HP is reeling from operational miscues

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by Grady Burkett, CFA (Analyst at Morningstar)

Hewlett Packard is in a difficult position. The firm faces increasingly fierce competition across its portfolio as it works through a protracted turnaround of its enterprise services business. We believe that HP has strong enough assets to stabilize its business, but the firm's earnings power and competitive position have deteriorated. We expect HP to manage through its current challenges, but investors should be prepared for occasional setbacks and should temper their expectations for future growth.
We separate HP into three distinct groups, each with fundamentally different growth and margin prospects: printers and personal computers, enterprise software and infrastructure, and services. Printers and personal computers, the largest of these segments, accounts for more than 40% of HP's operating income and roughly half of revenue. HP is the leader in both markets, and we believe that the firm will generate substantial cash flow from PCs and printers even as both come under increasing competitive and secular pressures. While neither business benefits from a defensible competitive advantage, printers and PCs remain important to HP's overall success in the traditional enterprise and commercial markets, in our view. HP's large commercial installed base provides the firm incremental opportunities to sell its stickier--and higher-margin--infrastructure products and software tools into the enterprise. More important to HP now, however, is the solid cash generation that we believe printers and PCs can consistently provide over the next several quarters as the firm strengthens its balance sheet.
HP separates its enterprise software and infrastructure businesses into distinct business units, but these businesses naturally fit together. The infrastructure business, which consists primarily of servers, storage arrays, networking equipment and related maintenance services, accounts for more than 40% of the firm's operating income. HP is the industry leader in x86 servers and maintains substantial market share in storage and switches. Customers face reasonably high switching costs when considering a change to their storage and core network infrastructure, and status quo is the default option for these systems. Additionally, HP owns valuable intellectual property utilized in its storage arrays and networking equipment, and we believe that HP earns gross margins above 50% from these products. Server virtualization has lowered customer switching costs substantially for x86-based servers, but we believe that HP still generates economic profits selling x86 servers as a result of the firm's scale, an attractive razor/blade business model for its chassis-based systems, and through related sales of software management tools and maintenance subscriptions.
HP's $4 billion software portfolio is small relative to the firm's overall revenue and operating income. Still, HP holds leading and defensible positions in IT infrastructure management software, security and business analytics, and we believe that the firm's software portfolio increases the stickiness of its enterprise relationships. Combined, HP's enterprise hardware and software businesses account for nearly 50% of the firm's overall operating profit, and we think that this collection of businesses holds a durable competitive advantage and is key to the firm's future success. While cloud computing, a terminal decline in HP's business critical servers, and increasing competitive pressures from traditional hardware vendors will pressure gross margin and revenue growth over the next several years, we think HP can adapt its enterprise product portfolio to effectively negotiate these challenges.
Finally, HP runs a massive services organization as a result of its 2008 acquisition of EDS. This business accounts for 20% of revenue, but will generate little to no operating profit in fiscal 2013 due to mismanagement and increasing competition. IT services firms can possess competitive advantages, depending on portfolio mix, but HP's services business is sprawling and complex and the firm is at a competitive disadvantage versus more focused players, like IBM, Accenture, and best-in-class offshore providers. In addition to competitive pressure, services firms generally face secular headwinds caused by cloud computing. Given these pressures, we believe that HP should sell or spin out its services business in order to alleviate management distractions and eliminate the temptation to over-allocate scarce corporate resources to a turnaround that may never materialize. Were HP to shed its services organization, the firm could once again be viewed as a friendly supplier by the IT service providers who may in turn be more likely to recommend HP's high-margin infrastructure offerings to their clients. 
Valuation

We have lowered our fair value estimate to $17 per share from $20, as we have significantly reduced our revenue and operating profit forecasts across HP's businesses.
We expect revenue to fall from $120 billion in fiscal 2012 to $100 billion in 2016. This forecast is based on our expectations for upper-single-digit annualized revenue declines in PCs, printers, and enterprise services; this will be partially offset by low-single-digit growth in enterprise infrastructure and related services and upper-single-digit revenue growth in software.
Assuming our revenue forecast plays out, HP should experience consolidated gross margin improvement despite ongoing pricing pressure across most of its businesses. Software, storage, networking, and related maintenance services should experience moderate growth and we estimate that these categories carry significantly higher gross margins than PCs, x86 servers and enterprise services, which should shrink over time. The net result is a 160-basis-point improvement in consolidated gross margin during the next five years. Still, the higher gross margin products also require significant ongoing investments in product development, sales, and marketing; we expect HP's fixed costs to grow over time despite management's ongoing efforts to rein in costs. The combination of rising operating expenses and declining revenue should lead to operating margin contraction, and we model HP's long-run operating margin to settle in at about 6% in steady-state.
We currently model capital expenditures to remain roughly flat at about $3.5 billion-$3.8 billion per year during the next five years, but we would not be surprised to see capital spending come in lower than our current forecast depending on how aggressive of a restructuring plan management ultimately chooses to pursue. Finally, we model $8.5 billion in acquisitions from fiscal 2013 through fiscal 2016, which shaves about $4 per share from our fair value estimate. While HP's top priority is to fix existing operations and strengthen its balance sheet, we think the company will have to continue to make targeted acquisitions in software, security, networking, and storage in order to remain competitive.
Risk

HP faces material threats in several of its divisions. PCs are undifferentiated, and discount notebooks, virtualization, and a general shift to the cloud from processing and storing data locally threaten to compress already challenged margins. A similar phenomenon is occurring in printing, as single-function devices become commodities. HP has good technology and is pushing into higher-end printers, but a successful transition is not guaranteed. The market for server technologies remains a stronghold for HP, but renewed interest from Cisco, Dell, and even Oracle raises concern. Failure to capture significant share in storage, networking, and servers could leave HP's server business vulnerable.
Management & Stewardship

Meg Whitman was appointed CEO in September 2011, replacing Leo Apotheker after less than a year at helm. As part of the change, Ray Lane has taken on additional responsibility, becoming executive chairman. The new management team brings a focus on operating HP's existing businesses, a sharp reversal from the previous regime's goal of transforming the firm via software acquisitions. Helping with the new strategy, HP enjoys a deep bench of management talent that should be able to keep each of HP's business units on track. 
Though we are growing more comfortable with the new regime's strategy, HP has been plagued by poor capital allocation decisions in recent years. Share repurchases averaging nearly $10 billion a year were egregious, considering the firm's balance sheet. The $11 billion Autonomy acquisition cannot be viewed as anything but destructive to shareholder value without some extremely optimistic projections. Furthermore, turmoil at the board level has led from one scandal to the next, creating instability and a lack of accountability for HP's recent performance. We believe the new management team is on the right track, but more evidence that HP is making capital allocation decisions that are to the benefit of shareholders is needed before we change our view on the firm's stewardship practices.
Overview

Financial Health: 
HP's financial health has deteriorated in recent years due to unnecessarily aggressive acquisitions and share repurchases. The company's $29.5 billion debt load seems manageable, however, and the firm holds approximately $9.5 billion in cash and equivalents on hand.
Profile: 
Hewlett-Packard manufactures and sells information technology products and services to businesses and consumers worldwide. Services accounts for about 20% of revenue, enterprise hardware, software and related services accounts for about 25%, printers and PCs account for 50%, and the remainder comes from financing.

New engines of growth will highlight that Google is more than an Internet search company.

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by Rick Summer, CFA, CPA (Analyst at Morningstar)

Google's GOOG third-quarter earnings report brought hand-wringing from the market and new issues to light for us. While we believe our long-term thesis is intact, we are concerned that we may have been overly optimistic about operating leverage, given the changing revenue mix. Still, although we may modestly decrease our fair value estimate after completing our analysis, we consider the company slightly undervalued at these levels. Perhaps most importantly, we see no evidence of diminishing competitive advantages.Revenues for Google Sites grew 15% compared with 2011, while revenue from the Google Network (ads placed on partner sites) grew 21% versus 2011. The strong dollar created a headwind to results as well, with a negative impact on Google's stand-alone revenue growth rate (excluding Motorola) of 600 basis points versus 2011. As Google Network revenue outpaced Google Sites, we believe this may be the start of an important trend: Google will increasingly rely on placing ads and distributing content for content owners to subscribers, but fee sharing and content acquisition costs will constrain the company's ability to gain operating leverage from the business.
With respect to operating costs, we note that other costs of revenue increased 57% sequentially (while Google's stand-alone revenue grew 5%). Even after accounting for effects of acquisitions and costs from the launch of the Nexus 7 tablet (Google's Android tablet), we estimate that other costs of revenue increased more than 30% versus the prior quarter. We believe this dramatic increase highlights Google's evolution toward a content distribution platform. Although the firm recognizes gross revenue by selling content on YouTube and Google Play, we suspect the bulk of the economics flow to the content owners, resulting in lower gross margins. If these efforts become even more significant relative to the total company, overall operating margins will suffer. Although we believe the company has other levers within is expense base to eventually expand margins, we may take a more cautious stance.
Thesis 03/05/12

After rising to prominence by attracting massive numbers of users and ad dollars for its Internet search product, Google is investing in its next act.As the pre-eminent leader in search, Google maintains more than 60% of worldwide market share; no other competitor has even 10%. We believe the company's early technical advantages attracted users who now use it habitually, creating a switching cost based on familiarity with the engine. While the firm may face near-term headwinds from efforts by Microsoft's MSFT Bing and social network Facebook, we expect the larger players to win share from weaker players, including AOL AOL and IAC's IACI Ask. Although we expect small movements in market share, we believe Google's dominance will persist and not lose more than 3-5 points of share.
A strong secular growth trend for online advertising is core to our thesis. The market for Internet search advertising is still growing in the double digits, while display advertising is growing thanks to newer innovations tying display ads to specific actions, including clicks, leads, and customers. Also, faster-growing geographies such as Asia are propping up overall growth rates as Western Europe has recently been slowing. We forecast global Internet ad spending to grow in the midteens annually during the next five years. We expect that Google will leverage its dominant position in Internet search and support strong growth in display and mobile advertising, allowing it to meet or exceed the overall industry growth rates.
Although competitors like AOL and Yahoo YHOO have routinely claimed competitive advantages in display advertising for content rather than search, Google is not on the sidelines. In fact, we estimate the company generated more than $4 billion in display advertising in 2011, exceeding Yahoo's display revenue for the year. While we would be more enthusiastic if it announced large deals with branded advertisers, we still expect Google will participate quite aggressively in this market. The company is continuing to innovate around its DoubleClick Ad Exchange in an attempt to offer advertisers ways to incorporate real-time bidding and directly target audiences with specific demographics as opposed to choosing websites. Ultimately, advertisers want specific targeting; providing technology that helps automate this targeting delivers tremendous value in maximizing budgets. Furthermore, Google recently announced a plan to invest an additional $100 million in its heavily trafficked YouTube website. As rich video content continues to move online, we are optimistic about YouTube's value and ability to monetize its content.The importance of Android cannot be overstated, particularly in light of the massive adoption of smartphone and tablets. Android is an open-source mobile operating system (the code is shared with the community using a free software license) to allow handset manufacturers and users to load applications that software makers build. During 2011, Android's installed base of smartphones vaulted to 38% market share according to Gartner, well ahead of market leaders Apple AAPL and Research in Motion RIMM. While many industry watchers are scratching their heads over the significance of a business that generates no direct revenue for Google, we are more enthusiastic: The move protects the firm's economic moat and provides new revenue streams. With Android living on smartphones, more users are likely to use Google's services. In fact, we have seen estimates of Google's market share in mobile search exceeding 90% last year.
Still, there are risks on several fronts. First, we cannot ignore the potential impact of social networks such as Facebook, Twitter, and LinkedIn LNKD. While we believe these will not be an immediate or direct threat to Google's search business, we do believe they are immediate and significant competitors for display ads. Additionally, these firms undoubtedly will invest in search capabilities, and we could be wrong about their ultimate success. We also believe the returns on capital for the new businesses will be lower than the returns in its core search business. As many companies are investing heavily in content strategies, Google will have to continue investing in an attempt to keep pace in attracting more branded advertisers.
Valuation

Our fair value estimate is $780 per share, representing a 2012 price/earnings multiple of 23 and an enterprise value/EBITDA multiple of 14. We forecast revenue to grow more than 12% annually during the next five years, slightly ahead of the growth rate for the overall online ad industry. Google reports its business in three market segments: Google websites, Google Network websites, and other.
Revenue driven by Google websites include its search engine and Web properties such as YouTube and Google Finance. Although we expect minor short-term loss of market share in search, we believe that improvements in monetization (the conversion of a search to a paid click on an advertisement) and overall market growth will help drive revenue. Additionally, with additional investment in display revenue technology and content on YouTube, we have modeled Google websites to grow more than 18% per year. We also expect uplift from mobile search to support strong revenue growth in this core business. Excluding YouTube, search is the most significant cash generator and highest-margin business for Google. We are more conservative in our view of revenue coming from Google Network. Google Network represents revenue earned by the placement of ads on partner websites. We anticipate this growth will lag the market, growing at 8% per year through 2015.
While we believe Google could easily drive operating margins substantially above 40%, it would have to ratchet down its investment in R&D and its data centers to achieve these targets in the short term. We expect operating margins to stay below 30%, reflecting increased investment and higher personnel costs caused by the pay raise instituted in January. After this year, we forecast operating margins to begin expanding again and reaching 32% in 2015. Because Google is heavily investing in new markets, we still expect free cash flow to be depressed over the next few years. However, we expect growth in free cash flows to exceed 25% annually through our explicit forecast period.
Risk

Although we believe Internet search is habitual, explicit switching costs are relatively low. Fickle consumers may move to a competitor that is able to establish a stronger brand or a more useful experience. Google is investing in new businesses where it is less competitive, which may lead to a deterioration in its operating margin and return on capital. Advertisers may find new ways to reach their target audience in a cost-effective manner, like Facebook. Finally, competition in technology is fierce, and employee retention may become more difficult and cause an increase in operating costs.
Management & Stewardship

Cofounder Larry Page was named CEO in April, taking over from Eric Schmidt. Schmidt was CEO from 2001 to 2011, a period that saw Google define its business model, become a public company, and stay at the forefront of the Internet advertising industry as the largest company by revenue and enterprise value. Schmidt is retaining his position as chairman of the board and serving a more active role in lobbying Washington. With Schmidt as a key executive, the company essentially has been managed by a three-person team of him, Page, and cofounder Sergey Brin. The company's equity has a dual-class structure that concentrates the voting power in the hands of these three executives, who hold two thirds of the voting rights. They also have a significant economic interest in the firm at more than 15%, which helps to align the interests of management with the shareholders.
We are comfortable with management at the firm, but employee retention will be a continual challenge for Google. Page's style and efforts will not mirror Schmidt's and may cause some short-term disruption. In fact, the senior vice president of product management resigned the week that Page's new title became official. Although we don't view the move as emblematic of any looming management issues, we would not be surprised to see other similar moves as competition for personnel is ruthless in the technology sector. To address these concerns, the company is rumored to have given a 10% pay raise to every employee effective in January.Generally, we are encouraged management's by the long-term focus on capital allocation, although the lack of transparency around milestones for new projects presents an analytic challenge. We are encouraged that past acquisitions including DoubleClick, Android, and YouTube are bearing fruit and deepening the company's moat. Additionally, the management has recently begun pruning products that have not been hitting internal success metrics, a positive development, in our view.
Overview

Financial Health: 
Google's balance sheet is flush with more than $44 billion in cash equivalents and about $4.2 billion in short-term debt and long-term debt.
Profile: 
Google manages an Internet search engine that generates revenue when users click or view advertising related to their searches. This activity generates more than 80% of the company's revenue. The remaining revenue comes from advertising that Google places on other companies' websites and relatively smaller initiatives, such as hosted enterprise products including email and office productivity applications.

Microsoft is trying to change the recent downward trajectory of its Windows OS franchise.

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by Norman Young (Analyst at Morningstar)

Although the conventional wisdom regards Microsoft as a technology giant in decline, we see glimmers of a more cohesive strategy through new Windows.Microsoft has been a step behind as competitors and new technologies have slowly eroded the moat around its Windows PC operating system. We believe Microsoft's new multiprong strategy to compete in the world of cloud computing and mobile devices should help rejuvenate its Windows OS and software franchise by creating a more cohesive user experience among multiple devices, which should strengthen the links among the users, the OS, and the application software.
The moat around the Windows operating system is the result of high switching costs that are due to an easy-to-use OS that is tightly integrated to diverse suites of application software, combined with the network effect of massive global market share that creates sticky users. The rise of cloud computing has weakened the links among users, the Windows OS, and its integrated application software suites, while also reducing the network effects as consumers discover acceptable OS and software substitutes. The rise of alternative computing devices further weakened the links between consumers and the Windows ecosystem by replacing the traditional desktop PC and changing usage patterns.
Although Microsoft is playing catch-up, Office 365 is its response to competing cloud-based productivity tools, offering subscription-based services for Office, Exchange, Lync, and Sharepoint. We think compatibility and continuity concerns will drive professional users to Office 365, helping to maintain the size of the installed base, which should reinforce the network effects of the Windows franchise. Given the substantial capital investment required to build and maintain such a robust cloud offering, we believe there are significant barriers to entry for this business that will limit entrants, allowing Microsoft to generate high returns on its investment over the long term.
Windows 8, the Surface tablet, and the Windows Store flesh out Microsoft's response to the challenges facing its Windows franchise. The new Windows OS will be used across many devices, providing a smooth, more cohesive user experience from PC to tablet to smartphone. The Surface and other Windows-based tablets are Microsoft's first foray into tablet computers; we believe a tablet that runs the Office productivity suite is more appealing to many consumer and business users relative to competing devices. The final piece of the strategy is the Windows Store, a digital distribution platform for Windows 8 where users can purchase and download apps, which is meant to create a community and marketplace for developers and consumers.
Many of these products are "me too" ideas, but we believe the combination of these products and services will build customer stickiness across multiple devices, which should help slow, stop, or possibly reverse the decline of the Windows franchise. We do not expect all facets of this strategy to be successful in the near term, but Microsoft has a record of investing significant resources over long periods in pursuit of its objectives. As the company works to reinvigorate its Windows division, the server and tools division remains a stalwart as its server and SQL database products continue to gain share even as the global market expands. Microsoft Business Division has seen solid growth in following the release of Office 2010; Office 2013 expected to be released in December 2012. Combined, the server and business segments represent 58% of total revenue and contribute 66% of operating income--enough to shoulder the load as the Windows makeover unfolds.
Valuation

Our fair value estimate is $35 per share, which implies a 2013 price/earnings multiple of 11.9. We forecast slowly declining revenue growth from the Windows division over the next 10 years because of a short-term slow erosion of market share of Windows-based PCs. We expect Windows 8, RT, cloud strategies, and Microsoft's entrance into tablet computing to slow the erosion in market share over the next three years. We forecast long-term revenue growth in the server and tools and business divisions, but we expect the hardware and management costs of cloud technologies will weigh on Microsoft Business Division's operating margins over the long term. Given the less advantageous pricing and poor economics associated with having a lower market share in the search business, we forecast that the online services business remains unprofitable for the foreseeable future.
Risk

Microsoft's flagship Windows operating system and Office productivity software suite are under assault from tablet computers, cloud alternatives, and OS X offerings from Google, Apple, and open-source providers like Linux. Windows-based PC shipments have slowly eroded from approximately 95% market share a decade ago to 90% today owing to shifting consumer preferences and the rise of OS X and Android-based tablet computers and smartphones. With the release of Windows 8, the Surface tablet, and the pending release of the Nokia Windows phone, Microsoft hopes to reverse market share declines while establishing beachheads in the smartphone and tablet markets. We believe the Surface and upcoming OEM Windows-based tablets are good first efforts and the inclusion of Office should help broaden the appeal of Windows tablets to traditional laptop users in addition to tablet users.
Management & Stewardship

Given their combined equity stake of 9.4%, we believe CEO Steve Ballmer's and chairman Bill Gates' interests are probably aligned with shareholders. Ballmer has served as CEO since January 2000 and has been with the company since 1980. He has done a satisfactory job building and protecting the core businesses, but the company has consistently had to play catch-up in key growth areas (Internet, online commerce, social networking) over the past decade. Large acquisitions in an attempt to regain lost ground (aQuantive and Skype, for example) have had a mixed record at best. Ballmer's fiscal 2012 performance-related bonus was reduced 4% because of slower-than-expected progress in the online business and a decline in Windows revenue.
Overview

Financial Health: 
Microsoft has more than $66 billion in cash and cash equivalents and approximately $12 billion in debt. We expect the company to generate about $20 billion in annual free cash flow, enabling it to comfortably service debt while investing in the business.
Profile: 
Microsoft develops and sells software, hardware, and services. The company is organized into five business segments: Windows and Windows Live, Microsoft Business Division,  server and tools,  online services, and entertainment and devices. Microsoft Business Division is the largest component of revenue at 33% in fiscal 2012, with server and tools and Windows and Windows Live each contributing 25%, entertainment and devices 13%, and online services 3.9%.

With pricing in place, and input costs easing, Clorox faces fewer headwinds.

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by Morningstar Equity Analysts

Clorox's CLX fiscal first-quarter results, which included modest sales growth and margin improvement, supported our thinking that spending to invest behind its brands (both in terms of advertising and product innovation--about 11% of consolidated sales) as well as investments to improve its cost structure are appropriate for the long-term health of the business. However, we are maintaining our cautiously optimistic outlook, given that Clorox competes in categories with high levels of private-label penetration and derives the bulk of its revenue from mature, developed markets. While we aren't forecasting robust growth from this household- and personal-care firm anytime soon, we still think Clorox will generate outsize returns and excess cash for shareholders over the longer term (with the strong brand equity inherent in its portfolio that results in leading share in several of the categories in which it competes). Management confirmed its full-year fiscal 2013 guidance for 2%-4% sales growth, 25-50 basis points of EBIT margin improvement, and earnings of $4.20-$4.35 per share (which slightly exceeds our $4.36 forecast). While we intend to update our discounted cash flow model for Clorox’s recent results, we don’t anticipate a material change to our $68 fair value estimate, which remains in place. Despite this, we view shares as slightly overvalued at 17 times the midpoint of the company's earnings per share guidance (compared with an average of 15 times for Morningstar's household- and personal-care coverage universe).
First-quarter sales, adjusting for foreign currency movements and acquisitions, ticked up 1.8% year over year, as lower volume (down 1%) was offset by higher prices (up nearly 3%). Volume weakness in the household business (due to lower shipments of charcoal products and cat litter, two categories where the firm recently raised prices) was offset by continued momentum in the cleaning segment, which included the highest level of volume growth for bleach in more than two years. Because the consumer spending environment has yet to meaningfully pick up steam, we intend to continue monitoring the impact that Clorox's higher prices have on the firm's volume over the coming quarters. If volume remains depressed, we wouldn't be surprised to see the firm roll back prices in a few of the categories where commodity cost pressures have retreated. Clorox's cost-saving initiatives combined with the higher prices it's charging at the shelf offset modest raw material inflation, increased supply chain costs, and unfavorable product mix, as gross margins expanded 90 basis points to 42.9% (excluding restructuring charges in the year-ago period). However, consolidated operating margins increased just 20 basis points, as Clorox ramped up its spending behind brand marketing support--in line with our thinking--to ensure that its products stand out in this intensely competitive operating environment.
Thesis by Morningstar Equity Analysts, 06/05/12

With 14% of total sales derived from bleach, 13% from trash bags, and another 11% from charcoal, Clorox is a consumer-packaged firm in a tough spot. Leading brands, including its namesake bleach, Glad, and Kingsford, haven't entirely insulated the firm as its categories have continued down the road of commodification over the years. Input cost inflation has compressed margins along the way, and while we still accord Clorox a narrow economic moat for its brand equities and economies of scale, the company's returns on invested capital have eroded.
For most household product firms, the name of the game is differentiated products in growing categories or growing markets. Clorox is doing a decent job considering the cards it has to play, but activist investor Carl Icahn trained his sights on the firm last year because he viewed the stock as underperforming. Icahn's attempt to flush out a buyer for the firm fell flat, as we expected it would. While it would be possible to unlock value in Clorox by breaking up the firm and selling off its brands, we don't believe there is a sound strategic argument to buying the firm outright or merging it with another company. Private-label penetration is high in many of the company's categories, sales are derived predominantly in developed markets, and 44% of total revenues are concentrated with only five domestic retailers. All these factors made the firm relatively susceptible to economic shocks during the last several years, and arguably a less attractive partner.
While the board wasn't interested in Icahn's offer, and no other buyers came forward, it should be noted that for all of its challenges, Clorox is a fairly well-run firm. Management has shed noncore assets, including its Armor All brand, and has made acquisitions to diversify its product base. During the last several years, Clorox acquired Burt's Bees, and in keeping with its strategic aim of building an infection-control business, which we view as complementary to its core foothold in bleach, the company completed tuck-in acquisitions of Caltech, Aplicare, and Healthlink. The timing for Burt's Bees was poor; at 2008 prices, management had to write down $258 million in goodwill last year when the optimistic projections underpinning the purchase price failed to materialize. However, we don't disagree with the aim of product diversification or the focus on the natural or organic niche. The issue is more about growth, and as Clorox has come to realize with its Green Works brand, consumers are willing pay for natural or organic products, but not necessarily the premium that was once expected. Instead, natural and organic products are becoming more mainstream, in which case Clorox should be fairly well-positioned given its scale and distribution network.
In the meantime, Clorox is doing a respectable job managing input cost inflation, which drove down gross margins by 160 basis points in 2011, and controlling costs, which boosted margins by 170 basis points during the same period. The firm is adept at navigating price increases to balance the inevitable volume declines, and has worked hard to expand into adjacent product categories to reduce its dependence on product lines, like trash bags and food containers, where consumers are likely more inclined to shop on price. This type of expansion can still smartly leverage a strong brand equity like Clorox or Glad, while also providing higher margins. Clorox's hard work hasn't been paying off as it had in the past, but the company is holding steady with its market shares. Pricing the firm has pushed through also appears to be sticking, which speaks to management's skills at gauging appropriate price points and the firm's strong brands. With commodity costs likely to ease in coming quarters Clorox should be able to regain some lost margin. If management invests back in the business on higher ROIC projects, which we fully expect it to do, the firm's narrow moat should remain intact.
Valuation

We are maintaining our fair value estimate of Clorox shares at $68, which implies a forward fiscal-year adjusted price/earnings of 16.8 times, enterprise value/EBITDA of 10.1 times, and a free cash flow yield of 5.3%. We expect soft consumer spending in developed markets to continue weighing on top-line results, so we forecast annual revenue growth of 3%-4% during the next five years (excluding the impact of acquisitions). Input cost inflation has been difficult to overcome, but we expect to see some modest margin expansion during our forecast period.
Clorox does a solid job of managing overhead expenses, and as it slowly reduces its dependence on sales of trash bags and charcoal, margins should show steady improvement. We forecast operating margins in excess of 19% by fiscal 2014, up about 150 basis points to the fiscal 2011 adjusted operating margin. Management expects to build margins 25 to 50 basis points a year so we see this estimate as fairly reasonable. Through 2016, we expect return on invested capital to average 22%, well in excess of our 9.0% cost of capital estimate, supporting our opinion that Clorox maintains a narrow economic moat. Even with a choppy revenue line and margin line, we place a low degree of uncertainty around our fair value estimate for the shares as we think projections of the company's cash flows fall within a fairly narrow range.
Risk

Clorox is influenced by the commodity-driven nature of its business. Volatile input costs, as well as the commodification of several of its categories (such as bleach and trash bags), can have a significant impact on profitability. The company also faces stiff competition from branded and private-label manufacturers in many of its product lines. In addition, with 44% of its sales resulting from its top five customers (26% from Wal-Mart alone), Clorox maintains significant exposure to consolidation among retailers.
Management & Stewardship

From our perspective, Clorox is a well-run organization, with returns on invested capital (including goodwill) that have been more than double our cost of capital estimate in each of the last 10 years. Donald Knauss, 60, assumed the CEO and chairman positions at Clorox in October 2006. Since taking over at the firm he has overseen the company's acquisition of Burt's Bees and push into consumer and professional health and wellness categories. Knauss coolly kept Carl Icahn at bay as the investor attempted to sell Clorox off to a bidder that never materialized. While overtures failed, with Knauss looking as steady and sure as ever, the effort drew attention to the firm's lagging stock price. Improved fundamentals, solid cash flows and healthy dividends and buybacks all point to management running Clorox for the long term and not the quarter, but the solid results are failing to boost the shares. At some point shareholders may lose patience. In the meantime we accord a standard stewardship grade to Clorox.  
It's worth noting that in fiscal 2011, in the midst of Icahn's run at the company, Clorox made numerous positive changes to its compensation program, including reducing the change in control severance payments and eliminating tax gross-ups for "golden parachute" tax liabilities. Compensation at Clorox is reasonable and, despite some fairly long-tenured board members, corporate governance at the firm is sound. 
Overview

Financial Health: 
We are not concerned by Clorox's nearly $2.6 billion of debt on its balance sheet, given the substantial cash flows it generates. During the next five years, we forecast debt/capital to fade to below 0.75 (from 1.03 in fiscal 2011) and operating income to cover interest expense between 7 and 8 times. We assign Clorox an issuer credit rating of A-.
Profile: 
For nearly 100 years, Clorox has operated in the household product industry, expanding its portfolio to include such leading brands as Clorox, Glad, Hidden Valley, and Kingsford. The firm distributes its products through mass merchants, grocery stores, and other retail outlets. With its acquisition of Burt's Bees in 2007, Clorox gained entry into the fast-growing natural personal-care category. International sales amount to 20% of the firm's consolidated total.

A more stable European economy should feed E.ON's growth plans

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by Travis Miller (Analyst at Morningstar)

E.ON EONGY reported nine-month operating income of EUR 4.0 billion and adjusted EBITDA of EUR 8.8 billion. Both are up substantially from 2011, as we expected, and remain in line with our full-year projections. Management reaffirmed its 2012 earnings guidance of EUR 4.1 billion-4.5 billion and EBITDA guidance of EUR 10.4 billion-11.0 billion. Management also reaffirmed its intent to pay a EUR 1.10 per share dividend.
However, management said it was reviewing its 2013-15 outlook, given increased uncertainty since it issued its outlook in March and reaffirmed it in May. We also will review our EUR 22 fair value estimate for a possible cut. We are reaffirming our long-term midcycle earnings estimate, so any near-term adjustments will have a minimal impact on our fair value estimate.Management initially forecast 2013 net income of EUR 3.2 billion-3.7 billion and EBITDA of EUR 11.6 billion-12.3 billion. Management also forecast an annual earnings per share growth rate exceeding 10% in 2011-15. Our projections were at the high end of those ranges, and we will review our outlook for a possible cut.
Although the nuclear shutdowns in Germany are behind it and the firm's wholesale gas trading margins have improved, E.ON still had to take a EUR 1.2 billion impairment charge in the quarter across several of its businesses.E.ON also in November made two moves that demonstrate its intent to sharpen its focus and pare back its growth capital spending. The company announced it plans to sell its 34% stake in Finnish energy company Fennovoima as part of its plans to exit the Finnish market and focus on the Danish and Swedish markets. Fennovoima had proposed building a new nuclear plant with E.ON's help. E.ON also sold its joint venture interest in Horizon Nuclear Power, which targeted new nuclear plant development in the United Kingdom.
Thesis 09/18/12
Nationalist protectionism and political meddling in European energy markets constrain E.ON's ability to create value from its attractive asset portfolio and have forced management to look beyond its core region for growth opportunities. Still, management has shown strict adherence to return on investment hurdles and free cash flow generation, both key metrics for investors. Even with the nuclear phaseout in Germany and lackluster energy demand in the depressed European economy, we think E.ON could be a good long-term investment for those seeking European diversification.
Founded in the 1920s as Germany's national power company, E.ON ranks among the world's three largest investor-owned utilities, along with France's Electricite de France and GDF Suez. Acquisitions in 2000-08 enlarged E.ON's international footprint to include the United States, the United Kingdom, Scandinavia, and continental Europe. Its largest was the EUR 11.5 billion purchase of Enel and Endesa assets in June 2008. E.ON also acquired stakes in U.S. renewable energy, a Nordic utility, power plants in Russia and Turkey, and an Italian utility in 2008-09.
However, the European financial crisis, collapse in commodity markets, and worldwide recession led management to reverse course in 2009. For 2011-13, management is targeting EUR 15 billion of divestments and using much of that capital to reduce debt or invest outside the eurozone. The divestitures included government-mandated disposals of certain power transmission and generation assets in Europe, sale of its regulated distribution utilities in the U.K. and U.S., and elimination of its minority interests in German municipal utilities (Thuga) and Russian energy firm Gazprom. Despite the challenging market conditions, we think E.ON achieved good returns from those deals.
We believe management has shown good discipline to protect its double-digit returns on capital. The prompt shutdown of 4 of its 11 nuclear plants in Germany in 2011 took a big bite out of those returns, but we expect returns to rebound by 2014-15. In 2011, E.ON's regulated and quasi-regulated businesses contributed the same amount of EBITDA as its merchant generation portfolio, and we expect that mix to continue for several years.
With a bleak outlook for generation margins and demand, management has turned its focus to renewable energy and conventional generation investments outside Europe. Management hopes to take advantage of the opportunities for renewable energy growth to fill the lost nuclear generation in Germany and to meet the European Commission's Energy Roadmap 2050, which aims to cut carbon emissions 80%-95% by 2050.
If European markets stabilize and E.ON's investment plan continues, shareholders should see strong returns for many years.
Valuation
We are reaffirming our $29 fair value estimate for E.ON's ADR shares after a first-half performance that puts E.ON on track to exceed our previous expectations.
We are raising our 2012 EBITDA projections primarily because of E.ON's faster-than-expected success renegotiating its gas supply contracts. We now estimate E.ON can earn EUR 10.8 billion EBITDA in 2012, up from EUR 9.9 billion previously. Offsetting this near-term benefit, we cut our 2013-15 EBITDA estimates 2%-3% to incorporate lower hedged and open generation margins. Our new earnings per share estimates are EUR 2.19 in 2012 and EUR 2.60 in 2013.
From trough earnings in 2011 to our normalized midcycle commodity market assumptions in 2015, we estimate E.ON can double its net income. Driving these results are our assumptions that European commodity markets remain near current levels for the next two years and that the nuclear phaseout in Germany proceeds as scheduled. This results in only one additional nuclear plant closure in E.ON's fleet during our five-year forecast. We discount our perpetuity value to account for the final nuclear plant shutdowns in 2017-22.Key profit drivers in 2013-beyond include E.ON's cost-control program, its renewable energy growth projects, and its full realization of benefits from its gas supply contract renegotiations this year. We expect these positives to offset an additional EUR 1 billion of costs we estimate from the full auctioning of carbon credits and mostly flat generation margins.
We assume E.ON invests an average of EUR 6 billion annually in 2012-16. In our discounted cash flow valuation, we use current market credit spreads and an 11.0% cost of equity to produce a 9.6% cost of capital. Our fair value estimate is based on an exchange rate of $1.31 per euro as of Sept. 17.
Risk
Our medium fair value uncertainty rating stems from the sensitive political environment throughout Europe and increasing earnings exposure to volatile energy commodity prices. A key uncertainty was resolved in mid-2011 when the German government passed legislation to shut down all of the country's nuclear plants and impose a tax on nuclear fuel until the plants retire. Although the outcome was a significant negative for E.ON, it allows the company to move forward with its post-nuclear strategy. Government-imposed limits on power prices in Germany and elsewhere are another recent concern. E.ON also could have trouble continuing to invest its large amount of capital at value-creating returns, especially given the influx of cash it has received through its divestitures. For U.S. investors, appreciation in the dollar relative to the euro will depress the ADR shares.
Management & Stewardship
Management has faced numerous hurdles the past three years and has embarked on an aggressive restructuring plan. This makes it very difficult for investors to determine core financial performance since 2007; however, we think management has negotiated fair prices for its divestments, and we like that it has retained its most valuable power generation assets. E.ON historically has achieved returns on capital near 10%. That's likely to fall, but we still think management has the right balance of growth and cost management to maintain returns in the high single digits.
The German corporate governance structure includes a board of management, which oversees day-to-day operations, and a supervisory board, which acts like the board of directors for a U.S.-based company. E.ON's supervisory board has 20 members, each with five-year terms. German law requires shareholders elect 10 members and E.ON employees elect 10. The strong employee presence is common throughout all but eliminates shareholder activism.
E.ON's 10 shareholder-elected supervisory board members have high-level experience across many sectors. In 2011, the supervisory board approved Werner Wenning as chairman. He succeeded Ulrich Hartmann, who retired in May 2011 after being chairman of the supervisory board for the previous eight years and the CEO and chairman of the board of management for the preceding ten years. 
The board of management has six members, appointed to five-year terms by the supervisory board. CEO and chairman Johannes Teyssen assumed the role from Wulf Bernotat in May 2010 after Bernotat passed the standard retirement age (60) and his contract expired. Teyssen has held key management jobs at E.ON for many years, including COO since 2004, and we expect a smooth transition. We like that compensation for the supervisory board and the board of management includes variable components linked to dividends, earnings before interest and taxes, return on capital, and stock performance.
Overview
Financial Health: 
E.ON's strong balance sheet has allowed it to re-sign credit agreements and issue debt through the credit crisis. As it moves toward completing its plan to sell EUR 15 billion of investments in 2011-13, E.ON has cut its net debt nearly in half, supporting its premium credit rating even through a trough earnings period. If energy prices rebound from recent lows and management reaches its target of EUR 9.5 billion of controllable costs by 2015, we expect interest and dividend coverage to remain strong. We were not surprised that management decided to cut the 2011 dividend to EUR 1.00 per share from EUR 1.50 per share in 2010, given our projections for its payout ratio to fall below management's 50%-60% target range. In August 2012, management reaffirmed its plan to pay out a EUR 1.10 per share dividend for the 2012 fiscal year.
Profile: 
E.ON is one of the world's largest integrated power and gas companies. It generates, transmits, and distributes electricity and natural gas in 30 countries, primarily in Europe. As of 2010, the firm was the largest German gas company and generated one third of Germany's electricity, sourcing about 40% of this with nuclear power. However, the country's nuclear shutdown legislation will reduce E.ON's power generation share significantly.

"Ode 2 2012"

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"Ode 2 2012"
by Will Durst
"And so we bid a not-so-fond farewell to the bow of another large unwieldy year as it sinks slowly over the horizon wobbling unsteadily towards the graveyard of memory. And cheers erupt from we folks on shore waving the double-handed “L for loser” sign above our heads. “So long. See ya. Don’t let the door slam you in the butt on the way out. And if you got any brothers or sisters, don’t give them this address.”

Normally there’s some small sense of nostalgia for a departing annum. An iota of regret for the calendar discarded. Not this one. Getting through the past 12 months was like navigating a Black Diamond ski run in roller skates with the wheels rusted shut. While wearing a crib. It was an oil-soaked pelican of years. The Year of Living Stupidly. Had the same connection to constructive change that Vladimir Putin has to the editorial board of Crochet Monthly. The Chinese need a new Zodiac sign: Year of the Flatulent Weasel.

But in the interest of keeping this particular piece of puffery positive it might be best if we confine our remarks to reflecting on the good that emerged from 2012.

Okay. Well, that was quick. Wait — got one: at least the presidential election is over. Of course, people are already running for 2016, so we got that to look forward to. Which is real similar to looking forward to having five-year twins playing in the back seat of a cross-country drive with a new set of drums and an unlimited supply of metallic sticks. And tambourines. Tons of tambourines. For four years.

You’d think even your average run-of-the-mill politician would possess the simple common human decency to wait till the current president was re-inaugurated, but nooo. These early birds are intent on stockpiling worms. You know what they say: Early money is like yeast. And very early money is like baking soda. And extremely early money is an egg wash brushed delicately across a pan full of hot cross buns.

When you think about it, the only thing that really went right with 2012 was we misread the Mayan Calendar. Everything else is either worse than we found it or the same. Middle East a mess? Check. Crazy people with guns? Check. Weather getting weird? Check. Congress unable to accomplish any sort of worthwhile task, including differentiating between their gluteus maximus and yellow paint? Double check.

Face it. These days, simple survival has become the goal. Continuing existence is the new victory dance. And then for a half a second you ruminate on how good we got it here. What kind of state the rest of the world is in. And most of our problems just kind of fade away, don’t they?

Sure, with great potential comes great responsibility. But it’s an exciting time. Fifteen years ago, the only people with GPS units were NASA. Now we got them in our cars and phones. We’re also in the middle of a cheeseburger renaissance and pretty good coffee is available almost everywhere. Not half bad perks. So, what do you say? Shall we give another a year a shot? But just 365 this time around. Don’t know about you but that extra day this year kicked my butt.”- http://www.cagle.com/2012/12/ode-2-2012/

Life Skills: "How to Protect Your Energy"

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"How to Protect Your Energy"
By Judith Orloff MD
“As you go through the intuitive healing process you need to know: each of us has our own special power. We carry it within; it waits to be awakened. Call it your inner self, your spirit, or light–however conceived, you must meet and come to know your core-essence. The source of all intuition, it is your fiercest ally and advocate against danger. By connecting with this part of yourself you’ll mount confidence, feel safer in the world. Then whatever or whoever crosses your path–even the devil incarnate–will be no match for your resilience.

I want you to flush out beliefs that divert you from your intuitive healing power. Begin by asking yourself, “What in my life throws me off center and why?” I’m referring to everything from a stranger flashing you a dirty look, to fear of rejection, to dealing with someone in pain. Interactions where your energy dims. Weak spots, points that need securing. And what about negativity? How do you deal with yours, or another’s? If a supervisor says, “You’ll never be successful,” or an ex-lover announces, “You’re incapable of a healthy relationship,” do you buy into it? We each have our triggers. The basis for centering and protection is grasping where we get caught, and then disengaging the trigger.
․ Four common beliefs that drain your intuitive healing power:
1. I’m not strong enough to protect myself. As children, many of us aren’t taught to believe in the full power we contain. Yes, our parents may support our intelligence, talents, physical attractiveness–even teach us sound ethical values, the difference between right and wrong. But what happens to our inner self? Might even devoutly religious parents fail to realize it is there? Our starting point is to recognize we possess a very real internal source which enables us to deeply see and know. Yet when something goes wrong, frequently our first impulse is to look outside ourselves for someone to “fix” us. We get sick; we rush to the doctor. We become depressed; we call a therapist. We’re in pain; we take a pill. It’s fine to seek expertise–but we have it backwards. Look inside first. Really, it’s not a big blank in there. Then act on what your wisdom tells you. What stops us? A likely culprit is the vulnerable child we each carry within. Mogul or mailman, mother or monk, this aspect of our psyche yearns to be taken care of, protected, and is unequipped to do it alone. He pops up in the darndest circumstances, reducing us to a helpless tiny tot. Of course we must tenderly acknowledge her needs–but know where to draw the line. Would you want a baby running your boardroom? Your life? Remember: Your inner self is more than your inner child. Far grander–capable of ministering to all your needs–is the radiance of your spirit. Feeling this, knowing this, is the best protection of all. You must become your own champion before anyone else can. When you believe in yourself, no one else can diminish you.

2. Other people’s negative thoughts can harm me. In my workshops, I’m struck by how worried participants are about being thwarted by other people’s negative thoughts. Such concerns need to be addressed. On an intuitive healing level, ill intentions or feelings can affect us, creating anxiety or physical dis-ease. We must train ourselves to deflect them. What is negative energy? Any force antithetical to your well-being. How does it turn up in everyday life? Let’s start at the lower end of the spectrum. Your neighbor doesn’t approve of you. A friend puts down your plan to start college at forty. Your ex-boyfriend’s girlfriend is sending you bad vibes. What do you do?
․ Strategies to develop intuitive healing:
• Don’t lead a lifestyle based on assuming others are out to get you. This perpetuates fear.
• If someone is sending you negative thoughts, avoid dwelling on them. The more attention you pay to negativity, the more influence you give it.
• Focusing on the strength of your inner self is the best defense against negativity, no matter how dramatic its manifestation. If you are solidly connected to yourself, nothing can get you.

3. I’m too sensitive for my own good. The arch-enemy of intuition is lack of sensitivity. Know this: There is no such thing as being overly sensitive. To grasp the concept, you may have to reconfigure old ideas that have been drummed into your head. When parents or teachers said, “You have to toughen up,” or especially with boys, “only sissies cry,” unknowingly they were undermining the very crux of your intuitive tie with the world. Male sensibility, in particular, has been bludgeoned by such rigid conditioning. But, for both sexes, to break down childhood armoring requires extraordinary commitment, trust, and resolve.

What I’m speaking of isn’t simply expressing your emotions. It’s slowly learning, in your own time frame, to remain wide open to an intuitive realm–being one with the wind, the moon, other people’s joys, sorrows, the continuum of life and death. From this comes an intimate ecstatic bond with all of existence, exactly what you don’t want to protect yourself from. Sensitivity only turns against you when you feel overwhelmed. But how do you stay receptive and not get obliterated by the intensity of such input? It is possible to remain vulnerable and feel safe. The answer is never to shut your sensitivity off but to develop it as a creative resource.

4. It’s my job to take on the pain of others. We’re trained that as big-hearted people it’s laudable to try to relieve the pain of others. A homeless person holding a cardboard sign, “I’m hungry. Will work for food” at a busy intersection; a hurt child; a distraught friend. It’s natural to want to reach out to them, ease their angst. But many of us don’t stop there. Inadvertently, we take it on. Suddenly we’re the one feeling desolate, off kilter, bereft, when we felt fine before. This loss of center is what I want to address. It does not serve us. I am adamant: the most compassionate, effective route to healing people is to be a supportive presence, not attempt to live their pain for them. Moreover, sometimes suffering has its own cycle that has to be respected, hard as that may be to witness.

We must lie to rest the old metaphysical prototype of the empathic healer. Typically grossly obese women (extra weight, they mistakenly argued, was the only way to stay grounded), who cured patients by absorbing symptoms with the technique of laying on of hands. The result? Patients would leave feeling better; the healers would be a sickly wreck. These women were convinced such a sacrifice was necessary to lessen the suffering of others. As a young physician, I almost got snagged in the same trap. During the first months of private practice, I used to drag myself home, flop into bed half-dead from everything I’d absorb: a sure path to burn-out. This tack wasn’t good for me or my patients.

I’ve learned the value of being a catalyst for people’s growth without compromising my well-being. Patients themselves have taught me I can’t do the work for them. That is not my job. Nor is it yours. Keep this in mind: it is none of our business to deprive anyone else of their life experiences. I understand the impulse to want to make things better. Compassion and the desire to console are human. But there’s a fine line between supporting someone and trying to do it for them. No matter how well-meaning or heartfelt your intention, doing too much is not an act of love but of sabotage. You can be caring and honest with someone, yet still let them be. Don’t equate honoring their growth process with abandoning them. A practical philosophy of intuitive healing must include preserving your energy as well as serving others. Striking a balance is essential."- http://beforeitsnews.com/•Dr. Judith Orloff, an Assistant Clinical Professor of Psychiatry at UCLA, has helped patients find emotional freedom for over 20 years. She passionately asserts that we have the power to transform negative emotions and achieve inner peace.