MARKET DIGEST

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MONDAY, AUGUST 21, 2017AUGUST 18, DJIA 21,674.51

DOWN 76.22

Good Morning. This is the Market Digest for Monday, August 21, 2017, with analysis of the financial markets and comments onBaker Hughes, a GE Company, NetApp Inc., Applied Materials Inc., Cheesecake Factory Inc., Parker-Hannifin Corp.,Johnson Controls Ltd., The Kraft Heinz Company, and PACCAR Inc.

IN THIS ISSUE:* Initiation of Coverage: Baker Hughes, a GE Company: Launching coverage with a BUY rating and $43 target (Bill

Selesky)

* Change in Rating: NetApp Inc.: Upgrading to BUY with $46 target (Jim Kelleher)

* Growth Stock: Applied Materials Inc.: Boosting target to $52 following strong 3Q (Jim Kelleher)

* Growth Stock: Cheesecake Factory Inc.: Maintaining HOLD on slowing comps (John Staszak)

* Growth Stock: Parker-Hannifin Corp.: Raising estimates for Industrial blue-chip (John Eade)

* Value Stock: Johnson Controls Ltd.: Looking for upgrade opportunity (John Eade)

* Value Stock: The Kraft Heinz Company: Recent weakness offers buying opportunity (John Eade and Annie Petrino)

* Value Stock: PACCAR Inc.: Boosting EPS estimates but reiterating HOLD (John Eade)

MARKET REVIEW:After spending much of the day in positive territory, stocks weakened in the final hour of trading on Friday and closed

lower to extend Thursday’s heavy losses. The Dow Jones Industrial Average was down 0.4%, while the S&P 500 declined 0.2%and the Nasdaq Composite lost 0.1%. Stocks fell for the second week in a row, with full week declines of 0.8% for the Dow, 0.7%for the S&P 500 and 0.6% for the Nasdaq. Year-to-date gains are now 15.5% for the Nasdaq, 9.7% for the Dow and 8.3% for theS&P 500.

Politics took center stage again last week, with concerns that the Trump agenda (healthcare & tax reform, deregulationand infrastructure spending) would be stalled on worsening relations between the president and members of Congress andcontinuing White House staff shuffles. With partisan politics at extremes, sweeping reform was never going to be easy. We believethe overriding positives of still historically low interest rates, healthy employment growth, and strong consumer/businessconfidence levels should remain far more of a market driver.

The 10-year Treasury yield ended the week at 2.20%, virtually unchanged from 2.19% the prior week. Yields have beenlargely in retreat since early July, after a late-June spike (which brought the 10-year to nearly 2.4%) evaporated. The 10-year yieldnow sits near lows of the year. Meanwhile, a flight to safety has been evident in gold, which at $1,290/oz. is up 10.7% in 2017and sits near highs for the year. Minutes from July’s Federal Open Market Committee meeting released last week indicated someconcerns from members about recent low inflation readings. We think the recent lower pace of inflation, as well as a slowdownin weekly leading indicators, combined with upcoming Fed balance sheet reduction, provides the Fed with reasons to delay ormoderate interest-rate tightening.

As equity weakness played out last week, our market indicators fell. Our technical composite slipped closer to the bearishzone as NYSE breadth fell further on fewer stocks above their 150-day moving average and weakness in the bullish percentage,while CBOE trading indexes saw a small dip on put/call hedging and an adverse move in the NYSE TRIN. Our strategic compositealso fell but remained in neutral territory, with market internals hurt by relative weakness in energy, consumer cyclicals andstrength in defensive consumer staples. Market externals were little changes as relative weakness in crude oil versus industrialcommodities was offset by weak U.S. dollar-driven gains in emerging stocks and debt. We note that small caps are near March-April lows. We expect to see some support for the market at the 3%-5% decline level (or about 2,400 on the S&P 500), while abreak below would point to a deeper correction.

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Small caps have indeed struggled of late, with the Russell 2000 down 5.4% over the past month and the index now flatfor the year-to-date period. Mid-caps have not fared much better, with the S&P 400 down 4.6% over the past month and up only1.9% for the year. Typically, large-cap strength would eventually lift small/mid-caps as investors searched out better bargains.But large-cap companies are enjoying several edges that include generally better pricing power, international exposure withbenefits from a weaker dollar, larger share-buyback programs that provide ongoing support for share prices, and ongoing shiftsfrom active management to passive (mostly large cap) index funds. Meanwhile, small caps contend with a higher risk level, whereeven slight earnings misses can be devastating to share prices amid lower trading liquidity. Large-cap favoritism is unlikely tochange.

Looking at this week’s economic calendar, the Chicago Fed national activity index for July will be released on Monday.Tuesday brings the FHFA house price index for June and the Richmond Fed manufacturing index for August. On Wednesday,new home sales for July will be released. Thursday will bring existing home sales for July, and the PMI composite flash and KansasCity Fed manufacturing index for August. On Friday, durable goods orders for August will be released.

MARKET DIGEST

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BAKER HUGHES, A GE COMPANY (NYSE: BHGE, $32.77) .................................................. BUY

BHGE: Launching coverage with a BUY rating and $43 target* Baker Hughes and General Electric’s oil and gas business completed their merger on July 3, 2017. GE has a 62.5%

interest in the new company and legacy Baker Hughes shareholders have a 37.5% stake.

* We expect GE’s strength in digital technology to complement Baker Hughes’ traditional energy services andequipment offerings. We also expect the combined company to compete more effectively with close rivalsHalliburton and Schlumberger.

* We are establishing EPS estimates of $0.36 for 2017 and $1.62 for 2018 for the new BHGE. Our estimates assumea gradual increase in crude oil prices, increased drilling activity and modest margin growth, with strongerimprovement in 2018.

* Our target of $43 implies a potential total return, including the dividend, of 32% from current levels.

ANALYSISINVESTMENT THESISWe are initiating coverage of Baker Hughes, a GE company (NYSE: BHGE) with a BUY rating and a price target of $43.

The company was formed in early July from the merger of the former Baker Hughes Inc. and General Electric’s oil and gasbusiness. We expect GE’s strength in digital technology to complement Baker Hughes’ traditional energy services and equipmentofferings. We also expect the combined company to compete more effectively with close rivals Halliburton and Schlumberger.Our target of $43 implies a potential total return, including the dividend, of 32% from current levels

RECENT DEVELOPMENTBaker Hughes and General Electric’s oil and gas business completed their merger on July 3, 2017. The new company,

now called Baker Hughes, a GE company, is the third-largest oil field services company in the world. Under the terms of themerger, initially announced last October, Baker Hughes converted to a partnership and GE contributed its oil and gas businessto that partnership. Former BHI shareholders received a special, one-time cash dividend of $17.50 per share on July 6, coveredby a $7.4 billion contribution from GE. GE has a 62.5% interest in the new company and legacy Baker Hughes shareholders havea 37.5% stake. Management expects the merger to generate total annual synergies of $1.6 billion by 2020.

We have a favorable view of the transaction. We expect the new company to compete more effectively with Halliburtonand Schlumberger, and believe that GE’s digital technology complements BHI’s service and equipment offerings.

On July 28, in its last report as an independent company, Baker Hughes Inc. reported an adjusted 2Q17 net loss of $46million or $0.11 per share, compared to an adjusted net loss of $392 million or $0.90 per share in the prior-year quarter. Theadjusted net loss was wider than our net loss estimate of $0.04 per share and the consensus loss estimate of $0.02 per share. Second-quarter revenue of $2.404 billion was comparable to the prior year and up 6% sequentially.

EARNINGS & GROWTH ANALYSISWe are establishing EPS estimates of $0.36 for 2017 and $1.62 for 2018 for the new BHGE. Our estimates assume a

gradual increase in crude oil prices, increased drilling activity and modest margin growth, with stronger improvement in 2018.The current consensus forecasts are $0.40 for 2017 and $1.64 for 2018. Our projections parallel our estimates for the company’sclose competitors Halliburton and Schlumberger.

FINANCIAL STRENGTH & DIVIDENDWe rate BHGE’s financial strength as Medium, the midpoint on our five-point scale. The company’s debt is rated A+/

stable by Standard & Poor’s and A3/stable by Moody’s. At the end of 2Q17, the company’s total debt/capitalization ratio was19.5%, well below the peer average. Short- and long-term debt totaled $3.009 billion, consisting of $331 million in short-termborrowings and $2.678 billion in long-term borrowings. BHGE had cash and equivalents of $4.133 billion at the end of 2Q17.

BHGE pays a quarterly dividend of $0.17 per share, or $0.68 annually, for a yield of about 2.0%. Our dividend estimatesare $0.68 for both 2017 and 2018.

MANAGEMENT & RISKSMartin Craighead, the former chairman and CEO of Baker Hughes, is the vice chairman of BHGE. Lorenzo Simonelli,

the former CEO of GE Oil & Gas, is the company’s new chairman.The primary driver of BHI’s business is capital spending by customers. Demand for the company’s services is largely

dependent on commodity prices, the number of oil rigs in operation, the number of oil and gas wells being drilled, the depth andcondition of those wells, production volumes, and well completions.

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COMPANY DESCRIPTIONBaker Hughes, a GE Company was formed from the merger of Baker Hughes Inc. and GE’s oil and gas business in July

2017. The new company is 62.5% owned by General Electric, and 37.5% owned by former BHI shareholders. The new BHGEis the world’s third-largest oil services company, with annual pro forma revenues of $23 billion and approximately 70,000employees.

INDUSTRYOur rating on the Energy sector is Market-Weight. While oil prices are moving higher, the Energy sector is not yet

rebounding in terms of capital investment or the replacement of lost production. But we believe those are the next steps in therecovery process. The sector accounts for 6.0% of the S&P 500. Over the past five years, the weighting has ranged from 5% to14%. We think that investors should consider allocating 5%-7% of their diversified portfolios to the Energy group. The sectorincludes the major integrated firms, as well as exploration & production, refining, and oilfield & drilling services companies.

By our calculations, the projected P/E ratio on 2018 earnings is 21.2, above the market multiple of 16.6 given thechallenging sector earnings outlook.

We forecast that West Texas Intermediate crude will average $52 per barrel in 2017, up from $43 in 2016 but well belowthe average price of $93 set in 2014. We also expect oil prices, which have been lower this year than we initially projected, to remainvolatile. We look for a full-year price range of $42-$60, down from our prior estimate of $43-$66. Our 2017 forecast for thewellhead price of Henry Hub natural gas remains $2.50-$3.60 per MMbtu.

VALUATIONBHGE shares have trended lower since they began trading on July 3, 2017. The shares are trading at a high 91.1-times

our 2017 EPS estimate, reflecting weak current-year earnings, and at a more reasonable 20.3-times our 2018 estimate, below thepeer group average of 22.0. BHGE is also trading at a trailing price/book multiple of 2.0, below the peer average of 2.7; at aprojected 2018 price/sales multiple of 2.7, compared to 2.6 for peers; and at a projected 2018 price/cash flow multiple of 6.3, wellbelow the peer average of 12.6. Our target price of $43 implies a multiple of 26.5-times our 2018 EPS forecast, and a total potentialreturn, including the dividend, of 32% from current levels.

On August 18, BUY-rated BHGE closed at $32.77, down $0.03. (Bill Selesky, 8/18/17)

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NETAPP INC. (NGS: NTAP, $39.35) ...................................................................................... BUY

NTAP: Upgrading to BUY with $46 target* NTAP shares have retreated from a recent peak above $45 and appear attractive at current prices near $39.

* In our view, NTAP is positioned for at least a year of revenue and earnings growth, driven by improving productsales.

* NTAP also has the potential for multiyear growth as service & maintenance revenues, starved by stagnant productsales in recent years, begin to benefit from an increase in the installed base.

* NTAP shares trade at significant discounts to historical comparables, peer-group metrics, and DFCF valuations.At the same time, NetApp is poised to deliver EPS growth exceeding that of direct peers, the technology sector,and the broad market.

ANALYSISINVESTMENT THESISWe are raising our near-term rating on NetApp Inc. (NGS: NTAP) to BUY from HOLD, and setting a target price of $46.

The shares have retreated from a recent peak above $45 on a combination of nonfundamental weakness (the summer Tech sectorcorrection) and a generally negative response to fiscal 1Q18 results. We see value in the stock at current prices near $39.

In our view, NTAP is positioned for at least a year of revenue and earnings growth, driven by improving product sales.NTAP also has the potential for multiyear growth as service & maintenance revenues, starved by stagnant product sales in recentyears, begin to benefit from an increase in the installed base.

NetApp has long targeted user adoption of its Clustered Data ONTAP operating system for fiber-attached storage (FAS).The company is now equally focused on several key growth drivers, most notably all-flash arrays, converged infrastructure, anddata management across hybrid cloud environments.

Our new BUY rating comes with caveats. NetApp is currently benefiting from integration issues at Dell EMC and turmoilat Hewlett Packard Enterprise; those dislocations will likely diminish in the coming quarters. All-flash niche players such as PureStorage also represent a competitive threat. In addition, previously easy comparisons at NetApp will become more challengingas FY18 progresses.

At the same time, we believe that NetApp has substantial opportunities to promote its all-flash products; to develop theconverged market and promote its upcoming hyper-converged solution; and to help enterprises manage data resources and storageacross hybrid environments.

Having pulled back from recent peaks, NTAP is trading within 12% of its average five-year price of $35.50 and appearsattractive at current levels. NTAP’s two-year forward P/E of 11.8 is below the trailing five-year P/E of 13.8, an anomaly amonghigh-profile tech stocks. In a rising market, the two-year forward relative P/E of 0.68 is also below the five-year trailing relativeP/E of 0.87. The stock looks equally attractive based on peer group comparisons and our 2- and 3-stage discounted free cash flowmodels.

The Street projects average two-year forward EPS growth of 12%, while we look for 13% growth. That is better thanour outlook for most direct peers, the technology sector, and the broad market. Reflecting this positive outlook, we calculate ablended value in the low $50s. Appreciation to our 12-month target price of $46, along with the current 2.0% dividend yield,implies a risk-adjusted 12-month return in the mid-teens, and is thus consistent with a BUY rating.

RECENT DEVELOPMENTSNTAP is up 12% year-to-date in 2017, compared with a 7% gain for the Argus Information processing & storage peer

group. NTAP rose 33% in 2016, while the (greatly reduced) storage peer group was up 41%. NTAP shares declined 36% in 2015,while the “old” peer group of Argus-covered storage equities declined 27%. NTAP rose 1% in 2014, rose 23% in 2013, fell 8%in 2012, declined 34% in 2011, and rose 60% in 2010, following a 146% surge in 2009 from cycle lows in 2008.

We believe that NetApp has a strong near-term opportunity to grow product sales amid industry consolidation andchallenges at competitors. Storage has long been dominated by spinning disk arrays; the transition to all-flash is following the usualtech sector pattern of initial low adoption followed by an accelerated adoption period that confounds industry pundits.

Large full-service competitors such as Dell EMC and Hewlett Packard have all-flash offerings. But Dell EMC has beensaddled with integration issues, while HPE is struggling to keep its server business relevant in the cloud era. And at both of thesecompanies, storage must fight for a place at a table already crowded by PCs, servers, enterprise services, networking, and otherofferings.

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NetApp’s focus on storage may be an advantage during a period of industry turmoil and consolidation. The companyalso has a clear strategy under CEO George Kurian. After a first phase of shifting its business to growth areas while building acost-efficient operating structure, NetApp is now delivering sustained revenue growth, higher margins, and stronger returns toshareholders.

For fiscal 1Q18, NetApp reported revenue of $1.33 billion, which was up 2% year-over-year but down 11% sequentiallyfrom seasonally strong 4Q17; above the $1.32 billion midpoint of management’s wide $1.24-$1.39 billion guidance range; andabove the $1.32 billion consensus estimate. Non-GAAP earnings of $0.62 per diluted share were up 36% year-over-year, thoughdown $0.24 from 4Q17; above the high end of management’s guidance range of $0.49-$0.57; and above the $0.55 consensusestimate.

In fiscal 1Q18, NetApp’s all-flash business achieved an annual revenue run rate in the $1.5 billion range, while rising95% year-over-year. Smoothing out all seasonal variation, annualized revenue would translate to about $375 million in quarterlyrevenue, or approximately 28% of total revenue for 1Q18. This figure includes some service sales; however, all-flash product salesare approaching 50% of total array product sales. NetApp has two significant growth opportunities in all-flash: converting theexisting installed base of customers, and displacing competitors’ legacy disk-based arrays.

NetApp is also focused on enabling data management across hybrid cloud environments. NetApp has long targeted useradoption of its Clustered Data ONTAP operating system for its fiber-attached storage (FAS). The proprietary “cDOT” OS is nowshipping on most product sales, including NetApp’s all-flash arrays.

The company’s data fabric simplifies and integrates data management in the cloud and in on-premises environments,which is a key customer requirement. The company’s channel partners (who drive four-fifths of sales) and direct sales force haveshifted from product-based sales to solutions-based sales to address what management sees as a $55 billion opportunity. TheGreenQloud niche acquisition adds cloud orchestration to the company’s toolkit.

Another market opportunity is growth is converged infrastructure, in which multiple IT components (storage, Ethernetnetworking, servers, etc.) share a single network or data center space. NetApp got into this business by pairing with Cisco (andearlier with VMWare. The (now EMC-free) partnership provides FlexPod converged infrastructure solutions that pair NetAppFAS gear with Cisco networking gear.

All-flash FlexPod strengthened NetApp’s #2 position in converged infrastructure, according to the CEO. FlexPodrevenues advanced 26% year-over-year in calendar 1Q17, according to IDC. In 1Q18, NetApp introduced FlexPod SF, whichincorporates elements of NetApp’s SolidFire technology, enabling programmable agility and scale-out. In fiscal 2018, NetAppand the FlexPod partnership plan to launch a hyper-converged solution, which adds a software layer to create a fully software-defined IT infrastructure.

These three key product areas – all-flash, converged infrastructure, and enabling hybrid cloud – should drive productsales growth in the low to mid-single digits in FY18-FY19. We believe that NetApp will be able to sustain total top-line growthover a longer period, however. That will require NetApp to use the current period of above-average product growth to rebuild itsinstalled base, and thus strengthen the long-term outlook for recurring revenues in software and hardware maintenance, andprofessional services.

Revenue from these service-related areas has been impaired, however, by years of declining product revenue. NetApplast grew product revenue in fiscal 2012, to a peak of $4.21 billion. Product revenue declined 3% in FY13, 4% in FY14, 7% inFY15, and 18% in FY16, before edging up 1% in FY17. Product revenue was $3.01 billion in FY17, or about 71% of the peaklevel in FY12.

Non-Product revenue – including software maintenance, hardware maintenance, professional and other services –coasted for years on earlier product strength. Non-Product has also become a more important revenue source, rising from 32%of sales in FY12 to 46% in FY16 and FY17. But as product sales have weakened, growth in non-product revenue has beendecelerating, from 11% in FY13, to 6% in FY14, and to the low single digits in FY15 and FY16.

The non-product category swung to negative (down 2%) in FY17, with software service (up 2%) doing better thanhardware maintenance & professional services (down 4%). Non-Product revenue was down 5% annually in 1Q18. As productgrowth improves, we expect the services and maintenance-related contribution to gradually turn positive, although we do not havea near-term timetable on this shift.

Our new BUY rating comes with caveats. NetApp is currently benefiting from integration issues at Dell EMC and turmoilat Hewlett Packard Enterprise; those dislocations will likely diminish in the coming quarters. All-flash niche players such as PureStorage also represent a competitive threat. In addition, previously easy comparisons at NetApp will become more challengingas FY18 progresses.

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In 1Q18, the formerly fast-growing Strategic Products category declined more than overall revenue on a sequential basis.There is a high degree of seasonality in NetApp’s business, and margins compress in low-revenue periods. Finally, productrevenue growth is likely benefiting from elevated NAND and DRAM prices; that strength may not last, as memory is the mostvolatile technology niche when it comes to price.

That said, we believe that NetApp has substantial opportunities to promote its all-flash products; to develop theconverged infrastructure market and promote its upcoming hyper-converged solution; and to help enterprises manage their dataresources and storage across hybrid environments. As accelerating product sales increase the installed base, growth should followin service & maintenance revenue (nearly half of total revenue).

For 2Q18, NetApp guided for revenue of $1.31-$1.46 billion, which at the midpoint would be up about 4% year-over-year. We expect product revenue to grow faster than non-product revenue for both the quarter and the full year. Managementprojects non-GAAP EPS of $0.64-$0.72, which at the midpoint of $0.68 would be up 14%.

NTAP appears attractive at current levels, based on historical comparable, peer group, and discounted free cash flowvaluation. The stock has been a multiyear laggard, but may now be positioned for multiyear outperformance based onmanagement’s sound strategy, competitive market factors, prospects for above-average product growth in the near term, and thepotential to restore growth in non-product revenue over time.

EARNINGS & GROWTH ANALYSISFor fiscal 1Q18, NetApp reported revenue of $1.33 billion, which was up 2% year-over-year, but down 11% sequentially

from a seasonally strong 4Q17; above the $1.32 billion midpoint of management’s wide $1.24-$1.39 billion guidance range; andabove the $1.32 billion consensus estimate.

The non-GAAP gross margin expanded sequentially to 64.1% in 1Q18 from 62.7% in 4Q17 and from 61.2% in 4Q16.NetApp’s significant restructuring program, which includes a 12% headcount reduction, has reduced operating costs. The non-GAAP operating margin narrowed sequentially on lower volume leverage, to 15.8%, down from 20.7% in fiscal 4Q17, butexpanded from 12.1% in the year-earlier quarter.

Non-GAAP earnings of $0.62 per diluted share for 1Q18 were up 36% year-over-year but down $0.24 from 4Q17; abovethe high end of management’s guidance range of $0.49-$0.57; and above the $0.55 consensus estimate.

For all of FY17, NetApp posted revenue of $5.52 billion, down less than 1% from $5.55 billion in FY16. Non-GAAPEPS totaled $2.73, up 28% from $2.14 in FY16.

For 2Q18, NetApp guided for revenue of $1.31-$1.46 billion, which at the midpoint would be up about 4% year-over-year. We expect product revenue to grow faster than non-product revenue for both the quarter and the full year. Managementprojects non-GAAP EPS of $0.64-$0.72, which at the midpoint of $0.68 would be up 14%.

Given improving margins and the strong product-sales profile, we are increasing our FY18 non-GAAP EPS forecast to$3.25 per diluted share from $2.99 and our FY19 estimate to $3.42 from $3.30.

The Street projects average two-year forward EPS growth of 12%, while we look for 13% growth. That is better thanour outlook for most direct peers, the technology sector, and the broad market. Both estimates are contingent on the companyachieving its strategic transformation and end markets remaining healthy.

Our GAAP forecasts are $2.57 per diluted share for FY18 and $2.68 for FY19. Our long-term EPS growth forecast is10%.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for NetApp is Medium-High. NetApp took on short-term debt to finance the $870 million

purchase of SolidFire in 2016.Total debt was $2.39 billion at the end of 1Q18. Debt was $2.41 billion at the end of FY17, $2.40 billion at the end of

FY16, and $1.49 billion at the end of fiscal 2015, following the issuance of $500 million in senior notes due 2021.Debt/cap was 46.4% at the end of fiscal 2017, 44.8% at the end of FY16, and 30.3% at the end of fiscal 2015.Cash was $5.32 billion at the end of 1Q18. Cash was $4.92 billion at the end of FY17, $5.46 billion at the end of FY16,

and $5.33 billion at the close of FY15.Net cash was $2.93 billion at 1Q18. Net cash was $2.56 billion at the end of FY17, $2.95 billion at the end of FY16, and

$3.85 billion at the end of FY15.Cash flow from operations was $986 million in FY17, $974 million in FY16, and $1.27 billion in FY15.In February 2015, NetApp announced a $2.5 billion share repurchase authorization. The company is committed to

completing this program by May 2018.In May 2017, the company hiked its quarterly dividend by 5% to $0.20 per common share. NetApp increased its quarterly

dividend by 6% to $0.19 per share in May 2016, by 9% to $0.18 in May 2015, and by 10% to $0.165 in May 2014.

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We are now modeling a 5% hike in the quarterly dividend in May 2018. We estimate annual dividends of $0.80 per sharein FY18 and $0.84 in FY19.

MANAGEMENT & RISKSGeorge Kurian has been CEO since June 2015. Ron Pasek, formerly of Altera, replaced Nick Noviello as chief financial

officer in March 2016.The acquisition of SolidFire represents a new risk, particularly given the poor performance of Engenio, the prior major

acquisition. Only time will tell if NetApp has bought a redundant or complementary asset. An additional risk comes from fundingthe integration of this asset while simultaneously reducing investment in traditional businesses.

The latest restructuring program, along with the program from early 2014, highlights risks related to reduced hardwareintensity in the next-generation, cloud-enabled data center. It also specifically raises questions about the wisdom of the Engenioacquisition. We could see impairments in goodwill and intangible assets as a result of business reassessment.

Competition is always a risk in the storage industry, particularly from EMC. NetApp also faces competition fromHewlett-Packard, Dell and Hitachi, as well as from smaller companies in the all-flash space. We regard NetApp’s ability to offerall its products around a common operating system (Data ONTAP) as a competitive advantage, particularly as data managementis dispersed across internal IT and external cloud-based resources.

We note that the financial services sector typically contributes 14%-15% of NetApp’s total revenue and that the U.S.government has also been a major NetApp customer, contributing 11%-12% of revenues. While sector concentration remains arisk, the impact appears to be diminishing.

COMPANY DESCRIPTIONNetApp Inc. is a pure-play data storage company, providing enterprise network storage and data management solutions,

including storage hardware, software and services. NetApp has several powerful partners, including IBM, VMware, Cisco,Microsoft, and Fujitsu. In May 2011, at the beginning of FY12, NetApp acquired “Big Data” hardware provider Engenio; and inFebruary 2016, it acquired all-flash array maker SolidFire. In FY17, NetApp generated $5.52 billion in revenue.

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 strongly outperforming thus far in 2017, with a gain of 17.1%.

Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2017earnings is 18.7, slightly above the market multiple of 18.4. Earnings are expected to grow 30.2% in 2017 following low single-digit growth in 2015-2016. The sector’s debt ratios are below the market average, as is the average dividend yield.

VALUATIONHaving pulled back from recent peaks, NTAP is trading within 12% of its average five-year price of $35.50 and appears

attractive at current levels. NTAP’s two-year forward P/E of 11.8 is below the trailing five-year P/E of 13.8, an anomaly amonghigh-profile tech stocks. In a rising market, the two-year forward relative P/E of 0.68 is also below the five-year trailing relativeP/E of 0.87. The stock looks equally attractive based on peer group comparisons and our 2- and 3-stage discounted free cash flowmodels.

Reflecting our more positive near- and long-term growth outlook for NetApp, particularly as increasing product salesrebuild the service & maintenance revenue opportunity, our revised discounted free cash flow analysis suggests a value in the mid-$50s, in a rising trend from the mid-$40s one year ago. Reflecting its superior growth prospects, NTAP trades at a significantdiscount to the peer average PEG multiple, and at a smaller discounts on P/E, price/sales, and price/book value.

We have calculated a blended value for NTAP in the mid-$50s, in a rising trend. Appreciation to our 12-month targetprice of $46, along with the 2.0% dividend yield, implies a risk-adjusted 12-month return in the mid-teens, and is thus consistentwith a BUY rating.

On August 18, BUY-rated NTAP closed at $39.35, down $0.21. (Jim Kelleher, CFA, 8/18/17)

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APPLIED MATERIALS INC. (NGS: AMAT, $44.30) ................................................................ BUY

AMAT: Boosting target to $52 following strong 3Q* Applied Materials delivered a fifth consecutive record quarter, with fiscal 3Q17 sales and EPS growing sharply and

topping expectations.

* Management expects 20% growth in global wafer fab equipment demand in 2017, up from its 15% growth forecastin May, and looks for further growth in 2018.

* In the first nine months of FY17, the company posted cash flow from operations of $2.91 billion, up from $1.67 billiona year earlier and well above the full-year total of $2.47 billion in FY16.

* The company’s increasingly efficient operations and growing volume leverage are leading to expanded marginsand accelerating profit growth. As such, we believe the shares remain undervalued even after their strong recentrun-up.

ANALYSISINVESTMENT THESISBUY-rated Applied Materials Inc. (NGS: AMAT) delivered a fifth consecutive record quarter, with fiscal 3Q17 sales

and EPS growing sharply and topping expectations. Revenue of $3.74 billion grew 33% year-over-year, while non-GAAP EPSof $0.86 grew 70%.

AMAT saw double-digit revenue growth in its three operating segments — Semiconductor Systems, Global Servicesand Display — and margins and earnings expanded in all businesses. In Semiconductor Systems, where overall revenue growthtopped 40%, DRAM-related revenue nearly doubled from the prior year, while NAND and Foundry were also strong. Revenuegrowth was positive in nearly all regional markets, with especially strong growth in Korea. In what we regard as a key metric, cashflow from operations thus far in FY17 already exceeds the full-year total in FY16.

CEO Gary Dickerson believes that AMAT currently has more opportunities than at any time in its history, given strongmarkets that include nontechnology verticals and are expanding to accommodate IoT, AI and big data. The company also believesits operations and platform give it sustainable advantages.

Management expects 20% growth in global wafer fab equipment demand in 2017, up from its 15% growth forecast inMay; the company looks for further WFE growth in 2018. Semiconductor companies and their merchant fab partners are seekingto execute challenging transitions to new technologies, including 3D NAND, FinFET (3D) CPUs, and 10 nm DRAM. Thesecompanies are counting on AMAT’s advanced solutions and expertise in materials innovation to facilitate these transitions.

We believe that Applied Materials’ ability to address significant technology transformations bodes well for AMATshares going forward. The company’s increasingly efficient operations and growing volume leverage are leading to expandedmargins and accelerating profit growth. As such, we believe the shares remain undervalued even after their strong recent run-up.We are reiterating our BUY rating on AMAT to a 12-month target price of $52, raised from $43.

RECENT DEVELOPMENTSAMAT is up 37% year-to-date versus a 15% gain for Argus-covered semiconductor stocks, a 19% gain for the SOX

semiconductor index, and a 9% rise for the S&P 500. The shares advanced 30% in 2016, compared to a 70% gain for Argus-coveredsemiconductor stocks. AMAT declined 25% in 2015, while semiconductor stocks in Argus coverage rose 9% for the year. AMATshares rose 41% in 2014, compared to an average 18% gain for the peer group. In 2013, AMAT advanced 55%, while the ArgusSemiconductor peer group rose 22%.

For fiscal 3Q17 (ended July 31), Applied Materials reported revenue of $3.74 billion, which was up 33% year-over-yearand 6% sequentially; toward the high end of management’s guidance range of 3.60-$3.75 billion; and above the consensus callof $3.69 billion. Non-GAAP earnings of $0.86 per diluted share were up 70% year-over-year and $0.07 on a sequential basis; nearthe high end of management’s guidance range of $0.79-$0.87; and two cents above consensus expectations.

For 3Q17, Semiconductor Systems revenue of $2.53 billion (68% of total) was up 42% annually and 6% sequentially.Operating profit grew 71% annually and the operating margin of 34.5% expanded from 28.6% a year earlier and from 33.6% in2Q17.

Within Semiconductor Systems, Foundry revenue (39% of SS total sales) was up 49%, and NAND (38% of SS total)was up 31%. DRAM (15% of SS total sales) showed even stronger demand, with revenue up 93% annually amid industry memoryshortages. Logic (8% of SS total) edged up 3% from the prior year.

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Global Services revenue (21% of total revenue) advanced 20% year-over-year; segment profit grew 22% and theoperating margin of 27.1% expanded by 50 points. Display revenue (11% of total) advanced 31% year-over-year; segment profitgrew 44% and the operating margin of 22.2% rose by 201 basis points.

Regionally, AMAT experienced solid annual sales growth in almost every major market. Except for Southeast Asia andTaiwan, which each posted declines, sales in all other major markets grew in the high double digits, led by Korea, where revenuenearly tripled. Total Asian revenue (85% of company total) rose 33%; non-Asian (13% of total) was also up 33%.

Applied Materials delivered a fifth consecutive quarter of record revenue and earnings. Management expects continuednew record levels of activity, and believes that growth can accelerate from current levels based on AMAT’s strong positioning.

AMAT believes that it has more opportunities at present than at any time in its history. Amid “pervasive” demand forelectronics, traditional technology markets are strong and getting larger, which is serving to smooth out historical seasonality. Newdemand drivers, including IoT, AI and big data, are “layering on” traditional markets such as computing and mobility. Ascompanies engage in digital transformation enabled by new technologies, technology demand is exploding across multiple non-technology verticals, including transportation, healthcare, manufacturing, retail, and others.

Applied believes it is better positioned than at any time in its history, with a portfolio of assets “uniquely levered toindustry inflections,” according to CEO Dickerson. AMAT is levering and combining its skills in deposition, removal, materialsmodification, inspection and metrology. Management has put in place a company-wide operating system that delivers “repeatablesuccess,” enabling efficient operations and margin expansion.

Beyond AMAT’s core operations, its markets remain healthy. The company expects continued “healthy” investment inmemory semiconductor-fabrication equipment, driven by explosive data growth around IoT, big data and AI. In NAND, thetransition to 3D scaling has several major levers – reducing film and stack heights, lateral scaling, multi-tier schemes – enabledby advanced materials engineering, which plays to AMAT’s market strengths.

In foundry, advances in AI are beginning to drive significant architectural changes. AI-enabled data centers and HPC(high performance computing) environments require logic content that is growing at twice the rate of memory content. In DRAM,amid the ever-pressing drive to attain smaller form factors, dimensional scaling of devices remains an ever-present challenge.AMAT technology delivers new innovations in patterning, such as self-aligned multi-patterning techniques, in conjunction withEUV lithography to deliver the necessary resolution. Applied has gained significant market share in patterning since 2012 as thechallenge of shrinking process nodes drives competitors from the market.

Given positive demand factors, AMAT now expects semiconductor wafer fabrication equipment (WFE) spending toincrease by 20% in 2017. That is up from the company’s 15% growth forecast offered in May. It also expects further spendinggrowth in 2018, suggesting that the demand drivers benefiting the company have legs. These estimates also incorporate veryconservative expectations for China, which many expect to emerge as a leading demand driver in coming years. China hasaccounted for 21% of AMAT’s revenue in FY17, up from 16% in FY16.

Display fabrication equipment demand is growing “even faster than wafer fab equipment,” according to the CEO.Growth is being fueled by the arrival of Gen 10.5 substrates (10 meters square), which are ideal for producing large-screen TVs.In the compute and mobility space, OLED enables new form factors that result in larger display areas for smartphone and mobiledevices.

EARNINGS & GROWTH ANALYSISFor fiscal 3Q17 (ended July 31), Applied Materials reported revenue of $3.74 billion, which was up 33% year-over-year

and 6% sequentially; toward the high end of management’s guidance of 3.60-$3.75 billion; and above the consensus call of $3.69billion. The non-GAAP gross margin expanded sequentially to 46.6% in 3Q17 from 46.3% in 2Q17 and from 43.7% a year earlier.

Reflecting mix and volume leverage along with cost discipline, the non-GAAP operating margin expanded to 28.6% in3Q17 from 27.7% in 2Q17 and from 22.8% in 3Q16. Non-GAAP earnings of $0.86 per diluted share were up 70% year-over-yearand $0.07 sequentially, near the high end of management’s guidance range of $0.79-$0.87, and two cents above consensusexpectations.

For all of fiscal 2016, revenue of $10.83 billion rose 12% from $9.66 billion in fiscal 2015. Fiscal 2016 non-GAAPearnings totaled $1.76 per diluted share, up 56% from $1.13 per diluted share in fiscal 2015.

For 4Q17, AMAT projects revenue of $3.85-$4.0 billion and non-GAAP earnings of $0.86-$0.94 per diluted share. Atthe respective guidance midpoints, revenue of $3.93 billion would be up 19% annually and 5% sequentially, and non-GAAP EPSof $0.90 would be up 38%. The prereporting consensus forecast for 4Q17 had called for non-GAAP EPS of $0.82 on revenue of$3.71 billion.

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We are raising our FY17 earnings forecast to $3.25 per diluted share from $3.14 and our FY18 forecast to $3.59 perdiluted share from $3.36. Our GAAP forecasts are $3.14 for FY17 and $3.42 for FY18. Our five-year average annual earningsgrowth rate estimate remains 11%.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on Applied Materials is Medium-High. AMAT issued $2.2 billion in debt in March 2017

to “increase onshore liquidity.” Since the end of 2Q17, AMAT has used some proceeds to retire debt.Cash & investments were $8.3 billion at the end of 3Q17, $4.7 billion at the end of FY16, $6.1 billion at the end of FY15,

and $4.1 billion at the end of FY14.Total debt was $5.30 billion at the end of 3Q17, $3.34 billion at the end of FY16, $4.54 billion at the end of FY15, and

$1.95 billion at the end of FY14.Net cash was $2.99 billion at the end of 3Q17, compared to $1.34 billion at the end of FY16 and $1.37 billion at the end

of FY15.Reflecting recent operational strength, cash flow in the first nine months of FY17 was $2.91 billion versus $1.67 billion

a year earlier. Cash flow from operations was $2.47 billion in FY16, $1.12 billion in FY15, and $1.80 billion in FY14.In April 2015, Applied Materials announced a three-year, $3 billion share repurchase authorization, beginning in 3Q15.

In 1H17, it spent $412 million to repurchase shares. AMAT spent $1.89 billion to repurchase shares in FY16 and $1.3 billion inFY15. We expect a steady pace of buybacks going forward.

The current annualized dividend of $0.40 yields about 0.9%. Although major acquisition plans have been scrapped, weare not looking for a dividend hike. Our dividend estimates are $0.40 per share for both FY17 and FY18.

MANAGEMENT & RISKSGary Dickerson became CEO in September 2013. Former CEO Mike Splinter is executive chairman. In August 2017,

new CFO Dan Durn replaced Bob Halliday, who had been CFO since 2013. Randhir Thakur is the EVP and general manager ofthe Semiconductor Systems Group.

The fallout from the failed combination with Tokyo Electron entails risks, such as loss of customers’ future business thatwas predicated on combination synergies. On the other hand, AMAT no longer has risks associated with integration issues.

An additional risk for Applied Materials is that strong multiyear growth in foundry orders could be coming to an end.We see limited risk on that front. More and more companies are adopting a fully fabless or “fab-light” strategy in which they usefoundries to build their products. The explosive growth not only in mobile devices but in mobile broadband ensures that demandfor high-performance semiconductors will continue to strengthen on both a cyclical and structural basis.

AMAT strained its balance sheet to pay for Varian. Cash was reduced from nearly $7 billion to $2.5 billion, and thecompany took on approximately $2 billion in debt. Fortunately, it appears that recent softness in semiconductor capital spendingis ending. We will continue to monitor this situation, which remains fluid. We believe that Applied Materials, strengthened byVarian, is well positioned to gain market share. In our view, global demand for digital solutions is strong and will remain so goingforward, keeping AMAT’s book of business healthy.

Offsetting strength in semiconductor capital equipment are cyclical declines in the display and solar PV businesses dueto overcapacity. Despite near-term challenges, we believe that the display business provides AMAT with additional avenues forgrowth over the long term. The fate of the solar PV business hangs in the balance, in our view.

COMPANY DESCRIPTIONApplied Materials produces semiconductor fabrication equipment, including products used in deposition, etching, ion

implantation, metrology, wafer inspection and mask-making. Acquisitions expanded AMAT’s presence in flat-panel displayfabrication equipment and in the solar semiconductor market. The $4.9 billion Varian acquisition enabled AMAT to build sharein high-performance and low-power applications processors. The company’s plans to combine with Tokyo Electron have nowbeen cancelled. AMAT generated FY16 revenue of $10.83 billion.

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.

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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 about 11.5%.

Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2017earnings is 18.1, near the market multiple of 18.2. Earnings are expected to grow 31.9% in 2017 following low single-digit growthin 2015-2016. The sector’s debt ratios are below the market average, as is the average dividend yield.

VALUATIONAMAT trades at 13.7-times our FY17 non-GAAP EPS estimate and at 12.4-times our FY18 non-GAAP forecast; the two-

year average forward P/E of 13.0 is well below the five-year (2012-2016) average of 17.8. The shares trade at an average 27%discount to the market multiple, well below the five-year historical premium of 17%. Other comparable multiples signalundervaluation by historical standards, and our price-based historical comparable valuation points to a value in the mid-$50s, ina clearly rising trend.

AMAT trades in line with peers on forward P/E and price/book ratio, but at a nice discount to peers on PEG.Our discounted free cash flow analysis suggests a value in the $100s, also in a rising trend and well above current prices.

Our blended valuation estimate is now above $90, up from the $60s in less than a year. Including the current dividend yield ofabout 0.9%, appreciation to our $52 target implies a risk-adjusted total return of about 16%, better than our forecast return for thebroad market and consistent with a BUY rating.

On August 18, BUY-rated AMAT closed at $44.30, up $1.18. (Jim Kelleher, CFA, 8/18/17)

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CHEESECAKE FACTORY INC. (NGS: CAKE, $42.88).......................................................... HOLD

CAKE: Maintaining HOLD on slowing comps* Management has reduced its 3Q same-store sales guidance from growth of 0.5%-1.5% to a decline of 1%.

* Cheesecake’s earnings are driven by same-store sales, and we expect declining comps to weigh on EPS.

* We are lowering our EPS estimates to $2.80 from $2.90 for 2017 and to $3.00 from $3.10 for 2018.

* We believe that CAKE is fairly valued at 14.8-times our revised 2017 EPS estimate, below the average for othercasual dining chains.

ANALYSISINVESTMENT THESISWe are maintaining our HOLD rating on Cheesecake Factory (NGS: CAKE). The company recently posted lower

second-quarter comp sales, and cut its third-quarter comp sales guidance from growth of 0.5%-1.5% to a decline of 1%. Thesecond-quarter decline follows 29 straight quarters of growth in same-store sales. Management attributed the weakness in partto unfavorable weather in the East and Midwest, which it believes resulted in less outdoor dining. We are disappointed that therevised guidance comes just six weeks after management’s initial forecast and believe that the weak comps will continue into thethird quarter.

RECENT DEVELOPMENTSOn August 2, Cheesecake Factory reported 2Q17 adjusted EPS of $0.78, flat with the prior-year period but below

management’s $0.85-$0.88 guidance range. EPS topped the consensus forecast by $0.02. Same-store sales declined 0.5%, as 2.4%lower traffic and 0.3% less favorable mix outweighed a 2.2% contribution from higher pricing. Management had forecast a 1.0%decline in comp sales, and the Street had called for a decline of 0.9%. On average, other casual dining chains saw same-store salesdecline 70 basis points in the second quarter. In 2Q17, total revenues rose nearly 2.0% to $570 million, below the consensusestimate of $573 million.

For 2017, management now projects EPS of $2.62-$2.70, down from a prior $2.93-$3.02. The company expects compsto decline 1% this year, down from a prior estimate of 0.5%-1.0% growth. It plans to open up to 8 new restaurants in 2017(compared to a prior estimate of 8-9), and expects labor costs to rise 5%.

In 2016, revenue increased 8.3% to $2.3 billion and earnings rose from $2.38 to $2.83.EARNINGS & GROWTH ANALYSISCheesecake Factory’s earnings are driven by same-store sales, and we expect declining comps to weigh on EPS. In view

of soft casual-dining demand and an excess of casual-dining restaurants, we believe a return to strong comp growth is unlikely.Wage inflation has also weighed on earnings this year.

Looking ahead, prospects for Cheesecake Factory appear unimpressive. Management said the company has outperformedthe casual dining industry. However, it now expects a 1% decline in full-year same-store sales. We look for comp sales to decline0.5% this year after previously projecting 0.3% growth.

We are lowering our third-quarter EPS estimate from $0.74 to $0.64 and our full-year estimate from $2.90 to $2.80. Weare also lowering our 2018 estimate from $3.10 to $3.00.

Based on ongoing cost-cutting efforts and management’s guidance, our long-term earnings growth rate estimate is 15%.Over the long term, we also expect the company to exceed its goal of operating 200 Cheesecake Factory restaurants and 150 GrandLux Cafes.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on Cheesecake Factory remains Medium-High, the second-highest rank on our five-point

scale. Operating income covered interest expense of $1.3 million by a factor of 31.4 in the second quarter, up from 25.1 in the prior-year period.

In June 2017, the company raised its quarterly dividend by 21% to $0.29, or $1.16 annually, for a yield of about 1.7%.Management has targeted a payout ratio of 25%. Our dividend estimates are $1.06 (reduced from $1.12) for 2017 and $1.32 for2018.

RISKSHigher food and beverage costs are an ongoing risk for restaurant companies. Dairy costs, in particular, affect Cheesecake

Factory, as cream cheese is the primary ingredient in the company’s namesake product. In addition, increased labor turnover, aswell as higher wage and benefit costs, may reduce the company’s earnings.

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COMPANY DESCRIPTIONBased in Calabasas, California, Cheesecake Factory operates a chain of upscale casual dining restaurants and offers a

menu of more than 200 items. In addition, it operates a bakery that produces more than 50 varieties of cheesecake and other bakedproducts for the company’s restaurants and other foodservice operators, retailers and distributors.

INDUSTRYWe have raised our rating on the Consumer Discretionary sector to Over-Weight from Under-Weight. While retail stocks

continue to drag on the sector, growth is accelerating in key areas including hospitality & restaurants, media, housing materials,and automotive parts and services. The sector accounts for 12.5% of the S&P 500. We think investors should consider allocating13%-14% of their diversified portfolios to the group. Over the past five years, the weighting has ranged from 8% to 14%. The sectorunderperformed in 2016, with a gain of 4.3%, after outperforming in 2015, with a gain of 8.4%. It is outperforming thus far in2017, with a gain of 12.0%.

Consumer Discretionary earnings are expected to increase 12.4% in 2018 and 5.2% in 2017 after rising 9.4% in 2016and 9.9% in 2015. On valuation, the 2018 projected P/E ratio is 18.3, above the market multiple of 16.5. The sector’s debt ratiosare high, with an average debt-to-cap ratio of 52%. Yields are below average at 1.4%.

VALUATIONGiven prospects for weaker same-store sales and less rapid earnings growth at Cheesecake Factory, we believe that a

multiple near that of other casual dining chains is warranted. Applying a peer-average multiple of 16 to our 2017 EPS estimate,we calculate a fair value near $46, above current prices. Our revised discounted cash flow model also points to a value slightlyabove current levels. As such, our rating remains HOLD.

On August 18, HOLD-rated CAKE closed at $42.88, down $0.48. (John Staszak, CFA, 8/18/17)

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PARKER-HANNIFIN CORP. (NYSE: PH, $155.15) ................................................................. BUY

PH: Raising estimates for Industrial blue-chip* Near-term trends, which had been a problem Parker-Hannifin, appear to have turned a corner, and we see better

revenue and earnings growth ahead.

* We also have a favorable view of the recent acquisition of filtration company CLARCOR.

* Based on our expectations for margin improvement and growth in new orders, we are once again boosting our EPSestimates for FY18.

* Our dividend discount model points to a fair value of $176 per share, which is our target price.

ANALYSISINVESTMENT THESISOur rating on Parker-Hannifin Corp. (NYSE: PH) is BUY. In our view, the company is on track to achieve its long-term

goals of raising margins and growing earnings. Over time, we expect it to generate high single-digit EPS growth, driven by 2%-4% revenue growth, margin improvement, and share buybacks. Near-term trends, which had been a problem, appear to have turneda corner, and we see better revenue and earnings growth ahead. We also have a favorable view of the recent acquisition of filtrationcompany CLARCOR. The shares have moved higher over the past year, but we see the potential for further strong performance.Our 12-month target price is $176.

RECENT DEVELOPMENTSPH shares have slightly underperformed the market over the past quarter, with a gain of 3.5% versus an increase of 4.2%

for the S&P 500. The shares have also underperformed the average industrial stock, as the Industrial ETF IYJ has risen 4.7% inthe past quarter. The shares have outperformed over the past year, however, with a gain of 27%, versus a 15% advance for themarket and the sector. The stock’s long-term performance record, over multiple market cycles, is solid as well. Over the last 10years, the shares have advanced 112% versus a 60% gain for the S&P 500 and a 75% increase for the average industrial sectorstock. The beta on PH shares is 1.40.

On August 3, PH reported fiscal fourth-quarter earnings that easily topped the consensus estimate. Adjusted EPS rose29% to $2.45, benefiting from an asset sale and margin improvement, and beat the consensus by $0.14. Revenue rose a solid 6%on an organic basis (18% including acquisitions) to $3.5 billion. The overall segment operating margin increased 120 basis pointsto 16.8%. For the full fiscal year, the company earned $8.11 per share.

Along with the results, management provided guidance for FY18. The company expects full-year adjusted EPS of $8.45-$9.15, based on contributions from recent acquisitions and continued margin improvement.

In addition to organic growth, the company has a growth-by-acquisition strategy. In February, Parker completed itsacquisition of CLARCOR, a diversified marketer and manufacturer of mobile, industrial and environmental filtration products,for approximately $4.3 billion in cash, including the assumption of net debt. CLARCOR, headquartered in Franklin, Tennessee,has annual sales of approximately $1.4 billion and 6,000 employees. The deal is expected to be accretive to Parker’s cash flow,EPS and EBITDA margin.

EARNINGS & GROWTH ANALYSISParker-Hannifin has three primary segments: Diversified Industrial North America (49% of 4Q sales), Diversified

Industrial International (34%), and Aerospace Systems (17%). Fourth-quarter results and outlooks by segment are summarizedbelow.

In the Industrial North America segment, revenues rose a sequentially stronger 7.4% on an organic basis. The adjustedsegment operating margin increased 20 basis points to 18.2%. Orders were up a solid 10%. Looking ahead to FY18, we expect20% growth in sales, including contributions from the CLARCOR acquisition. We also anticipate slightly lower margins in the16.9%-17.3% range.

Revenue in the Diversified Industrial International segment rose a solid 7.7%, while the adjusted operating margin rose140 basis points to 14.0%. Orders increased a solid 10%. Looking ahead to FY18, we now expect a low-double-digit increase insales, with improved margins in the 14.7%-15.1% range.

In Aerospace Systems, organic revenue growth weakened to 0.1%. The adjusted operating margin rose 210 basis pointsto 16.4%. Orders rose 1.0%. We look for low single-digit revenue growth in this segment in FY17. We also expect to see relativelyflat margins in the 15.5%-15.9% range.

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Management is keeping a close eye on costs. The total fourth-quarter operating margin rose 120 basis points from theprior year to 16.8%, ahead of management’s target range of 15.5%-15.9%. The full-year margin was 15.8%, near the high endof the range. Management is targeting further gains through 2020; its FY18 forecast is 15.9%-16.3%.

Turning to our estimates, based on our expectations for margin improvement and the recent increase in orders, we areboosting our FY18 EPS forecast to $9.10 from $8.90. Our estimate implies growth of 12% this year. We are also setting apreliminary FY19 EPS forecast of $10.23, again implying growth of 12% as margins continue to recover and revenue improves.Our long-term earnings growth rate forecast for PH is 8%.

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

company receives above-average scores on our three main financial strength criteria of debt levels, fixed-cost coverage andprofitability.

The company had $884 million in cash and marketable securities at the end of the fiscal year. Total debt was $6 billionor 53% of total capital. Pretax income covered net interest expense by a factor of 8 last year. Management has said that it iscommitted to maintaining a high investment-grade rating and plans to pay down the debt it has taken on to buy CLARCOR.

The company’s priorities for the use of cash are dividends, acquisitions, and share buybacks – in that order.Parker pays a dividend and targets a payout ratio of 30%. The current dividend rate is $2.64 annually, for a yield of about

1.7%. In January, management raised the payout by 5%. Our dividend forecasts are $2.64 for FY18 and $2.76 for FY19.MANAGEMENT & RISKSTom Williams became the company’s CEO in 2015. He was previously chief operating officer. He spent 22 years at

General Electric before joining Parker-Hannifin as vice president of the hydraulics business in 2003. Catherine A. Suever is theCFO.

Management continues to focus on its “New Win” Strategy. The plan focuses on engaging team members, providing apremier customer experience, and generating profitable growth. With this strategy, management is targeting sales growth of 150basis points above the industry rate, 17% operating margins, and a compound annual growth rate of 8% by the end of fiscal 2020.

Parker Hannifin is a virtual pure-play on the industrial economy. PH’s exposure to specific market niches (aerospace,refrigeration, air conditioning, telecom, semiconductors, construction machinery, trucks and automotive, among others) ismitigated by its wide range of motion-control customers, which span virtually every industry and are serviced by its worldwidedistribution network.

PH generates substantial revenue overseas and its results are typically linked to global economic trends. Worldwide, weestimate that global GDP rose 3.1% in 2016. We and the IMF look for stronger 3.4% growth in 2017, led by industrializedeconomies.

Parker-Hannifin is also sensitive to trends in the dollar. The impact of currency was minimal in the fourth quarter – a sharpimprovement from prior quarters that reflects recent stability/weakness in the dollar. Looking ahead, we think the greenback isfully valued and near a top, particularly if the Federal Reserve continues to move slowly to raise short-term rates. A stable or fallingdollar would be a positive development for the Industrial sector and Parker-Hannifin.

COMPANY DESCRIPTIONParker-Hannifin manufactures motion and control technologies and systems that are used to control fluids, gas, or air

in hydraulic, pneumatic and vacuum applications. It sells its products to aerospace, commercial and industrial customers, whichuse them to move materials and operate machines and vehicles. PH shares are a component of the S&P 500.

VALUATIONPH shares appear attractively valued at current prices near $156, in the upper half of their 52-week range of $118-$166.

From a technical standpoint, the shares had been in a bullish trend of higher highs and higher lows since reaching a low of $83in January 2016, though we note the potential for resistance at $165.

To value the stock on a fundamental basis, we use peer and historical multiple comparisons, as well as a dividend discountmodel. PH shares are trading at 15.1-times our FY18 EPS estimate, near the midpoint of the historical range of 10-20. On price/sales, the shares are at the top of their five-year range. The dividend yield of about 1.7% is above the midpoint of the five-yearrange. Compared to the peer group, PH multiples are mixed, but generally suggest fair valuation. Our dividend discount modelpoints to a fair value of $176 per share, which is our target price.

On August 18, BUY-rated PH closed at $155.15, down $0.42. (John Eade, 8/18/17)

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JOHNSON CONTROLS INTERNATIONAL PLC (NYSE: JCI, $37.05).................................. HOLD

JCI: Looking for upgrade opportunity* Top-line growth at JCI is proving more challenging than initially expected, and we are once again lowering our EPS

forecast for FY17.

* On a technical basis, the shares remain in a bearish trend of lower highs and lower lows that dates to September2016.

* The shares offer value, with a current P/E ratio at the low end of the historical range.

* We will look to get this well-managed company back on the BUY list if the shares fall back toward support in themid-$30s or sales begin to surprise on the upside.

ANALYSISINVESTMENT THESISOur rating on Johnson Controls International plc (NYSE: JCI) is HOLD. Johnson Controls is emerging from a

transformative period during which it has taken steps to become a top-quartile multi-industrial company with core growthplatforms in buildings and energy storage. We expect the transformation to lead to more consistent sales growth and marginimprovement. Currently, sales growth is a problem, and management has repeatedly lowered Street expectations. On a technicalbasis, the shares appear in a bearish trend of lower highs and lower lows that date to September 2016. Our dividend discountapproach, on our new estimates, pegs fair value around $40. We will look to get this well-managed company back on the BUYlist if the shares fall back toward support in the low $30s or sales begin to surprise on the upside.

RECENT DEVELOPMENTSJCI shares have underperformed over the past quarter, declining 11% while the S&P 500 has advanced 2.8%. They have

underperformed the index over the past year, with a drop of 21% while the S&P 500 has climbed 11%. The JCI shares have alsounderperformed the Industrial sector ETF IYJ over the past one- and five-year periods. The beta on JCI is 1.27.

Johnson Controls is emerging from a transformative period during which it has taken steps to become a top-quartile multi-industrial company with core growth platforms in buildings and energy storage. The company has made significant portfoliochanges over the past few quarters. On September 2, 2016, Johnson Controls merged with Tyco International Ltd. in a $16.5 billiondeal, creating a leader in building products and technology, integrated solutions, and energy storage. In October 2016, Johnsonspun off its $17 billion Adient automotive seating and interiors division. In October 2015, it entered into an air-conditioningproducts and technology JV with Hitachi appliances.

Johnson Controls recently reported fiscal third-quarter earnings that were up from the prior year and in line withconsensus expectations, though sales were again slightly below management’s guidance.

Sales totaled $7.7 billion, up 1% on an organic basis, while management has been projecting 2.5%-4.5% growth this year.The adjusted segment EBIT margin rose 200 basis points year-over-year to 13%. Adjusted diluted EPS increased 16% to $0.71;management’s range had been $0.70-$0.73.

Along with the 3Q results, management lowered its outlook for revenue growth and guided analysts to the low end ofits EPS forecast range of $2.60-$2.68. Its fourth-quarter EPS guidance is $0.86-$0.88.

EARNINGS & GROWTH ANALYSISJohnson Controls organizes its operations into two businesses: Building Technologies & Solutions (79% of 3Q sales);

and Power Solutions (21%). Recent trends and outlooks for each business are provided below.Building sales rose 2% on an organic basis in the quarter, in line with the trend over the past three quarters. Orders rose

1%, and the backlog of $8.4 billion rose by $100 million. The EBIT margin rose 110 basis points to 13.9%, benefiting fromproductivity and cost synergies. Based on recent order trends, we expect flat sales from this group in FY17, with higher margins.

In Power Solutions, sales slipped, declining 2% on an organic basis. OE shipments fell 6% while aftermarket shipmentsdeclined 2% due to changes in customer demand patterns. Shipments of Start-Stop batteries, which automatically shut down andrestart internal combustion engines to minimize idling time, thereby reducing fuel consumption and emissions, rose 17%. TheEBIT margin of 18.5% was up 40 basis points. For FY17, we continue to anticipate high-single-digit sales growth, driven by thesale of Start-Stop batteries.

Based on the weaker-than-expected sales trends, we are again lowering our FY17 EPS estimate, to $2.61 from $2.64.Our forecast is at the midpoint of management’s revised guidance range. We are also trimming our FY18 EPS forecast to $2.94from $3.02. Our long-term EPS growth rate forecast is 8%.

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

company scores above-average on our three main criteria of debt levels, fixed-cost coverage and profitability.At the end of FY16, the company’s debt-to-total capitalization ratio was 38%. Proceeds from asset sales in FY17,

including a $2 billion divestiture of its Scott Safety business to 3M Corp. (MMM: BUY) and the $130 million divestiture of itsADT South Africa business, are being used to pay down debt.

JCI pays an annualized dividend of $1.00. We think the dividend is secure and likely to grow. Our dividend estimatesare $1.00 for FY17 and $1.08 for FY18.

JCI has a history of buying back stock. During the quarter, the company repurchased $119 million of its stock andexpanded its full-year buyback program by $500 million. It now expects to purchase up to $750 million of its stock in FY17.

MANAGEMENT & RISKSAlex Molinaroli has served as JCI’s chairman and CEO since 2013. Mr. Molinaroli has held a range of executive positions

since joining the company in 1983, including president of the Power Solutions division. George Oliver, Tyco’s former CEO, isnow the president and COO of Johnson Controls. In March 2018, Mr. Molinaroli will become executive chair for one year andMr. Oliver will become chairman and CEO.

Management met with investors and analysts on December 5, 2016, to provide an outlook for the company. The guidancewas less than investors had expected, and the shares have been relatively weak performers ever since.

Highlights from the presentation included:— Management announced FY17 EPS guidance, before special items, of $2.60-$2.75. This compared to a pro forma

fiscal base of $2.31 per share, implying growth of 13%-19%. Management projected organic revenue growth of 2.5%-4.5% to$29.7-$30.2 billion. Both of these forecasts have recently been lowered.

— Looking out to FY20, the company expects annual revenue growth in the 3%-4% range and EBIT marginimprovement from 11.0% to 14.0%-14.8%. EPS is expected to grow at a 12%-15% rate. Management is also targeting animprovement in free cash flow conversion from 80% to 90%.

— Management plans a “competitive” dividend strategy.Investors in JCI shares face risks. The company is based in Ireland, and faces the risk that the U.S. government, led by

a president who has pledged to “Make America First,” may rescind tax benefits and deny contracts to U.S. companies that havereincorporated abroad. The Homeland Security Act of 2002, for example, prohibits such companies from receiving contracts fromthe Department of Homeland Security. Further restrictions may also be imposed by state and local governments.

The company continues to grow both organically and through acquisitions, including the recently concluded blockbusterdeal with Tyco. These acquisitions pose integration risks.

Johnson Controls generates substantial revenue overseas and its results are typically linked to global economic trends.Worldwide, we estimate that global GDP advanced at a relatively weak 3.1% rate in 2016; we and the IMF look for stronger 3.5%growth in 2017 and 3.7% in 2018.

Johnson Controls is also sensitive to trends in the dollar, which has recently weakened. A stable or falling dollar wouldbe a positive development for the Industrial sector and Johnson Controls.

COMPANY DESCRIPTIONJohnson Controls is a global industrial company that was founded in 1885. It has two segments: Building Solutions and

Power. Building Solutions is further broken down into Field (Applied HVAC and Fire and Security) and Products. The companycreates intelligent buildings, efficient energy solutions, integrated infrastructure, and transportation systems.

VALUATIONWe think that JCI shares are fairly valued at current prices near $37. The shares are now trading near the low end of their

52-week range of $36-$49. On a technical basis, the shares appear in a bearish trend of lower highs and lower lows that dates toSeptember 2016. In mid-January, the 50-day trend line crossed through the 200-day trend line and is still pointing lower.

To value the stock on a fundamental basis, we use peer and historical multiple comparisons, as well as a dividend discountmodel. JCI shares are trading at 12.5-times projected FY18 earnings, near the bottom of the historical range of 12-24. On price/sales, they are trading below the midpoint of the five-year range, while the dividend yield is near the historical average. JCI’svaluation multiples are slightly below industry averages. Our dividend discount approach, using our new estimates, pegs fair valuearound $40. We will look to get this well-managed company back on the BUY list if the shares fall back toward support in thelow $30s or begin to deliver positive sales surprises.

On August 18, HOLD-rated JCI closed at $37.05, up $0.16. (John Eade, 8/18/17)

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THE KRAFT HEINZ COMPANY (NGS: KHC $84.89).............................................................. BUY

KHC: Recent weakness offers buying opportunity* KHC shares have underperformed the S&P 500 over the past three months, falling 5.7% while the index has risen

2.6%.

* On August 3, KHC reported 2Q17 adjusted EPS that topped the consensus forecast and rose from the prior year.

* However, we are trimming our 2017 and 2018 EPS estimates based on recent sales pressure.

* We still see value. Our target price of $96 implies a multiple of 24-times our 2018 EPS estimate, above the peeraverage but warranted, in our view, by the company’s prospects for strong cost synergies and continued earningsgrowth.

ANALYSISINVESTMENT THESISWe are maintaining our BUY rating on The Kraft Heinz Company (NGS: KHC), one of the world’s largest food and

beverage producers, with a target price of $96. Although reported sales have been sluggish in recent quarters, we expectimprovement in 2017 as Heinz and Kraft continue to integrate their operations and leverage their respective sales platforms. Wealso expect the combined company to benefit from an increased focus on healthier, natural foods, and to generate strong costsavings and above-peer-average earnings growth over time. Based on the positive outlook, we believe that KHC shares arefavorably valued at 21-times our 2018 EPS estimate. Our target price of $96 implies a multiple of 24-times our 2018 EPS estimate,above the peer average but warranted, in our view, by the company’s prospects for strong cost synergies and continued earningsgrowth.

RECENT DEVELOPMENTSKHC shares have underperformed the S&P 500 over the past three months, falling 5.7% while the index has risen 2.6%.

The stock has slightly underperformed since it began trading under the KHC ticker on July 5, 2015, with a 16.7% gain, comparedto a 17.5% gain for the S&P 500. The beta on KHC is 0.9.

On August 3, KHC reported 2Q17 adjusted earnings that topped the consensus forecast and rose from the prior year.Second-quarter adjusted EPS rose 15.3% to $0.98, up from $0.85 in 2Q16. The Street had called for adjusted earnings of $0.95per share. The increase was mainly driven by the refinancing of preferred stock as well as by a lower tax rate. GAAP earningsrose to $0.95 per share from $0.63 a year earlier.

Net sales fell 1.7% to $6.68 billion, below the consensus of $6.78 billion. Unfavorable currency translation loweredreported sales by 0.8%. Organic net sales fell 0.9% from the year-earlier period, reflecting a 0.4-percentage-point impact fromlower pricing and a negative 0.5-percentage point impact from lower volume and a weaker product mix.

Operating income rose 15.5% to $1.9 billion, as the operating margin expanded to 28.8% from 24.1% in 2Q16. AdjustedEBITDA rose 0.7% to $1.88 billion.

The integration of Kraft and Heinz has thus far generated $1.45 billion in cost synergies. Management noted the firmis on track to achieve $1.7 billion in cost savings in 2017.

In the first half of the year, organic net sales fell 1.8%. Volume and mix had a negative 2.1-percentage-point impact, whileprice had a positive 0.3-percentage-point impact. First-half adjusted EPS rose 15.2% from the prior year to $1.82, driven bypreferred stock refinancing, lower tax expense, and margin expansion.

Management does not provide guidance, but does provide a general outlook for the current year. It expects organic salesgrowth to ramp up as the year progresses and looks for 2017 earnings to be driven by aggressive growth investments. It also expectsto generate additional cost synergies from the merger. Management noted most of the savings this year will occur in 4Q ratherthan 3Q. On the negative side, management said that retail markets remain competitive and that the company continues to faceunfavorable, though moderating, currency headwinds. It expects a full-year tax rate of 29%-30%.

In February 2017, the company withdrew its proposal to acquire Unilever after Unilever rejected the offer, citingdisagreements over strategy. However, KHC remains interested in acquisitions.

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EARNINGS & GROWTH ANALYSISKraft Heinz has four geographic segments: the United States (69% of 2Q17 sales), Canada (9%), Europe (9%) and Rest

of World (13%). Operating results by segment are summarized below.In the United States, 2Q organic net sales and overall net sales declined 1.2% to $4.63 billion. Pricing fell 0.4 percentage

points, while volume and product mix had a negative 0.8-percentage-point impact, driven by distribution losses in cheese andmeats as well as lower foodservice shipments. Adjusted EBITDA increased 0.9% from the prior-year period, to $1.5 billion, asthe EBITDA margin expanded by 140 basis points.

In Canada, organic sales decreased 3.1% from the year-earlier period to $618 million, better than the 14.9% declinerecorded in 1Q17. Higher sales of condiments and sauces were offset by the discontinuation of certain cheese products. There wasa negative 3.7-percentage-point impact from lower pricing, while volume and mix had a positive 0.6-percentage-point impact.Segment adjusted EBITDA rose 2.3% from the prior year to $197 million as the EBITDA margin expanded by 150 basis points.

In Europe, organic sales declined 0.8% to $620 million. This decline reflected a 1.6-percentage-point negative impactfrom pricing, partially offset by a positive 0.8-percentage-point impact from volume and product mix. The positive volume/mixwas driven by strong sales of condiments and sauces. Segment adjusted EBITDA fell 2.4% to $215 million, including a positive0.8-percentage-point impact from currency translation.

In the Rest of World, which includes the Asia Pacific region, Latin America, India, the Middle East, Russia, and Africa,organic sales grew 3.0% to $854 million, down from 8% growth in the first quarter due to a new sales tax regime in India and thetiming of shipments in Indonesia. Management expects these headwinds to be one-time events and looks for strong growth toresume. Pricing contributed 3.7 percentage points to growth while volume and mix had a negative 0.7-percentage-point impact.Segment adjusted EBITDA fell 8.6%, reflecting the impact of business investments to support growth and higher local-currencyinput costs.

Based on the company’s weak sales trends, we are lowering our 2017 adjusted EPS estimate to $3.70 from $3.75. Ourestimate implies 11% growth from 2016 adjusted earnings of $3.33. We are also lowering our 2018 EPS estimate to $4.00 from$4.05. The consensus earnings estimates are $3.64 for 2017 and $3.94 for 2018.

We expect sales in 2017 to benefit from new products and reduced currency headwinds, and look for significant margingains as Heinz and Kraft continue to integrate their operations. As noted above, the company expects $1.7 billion merger-relatedcost savings in 2017.

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

company’s debt is rated BBB-/stable by S&P and BBB-/stable by Fitch.At the end of 2Q17, the company had a debt/total capital ratio of 34.7%, well below the food industry average of 66.6%.

The company also scores high on profitability, with a 29.3% operating margin, well above the peer average of 20.8%Kraft Heinz pays a dividend. The company recently raised its quarterly payout by 4.2% to $0.625 per share, or $2.50

annually, for a yield of about 2.9%.The company generates strong cash flow, so we think the dividend is secure. Our dividend forecasts are $2.46 for 2017

and $2.58 for 2018.MANAGEMENT & RISKSBernardo Hees became CEO of Kraft Heinz following the merger in July 2015. He had been the CEO of Heinz since 2013

and served as CEO of Burger King Worldwide Holdings from 2010 through 2013.In addition to merger-related risks, KHC investors face risks related to the highly competitive nature of the food products

industry, the need to correctly anticipate and respond to changes in consumer preferences, and the high proportion of sales thatare made to the company’s largest customers (with Wal-Mart Stores accounting for 20% of sales in 2015).

COMPANY DESCRIPTIONKraft Heinz is one of the largest food and beverage companies in the world. Its leading brands include Heinz, Kraft, Oscar

Mayer, Planters, Philadelphia, Velveeta, Lunchables, Maxwell House, Capri Sun, Ore-Ida, Kool-Aid and Jell-O. The companywas formed through the merger of Kraft Foods and H.J. Heinz on July 2, 2015. (Heinz was previously owned by BerkshireHathaway — Warren Buffet is on KHC board — and 3G Global Food Holdings LP.) Management expects the merger to generateannualized cost savings of $1.7 billion by the end of 2017. The merger is also helping Kraft, which previously generated 98% ofits sales in North America, to expand internationally by leveraging Heinz’s strength in overseas markets. Prior to the merger, Heinzgenerated approximately 60% of its sales from outside North America, including 25% in emerging markets.

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VALUATIONWe think that KHC shares are attractively valued at prices near $84, below the midpoint of the 52-week range of $79-

$98. The technical outlook is mixed. The shares shot to a 52-week high in February on expectations of a merger with Unilever,but have since pulled back. We see support near $82.

We have a favorable view of the Kraft Heinz merger, as the two companies should be able to leverage each other’s salesplatforms and geographic strengths. As such, we expect the combined company to achieve strong sales growth and to reachmanagement’s target of $1.7 billion in annualized cost savings.

On a fundamental basis, the shares trade at 21-times our 2018 earnings estimate, in line with the peer average but at thelow end of their recent historical average range of 21-30. Our target price of $96 implies a multiple of 24-times our 2018 EPSestimate, above the peer average but warranted, in our view, by prospects for strong cost synergies and continued earnings growth.

On August 18, BUY-rated KHC closed at $84.89, down $0.62. (John Eade and Annie Petrino, 8/18/17)

MARKET DIGEST

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PACCAR INC. (NGS: PCAR, $63.00).................................................................................... HOLD

PCAR: Boosting EPS estimates but reiterating HOLD* PCAR shares have underperformed over the past quarter, with a gain of 1% compared to a gain of 2.8% for the

S&P 500.

* Compared to the industry ETF (IYJ), PCAR has underperformed over the past one-, five- and 10-year periods.

* We now look for EPS to stabilize and grow modestly in 2017-2018.

* The shares are trading at 15-times our 2018 EPS estimate, above the five-year historical average of 14. We wouldconsider an upgrade should the shares fall to the mid-$50s on a broad market pullback.

ANALYSISINVESTMENT THESISWe are maintaining our HOLD rating on PACCAR Inc. (NGS: PCAR), a major global manufacturer of trucks and

aftermarket truck parts. We view PCAR as a well-run company that produces a highly regarded line of trucks. PACCAR hascreated a specialized niche of higher-quality vehicles that command premium prices, but offer enhanced comfort, quality andreliability. Due to an industry-wide driver shortage, many operators choose PACCAR trucks in an attempt to attract and retaindrivers — which we believe is reflected in company’s recent market share gains. However, industrywide orders for heavy-dutytrucks have fallen since 2011 and further declines appear likely in 2017, though at a slower pace as oversupply in the market beginsto diminish. The shares are trading at 15-times our 2018 EPS estimate, above the five-year historical average of 14. Given thesluggish near-term earnings outlook, we are maintaining our HOLD rating.

RECENT DEVELOPMENTSPCAR shares have underperformed over the past quarter, with a gain of 1% compared to a gain of 2.8% for the S&P 500.

They have also underperformed over the past year, rising 6% compared to an advance of 11% for the index. Compared to theindustry ETF (IYJ), PCAR has underperformed over the past five- and 10-year periods. The beta on PCAR shares is 1.14.

PCAR recently posted 2Q results that were above consensus forecasts. Sales reversed trend and rose 7% to $4.7 billion.The net margin declined 50 basis points year-over-year to 7.9%. EPS of $1.06 were flat with the prior year but ahead of theconsensus forecast of $0.99. In the first half of the year, the company earned $1.94 per share.

Management does not provide guidance but does offer an industry outlook. It has once again raised its 2017 forecast forEuropean truck industry registrations in the above-16-ton segment by 7%, to 290,000-310,000 vehicles. It also projects US andCanada Class 8 retail sales of 200,000-220,000 vehicles, up 2% from its prior forecast. Management’s long-term outlook assumesa recovery in unit sales from a recent 2.7 million units to 2.9 million units in 2021. Long-term growth is expected to be led by SouthAmerica, Russia, India, AME and Asia (ex-China).

EARNINGS & GROWTH ANALYSISPACCAR operates in three reportable segments: Trucks (75% of 2Q revenue), Parts (18%) and Financial Services (7%).

Operating results by segment are discussed below.Truck revenues reversed trend and rose 6% to $3.55 billion. The segment pretax margin contracted by 70 basis points

to 9.1%. Management expects to see continued slowdowns in industry unit demand around the globe, although a higher marketshare in North America and Europe may put PACCAR at an advantage relative to industry peers.

In the Parts business, revenue rose a solid 9%. The pretax margin expanded 90 basis points to 18.5%. The parts businesshas benefited from investments in distribution, technology and products. Management expects this business to grow at a mid-single-digit rate in 2017.

Revenue in the Financial Services segment rose 3% year-over-year, and the pretax margin fell 590 basis points to 20.0%.The lower margin reflected higher interest expense.

Turning to our estimates, we are raising our outlook for 2018 based on the improving market and sales trends. Our 2017EPS estimate is now $3.98, up from our prior forecast of $3.62. We expect earnings to continue to recover in 2018, reflecting sharegains in key markets. As industry supply reaches an equilibrium point, we expect new orders to pick up in 2018. Our 2018 forecastis now $4.33, up from a prior $3.95.

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FINANCIAL STRENGTH & DIVIDENDOur financial strength ranking on PCAR is Medium. The company’s long-term debt is rated A1/stable by Moody’s and

A+/stable by Standard & Poor’s. Paccar had cash & securities of $3.0 billion at the end of 2Q. Total debt of $10 billion wasexclusively linked to the Financial Services group and accounted for 57% of total capitalization.

Paccar has a dividend policy that includes a standard quarterly dividend and a special annual dividend. The standardquarterly dividend was raised 4% in 1Q and is now $0.25. Our estimates for this portion of the dividend are $0.99 for 2017 and$1.03 for 2018. The company typically announces a special dividend in December, which it pays in January. Last December, thespecial dividend was $0.60, down from $1.40 the previous year and likely reflecting a fine the company paid to the EU in early2016. As such, our full-year dividend forecast for 2017, including the special dividend, is $1.59. We expect the special dividendto be $1.00 for 2018, resulting in total dividend forecast of $2.03.

PCAR has a share buyback program.MANAGEMENT & RISKSRonald Armstrong became the company’s CEO in 2014, succeeding Mark Pigott, who became executive chairman. Mr.

Armstrong previously served as PCAR’s president and has been with the company since 2002.PACR investors face a range of risks. The company operates in a highly competitive and economically sensitive industry,

and its earnings could be hurt by rising raw material costs as well as by costs related to new environmental and safety regulations.With approximately 40% of revenue generated outside the U.S., the company’s results are linked to global economic

trends, particularly in growth markets such as China and Brazil. Worldwide, we estimate that global GDP is strengthening. GDPadvanced at a 3.1% rate in 2016, and we (and the IMF) look for stronger 3.5%-3.6% growth in 2017-2018.

PACCAR is also sensitive to trends in the dollar. The impact of currency was minimal in the second quarter — a sharpimprovement from prior quarters that reflects the recent weakness in the dollar. Looking ahead, we think the greenback is fullyvalued and near a top, particularly if the Federal Reserve continues to move slowly to raise short-term rates. A stable or fallingdollar would be a positive development for the Industrial sector and PACCAR.

COMPANY DESCRIPTIONPACCAR manufactures and distributes light-, medium- and heavy-duty commercial trucks; distributes aftermarket

parts; and provides vehicle financing to customers and dealers. The company’s trucks are marketed under the Kenworth, Peterbiltand DAF names.

VALUATIONWe think that PCAR shares are fairly valued at current prices near $63. Over the past 52 weeks, the shares have traded

in a range of $48-$70. From a technical standpoint, the shares have been unable to pierce the $70 level and have fallen since earlyMay.

On the fundamentals, the shares are trading at 15-times our 2018 EPS estimate, above the five-year historical averageof 14. PCAR shares are also trading at the top of their historical range for price/sales and price/book. Given the modest EPS outlook,we are maintaining our HOLD rating. We would consider an upgrade should the shares fall to the mid-$50s on a broad marketpullback.

On August 18, HOLD-rated PCAR closed at $63.00, down $0.15. (John Eade, 8/18/17)

MARKET DIGEST

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