On August 25, HOLD-rated SPLK closed at $65.39, up $5.11. (Joseph Bonner, CFA, 8/25/17)

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STRYKER CORP. (NYSE: SYK, $139.88) .............................................................................. BUY

SYK: Selloff overdone; reaffirming $160 target

* Stryker shares fell 4.9% on August 23, the day after the company announced a voluntary recall of certain batchesof oral care products in its Sage Products business. We think the selloff provides a favorable buying opportunity.

* Stryker delivered strong 2Q17 results in its core orthopedics, medsurg and neurotechnology businesses, whichwere not affected by the Sage recall.

* The MAKO robotic system continues to see strong interest from surgeons. We think that the MAKO has thepotential to be a game-changer in orthopedic surgery.

* We are maintaining our 2017 adjusted EPS estimate of $6.47 and are raising our 2018 estimate to $7.08 from$7.03.

ANALYSISINVESTMENT THESISWe are reaffirming our BUY rating on Stryker Corp. (NYSE: SYK) with a price target of $160. We think the selloff

related to the Sage product recall provides a favorable investment opportunity.Stryker delivered strong sales growth in 2Q17. We expect performance over the remainder of the year to be driven by

the broader rollout of the Mako robotic surgical system for orthopedic procedures as well as by other new products. We think thatthe Mako system has the potential to be a game-changer in orthopedic surgery and that it will help the company to gain marketshare among surgeons.

RECENT DEVELOPMENTSStryker shares fell 4.9% on August 23, the day after the company announced a voluntary recall of certain batches of oral

care products in its Sage Products business. Stryker also trimmed its forecasts for EPS and revenue growth.The recalled products were made by a third-party manufacturer and the production of these products has now been

brought in-house. The recall was initiated due to concerns about the cross-contamination of oral care products made by themanufacturer on equipment shared with nonpharmaceutical products. Stryker is not aware of any serious adverse events associatedwith the recalled products.

The company now expects 2017 organic sales growth to come in at the low end of its previously stated range of 6.5%-7.0% and adjusted EPS to be at the low end of its forecast range of $6.45-$6.55. To put the financial impact in perspective, weestimate that the recall will lower revenue by $7-$14 million and EPS by $0.05-$0.10. The recall does not affect the orthopedics,medsurg and neurovascular products that we consider to be the company’s core businesses.

On July 27, Stryker posted 2Q17 adjusted EPS of $1.53, above the consensus estimate of $1.51 and up 10.1% from theprior year. GAAP net income rose to $391 million or $1.03 per share from $380 million or $1.00 per share a year earlier. Salesreached $3.012 billion, up 6.1% on a reported basis and 6.9% operationally.

By business segment, Orthopedics sales grew 6.5% on an operational basis. MedSurg sales rose 6.8%, and Neurotechnologyand Spine sales grew 6.9%.

The adjusted gross margin was 66.3%, up 10 basis points. Gains from a favorable product mix were offset by a negative1.5% impact from pricing as well as by currency headwinds. The adjusted operating margin was 25.0%, down 20 basis points,reflecting higher spending on product platforms and surgical training for MAKO robotic systems.

Stryker is continuing its commercial rollout of the Mako robotics-assist system for orthopedic surgery. In 2Q17, it placed26 MAKO robotic units worldwide (+53% year-over-year), with 20 in the U.S. This brings the total worldwide installed base to425 units, including 364 in the U.S.

Although both total knee and total hip replacements on the MAKO system were approved in 2015, Stryker has beendeliberate in the rollout of the Mako as it has focused on surgeon education. In fact, it appears that surgeon demand for the MAKOsystem is greater than the capacity for training. It takes about five months to bring surgeons through the training queue. In fact,the one barrier to wider MAKO adoption is Stryker’s ability to hire and train MAKO specialists to educate surgeons and OR staff.

The company is conducting a study to measure the post-surgical outcomes of MAKO procedures with respect to bonepreservation, range of motion, pain, stability and length of post-surgical rehab. The results of the study are expected to be releasedin 1Q18.

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EARNINGS & GROWTH ANALYSISAs noted above, management now expects 2017 organic sales growth to come in at the low end of its previously stated

range of 6.5%-7.0% and adjusted EPS to be at the low end of its forecast range of $6.45-$6.55. Nevertheless, we believe that Strykercontinues to post strong results in its core businesses. As such, we are reaffirming our 2017 adjusted EPS estimate of $6.47. Weare raising our 2018 estimate to $7.08 from $7.03, based on our expectations that increased use of the MAKO system will resultin higher sales of replacement hip and knee joints.

RISKSStryker faces pricing pressures from insurers and hospitals. Although insurers do not set prices for medical devices, they

do set reimbursement rates for the procedures in which these devices are used. Any reduction in reimbursements could leadhospitals to seek pricing concessions from suppliers.

Stryker also faces regulatory risks. Prior to marketing, Stryker’s products must be approved by the FDA or the relevantagencies in overseas markets.

COMPANY DESCRIPTIONBased in Kalamazoo, Michigan, Stryker manufactures and markets medical devices, primarily in the orthopedic market.

The Orthopedics segment sells joint reconstructive products (hips, knees and shoulders) and trauma implants. The MedSurgEquipment segment sells powered surgical instruments, surgical navigation systems, endoscopic products, medical video imagingequipment, and hospital beds and patient-handling systems. The Neurotechnology unit includes the neurovascular business as wellas the interventional spine and spinal implants business.

VALUATIONSYK trades at 19.4-times our 2018 EPS estimate, above the average multiple of 18.4 for our coverage universe of medical

device stocks. We believe the premium valuation is warranted given the company’s solid growth prospects in the Orthopedics andMedSurg businesses, which should benefit from recent acquisitions. We also see the Mako robotic surgical system as a cleardifferentiator in orthopedic surgery and as a means for Stryker to gain market share among surgeons.

On August 25, BUY-rated SYK closed at $139.88, up $1.11. (David Toung, 8/25/17)

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TIME WARNER INC. (NYSE: TWX, $101.42) ......................................................................... BUY

TWX: Mixed 2Q17; reiterating BUY

* Time Warner reported 3% adjusted EPS growth on 5% revenue growth in 2Q17, though sports rights paymentsand original programming costs narrowed the operating margin.

* In October 2016, AT&T announced that it would acquire Time Warner in a 50/50 cash-and-stock transaction. Whilethe deal remains under regulatory review, the parties expect it to close by the end of 2017.

* TWX shares are trading at a 6% discount to the AT&T offer price, and are likely to trade on the market’s perceptionof whether the merger will be completed rather than on business fundamentals.

* We are raising our 2017 and 2018 EPS estimates by a penny to $6.06 and $6.44, respectively.

ANALYSISINVESTMENT THESISWe are maintaining our BUY rating on Time Warner Inc. (NYSE: TWX) to a target price of $107, near the AT&T offer

price. TWX shares are trading at a 6% discount to this offer, and are likely to trade on the market’s perception of whether the mergerwill be completed rather than on business fundamentals. AT&T’s argument is that the Time Warner acquisition would be a verticalintegration, the type of merger that is typically not blocked by regulators. AT&T can also point to Comcast’s acquisition of NBC/Universal as an example of a deal that regulators approved with conditions. However, no merger of this size between a majortelecom and a top integrated media company has ever been attempted. As such, regulators will obviously take a hard look at thedeal.

Although we do not expect TWX shares to trade on fundamentals, the company’s businesses continue to perform well.TWX expects high single-digit growth in subscriber revenue in 2017, even as the cable subscriber universe continues to shrink.As Time Warner’s Hulu deal illustrates, the company is moving aggressively to partner with emerging digital distributors. Wesee these moves as an opportunity to expand its distribution and as a hedge against what may be a secular decline in cablesubscribers. As new SVOD and OTT services enter the market, both in the U.S. and internationally, we see increased demand forthe kind of premium branded video content produced by Time Warner.

Over the next several years, we expect earnings at TWX to be driven by robust increases in subscription fees, an expandedsubscriber base, and monetization at HBO, all underpinned by high-quality theatrical and television entertainment from theWarner Bros. studio.

Time Warner’s forward enterprise value/EBITDA multiple of 10.9 is 12% above the peer average, compared to anaverage discount of 1% over the past two years.

RECENT DEVELOPMENTSTime Warner’s second-quarter results beat the consensus revenue estimate by $11 million and the consensus non-GAAP

EPS estimate by $0.14.Second-quarter revenue rose 5% year-over-year to $7.3 billion, driven by robust growth at the Warner Bros. studio due

to a strong theatrical and home video slate and subscription revenue growth at Turner Networks. Adjusted operating income wasessentially flat with the prior year as growth at HBO and Warner Bros. was offset by a decline at Turner — due to contractual step-up payments for the first year of its broadcast license agreement with the NBA. The adjusted operating margin narrowed by 140basis points from the prior year, to 23.9%. Adjusted results exclude $101 million in AT&T-related merger costs in 2Q17 and an$89 million gain on assets in 2Q16.

GAAP EPS from continuing operations rose to $1.34 from $1.20 in 2Q16. Adjusted diluted EPS rose 3% to $1.33.On October 23, 2016, AT&T announced that it would acquire Time Warner in a 50/50 cash-and-stock transaction. While

the deal continues to undergo regulatory review, the parties expect it to close by the end of 2017. Although we would generallyexpect the merger to get a friendlier reception in Washington under a Republican administration, Donald Trump spoke out againstthe deal during last year’s campaign. Presumably, the Justice Department will review the deal on its legal merits, but the marketremains skittish. The TWX share price remains 6% below AT&T’s offer price, a gap that has closed slightly from 9% at the endof May. We believe the gap reflects continued investor uncertainty.

We see the Time Warner acquisition as a strategic move by AT&T to ensure access to premium branded content not onlyfor its DirecTV direct satellite video distribution business but also for its nascent wireless video business. Time Warner is hometo a portfolio of high-performance media assets, including cable and OTT service HBO, the Turner portfolio of cable channels,

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and the vaunted Warner Bros. film and television studio. HBO is arguably the most important of these assets for AT&T. As theleading premium branded cable channel with, by some estimates, 29 million subscribers, and strong digital channels in HBO GOand HBO NOW, HBO would fit nicely into AT&T’s digital streaming packages. AT&T management sees mobile video as thefuture of the wireless business as wireless bandwidth increases and as network technology evolves from LTE to 5G over the nextfew years. Verizon has taken a similar, though more conservative, approach in a series of smaller acquisitions, including AOL,the Huffington Post, and Yahoo’s operating assets.

AT&T has offered $107.50 per Time Warner share, comprised of $53.75 in cash and $53.75 in AT&T stock. The equityvalue of the transaction is $85.4 billion and the total transaction value is $108.7 billion, including Time Warner’s net debt. TheAT&T offer is 20% above the TWX closing price on October 21, 2016 and 40% above the TWX share price in late September2016, before merger rumors began to circulate.

One part of AT&T’s rationale for the deal is that it represents a vertical integration by AT&T of an adjacent businessin its supply chain, rather than a horizontal integration of a direct competitor, which would be more problematic from a regulatorystandpoint. We expect AT&T to emphasize the regulatory approval of the Comcast/NBCU merger as it works to overcomeregulatory skepticism. However, given AT&T’s size and substantial presence in both U.S. video distribution and wireless telecom,regulators are likely to give this deal extra scrutiny. We expect them to insist, at a minimum, on restrictive conditions beforegranting approval. We note that AT&T has a checkered history of regulatory overreach in M&A, exemplified by its failed attemptto acquire T-Mobile a few years ago.

AT&T management has further justified the deal by projecting accretion to both adjusted EPS and free cash flow per sharein the first year after the closing. However, we expect adjusted results to ignore merger integration costs. AT&T looks for $1 billionin run-rate cost synergies within three years of the closing.

Time Warner management sees the AT&T merger as a way to accelerate the transformation of video delivery. TimeWarner, as an early backer of the “TV Everywhere” concept, has been repeatedly frustrated by slow-moving multichannel videoprogram distributors as it has sought to simplify both the subscriber authentication of mobile devices and content discovery.AT&T’s direct broadcast satellite and wireless assets might just speed up this transformation.

We believe that Time Warner is probably selling out at the right time and view the deal as a positive for Time Warnerinvestors. Professionally produced long-form content will likely see strong demand from audiences well into the future. However,short-form, non-professionally produced content is burgeoning on the web, and capturing a significant share of youngeraudiences’ viewing time. Time Warner is clearly capable of producing hit branded content, from “Harry Potter” to “Big BangTheory.” The question is whether the flood of cheaply produced short-form video will inevitably devalue professionally producedbranded intellectual property.

In May 2016, Time Warner announced that it would pay $583 million in cash for a 10% stake in subscription video-on-demand (SVOD) distributor Hulu. Hulu is a joint venture of Disney, Twenty-First Century Fox and Comcast, and providestelevision shows on demand after their original network airing. Disney, Fox, and Comcast will each retain a 30% interest in Hulu.Time Warner management thinks that a 10% interest will easily pass muster with regulators since TWX will have no active rolein Hulu’s corporate governance.

Time Warner has also agreed to license its Turner Networks, including TBS, TNT, CNN, Cartoon Network, and TurnerClassic Movies, for both live-stream and on-demand access to a new Hulu live streaming service that launched in May 2017.Hulu’s new service is just one of a number of recent entries in the emerging market for the digital streaming of “skinny” channelbundles – similar to those already offered by Dish’s Sling TV, Sony’s Vue, AT&T’s DirecTV Now, Verizon GO90, and CBS AllAccess. Time Warner’s investment valued Hulu at almost $6 billion.

EARNINGS & GROWTH ANALYSISWe are raising our 2017 and 2018 EPS estimates by a penny to $6.06 and $6.44, respectively.Our estimates imply 5% adjusted EPS growth over the next two years, below our long-term growth rate projection of

12%. We note that Time Warner has beaten consensus EPS estimates in every quarter since 4Q08. In November 2015, managementwarned that due to currency headwinds, it no longer expected to reach its goal of generating more than $8.00 in 2018 EPS.

The Turner (cable networks) division is the company’s largest and most profitable segment, generating more than halfof adjusted OIBDA. Revenue was up 3% but operating income fell 7% in 2Q17. The revenue growth was driven by a 13% increasein subscription revenue, partially offset by an 8% decline in content revenue, as advertising revenue fell 6%. The increase insubscription revenue was driven by higher domestic rates and growth at Turner’s international networks, partly offset by a lowerdomestic subscriber count. The decline in advertising revenue reflected a tough prior-year comparison due to last year’s broadcast

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of the NCAA Division 1 Men’s Basketball Tournament and Final Four games, combined with the broadcast of comparativelyfewer NBA games in 2Q17. Turner is in the process of rebranding its two flagship networks, TBS and TNT. TBS is adding live-action comedies and late-night talk shows, while TNT is adding programs with edgier content. Of course, both networks willcontinue to carry sports, with the NCAA on TBS and NBA on TNT.

Management expects subscription revenue growth at Turner to rise in the high single digits in 2017 as contractual step-ups take effect.

HBO grew revenue by 1% and operating income by 10% in 2Q17, driven by 8% growth in subscription revenue and lowercosts. The growth in subscription revenue reflected higher domestic rates and an increase in subscribers, as well as internationalgrowth. We see HBO Now as an important first move by Time Warner into the digital streaming space, and expect it to benefitfrom premium HBO content. We think that CEO Jeff Bewkes has correctly identified on-demand anywhere/anytime viewing ofvideo content as a strong secular trend, particularly among millennials. HBO should also be able to boost subscription revenueas it moves through its distribution renewal cycle over the next few years.

At Warner Bros., 2Q revenue increased 12%, while operating income fell 28%, driven by theatrical box office successes,particularly of “Wonder Woman.” Like other major media companies, TWX is pursuing a franchise strategy on the theatrical sideby relying heavily on its DC Comics characters. Another major franchise release, “Justice League,” is slated for late 2017.

As the Hulu and AT&T deals suggest, the company is taking steps into the digital distribution of its high-value brandedvideo content, thereby hedging against the secular decline in cable subscribers. Management expects cable subscribers to continueto decline at about 2% per year. In addition to Hulu and HBO Now, which the company launched in April 2015, the company hasa number of other digital initiatives. It launched FilmStruck, an over-the-top streaming service from the Turner Classic Movieschannel and its partner, the Criterion Collection, in October 2016. In addition, its streaming partnership with Chinese internetbehemoth Tencent Holdings has passed 10 million subscribers. The company has also launched e-League on TBS, in partnershipwith WME/IMG and Amazon’s live-streaming videogame site Twitch.

On April 13, 2016, CBS and Turner announced that they had extended their multimedia rights agreement to televise theMarch Madness NCAA Division 1 Men’s Basketball Championship. The new eight-year deal extends CBS/Turner’s rights outto 2032. The rights fee for the eight-year period will be $8.8 billion or $1.1 billion per year. CBS and Turner will continue to sharethe rights, with the Final Four and Championship games alternating between CBS and Turner’s TBS network each year. Marqueesporting events like the NCAA on TBS and the NBA on TNT are key drivers of ad revenue for the Turner networks since sportingevents are watched live, making the advertising more valuable than it is with other types of programming.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on TWX is Medium, the midpoint on our five-point scale. The credit agencies give Time

Warner investment-grade ratings in the high Bs, with stable outlooks. S&P put the company on positive credit watch for an upgradeon October 24, the day after the AT&T merger announcement.

Time Warner’s quarterly dividend is $0.4025, or $1.61 annually, for a yield of about 1.6%. Our dividend estimates are$1.61 for both 2017 and 2018. We do not expect Time Warner to increase its dividend while the AT&T merger is pending. TimeWarner has also ceased repurchasing stock since the merger announcement in October 2016.

RISKSInvestors in Time Warner face numerous risks. The newest risk relates to the AT&T merger. AT&T has offered a

premium for TWX shares, which have moved toward that premium. If the deal is not approved by the regulators, the share pricecould fall sharply.

The advertising market is closely correlated with the health of the economy, and could quickly soften if economic activityfalters. The Filmed Entertainment and Networks divisions, including the fabled Warner Bros. studio, face the usual “hit-or-miss”risks of producing content for a fickle public. An additional factor has been the secular decline in DVD sales, which has impactedprofitability at these divisions. All of the company’s traditional media businesses, including Filmed Entertainment and Networks,face secular issues of audience fragmentation and increased competition as advertising dollars move to web-based media.

Time Warner faces the uncertainty of a major shift in methods of distribution from older models like linear (televisionchannel) programming and physical DVD distribution to new digital distribution methods that may not provide suitable returnson its investment in branded content. Device manufacturers and operating system developers like Apple and Amazon have becomevital to the distribution chain, and could well disrupt the traditional media power structure, perhaps relegating content producerslike Time Warner to a subordinate role.

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With the Time Warner Cable spinoff, Time Warner became a more focused company with a much greater dependenceon advertising revenues, which tend to be highly sensitive to economic slowdowns. Time Warner’s revenues, earnings, and cashflow could thus become more variable.

COMPANY DESCRIPTIONTime Warner’s businesses include television networks and filmed entertainment production and distribution. The

company’s many brands include HBO, TBS, CNN, and Warner Bros. Time Warner is considered a large-cap growth stock. TimeWarner spun off its Time Inc. magazine publishing business in June 2014 and its Time Warner Cable business in 2009. Thecompany derives close to 30% of its revenue from outside the U.S.

VALUATIONTWX shares have risen 6.4% on a total-return basis year-to-date, compared to an 11% gain for the S&P 500. The shares

trade at a 6% discount to AT&T’s offer price. TWX shares are likely to trade on the market’s perception of whether the mergerwill be completed, rather than on business fundamentals. The shares are trading above the high end of their five-year average rangefor trailing enterprise value/EBITDA (12.3 versus a range of 10.4-11.6), and above the peer median of 10.4. For the sake ofcomparison, close competitors Disney and 21st Century Fox have trailing EV/EBITDA multiples of 10.7 and 9.6, respectively.Time Warner’s forward enterprise value/EBITDA multiple of 10.9 is 12% above the peer average, compared to an averagediscount of 1% over the past two years.

We are maintaining our BUY rating on TWX to a target price of $107, near the AT&T offer price.On August 25, BUY-rated TWX closed at $101.42, up $0.10. (Joseph Bonner, CFA, 8/25/17)

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UNDER ARMOUR INC. (NYSE: UAA, $17.18) ...................................................................... HOLD

UAA: Stock fully valued; maintaining HOLD

* Although Under Armour’s direct-to-consumer and international businesses are growing rapidly, we do not expectthem to outweigh the overall deceleration in revenue.

* On August 1, Under Armour reported a 2Q17 loss of $0.03 per share, down from earnings of $0.01 per share inthe prior-year period. Overall second-quarter sales rose 8.7% (down from 12% growth in 4Q16) to $1.09 billion,above the consensus estimate of $1.08.

* Consistent with management’s revised guidance, we are lowering our 2017 EPS estimate from $0.50 to $0.44 andour 2018 estimate from $0.60 to $0.54.

* Under Armour shares are trading at 39.2-times our revised 2017 estimate, well above the average for other apparelcompanies in our coverage group. Given this relatively high valuation and prospects for slower growth in the nearterm, we believe that a HOLD rating remains appropriate.

ANALYSISINVESTMENT THESISWe are maintaining our HOLD rating on Under Armour Inc. (NYSE: UAA). In 2Q17, Under Armour’s footwear business

– a key to future growth — fell 2%, slowing more than we had anticipated. Although the direct-to-consumer and internationalbusinesses are growing rapidly, we do not expect them to outweigh the overall deceleration in revenue. On valuation, the sharesappear fully valued at 39.2-times our 2017 EPS estimate. As such, we believe that a HOLD rating remains appropriate. If revenuegrowth improves more than we anticipate, we would consider returning the stock to our BUY list. For investors interested inconsumer discretionary stocks, we recommend shares of BUY-rated Carnival Cruise Lines (CCL).

Our long-term rating remains BUY, based on the company’s innovative products and emphasis on its direct-to-consumerbusiness. We caution that UAA shares are likely to be volatile and thus suitable only for risk-tolerant investors.

RECENT DEVELOPMENTSOn August 1, Under Armour reported a 2Q17 loss of $0.03 per share, down from earnings of $0.01 per share in the prior-

year period. However, the loss was narrower than the consensus loss estimate of $0.06 per share, reflecting higher-than-expectedapparel sales. Overall second-quarter sales rose 8.7% (down from 12% growth in 4Q16) to $1.09 billion, above the consensusestimate of $1.08 billion. International revenue, which accounted for 20% of total sales, rose 57% as reported and 54% in constantcurrency. Footwear sales fell 2%, to $237 million, below the consensus estimate of $261 million. Apparel revenue increased 11%to $681 million, above the consensus of $657 million. Direct-to-consumer revenue, which represents more than a third of sales,rose 20% to $386 million.

The gross margin fell 190 basis points to 45.8%, driven by less favorable channel and product mix, offset in part by carefulinventory management. The consensus estimate had called for a gross margin of 46.2%. Operating income fell from nearly $19.4million to a loss of $4.8 million. Reflecting a much higher cost of goods sold, the operating margin declined from 1.9% to a negative0.4%, better than the consensus estimate of a negative 2.2% operating margin.

Interest expense increased from $5.8 million to $7.8 million.As discussed in a previous note, full-year 2016 revenue grew 22% to $4.8 billion, while operating earnings rose 7.5%

to $0.57.On April 7, 2016, Under Armour issued shares of Class C nonvoting stock to shareholders of record as of March 26. All

Class A and Class B shareholders received one share of Class C stock for each share owned; the additional shares had the sameimpact as a two-for-one stock split.

Under Armour expects international sales to contribute 18% of revenue by 2018. The projected growth assumes increasedbrand recognition, new distributors in Latin America and the Asia-Pacific region, and additional partnerships in China.

Management believes that its North American wholesale and apparel businesses still have significant room for growth.It also expects substantial growth in its basketball, golf, soccer, and running businesses.

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EARNINGS & GROWTH ANALYSISManagement expects revenue growth to slow significantly this year. Gross margins are also likely to be hurt by rising

inventory, which rose 8% in 1Q and 17% in the fourth quarter. For all of 2017, management now projects revenue growth of 9%-11%, down from a prior 11%-12%. The gross margin is expected to decline 120 basis points in FY17 to 45.2%. Management alsoprojects operating income of $280-$300 million, down from a prior $320 million, based on expectations for weaker gross marginsand less favorable operating leverage. Interest expense is expected to total $40 million and the tax rate is projected to be 31%-32%, down from 32%-34% previously. Adjusted earnings are expected to total $0.37-$0.40 per share. Consistent withmanagement’s revised guidance, we are lowering our 2017 EPS estimate from $0.50 to $0.44 and our 2018 estimate from $0.60to $0.54.

Over the long term, we expect UAA’s innovative product technology to attract more customers and to generate highersales and margins. In 2011, the company launched Charged Cotton, which has the softness of natural fiber, yet dries five-timesfaster. Charged Cotton has been a driver of unit growth. Another product, Storm Cotton, combines the feel of cotton with a water-repellent finish. These innovative cotton materials are helping the company to address the huge active apparel market.

FINANCIAL STRENGTHOur financial strength rating for Under Armour is Medium-High, the second-highest rank on our five-point scale. At the

end of 2Q17, cash and cash equivalents were $167 million, down from $250 million at the end of 2016. In the second quarter,inventories grew 8% year-over-year to $1.2 billion.

Long-term debt at the end of the quarter was $778 million, down from $838 million at the end of 2Q16. In May 2014,the company closed on a $150 million term loan. It drew $100 million of term-loan debt in 4Q to fund the Endomondo acquisition.The higher debt also reflected borrowings to finance two Connected Fitness acquisitions. Long-term debt/capital was 27.8% atthe end of the second quarter.

The company’s debt is not rated by any of the major credit agencies.Under Armour did not pay a cash dividend in 2015, and we do not expect it to initiate one in 2016 or 2017 given its plans

to expand its product line and broaden distribution.RISKSUnder Armour is in a highly competitive business whose products are often discretionary purchases. As such, sales are

likely to suffer in an economic downturn.As UAA expands beyond its original niche of moisture-wicking apparel, it is likely to face competition from well-

entrenched competitors, including Nike, Adidas and The North Face.So-called “technical” apparel that is highly breathable or that offers warmth without excessive bulk is also becoming

more mainstream. While this could be positive for UAA, as more consumers recognize the benefits of the company’s products,similar products are available from competitors, including Wal-Mart, J.C. Penney, and Kohl’s.

The shoe business is another risk, as well as being a huge opportunity. We believe that the shoe business is more complexthan apparel, and that the company must demonstrate that its products have the comfort, functionality and durability ofcompetitors’ offerings. The demands of different sports vary widely, and it may be difficult to make shoes that have the necessaryfunctionality for specific activities. While the shoe business could become bigger than UAA’s apparel business, it is also highlycompetitive and has lower gross margins than apparel.

We note that UAA shares trade at high multiples and that high expectations are built into earnings estimates. The sharesare subject to sharp selloffs if the company disappoints investors.

CEO Kevin Plank has majority control and is in a position to direct the election of the company’s board. We like to seeinsider ownership, though it could be difficult for outside investors to change company policies or direct a change of control.

COMPANY DESCRIPTIONUnder Armour manufactures and distributes performance apparel, footwear, and accessories for men, women and

children, and its products have become popular with competitive athletes and consumers with active lifestyles. The company’sproducts are sold in more than 25,000 retail outlets worldwide.

VALUATIONUnder Armour shares are trading at 39.2-times our revised 2017 estimate, well above the average for other apparel

companies in our coverage group. Given this relatively high valuation and prospects for slower revenue and earnings growth inthe near term, we believe that a HOLD rating remains appropriate. If revenue growth improves more than we anticipate, we wouldconsider returning the stock to our BUY list.

On August 25, HOLD-rated UAA closed at $17.18, up $0.13. (John Staszak, CFA, 8/25/17)

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NEW JERSEY RESOURCES CORP. (NYSE: NJR, $43.80) ..................................................... BUY

NJR: Raising target price by $3 to $49

* On August 2, New Jersey Resources posted fiscal 3Q17 operating earnings of $17.4 million or $0.20 per share,up from $11.1 million or $0.13 per share in fiscal 3Q16. Operating revenues rose 16% to $457.5 million from $393.2million in fiscal 3Q16.

* Our positive view of NJR reflects the company’s clear earnings visibility and steady dividend growth, strongmanagement execution, and continued investment in infrastructure projects and energy efficiency programs.

* We view New Jersey Resources as a stable, regulated utility that should provide investors with growing dividendincome and the potential for moderate share price appreciation.

* Our revised target of $49 represents a potential gain, including the dividend, of about 14% from current levels.

ANALYSISINVESTMENT THESISWe are raising our 12-month target price on BUY-rated New Jersey Resources Corp. to $49 from $46. Our revised target

represents a potential gain, including the dividend, of about 14% from current levels. We think the increase in our target price betterreflects the company’s strong fundamentals as well as the nation’s increasing demand for natural gas. In our view, the company’sbalance sheet and earnings prospects are strong. Our positive view of NJR reflects the company’s clear earnings visibility andsteady dividend growth, strong management execution, and continued investment in infrastructure projects and energy efficiencyprograms.

In all, we view New Jersey Resources as a stable, regulated utility that should provide investors with growing dividendincome and the potential for moderate share price appreciation. The company’s regulated business is complemented by potentiallyhigher-return nonregulated operations. In all, we look for annual earnings growth at NJR of 4%-5%, and total returns toshareholders, including the dividend, of 5%-6% annually. We also expect NJR to outperform most other stocks in the gasdistribution sector.

RECENT DEVELOPMENTSOver the past three months, NJR shares have gained 6%, compared to an advance of 2% for the S&P 500. Over the past

52 weeks, the shares have gained 28%, compared to an advance of 13% for the index. The five-year track record shows an increaseof 95% for NJR, versus 74% for the S&P 500. The beta on NJR shares is 0.19.

On August 2, New Jersey Resources posted fiscal 3Q17 operating earnings of $17.4 million or $0.20 per share, up from$11.1 million or $0.13 per share in fiscal 3Q16. Operating revenues rose 16% to $457.5 million from $393.2 million in fiscal 3Q16.

For the nine-month period ended June 30, 2017, operating earnings were $161.9 million or $1.88 per share, comparedto $140.1 million or $1.63 per share in the same period in FY16.

NJR expects its regulated businesses to generate between 60% to 75% of total operating earnings in FY17, while theregulated New Jersey Natural Gas (NJNG) continues to be the largest contributor. Expected contributions from its subsidiariesfor FY17 are New Jersey Natural Gas, 55%-65%; NJR Midstream, 5%-10%; NJR Clean Energy Ventures, 15%-25%; NJR EnergyServices, 5%-15%; and NJR Home Services, 1%- 3%.

The regulated New Jersey Natural Gas subsidiary posted operating earnings of $6.1 million in fiscal 3Q17, comparedwith $3.6 million in fiscal 3Q16. The almost 70% jump in fiscal 3Q17 earnings was primarily due to positive rate increase requestsand higher utility gross margin from new customer additions.

NJNG expects to invest approximately $107 million in capital expenditures through fiscal 2019 to add 26,000-28,000new natural gas customers representing an annual growth rate of an above average 1.7%

The NJR Midstream segment posted operating earnings of $3.0 million in fiscal 3Q17, compared with $2.3 million infiscal 3Q16. The 30% improvement in year-over-year results was primarily due to Acquired Funds Used during Constructionassociated with the company’s investment in the PennEast Pipeline project.

The nonregulated NJR Clean Energy Ventures subsidiary posted operating earnings of $6.3 million in fiscal 3Q17,compared with $2.4 million in fiscal 3Q16. The improvement was due to an increase in tax credits.

The nonregulated NJR Energy Services subsidiary posted operating earnings of $933,000 in fiscal 3Q17, compared with$276,000 in fiscal 3Q16. Higher quarterly results primarily reflect a decrease in O&M expense. Results for fiscal 3Q17 wereaffected by unseasonable weather.

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EARNINGS & GROWTH ANALYSISNJR expects FY17 operating earnings of $1.65-$1.75 per share. The company will report fiscal 3Q17 results on

November 11.Our FY17 EPS estimate is $1.74, and our FY18 EPS estimate is $1.86. We expect that the company will maintain strong

cost controls, further improve its balance sheet, continue with its infrastructure improvement program, and focus on its core naturalgas utility, NJNG. We look for solid growth in natural gas sales through 2019 and expect that the company will maintain positiverelations with state and federal regulators. The company should also benefit from its solar projects program, which is likely toprovide a higher return on assets than natural gas distribution.

Over the long term, we expect NJNG to post relatively strong annual customer growth of 1.6%-1.7%, aided by improvingeconomic conditions in the company’s central New Jersey service territory. We also expect earnings to benefit from potentiallyhigher-return, nonregulated operations and from customer conversions to natural gas from more expensive fuels.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for NJR is High, the top of our five-point scale. The long-term debt/total capital ratio was

44% at the end of fiscal 3Q17, compared to 45% at the end of FY16. The long-term debt/total cap ratio is well below the industryaverage of 55%.

Cash flow from operations for the first nine months of FY17 was $223.1 million, compared to $96.6 million in the sameperiod in FY16. Long-term debt totaled $1.211 billion at June 30, 2017, compared to $1.055 billion at September 30, 2016.

NJR’s current quarterly dividend is $0.255 per share, or $1.02 annually, for a yield of about 2.3%. Our dividend estimatesare $1.05 for FY17 and $1.11 for FY18. Over the last five years, the company’s dividend has grown at an average annual rate ofabout 4.3%. We expect annual dividend growth of 4.0%-5.0% over the next few years.

MANAGEMENT & RISKSLaurence M. Downes is the CEO of New Jersey Resources and its principal subsidiary, New Jersey Natural Gas. Mr.

Downes joined NJR in 1985 and has served as CEO since 1995. Mr. Downes is a director and past chairman of the American GasAssociation and the Natural Gas Council, as well as a trustee of the American Gas Foundation. Patrick Migliaccio is the CFO.

Risks for NJR shares include liquidity and credit issues, volatility in commodity prices, adverse weather conditions,regulatory constraints, and potential environmental and safety-related liabilities.

COMPANY DESCRIPTIONNew Jersey Resources provides retail and wholesale energy services to customers in New Jersey and other states, from

the Gulf Coast to New England, as well as in Canada. Its principal subsidiary, New Jersey Natural Gas, is one of the fastest-growinglocal gas distribution companies in the U.S., serving approximately 500,000 customers in central and northern New Jersey. Othermajor subsidiaries include NJR Clean Energy Ventures, NJR Energy Services, NJR Midstream and NJR Home Services.

INDUSTRYOur 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 is underperforming thus far in 2017, with a gain of 7.8%.The sector accounts for 3.2% of the S&P 500. Over the past five years, the weighting has ranged from 2.0% to 4.0%. We

think the sector should account for at most 2%-3% of diversified portfolios. The sector includes the electric, gas and water utilityindustries.

By our calculations (using 2018 EPS), the sector price/earnings multiple is 17.0, above the market average of 16.6.Earnings are expected to rise 6.4% in 2018 and 6.9% in 2017 after rising 21.5% in 2016 and falling 14.9% in 2015. The sector’sdebt-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 does offer an attractive dividend yield of about 3.4%.

VALUATIONNJR shares appear undervalued at current prices near $43-$44. Over the past 52 weeks, the shares have traded between

$30 and $44. In our opinion, NJR shares are an attractive holding for investors seeking the security of regular dividend paymentsand the potential for moderate capital appreciation.

NJR shares are trading at 23-times our FY18 EPS estimate, close to the average multiple for regulated natural gasdistribution utilities with nonregulated pipeline and storage operations. Even so, we believe that the company’s financial strength,favorable risk profile, visible forward earnings stream, strong cost controls, and attractive, integrated structure make NJR acompelling investment. The company’s generally positive relations with New Jersey regulators should also go a long way towardpreventing any precipitous falloff in profitability.

Our revised 12-month target price of $49, along with the dividend yield, implies a potential total return of about 14%.On August 25, BUY-rated NJR closed at $43.80, up $0.10. (Gary Hovis, 8/25/17)

MARKET DIGEST

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OGE ENERGY CORP. (NYSE: OGE, $36.22) ........................................................................ HOLD

OGE: Despite strong 2Q17 EPS, reiterating HOLD on valuation

* On August 3, OGE Energy Corp. posted 2Q17 earnings of $105 million or $0.52 per share, compared to $72 millionor $0.35 per share in 2Q16. Operating revenues for 2Q17 were $586 million, compared to $551 million in 2Q16.

* Our 2017 EPS estimate is $1.96, based primarily on our expectations for above-peer-average annual kilowatt hoursales growth of 1.3%-1.4%. We also expect OG&E’s growing rate base to support higher returns on equity.

* Our long-term rating remains BUY. We view the company’s visible forward earnings stream and attractiveintegrated structure, along with management’s demonstrated execution ability, as compelling reasons forinvestors to maintain their current positions.

* We expect the company to benefit from strong growth in kilowatt-hour sales, an expanding infrastructureimprovement program, and long-term earnings contributions from the limited partnership, Enable MidstreamPartners, LP.

ANALYSISINVESTMENT THESISOur rating on OGE Energy Corp. (NYSE: OGE) remains HOLD based on valuation. Our long-term rating remains BUY.

We view the company’s visible forward earnings stream and attractive integrated structure, along with management’sdemonstrated execution ability, as compelling reasons for investors to maintain their current positions. Added benefits are thecompany’s strong cost controls, well-run generation facilities, and growing dividend, as well as recent favorable rate casedecisions. Management also believes that the company has adequate liquidity through its current cash balances, cash fromoperations and credit facility to meet all anticipated cash requirements through 2019. We expect these factors, along with thecompany’s equity interest in Enable Midstream, to generate total annual returns for shareholders of 5%-6% over the next four tofive years.

RECENT DEVELOPMENTSOver the past three months, OGE shares have gained 3%, compared to an increase of 1% for the S&P 500. Over the past

52 weeks, the shares have gained 17%, compared to a 12% gain for the index. The five-year track record shows an increase of34% for OGE, versus 74% for the S&P 500. The beta on OGE shares is 0.79.

On August 3, OGE Energy Corp. (OGE), the parent company of Oklahoma Gas & Electric Co. (OG&E) and holder ofa 25.7% limited partner interest and 50% general partner interest in Enable Midstream Partners, LP, posted 2Q17 earnings of $105million or $0.52 per share, compared to $72 million or $0.35 per share in 2Q16.

Operating revenues for 2Q17 were $586 million, compared to $551 million in 2Q16.OG&E, the company’s regulated electric utility subsidiary, contributed earnings of $86 million or $0.43 per share in

2Q17, compared with earnings of $72 million or $0.35 per share in 2Q16. The 19% increase reflected lower operating expenses,which included lower depreciation expense related to the reduction in depreciation rates as directed by the Oklahoma CorporationCommission.

Despite the impact of mild late-winter temperatures, gross margin increased due to customer growth and highertransmission revenues.

Natural Gas Midstream Operations (Enable Midstream) contributed earnings to OGE Energy of approximately $18million, compared to breakeven results in 2Q16. The increase is due in part to higher natural gas volumes driven by significantdrilling rig activity and favorable customer contract execution. Enable Midstream issued cash distributions to OGE Energy ofapproximately $35 million in both 2Q17 and 2Q16.

EARNINGS & GROWTH ANALYSISOGE Energy’s earnings guidance for 2017 is $1.93-$2.09 per share. The company is expected to report its 3Q17 financial

results on November 1.Our 2017 EPS estimate is $1.96. We assume that earnings at Enable Midstream (Midstream Operations) will continue

to be hurt by low natural gas and NGL prices for the remainder of this year. However, we also look for above-peer-average annualkilowatt hour sales growth of 1.3%-1.4%, based on our expectations for continued economic improvement in OGE’s Oklahomaand western Arkansas service areas, an expanding customer base, and success with OGE’s strong cost controls.

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Our 2018 EPS estimate is $2.06, which assumes higher crude oil and natural gas prices toward the beginning of 2018,including increased earnings distributions to OGE Energy from Enable Midstream. We also expect OG&E’s growing rate baseto support higher returns on equity.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for OGE Energy is Medium-High, the second-highest rank on our five-point scale. The

company’s debt ratings are investment grade. OGE Energy plans to increase capital expenditures for electric system reliabilityupgrades in 2017 and 2018, and its strong cash flow should cover almost 75% of this cost. In addition, we look for the companyto reduce its debt obligations to about 45% of total capitalization by the end of 2017 from the current 46% at the end of 2016. Overthe next three to four years, we expect strong increases in cash flow. In addition, we believe that OGE will continue to maintainits disciplined approach to capital spending.

Assuming prudent external financing for capital expenditures and continued customer growth in its electric serviceterritory, we expect the company to generate annual shareholder returns of 5%-6% over the next four to five years.

The annualized dividend is currently $1.21 per share. Based on the company’s growing cash flow and strong financialposition, we expect dividend payouts of $1.24 in 2017 and for 2018, we are looking at $1.27. The current yield is about 3.3%, whichshould provide downside support for the stock and be attractive to income-oriented investors.

MANAGEMENT & RISKSManagement is committed to electric and gas service expansion strategies in its regulated service territories. In terms of

its nonregulated operations, the company believes that significant long-term growth opportunities exist for its Enable MidstreamPartners LP. We think the company’s platform for growth, including the new energy partnership, is solid, and are confident inmanagement’s ability to provide shareholders with increased value over the long term.

Key risks for stocks in our electric utility universe involve liquidity and credit issues; commodity price fluctuations; theeffect of adverse weather conditions on revenues; regulatory issues (especially construction cost recovery); and potentialenvironmental and safety liabilities. In addition, the capital-intensive nature of the utility industry creates ongoing liquidity riskthat must be actively managed by each company. Finally, we note that we would likely reduce our earnings estimates for OGEif economic conditions were to weaken in the company’s service territory.

COMPANY DESCRIPTIONOGE Energy is the parent company of Oklahoma Gas & Electric Co. (OG&E), which serves approximately 836,000

customers in Oklahoma and western Arkansas. OGE is also the holder of a 26.3% limited partner interest and a 50% general partnerinterest in Enable Midstream Partners LP, a natural gas pipeline and processing business with principal operations in Oklahomaand Texas. The partnership includes the midstream business of OGE Energy’s former subsidiary, Enogex LLC.

INDUSTRYOur 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 is underperforming thus far in 2017, with a gain of 7.8%.The sector accounts for 3.2% of the S&P 500. Over the past five years, the weighting has ranged from 2.0% to 4.0%. We

think the sector should account for at most 2%-3% of diversified portfolios. The sector includes the electric, gas and water utilityindustries.

By our calculations (using 2018 EPS), the sector price/earnings multiple is 17.0, above the market average of 16.6.Earnings are expected to rise 6.4% in 2018 and 6.9% in 2017 after rising 21.5% in 2016 and falling 14.9% in 2015. The sector’sdebt-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 does offer an attractive dividend yield of about 3.4%.

VALUATIONOver the past 52 weeks, HOLD-rated OGE shares have traded between $30 and $37. Despite the company’s positive

fundamentals, including an expanding rate base and a strong financial position, we see an unexciting total return potential for OGEshares over the next 12 months. The OGE shares are currently trading at a relatively high P/E multiple of 17.5. In addition, theshares are trading above our former target price of $30 and above their five-year historical average P/E of 14.9. Thus, we believethat a HOLD rating is appropriate.

At the same time, we are maintaining our long-term BUY rating. We view the company’s visible forward earnings streamand attractive integrated structure, along with management’s demonstrated execution ability, as compelling reasons for investorsto maintain their current positions. Added benefits are the company’s growing dividend, generally positive relations withregulators, and well-run electric generation facilities. The company also has a strong balance sheet and continues to add newcustomers in a growing service area economy.

MARKET DIGEST

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Looking ahead, we expect OGE Energy to benefit both from its well-managed regulated utility, OG&E, and thepotentially higher-return Midstream Operations segment, and look for total annual returns to shareholders of 5%-6% over the next4-to-5 years. The annualized dividend of $1.21 per share yields about 3.3%, and may appeal to income-oriented investors.

On August 25, HOLD-rated OGE closed at $36.22, down $0.04. (Gary Hovis, 8/25/17)

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Argus Market Digest€¦ · Good Morning. This is the Market Digest for Monday, August 28, 2017,...

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