EARNINGS LETTER

3rd Quarter, 2018

Investors in our stock market in recent years have for the most part enjoyed reading the reports of the companies they have invested in or the commentaries of advisors they have engaged. That was due in no small part to rising stock prices which continued to go higher with some intermittent declines until this past October when many stopped in unison. That change in the market’s behavior coincided with utterances of economists and market strategists, many of whom pointed out that the possibility of the Federal Reserve ratcheting rates higher which would push down the prices of bonds, real estate, farms, oil and gas production, and stocks. Higher interest rates also could curtail the expansion plans of small businesses and reduce borrowing to finance shale oil production which has created thousands of jobs. Our reading of our current Fed Chairman Jerome Powell’s public statements leads us to believe that he is a learned economist and practical man who is aware of his power and the need to prudently assess risks as the leader of the Fed. He has stated that the Federal Reserve Board under his leadership will carefully consider the economic conditions in our economy before voting on any change in rates and expressed a preference for waiting for the next meeting if there is doubt about the advisability of any rate change. We think the economy and the financial markets will benefit from his cautious and collegial leadership. He is a good choice for a job that is increasingly important for us all.

During the past quarter, the companies we have investments in have increased their sales by 10% and their earnings by almost 22%. The comparable figures for the S&P companies are sales growth of 9.3% and earnings up 26.1%.

Red Hat

On October 28, 2018, IBM announced the acquisition of Red Hat for $190 per share or $34.5 billion in cash, a record price for a software company. Red Hat will remain an independent business within IBM. CEO Jim Whitehurst will report directly to IBM CEO Ginni Rometty and Red Hat will retain all its employees and its headquarters in Raleigh, NC. The commercial success of the combined businesses depends on Red Hat’s continuing to work with open source communities to develop new software products for the hybrid cloud and certifying that Red Hat Linux (RHEL) and its cloud-native platforms run all software, and work on all hardware and public clouds.

The combination of Red Hat and IBM cements their leadership in hybrid cloud, an emerging $1 trillion market according to IBM. Enterprises still need to move 80% of their workloads to the cloud.  These workloads, which comprise data and key business processes, are more complex and are much harder to move from servers in a data center. IBM’s average client has 1,000 applications and uses five to 16 different clouds. IBM’s scale and deep customer relationships should enable Red Hat to accelerate the movement of applications to OpenShift, its cloud-based platform-as-a-service and speed the adoption of its cloud management and automation tools.

Red Hat reported fiscal second quarter results on September 19, 2018 with revenue of $823 million up 14% over the same period a year ago. Earnings per share of 85¢ rose 16% over 77¢ achieved in the same period last year. Revenue from subscriptions of RHEL rose 8% to $527 million, which was down from the 14% to 15% year-over-year growth delivered over the past few years. Slower revenue growth resulted from fewer large renewals because Red Hat had decided 2 ½ years ago to encourage customers to renew their subscriptions for three years instead of for one year.  The company also failed to renew one of its top 25 deals because of poor performance by the sales team responsible for the business. The sales team no longer works for Red Hat. Selling capacity was also constrained because the sales force and customers focused on the new cloud-based offerings. Strong revenue growth for these subscriptions offset most of the slower growth in the company’s middleware business, leading to revenue growth for Application development and emerging technologies of 31% to $196 million for the quarter. While the fundamentals of the business remained strong, many investors sold the stock because management stated that it would take several quarters for revenue growth to return to prior levels. The company’s stock price fell 34% from its high in June to $117 per share during October. Red Hat’s stock price is now up 47% since the beginning of the year. You will realize a large gain when the acquisition closes in the second half of 2019. If you plan to make charitable gifts before then, you may want to consider using shares of Red Hat.

CME

During the third quarter CME’s revenue of $904.2 million rose 2% above a year ago and average daily volume of 15.6 million contracts declined 1% as trading volumes generally slowed on exchanges around the world after a very strong first half of the year. CME’s adjusted earnings of $1.45 per share rose 22% from the prior year benefitting from solid expense management and a lower tax rate. Open interest of 120 million contracts at the end of the quarter rose 6% from a year ago indicating continuing strong demand for CME’s futures and options contracts.  CME continues to invest to expand and deepen the risk management tools it provides its customers. In September, CME launched its new interactive CME Liquidity Tool to help customers analyze liquidity measures including current and historical bid-ask spreads, book depth and cost to trade statistics across CME’s product line. It provides trading data and analysis for specific customer transactions and generates interactive charts and graphics to speed customer decision making.  Some customers are using the tool to analyze trading opportunities during the Chicago, London and Singapore trading hours. The Bid-Ask Spread function within the liquidity tool graphically displays the difference between the price the buyer is willing to pay and the price a seller is willing to accept. Cost to Trade can tell users how much it will cost to buy or sell a certain lot size and Book Depth indicates the number of buy and sell orders at each price level.

CME built on its exclusive 20-year partnership with NASDAQ by extending its futures and options on futures license another ten years through 2029, solidifying CME’s position as the largest equity index futures trading platform in the world. These contracts generated average daily volume of 437,000 contracts per day this year through October 1, an increase of 52% over the prior year. Market volatility and trading volumes have picked up in October and November with volume reaching 20.6 million and 21.7 million contracts a day respectively, up 38% and 21% from the same period a year ago.  On December 5, CME declared its annual variable dividend in the amount of $1.75 per share, payable on January 16.  This is in addition to its regular $0.70 quarterly dividend or $2.80 annually for a total of $4.55 per share during the year.  The total return on CME’s shares is 33% since the beginning of the year.

ADP

 ADP’s revenue of $3.3 billion and adjusted earnings of $1.20 per share during its fiscal first quarter rose 8% and 28% respectively from the prior year. Seven percentage points of the growth in revenues was organic and one percentage point came from last year’s acquisition of Global Cash Card. ADP’s earnings before interest and taxes increased 18% and the operating margin rose 180 basis points to 20.7% with operating leverage coming from revenue growth, operational efficiencies and transformation initiatives. ADP’s strengthened competitive position comes after several years of investment to upgrade its product platforms while streamlining service.  These improvements have resulted in better customer satisfaction, improved client retention and strong new business sales that were booked with better pricing.

ADP’s growth was broad-based across geographies and client size. Sales of multi-national solutions were particularly strong and rose 15% during the quarter. New business bookings increased 8%, growth in existing client payrolls was 2.4% and the number of employees paid by PEO Services was up 9% to 528,000. On the conference call following the release of earnings, Carlos Rodriguez, ADP’s CEO, was asked if they are seeing any cracks in the U.S. economy and his one-word answer was “zero”. ADP continues to benefit from higher interest rates received on its growing balance of funds held for clients.  During the quarter, interest earned on these funds rose 19% to $119 million as the average balance increased 5% to $22.2 billion and the average interest rate received rose 30 basis points to 2.1%.  The total return on ADP shares since the beginning of the year is 22%.

Visa

 Visa delivered a strong fourth fiscal quarter and fiscal year 2018 with earnings per share of $1.21 and $4.61 rising 34% and 32%, respectively. U.S. corporate tax reform added ten percentage points to earnings per share growth in both periods. Revenue rose 12% in the fiscal quarter and year to $5.4 billion and $20.6 billion, respectively. Fiscal fourth quarter payments volume of $2.1 trillion increased 11% in constant currencies with growth of 12% in the U.S. where Visa generates 45% of its payments volume. The sharp weakening in some emerging market currencies, particularly the Argentinian peso, the Turkish lira and the Brazilian real, combined with U.S. dollar strength during the quarter slowed revenue growth by two percentage points. During the year, payments volume rose 11% and processed transactions increased 12%.

In fiscal 2018 Visa added 7 million merchants lifting the number of merchants globally who accept Visa to 54 million, more than double the size of American Express’s merchant network. Visa also opened 80 million new card accounts. The total number of cards issued by its 15,900 financial institution clients rose to 3.3 billion, 73% more than Mastercard. Visa’s network processed 160 billion payment transactions and $8.2 trillion in payments volume during the fiscal year, an average of 439 million payments and $22 billion per day. Its payments volume grew twice as fast as global personal consumption expenditure growth of 5.5% during the year. Visa’s payment processing market share of global consumption spending increased by 0.5 percentage points to over 16%. Globally, consumers still use cash and check for about one-third, or $17 trillion, of their payments each year. Visa’s total return since January 1 is 22%.

Costco

Strong same-store sales, member retention and new member signups drove healthy revenue and earnings growth for Costco during its 16-week fiscal fourth quarter and year ended September 2, 2018. Fiscal fourth quarter revenue of $44.4 billion rose 5% over the 17-week period a year ago with same-store sales growth which exclude gas price and foreign exchange rate fluctuations of 7.2%. Revenue growth would have been 11.6% without an extra week in the prior period. The number of Costco member households rose 4% to 51.6 million. Members renewed at a rate of 87.9% worldwide and 90.4% in the U.S. and Canada during the quarter, improvements of 0.7% and 0.4%, respectively, over the year-ago period. These members increased their number of Costco warehouse visits by 4.9% during the quarter and spent 4.4% more each visit. Gross margin on Costco’s sales declined 0.35% to 10.93% in the quarter driven by a 20% rise in gas prices. Costco sells gas at a very low margin at 567 of its 762 warehouses. Gas sales now generate 12% of Costco’s total sales and along with other ancillary services such as the pharmacy, optician and food court, attract store traffic. Higher store traffic and sales volume improve the return on Costco’s selling, general and administrative expenses. These fixed costs, which include wage increases effective in June 2018, declined as a percentage of sales by 0.15% during the quarter to 9.82%. This added $65 million or 4.5% to operating income during the quarter and contributed to earnings per share growth of 13.5% to $2.36.

Costco’s fiscal 2018 revenue grew 9.7% to $141.6 billion, making Costco the world’s third largest retailer after Walmart and Amazon. Sales at stores open more than one year rose 6.8% excluding the impacts from changes in gas prices and foreign exchange rates, an increase of three percentage points over fiscal 2017. Sales and new membership fee income from 21 new warehouse openings during the year also contributed to revenue and profit growth. Earnings per share of $7.09 increased 16.6%. Membership fee income of $3.1 billion rose 10% and contributed 2.2% of Costco’s revenue and 70% of its operating income, consistent with prior years. The total return on Costco shares since January 1 is 22%.

Alphabet

Alphabet’s 21% increase in third quarter revenue to $33.7 billion was driven by advertising revenue growth of 20% to $29.0 billion and cloud, Play Store and hardware revenue growth of 29% to $4.6 billion. Adjusted earnings per share rose 24% to $11.86 and exclude gains and performance fees earned on Google’s venture capital investments. Revenue-generating ad views on Google sites, including Google search and YouTube, increased 62%, four percentage points higher than in the second quarter, driven by consumers’ increasing use of smartphones for e-commerce, internet searches and watching videos.

Google’s core advertising business operates in the rapidly-growing digital advertising industry. U.S. digital ad spending in the first half of 2018 rose 23% to $49.5 billion. Spending for ads delivered to mobile phones increased 42% and now accounts for 63% of digital ad sales, a nine-percentage point increase from 54% in 2017. Google search accounts for 63% of all internet queries in the U.S. and 93% of U.S. mobile searches. Mobile search ad spending grew 37% in the first half of 2018 to $13.5 billion. Google’s capital expenditures of $5.6 billion, 80% of which were spent in the U.S., rose 58% in the third quarter and were used primarily to upgrade computers in existing datacenters, invest in ad platform software development and to build 20 new datacenters. These significant investments in computing and network infrastructure have contributed to the rate at which data travels across networks, enabling the growth of the digital video advertising industry. U.S. digital video ad spending in the first six months of 2018 grew 35% to $7 billion. Alphabet’s share price is unchanged since January 1.

IDEXX Laboratories

IDEXX Laboratories’ third quarter revenue of $545 million grew 12% in constant currencies over the same period a year ago. Unfavorable foreign currency translation reduced growth in U.S. dollars by one percentage point. Companion Animal Diagnostics recurring revenue, which includes sales of in-clinic instrument consumables, reference lab services and rapid assay tests, rose 13% organically to $409 million. IDEXX’s sales force incentives drove a 26% increase in global Catalyst (blood chemistry analyzer) placements to 1,611 with 57% placed in new or competitive accounts. The company placed 319 Catalysts in new or competitive accounts in the U.S., 75% of total placements and a 15% increase over the same period a year ago. Placements of chemistry analyzers in new or competitive accounts deliver the most growth in recurring sales of instrument consumables. The international commercial organization focused on new Catalyst placements during the quarter at the expense of placing premium hematology analyzers and selling reference lab services. IDEXX expects sales of reference lab services and other products to recover outside North America with the introduction of IDEXX 360, a program that allows vets to pay for the instrument of their choice by committing to higher volumes of in-clinic or reference lab tests.

IDEXX’s unique set of diagnostic tests, such as SDMA for early kidney disease, fecal antigen for intestinal worms and 4Dx for Lyme disease and tick-borne illnesses, find more underlying disease and find it earlier. These tests increase the medical justification to run preventive care blood work on pets of all ages. The Preventive Care Challenge program offers a turnkey program for reference lab tests (the results are not urgent) with bundled pricing to encourage use. IDEXX’s sales reps work closely with each practice to implement the program. About 2,000 practices in the U.S. have adopted the program and increased their spending on IDEXX’s diagnostic tests by 16% year-over-year. The company serves about 23,000 customers in the U.S., so the rollout of this program is in its early stages. IDEXX’s stock price is up 26% since the beginning of the year.

Ecolab

Ecolab’s third quarter revenue of $3.75 billion grew 7% organically over the third quarter of 2017 with higher sales volumes accounting for five percentage points of the growth and higher prices accounting for the rest. Acquisitions, divestitures and unfavorable foreign currency translation reduced reported growth in U.S. dollars to 5%. The volume gains reflect Ecolab’s success in winning new business and selling more of its newer products and programs. Operating income rose 3% to $617 million as the price increases did not fully offset increased raw material and transportation costs during the quarter. Earnings per share rose 11% to $1.53, excluding special gains and charges as well as discrete tax items.

Revenue for the Global Institutional and Energy businesses of $1.34 billion and $890 million rose 5% and 10%, respectively. Strong growth in the upstream business and moderate growth in the production and downstream businesses contributed to Energy’s strong revenue growth during the quarter. Price increases contributed three percentage points to Energy’s revenue growth. Global Industrial revenue of $1.41 billion rose 7% during the quarter with sales in its Water business up 7%. This business fields 5,500 of the company’s 27,000 field representatives and serves light industry (hotels and manufacturing plants), heavy industries (chemicals, steel manufacturing and power generation) as well as mining. When Ecolab acquired Nalco in 2011, its field service representatives focused more on the type of water they treated than on the industry they served. The Water business now has the industry expertise that differentiates other Ecolab businesses from their competitors. The Transportation business serves car manufacturing plants for Ford, BMW and other large manufacturers globally. Initially, Ecolab improved the efficiency of their cooling towers and boilers, but once on-site, the field service reps realized that car plants used most of the water in the paint booth. Ecolab’s R&D team developed a process to recover the water used during the painting process and then added programs to treat the metal before it was painted. These programs deliver four times the revenue and higher profits than the original business. The total return on Ecolab’s stock is 17% since January 1.

Mettler-Toledo

Mettler-Toledo’s third quarter revenue of $735 million grew 7% in local currencies. Unfavorable foreign currency translation reduced sales growth in U.S. dollars by two percentage points to 5%. Laboratory sales were strong, growing 9% organically over the same period last year and were up almost 20% in China. Earnings per share rose 17% to $5.12. Mettler continues to invest for growth as demand for its products remains strong and sales, orders and leads look solid. Higher interest rates, a stronger dollar and uncertainties and costs from tariffs have slightly clouded their optimistic view of the global economy.

The company provided an update on its Blue Ocean program at its Investor Day on November 12, 2018. Mettler began the program to move its 67 enterprise resource planning systems and 35 customer relationship management systems to one global platform ten years ago. Management expects to complete the conversion in 2020 when the new Tampa Product Inspection facility and the French marketing organization go onto the platform. Blue Ocean harmonizes the company’s global processes with a single database for its 500,000 customers who purchase 135,000 products with an average order size below $2,000. Mettler has created “e-shops” for many of its clients and now has one-third of its orders placed electronically through client portals. The portals make the business stickier by simplifying the purchasing process. The company combines pricing information with profitability and customer conversion data from Blue Ocean to provide a very detailed view of opportunities for pricing and resource allocation. In May, when the tariffs were first announced, Mettler had the data to determine their impact by product and component in 24 hours. Mettler-Toledo’s stock price has declined 5% since the beginning of the year.

Wabtec

Although Wabtec’s third quarter earnings of 91¢ per share were 30% higher than the 70¢ per share earned during the year ago quarter, the stock price dropped 5% after they were announced and discussed by management. Analysts and investors were disappointed that the company’s cash flow from operations during the quarter was only $38 million. Execution on Wabtec’s troublesome UK transit car refurbishment contract resulted in a delay of an expected $30 million in progress payments. Cash flow also was reduced by a $24 million U.S. tax payment for repatriation of foreign earnings and a $2.3 million Indian tax payment. A $14 million foreign exchange translation loss brought the cash shortfall up to $70.3 million from $100 million expected by many analysts. That would have meant that cash flow from operations would have exceeded after-tax earnings, which has occurred before during the second half of the year when revenues are rising as they are now. Many investors are focusing on the cash generated by Wabtec’s businesses because the company has contracted to acquire full control of GE Transportation through a tax-advantaged transaction for which it has raised $2.5 billion through debt issuance and obtained a $400 million bank term loan. The proxy materials providing financials for GE Transportation show that it has received orders from customers that could increase its operating earnings before depreciation, interest and taxes from $750 million this year to over $900 million next year. The document also shows that GE Transportation’s pension plans are not underfunded. More recently, GE Transportation announced on October 31 that its new orders for $1.9 billion included orders for 603 locomotives. Its third quarter operating profit was $162 million on sales of $932 million. The acquisition, which could close during the first quarter of next year, will make Wabtec a stronger more profitable company. Wabtec’s stock price is down 3% since the beginning of the year.

Johnson & Johnson

Good execution in Johnson & Johnson’s Consumer and Medical Device businesses contributed to third quarter revenue of $20.3 billion, organic growth of 6.1% over the third quarter of 2017. The impact of acquisitions, divestitures and foreign currency translation headwinds reduced revenue growth in U.S. dollars to 3.6%. Earnings per share of $2.05 rose 7.9% and exclude amortization of purchased intangible assets and one-time items. The Pharmaceutical division delivered another strong quarter with revenue of $10.3 billion, an increase of 8.2%. Revenue for the company’s two largest drug classes, immunology and oncology, grew 5% and 39%, respectively, to $3.4 billion and $2.6 billion. Nine drugs achieved revenue growth above 10% with revenue from cancer drugs Darzalex (multiple myeloma) and Imbruvica (leukemia and lymphoma) leading the way, growing 60% and 40% respectively. Revenue for the company’s long-acting antipsychotic drugs Invega Sustenna and Invega Trinza rose 18% as more patients receive these drugs every month or quarter to control the symptoms of schizophrenia. The Consumer business’ revenue of $3.4 billion rose 5.4% over the same period a year ago. Sales of J&J’s beauty products rose 6.5% with contributions from Neutrogena products, especially its new hydrating skin creams, and new OGX hair care products. Revenue for OTC drugs rose 6.8% and gained 0.6 points of U.S. market share with good sales growth from Zyrtec, Tylenol and Imodium. The relaunch of J&J’s baby products in the U.S., China and India is off to a good start. Sales for the quarter were unchanged from a year ago, which is a significant improvement from the revenue declines posted over the past two years.

Revenue of the Vision and Interventional medical device businesses grew 5.6% and 19.4%, respectively, to $1.13 billion and $653 million. Sales in these businesses, where J&J has the most innovative products on the market, accounted for 27% of the quarterly revenue of $6.6 billion for the Medical Device business, up from 25% in the same period a year ago. Revenue growth for the Medical Device business was 2.9%. Surgery’s revenue rose 3.8% to $2.4 billion as the business benefited from strong sales of its powered surgical staplers used in laparoscopic surgery and its biologic hemostat patch that stops heavy bleeding. Orthopedic sales fell 3% over the same period a year ago, with sales of knee and spine products declining less in this quarter than in previous quarters. Medical Device sales have been helped by the launch of at least 15 new products and the completion of 26 transactions, including the divestiture of the company’s diabetes testing business. The total return on J&J’s stock price since January 1 is 8%.

Varian Medical Systems

Varian Medical Systems’ fiscal fourth quarter and full year revenue of $801.6 million and $2.9 billion each rose 11% over the same periods last year. Foreign currency translation lifted constant currency revenue growth to 12% during the quarter and reduced constant currency revenue growth to 10% for the year. Quarterly earnings per share rose 11% to $1.16, while earnings per share for the year were $4.42, up 36% over 2017. A strong portfolio of radiation systems and innovative software along with good execution in the field contributed to Oncology Systems’ revenue growth of 13% for the quarter and 14% for the year to $756 million and $2.8 billion, respectively.

Fourth quarter Oncology Systems orders rose 13% to $1.1 billion. Varian received 84 Halcyon orders in the quarter, compared to 98 total orders since the system’s launch in May 2017. Halcyon is meeting the company’s high expectations. In addition to industry-leading 99% uptime and a seven-day installation period, the recently launched on-board CT imaging system has increased interest in Halcyon in every geography. Clinics in developing countries can offer advanced radiation treatments because they can obtain 3-D visualization of the tumor and nearby critical structures in 17 seconds, and thus ensure that the dose is delivered to the right place. In developed countries, the diagnostic quality of the CT images expands the use of Halcyon to pancreatic and liver tumors which require detailed images. Varian has developed software that uses machine learning to contour the tumor and critical structures in about two seconds. This step is the most critical and time-consuming step in treatment planning. When Varian introduced image-modulated radiation therapy in 2000, it took eight hours for a medical physicist to do the contouring. The quality of the automatic contouring allows radiation oncologists to adapt a treatment plan to changes in a tumor’s size or location and deliver the treatment on a Halcyon within the standard 15-minute treatment period. The company’s deep experience with image visualization and data analytics enabled the development of software that can adjust diagnostic MRI and PET scans so that the images match the changes seen in the on-board CT scan. The software then contours the modified MRI and PET scans so a radiation oncologist can develop a treatment plan using them if desired. Varian’s stock price has risen 8% since January 1.

Air Lease

Air Lease’s revenues of $451 million rose 20% from the same quarter a year ago and adjusted earnings of $1.32 per share rose 15%.  During the quarter, the company took delivery of seven aircraft from its order book and sold ten aircraft, realizing gains of $24 million compared to a year ago when seven aircraft were sold generating $7 million in gains.  Air Lease ended the quarter with 268 aircraft on lease, up 14% from a year ago, to 94 airline customers.  The aircraft have an average age of 3.8 years and average lease term remaining of 6.8 years, representing $11.4 billion of future lease payments.  The depreciated value of the 268 owned aircraft is $15.1 billion which Air Lease finances with $11.1 billion of debt and its shareholder equity.  Ninety-two percent of the debt is fixed rate at a composite interest rate of 3.45% which is up 25 basis points since the beginning of the year.  The return on shareholder equity was 16.8% during the quarter.  Between now and the end of 2019, the company expects delivery of 103 new Boeing and Airbus airplanes with 96% of these aircraft already placed with airline customers.  Despite its good results and the continued strong demand for aircraft from airlines to replace aging aircraft and to accommodate growth in passenger traffic, Air Lease’s total return is minus 24% since the beginning of the year.

Although we still think that Core Laboratories is probably the best-managed oil and gas service company we have studied, we have sold the stock because the company has been unable to grow the revenue and profits of Reservoir Description, its largest business. This business provides analyses of cores taken from rock cut during drilling to determine the permeability of reservoir rock and the way the reservoir liquids may change as the oil and gas is produced. Importantly, it allows production from the field to be managed by adding chemicals to the fluids in the reservoir as oil and gas production changes the mix. This highly profitable business usually persists as long as production continues and often becomes more intense as production begins to wane over the years. Reservoir Description’s revenues in the past have risen after the major international oil companies, such as Exxon, or national oil companies like Aramco, have drilled exploratory wells to delineate a field and announced a final investment decision (FID). That decision notifies service companies that the prospect will be developed, and service contracts will be signed. Last year 20 FIDs were announced. This year 25 are expected, although to date no more than 20 have been announced. The vast increase in shale oil production in the U.S. and the concomitant increase in drilled but uncompleted wells apparently have caused the major oil companies and national oil companies to defer development of new offshore fields like Exxon’s vast discoveries offshore Guyana.

SGS

After attending SGS investor meetings in Europe and meeting with its CEO at our offices, we sold the shares held in client accounts.  Management reduced its forecast of achievable margin improvements expected in the next two years and explained how difficult it has been to achieve consistent profitable growth, despite embarking on a plethora of organizational initiatives to improve efficiency and productivity.  In particular, weakness in the energy market has reduced demand for SGS testing, inspection and certification services for its large Oil, Gas and Chemicals and Industrial businesses.  The untimely death of its Chairman Sergio Marchionne, who hand-picked many members of the company’s current management team, creates some uncertainty regarding the future direction of the company.  SGS total return since the beginning of the year is minus 6%.

S&P Global

S&P Global’s revenues of $1.5 billion and adjusted earnings of $2.11 per share rose 2% and 23% respectively from last year’s third quarter.  Management’s continued focus on margin-improving technology projects and investments in unique data, analytics and content resulted in adjusted operating profit growth of 11% to $767 million and an operating margin of 49.6%, up from 45.7% a year ago.  Revenues from S&P Ratings business of $700 million declined 5% from the prior year as global bond issuance dropped 7% during the quarter.  Reduced corporate debt issuance in the U.S. was a result of the Tax Cuts and Jobs Act which requires U.S. companies to repatriate overseas cash balances from profits generated abroad.  U.S. debt issuance decreased 16% to $485 billion in the third quarter with corporate investment grade rated bonds and high yield bonds declining 24% and 45% respectively.  These declines were partially offset by new CLO (collateralized loan obligation) issuance.  European debt issuance rose 18% to $365 billion.

Revenue from the S&P Dow Jones Indices business rose 10% to $205 million as increased investment allocation to ETFs and market appreciation boosted assets under management linked to S&P Indices to $1.5 trillion, an increase of 24% from a year ago.  Market Intelligence revenue rose 10% to $464 million with strong growth of 12% in active users of its primary desktop subscription applications, S&P Capital IQ and SNL Financial.  Platts revenue increased 5% to $204 million as subscription revenue growth offset a decline in fees from trading volume of certain commodities.  S&P Global’s stock price declined 4% on September 28 when the third quarter debt issuance data was released, and declined with the overall market in October.  We sold shares in November, after the stock price partially recovered, to realize the loss this year.  We will continue to evaluate the company, which we did not buy for the revenue derived from US debt issuances.

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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.

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2018 – 4th Quarter EARNINGS LETTER