4th Quarter, 2015

The good overall fourth quarter results achieved by your companies attest to the skills their managers have mastered since the recovery from the Great Recession began in 2010. In one company after another, these managers from the division levels on up have succeeded in maintaining near record profitability even as sales for their products or services has slackened. The demonstrable proficiency of these managers strengthens our belief that they will enable your companies to grow steadily by continually adding products or services for existing customers or by adapting existing products or services for users in adjacent markets. Despite the proven skills of your companies’ managers, the majority of the companies achieved no more than single digit sales growth, although nearly half attained 10% earnings growth for the quarter. Persistent sales and earnings growth during a period when all commodity prices, and especially oil, have fallen far below levels imagined by industry experts a year ago makes us think that the prosaic businesses we own will serve us well during a time fraught with political and economic change. We are busily examining other companies run by managers whose strength of character seems comparable to that of the managers of the companies you and we own. The year-to-date return of the S&P 500 is minus 1%.

Automatic Data Processing

ADP’s fiscal second quarter revenues of $2.8 billion and earnings of 72¢ per share rose 8% and 6% respectively on a constant dollar basis from the same period a year ago. The number of employees on existing client payrolls rose 2.5% from a year ago. Its fully outsourced HR solution TotalSource generated 18% revenue growth to $737 million while its core employer services business revenue was up 6% on a constant dollar basis. ADP’s new business bookings rose 15% from the same period a year ago as customers seek ADP’s assistance with the growing complexity of managing human resources. During the quarter, ADP made investments to increase operational resources to support implementation and servicing teams ahead of the recurring revenue contribution from its strong new business pipeline. ADP acquired 5.2 million of its shares for $85¾ per share, for a total of $446 million in the quarter. This reduced the company’s shares outstanding by 1.1%. Its fully diluted shares outstanding have declined 4.2% from a year ago as a result of continued share repurchases. The quarterly dividend payment of 53¢ per share was increased 8% from a year earlier and provides a 2.5% annual dividend yield to shareholders. ADP’s total return is 3% since the beginning of the year.

CME Group Inc.

CME’s fourth quarter revenues of $814 million and adjusted earnings of 92¢ per share were only 3% less than the year earlier quarter when the average daily contract volume was the second highest in the company’s history. CME’s full year results were excellent with revenues up 7% to $3.3 billion and adjusted earnings of $3.86 per share up 14%. The company’s cost conscious management improved its operating efficiency even as it continued to invest in innovative new products. Its total operating expenses declined by 1% which helped CME produce an operating profit margin of 61%, up from 58% in the prior year. During the year, CME secured the rights to the popular FTSE Russell stock indexes. It recently launched its Ultra 10-year Treasury product, the most successful start for a new contract in CME’s history. In January, CME distributed almost $1 billion to shareholders in its annual variable dividend which at $2.90 rose 45% from the prior year. In addition, CME just announced a 20% increase it its regular dividend to an annual rate of $2.40 per share. The company’s dividend yield has exceeded 5% annually over the past four years. CME’s total return is 7% since January 1.


Visa’s fiscal first quarter revenues of $3.6 billion grew 8% in constant currencies over the same period a year ago. The strong U.S. dollar reduced revenue growth by 3%. Management’s good control of operating expenses kept their increase to 2% during the quarter. Earnings per share rose 10% to 69¢. Stable U.S. consumer spending over the last 9 months contributed to U.S. payment volumes growing 10% to $713 billion during the quarter as consumers continue to make more payments with credit and debit cards. International payment volumes, which include transactions in Canada, South America, Asia, Australia and New Zealand, grew 14% in constant currencies, but were flat when converted to U.S. dollars. Visa processed 19 billion transactions on its payment network, an increase of 8% over the fiscal first quarter of 2015. Cross border payment volume growth slowed to 4% this quarter from 5% last quarter as the strong dollar and low oil prices reduce travel to the U.S. from Canada, China and countries in the Middle East. Many travelers from China and the Middle East now visit Europe. Visa expects to capture their credit card spending once it completes the acquisition of Visa Europe later this year.

The growing adoption of Visa Checkout demonstrates Visa’s commitment to delivering new services to merchants while making e-commerce and mobile commerce easier for consumers. Customers that use Visa Checkout to pay for on-line purchases sign in to their account which securely stores any credit or debit card numbers and their billing address. They then push a button on the screen to pay. Consumers who pay with Visa Checkout complete their purchases 86% of the time compared with a 57% completion rate on merchants’ own web sites. High abandonment rates are an ongoing challenge for merchants trying to increase their on-line sales, especially those on mobile devices. Visa works with the 270,000 large and small merchants who offer Visa Checkout to develop promotions and marketing campaigns that bring new shoppers to merchant web sites and increase the size of their purchases. Visa helped Williams-Sonoma, one of its 200 large merchants, to install videos that use unique YouTube technology that allows customers to click on images in the video and then purchase the items using Visa Checkout. These videos have been viewed more than one million times. The Visa Checkout network is growing rapidly. It now serves 10 million consumers, up from 5 million six months ago. Visa added India and Europe to the 16 countries that currently offer Visa Checkout in February. Visa’s total return is minus 7% since January 1.

Express Scripts

Express Scripts delivered solid fourth quarter and full year 2015 results. Express Scripts’ fourth quarter 2015 revenue of $26.2 billion was $100 million lower than its revenue in the same period a year ago, while 2015 revenue of $101 billion did not change from a year ago. Fourth quarter gross profit of $2.3 billion grew 8% over the same period a year ago, while gross profit for the year of $8.4 billion rose 6%. Growth in gross profit is a more meaningful measure of the success of the business than revenue is because Express Scripts makes more money when it reduces drug costs for its clients. Drug purchases for its clients are a major component of Express Scripts’ revenue. Earnings per share for the quarter and the year of $1.56 and $5.53 rose 12% and 13% respectively. Net income growth accounted for 4% of the earnings per share growth in both periods and a lower share count accounted for the rest. Adjusted earnings exclude Medco transaction costs and amortization of purchased intangible assets. Express Scripts had a successful selling season, retaining 97% of its existing clients and replacing most of the lost business with that of 120 new clients. The January 1, 2016 implementation of new client drug benefit plans and changes to plans of existing clients was the best in the company’s history.

Investors, however, show little interest in Express Scripts’ strong execution and innovative clinical programs that increase access to drugs at fair prices or its successful selling season. Concerns about its strained relationship with Anthem, its largest client, have sent Express Scripts’ stock price down 20% since the beginning of the year. In 2009, Express Scripts acquired Anthem’s pharmacy benefit business for $4.7 billion in cash. The deal included a 10-year outsourcing contract for pharmacy benefit management services. On January 12, 2016, Anthem’s CEO Joseph Swedish stated that his company is currently overpaying for its drugs by more than $3 billion annually. He then asserted that Anthem expects to reap these savings for 2016 through 2019 as a result of a contractually required drug price review that began on December 1, 2015. Express Scripts keeps all client discussions strictly private, but CEO George Paz said publicly that Anthem is not entitled to $3 billion in savings and that the pricing discussions continue. It took several months of tough negotiations for the companies to agree on pricing during the first review that began in December 2012. Anthem offers its clients an open drug formulary and a broad retail pharmacy network, and thus uses none of Express Scripts’ tools that enable clients to lower their drug costs. Anthem cannot terminate the outsourcing contract because of the pricing dispute, but the CEO’s public comments make it appear less likely that Anthem will renew its contract at the end of 2019. If Anthem succeeds in acquiring the major health insurer Cigna, Frank Cordani, Cigna’s CEO, will replace Swedish as Anthem’s CEO, which would leave ample time to resolve this public dispute. Express Scripts’ current stock price reflects the loss of Anthem’s business in 2019. In the meantime, Express Scripts’ health plan clients, while fully aware of the dispute, continue to work closely with Express Scripts to help them win new business.

IDEXX Laboratories Corp.

IDEXX Laboratories’ fourth quarter and full year sales of $400 million and $1.6 billion each grew 11% organically over the same periods a year ago. Earnings per share for the quarter rose 2% to 48¢, while full year earnings of $2.11 per share grew 11%. Unfavorable foreign exchange rates reduced earnings for the fourth quarter and the year by 7% and 3% respectively. Earnings from both periods exclude the costs of moving all consumable products to direct sales in the U.S. Premium instrument placements at existing and new customers achieved new records and exceeded the company’s forecast in 2015. Global Catalyst chemistry analyzer placements rose 59% to 4,944 and premium hematology analyzer placements rose 17% to 3,744. IDEXX now has an active installed base of 20,000 Catalysts and 21,500 premium hematology analyzers in vet clinics around the world. In the fourth quarter, 59% of Catalyst placements were to new accounts in the U.S. and 40% of Catalyst placements outside the U.S. went to new accounts. Strong instrument placement growth during the year and 13% growth in revenues from the global network of reference labs contributed to diagnostic recurring revenue growth of 13% to $1.15 billion or 72% of sales.

In January, IDEXX launched SediVue, the first in-clinic urine sediment analyzer. SediVue automates the analysis of urine samples, the third component of a complete diagnostic assessment that includes chemistry and hematology. Analyzing the sediment in urine currently takes a trained technician 20 minutes to identify different solids using a microscope. SediVue contains a digital microscope that automates this process. The instrument takes 70 images of the sediment and prioritizes them in order of medical importance in three minutes. It uses a form of face recognition software to identify each solid. The vet can choose to have the instrument label the images so that she, her staff and the pet owner can understand the analysis. The instrument’s list price is $20,000 and it generates annual consumable revenue of $3,000 to $6,000 depending on the number of analyses performed. Customer interest in SediVue shows almost no correlation to the current level of IDEXX diagnostic use, which gives IDEXX’s experienced sales force the chance to offer its entire diagnostic suite to many new vet clinics. IDEXX Laboratories’ stock price is up 6% since January 1.

Mettler-Toledo International Inc.

Mettler-Toledo’s targeted marketing programs and strong new product pipeline contributed to sales and earnings growth by increasing sales of new products that command higher prices and better margins. The company has a database of over 5 million customers which includes personal information and detailed information about their industry, workplace, applications for precision instruments and products that Mettler could sell them for those applications. The company introduced Spinnaker, its sales and marketing program, more than ten years ago to develop marketing strategies to generate leads and to determine how best to deliver the targeted messages they develop. In most cases, a phone call from a telesales representative suffices. Most Spinnaker programs are developed from local best practices where a local team develops a set of tools to implement the practice and a training program to use them. These programs are then disseminated throughout the company, often through on-line webinars. Spinnaker has increased leads generated for each sales person by five to ten times, so in 2015 Mettler added 200 people in the field, or 4% of the sales-oriented people at the company, to take advantage of them. A 2016 Spinnaker initiative being developed by a small team of experts uses data analytics to identify instruments that are more than 10 years old in the company’s database of 10 million instruments and to develop targeted marketing campaigns to encourage their replacement. Marketing teams have cleansed and enriched this data, which needs to have detailed information such as the model of the instruments the customer owns. Internal telesales representatives then call the owners to discuss the features of the new instrument and the benefits of upgrading. Some of the 200 field personnel the company plans to add in 2016 will handle these leads.

Mettler-Toledo’s fourth quarter sales of $673.5 million and 2015 sales of $2.4 billion each grew 3% in local currencies. The strong Swiss franc and U.S. dollar reduced revenue growth by 6% during the quarter and 7% during the year. Excluding declining sales in Brazil, Russia and China, which account for 20% of the total, sales grew 5% during the quarter and 7% during the year. 2015 operating profit rose 5% to $532.1 million as productivity initiatives increased the operating margin of 22.2% by 1.2 percentage points. Earnings per share of $4.61 for the quarter and $12.78 for the year each rose 10% over the same period a year ago. Unfavorable foreign exchange rates reduced earnings per share growth by 5% in both periods. Mettler-Toledo’s stock price is down 2% since the beginning of the year.

Ecolab, Inc.

Ecolab’s fourth quarter sales of $3.4 billion declined 1% in constant currencies and full year sales of $13.5 billion rose 1% over the same periods a year ago. Foreign exchange translation reduced the quarter’s sales growth by 6% and sales growth for the year by 5%. Earnings per share for the quarter and the year of $1.22 and $4.37 grew 2% and 5% respectively. Foreign exchange translation also reduced the quarter’s earnings by 13¢ or 11% and the year’s earnings by 33¢ or 8%. Earnings in both periods exclude special charges which consist primarily of charges associated with the restructuring of Ecolab’s European and Energy businesses and the impact of currency devaluation and a difficult operating environment in Venezuela. In December 2015, Ecolab fully impaired the value of its assets and intercompany receivables in Venezuela. This business generates revenue of $200 million and still serves customers, with about 75% of them in the Energy business. The company realized $45 million and $60 million in incremental cost savings from lower headcounts in the Energy and European businesses respectively.

With the exception of the Energy business, Ecolab delivered good results in 2015. Revenues for Global Industrial, Global Institutional and Other businesses (Equipment Service and Pest Control) grew 4%, 3% and 8% respectively. Food & Beverage and the Water businesses had particularly strong years with revenues growing 6% and operating income rising 12% in both businesses. Food & Beverage’s Total Plant Assurance program, which combines in-plant cleaning and sanitizing with water treatment and pest elimination services, enabled Ecolab to win new business with its key global customers. The Water business’ advanced FLOCMASTER technology includes a unique make-up station that delivers a dewatering polymer in a higher concentration than existing systems to sludge in a wastewater treatment plant. Automatic metering of the polymer based on incoming sludge flow and better mixing removed 15% more water from the sludge and reduced polymer and water use. A Northern European processing plant that installed this technology reduced its annual sludge volume by 13%, solid waste disposal costs by $43,000 and fresh water use by 85%. The performance of Ecolab’s energy business, with 2015 revenues down 8% to $3.8 billion and operating income down 14% to $551 million, continues to weigh on the stock price. Ecolab expects Energy revenues to decline slightly in 2016 before returning to growth in 2017 when market conditions stabilize. Ecolab’s total return is minus 9% year-to-date.


Wabtec’s fourth quarter sales of $832.8 million and earnings of $1.05 per share were 1.5% and 10.5% higher than the comparable results during its 2014 fourth quarter. The strong dollar reduced reported sales by $27 million or 3%. These results nonetheless enabled Wabtec to meet its forecast earnings of $4.10 per share for 2015. They were achieved through rigorous application of the Wabtec Performance System, which enabled the company to reduce total employment by 5% during the quarter. That along with meticulous supply management, lifted the company’s operating margin to 18.2%, 1.5% higher than a year earlier. In reviewing the quarter and commenting on its 2016 goals, management forecast low single digit revenue growth and earnings of at least $4.30 per share even though it expects new freight car deliveries will be 25% lower than this past year. This decline, along with a 5% reduction in components for new freight locomotives and less demand for replacement of worn components due to an anticipated drop in North American railroad carloads, will make Wabtec’s 2016 freight revenues $100 million less than last year’s. Management anticipates a 4% rise in sales of components for transit cars delivered this year and that higher revenues from Positive Train Control System (PTC) will replace or surpass the freight revenue reduction. This past year, transit revenues were suppressed by delayed deliveries from Bombardier, the large Canadian transit car maker. The difficulties they experienced reportedly are resolved. PTC sales during the fourth quarter were $108 million, the highest for any quarter to date. Third quarter sales were $95 million. Management expects that PTC sales to US transit customers financed by federal funds authorized by the FAST Act (Fixing America’s Surface Transportation) passed in December will rise sequentially during each quarter of 2016.

Wabtec’s good earnings and its forecast of 5% or slightly better earnings growth helped the stock price recover from its 10% drop in January. We believe that we will have to wait for any further rise until the consummation of Wabtec’s $1.8 billion acquisition of Faiveley Transport sometime this summer. Importantly, Wabtec has already secured the assent of the Faiveley family, the owners of 51% of the company, and is in the process of seeking the approval of workers councils in Europe and the requisite government agencies. The acquisition reunites the North American and European ownership of the former Westinghouse Airbrake Company. More importantly, the addition of Faiveley’s revenues, customers, technology and manufacturing skills will bring $1.1 billion of profitable revenue to Wabtec and shift Wabtec’s revenues from a 63% dependence on the cyclical freight market to a more balanced 54% dependence on transit which is less profitable during boom years but more predictable. Faiveley’s headquarters is northwest of Paris in Gennevilliers, France. It has 21 manufacturing sites in Europe which gives it access to the European transit market, the world’s largest. Faiveley also has 14 manufacturing sites in Asia, including its profitable newly reorganized China division which has six operating companies with facilities in Shanghai, Datong, Shijiazhuang and Qingdao. This division currently provides brake systems, couplers, air compressors and doors for Chinese transit systems. In April 2015, it secured its first order for hydraulic brakes for the trams on the first two lines for Shanghai’s new Songjiang District tramway. Under Faiveley’s new chief executive officer Stephane Rimbaud-Measson, who worked with Ray Betler, Wabtec’s President and CEO, when both were at Bombardier, the company increased its operating margin to 9% on sales of $1.1 billion in 2015. His stated goal is to lift the margin to 12% by 2019. Wabtec’s stock price is up 9% since the beginning of the year.

Air Lease Corporation

Air Lease’s revenues of $326.7 million and $1.2 billion for the fourth quarter and the full year rose 14% and 16% respectively from the same period a year ago. Adjusted earnings of $1.21 and $4.64 per share rose 11% and 15% for the quarter and year respectively. During the quarter, the company took delivery of six new aircraft from Boeing and Airbus from its order book, acquired three additional aircraft and sold four aircraft. During the year its leased fleet grew to 240 aircraft with a book value of $10.8 billion, increases of 13% and 20% respectively. After deducting net debt and other liabilities, Air Lease’s book value of $27.30 per share rose 9% from the prior year. Its average fleet age is 3.6 years with an average of 7.2 years on the remaining lease term. During the year, Air Lease signed agreements with 46 customers for 120 aircraft increasing committed rental revenue by 26% to $20.9 billion. The International Air Transport Association reported global passenger traffic growth of 6.5% while airline seat capacity rose 5.6% underpinning strong demand for aircraft. Despite the strong results and positive underlying fundamentals, Air Lease’s stock price is down 8% since the beginning of the year.

Varian Medical Systems

Varian Medical Systems’ fiscal first quarter revenues of $757 million rose 7% in constant currencies over the same period a year ago. The strong U.S. dollar reduced reported sales by 4%. Earnings per share of 97¢ declined 2% from the 99¢ earned in the year ago quarter. Earnings from both quarters exclude one-time restructuring expenses. While Oncology Services’ revenues grew 9% to $533 million, gross margins declined three percentage points to 42.4% because sales of less sophisticated instruments to international markets in the Middle East and Eastern Europe jumped from 48% to 55% of sales during the quarter. Good operating expense control offset some of the impact of the sales mix on net income. First quarter orders of $533 million fell 1% with order growth of 2% in North America offset by declines in Europe and Asia of 5% and 7% respectively. The variability of order growth from quarter to quarter has taught Varian to assess the strength of its business by looking at growth for the last 12 months which has remained stable at 4.5% in North America and at 6.5% in U.S. dollars in international markets. Revenues for the Imaging Components business declined 15% to $141 million. Although sales volumes of x-ray tubes fell during the quarter because its largest customer Toshiba had excess inventory, demand for high-end, high-margin flat panel displays increased. Gross margin for this business declined 1.5 percentage points to 40.7%, an improvement over the gross margin of 38.7% from the previous quarter.

Varian continues to introduce new software and accessories that increase the safety of radiation treatments and the ability to treat more types of cancer and patients with more than one tumor. Varian sells new software products that use data analytics to improve treatment planning, image management, radiation system quality assurance, patient outcomes and clinical management. New software that makes CT scans provided by the radiation system as good as those delivered by a standalone instrument and a new method of delivering the radiation dose that significantly reduces exposure to healthy tissue were introduced to the radiation oncology community in October 2015 and should be available for sale in 2017. In September 2015, the Global Taskforce for Radiotherapy for Cancer Control reported that new cancer cases are expected to reach 24.6 million per year in 2035, up from 14.1 million cases in 2012. Increased access to radiotherapy, which is currently available to less than 5% of cancer patients in low to middle income countries, could save or extend lives for millions of people and reduce the economic burden of cancer worldwide. It was $2 trillion in 2010. The Commission also identified the need for 8,700 new radiation systems by 2035, a 66% increase over the existing 13,100 systems today. Varian’s stock price is down 4% since January 1.


Roche’s 2015 revenues of CHF 48.1 billion grew 5% in constant currencies over 2014 with revenues for the Pharmaceutical Division of CHF 37.3 billion rising 5% and revenues for the Diagnostics Division of CHF 10.8 billion rising 6%. Unfavorable foreign exchange rates reduced revenue growth in the divisions by 3% and 6% respectively. Core earnings of CHF 13.49 per share rose 7% over 2014, excluding the impact of the sale of Neupogen rights to Amgen in 2014. Core earnings exclude amortization of intangible assets, restructuring charges and other non-recurring expenses. The company continues to improve its operating efficiency and working capital management despite significant investments in new factories and acquisitions. Operating profit increased 7% to CHF 17.5 billion excluding the sale of the Neupogen rights. Cost of sales increased 7% as production in new factories for both divisions reduced capacity utilization in the existing plants and thus increased cost of goods sold. A 12% decline in general and administrative expenses offset this increase as well as a 5% increase in marketing costs associated with the successful U.S. launch of Esbriet, a drug that slows the progression of a fatal lung disease. Roche reduced accounts receivable by CHF 700 million despite an increase in sales of 5%. The company invested CHF 2.1 billion in acquisitions during the year and spent CHF 3.1 billion on new facilities to manufacture biologic drugs and diagnostic assays without increasing its net debt.

The Pharmaceuticals Division delivered strong growth in the U.S. with revenues of CHF 17.6 billion growing 6%. Revenues of Herceptin, the mainstay of Roche’s drugs to treat HER2-positive breast cancer, rose 13% during the year to CHF 2.4 billion. Globally, Herceptin sales rose 10% to CHF 6.5 billion. Sales of Perjeta, Roche’s new breast cancer drug that is used in combination with Herceptin before the cancer is surgically removed, rose 61% to CHF 1.4 billion. Total oncology drug sales rose 8% to CHF 23.7 billion and Immunology sales grew 24% to CHF 6.2 billion. On March 15, 2016, the FDA granted priority review to Roche’s cancer immunotherapy drug to treat advanced bladder cancer. The drug received a Breakthrough Therapy Designation in 2014 which expedites the development and review of medicines to treat serious life-threatening diseases. It is the first new drug to shrink tumors in metastatic bladder cancer in 30 years. Priority review shortens the review period by four months.

Professional Diagnostics, which accounts for 57% of the Diagnostics Division’s revenue, posted 2015 sales of CHF 6.2 billion, up 8% over 2014 with immunoassay revenues growing 13% to CHF 3 billion. Roche offers the broadest immunoassay menu with over 100 assays that run on the largest installed instrument base. The company expects to launch a new high-speed analyzer in the EU in 2016 that will double sample throughput without increasing the size of the instrument. In September 2015, Roche launched an oncology assay in the EU that identifies 42 mutations in the epidermal growth factor receptor (EGFR) gene in either tumor tissue or in blood plasma. This test helps identify patients with non-small cell lung cancer who might respond to drugs like Tarceva. Being able to conduct genetic testing on a blood sample allows the 25% of patients with lung cancer who cannot undergo a biopsy to be tested. The total return on Roche ADR’s is minus 7% since the start of the year. Investor fears of future competition of biosimilar drugs to its cancer drugs Rituxan, Herceptin and Avastin, along with a proposal by the Centers for Medicare and Medicaid Services to reduce the fees paid to clinics that deliver drug treatments in their facilities has kept the stock price down.


Nestlé’s 2015 revenues of CHF 88.8 billion grew 4.2% organically over 2014 revenues with the strong Swiss franc reducing reported growth by 7.4%. Volume growth contributed 2.2% to organic revenue growth while pricing contributed 2%. Good management of operating costs, working capital and capital expenditures allowed Nestlé to lift its operating margin to 15.4% from 15.3% in constant currencies while increasing its consumer marketing spending by 12%. Although Nestlé’s capital spending as a percent of sales of 4.4% did not change from 2014, the company invested in its growing businesses by building its third Nespresso factory in Switzerland, opening pet care factories in Poland and Mexico and upgrading its Product Technology Center for frozen food outside Cleveland, OH. Reducing the number of products it sells from 100,000 to 70,000 to lower inventories and working with large vendors to secure global contracts to lower payables has lowered average working capital from 8.5% of sales in 2012 to 4.7% of sales in 2015. These disciplined uses of cash contributed to Nestlé’s 2015 free cash flow of CHF 9.9 billion or 11.2% of revenues, one of the best results in the food industry.

Nestlé has made progress on its strategic priority to “embrace digital.” The company has implemented its single e-business strategy that encompasses both digital marketing and e-commerce in 20 of its most important markets. If e-commerce were one of Nestlé’s markets, it would be one of the top five. The U.S. is Nestlé’s largest market and accounts for 25% of total sales. Amazon is the primary distributor in the U.S., U.K., Germany and China for Cailler, Switzerland’s oldest brand of chocolate and Nestlé’s new global brand of premium chocolate. The company’s e-commerce programs in China are growing rapidly with 50% of pet care products, 30% of coffee and 30% of infant formulas sold on-line. Nestlé’s partnership with Alibaba helps it sell products made outside China and reach consumers in smaller cities through Alibaba’s TaoBao Rural e-commerce site. Nestlé also uses Alibaba’s data to develop targeted advertising and new products. Nestlé’s total return is minus 3% since the beginning of the year.

Red Hat

Red Hat’s third fiscal quarter revenue of $524 million grew 21% in constant currencies over the same period a year ago. Cash earnings per share of 48¢ increased 14% over the cash earnings per share of 42¢ a year ago. Cash earnings exclude share-based compensation expense, amortization of intangible assets, transaction costs related to acquisitions and non-cash interest expense from the company’s convertible debt. Cash operating income grew 13% to $123 million which yielded an operating margin of 23.5%. Red Hat generates large amounts of cash because it receives the full payment for its subscriptions when they are billed. It then recognizes revenue over the subscription’s life; therefore, growth in deferred revenue provides an accurate picture of the company’s success in getting new business. As in all subscription-based businesses, Red Hat expenses sales commissions when they occur which depresses reported income. Deferred revenue increased $147 million or 14% to $1.49 billion over the same period a year ago.

Revenue from subscriptions which offer technical support for Red Hat’s version of the Linux operating system (Red Hat Enterprise Linux or RHEL) and other software was $458 million for the quarter, up 22% over the same period a year ago. Subscription revenue accounted for 87% of the quarter’s revenues, while training and services revenue of $66 million grew 16%. Infrastructure subscriptions, which consist mostly of subscriptions to RHEL, grew 18% to $373 million with subscriptions purchased on-demand in the public cloud growing 65% to $25 million. Revenues from Red Hat’s newer software and cloud offerings in its application development and emerging technologies business grew 45% to $84 million during the quarter. The company renewed its top 25 deals at 120% of the prior value. Cross-selling was strong as more than 70% of the company’s 30 deals over $1 million included several of its new software offerings.

The most important event of the quarter was the announcement of Red Hat’s and Microsoft’s partnership to support their vision of the hybrid cloud where applications can run on servers in the datacenter, in a private cloud in a datacenter or on the public cloud which is run by a third-party. All public clouds use Linux as their operating system, but only Red Hat certifies that applications that run on RHEL can be transferred seamlessly across all computing environments. As part of the partnership agreement, RHEL becomes the preferred choice for running enterprise Linux applications on Azure, Microsoft’s public cloud. Customers with a Red Hat subscription can move it to Azure at no cost, and since February 15, 2016, Azure users can select RHEL as their operating system on a pay-as-you-go basis. Microsoft and Red Hat engineers based on Microsoft’s campus provide integrated end-to-end support for all Red Hat products that run on Azure. The integrated support is the most unique aspect of the partnership. Investor hopes and fears about the success of the hybrid cloud lifted Red Hat’s stock price 15% in the fourth quarter of 2015 and then pushed it down 13% since January 1. Red Hat’s stock price currently is where we purchased it in late September.


SGS’ revenues of CHF 3.0 billion and CHF 5,7 billion in the second half and full year of 2015 respectively each rose 4% from the prior year on a constant currency basis. Adjusted net income rose 5% in both the second half and the full year. These figures are adjusted to exclude restructuring expenses of CHF 64 million taken in the first half of 2015 to reduce costs primarily in its Minerals business and for a CHF 32 million settlement received during the second half 2014. During 2015, 55% of revenue growth was organic and 45% was contributed by acquisitions. The company invested a total of CHF 103 million in 10 acquisitions during the year. The acquired businesses added CHF 45 million in revenues and CHF 9 million operating profit during the year. The fall in commodity prices lowered revenues 3% over the prior year in Oil, Gas and Chemicals, Minerals and Industrial Services. Solid organic revenue growth of 12%, 8% and 7% came from Governments and Institutional Services, Automotive Services which expanded its vehicle inspections business and Systems and Services Certification which saw strong adoption of new 2015 quality standards and strong demand from food customers. The large and highly profitable Consumer Testing business generated 5% organic growth. SGS’ total return is 8% since the start of the year.

Core Laboratories

Core Laboratories’ fourth quarter revenues and earnings of $182.7 million and 65¢ per share were down 27% and 58% respectively from the comparable results for the year ago quarter. The size of these declines are well within the estimated range Core’s management gave for the impact of the extensive oil and gas drilling contraction in North America and throughout the world. At year-end, the U.S. active rig count of 714 was 62% below the number of rigs working a year earlier. By the end of last week, that number had fallen to 480. The North American rig count is an important indicator of Core’s prospects because U.S. shale oil producers are the source of the world’s incremental oil production, which along with a looming possibility of a flood of Saudi and Iranian oil, had driven the oil price down below $30 a barrel earlier this year. Core’s Production Enhancement Division is a leader in developing productivity enhancing technology-based tools for oil and gas producers. It has devised oil and water soluble chemicals that are inserted into fissures made in the shale by perforating guns, during the completion of shale oil wells. These chemicals then precisely identify which fissures in the shale are producing oil and those that are not when the produced oil is analyzed after the initial fracking. Use of this tool makes the completion process provide actionable information along with the oil which makes pressure pumping more efficient, saves energy and crew expenses, measures frack fluid cleanup, lessens water usage and reduces the possibility of formation damage. The steep decline in North American drilling has shrunk the profit of Core’s Production Enhancement division which only two years ago was its most profitable. Its 2015 fourth quarter earnings were a meager $7.3 million, just over 15% of the $45.6 million earned in the fourth quarter of 2014. The use of its tools for development of new production even at new depths in existing fields makes Production Enhancement business dependent on the drilling cycle unlike Core’s largest division Reservoir Description which provides tools for the scientific management of the changing fluids in producing reservoirs onshore and offshore. Analyses of reservoir fluids from producing fields now constitutes over 50% of Core’s revenues. During the fourth quarter, Reservoir Description provided 72% of Core’s operating profit. Core’s total return is 2% since the beginning of the year.

Donaldson Inc.

We sold the remainder of your Donaldson shares because we expect that weakness in its customers’ end-markets will continue for the foreseeable future, increasing the likelihood that its stock price may drop as investors sell. During its quarter ended January 31, each of its seven distinct end-markets experienced declining sales. All three of its global geographies also reported sales declines. In past cycles weakness in a few markets could be offset by strength in others. This diversification is not helping now. The company’s agricultural, mining, construction, industrial, gas turbine, disk drive and semi-conductor customers are all declining together. Even its replacement filter business is down as equipment utilization weakens and distributors reduce inventories.

CDK Global

We sold the remainder of your CDK shares at a substantial gain from the market value of the shares after their spin-off from ADP in October 2014. After announcing a wide-ranging “transformation plan” at its Investor Day last June, CDK’s long-time leader Steve Anenen abruptly announced in December that he would be leaving the company. Steve’s successor Brian MacDonald was appointed to CDK’s Board of Directors one day before last year’s Investor Day. We think that implementation of the transformation plan adds to the risk of loss from holding the stock. The plan calls for adding significant debt to the balance sheet to fund share repurchases. In addition, the company’s plan to drastically boost its already attractive margins by raising prices, reducing sales and service costs and cutting research and development expenses is unlikely to be welcomed by automotive dealers who are its customers.

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Justin Berrie who joined our investment team last year, now contributes to the earnings letter. Barbara Tarmy left Capital Counsel on March 4, 2016.

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.