3rd Quarter, 2015

The good overall third quarter earnings produced by your companies in most instances results from understanding their customers’ needs and knowing how to use that to compete effectively for sales in markets made more difficult by punishing currency movements and collapsing commodity prices. The earnings for your companies collectively rose 3.6% compared to a decline of 1.6% for the S&P companies. Later this week, the Federal Reserve Board, after months of deliberations, probably will vote to raise short-term interest rates and explain their reasons for doing so. Their current policy requires them to issue an economic forecast which invariably stimulates a torrent of commentary and predictions.

The Fed’s monetary policies, of course, influence fluctuations in currency markets. Its prolonged zero interest rate policy also may have encouraged oil, natural gas, mining and agricultural producers to increase borrowings to expand production that has resulted in collapsing commodity prices. Low prices impact the ability of borrowers to service their loans, forcing some sales of producing properties. The debt of these highly leveraged oil and gas companies constitutes almost 60% of the junk bonds outstanding. Mining companies, likewise, are large issuers of bonds outside our markets that have been downgraded to junk status. Losses on high yield bonds are receiving publicity following the suspension of redemptions in the Third Avenue Focused Credit Fund, a mutual fund with assets of $789 million. This event has pushed down the price of Black Rock’s High Yield Composite Bond ETF, a $12.7 billion fund, that now is down over 11% for the year. The evident stress in the bond market may make the contraction following the shale boom worse for many industrial companies whose particular skills allowed them to earn reliable profitable recurring revenue from oil and gas companies. The anxieties evident in the bond market probably will spill over into our stock market and we should get a welcome opportunity to buy stocks of companies meeting our criteria. The year-to-date return of the S&P 500 is minus 0.4%. Forty percent of the stocks in the index are down more than ten percent.

As we await a plethora of forecasts, we remind ourselves that the managements of our companies always provide the best assessment we can obtain of the economic prospects for the coming year. All our managements expect next year will be tough, although many are enthusiastic about the opportunities they see. As we contemplate the year ahead, we think of an observation given to us by a wise older man who asked us to think about “the knowledgeable forecasts” we heard and read at this time last year. Most of what proved important was left out.

Express Scripts

Express Scripts’ third quarter revenues of $25.2 billion were 2% lower than its revenues of $25.8 billion in the third quarter of 2014, while gross profit increased 5% to $2.2 billion. These results demonstrate that the company’s model of alignment is working. When clients save money, Express Scripts’ increases its profitability, as CEO George Paz noted on the third quarter earnings call on October 28, 2015. Operating earnings per claim rose 4% to $5.51 as a result of managing the drug formulary, fulfilling more specialty drug prescriptions through its Accredo specialty pharmacy and increased use of generic drugs. Adjusted earnings per share of $1.45 rose 12% from $1.29 a year ago. Net income growth rose 3% with a lower share count accounting for the rest of the growth. Adjusted earnings per share exclude Medco transaction costs and amortization of intangible assets.

Members like Express Scripts’ re-engineered web site. They now see all their savings opportunities on their personal home page. The number of patients responding to savings offers doubled the day after the launch of the web site. The company also relaunched its smart phone apps with finger touch security (e.g., iTouch for the iPhone). This change improved security and made members more likely to use the app. Encouraging members to use these self-service tools to answer their questions reduces the number of calls they make to Express Scripts’ call centers which immediately reduces costs. Express Scripts’ stock price is up 0.4% since January 1.

Automatic Data Processing

ADP’s fiscal first quarter revenues of $2.7 billion increased 9% and adjusted earnings of 72¢ per share rose 11% on a constant dollar basis from a year ago. Worldwide new business bookings rose 13% from the same period a year ago, reflecting continued strong demand for the company’s human capital management and Affordable Care Act (ACA) solutions. Organic growth in the number of employees on each existing clients’ payroll was 2.3%. ADP’s comprehensive PEO (professional employer organization) generated 18% revenue growth to $698 million as average worksite employees reached 389,000, an increase of 13%. ADP’s interest earned on client funds balances declined 3% to $88 million from a year ago as a 3% increase in average funds balances to $19.4 billion was more than offset by a 10 basis point decline in average yield to 1.8%.

ADP’s ability to develop innovative solutions which help businesses of all sizes meet the challenges of new complex compliance requirements has led many businesses to engage ADP for health compliance solutions since the Affordable Care Act was enacted in 2010. In August, the company introduced the ADP Private Exchange to meet its clients’ developing needs. It enables businesses to build and implement a health care insurance exchange strategy for their employees that can help control costs. The solution, which is integrated into ADP’s broader human capital management platforms, provides a retail-oriented shopping experience, defined contribution plan administration, public exchange enrollment, ACA compliance and flexible spending accounts. These new products have helped ADP deliver double-digit new business sales growth during each of the past four years. ADP’s total return is 2.4% since the beginning of the year.

CME Group Inc.

CME’s third quarter revenues of $850 million rose 11.5% and expenses increased just 0.6% resulting in adjusted earnings of $1.02, up 21% from the same period a year ago. The strong revenue growth was driven by a 7% increase in average daily volume to 14.4 million futures and options contracts and a 4.7% increase to 75.9% in the average rate received per contract traded. We are pleased to see CME’s expense discipline this year drive operating leverage which is more valuable than financial leverage. At 62.7%, its operating margin is the highest since 2011 and is up 4.3 percentage points from a year ago. During the quarter, electronic trading revenue from customers outside the U.S. reached a record 32%. Volatility in CME’s underlying commodity, foreign exchange and interest rate markets continues to boost transaction volumes. While the volume of interest rate contracts fell from a year ago when volumes surged to 7.2 million contracts per day, volumes in all other product lines rose. Equity index contracts were up 27%, foreign exchange +7%, energy +26%, agricultural commodities +20% and metals +15% from a year ago.

On December 9, CME declared its annual variable dividend in the amount of $2.90 per share, up from $2.00 per share a year ago. The dividend will be paid on January 12 to shareholders of record on December 28. The variable dividend and CME’s 50¢ quarterly dividend result in total dividends of $4.90 per share, representing an annual dividend yield of more than 5%. CME’s total return since the beginning of the year is 6%.


Visa delivered strong revenue and earnings growth despite the impact of the strong U.S. dollar, low gasoline prices and weak economic conditions in Canada, Australia, Brazil and Russia on the company’s payment volumes. Fourth fiscal quarter and full year revenue of $3.6 billion and $13.9 billion grew 14% and 12% in constant currencies over the same periods a year ago. The strong dollar reduced revenue growth by 3% in both periods. Earnings per share increased 14% to 62¢ for the quarter and 16% to $2.62 for the year. U.S. consumers continue to replace cash with credit card payments. Domestic payment volumes grew 10% to $2.7 trillion for the year, vastly exceeding growth in personal consumption of 3%.

On November 2, 2015, after reporting its financial results, Visa announced that it would acquire Visa Europe for €21.2 billion. Visa Europe is currently owned by over 3,000 financial institutions in 38 countries. These banks have issued over 500 million Visa cards with payment volumes of €1.7 trillion. When the acquisition closes next spring, member banks will receive €11.5 billion in cash and €5.0 billion in preferred stock that is convertible to common stock. They will receive a maximum earn-out of €4.7 billion in cash based on net revenue targets, which are easy to measure, four years after the deal closes. The equity and the cash earn-out allow Visa Europe’s owners to share in the growth of Visa’s global business. They want to benefit from Visa Inc.’s global scale, its steady capital investment in its payment systems and its ability to develop new services for merchants and consumers. Visa will create a European region based in London following the model of the Asian region it created with headquarters in Singapore. The company plans to spend at least two years creating a single payment system that incorporates the specific requirements of each European country. Once Visa Europe is fully integrated, it will become Visa’s second largest region with 28% of global payment volumes. On December 10, Visa issued $16 billion in debt with an average interest rate of 3.0% to 3.1% to finance the transaction and to repurchase stock to offset the issuance of the preferred shares. The total return on Visa shares is 17% since the beginning of the year.

IDEXX Laboratories Corp.

IDEXX Laboratories’ third quarter revenues of $406 million grew 6% over the third quarter of 2014 and earnings per share rose 2% to 54¢ from 53¢. The strong U.S. dollar reduced revenue growth by 6% and earnings growth by 7%. The gyrations in the company’s stock price this year reflect the successes and shortcomings of the move to the all-direct selling strategy that occurred at the beginning of the year. IDEXX’s stock price dropped 10% on October 28, 2015 after the company reported its third quarter results and is down 8% year-to-date. The growing productivity of the sales force is visible in the 54% increase in premium analyzers placed in U.S. vet clinics during the quarter and the 13% volume-based growth in U.S. reference lab revenue. IDEXX placed 569 Catalyst chemistry analyzers in U.S. clinics during the quarter with 268 going to new accounts, an increase of 16% over the last year. Sales reps’ success in educating vets about IDEXX’s unique test menu, especially SDMA, its new kidney disease assay, increased test volumes with its existing customers. In the three months since the launch of SDMA, IDEXX has tested over 1 million patient samples for 12,000 clinics, including 1,600 clinics that do not use IDEXX as its primary reference lab.

Although IDEXX’s move to all-direct sales has gone well, distributors increased placements of competitive instruments 3% during the fourth quarter of 2014 and the first two quarters of 2015. As IDEXX’s sales reps got to know the customers in their new territories and visited more often, they secured their existing customers and are recouping the share they lost earlier this year. Each quarter’s instrument consumables sales depend on instrument placements in the previous four quarters, so instrument consumable sales were lower than originally forecast this quarter and will be lower in the fourth quarter. Instrument consumables sales will rise inexorably in 2016 as vets run more diagnostic tests on their newly placed premium chemistry and hematology analyzers.

Mettler-Toledo International Inc.

Mettler-Toledo’s addition of 200 field representatives contributed to 10% revenue growth in the Americas and 1% revenue growth in Europe over the third quarter of 2014. These new employees both increased the instrument replacement rate through sales to existing customers and increased market share by selling instruments to competitors’ customers. Third quarter sales of $604.2 million grew 3% in local currencies. The strong US dollar and the weak euro reduced sales growth by 7%. Earnings per share rose 11% to $3.23 from $2.92 a year ago. They rose 16% excluding the impact of currency.

Process Analytics, with sales of $200 million or about 8% of Mettler’s total 2014 sales, is one of the fastest growing and most profitable of the company’s 25 businesses. Revenue is up 8% year-to-date and is growing twice as fast as company revenue. High margin consumables account for 40% of revenue compared with 23% of Mettler’s total revenue. Process Analytics supplies sensors and transmitters that continuously monitor water quality in industrial processes. The sensors degrade over time and must be replaced. Metter-Toledo has embedded a small chip in its sensors which monitors performance throughout its life. Facility managers track the performance of all the sensors in their plants, and thus, can replace them before they fail and cause unplanned down time. Mettler precalibrates replacement sensors so they work reliably as soon as they are installed. Thornton, Mettler’s ultrapure water monitoring business, accounts for about 25% of Process Analytics’ sales. Pharmaceutical companies, semiconductor manufacturers and power plants are some of the largest users of ultrapure water. Thornton’s systems measure water quality continuously as it flows through the plant to ensure that it is free of minerals and organic contaminants. Mettler recently acquired a technology from a small German company that uses lasers to detect the presence of microbes in water. The company modified this technology so that it works reliably in manufacturing environments that run 24/7. This technology will improve the productivity of pharmaceutical manufacturing processes because it provides in-line results instantaneously. Today, water samples are tested in a lab where it takes three to four days to grow bacterial cultures. Mettler-Toledo’s stock price is up 9% since January 1.

Ecolab, Inc.

Ecolab’s third quarter sales of $3.4 billion grew 1% in local currencies over the third quarter of 2014. Acquisition of a water treatment company in China accounted for all of the growth. The strong U.S. dollar reduced reported sales growth by 7%. Adjusted earnings of $1.28 per share rose 6% from $1.21 per share a year ago. Strong growth in Ecolab’s other businesses offset a 12% decline in revenue in the Energy business. New account gains and growing sales of new products that reduce water and energy use in both Global Institutional and Global Industrial contributed to the 6% organic revenue growth in each business during the quarter to $1.1 billion and $1.3 billion respectively. Operating profit rose 1.8 percentage points to 23.1% in Global Institutional and 15.8% in Global Industrial as both businesses benefitted from lower raw material costs, improved operating efficiency as well as higher prices and margins on new products. The 40% decline in WellChem’ sales, Ecolab’s upstream business that supplies North American land-based oil exploration, has reduced it to 10% of Energy’s sales, down from 18% expected in 2015 based on an oil price of $50. The oilfield chemicals and downstream businesses continue to grow internationally, but could not offset the decline in the upstream business. Although operating income in Energy fell 21% to $133.4 million, reduced raw material costs fully offset the impact on the company’s operating income. The total return on Ecolab’s stock is 9% since the beginning of the year.


Wabtec is one of the best managed companies in your portfolio because its management knows how to inspire its employees to adhere rigorously to the Wabtec performance system which recognizes all who successfully reduce costs while maintaining or even improving quality. It enables everyone to learn by doing, including employees of acquired companies. Despite a ten year record of delivering sustained earning growth with only one interruption, a 10% decline in 2009, Wabtec’s stock price dropped 13% after it reported on October 22, 2015. Its third quarter earnings of $1.02 per share were 10% higher than the 93¢ earned in the third quarter last year after a 2¢ per share charge for cost of its proposed Faiveley acquisition. Foreign exchange translation losses reduced sales by 4½% which brought the year-over-year third quarter gain down to 2%. When the company reported earnings, it merely reaffirmed its previous earnings and sales forecast for 2015 of $4.10 per share, up 13% on a 9% increase in sales. It provided no forecast for 2016 which conformed to its practice over the past five years. In commenting on the results, Wabtec’s CEO, Al Neupaver, stated that orders for new freight cars had peaked. Manufacturing components for new freight cars generated 10% of Wabtec’s total 2015 revenues. The revenue earned per car is $4000. The components provided, especially brakes, are among the company’s more profitable products, but they are not significantly more profitable than replacement brake shoes or rebuilt brakes which generate a like amount of revenues. New freight car deliveries will not suddenly stop. The pace will slow. Wabtec’s backlog extends out into 2017. Replacement revenues for freight cars and locomotives, an equally important market, are affected adversely by the current decline in U.S. freight car loadings for coal and oil, and more recently for general merchandise as well.

The best news in the quarterly report was the 20% growth in revenues to $95 million for Positive Train Control Systems (PTC). It contributed 11% of the quarter’s earnings and is Wabtec’s fastest growing product. The legislation extending the effective deadline until 2020 for all U.S. freight and passenger railroads, including commuter lines, to install PTC was enacted at the end of October. The FAST Act (Fixing America’s Surface Transportation Act) passed earlier this month, authorizes the Transportation Department to provide over the next five years commuter railroads and states with grants and loans of up to $2 billion to finance PTC installation. Wabtec’s stock price is down 19% since the beginning of the year.

Air Lease Corporation

Air Lease’s third quarter revenues of $313 million and earnings of 71¢ per share rose 20% and 22% respectively. Passenger demand for air travel remains strong as does airline demand for new planes in the company’s order book. During the quarter, the company took delivery of nine new aircraft, acquired three aircraft in the secondary market and sold four aircraft from its fleet. Its 235 owned planes are 100% leased by 89 airlines in 50 countries. All but four of the sixty-five aircraft on order scheduled for delivery over the next two years are contracted for by new and existing airline customers. About 40% of the deliveries in the next two years are Boeing’s next generation 737-800 single aisle aircraft which is sought after for its reliability, versatility and lower maintenance and operating costs. Air Lease’s 235 planes include 100 manufactured by Boeing, 90 by Airbus, 26 by Embraer and 19 by ATR (a French-Italian manufacturer). Forty-three percent of the aircraft are leased to airline customers in Asia, 30% in Europe, 10% in the Middle East and Africa, 9% in Mexico, South America and Central America, 4% in Pacific, Australia and New Zealand and 4% in the U.S. and Canada. The planes in its fleet have an average age of just 3.5 years and an average 7.3 years remaining on the leases. The lease payments on these contracts exceed the company’s outstanding debt. The aggregate fleet net book value of $10.4 billion is financed with $7.5 billion of debt, which equates to 2.5 times equity. More than 81% of the debt is fixed with an average maturity of five years. The composite interest rate is 3.61%. In October, Air Lease announced that S&P upgraded its credit outlook on the company to positive from stable. Air Lease’s total return is minus 7% since January 1.

Varian Medical Systems

Varian Medical Systems’ fourth quarter sales of $818 million and full fiscal year sales of $3.1 billion each grew 6% in constant currencies over the same periods a year ago. The strong U.S. dollar reduced sales growth for the quarter and the fiscal year by 5% and 4% respectively. Earnings for the year rose 5% to $4.29 from $4.09 a year ago. Both results exclude the amortization of purchased intangible assets, restructuring and transaction costs associated with two acquisitions the company made this year. Varian’s repurchase of 5 million shares during the year accounted for all of the earnings per share gain.

Oncology Systems had a good quarter with revenues of $633 million up 9% and orders of $919 million up 5% in constant currencies. Orders in North America rose 4% while orders in Europe, the Middle East and India rose 25%. Varian booked orders for over 100 radiation systems in this region during fiscal 2015. Revenue and orders for the fiscal year each rose 6% to $2.3 billion and $2.7 billion respectively. The company’s innovations continue to make radiation treatments safer and easier to perform. RapidPlan, an add-on to Eclipse, the company’s top-selling treatment planning software, provides models that serve as baselines for developing treatment plans. Among the many papers presented on initial results with RapidPlan at the 2015 conference for radiation oncologists, clinical trials of RapidPlan at the University of Michigan confirmed that it reduced the time to develop a complex treatment plan of similar quality from 2 ½ to 3 hours to 20 to 30 minutes. RapidPlan is available to all 3,800 Eclipse users and 314 clinics have already ordered it.

Poor performance from Varian’s Imaging Components business, which accounted for 20% of the company’s fiscal 2015 revenue, offset revenue and earnings growth from the larger Oncology Systems business. Revenue fell 7% to $611 million from $660 million the previous year. Varian is the technology leader and largest independent supplier of x-ray tubes and flat panel displays used in digital radiographic imaging. Oncology Systems accounts for about 15% of Imaging Components’ revenue and purchases 1,500 tubes and large panels for the on-board imaging system that provides x-ray images of tumors to ensure proper patient positioning before each radiation treatment session. Varian’s Security and Inspection Products (SIP) is also part of this division. While x-ray tube revenue was down 1% for the year and revenue for the faster growing flat panel business fell 4%, revenue for SIP fell 37%! Oil producing countries account for 80% of sales because they use Varian’s cargo screening systems to protect shipping around their oil fields. Varian does not expect these governments to order new systems in the near future. Management has already reduced Imaging Components’ head count by 10%, developed low cost flat panels to improve profitability in the competitive low end of the market and is looking at strategic options for the SIP business. Varian’s stock price is down 10% since January 1.


Roche’s nine month sales of CHF 35.5 billion grew 6% in constant currencies over the same period a year ago with revenue from the Pharmaceuticals and Diagnostics divisions each growing 6% to CHF 27.7 billion and CHF 7.8 billion respectively. The Swiss franc weakened against the U.S. dollar and strengthened against the euro, reducing reported sales growth by 3.5%. Esbriet, Roche’s newest drug which was launched in the U.S. late last year after receiving FDA approval on October 16, 2014, delivered sales of CHF 157 million during the third quarter and CHF 386 million so far this year. Esbriet delays the progression of idiopathic pulmonary fibrosis, a rare disease of unknown origin that causes irreversible scarring and thickening of the lung. Approximately 100,000 patients in the U.S. and 110,000 patients in the E.U. have IPF. Clinical data presented in Amsterdam in late September demonstrated a 38% reduction in the risk of death for IPF patients who stayed on the drug for two years. Roche’s marketing program has established Esbriet as the market leader in the U.S. and it maintains its market leadership in the E.U. with over 60% share. Underlying demand in the U.S. remains strong. Only 20% to 25% of IPF patients currently undergo any treatment, and community pulmonologists are starting to prescribe Esbriet for earlier-stage patients who will benefit longer from taking the drug. The total return on Roche ADRs is 2% since the beginning of the year.


Nestlé’s nine month sales of CHF 64.9 billion grew 4.2% organically over the same period a year ago. Volume growth contributed 2% to revenue growth and price increases contributed 2.2%. Foreign currency translation reduced reported revenue growth in Swiss francs by 6.7%. The lack of sales from Maggi Noodles during the third quarter reduced nine-month organic sales growth by 0.3 percentage points. Maggi noodles returned to stores in India on November 9, 2015 following tests by government accredited labs showing that the noodles are safe to eat. Sales from developed markets of CHF 36.9 billion rose 2.2% year-to-date with growth in Europe, Japan and Australia above the company average. Sales in developing countries rose 6.8% to CHF 28.0 billion. Nestlé USA’s relaunch of Lean Cuisine and Stouffer’s frozen food products continues to perform well. Consumers want natural, healthy foods that are “free” of gluten, artificial colors, flavors and preservatives. Lean Cuisine Market Place meals address consumers’ current interest in healthy diets and eating instead of offering low-fat, low-calorie meals. Nestlé has begun to convince consumers that freezing is a natural preservative that best conserves all nutrients when compared to chilled fresh foods that may require preservatives to extend their shelf lives. U.S. sales are now growing in high-single digits, increasing Nestle’s market share and the overall growth of the category. Demand is extremely strong. The company’s challenge is actually meeting this demand with a pipeline of new products and investments to maintain momentum.

Powdered and Liquid Beverages grew 5.8% organically to CHF 14.0 billion during the first nine months of 2015. Volume growth of 3.1% was above the company’s average. Nestlé’s coffee businesses accounted for most of the growth with strong volume growth in Nescafé soluble coffee in Latin America and in China. Sales of Nescafé Dolce Gusto, the company’s single serve coffee system which makes hot drinks ranging from espresso to chai lattés, grew in all regions. Nestlé introduced Dolce Gusto in Europe in 2006 and now sells the systems and single serve pods in 70 countries. Dolce Gusto is one of Nestlé’s CHF 1 billion brands with sales growing above 10% annually. The total return on Nestlé ADRs is 4% since January 1.


At the end of October SGS hosted its annual investor meeting where its capable new CEO Frankie Ng and CFO Carla de Geyseleer provided details regarding its updated strategic plan which involves the realignment of certain business lines and an updated strategic focus. The most significant new business line shifts its food testing business from consumer to agriculture to form its Agriculture, Food & Life (AFL) business segment. AFL will benefit from increasing concerns from consumers and more regulations from governments on food safety and security. With AFL’s annual revenues of CHF 875 million, SGS is one of the largest Agri-Food certification, testing and inspection companies from farm to fork. The strategic plan calls for a reduction in costs to increase profits by improving back-office efficiency through shared services at regional hubs. Major finance and administrative back-office processes which today are performed in 35 countries will be moved to three shared service centers. Once completed this will generate more than CHF 20 million in annual savings. Furthermore, by transforming its procurement process through strategic sourcing, improving transactional efficiency, enhancing supply chain management and optimizing its real estate footprint, the company plans to generate CHF 40 million of savings this year, CHF 60 million in 2016 and CHF 80 million in 2017. Its renewed focus on cash generation and working capital management is already paying off as working capital generated cash of CHF 9 million in the first half of the year versus using CHF 180 million of cash in the same period the prior year. Further improvement is promised in the year ahead and management incentives have been introduced based upon organic growth, free cash flow and return on invested capital. SGS total return is minus 5.5% for the year. The stock price has risen 7% since the end of September.

Core Laboratories

Core’s third quarter revenues of $197 million and 78¢ per share were respectively 28% and 48% below the comparable results for the year ago quarter. These percentage declines are worse than the 24% and 45% declines in revenues and earnings experienced during the second quarter when the company earned 81¢ per share. At the end of September, three weeks before Core released its third quarter results, management, while reaffirming its prior third quarter forecast, announced that revenues and earnings in the next two quarters would be lower. The reason for issuing a reduced estimate for the coming quarters is an anticipated further 15% drop in the revenues for Production Enhancement products provided to U.S. shale oil producers. Although U.S. shale oil production had fallen 500,000 barrels a day since April, an oil glut and declining prices are forcing producers to defer production. That means many wells that have been drilled are not being completed. Completion costs for most shale oil wells exceed drilling costs. The only onshore producing formation now recording increased production is the Permian Basin. It is up slightly. Core’s forecast anticipates a further 200,000 barrel a day reduction in U.S. shale oil production which would make revenues about $15 million lower than the third quarter for both the fourth quarter and the first quarter of 2016. Earnings in each of the quarters then would fall to 65¢ or less. The impending deterioration has caused Core to make staff cuts and reinstate furloughs. It also is realizing cost reductions through automation and multi-skill training programs which enable technical employees to acquire skills that enable them to perform several tests for customers simultaneously.

Demand for reservoir fluid analytics from operators of deepwater wells in the Gulf of Mexico remains strong and currently constitutes half of Core’s offshore revenues. These operators are major customers for Core’s fluid analytics services which is Core’s best business. It produces over 35% of Core’s total revenues and is still growing in a difficult market for oil service companies. These analyses enable operators to manage the effects of withdrawal of petroleum-laden fluids from the reservoir and thereby maximize production. Its customers are primarily the major oil companies and the national oil companies who together account for 45% of Core’s total revenues. The June acquisition of Sanchez Technologies, based in France, strengthens Core’s reservoir fluid analytics lead because Sanchez is the company that designs and manufactures the automated pressure-volume-temperature instruments Core uses to determine the behavior of the changing composition of the liquids in the hottest and deepest petroleum reservoirs. The acquisition cost $17.2 million. It occurred because Sanchez needed financing to develop new instruments and Core wanted to provide better analyses for its customers. Core’s total return is minus 5% since the start of this year.

Donaldson Inc.

Donaldson’s fiscal first quarter revenues of $538 million and adjusted earnings of 34¢ per share declined 3.6% in constant currency and 15% respectively from the same period a year ago. Donaldson’s weak fiscal first quarter results reflect global downturns in demand for equipment that utilize its filters in agriculture, mining, oil and gas, and construction. Sales of these first-fit off-road filters which generate 10% of company revenues declined 20% to $55 million during the quarter. Aftermarket filters sales, which represent 43% of total revenues, fell 3%. These filters need to be regularly replaced based upon equipment usage in the field. The company’s smaller on-road (Class 8 trucks) segment and aerospace & defense filter businesses which generate 7% and 4% of company revenue rose 3% and 4% respectively. Donaldson’s industrial filters comprise 24% of revenues and consist primarily of dust collection systems used in a variety of manufacturing and industrial settings. These sales fell 3% from a year ago while gas turbine filtration systems which generate 4.5% of sales fell 16%. Specialty filter applications, which include filters for disk drives, membrane production and venting applications, generate 7.5% of revenues and were flat. The company further reduced its workforce and has made decisions to reduce capital and operating expenses. The stock is our biggest decliner for the year, yielding a total return of minus 28%. Most of the decline has taken place since June 30 after we reduced our position in the company.

CDK Global

CDK’s fiscal first quarter revenues of $515 million were flat with the same period a year ago as a result of a 3% foreign exchange transaction loss and a 2% loss on the sale of its internet sales leads business on May 21, 2015. Adjusted diluted earnings of 38¢ per share rose 15% from a year ago. Its North American Auto Retail business generated 7% constant currency revenue growth to $332 million and pre-tax earnings increased 14%. The pre-tax margin expanded from 29.1% a year ago to 30.8%. The number of dealer sites rose 4% to 14,277 and the average revenue per site increased 5% from a year ago. International Auto Retail revenues of $78 million rose 4% on a constant currency basis. International dealer locations declined 2% but average revenues rose 5% per site. Digital Marketing revenues of $104 million are up only slightly from a year ago. An increase in average revenue per website was offset by a drop in the number of websites managed. During the quarter, CDK signed an agreement with Infinity to provide website services to their dealerships.

On September 28, CDK announced a plan to open a new Client Service Center of Excellence to consolidate its facility footprint, reduce its costs and improve its service and implementation process. The new center, located in Norwood, Ohio, part of Greater Cincinnati, will employ 1,000 associates. CDK management expects facility rationalization to provide $5 million in cost savings in fiscal 2016, while its reengineered implementation process will reduce implementation time for new clients by 30%, saving an additional $5 million. CDK Global’s total return is 14% from the beginning of the year.


Hexcel’s third quarter sales of $448.8 million declined 1% from $451.9 million in the third quarter of 2014. Sales of $314.5 million in Commercial Aerospace grew 6% from $296.5 million a year ago with sales from new aircraft programs, primarily the Airbus 350, rising over 50% during the quarter. Weak performance in the Space and Defense and Industrial businesses, which account for 30% of total sales, offset the good performance of the company’s most important business. Earnings per share fell 3% to 55¢ from 57¢ a year ago. Capital expenditures of $249 million contributed to an $85 million use of cash through September 30. Inventory levels increased 12% to $326 million to ensure supply to strategic programs and to provide safety stock during the final phase of the company’s resource planning systems upgrade. Hexcel reduced its 2015 free cash flow forecast from a positive $10 to $50 million to none. With the volatility of its defense and wind turbine materials businesses and the $1 billion investment in new manufacturing capacity that Hexcel must make to meet its supply contracts for new aircraft programs, we were dismayed that the company used $100 million of the $300 million in 10-year notes it issued in July to repurchase two million shares of stock during the quarter. We sold your shares on October 20th after the company reported its third quarter results.

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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 seek to invest in profitable well-managed companies that generate recurring free cash flow. These companies should 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 have provided our clients with good long-term results. The financial strength of the companies held in client portfolios has lessened the drop experienced when markets decline.

Client portfolio holdings may change, and stocks of companies noted may or may not be held by one or more client portfolios from time to time. Investors should not consider references to individual securities as an endorsement or recommendation to purchase or sell such securities. Transactions in such securities may be made which seemingly contradict the references to them for a variety of reasons, including but not limited to, liquidity to meet redemptions or overall client portfolio rebalancing. Investing in the stock market involves gains and losses and may not be suitable for all investors. Investment return and principal value of an investment will fluctuate.