2nd Quarter, 2018

In thinking about the introduction to our comments on your companies’ second quarter earnings which all of us read and re-read, our focus kept returning to the persistent ability of the managements of the companies we own to increase the profitability of their businesses. During the past quarter, three of our companies increased their earnings by 39% or more. The disciplined cost control sustained by management while they invest for growth is a skill that we have cited in the past. It becomes more crucial as it becomes a pervasive part of doing the work required to make the product or service better for customers. It helped your companies report average revenue growth of 13% and earnings growth of over 26%! The double-digit earnings growth attained by all your companies resulted from realization of higher margins.

IDEXX Laboratories

IDEXX Laboratories’ second quarter revenue of $581 million rose 12% in constant currencies over the same period a year ago. Favorable foreign exchange rate translation added two percentage points to revenue growth in U.S. dollars. Higher productivity from IDEXX’s field sales representatives aided by the company’s investment in sales force automation contributed to operating expense growth of only 7.5%, which lifted operating profit 17% to $146 million and operating margin 1.1 percentage points to 25.1%. Earnings per share rose 33% to $1.23 over the second quarter of 2017.

IDEXX currently has 40% share of the $4.2 billion global market for pet diagnostics and software. It is the global leader in both in-clinic and reference lab testing and is the only company to offer both worldwide. The strategic decision to have one sales force sell diagnostic services to vets has paid off handsomely. Rather than placing an in-clinic diagnostic instrument with vets in exchange for a multi-year commitment to testing volumes to pay for the instrument, the company launched IDEXX 360 in North America to increase the use of its proprietary diagnostic tests. This program allows vets to acquire in-clinic instruments, digital X-ray equipment or software with a five or six-year commitment to increase overall test volumes whether it be in-clinic assays or increased reference lab volume. Management expects about 60% of all deals in 2018 to take advantage of this program. In the second quarter it contributed to the placement of 346 or 77% of the Catalyst chemistry analyzers in competitive accounts in North America and 32% year-over-year growth or 650 placements of SediVue, IDEXX’s proprietary digital urinalysis instrument. These instrument placements deliver the most profitable long-term recurring revenue streams for the company. IDEXX Laboratories’ stock price has risen 55% since the beginning of the year.


The second quarter earnings announcement of Wabtec and GE Transportation delivered good news to Wabtec shareholders who will become owners of 49% of GE Transportation through a $10-billion tax advantaged transaction that should close during the first part of next year. Wabtec’s second quarter operating profit of $123.5 million on sales of $1.1 billion lifted it 9% above last year’s quarterly operating profit after deducting a $9 million payment related to the GE acquisition costs and a $4 million payment for an Indian tax law change. Wabtec’s Faiveley Transit division has a profitable manufacturing plant in India. GE Transportation’s quarterly operating profit of $155 million on sales of $942 million was 20% higher than its first quarter profit and an indicator of the increased demand for freight shipments by rail in North America. Wabtec’s sales of brakes and other freight car components to U.S.-Canadian railroads and rail car builders were 19.5% higher during this year’s second quarter than a year ago. That lifted net income 34% above last year results. The second quarter report contained only one minor disappointment, a report of a 2% decline in the operating income of Wabtec’s transit business caused by penalties resulting from delays in completing to rigid specifications the overhaul of transit cars for U.K. transit authorities. It is nearly fully completed and the payment and penalty remaining is small. Wabtec’s stock price has risen 29% since the beginning of the year.

On Friday September 14, the JP Morgan analysts covering Electrical Equipment & Multi-Industry companies released a nine-page critique of the information Wabtec filed in connection with its issuance of $2.5 billion of notes to finance its acquisition of GE Transportation. The analysts were credible because they correctly criticized GE’s earlier debt issuance to finance the acquisition of Baker Hughes. We have subsequently reviewed their assertions with Wabtec’s management and understand that the JP Morgan analysts misconstrued the cash flow projections provided by GE and Wabtec. They arose from timing differences caused by GE using straight -line costs while Wabtec used actual or estimated costs derived from experience. The assertions that the forecast numbers were vastly reduced are incorrect. The numbers vary but that variance results from timing not profit differences. Neither the estimated earnings nor cash flow from the acquisition was reduced. The JP Morgan report initially knocked Wabtec’s stock down almost 14%. It has since recouped half the decline.


Costco will report results from its fiscal 2018 fourth quarter, a sixteen-week period ending September 2, and full fiscal year on October 4, 2018. On September 6, 2018, the company reported store sales of $43.4 billion for the fourth quarter and full-year sales of $138.4 billion, increases of 5.0% and 9.7%, respectively. At stores open more than one year, sales rose 6.8% during the year, excluding changes in gas prices and foreign exchange rates. Same-store sales in the U.S. grew 7.4%. Management’s focus on improving website navigability and targeted email marketing contributed to a 31.3% rise in e-commerce sales during the year. Costco currently operates 762 warehouses in 11 countries, 87% of which are in North America. The total return on Costco’s stock is 26% since January 1.


After generating record futures and options contract volume in the first quarter of the year, CME reported its second highest average daily volume of 18.4 million contracts in the second quarter, an increase of 12% above the prior year. Growth from Asia was the strongest, up 30%, followed by Europe and the U.S. Double-digit volume growth came from five of its six asset classes led by metals, foreign exchange and agricultural contracts which rose 26%, 18% and 16% respectively. Total revenue of $1.06 billion rose 15% propelled by a 14% increase in clearing and transaction fees on strong volume gains and a 2% improvement in the rate per contract to 76¢. Market data revenue of $113.8 million rose 18% after a price increase was implemented on April 1.

Continued expense discipline resulted in operating expenses of $313 million, a 6% increase from a year ago, boosting operating income by 18% to $707 million. The reduction in CME’s overall tax rate to 25% from 35%, higher investment income from the interest it earns on customer margin balances deposited at the Fed and a double-digit increase in earnings from its 27% ownership of S&P Dow Jones indices, resulted in an adjusted earnings increase of 41% to $1.74 per share. CME’s total return since the beginning of the year is 19%.


Visa’s third fiscal quarter net revenue grew 15% over the same period a year ago to $5.2 billion. Earnings per share, excluding a $600 million litigation provision, increased 39% to $1.20 as the company’s effective tax rate declined more than eleven percentage points to 18.2%. Exchange rate shifts added 3% to earnings per share growth. Payments volume in constant dollars grew 11% with particularly strong growth in the CEMEA (Central Europe, Middle East and Africa) and LAC (Central and South America and the Caribbean) regions which grew 19.2% and 16.3%, respectively. Growing global economies, rising gas prices and credit card purchases by small businesses helped drive payments volume. Processed transactions of 31.7 billion increased 12% for the third consecutive quarter. Expenses grew nearly in line with revenues at 14%. Personnel costs of $852 million grew 22% reflecting Visa’s investment in talent, higher employee incentives from better than expected performance, and the increase in 401(k) matching contributions for U.S. employees. The total return on Visa’s stock is 29% since January 1.

Visa’s efforts to increase adoption of contactless payments has encouraged consumers to use them instead of cash for smaller transactions such as buying transit tickets. Consumers make contactless payments when they present cards with radio frequency identification technology or mobile phones with near-field communication technology to enabled payment terminals. While still in the early stages of adoption in the U.S., use of contactless payments is increasing rapidly internationally. Globally, the share of contactless in-person payments has risen from 12% to 20% in the past year. More than one-third of domestic in-person transactions are contactless in over 30 countries. These countries account for 70% of Visa’s non-U.S. face-to-face transactions. In London, the proportion of Tube rides purchased with contactless cards has doubled since 2016 from 25% to 50%. More than 2.5 million contactless transit journeys occur there daily, 80% of which are purchased with Visa cards. In India, where Visa processes over 50% of the electronic payments, Visa’s work with the government and card issuers to increase awareness and use of contactless payments helped convince Mumbai’s Integrated Ticketing System to begin accepting contactless payments this year. More than 11 million commuters use this system daily to purchase tickets for buses, trains, taxis and motorized rickshaws.


ADP’s fiscal fourth quarter and full year revenues of $3.3 billion and $13.3 billion each rose 8% from the comparable period a year ago. Adjusted earnings of 92¢ and $4.35 per share rose 39% and 18% respectively, excluding charges for the Company’s Early Retirement Program and transformation initiatives. The total return on ADP shares since the beginning of the year is 27%. During the year, ADP’s new business bookings rose 8% to $1.8 billion, which will provide solid revenue growth in the coming fiscal year. Reflecting a continued acceleration in hiring, the number of employees on each existing customer’s payroll increased 3.1% in the quarter and 2.7% for the fiscal year. The average number of employees paid by ADP’s PEO Services rose 8% in the quarter to 523,000 and 9% for the fiscal year to 504,000. Interest earned on funds held for clients of $126 million and $466 million rose 20% and 17% for the quarter and fiscal year respectively as the average balance and average interest yield both increased.

On August 1, ADP announced the acquisition of Celergo to strengthen its leadership position in international payroll management services. Founded in 2004, Celergo’s proprietary cloud-based platform provides payroll, cross-currency and expatriate payment services throughout 150 countries. ADP is uniquely positioned as the only global company that can help businesses manage their full “hire-to-retire” needs for their employees and freelance workers worldwide.

Red Hat

Red Hat delivered good revenue and earnings growth during its first fiscal quarter of 2019 which ended on May 31, 2018. Revenue of $814 million rose 17% in constant currencies over the same period a year ago with favorable foreign currency translation lifting revenue growth reported in U.S. dollars to 20%. GAAP earnings per share was 59¢, up from 41¢ a year ago and non-GAAP earnings per share rose 24% to 72¢. Non-GAAP earnings exclude share-based compensation expense, amortization of purchased intangible assets, acquisition-related transaction costs and non-cash interest expense from its convertible debt.

Revenue from subscriptions of $711.5 million grew 16% over the first quarter of 2018 with revenue for Red Hat Enterprise Linux, which is used on servers in data centers and in public clouds, growing 11% to $522 million. Subscription revenue for Application development and emerging technologies rose 32% to $189 million, a decline from 40% revenue growth reported in the first three quarters of 2018. Quarterly revenue for the $400 million middleware business grew at the industry average of 9% instead of at 20% to 25% in previous years. Most of the early growth came from companies deciding to reduce operating costs by replacing their existing middleware from IBM or Oracle with JBOSS open source software supported by Red Hat. In the past few quarters, however, customers have delayed replacing their middleware while they evaluate technology options to modernize their application development process. Red Hat expects many of its larger customers to make these decisions in their next calendar year budget cycle. While the company expects to win the business along with new subscriptions for its OpenShift application development platform, it will take a few quarters for the impact of these decisions to lead to higher growth for Red Hat’s middleware portfolio.

OpenShift subscriptions remain strong with 100 new customers installing the platform in the first quarter, lifting total customers to 800. Red Hat has found that companies first use OpenShift to develop new applications in the cloud, but once they see how easy it is to move applications from the cloud to their data centers, they modify their large legacy applications so they can run on OpenShift as well. Revenue from customers that have moved their legacy applications to OpenShift is about four times higher than the revenue from their initial purchase. Investor disappointment with the temporary slow-down in middleware revenue growth sent the company’s stock price down 14% on June 22, 2018, the day after they announced their first quarter results. Red Hat’s stock price is up 20% since the beginning of the year.


Alphabet’s second quarter revenue of $32.7 billion grew 26%, or 23% in constant currency, its ninth consecutive quarter of greater than 20% year-over-year growth. Excluding a €4.3 billion European Commission (EC) fine pertaining to Android and the positive effect of an accounting rule change on equity security investments, Alphabet’s earnings per share rose 19% to $10.58. In the Android case, the EC faulted Google for preventing smartphone manufacturers from pre-installing certain Google apps, such as the Play Store and Google Search, unless they use Google’s supported version of the Android operating system. Android’s source code is open and can be downloaded and modified freely by any third-party device manufacturer, however Google only supports versions that it develops to ensure technical compatibility. The EC also faulted Google’s bundling of its Search, Chrome browser and Play Store apps with its supported version of Android, as well as the financial incentives Google paid to large device manufactures for the exclusive pre-installation of Google Search between 2011 and 2014. Google will appeal the decision.

Google’s advertising business continues to grow robustly with revenue of $28.1 billion in the quarter, 24% more than a year ago, led by mobile search and YouTube. The number of ad views generating revenue for Google on its own sites increased 58% from a year ago and 15% from a quarter ago. Google’s new machine learning tools help its advertising clients reach more consumers with more effective targeted ads. Marketers who use Google’s Responsive Search Ads for desktop and mobile phones to place text ads in Google searches provide 15 text headlines and four descriptions for each ad. Text ads display above and below Google search results and have three parts: headline, web address and description. The Responsive Search Ad program uses machine learning to assemble the text into combinations that avoid redundancy and over time learn which combinations are most relevant for different queries. This ad optimization program has helped advertisers garner as many as 15% more views. Alphabet’s stock price has risen 10% since January 1.


Ecolab’s second quarter revenue of $3.69 billion grew 5% in constant currencies and before the impact of acquisitions and divestitures over the same period a year ago. Reported revenue growth in U.S. dollars was 7%. The company’s three large businesses, Global Industrial with revenue of $1.35 billion, Global Institutional with revenue of $1.31 billion and Global Energy with revenue of $854 million grew 5%, 3% and 6%, respectively, and accounted for 95% of the company’s quarterly revenue. The quarter’s earnings per share of $1.27 was 13% higher than earnings per share of $1.12 from a year ago. Earnings per share in both periods exclude special items and one-time tax effects.

Management expects revenue and earnings growth to accelerate because of a 22% increase in large business wins in key corporate accounts during the first half of the year that will begin to contribute to sales in the second half of the year. On July 31, 2018, Ecolab announced a program to reduce annual SG&A costs by $200 million by 2021. The company is starting to see the benefits of the successful installation of their SAP enterprise resource planning system in the U.S. where it has about one-third of its production capacity. With better visibility of their supply chain, management learned that 12% of the trucks they thought were full were not actually full. With freight transportation costs increasing steadily, this information will help Ecolab determine where to sell directly to customers and where to partner with distributors. Automating customer ordering through an online portal will reduce the number of invoices (currently 9%) which are held back because of incorrect prices. Automating the ordering process also gives Ecolab’s 26,500 field service representatives more time to work with customers to optimize their existing operations and to sell new services. Improving their efficiency will deliver the most profitable growth for the company. The total return on Ecolab’s stock is 17% since January 1.


Mettler-Toledo’s sales of $722 million grew 7% in local currencies over the second quarter of 2017. Favorable foreign currency translation added three percentage points to revenue growth in U.S. dollars. Operating earnings rose 15% to $169 million as revenue growth outpaced a 3% increase in SG&A spending. On-going cost savings initiatives offset some of the additional investment in field sales and support staff who have contributed to the company’s sales growth. Earnings per share of $4.65 grew 19% over earnings per share of $3.92 reported a year ago and exclude restructuring costs which are larger this year because of the consolidation of Mettler’s U.S. Product Inspection business in its new facility in Tampa, FL and amortization of intangible assets associated with its recent acquisitions.

Sales in China were particularly strong this quarter, rising 15% over the same period a year ago when revenue grew 20%. Laboratory and Industrial revenue for the quarter grew 20% and 10%, respectively. Laboratory sales account for 45% of total sales in China compared to 50% for the company. Large numbers of scientists graduate from university every year and each one becomes a potential customer for Mettler’s balances, pipettes and pH meters which are generally used by individual scientists. Most scientists in China currently share instruments because their salaries are low. As salaries rise, they will benefit from the productivity improvements that result from having their own lab instruments.

Mettler-Toledo has done business in China since 1986. Its Chinese business accounted for 17% of 2017 sales, about $460 million, and is one of its most profitable. Mettler shifted its customer base over the past 10 years from 80% multinational companies and government/state-owned enterprises to 60% local Chinese companies, 15% multinationals and 25% government. These local industrial companies are building research and development labs to improve the quality of their products as part of the recent five-year plan. Mettler thus facilitates the execution of the five-year plan and is not an industry of interest to the government. The company has never felt pressure to have joint ventures or to turn over intellectual property. All subsidiaries are wholly-owned and all sales are direct. Mettler also continues to reduce its manufacturing costs by increasing the number of products it makes in China. The company’s gross margin will be affected by the tariffs on imports of Chinese products, but Mettler expects to increase prices and to adjust its supply chain to offset them. Mettler-Toledo’s stock price is down 1% since January 1.

Johnson & Johnson

Johnson & Johnson’s second quarter sales of $20.8 billion rose 8.7% in constant currencies over the second quarter of 2017. Favorable foreign exchange translation added 1.9 percentage points to revenue growth. Organic sales rose 6.3% over the same period a year ago, excluding the impact of acquisitions and divestitures of 2.4 percentage points. Earnings per share of $2.10 grew 11.5%. Earnings exclude amortization of intangible assets and other one-time charges in both periods.

Pharmaceutical sales, excluding sales from Actelion’s two marketed drugs, rose 11% to $10.4 billion. Sales of these drugs lifted revenue growth to 17.6% for the quarter. Sales of J&J’s immunology drugs rose 11.5% to $3.3 billion despite a 14% decline in Remicade sales because of biosimilar competition. Sales of Stelara, a large molecule drug used to treat psoriasis, psoriatic arthritis and Crohn’s disease, rose 34% to $1.3 billion, displacing Remicade as the company’s largest drug. Stelara’s efficacy and its ability to eliminate all symptoms of disease after the first dose has contributed to its strong uptake by Crohn’s patients. Later this year, J&J plans to file the results of a successful Phase 3 study for Stelara in ulcerative colitis with the FDA. It is also an inflammatory bowel disease with large unmet medical needs.

Strong sales growth in OTC drugs, J&J’s largest Consumer franchise, and Oral Care, because of increased promotion of Listerine’s existing and new products, contributed to Consumer’s second quarter organic revenue growth of 0.9% to $3.5 billion. Excluding the decline in sales of Baby Care products in the U.S. as retailers restocked their shelves in advance of the July 1 launch of the new product line and the impact of the transportation strike in Brazil, Consumer’s revenue grew 2% over the same period a year ago. Medical Devices’ revenue of $7.0 billion rose 2.9% excluding the 0.8 percentage point contribution of acquisitions and divestitures to revenue growth. The Interventional Solutions business, which sells devices to treat strokes and atrial fibrillation, posted revenue of $667 million, a 17% increase. Vision Care also delivered excellent second quarter results with revenue growing 9.6% to $1.2 billion. Surgery revenue rose 3.5% to $2.5 billion, while continued share loss in the Spine and Knee businesses reduced Orthopedics revenue of $2.2 billion by 3.0% from the same per a year ago. The total return on Johnson & Johnson stock is 2% since the beginning of the year.

Varian Medical Systems

Varian Medical Systems delivered strong fiscal third quarter results with revenue of $709 million, up 12% from the fiscal third quarter of 2017. Oncology Systems’ sales rose 18% to $667 million, while revenue from Varian’s small Particle Systems business declined $28 million to $42 million. This business builds and sells radiation therapy systems which use heavier protons instead of X-rays to treat tumors, especially those in children, or tumors near the eye or spinal cord. Earnings per share grew 27% to $1.04 from 82¢ a year ago. Oncology System’s investment in its sales force in Europe, the Middle East, Africa and India (EMEA) contributed to third quarter sales growth in the region of 35% (28% in constant currencies) to $230 million from $169 million a year ago. Orders rose 27% with significant wins in Spain, Poland, Kenya and Nigeria along with an order for 20 TrueBeams from the U.K.’s National Health Service. Large orders from Western Europe have contributed to strong revenue growth this year because the rooms for the radiation systems are usually built and funds are available to pay for them when the orders are placed. Varian’s stock price has declined 1% since the beginning of the year.

Air Lease

Lease revenues of $393.5 million during the quarter rose 10% from a year ago as Air Lease took delivery of 14 new aircraft, bringing the total number of owned aircraft to 271 and the number of managed aircraft to 49, leaving 336 aircraft in their order book with Boeing and Airbus for delivery in the next four and a half years. The average age of its leased aircraft is 3.8 years with a remaining lease term of 6.8 years. Aircraft sales and management fees generated $4.3 million in revenues during the quarter as the company chose not to sell any aircraft versus $22.8 million a year ago when it sold 17 aircraft and booked a $18 million gain. Adjusted earnings of $1.01 per share rose 26%.

Global demand for aircraft remains strong. While the expected useful life of an aircraft is 25 years, Air Lease sells aircraft starting at 8 years of age which improves their marketability because there are several more years remaining on the initial lease term. This strategy keeps its fleet young and minimizes the residual value risk of the aircraft. To date, Air Lease has sold its aircraft at prices averaging 10% above their book value. On August 6, Air Lease announced the sale of 18 aircraft with an average age of 8 years to Thunderbolt II Aircraft Lease Limited, a new structure financed by aircraft asset backed securities based on cash flows from leases. Management provided an in-depth review of the new structure at a September 6 investor meeting. Thunderbolt II provides a predictable funding source to facilitate the sale of mid-life aircraft while enabling Air Lease to maintain the profitable management fees from the aircraft lease and its relationship with the airline customer. Air Lease retains a 5% equity participation and will receive incentive fees based upon successful re-leasing and sale of aircraft. Air Lease total return is minus 5% since the beginning of the year.


During the first six months of 2018, SGS’ revenue of 3.3 billion Swiss Francs rose 6.5% in constant currency with acquisitions accounting for 0.9% of revenue growth during the period. By geography, revenue growth was strongest in Asia/Pacific, followed by the Americas and Europe/Africa/Middle East which rose 8.0%, 5.9% and 3.9% respectively. A 4.5% increase in the company’s average total headcount and improvements in lab network utilization reflect the successful implementation of SGS’ transformation and efficiency initiatives. This improved operational efficiency contributed to a rise in adjusted operating margin to 14.6% from 14.2% a year ago. Adjusted earnings of CHF 0.45 per ADR rose 12.2%. All nine business segments reported positive organic revenue growth over the first half of 2017 with Minerals generating the strongest growth rate of 13.8%. Trade inspection volumes have increased due to strong global demand for coal, oil and gas. The rebound in minerals exploration and production has lifted geochemistry lab testing volumes at existing labs and SGS has won new lab testing business in Australia, Brazil, Canada and South Africa. Minerals’ adjusted operating income jumped 26% and achieved a 150 basis-point improvement in operating margin to 15.2%. The total return on SGS ADRs since January 1 is 3%.

Core Laboratories

With the oil price near $70 a barrel and U.S. oil production in July averaging 10.8 million barrels a day, it would seem reasonable to expect that Core Laboratories’ stock price would be up since the beginning of the year. It is not, although its reported second quarter earnings of 57¢ per share were 21% above last year’s quarterly results and met Core’s revised forecast issued in June. Revenues for Reservoir Description, Core’s largest and heretofore most profitable business, rose only 1.3% as it continues to await deliveries of cores for analysis from large oil company clients who have discovered oil-bearing offshore structures containing vast quantities of oil. An example is Exxon’s immense discovery offshore Guyana where it has successfully drilled its eighth exploratory well. It is one among the many clients who have relied on Core’s increasingly precise analyses to understand the fluid and rock structures discovered. Once engaged, Core’s engineers devise a plan to manage the reservoir fluid which is amended as the chemical composition of the fluids change as oil and gas is extracted. The long-term prospects for Core are good and the company is a leading innovator in its business which has earned it the respect and loyalty of its customers. They have endured punishing profit declines during the oil price collapse and are cautious and, as we can see, inclined to defer commitments until there can be no further postponements. We consider Core a source of funds for new investment in companies we may wish to add to your portfolio because the gain is small and the timing of the revival of its largest and previously most profitable business remains unknown. Core Lab’s stock price has declined 2% since the beginning of the year.

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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.