3rd Quarter, 2014

Your companies’ strong third quarter earnings, which in most instances resulted in double digit increases above the earnings produced in the year ago quarter, attest to the operating skills of the managers of the divisions within these well run companies. The strength of these results from providing mundane products or services persist because senior management in your companies, most of whom worked their way up to leadership positions, encourage the men and women running their divisions to think of changes in work flows or the composition or uses of products or services that might reduce costs, improve productivity or increase sales. Successful implementation of initiatives such as these within large organizations requires teamwork, careful attention to detail and application of technology or innovative methods to do the same job, but yield better quality at lower cost. Crucially, all require support from the top. Detailed knowledge of the product or service makes sales easier and results in better understanding of customer needs. The innumerable small advantages secured by companies empowering their division managers enables them to adapt quickly to exploit opportunities as your companies are doing now, while the skills gained prepare them to adjust when business becomes more difficult. Few economists or pundits seem alarmed by the 40% drop in oil prices since June which calls to mind, the 70% oil price drop in 2008. The aftermath of that was horrible, but the eight companies whose shares we still own from those days have prospered mightily. Since the start of the year, the S&P has returned 13.4%.

Sigma Aldrich Corp.

On September 22, 2014 Sigma-Aldrich announced its acceptance of Darmstadt, Germany-based Merck KGaA’s offer to acquire the company for $140 per share in cash, a 37% premium to Sigma’s closing stock price of $102.37 on September 19. Sigma’s stock has returned 46% since January 2. The company delivered steady innovation in both its business and its operating practices over the years. Rakesh Sachdev, the current CEO, accelerated Sigma’s technology licensing program which enhanced the dissemination of new technologies to the life science research community. Sigma’s web site provides information that facilitates the use of these products and makes them easy to buy. In 2013, Sigma launched the Applied business to serve customers in regulated businesses who repeatedly purchase premium quality reference and analytical standards to perform routine tests.

The company’s expertise in sourcing and in quality control allows customers to choose the level of product quality they require and the price they wish to pay. Sigma continues to refine its supply chain to deliver products to its customers more quickly and with lower freight costs and duties. This stream of innovation leads to predictable financial results. Sigma’s revenue and earnings per share grew 6.7% and 10% respectively compounded annually over 10 years. The company also generated free cash flow equal to net income on average over this period. Sigma’s concentration upon relentless improvements in its operating efficiency and its careful use of capital to broaden its product offering produced the financial results that we look for in companies we own and consider as investments.

Automatic Data Processing

ADP spun off CDK Global on October 1, 2014, issuing one share of CDK for every three shares of ADP held. This decision made by the Board of ADP benefits both ADP and CDK. It enables each company to focus exclusively on their respective dominant franchises. For ADP, it is human resource management with payroll services at the core. Payroll services are surrounded by a growing list of add-on products and services including benefits administration, time and attendance, retirement services, health care and Affordable Care Act compliance. CDK Global will focus its resources exclusively on furthering its position as the largest and most profitable worldwide provider of vehicle dealer management systems and digital marketing solutions. ADP and CDK each reported strong fiscal first quarter results.

ADP’s total revenues of $2.6 billion and earnings of 62¢ per share from continuing operations rose 9% and 13% respectively. This solid growth in recurring revenues is nearly all organic. The company continues to increase client retention and grow its loyal customer base by providing comprehensive service and compliance expertise across sophisticated technology platforms. Its existing U.S. clients added 3.1% more employees on average to their payrolls while its professional employer organization, which provides comprehensive employment administration including healthcare coverage, gained 15% more worksite employees to 345,000. Operating and sales efficiencies lifted the pre-tax margin 0.5 percentage points during the quarter to 17.6%. The average client fund balance rose 7% to $18.7 billion while the average interest yield declined 0.1% to 1.9%. Interest earned on funds held for clients increased 1% year-over-year to $90.3 million. This is the first increase in the dollar value of interest earned on client fund balances in 13 quarters. Adjusting for the spin-off of CDK, the return on ADP’s shares is 23% since the beginning of the year.

CDK Global

CDK’s fiscal first quarter revenues of $516 million and adjusted earnings of 41¢ per share rose 7% and 24% respectively from the same period a year ago. The number of Dealer Management System (DMS) client sites in North America rose 3.2% to 13,692. Importantly, the average revenue generated at each client site rose 5.3%. Its North American margin of 28.4% improved 3.9 percentage points from the same period a year ago. CDK benefitted during the quarter from more client upgrades to its latest DMS technology platform as upgrades are more profitable than new client installations. This level of margin improvement won’t be achieved every quarter, but the company methodically targets cost efficiencies to drive continuous operating improvements. Improving margins are more difficult to achieve in Digital Marketing because lower margin advertising revenue is growing faster than subscription-based website revenue. During the quarter, Digital Marketing revenue of $103.7 million rose 19% and operating profit rose 12% as the reported margin fell 0.5 percentage points to 7.9%. CDK now manages 7,828 websites for its dealer and manufacturer customers, up 2% from a year ago. The average revenue generated from each of these websites rose 8%. CDK’s share price, which initially dropped in the weeks following the spin-off as index funds and others sold, have since rebounded leaving them 30% above the $31 closing price on October 1.

IDEXX Laboratories Corp.

IDEXX Laboratories’ stream of new products and its effective salesforce contributed to exceptional third quarter results. Revenues of $384 million grew 13% over the third quarter of 2013, while earnings per share rose 21% to $1.05. Earnings exclude costs associated with the transition to an all-direct sales strategy which IDEXX launched on October 27, 2014, two months ahead of schedule. While many factors contributed to the decision to stop selling rapid assays and consumables for in-clinic instruments through distributors in the U.S., the value that vets place on additional support from IDEXX sales reps who share their detailed knowledge of how to best combine in-house testing with specialty testing from the reference labs to deliver better medical results proved decisive. That was smart. Distributors, who sell products from more than 100 companies, do not have time to provide detailed information about a single product to vet practices. IDEXX also captures $50 million in revenue it paid to distributors to sell their products. While most of the additional revenue will pay for one-time charges associated with the move to direct sales in 2015, we think the ongoing savings will contribute to operating profits as the consumables sales grow. The company completed the expansion of its territory salesforce, telesales and field service staff in October and announced the launch of a redesigned web site. It offers advanced clinical information which is updated monthly in addition to easy ordering for the 100,000 visitors to the site.

IDEXX began selling the Catalyst One chemistry analyzer on November 3, 2014. This instrument has all the features of its flagship Catalyst Dx, except that it analyzes one sample at a time instead of two. The Catalyst One also runs a test for thyroid function. IDEXX developed the technology to run this immunoassay in the same format as its chemistry tests so clinics can add the thyroid test to a standard chemistry profile. Vets can cover the leasing cost of the Catalyst One by performing one chemistry profile per day. As a result, over 80% of all new chemistry analyzer orders in the U.S. so far this year have been for the Catalyst One. The company expects the 6,000 practices which still use the older VetTest analyzer to increase their business with IDEXX and to upgrade to Catalyst One. IDEXX’s stock price is up 39% since the beginning of the year.

Express Scripts

Express Scripts delivered solid third quarter performance with gross profit of $2.2 billion and earnings per share of $1.29, increases of 4% and 19% respectively over the third quarter of 2013. Both gross profit and earnings exclude amortization and transaction costs associated with the Medco acquisition. Net income contributed 8% to earnings per share growth and a lower share count contributed 11%. Express Scripts paid $1.0 billion to repurchase 14.1 million shares of stock during the quarter at an average cost of $71.89, reducing shares outstanding at the end of the third quarter to 746 million from 823 million shares a year ago. Home delivery and specialty claims of 33.1 million this quarter were up 3.4% from 32.0 million claims in the second quarter. Express Scripts’ health plan clients have adopted more aggressive home delivery plans that allow members to fill their first two prescriptions at a pharmacy and then automatically switch them to mail. CFO Cathy Smith, the former CFO of Wal-Mart International, leads the effort to make home delivery easier for members to use. This initiative has improved both member and client satisfaction with this service.

Operating earnings per claim rose 14% to $5.30 during the quarter, driven by the performance of the National Preferred Formulary and better management of ingredient costs. Over 90% of commercial clients from both the Medco and Express Scripts customers joined this formulary in 2014 and saved $700 million in drug costs. More commercial clients joined the formulary in 2015, bringing the number of members covered by the formulary from 20 to 25 million. Express Scripts expects to save over $1 billion in prescription drug costs in 2015, an increase of more than 50% over 2014, with one-fourth the member disruption. Drug manufacturers realize they need to work with Express Scripts on pricing to get their drugs on a restricted formulary. The company hosts an annual Pharma Outcomes Conference where drug manufacturers meet with Express Scripts’ PBM and specialty pharmacy Accredo to discuss new drugs coming to market and their place in restricted formularies. The company’s supply chain staff works all year with these manufacturers to understand their market needs and their goals to help them find the best way to get their drugs on the National Preferred Formulary. Express Scripts’ stock price is up 21% since the beginning of the year as investors learn more about how the company uses its innovation, scale and alignment with its clients to accelerate profitable growth.

Mettler-Toledo International Inc.

Mettler-Toledo’s third quarter revenue of $629 million rose 6% in local currencies over the same period a year ago with 7% sales growth in the Americas and Asia and 4% growth in Europe. Sales in China grew 4% with 2% of the growth attributed to the completion of two large projects. European sales exceeded the company’s forecast having risen 7% during the same period a year ago. While conditions in Europe remain challenging, customers continue to replace their instruments at a normal rate. CEO Olivier Filliol noted that the European sales teams achieved good results because they are the most effective users of the company’s lead generation and other marketing programs.

Core laboratory and product inspection revenue were strong across all regions as global food companies invest more in food safety applications to protect their brands. These companies are also standardizing their quality programs globally which makes Mettler the preferred partner to deliver consistent solutions worldwide through its local applications experts and service teams. The company plans to add 200 people to its sales and service staff in the next 12 to 18 months as a result of its detailed analysis of growth opportunities by product category, geography and customer segment. Mettler’s 70 country managers analyzed territory coverage and the size and mix of end-user industries to identify opportunities to increase sales and market share. They identified more than 200 projects that were then prioritized by return on investment. Staff additions in the U.S. or Europe will be in the core laboratory or product inspection businesses, two of Mettler’s most profitable businesses. In a country like Turkey, where the company is building its sales presence, staff may be added throughout its businesses. Mettler’s productivity programs will offset the cost of the additional personnel.

Earnings of $2.92 per share grew 13% as the company’s margin enhancement and cost control initiatives increased the quarter’s operating margin by 50 basis points to 20.1% from 19.6% a year ago. These results and management’s clear description of opportunities for growth in 2015 sent the stock price up 5% the day after Mettler announced its third quarter results on November 6. Its stock price has risen 20% year-to-date.

Ecolab, Inc.

Ecolab’s third quarter sales of $3.7 billion grew 6% organically over the same period a year ago as new customers adopted solutions that reduce their operating costs by lowering water and energy use. Volumes rose 5% while the uptake of new products contributed to a 1% price increase. This price increase and Ecolab’s investment in productivity and efficiency initiatives increased operating profit by 20% to $571.4 million. Operating margins increased 1.1 percentage points to 15.6%. Earnings rose 16% to $1.21 per share from $1.04 per shares a year ago. Global Industrial sales rose 3% during the quarter to $1.25 billion. Food & Beverage’s sales increased 4% as more key global companies adopted its Total Plant Assurance program, which combines cleaning and sanitizing, water treatment and pest elimination services to deliver improved food safety, lower operating costs and better quality assurance. Water’s sales rose 3% during the quarter with good growth in all industries. Ecolab’s mining business recorded slight gains during the quarter. Some of this growth was offset by a decline in sales of the paper chemicals business. Double-digit sales growth in Latin America failed to offset low capacity utilization and plant closures in other parts of the world. Ecolab’s aggressive efforts to win new business in the Global Institutional business helped it deliver 3% sales growth in the third quarter despite weak sales in restaurants in North America and Europe. Moderate growth in global lodging room demand and strong growth in fast food outlets and in food retailers offset most of the weakness.

The Global Energy business posted strong results with sales of $1.1 billion, organic sales growth of 14%. The exploration, production and refining businesses all contributed to the growth. Ecolab’s stock, however, has returned negative 6% since mid-July. Investors are concerned about growth in this profitable, sticky business with oil prices below $70 per barrel. While low oil prices may curtail exploration programs, only 15% of Global Energy’s sales come from exploration. The remaining 85% treats water in producing wells and in refineries. The business will take advantage of lower volumes to implement productivity and efficiency programs that will maintain margins and allow it to add new volumes more profitably when oil prices rise. In 2008, revenues fell only 3% when oil prices dropped 70% percent.


Wabtec’s third quarter sales and earnings of $797 million and 93¢ per share were 26% and 22% higher than the results for the quarter last year. Over a third of the $166 million revenue increase came from the acquisition of Fandstan which was completed on June 6, 2014 for $199.4 million. Fandstan also contributed $100 million to the increase in Wabtec’s transit order backlog which rose to $1.3 billion, 11% above a year ago. Acquisition costs, including non-cash accounting charges, reduced Wabtec’s operating margin to 17.1% from 17.5% in last year’s quarter. It is important to recognize that this decline is not indicative at all of an inability to realize operating efficiencies from application of Wabtec’s performance system. The response from managers and workers to our questions at an all-day meeting in late September at Fandstan’s German plant elicited multiple differing examples of how cost savings could be readily realized. They seemed ready to do it. The quality of this year’s third quarter earnings is better than a year ago or the two preceding quarters because cash flow from operations exceeds earnings. Cash flow in the quarter was $93 million while earnings were $90 million. That is the first delivery of an ongoing commitment management announced publicly! The acceleration of Wabtec’s earnings growth during the quarter was propelled by an increase in Positive Train Control (PTC) revenues to $75 million, half of which came from Class I US railroads, 25% from US transit systems and 25% from international customers. According to the American Association of Railroads, 50% of US locomotives are now equipped with onboard computers and one-third of the wayside PTC equipment has been deployed. An extension of the Rail Safety Improvement Act’s deadline for full US deployment by the end of 2015 still is widely expected by all the government and industry organizations directly affected. During the third quarter, Wabtec purchased 124,600 shares at an average price of $80.25. Its stock is up 17% since the beginning of the year.

Precision Castparts

Precision Castparts’ sales and earnings for its fiscal second quarter ending September 28 sent it stock price down to $215, its low for the year. It is now $243, 10% below its price at the start of the year. The negative reaction to the company’s earnings which were $3.24 per share, 12.5% higher than the $2.88 earned in the year ago quarter emanated from the low 4% organic sales growth achieved during the quarter. With the inclusion of acquisitions reported sales for the quarter were $2.52 billion, a 7.7% year-to-year increase after subtracting $106 million for intra-company sales and contractual pass throughs of metal pricing to customers. Precision Castparts’ contracts with customers after an initial learning period contain annual 2% price reductions. This means that margins are more crucial than revenue growth in building value within the business. In the past quarter, which included two weeks of downtime for maintenance of the company’s forges and for the first time its titanium furnaces, the company managed to eke out almost a half percent increase in its overall operating margin, bringing it up to 28%. Precision achieves productivity-improving margins by rigorously managing its facilities, equipment and employees to produce more volume. Acquisition of a producer of metals such as Timet two years ago, which complemented Precision’s existing nickel alloy expertise or an airframe component machining company such as Aerospace Dynamics (ADI) acquired earlier this year, allows the company to do more on parts from customers and thereby increase profits by using its assets more. Incidentally, the acquisition of ADI, based in Valencia California, brought Airbus as a customer which heretofore was insignificant because management was reluctant to manufacture in Europe. The company’s acquisitions are focused upon creating opportunities to perform more work within the company on parts produced for customers. Forging a Timet titanium billet to customer specifications and then machining it on ADI equipment into a finished component while capturing valuable revert alloy that Precision can reprocess adds value. Higher utilization raises returns and sharpens manufacturing skills, although this sort of vertical integration results in more internal sales, which reduces reportable sales. That sours many of the analysts commenting on the Company’s results. During the next two quarters, Precision’s sales growth should slowly strengthen because aerospace fastener sales are now rising as airframe production increases almost a year later than originally planned. Another beneficial occurrence is the inventory destocking of engine components by Rolls Royce, which has cut sales by $25 million a quarter is ending. During the past quarter, Precision bought 2,260,000 shares at an average price of $232 per share.

Air Lease Corporation

Air Lease’s third quarter revenues of $261.9 million and earnings of 58¢ per share rose 21% and 26% respectively from the same period a year ago as the company continues to experience strong demand from airlines for its order book of new fuel efficient aircraft. The International Air Transportation Association reported that demand growth, as measured in revenue passenger kilometers for the first nine months of 2014, was up 5.9% with the passenger load factor exceeding 80%. This highlights the need for more aircraft to support expanding airline fleets, although 80% of Air Lease’s order book targets replacement of older aircraft within its customer’s fleets. During the quarter, the company delivered nine new aircraft from its order book and sold four aircraft from its lease portfolio for a gain of $8.8 million or 5¢ per share. The company further increased its liquidity, the duration of its debt portfolio and the amount of fixed rate debt by issuing $500 million due 2018 at a fixed interest rate of 2.125% and $500 million due 2024 at 4.25%. This fixes the rate on 76.3% of Air Lease’s $6.6 billion of debt at a composite interest rate of 4.22%. As of September 30, Air Lease owned 212 aircraft which are all leased to 77 airlines in 47 countries. In addition, the company currently manages 12 aircraft for third parties. Its aircraft lease portfolio has a weighted average age of 3.5 years, a remaining lease term of 7.3 years and a net book value of $8.9 billion.

During November, Air Lease announced that it partnered with Napier Park Global Capital LP to form a new aircraft leasing joint venture. Air Lease will manage the $2 billion of aircraft slated to be acquired over the next two years. Air Lease owns 9.5% of the venture. This provides Air Lease with access to additional capital which will magnify the profitability of its fleet management business. Air Lease’s stock price is up 15% since mid-January.

CME Group Inc.

Led by resurgent volumes of interest rate contracts traded, CME’s revenues rose 7% to $762 million while adjusted earnings rose 12% to 84¢ per share. The average daily volume of interest rate contracts of 7.2 million rose 23% and accounted for more than 90% of the increase in average daily volume to 13.5 million contracts during the quarter. Reflecting the success of important growth initiatives to expand its customer base globally, 60% of the growth during the quarter came from outside the U.S. The company took action during the quarter to reduce its expense base in order to accelerate future earnings growth. The primary component of this is the reduction of its workforce by 150 people, a 5% reduction, primarily in technology and administration. Strong contract volumes executed at the exchange continued after the quarter ended. October was a record month with 17.6 million contracts per day, up 58% from October 2013. Open interest at the end of October stood at 104.9 million contracts, up 25% from the beginning of the year. On October 15th, a record 35 million contracts traded, about three times the norm of which 26 million were from North America, 7.4 million from Europe and 1.1 million from Asia. Its ability to flawlessly execute this level of activity on behalf of its customers highlights the CME’s technology and clearing capability in addition to its expanded global customer base. The return on CME’s shares is 16% since the beginning of the year.

Donaldson Inc.

Donaldson’s first fiscal quarter sales of $597 million were flat with the same period a year ago while earnings of 40¢ per share were one penny lower. The negative impact of foreign currency translation reduced both sales and earnings by 2%. Lower filter sales for new agricultural, mining and construction equipment during the quarter were offset by a pick-up in sales for on-highway trucks and replacement filter sales. A bright spot in first fit came from a 16% increase in sales of on-highway truck filters globally. North American and Latin American sales rose 19% and 23% respectively due to higher new truck build rates. Europe grew 33% primarily due to increased market share on the new Euro 6 emissions standard compliant trucks now in production. Sales to manufacturers of off-road products, which include agricultural equipment, mining and construction, fell 17% from the same period a year ago. Strong double-digit growth of replacement industrial dust collectors offset the decline in new installations which resulted from less capital investment on new industrial capacity. The gas turbine filter business fell 10% during the quarter but will rebound in coming quarters based on customer orders and shipment schedules. Donaldson’s introduction of new technologically innovative products has increased its market share with engine equipment manufacturers which in turn leads to more sales of replacement filters. During the quarter, 66% of its Engine filter sales were replacement filters, up from 61% a year ago. Engine replacement filter sales rose 9% from the prior year as the company continues to invest in distribution centers and sales people to boost sales in underserved markets in Latin America, Southeast Asia, India, China and Eastern Europe. During the quarter, Donaldson repurchased 3.34 million shares, 2.3% of its diluted shares outstanding for $134.3 million or $40.19 per share. Along with the impact of prior share repurchases the company’s share count has declined 5.3% year-over-year. Donaldson’s shares have had a negative 11% return this year after they provided a 34% return last year.

Varian Medical Systems

Varian Medical Systems’ fiscal fourth quarter and full year revenues were $812 million and $3.0 billion, up 5% and 4% respectively from a year ago. Earnings of $1.11 per share for the quarter and $4.14 for the year rose 3% and 4% respectively. Oncology Systems’ quarterly revenues of $622 million rose 6%, while 2014 revenues rose 4% to $2.3 billion, accounting for 77% of Varian’s revenue in both periods. Orders grew 9% in the fourth quarter with 11% order growth in North America, the strongest order growth the company has seen in over two years. Varian booked several large multi-system hospital orders in the U.S. and experienced strong order growth in Canada. Varian also had strong results in the U.K. Guy’s and St. Thomas Hospital in London ordered eight TrueBeam radiation systems and a full suite of software. The National Health System also ordered ten TrueBeams, on top of a 20 TrueBeam order last year as the NHS modernizes its radiation systems to provide advanced cancer treatments and to shorten treatment times. TrueBeam, launched in 2010, contains the first new radiation source developed in decades according to Kolleen Kennedy, the President of Oncology Systems. It now comprises most of the new systems ordered around the world. Even with 1,000 systems installed, TrueBeam comprises only 10% to 15% of Varian’s installed base. The number of radiation systems sold during fiscal 2014 grew 12% over 2013 which ensures a stream of service, accessory and software upgrades in the future.

Software sales rose 26% in 2014 to just under $550 million. Full-Scale, Varian’s cloud-based hosting system for its oncology information system and its treatment planning software, allows clinics to transfer the management of their IT systems to Varian. While Full-scale reduces IT costs for the clinics and keeps their software and hardware up-to-date, it also deepens their commitment to Varian’s technology. Vantage Oncology, a network of over 60 clinics set up a system with four database hubs that serve 48 clinics which use Varian’s software. The head of clinical operations now manages four databases instead of 48. Varian completed several acquisitions and licensing agreements during the year to enhance its software offering. In April 2014, the company acquired Velocity Medical Solutions, a privately-held software company formed by medical physicists at Emory University. Velocity allows clinicians to collect imaging and treatment data from a variety of sources, including data on compact discs. The software enables clinicians to create a single image to which new data is added with every treatment. They can see how the treatment is progressing daily and can adjust it as needed. Velocity also captures images from radiology groups once a patient completes treatment and begins long-term monitoring. Clinicians also use Velocity to track retreatment for the 30% of patients who experience metastases at some point. Over 200 clinics around the world used Velocity when Varian acquired it. Fourth quarter orders were greater than the entire past year’s sales, an indication that Varian’s global sales and service teams are reaching the 4400 clinics that use Varian technology. Varian’s stock price has risen 14% since the beginning of the year.


Roche’s nine-month revenue rose 5% at constant exchange rates to CHF 34.8 billion with revenue from its HER2-positive metastatic breast cancer drugs growing 21%. They added CHF 1.0 billion to revenue over the same period a year ago. Increased use of Perjeta, an antibody that binds to a different part of the HER2 receptor than does Herceptin, has driven the growth of both Perjeta, where revenue rose 255%, and Herceptin, where revenue grew 7% to CHF 4.9 billion. Oncologists add Perjeta to patient treatments 55% of the time after surgery to remove the local tumor and 80% before surgery. Recent results from a large Phase III study showed that median overall survival for patients who added Perjeta to Herceptin after surgery increased by 16 months, lifting median survival to 56.5 months, almost five years!

The Diagnostics Division, led by the Professional Diagnostics business which accounts for 56% percent of revenue, delivered revenue growth of 8% at constant exchange rates. Clinical chemistry and immunoassay sales continue to grow at above-market rates of 8% and 12% respectively. Roche strengthened its Molecular Diagnostics business with the launch of fully-automated high and medium volume instruments with assays for blood donor screening. Roche will add assays for viral load and women’s health screening over time. The recently acquired point-of-care Cobas Liat system received European approval for its Strep A assay. Along with an already approved test for Influenza A/B, the Liat performs all DNA amplification and analysis in a closed tube and delivers results in 15 to 20 minutes. Patients with the flu or strep throat no longer have to wait one or two days for a reference lab to deliver test results for these common illnesses. Revenue for Roche’s Tissue Diagnostics business rose 8% with revenue from its service that develops companion diagnostics for external partners up 33%. Roche ADRs have returned 10% since the beginning of the year.


SGS hosted investors in Shanghai and Hong Kong in October to give investors an opportunity to meet with its local management team who have built a thriving operation. China generates 14% of total revenues and is amongst its fastest growing and most profitable. The company employs 15,000 people at 60 locations across the country. SGS began operating in China in 1991 and today is the largest international testing, inspection and certification provider with annual revenues of $850 million. SGS has received more than a dozen local and international accreditations enabling it to operate and provide services across a range of markets including food safety, energy, electrical and electronic, automotive, building, infrastructure and environmental. It recently received China Compulsory Certification laboratory testing services accreditation. Historically, only government institutions and state-owned enterprises were accredited.

SGS’ largest business in China is consumer testing services. This includes textiles, toys, electronics, consumer products and food. Global food sales exceed $4 trillion per year. The company provides services from farm to fork to ensure safe, sustainable and high quality products. More food testing is driven by increased consumer awareness and regulations which require greater traceability and transparency of supply chains. The company conducts testing for toxins, pesticide residue, micro-organisms, bacteria and allergens. Testing is also conducted to uncover adulteration and mislabeling. Multinational companies such as Nestlé rely on SGS to verify their compliance with Global Food Safety Institute requirements.

SGS makes small acquisitions which can prosper after becoming part of the company. An example, which SGS highlighted in Shanghai, is Pfinde, which provides U.S. and Canadian pipeline inspection services. It was acquired in November 2011 with $24 million of revenue. Its key customers are pipeline owners Enbridge, Kinder Morgan and Trans-Northern Pipelines. This year it will generate $40 million in revenues and will complete 120 in-line inspections of pipeline walls using varying testing tools, up from 50 at the time of the acquisition. In addition to pipelines, SGS provides non-destructive testing services globally to refineries, LNG plants and other industrial facilities in 35 different countries utilizing 1,900 employees. China operates 200 refineries.

During the meetings, management reported that during the third quarter organic growth improved from the first half of the year. Revenue growth in September was 6% and was a bit higher than that in October. Its depressed Minerals testing business has improved from the trough level reached in February. The return on SGS ADRs is down 6% this year as the Swiss Franc has dropped by 9% against the dollar.

Core Laboratories

Core’s third quarter revenues and earnings once again just met management’s forecast. Revenues of $276 million for the quarter were not quite $3 million more than the year ago quarter’s revenue. They were reduced by $6.3 million because management decided to phase out products of its Production Enhancement division that were becoming commoditized. The decision adheres to management’s commitment to provide customers with the best available solutions and not to tie up capital in businesses with eroding margins. It also lifted the operating margin of Core’s most profitable division, Production Enhancement, by over 2 percentage points to 37.4%, enabling it to produce 51% of Core’s profit for the quarter. Earnings per share of $1.53 before foreign exchange losses were 13% higher than the $1.36 earned in last year’s third quarter.

During the past quarter, Core’s Reservoir Description division, its largest source of revenue, booked some initial revenue and profit from analyzing some of the five core’s from deep water Gulf of Mexico wells that it has waited to work on since the beginning of this year. These initial analyses, when completed each produce revenues of $3 million and are quite profitable. The cores are also a recurring source of revenue once production begins. Analyses of the changes in the composition of the fluids in the reservoirs require use of the cores. Over half of Core’s Reservoir Description Revenues are derived from recurring fluid analyses which is the fastest growing service provided by the company. Most of these analyses are performed regularly in older offshore fields such as those in the North Sea and the shallower parts of the Gulf of Mexico. Over 85% of Core’s Reservoir Description revenues are from enhanced recovery work on producing fields.

The persistent growth of Core’s revenues from fluid analysis along with those obtained from Production Enhancement tools that provide timely insight into the effects of fracing oil bearing shale formations provides Core with a steady recurring source of revenue and earnings even if oil prices remain suppressed. Core’s oil soluble tracers enable drillers to identify the oil coming from as many as thirty separate tunnels in fractured shale created by perforating charges from thirty stages along a mile long horizontal well bore. That reduces pressure pumping costs and water usage by a least 20%. Importantly, it allows the operator to quickly know what has happened at each stage in the process. Managing production with these tools not only reduces costs and risks, it increases production. Core counts among its customers major US shale oil producers who are already proficient at using its new tools to realize economies of scale. In 2008, when the oil price dropped 70% from its high in June, Core’s stock price fell 58%. Core’s stock price at $113 is 49% below its high, while the oil price has fallen 40% from its high this past June. During the third quarter, Core bought 562,913 shares at $151. Thereafter in October, it paid $139 to buy 119,254 shares.

FEI Company

FEI Company posted its third consecutive quarter of orders growing faster than sales with third quarter orders 10% greater than sales. Orders grew 7.4% organically to $269 million, excluding $19 million in foreign exchange adjustments made at the end of the quarter because of the strengthening of the U.S. Dollar. The backlog is up 14% this year to $539 million compared to $482 million a year ago. New products made up 70% of Industry orders and over 50% of Science orders during the quarter. They reflect the value FEI’s customers see in the new products and improved workflows. Industry orders rose 59% organically to $154 million. The top three wafer manufacturers accounted for more than 50% of the company’s product orders during the quarter. These companies need FEI’s specialized instruments to increase manufacturing of integrated circuits with geometries below 20 nanometers. They also need additional transmission electron microscopes designed for examining wafers to develop manufacturing processes in the lab for chips with 10 nanometer geometries. FEI also has found that once a manufacturing site spends $10 million to acquire its two near-line instruments, the company’s application engineers identify additional opportunities to use these tools as wafer manufacturers move to full production.

Science orders of $96 million were down 26% organically during the quarter. Increased orders from the U.S. and Europe did not offset the continued weakness in orders from Chinese life science researchers. FEI believes that orders worth $10 to $20 million have been delayed into 2015 because of the ongoing anti-corruption campaign. Electron microscopy has entered the mainstream of structural biology, so orders for the $5 million Krios transmission electron microscope remain strong. Materials Science, the company’s main Science market, is growing as well. FEI announced two collaborations with advanced materials engineering institutes this year: One in June with the University of Manchester and British Petroleum to study metal corrosion and one in November with the University of Connecticut and General Electric for advanced characterization of materials. The UConn Microscopy Center will house seven FEI instruments including high-end and mid-range transmission electron microscopes. FEI will also provide applications engineers to set up the center and will service the instruments. This center will serve as a working showcase for FEI’s workflows on the east coast.

FEI’s third quarter sales of $228 million grew 3.5% organically over the same period a year ago. Earnings per share, excluding one-time moving charges, were 69¢, up 2¢ from a year ago. FEI’s stock price has been extremely volatile this year, reaching a high of $111 on March 5 and a low of $73 on October 14. The return on FEI’s stock is unchanged since the beginning of the year.


Nestlé’s nine months sales of CHF 66.3 billion grew 4.5% organically over the same period a year ago. Sales growth was split evenly between increased volumes of 2.3% and increased pricing of 2.2%. Sales in developed markets of CHF 36.9 billion grew 0.5% and accounted for 56% of Nestlé’s sales. Emerging markets sales of CHF 29.3 billion grew 9.5%. The environment remains challenging. Growth is slowing in emerging markets and remains stalled in developed markets. While sales growth in some categories has been weak, Nestlé continues to see strong growth in its innovative products, all of which pass the 60/40+ test. These products taste better than their competitors’ products and have more vitamins and less sugar, salt and fat. The Growth in premium frozen pizza brands in the U.S. remains strong, and the recent launch of DiGiorno’s Crispy Thin Crust pizza has gone very well. Sales in U.S. frozen foods, Nestlé’s second largest U.S. business, however, have declined this year because the company has removed trade support from segments where retailers make no distinctions among brands and discount all products. Nestlé is committed to profitable long-term growth and will not invest in categories where they are not paid for added value.

In addition to Nestlé’s commitment to science-driven innovation to advance the role of nutrition in maintaining health and wellness, the company continues to adjust the balance between its decentralized local businesses and its centralized services. On September 26, 2014 Nestlé announced the formation of Nestlé Business Excellence, a new executive board level function that integrates GLOBE, its company-wide IT system, Nestlé Business Services, its shared services group, and Nestlé Continuous Excellence, its productivity program. Chris Johnson, the current Executive Vice President of the Americas region, will lead this new service. From 2000 to 2006, he oversaw the implementation of GLOBE, the single IT platform that standardized the company’s business processes, data and systems. GLOBE increased the transparency of the business and provided the foundation for Nestlé’s Continuous Excellence and its shared business services. Nestlé initiated its productivity program in its factories in 2007 and expanded lean process development throughout the organization three years later. Today, 80% of Nestlé’s 340,000 employees are directly involved in over 30,000 projects to drive waste out of the system. Nestlé Business Services, which also began operating in 2007, provides human resource support, financial services, global procurement and digital services (e-commerce and media) from five regional centers located in Ukraine, Egypt, the Philippines, Brazil, and Ghana. It also includes corporate services at Nestlé’s headquarters in Vevey, Switzerland. Combining these corporate programs into one group allows the company to take advantage of its scale to move best practices faster throughout the company. It also enables local business managers to devote all their time to generating demand for their products. Nestlé’s ADRs have returned 4% since January 2.

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Capital Counsel’s investment strategy combines disciplined fundamental analysis with patient execution. We hope this letter helps you understand that stock selection is at the core of our investment strategy. We invest in profitable well-managed companies that generate recurring free cash flow. These companies possess strong balance sheets and earn attractive rates of return on shareholders’ capital. We know the companies and their proven execution focused managers well. They deal with problems openly and effectively, and have incentives aligned with shareholders. We evaluate the company, as an informed private buyer might, to determine the value of the business based upon its ability to generate free cash flow. We manage concentrated portfolios which provide our clients with good long-term results. The financial strength of the companies held in client portfolio lessens the drop experienced when markets decline.

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