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Stock Analyst Update

The Week in Stocks: MasterCard Rings up a Great Quarter

Plus, Canadian income trusts blow up, CVS and Caremark merge, and more.

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MasterCard's (MA) third-quarter results, announced Wednesday, came in above Morningstar analyst Ryan Batchelor's expectations, thanks to very strong credit card use volume. Earnings per share rose 80% from the year-ago period. After adjusting for legal settlement expenses incurred in last year's third quarter, operating profits jumped more than 40%, thanks to higher revenue and operating margin expansion. Revenue rose 14%, thanks to a 19% increase in transactions processed and a 15% increase in the dollar volume spent with MasterCards, partially offset by higher rebates and incentives that the firm provides to its customers. Although there was a slight decline in the number of credit card transactions processed, heavy debit card use more than made up for it. In short, Batchelor's thesis is playing out better than he expected. Therefore, he has raised his fair value estimate for MasterCard by $10.
 Full Analyst Report: MasterCard

Canadian Income Trusts Take a Dive
The Canadian finance ministry turned the income trust market upside down Tuesday when it proposed to eliminate the securities' tax advantages. For instance, under the proposal, current trusts will be taxed at a 31.5% rate starting in 2011, essentially eliminating the tax benefits they currently enjoy. This will deal a blow to Morningstar's fair value estimates for some of these companies, given that the higher tax outlays will reduce our long-term cash-flow projections. Another repercussion is that certain trust projects may no longer be economical under the new tax regime. For example, with a greater cost of capital, trusts may be forced to delay or abandon more-expensive oil and gas projects, and production may suffer.
 Full Analyst Report: Canetic Resources Trust
 Full Analyst Report: Enerplus Resources Fund
 Full Analyst Report: Harvest Energy Trust
 Full Analyst Report: Pengrowth Energy Trust
 Full Analyst Report: Penn West Energy
 Full Analyst Report: Primewest Energy Trust
 Full Analyst Report: Provident Energy Trust

CVS, Caremark to Merge
On Wednesday, CVS (CVS) and Caremark RX (CMX) announced their intention to merge, with Caremark shareholders receiving 1.67 shares of CVS for each share of Caremark. If consummated, the deal will create a company with $75 billion in annual sales that dispenses more than one fourth of the nation's prescriptions. Morningstar analyst Mitchell Corwin's initial take is that while the companies will gain a tremendous amount of scale that they can leverage to improve purchasing power, it's unclear whether that benefit will accrue to shareholders or consumers. For the time being, Corwin is placing his fair value estimate for CVS and Caremark under review while he analyzes the financial implications of the transaction in more detail.
 Full Analyst Report: Caremark RX
 Full Analyst Report: CVS

No Pain, Plenty of Gains in Cephalon's Third-Quarter Results
Cephalon's (CEPH) third-quarter results blew Morningstar analyst Heather Brilliant's estimates out of the water. Third-quarter sales growth increased by an impressive 56%, helped by strong growth in its central nervous system and pain franchises. Profitability increased impressively, with the operating margin reaching 31.4%, about double last year's. Brilliant thinks Fentora--Cephalon's recently launched medicine for breakthrough pain in cancer patients that is intended to replace Actiq--will bolster growth and already appears to be off to a very strong start. Cephalon had some disappointing announcements earlier in the year, namely poor results for a few of the drugs in its pipeline. Further, as reported in Friday's Wall Street Journal, its drugs may be used widely for off-label indications, a practice the Food and Drug Administration frowns upon. Thus, Brilliant plans to weigh these countervailing issues against the Cephalon's strong growth this year in adjusting her fair value estimate.
 Full Analyst Report: Cephalon

Cadbury Schweppes Revises Financial Targets
Ahead of its investor meetings in London and New York, Cadbury Schweppes (CSG) announced new financial targets for 2007 and beyond. Morningstar analyst Mitchell Corwin was not surprised to see the company scrap its annual operating margin improvement goal of 50-75 basis points. Further, Corwin believes that a difficult commodity environment and the need to increase spending behind marketing and innovation to drive sales growth make consistent margin expansion an unrealistic expectation in the future. Yet, with nearly 10% market share in worldwide confectionery, Corwin thinks Cadbury remains well positioned to build upon its solid foundation and deliver strong returns for investors over the long run. Thus, after revisiting his assumptions in full after the company made its presentations, Corwin left his fair value estimate unchanged.
 Full Analyst Report: Cadbury Schweppes

Cutting Our Fair Value Estimate for Whole Foods
Morningstar analyst Mitchell Corwin thought Whole Foods Market (WFMI) was being overly cautious in the prior quarter when it announced expectations of 15%-20% sales growth for fiscal 2007 despite an anticipated acceleration in square-footage growth. It turns out that those targets were too ambitious. Declining comparable-store sales growth trends and a back-loaded store-opening schedule next year caused the company to modify its expectations for 2007 sales growth to 13%-17% when it reported fourth-quarter results Thursday. While Corwin continues to find Whole Foods' long-term prospects compelling and doesn't subscribe to the notion that the growth engine is losing steam (as the firm is nowhere near its saturation point and its stores deliver easily the most-compelling food-shopping experience, in his opinion), he can't ignore the impact of what is likely to be a weak fiscal 2007. Thus, he's lowering his fair value estimate for the company's shares by $13.
 Full Analyst Report: Whole Foods Market

Novell, Microsoft Collaboration Is More Smoke than Fire
In the past, Microsoft (MSFT) has competed bitterly with Linux-based software companies distributing and supporting open-source alternatives to Microsoft platforms, particularly Red Hat (RHAT) and Novell (NOVL). On Thursday, the company did an about-face in signing a collaboration agreement with Novell, thereby tacitly legitimizing Linux in the enterprise architecture. The partnership's intent makes sense in the view of Morningstar analyst Rick Summers. For instance, many customers of both companies run both Linux and Windows (Microsoft) platforms. Thus, the technical collaboration would ostensibly ensure that the separate platforms can coexist and allow for more-seamless management. It also should assure customers that they can continue running both Linux and Windows in their environment with Microsoft's reluctant approval. Yet, execution of the deal is another matter. For instance, Summers notes that no new product announcements were made in conjunction with the establishment of the new partnership. What's more, the road from collaboration to better products can be long and rocky. Yet, neither company seems to be making a meaningful investment. As such, Summers doesn't expect the agreement to drive additional revenue for either company. For that reason, he and fellow analyst Toan Tran are sticking with their fair value estimates for Novell and Microsoft, respectively.
 Full Analyst Report: Microsoft
 Full Analyst Report: Novell

Roundup of This Week's Feature Commentary
Tuesday brought some unfavorable news for investors in Canadian income trusts like Pengrowth Energy Trust (PGH). The Canadian government--already smarting over hundreds of millions of dollars in lost tax revenue from these tax-favored trusts--moved to equalize the tax treatment of income trusts and traditional corporations. The finance ministry's proposal would give existing trusts until 2011 to adjust to the new tax rules, while trusts forming right now (such as BCE (BCE) and Telus (TU)) would have to start paying taxes right away in 2007. Not surprisingly, the New York-listed trusts were down sharply this week. Morningstar DividendInvestor equity strategist Josh Peters believes this validates, at least in part, the skeptical attitude he's had toward these securities. In this piece, Peters reiterates why he's been leery of Canadian income trusts and describes the implications, if any, this development could have on tax-favored U.S. entities like REITs and master-limited partnerships. In addition, Peters passes along a  note that Morningstar analyst and Canadian income trust expert Kish Patel wrote to describe the unfolding situation.
Caution Is Rewarded Again

In this piece, Morningstar director of stock research Pat Dorsey discusses how investors can profit from stock options. Dorsey walks through the nuts-and-bolts of options investing and explains how investors can gain an edge using options by keeping a steady eye on company fundamentals rather than market volatility. To make his point, Dorsey presents a real-life example and ticks off some other interesting options-investing opportunities.
Your Edge with Options

With all the books in print (200,000 new ones published last year alone), what could Christopher Browne's The Little Book of Value Investing add? If you ask Morningstar analyst Matt Nellans, almost nothing--but that's the point. As Nellans observes, the value investing framework somewhat obviates the need for relentless innovation. After all, buying stocks for less than they're worth is an easy concept to grasp and the idea doesn't need much scholarly refinement. Maybe, Nellans muses, that's why few business schools offer value investing classes. Nevertheless, Nellans offers his own take on Browne's contribution to the value-investing canon in this spirited, insightful review.
Christopher Browne's "Little Book of Value Investing"

Alleghany's (Y) shrewd value-investing philosophy, talented management team, and information advantages at its insurance subsidiaries endow favorable prospects. Morningstar director of stock research, Pat Dorsey, pounds the table for this "miniature Berkshire Hathaway" in a video report.
Video Report: Alleghany

This Week's 10 Most Popular Stock Analyses
 Apache (APA)
 Carpenter Technology (CRS)
 Expeditors International of Washington (EXPD)
 Getty Images (GYI)
 MasterCard (MA)
 The Western Union Company (WU)
 Microsoft (MSFT)
 Newfield Exploration (NFX)
 Genzyme (GENZ)
 Cemex SAB de CV (CX)

Jeffrey Ptak has a position in the following securities mentioned above: MSFT. Find out about Morningstar’s editorial policies.