MARKET DIGEST

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FRIDAY, NOVEMBER 17, 2017NOVEMBER 16, DJIA 23,458.36

UP 187.08

Good Morning. This is the Market Digest for Friday, November 17, 2017, with analysis of the financial markets and commentson Unilever N.V., Cisco Systems Inc., NetApp Inc., PayPal Holdings Inc., Twenty-First Century Fox Inc. and WalgreensBoots Alliance Inc.

IN THIS ISSUE:* Initiation of Coverage: Unilever N.V.: Launching coverage with a HOLD rating (Stephen Biggar and Phil Seligman)

* Growth Stock: Cisco Systems Inc.: Returning to revenue growth; raising target to $44 (Jim Kelleher)

* Growth Stock: NetApp Inc.: Hyper-converged, flash resonating; raising target to $60 (Jim Kelleher)

* Growth Stock: PayPal Holdings Inc.: Raising target by $7 to $87 (Stephen Biggar)

* Value Stock: Twenty-First Century Fox Inc.: Mixed fiscal 1Q18; maintaining HOLD (Joseph Bonner)

* Value Stock: Walgreens Boots Alliance Inc.: Maintaining HOLD rating and FY18 estimate (Chris Graja)

MARKET REVIEW:Stocks rallied on Thursday following strong earnings from Cisco and Wal-Mart and new industrial production and

employment data. The House passed its version of the tax-cut bill, as expected, though the legislation still faces significant hurdlesin the Senate. On the employment front, the Labor Department said that first-time unemployment claims rose by 10,000 to 249,000for the week ended November 11, above the Bloomberg consensus forecast of 235,000. The Dow rose 0.80%, the S&P 0.82%,and the Nasdaq 1.3%. Crude oil fell slightly to about $55 per barrel, while gold traded near $1278 per ounce.

2016 - DJIA: 19,762.60

1934 - DJIA: 104.04

Independent Equity Research Since 1934ARGUS

A R G U S R E S E A R C H C O M P A N Y • 6 1 B R O A D W A Y • N E W Y O R K , N. Y. 1 0 0 0 6 • ( 2 1 2 ) 4 2 5 - 7 5 0 0LONDON SALES & MARKETING OFFICE TEL 011-44-207-256-8383 / FAX 011-44-207-256-8363

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MARKET DIGEST

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UNILEVER N.V. (NYSE: UN, $56.96)................................................................................... HOLD

UN: Launching coverage with a HOLD rating

* We expect Unilever, a leader in the consumer products industry, to benefit from new product launches, expansionin emerging markets, and ongoing efforts to improve productivity.

* However, UN shares have risen 40% year-to-date and appear fully valued relative to peers.

* Management projects underlying sales growth of 3%-5% in 2017, above its forecast of 2% growth for the industryas a whole. The company also appears on track to reach its operating margin target of 20% by 2019.

* Although Unilever boosted its payout by 12% in 1Q17, the annualized dividend yield of 2.7% (down from 3.7% inOctober 2016) may be too low to attract income-oriented investors.

ANALYSISINVESTMENT THESISWe are initiating coverage of Unilever N.V. (NYSE: UN), a leading international consumer products company, with a

near-term HOLD rating. Looking ahead, we expect Unilever to benefit from new internally developed or acquired products,further expansion in emerging markets, and ongoing efforts to improve productivity. However, UN shares have risen 40% year-to-date and appear fully valued relative to peers. In addition, although the company boosted its payout by 12% in 1Q17, theannualized dividend yield of 2.7% (down from 3.7% in October 2016) may be too low to attract income-oriented investors. Basedon these factors and the absence of near-term catalysts, we believe that a HOLD rating is appropriate. We note that Unilever, whichrejected a bid from Kraft Heinz earlier this year, remains a potential acquisition target.

RECENT DEVELOPMENTSUN shares have outperformed year-to-date, surging 40% while the S&P 500 has risen 14%. The shares have a beta of

0.84.On July 20, Unilever reported a 1H17 adjusted net profit attributable to shareholders’ equity of 3.206 billion euros

(US$3.466 billion) or 1.13 euros (US1.22) per diluted share, up from 2.812 billion euros (US$3.138 billion) or 0.99 euros(US$1.10) per share a year earlier. EPS topped the consensus estimate of 1.10 euros (US$1.19).

Underlying sales in the first half rose 3.0% year-over-year, which management believes is faster than overall industrygrowth. Reported sales rose 5.5% to 27.7 billion euros, aided by a 1.7-percentage-point positive currency impact and 0.8-percentage-point benefit from acquisitions, net of divestitures. However, underlying sales growth was driven entirely by priceincreases, as higher volume in the Home Care and Refreshment segments was offset by lower volume in the Foods segment. (Inthe Personal Care segment, volume was flat.) Management expects stronger volume growth and more moderate price hikes in2H17.

Underlying operating profit rose 17.1% in the first half, and the underlying operating margin expanded by 180 basispoints to 17.8%. The reported operating margin rose 310 basis points, to 17.5%. The gross margin grew 40 basis points, to 43.1%.

For all of 2016, sales fell 1.0% to 52.713 billion euros (US$58.564 billion). However, excluding negative currency effectsand the impact of divestitures and acquisitions, sales rose 3.7%. The gain reflected a 2.8-percentage-point contribution from higherpricing and a 0.9-point impact from volume growth.

The company has four business segments: Personal Care, Home Care, Foods, and Refreshments. Segment results for1H17, excluding the impact of M&A, are summarized below.

In Personal Care, underlying sales rose 2.6%, to 27.7 billion euros, driven entirely by price increases. The underlyingoperating margin rose 240 basis points, which management attributed to brand improvements and marketing efficiencies.

In the Home Care segment, underlying sales grew 3.3%, with a 2.5-percentage-point impact from price increases anda 0.8-point impact from higher volume. The underlying operating margin rose 110 basis points, driven by a higher gross marginand greater marketing efficiencies.

In the Refreshments segment, underlying sales rose an impressive 6.1%, with a 4.9-percentage-point contribution fromhigher pricing and a 1.2-point impact from higher volume. The underlying operating margin rose 230 basis points on higher grossmargins for ice cream and tea.

In the Foods segment, underlying sales rose 0.6% as higher pricing more than offset lower volume. The underlyingoperating margin expanded by 100 basis points, mainly on improved marketing efficiencies. The segment has a strong presencein the foodservice industry and continues to modernize its portfolio and expand into emerging markets.

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Third-quarter reported sales declined 1.6% from the prior year, which included a negative currency impact of 510 basispoints. Underlying sales grew 2.6% for the quarter, driven by a 240-basis-point contribution from higher pricing and a 20-basis-point contribution from higher volume. Underlying sales for the nine-month period rose 2.8%.

In February 2017, Kraft Heinz offered to acquire Unilever for $143 billion in cash and stock, representing an 18%premium to UN’s closing price prior to the announcement. Although Unilever rejected the offer, it could again become anacquisition target. Meanwhile, the failed takeover attempt appears to have spurred management to improve performance.

On April 6, the company announced that it would use M&A to further strengthen its portfolio of businesses, review itslegal structure, spend 5 billion euros on stock buybacks by the end of 2017, raise its dividend, and target an underlying operatingmargin of 20% by 2020. It also raised its target for cumulative cost savings by 2019 to 6 billion euros from a prior 4 billion euros.It expects to achieve these savings through more efficient manufacturing, product reformulations, and improved supply-chainmanagement. It plans to divest the underperforming spreads business (not including Hellman’s Mayonnaise); combine the Foodsand Refreshments segments; and review its maintenance of dual corporate headquarters in Rotterdam and London, which makesM&A deals more complex and has been further complicated by Brexit.

According to an October 5 New York Times article, Unilever has invited private equity firms to submit bids for its spreadsbusiness, with a projected sales price of about 6 billion pounds ($7.87 billion). Management expects to finalize the deal by theend of the year. The proceeds will likely be used to cover restructuring costs or pay for new acquisitions. On September 22,Unilever also announced that it would acquire South African holding company Remgro Ltd.’s 26% interest in Unilever SouthAfrica in exchange for the Unilever South Africa spreads business, plus a cash consideration.

While Unilever has always been active in M&A, it appears to be stepping up the pace of acquisitions, albeit with a focuson niche businesses. From April to early October 2017, it announced six deals, completed one of these transactions, and establisheda joint venture to expand its operations in Myanmar.

EARNINGS & GROWTH ANALYSISUnilever management projects 2017 underlying sales growth of 3%-5%, above its forecast of 2% growth for the industry

as a whole. Sales rose 2.8% in the first nine months of 2017, almost all driven by price increases, as volume gains in some regionswere offset by declines in others. Management expects volume to accelerate and price increases to moderate in the second halfof the year.

Unilever appears on track to reach its target 20% operating margin by 2019. It generated cost savings of 1 billion eurosin the first half of the year, and expects to boost its full-year operating margin by 100 basis points, up from the 80 basis pointsprojected in April. That said, it expects margins to face pressure in the second half from higher product development and marketingcosts. As noted above, the company expects to generate 6 billion euros in cumulative cost savings by 2019. It plans to invest abouttwo-thirds of these savings into the business, with the remaining 2 billion euros dropping to the bottom line.

Turning to our estimates, we project 2017 revenue of 54.3 billion euros (US$60.8 billion) and EPS of 2.24 euros(US$2.51). In 2018, we look for revenue growth of 3.5%, to 56.2 billion euros (US$64.1 billion), and EPS of 2.47 euros (US$2.82),up 10.3% from our 2017 forecast. Given the company’s active M&A program and the likely sale of the spreads business, we expectlong-term revenue growth, excluding currency effects, to be near the high end of management’s 2017 forecast of 3%-5% growth.We see net earnings growing at a slightly faster pace, driven by solid cost controls, productivity gains, and an improved revenuemix.

FINANCIAL STRENGTH & DIVIDENDWe rate UN’s financial strength as Medium-High, the second-highest rank on our five-point scale. The company’s long-

term credit is rated A1 stable by Moody’s, A+ negative by Fitch, and A+ stable by Standard & Poor’s.Long-term debt totaled 18.4 billion euros (US$20.3 billion) at the end of 1H17, compared to 14.3 billion euros (US$16.3

billion) a year earlier. Short-term debt was 5.1 billion euros (US$5.6 billion) at the end of the first half, compared to 5.8 billioneuros (US$6.6 billion) at the end of 1H16. The long-term debt/cap ratio was 52.2% at the end of 1H17, up from 48.6% a year earlier.

Cash and cash equivalents totaled 5.0 billion euros (US$5.6 billion) at the end of 1H17, compared to 3.1 billion euros(US$3.6 million) a year earlier. Unilever is also generating solid free cash flow (1.4 billion euros or US$1.5 billion in 1H17) thathas allowed it to raise its dividend and boost contributions to its pension plan. The company remains in compliance with all debtcovenants.

The current annualized dividend is 1.43 euros ($1.66). The current yield in U.S. dollars is 2.9%, down from about 3.7%last October as the stock price has risen. The payout ratio is 65% based on our 2017 EPS estimate. The company raised its dividendby 12% in 1Q17 and by 6% in 1Q16. Our U.S. dollar dividend estimates are $1.66 for 2017 and $1.85 for 2018.

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RISKSUnilever, which does business in 190 countries, faces increased competition from startup companies as well as from local

rivals in many international markets. It also faces risks from changing economic conditions, unfavorable currency translation,volatile commodity markets, and political uncertainty. The company is also subject to regulations related to the acquisition of localbusinesses, as well as to a wide range of labor and environmental regulations.

COMPANY DESCRIPTIONUnilever N.V. is a leading international consumer goods company, and one of the largest providers of personal care

products. It operates through four segments: Personal Care, Foods, Home Care, and Refreshments. Leading brands include Dove,Lifebuoy, Hellman’s, Knorr, Lipton, and Ben & Jerry’s. The company is based in the Netherlands and the U.K. (where it operatesunder the name Unilever plc) and has approximately 170,000 employees worldwide. It posted 2016 sales of $58.7 billion.

INDUSTRYWe have lowered our rating on the Consumer Staples sector to Under-Weight from Market-Weight. Investors are voting

with their feet in this sector, recently reducing the sector’s weighting in the S&P 500 to a multiyear low of 8.5%. We note thatconsumers who shifted to generic products when money was tighter are simply not returning to familiar brand names. The sectoraccounts for 8.5% of the S&P 500, with a five-year range of 9%-13%. We think investors should consider allocating 7%-8% oftheir diversified portfolios to this group. The sector includes industries such as food, beverages, household products and grocerystores. The sector underperformed in 2016, with a gain of 2.6%, but outperformed in 2015, with a gain of 3.8%. It isunderperforming the market thus far in 2017, with a gain of 7.4%.

According to our models, the projected P/E ratio on 2018 earnings is 19.5, ahead of the market multiple of 17.1. Sectorearnings are expected to increase 8.2% in 2018 and 7.5% in 2017 after rising 4.2% in 2016. The sector’s debt ratios are reasonable,with an average debt-to-cap ratio of 45%, in line with the market average. Yields of 2.9% on average are higher than the market’syield of about 2.0%.

VALUATIONUN shares have traded between $39 and $61 over the past year and are currently near the top of that range. On valuation,

the shares are trading at 22.7-times our 2017 EPS estimate, above the average multiple of 18.6 for a peer group of householdproducts companies (Colgate, Kimberly-Clark, and Newell Brands), and the average of 18.6 for a foods and refreshments peergroup (General Mills, Kraft Heinz, and ConAgra). The shares also trade at 20.2-times our 2018 forecast, above the multiples of17.2 for the household products group and 17.8 for the foods and refreshments group. Although we believe that these premiumsare warranted based on Unilever’s potential as a takeover target and management’s efforts to improve results, we do not expectthe shares to outperform over the next year. As such, we are initiating coverage with a HOLD rating.

On November 16, HOLD-rated UN closed at $56.96, up $0.24. (Stephen Biggar and Phil Seligman, 11/16/17)

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CISCO SYSTEMS INC. (NGS: CSCO, $35.88) ........................................................................ BUY

CSCO: Returning to revenue growth; raising target to $44

* CSCO shares popped 6% after Cisco Systems posted revenue and non-GAAP EPS that topped consensusestimates.

* Cisco has introduced significant innovation in recent quarters, including Intersight, a data center automationsolution, and the Network Intuitive, Cisco’s intent-based networking solution (IBNS).

* Cisco is well-positioned to help customers transition their network and data center applications to a hybrid cloudenvironment. Cisco is also encouraging customer transitions to subscription-based services, driving higher levelsof recurring revenue.

* Despite finally recapturing multiyear highs above $36, CSCO shares trade at just a modest premium to historicalrelative P/E valuations, and at a discount to DFCF valuation.

ANALYSISINVESTMENT THESISBUY-rated Cisco Systems Inc. (NGS: CSCO) rose 6% after reporting fiscal 1Q18 results that indicate early success in

the company’s efforts to transform its business model. Revenue for fiscal 1Q18 (ended October 2017) of $12.14 billion declinedless than 2% annually but nipped the consensus call of $12.11 billion. Non-GAAP EPS of $0.61 was down less than 1% year-over-year and a penny ahead of consensus.

Cisco has realigned its product categories to better align with the company’s evolving business model. The core of theproducts business, Infrastructure Platforms (switching, routing, data center, and wireless) declined in mid-single digits year-over-year, consistent with general trends in switching & routing. The application business, which includes collaboration, telepresence,IoT, analytics and UC, rose in double digits.

Within product revenue, overall software revenue advanced 8%, offsetting equipment sales weakness. Cisco like alltechnology companies is seeking to move away from “hand-off” product sales and to shift to recurring revenue and, in software,to subscription-based sales. A key measure of this success is deferred revenue; for 1Q18, deferred product revenue was up 16%,led by high-30% growth in deferred software & subscriptions revenue.

Cisco has introduced significant innovation in recent quarters, including Intersight, a data center automation solution,and the Network Intuitive, Cisco’s intent-based networking solution (IBNS) designed to bring intelligent provisioning, automatedmanagement, granular customization, AI-based adaptation and security to network architecture. The Network Intuitive hasalready gained 1,100 customers in three months.

These subscription-based offerings are key to driving recurring revenue. In our view, Cisco is well-positioned to helpcustomers transition their network and data center applications to a hybrid cloud environment, aided by the new innovations anda robust M&A strategy.

Cisco guided for a 1%-3% annual sales gain for fiscal 2Q18; if that sales goal is met, Cisco would post its first positiverevenue comparison in eight quarters. As the product mix begins to reflect a richer software contribution and becomes moresolutions-based, we look for gradual margin expansion. We believe Cisco can grow non-GAAP EPS in low single digits in FY18,with slight acceleration in FY19.

Despite finally recapturing multiyear highs above $36, CSCO shares trade at just a modest premium to historical relativeP/E valuations, and at a discount to DFCF valuation. We are reiterating our BUY rating to a 12-month target price of $44 (raisedfrom $41).

RECENT DEVELOPMENTSCSCO shares are up 19% year-to-date in 2017, while the Argus communications equipment peer group is up 7%, and

the S&P 500 is up 15%. Cisco shares rose 11% in 2016, compared to a 9% peer group gain. CSCO declined 2% in 2015 whilethe peer group dropped 6%, and rose 24% in 2014, better than the 1% average peer-group gain. CSCO rose 14% in 2013 and 9%in 2012, after falling 11% in 2011 and 16% in 2010.

For fiscal 1Q18 (ended October 28, 2017), Cisco reported revenue of $12.14 billion, which was down 2% on a GAAPbasis and sequentially stable. Fiscal 1Q18 revenue was squarely within management’s implied guidance range of $11.98-$12.23billion; revenue slightly topped the $12.10 billion consensus forecast.

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Non-GAAP earnings totaled $0.61 per diluted share, which was down less than 1% year-over-year and up one centsequentially. Non-GAAP EPS was at the high end of management’s $0.59-$0.61 guidance range and topped the consensus forecastby a penny.

Cisco has realigned its product categories to better align with the company’s evolving business model. The core of theproducts business, Infrastructure Platforms, includes four formerly discrete businesses: switching, routing, data center, andwireless. Infrastructure Platforms revenue of $6.97 billion (57% of total) declined 4% annually while remaining sequentiallystable. The bulk of the decline was in routing, primarily for service provider customers and to a lesser extent for enterprisecustomers.

Within infrastructure Platforms, Cisco faces the common quandary of transitioning customers to new solutions-basedapproaches while managing the roll-off and wind-down of mature product categories. In June, Cisco launched Network Intuitive,which automates provisioning and customization in network applications. In September, Cisco introduced Intersight, a data centerautomation solution. The Network Intuitive launch generated good order momentum in campus switching.

While Intersight is just getting started, the Catalyst 9000 switching platform that powers Network Intuitive has alreadyattained 1,100 customers, according to CFO Kelly Kramer. Most Catalyst 9000 customers are using the product on a subscriptionbasis, and are pairing it with Cisco’s most advanced software.

The second-largest product category is applications, which includes collaboration, telepresence, IoT, analytics andUnified Communications. Applications revenue (10% of total) was up 6% annually and flat sequentially. Applications are centralto every business strategy, according to Cisco, and are most effective deployed across a highly secure network that can monitorperformance across a complex multi-cloud environment.

M&A is an important part of Cisco’s business portfolio evolution. Cisco’s $3.9 billion acquisition of (pre-public)AppDynamics in spring 2017 provides end-to-end network analytics across the network from data center to application. Ciscorecently acquired Perspica to enhance machine-learning capabilities across the portfolio. And Cisco’s planned acquisition ofBroadSoft, announced in October, will strengthen Cisco in cloud-based PBX (business telephony), unified communications,collaboration and call center. All three of these companies are or will be part of the Applications segment.

Security (5% of revenue), an unchanged category, grew revenue 8% year-over-year and 5% quarter-over-quarter. Ciscoaims to provide a comprehensive solution across network, data center and hybrid cloud. The other category, which houses theService Provider Video (SVP) business along with some emerging technologies, declined 16% annually while representing lessthan 3% of revenue.

Services revenue (25% of total) edged up 1%, driven by growth in software & solutions services. A key focus in Servicesis generating return business and recurring revenue.

For Cisco overall in 1Q18, recurring revenue of $3.88 billion was up 3% annually and was equivalent to 32% of totalrevenue. The shift in the business model away from “hand-off” Product sales and to ongoing solutions-based relationships ispositively reflected in deferred revenue trends, which are recorded on the balance sheet.

For Cisco overall, current and non-current deferred revenue of $18.57 billion as of quarter-end 1Q18 was up 10%annually. While services revenue was up just 1%, Services deferred revenue (59% of deferred revenue) was up 5% annually.

Total product deferred revenue (41% of deferred revenue) advanced 16% year-over-year. That included a 37% jump indeferred product revenue from software & subscriptions. As a higher proportion of revenue shifts to recurring and is booked asdeferred revenue, Cisco should be better able to plan and allocate operating costs and to drive higher margins.

For 2Q18, Cisco forecast 1%-3% year-over-year revenue growth and non-GAAP EPS of $0.58-$0.60 per diluted share,which at the midpoint would be up 4% annually.

As the product mix begins to reflect a richer software contribution and becomes more solutions-based, we look forgradual margin expansion. We believe Cisco can grow non-GAAP EPS in low single digits in FY18, with slight acceleration inFY19.

EARNINGS & GROWTH ANALYSISFor fiscal 1Q18 (ended October 28, 2017), Cisco reported revenue of $12.14 billion, which was down 2% on a GAAP

basis and sequentially stable. Fiscal 1Q18 revenue was squarely within management’s implied guidance range of $11.98-$12.23billion; revenue slightly topped the $12.10 billion consensus forecast.

The non-GAAP gross margin for 1Q18 was stable sequentially with 63.7% in 4Q17, while declining 65.2% in the year-earlier quarter. Gross profit declined from the prior year because of weaker high-margin carrier routing sales; higher input costsfor DRAM; and other mix factors. Reflecting gross margin compression along with impacts from recent substantive acquisitions,the non-GAAP operating margin narrowed to 30.4% in 1Q18 from 31.4% in 4Q17 and from 31.6% in the year-earlier quarter.

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Non-GAAP earnings totaled $0.61 per diluted share, which was down less than 1% year-over-year and up one centsequentially; lower taxes and lower share count helped moderate the operating income decline. Non-GAAP EPS was at the highend of management’s $0.59-$0.61 guidance range and topped the consensus forecast by a penny.

For all of FY17, revenue of $48.01 billion declined 2.5% from $49.25 billion in FY16. Non-GAAP earnings of $2.39per diluted share for FY17 rose 1.2%.

For 2Q18, Cisco forecast 1%-3% year-over-year revenue growth, which would equate to sales of $11.7-$11.9 billion.If that sales goal is met, Cisco would post its first positive revenue comparison in eight quarters. Non-GAAP gross margin wasforecast at 62.5%-63.5%; non-GAAP operating margin at 29.5%-30.5%; and non-GAAP tax provision at 22%, consistent with1Q18 and FY17.

Non-GAAP EPS was guided to $0.58-$0.60 per diluted share, which at midpoint would be up 4% annually. At respectiveguidance midpoints, revenue of $11.8 billion was $100 million above pre-reporting consensus, while non-GAAP EPS was a pennyabove the pre-reporting Street forecast.

Cisco expects cost pressures, particularly for DRAM memory, to persist across 2Q18 and potentially into comingquarters. Given the likely negative impact on gross margins, we are moderating our FY18 earnings projection to $2.47 per dilutedshare, from $2.52. Although we expect increasing software mix to drive low to mid-single-digit growth in FY18 non-GAAP EPS,off the lower base, we are reducing our FY19 non-GAAP EPS estimate to $2.60 per diluted share from $2.62. Our estimates assume3% non-GAAP EPS growth in FY18 and 5% growth in FY19.

Our GAAP EPS estimates are $1.94 for FY18 and $2.17 for FY19. Our five-year earnings growth rate forecast is 8%,reduced from 9%.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for Cisco is High, the top of our five-point scale. The ranking is under review, given Cisco’s

rising debt load. Cisco also has a large offshore cash position which may be impacted by future tax reform. On that basis, we willlikely hold off on any change in financial strength ranking until any new tax policy is in place.

Cash was $71.6 billion at 1Q18. Cash was $70.49 billion at the end of FY17, $65.8 billion at the end of FY16 and $62.2billion at the end of FY15.

Debt was $35.9 billion at 1Q18. Debt was $33.72 billion at the end of FY17, $28.6 billion at the end of FY16, and $25.3billion at the end of FY15. Cisco initially took on $6.3 billion in long-term debt in FY05 to pay for its Scientific-Atlanta acquisition.

Cash flow from operations was $13.88 billion in FY17, $13.57 billion in FY16, and $12.55 billion in FY15.In fiscal 2017, Cisco returned $9.2 billion to shareholders, including $3.7 billion in share repurchases and $5.5 billion

in dividends. Cisco returned $8.7 billion to shareholders in FY16, representing 75% of free cash flow. Returns included $3.9 billionin buybacks and $4.8 billion in dividends. Cisco spent $4.2 billion on stock buybacks in FY15, $9.5 billion in FY14, and $6.1billion in FY13. It has spent about $97 billion on repurchases since launching its buyback program.

Cisco announced a 12% increase in its quarterly dividend, to $0.29 per share, in February 2017. Cisco previously hikedits quarterly dividend by 24% to $0.26 per share in February 2016. This follows a 10.5% hike in February 2015, to $0.21, and a12% hike in February 2014, to $0.19. Cisco initiated its dividend in March 2011 at a quarterly rate of $0.06 per share.

We estimate that Cisco will spend $6.1 billion on dividends in FY18 and $6.6 billion in 2019. Cash flow from operationsis expected to cover the dividend in both years by a factor of 2.1-2.2.

Our annual dividend estimates are $1.22 for FY18 and $1.34 for FY19.MANAGEMENT & RISKSChuck Robbins became CEO in July 2015. Mr. Robbins has been at Cisco since 1997 and previously served as SVP of

Worldwide Operations, where he led the global sales and partner team. Kelly Kramer became CFO in calendar 2014.Investments in Intersight or in IBNS may not be validated in the market or may be superseded by other technologies. We

see these investments as nonetheless vital to Cisco’s future, as the ever-enveloping cloud creates new paradigms for the network,the data center, and the company.

Cisco risks “cutting into muscle” when it restructures its core businesses of routing and switching. Over the years, Ciscohas a very good track record in directing investments into promising growth areas, and we regard the new program as more of thesame.

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In June 2015, Cisco announced a new executive leadership team, composed of 10 senior executives chosen by incomingCEO Chuck Robbins. Among the current leaders, Pankaj Patel is chief development officer and remains head of engineering;Rebecca Jacoby is SVP Operations; Hilton Romanski is chief technology and strategy officer; Karen Walker is chief marketingofficer; and Chris Dedicoat is SVP Worldwide Sales. The company further redefined its growth goals in March 2016, resultingin the restructuring program announced in August 2016.

CEO Robbins’ appointment of a new executive team is both sensible and decisive, though not without risks. Despite theabsence of seasoned leaders from an earlier generation, the new team is full of seasoned executives and should be well preparedto enact a fully next-generation strategy for an evolving technology world.

The push into cloud computing levers Cisco’s existing networking and data center investments, and in our view carriesless risk than prior stand-alone expansions into new markets (i.e., the ill-fated push into the consumer electronics space). Morebroadly, by serving every segment of the communications equipment marketplace, Cisco is at risk if the fragile recovery inequipment demand fizzles out. The costs of supporting such a broad-brush product portfolio are considerable. We believe thatthese risks are offset by the company’s extensive relationships with communications equipment buyers, as well as by itstechnology leadership, aggressive but prudent business development program, and strong balance sheet.

COMPANY DESCRIPTIONCisco is a worldwide leader in communications equipment. Originally created to provide routers and switches for

Ethernet-based data networks within enterprises, the company has expanded into virtually every niche of the networking marketand into information processing as well. Fiscal 2016 sales were $49.2 billion.

INDUSTRYWe have raised our rating on the Technology sector to Over-Weight from Market-Weight. Technology is showing clear

investor momentum, topping the market in the year-to-date and trailing one-month and three-month periods. At the same time,the average two-year-forward EPS growth rate exceeds our broad-market estimate and sector averages. This has kept technologysector valuations from becoming too rich, and resulted in PEG ratios that are below the median for all sectors.

Over the long term, we expect the Tech sector to benefit from pervasive digitization across the economy, greateracceptance of transformative technologies, and the development of the Internet of Things (IoT). Healthy company and sectorfundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad internationalbusiness exposure.

In terms of performance, the sector rose 12.0% in 2016, above the market average, after rising 4.3% in 2015. The sectoris outperforming thus far in 2017, with a gain of 23.7%.

Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2018earnings is 17.5, above the market multiple of 17.1. Earnings are expected to grow 14.8% in 2018 and 29.3% in 2017 followinglow single-digit growth in 2015-2016. The sector’s debt ratios are below the market average, as is the average dividend yield.

VALUATIONCSCO trades at 14.7-times our FY18 non-GAAP EPS forecast and at 14.0-times our FY19 projection; the two-year

average forward P/E of 14.3 exceeds the five-year (2013-2017) average multiple of 11.6. In a fast-rising market, however, relativeP/E is only slightly above historical norms. On a forward two-year basis, Cisco is trading at 77% of the market P/E, comparedwith its five-year historical average of 71%. Comparable analysis suggests a value in the high $20s to low $30s, in slightly risingtrend.

Our discounted free cash flow valuation exceeds $50, in a stable to slightly rising trend as global caution is partly offsetby the company’s strong cash generation and continued operating efficiency. Our blended valuation assessment supports a valuein the upper $40s, in a stable to slightly rising trend. Peer comparisons also support our undervaluation thesis, as CSCO is tradingbelow its peer group on P/E, price/sales, price/book, and PEG.

Appreciation to our 12-month target of $44 (raised from $41), along with the 3.4% dividend yield, implies a risk-adjustedreturn exceeding our forecast total return for the broad market. On that basis, and amid Cisco’s massive technology transition, wereiterate our BUY rating on the shares.

On November 16, BUY-rated CSCO closed at $35.88, up $1.77. (Jim Kelleher, CFA, 11/16/17)

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NETAPP INC. (NGS: NTAP, $53.11) ...................................................................................... BUY

NTAP: Hyper-converged, flash resonating; raising target to $60

* NTAP shares jumped 15% after NetApp reported above-consensus 2Q18 results and guided sharply aboveconsensus for 3Q18.

* Fiscal 2Q18 product sales increased 14% annually and 12% sequentially. Flash array and related sales were upover 60% annually

* NetApp has successfully spurred user adoption of its Clustered Data ONTAP operating system for fiber-attachedstorage (FAS).

* We believe that NetApp has substantial opportunities to drive all-flash product sales; to develop the convergedmarket and promote its hyper-converged solution; and to help enterprises manage data resources and storageacross hybrid cloud environments.

ANALYSISINVESTMENT THESISBUY-rated NetApp Inc. (NGS: NTAP) posted a highly positive fiscal 2Q18 (ended October 2017), as revenue grew 6%

annually while beating consensus expectations. A 16% surge in the share price at the 11/16/17 open appears to reflect enthusiasmand optimism regarding the company’s hyper-converged solutions. While currently a small contributor, hyper-converged ispoised to grow rapidly in support of hyperscale cloud environments.

Positive results reflected accelerating momentum in next-generation solutions, including converged infrastructureofferings and flash-base storage arrays. Based on past cost-reduction activities and volume leverage, NetApp grew its non-GAAPEPS by 36% year-over-year, to $0.81 per diluted share, exceeding Street the estimate of $0.69.

Sustaining a trend that first became evident in 4Q17 and carried across 1Q18, fiscal 2Q18 product sales were up in double-digits, rising 14% annually and 12% sequentially. CEO George Kurian attributed strong customer uptake to what NetApp callsits “data fabric strategy,” an integrated approach to managing and safeguarding customer data across enterprise IT environmentsspanning on-premises to cloud.

When we upgraded NTAP at $39 in August, we noted that NetApp was likely benefiting from integration issues at DellEMC and turmoil at Hewlett Packard Enterprise; those dislocations are expected to diminish in coming quarters. At the same time,NetApp has successfully spurred user adoption of its Clustered Data ONTAP operating system for fiber-attached storage (FAS).We believe that NetApp has substantial opportunities to drive all-flash product sales; to develop the converged market and promoteits hyper-converged solution; and to help enterprises manage data resources and storage across hybrid cloud environments.

NetApp guided well above consensus for 3Q18 revenue and EPS. Argus is modeling NetApp to deliver low- to mid-teensEPS growth for FY18 and FY19. That is better than our outlook for most direct peers, the technology sector, and the broad market.Based on the increasingly positive outlook, we calculate a blended value in the low $60s. Appreciation to our 12-month targetprice of $60 (raised from $46), along with the current 1.8% dividend yield, implies a risk-adjusted 12-month return in the mid-teens, and is thus consistent with a BUY rating.

RECENT DEVELOPMENTSNTAP is up 49% year-to-date in 2017, compared with a 14% gain for the Argus information processing & storage peer

group. As of mid-November, the shares are up 33% from our mid-August 2017 upgrade at $39.35. We upgraded the shares basedon our belief that NetApp had developed a clear strategy under CEO George Kurian. After a first phase of shifting its businessto growth areas while building a cost-efficient operating structure, NetApp is now delivering sustained revenue growth, highermargins, and stronger returns to shareholders.

We also reasoned that NetApp could gain all-flash market share in the intermediate-term amid Dell-EMC integration andturmoil at Hewlett-Packard Enterprise. In the traditional SAN space, Brocade’s dangling status (awaiting deal close by BroadcomLtd.) is providing NetApp with share-gain opportunities, particularly as Brocade is lacking in all-flash capability.

NTAP rose 33% in 2016, while the (greatly reduced) storage peer group was up 41%. NTAP shares declined 36% in 2015,while the “old” peer group of Argus-covered storage equities declined 27%. NTAP rose 1% in 2014, rose 23% in 2013, fell 8%in 2012, declined 34% in 2011, and rose 60% in 2010, following a 146% surge in 2009 from cycle lows in 2008.

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For fiscal 2Q18, NetApp reported revenue of $1.42 billion, which was up 6% year-over-year and 7% sequentially fromseasonally weak 1Q18; above the $1.32 billion midpoint of management’s $1.31-$1.46 billion guidance range; and above the$1.38 billion consensus estimate. Non-GAAP earnings of $0.81 per diluted share were up 36% year-over-year and up $0.19 from1Q18; above the high end of management’s guidance range of $0.64-$0.72; and above the $0.69 consensus estimate.

NetApp is focused on enabling data management across hybrid cloud environments via user adoption of its ClusteredData ONTAP (cDOT) operating system for fiber-attached storage (FAS). The transition from 7-mode to cDOT OS “is now behindus,” stated the CEO. Clustered Data ONTAP is shipping on most product sales, including NetApp’s all-flash arrays.

For 2Q18, combined hardware maintenance & service and software maintenance revenue (43% of total) declined 2%year-over-year but improved 2% quarter-over-quarter. That was down from a 5% annual decline in 1Q18 as headwinds and toughcomps facing services begin to abate. Services is expected to return to growth in fiscal 2019.

In fiscal 2Q18, total product sales of $807 million (57% of revenue) were up a very strong 14% year-over-year and 12%sequentially. NetApp’s all-flash business achieved an annual revenue run rate in the $1.7 billion range, up from an annualized $1.5billion in 1Q18. All-flash array business, inclusive of FAS, EF and SolidFire products, increased 60% year-over-year. Adjustingfor seasonal variation, annualized revenue would translate to about $410-$435 million in quarterly revenue. That is equivalentto approximately 30% of total revenue and 53% of product revenue for 2Q18. This figure includes some service sales. NetApphas two significant growth opportunities in all-flash: converting the existing installed base of customers, and displacingcompetitors’ legacy disk-based arrays.

Strength in Flash is also driving success in SAN and in converged infrastructure. The company’s clustered storagesolutions, including the Data ONTAP solution, have “substantial and structural technological advantages” over competitors’products, according to the CEO. Management believes its flash-based solutions are helping NetApp gain share in the SAN marketas it displaces legacy, non-flash-enabled SAN vendors.

NetApp’s EF570 all-flash array was designed specifically for performance-driven intensive workloads such as big dataanalytics, technical computing and video surveillance. NetApp called EF570 the first enterprise all-flash array to support NVMeover InfiniBand for ultra-low-latency applications.

Another market opportunity is growth in converged infrastructure, in which multiple IT components (storage, Ethernetnetworking, servers, etc.) share a single network or data center space. NetApp got into this business by pairing with Cisco (andearlier with VMWare). The (now EMC-free) partnership provides FlexPod converged infrastructure solutions that pair NetAppFAS arrays (flash and hybrid) with Cisco networking gear.

For 2Q18, the all-flash FlexPod helped NetApp cement its No. 2 position in converged infrastructure and drove 20% year-over-year growth in FlexPod revenue. Management believes the FlexPod partnership and its best-of-breed solution positionsNetApp to win against full-stack vendors. NetApp’s SolidFire business also has a new Element OS offering, which integrates withONTAP systems across the data fabric via SnapMirror integration.

Notably, SolidFire innovations are incorporated into NetApp HCI (hyper-converged infrastructure). NetApp HCI, whichthe CEO called the first enterprise-scale HCI solution, began shipping at the close of 2Q18. NetApp announced an enhancedpartnerships with Microsoft Azure. In October Microsoft and NetApp launched Azure NFS (Network File System), which NetAppcalled the first NFS service in the cloud. NetApp believes hyperscale customers are attracted by NetApp’s integrated cloud strategyacross all enterprise elements.

HCI is currently a small part of NetApp’s business, with the initial product barely launched. Based on the company’ssolid position with major cloud companies, and based on enterprises’ need to keep any on-premises hardware and software fullysecure, up to date, and cloud-integrated, we see this as a natural market extension for NetApp. And while it is very early days (theHCI product began shipping in October 2017), market excitement around the launch is palpable.

EARNINGS & GROWTH ANALYSISFor fiscal 2Q18, NetApp reported revenue of $1.42 billion, which was up 6% year-over-year and 7% sequentially from

seasonally weak 1Q18; above the $1.32 billion midpoint of management’s $1.31-$1.46 billion guidance range; and above the$1.38 billion consensus estimate.

The non-GAAP gross margin expanded sequentially to 64.6% in 2Q18 from 64.1% in 1Q18 and from 62.9% a yearearlier. NetApp’s significant restructuring program has reduced operating costs. The non-GAAP operating margin expandedsequentially, to 19.1% in 2Q18 from 15.8% in fiscal 1Q18 and from 15.2% in the year-earlier quarter.

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Non-GAAP earnings of $0.81 per diluted share were up 36% year-over-year and up $0.19 from 1Q18; above the highend of management’s guidance range of $0.64-$0.72; and above the $0.69 consensus estimate.

For all of FY17, NetApp posted revenue of $5.52 billion, down less than 1% from $5.55 billion in FY16. Non-GAAPEPS totaled $2.73, up 28% from $2.14 in FY16.

For 3Q18, NetApp guided for revenue of $1.43-$1.58 billion, which at the $1.5 billion midpoint would be up about 7%year-over-year. We expect product revenue to grow faster than non-product revenue for both the quarter and the full year. Thecompany modeled non-GAAP gross margins of about 62% and operating income of about 20%. On that basis, managementprojects non-GAAP EPS of $0.86-$0.94, which at the midpoint of $0.90 would be up 9% year-over-year. That is potentially thehighest quarterly EPS in company history, but comparisons are beginning to become more difficult.

Given improving margins and the strong product-sales profile, we are increasing our FY18 non-GAAP EPS forecast to$3.31 per diluted share from $3.25. We are also boosting our FY19 estimate to $3.51 per diluted share, from $3.42. Both estimatesare contingent on the company achieving its strategic transformation and end markets remaining healthy.

Our GAAP forecasts are $2.68 per diluted share for FY18 and $2.86 for FY19. Our long-term EPS growth forecast is10%.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for NetApp is Medium-High. NetApp took on short-term debt to finance the $870 million

purchase of SolidFire in 2016. The company issued $800 million in bonds in September 2017; proceeds are being used to retirebonds coming due in September 2017. Already, $750 million of this debt has been retired, so 2Q18 quarter-end numbers do notreflect the balance sheet with complete accuracy as it stands as of mid-November 2017.

Total debt was $3.00 billion at the end of 2Q18. Debt was $2.41 billion at the end of FY17, $2.40 billion at the end ofFY16, and $1.49 billion at the end of fiscal 2015, following the issuance of $500 million in senior notes due 2021.

Debt/cap was 52.0% at 2Q18, up from 46.4% at the end of fiscal 2017. Debt/cap was 44.8% at the end of FY16 and 30.3%at the end of fiscal 2015.

Cash was $5.97 billion at the end of 2Q18. Cash was $4.92 billion at the end of FY17, $5.46 billion at the end of FY16,and $5.33 billion at the close of FY15.

Net cash was $2.93 billion at 1Q18. Net cash was $2.56 billion at the end of FY17, $2.95 billion at the end of FY16, and$3.85 billion at the end of FY15.

Cash flow from operations was $986 million in FY17, $974 million in FY16, and $1.27 billion in FY15.In February 2015, NetApp announced a $2.5 billion share repurchase authorization. The company is committed to

completing this program by May 2018.In May 2017, the company hiked its quarterly dividend by 5% to $0.20 per common share. NetApp increased its quarterly

dividend by 6% to $0.19 per share in May 2016, by 9% to $0.18 in May 2015, and by 10% to $0.165 in May 2014.We are now modeling a 5% hike in the quarterly dividend in May 2018. We estimate annual dividends of $0.80 per share

in FY18 and $0.84 in FY19.MANAGEMENT & RISKSGeorge Kurian has been CEO since June 2015. Ron Pasek, formerly of Altera, replaced Nick Noviello as chief financial

officer in March 2016.The acquisition of SolidFire represents a new risk, particularly given the poor performance of Engenio, the prior major

acquisition. Only time will tell if NetApp has bought a redundant or complementary asset. An additional risk comes from fundingthe integration of this asset while simultaneously reducing investment in traditional businesses.

The latest restructuring program, along with the program from early 2014, highlights risks related to reduced hardwareintensity in the next-generation, cloud-enabled data center. It also specifically raises questions about the wisdom of the Engenioacquisition. We could see impairments in goodwill and intangible assets as a result of business reassessment.

Competition is always a risk in the storage industry, particularly from EMC. NetApp also faces competition fromHewlett-Packard, Dell and Hitachi, as well as from smaller companies in the all-flash space. We regard NetApp’s ability to offerall its products around a common operating system (Data ONTAP) as a competitive advantage, particularly as data managementis dispersed across internal IT and external cloud-based resources.

We note that the financial services sector typically contributes 14%-15% of NetApp’s total revenue and that the U.S.government has also been a major NetApp customer, contributing 11%-12% of revenues. While sector concentration remains arisk, the impact appears to be diminishing.

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COMPANY DESCRIPTIONNetApp Inc. is a pure-play data storage company, providing enterprise network storage and data management solutions,

including storage hardware, software and services. NetApp has several powerful partners, including IBM, VMware, Cisco,Microsoft, and Fujitsu. In May 2011, at the beginning of FY12, NetApp acquired “Big Data” hardware provider Engenio; and inFebruary 2016, it acquired all-flash array maker SolidFire. In FY17, NetApp generated $5.52 billion in revenue.

INDUSTRYWe have raised our rating on the Technology sector to Over-Weight from Market-Weight. Technology is showing clear

investor momentum, topping the market in the year-to-date and trailing one-month and three-month periods. At the same time,the average two-year-forward EPS growth rate exceeds our broad-market estimate and sector averages. This has kept technologysector valuations from becoming too rich, and resulted in PEG ratios that are below the median for all sectors.

Over the long term, we expect the Tech sector to benefit from pervasive digitization across the economy, greateracceptance of transformative technologies, and the development of the Internet of Things (IoT). Healthy company and sectorfundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad internationalbusiness exposure.

In terms of performance, the sector rose 12.0% in 2016, above the market average, after rising 4.3% in 2015. The sectoris outperforming thus far in 2017, with a gain of 23.7%.

Fundamentals for the Technology sector look reasonably balanced. By our calculations, the P/E ratio on projected 2018earnings is 17.5, above the market multiple of 17.1. Earnings are expected to grow 14.8% in 2018 and 29.3% in 2017 followinglow single-digit growth in 2015-2016. The sector’s debt ratios are below the market average, as is the average dividend yield.

VALUATIONNTAP is trading at a two-year forward P/E of 15.5, which is now above the trailing five-year P/E of 13.8. In a rising

market, however, the two-year forward relative P/E of 0.88 is approximately in line with the five-year trailing relative P/E of 0.87.The stock looks equally attractive based on peer group comparisons and our 2- and 3-stage discounted free cash flow models.

Reflecting our more positive near- and long-term growth outlook for NetApp, particularly as increasing product salesrebuild the service & maintenance revenue opportunity, our revised discounted free cash flow analysis suggests a value in the mid-$60s, in a rising trend from the low-$50s one year ago. Reflecting its superior growth prospects, NTAP trades at a discount to thepeer average PEG multiple, and at discounts on price/sales and price/book value.

We have calculated a blended value for NTAP in the low- to mid-$60s, in a rising trend. Appreciation to our 12-monthtarget price of $60 (raised from $46), along with the 1.8% dividend yield, implies a risk-adjusted 12-month return in the teens,and is thus consistent with a BUY rating.

On November 16, BUY-rated NTAP closed at $53.11, up $7.29. (Jim Kelleher, CFA, 11/16/17)

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PAYPAL HOLDINGS INC. (NYSE: PYPL, $77.70) .................................................................. BUY

PYPL: Raising target by $7 to $87

* On November 16, PayPal announced that it would sell $6.8 billion of consumer receivables to Synchrony Financial.The deal, which is expected to close in 3Q18, will also extend an existing co-brand consumer credit card programwith Synchrony.

* We view the Synchrony deal favorably as it will free cash flow for other uses, reduce credit risk, and improveoperating margins, which should in turn result in a higher valuation.

* We are maintaining our 2017 EPS estimate of $1.87, implying 25% growth this year. Based on our expectationsfor stronger economic trends next year, we are raising our 2018 forecast by $0.05 to $2.30, implying 23% growth.

* Our revised target price of $87 implies a projected 2018 P/E of 37.8, above the multiples of 28 for Visa andMasterCard, but merited, in our view, based on PayPal’s stronger growth prospects. The shares also trade at PEGratio of 1.7, below the multiples of both Visa and MasterCard.

ANALYSISINVESTMENT THESISWe are maintaining our BUY rating on PayPal Holdings Inc. (NYSE: PYPL) following the announcement that it will

sell $6.8 billion in receivables to Synchrony Financial. We are also boosting our target price to $87 from $80. We view theSynchrony deal favorably as it will free cash flow for other uses, reduce credit risk, and improve operating margins, which shouldin turn result in a higher valuation. PayPal management noted that cash proceeds from the deal would be reinvested in its corebusiness, used for M&A, or returned to shareholders.

PayPal, which was spun off from eBay in July 2015, is taking advantage of the changing payments landscape, and webelieve that several trends favor the company’s growth. These include greater adoption of mobile devices for payments, and thetechnological integration of different payment types and channels. With 218 million active accounts, PayPal is a leader ininnovative payment mechanisms and has strong brand recognition.

Unlike MasterCard and Visa, PayPal’s network enables account holders to both pay and be paid for merchandise orservices. PayPal is accepted at more than 75 of the top 100 retailers in the U.S., and we expect even greater penetration in the nextyear. Total payment volume rose 30% to $114.0 billion in 3Q17 (the strongest rate of growth for PayPal since its IPO), and thenumber of payment transactions rose 26% to $1.90 billion.

In our view, the company has several strengths that put it ahead of the competition as it seeks to grow payment volumes.These include a strong international presence, with 100 million non-U.S. users in more than 200 countries. The company alsoprovides merchants with end-to-end payment authorization and settlement capabilities, as well as instant access to funds.

Our revised target price of $87 implies a projected 2018 P/E of 37.8, above the multiples of 28 for Visa and MasterCard,but merited, in our view, based on PayPal’s stronger growth prospects. The shares also trade at PEG ratio of 1.7, below the multiplesof both Visa and MasterCard.

RECENT DEVELOPMENTSOver the past year, PYPL shares have risen 98%, versus a gain of 19% for the broad market.On October 20, PayPal reported adjusted 3Q17 EPS of $0.46, up from $0.35 a year earlier and above the $0.43 consensus.

Revenues rose 21% to $3.24 billion (or 22% on an FX-adjusted basis) and adjusted net income rose 32% to $560 million.Total 3Q payment volume rose 30% from the prior year to $114.0 billion, and was primarily responsible for the revenue

gain. The number of active PayPal accounts was 218 million at September 30, 2017, up 14% from a year earlier, while the numberof payment transactions was 1.90 billion, up 26%.

In November 2017, PayPal announced an agreement under which Synchrony Financial would acquire about $6.8 billionof PYPL’s consumer receivables. The deal, which is expected to close in 3Q18, would also extend an existing co-brand consumercredit card program, with Synchrony becoming the exclusive issuer of PayPal’s online consumer financing program for 10 years.The company said the receivables were being sold at par value.

In July 2017, PayPal acquired TIO Networks, a bill payment processor that serves telecom, wireless, cable, and utilitybill issuers in North America, for $238 million.

On July 17, 2015, eBay Inc. completed the spinoff of PayPal, distributing one share of PayPal stock for each share ofeBay.

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EARNINGS & GROWTH ANALYSISWe expect revenue growth at PayPal to benefit from higher consumer spending, increased merchant acceptance of the

company’s services, growth in the number of mobile devices using mobile payment apps, and an increase in average transactionsper active account (the latter increased to 32.8, on an annualized basis, in 3Q17, up 9% from 30.2 a year earlier). Anotherencouraging sign is the expansion of active accounts, which grew 14% year-over-year in 3Q to 218 million. This was also up 8million sequentially, the fastest pace since the company’s spinoff from eBay. In addition, PayPal should benefit from trends thathave boosted growth for credit card processors, such as the increasing use of digital payments over checks and cash for bothconvenience and security.

We expect further market share gains as the company leverages its platforms globally and takes advantage of its strongbrand recognition and rapid growth in merchant acceptance. PayPal is rapidly establishing new partnerships. In 3Q, it announceda partnership with Skype to allow users in 22 countries to send money to other Skype users with PayPal via the Skype mobile app,and expanded a partnership with MasterCard into Canada, Europe, Latin America and the Caribbean, the Middle East and Africa.This follows 2Q partnerships with Baidu (enabling Chinese consumers to pay with Baidu Wallet), Bank of America and JPMorganChase (enabling bank-issued cards to be added to PayPal accounts), Citigroup (allowing cardmembers to use ThankYou points),Visa (extending a current agreement to Europe) and Apple (enabling iTunes in-app purchases with PayPal).

We look for revenue growth of 20% in 2017, up from 17% in 2016. We note that net revenue as a percentage of totalpayment volume (known as the “take rate”) fell to 2.84% in 3Q17. This metric has been drifting lower as the company adds largermerchants, which tend to have lower take rates. However, operating margins should also benefit as the company leverages itsnetwork scale.

The company has been transparent with its 2017 financial goals, and, along with third-quarter results, raised its revenuegrowth guidance to 20%-21% (from 19%-20%) on an FX-neutral basis (19%-20% at current spot rates). It also raised its operatingEPS forecast to $1.86-$1.88 from $1.80-$1.84. PayPal also has a three-year outlook, which calls for FX-neutral revenue growthof 16%-17% per year, stable to growing operating margins, and free cash flow growth in line with revenue gains.

On the 3Q conference call in October, the company noted that its initial guidance for total payment volume growth in2018 was in the mid- to high 20% range, along with a 20% rise in revenues. Following the Synchrony announcement on November16, PayPal reiterated its non-GAAP EPS guidance and its operating income growth forecast of 20%, but lowered its revenuegrowth forecast to 16.5% to reflect the sale of the receivables portfolio. We project total payment volume growth of 27% in 2018.

We are maintaining our 2017 EPS estimate of $1.87, implying 25% growth this year. Based on our expectations forstronger economic trends next year, we are raising our 2018 forecast by $0.05 to $2.30, implying 23% growth.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating on PayPal is Medium-High. Balance sheet metrics are favorable, with cash and short-term

investments as of September 30, 2017 of $4.9 billion and no long-term debt. The company has a limited operating history as apublic company.

Free cash flow is expected to be reinvested in the business and used for acquisitions and buybacks. Along with 1Q17earnings, the company announced a $5 billion share buyback plan, a considerable increase from a $2 billion repurchase programauthorized in 4Q15. At September 30, 2017, the company also had $300 million remaining under its prior authorization. Thecompany does not expect to pay a regular cash dividend.

MANAGEMENT & RISKSPayPal is led by president and CEO Dan Schulman, who joined the company in 2014 from American Express. In August

2015, John Rainey joined PayPal as chief financial officer. He was previously with United Continental Holdings.PayPal faces considerable competition in the payments market from well-established brands, including Apple’s

ApplePay, Visa’s Checkout, MasterCard’s MasterPass, and American Express’s Later Pay services, as well as other digitalproducts from Facebook and Google. Customers generally have a range of payment options in addition to PayPal at the point ofsale, and the company must compete on convenience and transaction price. The company must also respond quickly to changingcustomer preferences, including the increasing demand for mobile payment services.

COMPANY DESCRIPTIONSpun off from eBay in July 2015, PayPal is a technology platform company that enables digital and mobile payments

on behalf of consumers and merchants worldwide. It accepts payments from merchant websites, mobile devices and applications,and at offline retail locations through its PayPal, PayPal Credit, Venmo and Braintree products.

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PayPal processes transactions in more than 200 markets and in more than 100 currencies, and allows customers towithdraw funds from bank accounts in 56 currencies and hold balances in PayPal accounts in 25 currencies.

VALUATIONPayPal trades at 33.5-times our revised 2018 EPS estimate. The shares have a 52-week trading range of $38-$77.We expect PayPal to show steady growth in payment volumes as it adds merchants, signs additional partnerships,

increases the number of transactions per customer, and benefits from greater global spending. PayPal competes in the paymentsspace with American Express, Discover, Visa and MasterCard, as well as with other mobile payment services such as ApplePay.Unlike Visa and MasterCard, PayPal currently offers forms of credit to its customers, although a recent agreement to sell itsreceivables portfolio to Synchrony Financial would remove this element of credit risk. The deal should also free cash flow for otheruses and improve operating margins, allowing for a higher valuation.

To value the stock, we believe that processing pure-plays Visa and MasterCard still offer the best peer comparisons.PayPal is a smaller player in the payments market, though it also has a strong brand and a record of innovation. As such, we expectit to post above-industry-average earnings growth for many years, and believe that it merits a premium multiple. Our 12-monthtarget price of $87 (raised from $80) implies a multiple of 37.8-times our 2018 EPS estimate, above the multiples of about 28 forVisa and MasterCard. PYPL shares also trade at a more favorable PEG ratio of 1.7, versus 2.0 for Visa and MasterCard.

On November 16, BUY-rated PYPL closed at $77.70, up $4.27. (Stephen Biggar, 11/16/17)

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TWENTY-FIRST CENTURY FOX INC. (NGS: FOXA, $29.32) ............................................... HOLD

FOXA: Mixed fiscal 1Q18; maintaining HOLD

* Fox posted strong 8% revenue growth in the September quarter, though earnings fell from the prior year.

* In December 2016, Fox offered to acquire the 61% of Sky plc that it does not already own for 11.7 billion pounds.At 11.4-times EBITDA and a 50% premium to its previous offer in 2010, Fox will certainly not be underpaying forSky.

* The closing of the Sky transaction has been pushed back to June 2018 from December 2017 in the face of pressurefrom UK regulators.

* Fox News ratings have benefited from larger audiences in the first year of the Trump presidency, even as thenetwork has lost primetime on-air and executive talent. Fox News is a primary driver of results in the CableNetworks segment.

ANALYSISINVESTMENT THESISWe are maintaining our HOLD rating on Twenty-First Century Fox Inc. (NGS: FOXA). The high cost of sports rights,

the need for continued investment in new programming, and currency headwinds have made Fox’s results highly variable. Wethink the company’s new bid for the 61% of broadcast satellite operator Sky plc that it does not already own has a good chanceof succeeding, though concerns about Murdoch family ownership, not to mention Brexit, provide some uncertainty. At 11.4-timesEBITDA and a 50% premium to its previous offer in 2010, Fox will certainly not be underpaying for Sky.

Fox News ratings have benefited from larger audiences in the first year of the Trump presidency, even as the networkhas lost primetime on-air and executive talent. Fox News is a primary driver of results in the Cable Networks segment, and itsrecent sexual harassment scandals, coming some years after the “News of the World” invasion-of-privacy scandal in the UK, pointto serious and recurring management issues at Fox. Perhaps the younger Murdoch brothers, now in key management positions,will be able to manage Fox in a more professional manner going forward.

RECENT DEVELOPMENTSFox reported results for the fiscal 1Q18 (ended in September) on November 8. First-quarter revenue rose 8% to $7 billion.

Revenue was driven by growth in both subscription fees and advertising in the Cable Networks, offset by a significant declinein the Filmed Entertainment segment and a modest decline in the Television segment. Management’s favorite metric, segmentOIBDA, was flat with the prior year at $1.79 billion. Segment OIBDA narrowed by 200 basis points from the prior year to 25.6%.Adjusted EPS fell 4% to $0.49. Adjusted EPS excluded a $0.01 charge for equity affiliate adjustments, a $0.04 loss in the “Other”segment, and a $0.01 negative impact from impairment and restructuring charges. In 1Q17, EPS excluded a $0.02 charge for equityaffiliate adjustments, a $0.01 loss from “Other,” and $0.07 in impairment and restructuring charges. GAAP EPS from continuingoperations attributable to Fox rose to $0.45 from $0.44 in 1Q17.

On December 15, 2016, Fox made another offer to acquire the 61% of pan-European direct broadcast satellite operatorSky plc that it does not already own. Fox made an all-cash offer of 10.75 pounds per share (11.7 billion pounds or $14.8 billionin total at then-current exchange rates). Fox expects to finance the transaction with cash on hand and an incremental $10 billionin debt. The offer represented a 40% premium to Sky’s market price on December 6, prior to Fox’s preliminary offer. Fox’s offerimplies a Sky enterprise value of 25 billion pounds and a value of 11.4-times FY16 EBITDA. Fox expects the transaction to deliverdouble-digit adjusted core EPS growth in the first and second years after the closing, excluding purchase price and intangibleamortization. Fox’s expected EPS accretion does not assume any material synergies. The deal remains subject to the approval ofSky shareholders and U.K. regulatory agencies. The European Commission has already approved the transaction. The shareholdervote will require an affirmative vote of at least 75% by value and 50% by number of Sky shareholders, and will exclude the Fox-owned shares. Fox had made an offer to acquire Sky in 2010 for 7.8 billion pounds; however, that offer was rejected by U.K.regulators in 2011 in the wake of the “News of the World” telephone hacking scandal, with Rupert Murdoch being declared “nota fit person” to run the merged company. The current offer is also being closely scrutinized by UK authorities, particularly withregard to the amount of control the Murdoch family may wield over UK media outlets when the deal is completed. The partiesoriginally expected the merger to close by the end of 2017, but now believe that it could be delayed until June 2018. The delaypast December 31, 2017 will cost Fox another 105 million pounds due to the payment of a special dividend to Sky shareholdersin accordance with the deal terms.

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Fox and Sky are just the latest content production and distribution entities to attempt to merge. Comcast and NBCUniversal completed their merger back in March 2013. AT&T acquired DirecTV in July 2015, and the AT&T Time Warner dealis pending approval. Fox has been looking to acquire Sky for some time, and management expects Sky to add criticaldiversification to Fox revenue, lessening the company’s dependence on both advertising and affiliate distribution. With themerger, Fox will also diversify away from the U.S. and into the European market. Pro forma revenue is expected to be $42 billion.

James Murdoch had been CEO of Sky’s predecessor BSkyB from November 2003 until he was forced out in April 2012amid the “News of the World” phone hacking scandal. Mr. Murdoch became CEO of Sky again in January 2016 after Sky acquiredFox’s interests in Sky Deutschland and Sky Italia.

EARNINGS & GROWTH ANALYSISWe are lowering our FY18 EPS estimate to $1.91 from $1.99 and maintaining our FY19 forecast of $2.18. Management

expects operating expenses to grow in the high single-digit range in FY18.Executive Co-chairman Lachlan Murdoch acknowledges the need to cater to the changing viewing patterns of younger,

more digitally savvy consumers, with their preference for streaming over-the-top, subscription video on-demand or virtualmultichannel video programming distributors (vMVPD’s), and emerging mobile platforms, though he also stresses continuity.Indeed, management’s explicit strategy is to make its programming more available not less so. While we thus expect to see moredigital deals, they will be less valuable nonexclusive deals rather than the exclusive worldwide rights deals that Netflix is seeking.Fox recently moved much of its programming off of Netflix and on to Hulu. The continuity part of the strategy is Fox’s continuedsupport of the traditional cable distribution bundle.

Mr. Murdoch has noted Fox’s penchant for building new businesses internally, in the manner of Fox Sports 1, FoxBusiness News, Fox News, Fox Sports, and the Fox Network, rather than growing through acquisitions. He also believes that thecompany does not have any “gaping holes” in its portfolio of media assets. The company may continue to make tuck-inacquisitions; however, we recognize that increased M&A activity in the local television station space may be too much formanagement to resist, especially in a less strict regulatory environment. Of course, Fox still has to complete and begin integratingthe quite large Sky acquisition. Fox is also likely to focus on “building its brands,” especially the high-profit cable channels, tomake them essential content for most viewers regardless of changes in the cable network bundle or the impact of new OTT bundles.Fox believes that it is bucking the industry-wide trend of declining cable subscribers (estimated at about 2% a year). It expectssubscribers acquired through new vMVPD agreements, like those with DirecTV Now or Hulu Live, to keep overall subscriptionsflat with the prior year.

The company’s primary revenue and profit driver, the Cable Networks business, again reported 9% growth in segmentOIBDA, to $1.5 billion, in fiscal 1Q18, on revenue growth of 10%. The segment results reflected an 11% increase in domesticaffiliate revenue due to contractual rate increases and a 3% increase in domestic advertising revenue due to growth at the domesticsports channels. International affiliate revenue rose 11% and International advertising revenue rose 10%. Fox News’ ratings havebenefited from larger audiences in the first year of the Trump presidency, even as the network has lost primetime on-air andexecutive talent. Fox projects high single-digit affiliate revenue increases but also high single-digit expense growth in the CableNetworks segment in FY18.

The Television segment reported a 36% decline in 1Q segment OIBDA, to $122 million, on 3% revenue growth. Whilehigh-margin retransmission consent fees drove the growth in revenue, the decline in segment OIBDA was driven by higher sportsprogramming license costs. Retransmission revenue is expected to continue to grow at a double-digit pace.

In the Filmed Entertainment segment, 1Q18 OIBDA fell 18% to $$256 million on 3% revenue growth. Lower TVlicensing revenue drove the decline in OIBDA. Filmed Entertainment has two wide releases scheduled for the December quarter,the animated children’s film “Ferdinand,” and a musical, “The Greatest Showman,” starring Hugh Jackman. It will also release“The Post,” which it is targeting for an Academy Award.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for Fox is Medium, the midpoint on our five-point scale. S&P gives Fox a BBB+ investment-

grade rating. However, S&P put Fox on negative credit watch in December 2016 after the announcement of the offer for Sky plc.This was not surprising given Fox’s plan to take on an incremental $10 billion in debt.

Fox’s semiannual dividend is $0.18, for a yield of about 1.3%, at the low end of the peer group range. Our dividendestimates are $0.43 for both FY18 and FY19. The company did not repurchase shares in 1Q18. Repurchases also sloweddramatically to $619 million in FY17 from $4.98 billion in FY16. Fox is husbanding cash for its purchase of Sky plc. The sharecount fell 0.5% year-over-year in 1Q18.

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MANAGEMENT & RISKSThere are many family-controlled companies in the media business, but very few have the size and scope of Fox.

Executive Chairman Rupert Murdoch is a classic media mogul whose age, 86, makes succession an issue. However, theappointment of the Murdoch sons, Lachlan and James, respectively, to the roles of Executive Chairman and CEO of Fox in July2015 may have lessened some of the concerns surrounding succession. James Murdoch bore a measure of responsibility for the“News of the World” scandal in his role as head of News Corp. International.

While the spinoff of the publishing assets has freed Twenty-First Century Fox from the secular decline in publishing,the media entertainment company has become more narrowly focused in terms of both geography and range of assets. Thisnarrowed focus carries its own risks, as diversification may no longer offset underperformance in a particular business orgeographic region.

Fox stumbled into new scandals in 2016-2017 with the sexual harassment charges against former Fox News founder andCEO Roger Ailes and, more recently, against Fox News star Bill O’Reilly. We think the scandals can be chalked up to someparticularly bad management of Mr. Ailes and Mr. O’Reilly. Fox has been settling claims and lawsuits related to the scandals,which have now been replaced on the front pages with sexual harassment scandals at other firms. Fox News has long been a ratingsjuggernaut, and, along with other news outlets, has benefited from heightened viewer interest in political news since the 2016presidential election. However, the loss of both on-air and executive talent over the last year has raised investor concerns aboutthe network’s ability to maintain its ratings momentum without its longtime leaders.

Fox is a highly cyclical company with close to 30% of its revenue derived from television advertising. As such, thecompany faces risks as the television and cable universe continues to shrink in the face of media fragmentation and the rise of theinternet, social, and mobile media. Fox and its Fox Entertainment Group also face the usual hit-or-miss risks of developing popularcreative content for a fickle viewing public.

COMPANY DESCRIPTIONTwenty-First Century Fox is a global diversified media company. Its operations span both content providers and delivery

systems. Its assets include the FOX channel; cable channels FX, Fox News, STAR; the movie and television studio TwentiethCentury Fox; pay-television; and an equity interest in British pay TV broadcaster BSkyB. Fox spun off its newspaper andpublishing assets into the new News Corp. in June 2013. Sky Italia and Sky Deutschland were sold to BSkyB in November 2014.Executive Chairman Rupert Murdoch and his family retain a nearly 39% controlling interest in the company. Fox derived 28%of its revenue from outside the U.S. in FY17.

VALUATIONFOXA shares have traded between $25 and $32 over the past 52 weeks and are currently above the midpoint of the range.

The shares are up 6% year-to-date on a total-return basis, compared to a 17.5% increase for the S&P and a 2% return for the S&PMedia Index. The shares are trading below their five-year average range for trailing enterprise value/sales (2.4 versus a range of2.5-2.9), though this historical comparison may be of limited value due to the corporate reorganization in July 2013 and thedivestiture of the DBS businesses in 2014. We see the peer comparison as more relevant. The trailing enterprise value/EBITDAratio of 9.8 is below the peer median of 10.2 and Disney’s 11.0. Fox’s forward enterprise value/EBITDA multiple of 9.0 is 3%below the peer average, less than the average discount of 8% over the past two years. Our rating remains HOLD.

On November 16, HOLD-rated FOXA closed at $29.32, up $0.59. (Joseph Bonner, CFA, 11/16/17)

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WALGREENS BOOTS ALLIANCE INC. (NGS: WBA, $71.30) ............................................... HOLD

WBA: Maintaining HOLD rating and FY18 estimate

* In fiscal 4Q17 WBA earned an adjusted $1.31 per share, up 22% from the prior-year period. The 4Q result toppedour estimate of $1.22, and exceeded the adjusted consensus of $1.21. Management said that the 4Q performancebenefitted from higher prescription volumes through U.S. pharmacies and from growing market share.

* We are maintaining our FY18 adjusted EPS estimate of $5.50 per share. The one theme in our model is expenseleverage. We are also modeling a continuing decline in gross margin based on reimbursement pressure andbusiness mix from increasing participation in preferred networks, offset by a lower expense rate.

* We are initiating a FY19 adjusted EPS estimate of $6.05 per share representing approximately 10% growth. We’remodeling approximately 6% sales growth helped by improving productivity on the acquired Rite Aid stores. Weexpect continuing erosion in gross margin and we expect to see expense-benefits from an initiative to close low-productivity stores. We are also expecting continuing share repurchases.

* As a framework for valuing the company, the five-year average enterprise-value multiple is about 12-times trailingEBIT, a level were M&A deals often occur. CVS is trading at 10-times. At a multiple of 11, and using our EBITforecast for the next four quarters, of approximately $8.5 billion, the shares would be worth approximately $66 inabout a year. At 12-times, the shares would be worth $74.

ANALYSISINVESTMENT THESISWe are maintaining our HOLD rating on Walgreens Boots Alliance Inc. (NGS: WBA). Under Executive Vice

Chairman and CEO Stefano Pessina, the deal making has continued with termination of the plan to acquire Rite Aid, the No. 3U.S. pharmacy chain, and a new – regulator approved — proposal to purchase 1,932 Rite Aid stores, along with three distributioncenters and the related inventory.

We believe that acquisitions and new alliances will continue to take center stage over the next several years. Mr. Pessinahas said that vertical consolidation will reduce costs and bring more synergies to the industry. He has said that he is open to anymerger that offers substantial and sustainable value. He has also said that companies don’t necessarily have to merge becausecommercial agreements can be as effective as a merger.

WBA has recently formed new business relationships with Prescription benefit managers and major industry playersincluding: OptumRx, Prime Therapeutics, the U.S. Government’s TriCare, and Express Scripts. There is even a non-healthcareagreement where FedEx will have package drop-off and pick-up in all Walgreen’s stores by the end of 2018.

Legacy Walgreen holders should now know that this is a vastly different investment than the quiet Midwestern drugstorechain that had no balance sheet debt and a simple plan to put one of its stores on the busiest corner in every neighborhood in America(generally on the right-hand side of the road that people use to drive home from work). Of course that idyllic plan was interruptedby the company’s failed negotiations with Express Scripts and a resulting loss of market share as well as growing reimbursementpressure in the pharmacy business which is weighing on margins.

The dynamic Mr. Pessina, who is in his 70s, is undoubtedly globally focused. His company has a presence in more than25 countries, including Boots pharmacies in Thailand, and Lithuania, support services to pharmacies in Russia and Turkey, anda joint venture in China.

These operations in developing markets provide sizzle and the potential for future growth that is likely to exceed the pacein its core (mature) U.S. and UK drugstore markets. Nevertheless, WBA remains a developed-market story for the foreseeablefuture. We would estimate that approximately 85% of the company’s revenue and approximately 95% of its operating profit aredenominated in U.S. dollars and British pounds. That percentage is likely to rise as the company adds the additional Rite Aidlocations in the United States.

We prefer the acquisition of selected stores to the acquisition of the entire company, although we still prefer organic storeopenings. WBA has a history of opening productive stores in good locations, but the proposed acquisition appears to give WBAa more rapid entry to under-penetrated markets.

Mr. Pessina has a lot of his own money invested in WBA, and being the company’s largest shareholder gives himtremendous credibility when he talks about allocating capital and acting in a very rational and unemotional way to create valuefor shareholders.

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Despite all of the company’s far-flung distribution agreements and joint ventures, we believe that the most importantdrivers of operating profit are less exotic: Walgreen’s U.S. drug stores and Boots, which is a big drugstore chain in the UK.

Our analysis suggests that WBA shares are trading at close to fair value.RECENT DEVELOPMENTSWalgreens Boots Alliance reported fiscal 4Q17 results on October 25. WBA earned an adjusted $1.31 per share, up 22%

from the prior-year period. EPS topped our estimate of $1.22, and exceeded the adjusted consensus of $1.21 per share accordingto StreetAccount. Management said that the 4Q performance benefited from higher prescription volumes through U.S. pharmaciesand from growing market share. GAAP EPS for the fourth quarter decreased by 20% to $0.76 per share, mostly on the terminationfees related to the Rite Aid deal.

WBA initiated FY18 non-GAAP guidance of $5.40-$5.70 per share. The consensus for adjusted earnings had beenapproximately $5.42 prior to the earnings release. Our pre-release estimate had been $5.50.

Sales of $30.1 billion were up 5.3% in fiscal 4Q. On a currency-neutral basis, sales increased 6.4%. Total sales were,above the StreetAccount consensus of $29.9 billion, but below our estimate of $31.4 billion.

To help investors put the company into perspective, Retail Pharmacy USA represented about 74% of FY17 total sales.Within Pharmacy USA, prescription sales represented 69% of the division’s total, or 52.1% of the company’s total sales. As wediscussed in a recent note on CVS, Medicare, Medicaid, managed care companies, government agencies and private insurancecompanies represent a huge, 98% of U.S. Pharmacy division sales.

USA Retail Pharmacy sales increased 7.5%, to $22.3 billion, with comps up 3.1%. Total sales were above theStreetAccount consensus of $22.1 billion. The comp increase was below the StreetAccount consensus of 4.3%.

Front-end comps were down 2.1%, hurt by a reduction in promotions and a decline in food and general merchandisecategories, offset by higher sales in health and wellness and beauty categories. The company’s decision to pull back on promotionsdid help gross margin.

Pharmacy comps were up 5.6%. Growth in Medicare Part D volume continued and WBA saw a 120-basis-point increasein market share to 20.5%. Comparable prescriptions filled were up 8.7%, again helped by growth in volume from Medicare PartD. Adjusted operating income of $1.4 billion was up 27.5% and exceeded the StreetAccount consensus of $1.24 billion. Adjustedoperating margin for the segment was up 100 basis points to 6.3%.

In the Retail Pharmacy International segment, the division’s total sales were $2.9 billion, down by 3.2%, hurt mainly byweakness in foreign currencies relative to the U.S. dollar. Segment sales were down 0.4% on a constant-currency basis. Operatingincome in the Pharmacy International segment was $219 million, up 5.7% which was slightly below the StreetAccount consensusof $224 million. Adjusted operating margin was up by 80 basis points to 8.9% of sales. Comparable sales declined 0.2% on aconstant currency basis. Pharmacy comps were up 0.5% on growth in the U.K. The retail part of the segment saw comps decrease0.5%.

Pharmacy Wholesale posted sales of $5.4 billion, which was slightly below the consensus of $5.48 billion. Total saleswere up 0.8%, but dragged down by a stronger U.S. dollar. The division’s comparable sales were up 5.4% on a constant-currencybasis although it is seeing some competitive pressure in continental Europe. Adjusted operating income of $221 million was up6.3% the average analyst estimate of $271 million.

Operating cash flow for FY17 was $7.25 billion; this was below the prior year’s $7.85 billion. One issue is that the prioryear had a benefit from the change in fair value of warrants.

For the full year of fiscal 2017, the company earned $5.10 per share on an adjusted basis.EARNINGS & GROWTH ANALYSISWe are maintaining our FY18 adjusted EPS estimate of $5.50 per share. The one theme in our model is expense leverage.

We are also modeling a continuing decline in gross margin based on reimbursement pressure and business mix from increasingparticipation in preferred networks, offset by a lower expense rate. Neither our estimate nor the company guidance assumes a majorpositive or negative impact from the company’s plan to acquire just over 1,900 Rite Aid stores. As a refresher, this purchase wasapproved by regulators, but the earlier proposal to acquire all of Rite Aid was not. We expect continuing share repurchases. Theaverage analyst estimate is $5.54 per share.

We are initiating a FY19 adjusted EPS estimate of $6.05 per share representing approximately 10% growth. We’remodeling approximately 6% sales growth helped by improving productivity on the acquired Rite Aid stores. We expect continuingerosion in gross margin and we expect to see expense-benefits from an initiative to close low-productivity stores. We are alsoexpecting continuing share repurchases.

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Our five-year growth rate estimate for Walgreens remains 12%, although this is subject to change. Our bias is for reducingour estimate. We think that double-digit EPS growth is possible for a few years. The company’s expectation is for adjusted earningsto grow in the low double digits. Our growth assumptions include sales growing slightly faster than GDP in the U.S. and the UK.In the U.S. pharmacy business, we see higher utilization offset by reimbursement pressure. In the International Retail Pharmacybusiness, we see growth in health and beauty, and expansion into new markets offset by competitive pressure and the likelihoodof lower dispensing fees. In the Wholesale business, we see opportunities to enter new countries, to win business in existingcountries and to sell more to existing customers. We expect some offset from competition and from lower reimbursement rates.To be sure, the company has lots of initiatives to improve earnings, but double digit growth is an impressive accomplishment fora company with more than $100 billion of sales.

FINANCIAL STRENGTH & DIVIDENDOur financial strength rating for WBA is Medium-High, the second-highest rank on our five-point scale. We are pleased

that the company will buying selected stores from Rite Aid rather than buying the entire chain.We have had some concern that there has been significant management turnover in the U.S., but that is fading into the

past. We are very impressed by George Fairweather, who is the third CFO in a relatively short time. Ultimately the proof is in thenumbers and WBA will have to prove that its earnings stability and free cash flow generation belong in the company of Costco,Wal-Mart and Home Depot, as the old Walgreen did. Our initial take is that management is showing an encouraging mix ofcreativity and prudence in making deals.

There are three reasons that WBA hasn’t historically received our highest financial strength rating. First, margins aresignificantly lower than we’d like to see for a company with a rating of High. Second, the business is subject to governmentregulation, particularly on reimbursement. Finally, it has significant fixed obligations, in the form of operating leases.

Debt was approximately 31% of capital at the end of 4Q17, which certainly isn’t excessive in isolation. Debt was 39%of capital at the end of 4Q16.

Walgreens owns about 14% of its U.S. stores, 4% of its international stores, and leased the remainder. We estimate thatthe present value of the WBA lease obligations is about $20 billion at the end of FY17, which would bring the adjusted debt/capitalratio to about 54% based on 4Q17 debt levels. Lease-adjusted debt is about average by retail standards, and the company has astrong record of generating cash. Earnings coverage of fixed charges has been pretty consistent between 3-times and 3.7-timesover the last five years. The company ended FY17 at 3.01-times.

Based on year-end debt levels and rental expense and EBIT, adjusted debt was approximately 3.8-times adjustedEBITDAR for FY16, which seemed a bit high relative to the company’s credit ratings. This included some of the debt to acquireRite Aid. WBA ended FY17 with adjusted debt at about 3.2-times adjusted EBITDAR. We expect adjusted debt to settle at about2.5-times-to-3-times EBITDAR when the company integrates the 1,900 Rite Aid stores it is acquiring and starts reaping thesynergies.

Walgreens’s credit ratings are BBB, from Standard & Poor’s and Baa2 from Moody’s. Both agencies now have stableoutlooks. WBA’s short-term ratings are A-2 and P-2, which are not top tier but should allow the company to access the short-termborrowing markets in most market environments.

Walgreens ended FY17 with $3.3 billion in cash and equivalents versus $3 billion at the end of FY15, which providesa clearer comparison than 4Q17, when cash was $9.6 billion. At the end of FY16, the cash position was elevated with borrowedfunds slated for the planned acquisition of Rite Aid.

Walgreens paid a dividend in every quarter since 1933. The company paid total dividends of $0.38 in FY08, $0.475 inFY09, $0.55 in FY10, $0.70 in FY11 and $0.90 in FY12. On June 19, the company raised its payout to $0.275 from $0.225,effective with the September 12 payment. The company paid FY13 dividends of $1.10 per share. On July 10, 2013, the companyraised the quarterly payout to $0.315. WBA paid FY14 dividends of $1.26 per share. On August 6, 2014, the company announcedan increase in its quarterly dividend to $0.3375 per share from $0.315. FY15 dividends totaled $1.35. On July 9, 2015, WBAannounced another increase in the quarterly payout to $0.36. FY16 dividends totaled $1.44 and FY17 dividends totaled $1.50.On July 12, 2017, WBA raised the quarterly payout by 6.7% to $0.40. Our FY18 dividend estimate is $1.60 per share. We areinitiating a FY19 dividend estimate of $1.70 per share.

Over the last five years, Walgreens has raised the dividend at an annualized rate of 9%. Our expectation is that WBAwill continue to increase the dividend. The company’s long-term objective is to pay a dividend of about 30%-35% of adjustedearnings.

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At the end of FY16, the company’s share repurchase plan expired with approximately $2.16 billion of unused capacity.The company suspended the plan concurrent with the announcement of the Rite Aid transaction. In June of 2017, WBA authorizeda $5 billion repurchase plan. In October of calendar 2017, which is in the first quarter of FY18, the company announced that itcompleted that authorization and initiated a new plan to repurchase an additional $1 billion of shares.

The annual report for FY17 points out that Mr. Pessina controls about 14% of the company’s stock. This represents asubstantial base of voting power.

MANAGEMENT & RISKSWalgreens Boots Alliance is a holding company with no business operations of its own. The company will rely on

dividend payments from Walgreen and Alliance Boots. We believe that former Walgreen holders should recognize that this is avery different company from the “Steady Eddie,” chain that once had no balance-sheet debt and an enviable record of payingdividends. The market environment is also different and what may appear to be a solid business strategy today may be under salesor margin pressure tomorrow.

While the current company has been more active in making deals and forming alliances than the old Walgreen, we believeit is probably necessary in the rapidly evolving environment and it is also a core competency of Mr. Pessina, who has a hugefinancial stake in the success of the company, with his ownership of about 14% of the shares.

In addition to currency risk, the former Walgreen faces a new regulatory environment with exposure to Europe, thechallenge of a changing corporate culture, challenges related to potentially entering emerging markets and the logistic ofdelivering medicines and medical supplies through more than 390 distribution centers in 20 countries. There is a new level ofuncertainty related to Brexit — the United Kingdom’s recent decision to leave the European Union.

We’re likely to see a host of new regulations and the potential for ongoing speculation about the company’s abilities togain greater tax benefits from its current structure. We expect the tax rate to be in the high 20s, down from the mid-30s at legacyWalgreen’s as a result of adding more earnings from countries with lower tax rates than the U.S. One risk if the company-becomesmore aggressive in its tax strategy is that Walgreen in the U.S. is a customer facing company. Main Street shoppers may crossthe street and go to CVS if they don’t believe that WBA is paying its fair share of taxes. WBA must also maintain good relationswith the U.S. government which is both a regulator and an entity that is a very large and growing player in the prescription businessthrough Medicare and Medicaid. It is possible that the U.S. tax rate could decline as a result of the Trump administration’s plansfor tax reform.

There has also been management turnover. On August 4, 2014, the company announced that Timothy McLevish wouldreplace Wade Miquelon as CFO. Mr. McLevish was previously CFO at Kraft Foods which is headquartered near Walgreensheadquarters outside Chicago. In January of 2015, George Fairweather became CFO. Mr. McLevish became an “advisor.” Thecompany also announced that Greg Wasson was retiring as President and CEO. Stefano Pessina initially played the role of actingCEO, but he has since dropped the “acting” title and become the full-time CEO. Rick Hans, the long-time head of Walgreensinvestor relations also retired.

Mr. Pessina is WBA’s biggest holder with control of approximately 14% of shares, which he acquired when AllianceBoots was sold to Walgreen.

Mr. Pessina is a proven leader and a skilled deal maker who has roots in his family’s pharmaceutical wholesaler business.Many investors regard his presence as a favorable development because he has the perspective of a business owner, although hemay have different perspectives from Mr. Wasson, who spent his entire 30-year career at Walgreen, beginning as a pharmacyintern. The dynamics of this industry are changing rapidly and they are being shaped by deals, including CVS Caremark, MedcoExpress Scripts, the negotiation between Express and Walgreen and the growth of United Healthcare’s PBM OptumRx. Therewas considerable speculation about a deal with WBA and a PBM. We think this speculation has probably cooled, but there is newspeculation about CVS buying a health insurance company. And concerns about Amazon becoming a player in healthcare arelikely to persist. Mr. Pessina said in the 3Q call that he thought that Amazon had better opportunities to focus on, especially giventhe regulatory issues of running a pharmacy. We mostly agree, but Amazon just entered a competitive, low margin industry withWhole Foods. The drugstore business is competitive, there are barriers to entry and margins are relatively low, but it is huge andcould help to drive the top-line growth at AMZN that the Street seems to be rewarding.

These concerns have weighed on WAG and CVS, but they seem to have recently eased. Our recent note on CVS has anextensive analysis of issues related to the potential for AMZN distributing medicines. One thing we can be sure of is that the newlandscape is more dynamic than the old drug store business. Mr. Pessina’s skill as a deal maker may prove to be a significant asset.

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Competitive pressures in the U.S. pharmacy business surely have increased over the last several years. While prescriptiondrugs are likely to be much less cyclical than other products, there is evidence that some individuals avoid going to the doctor,stop taking medicines or split pills to save money when times are tough. The industry could also be pressured by changes in co-payments, a lack of new drugs, worries about side effects, and conversions of major prescription drugs to over-the-counter sales.Walgreens has recently boosted sales by acting as a preferred provider in Medicare Part D plans, but the aggressive pricing of theseplans hurt gross margin.

The threat of further pressure on reimbursement rates is another considerable risk to profitability levels for Walgreen andother drugstores. In addition to the U.S. pressures we discuss regularly, WBA is exposed to reimbursement pressure from the U.K.National Health Service, which is trying to save money. We believe that the concerns are likely to continue. The point in favorof the drugstores is that we believe prescriptions represent a cost-effective way to treat many medical conditions and we thinkWBA delivers medicine safely and efficiently. We don’t believe that the company’s margins are at a level that would raise theire of politicians. Although margins could come under pressure more naturally if more business shifts to lower margin Medicareand Medicaid plans or to having prescriptions filled under lower-margin 90-day at retail programs. Margins could also be hurtby less favorable dynamics in the market for generic medicines, including fewer generic conversions, inflation in generic drugcosts that can’t be passed on to customers, or deflation in generic prices that reduce gross margin dollars.

The company does have some concentration of revenue. OptumRx represented over 12% of sales in the Retail USAdivision, in FY16, but it was not called out in FY17. NHS England represented about 20% of sales in the Retail Internationaldivision in FY16, but it was not mentioned in the FY17 annual report.

Hiring and retaining pharmacists have traditionally been major challenges for the industry. We believe that some of thispressure will ease now that WBA has slowed its pace of store openings and even slated some store closings. We also think thatsoft hiring prospects in many fields could lead more students to pursue health-related professions. An emerging risk is that wagesin the retail sector are rising as Wal-Mart has discussed. We have also heard competitors say that there could be more wage pressurein the UK market. The company has also called out risks relate to its defined benefit pension fund in the UK.

Walgreen has been striving to make stores more convenient by opening 24-hour stores and drive-thru windows. We seethis convenience as a major reason that many shoppers - especially those with insurance - wouldn’t be lured by low cash pricesat Wal-Mart. Some seniors are concerned about the walking distance from the parking lot into Wal-Mart and other big-box stores.We actually think that a number of seniors do as much of their shopping as possible at WBA and CVS because the parking is nearthe front door and the stores are small and often close to home. On the subject of big-box stores, CVS now has a larger footprintand more buying power as a result of taking over the pharmacies at Target stores. WBA may also face costs to maintain and upgradeits e-commerce platform.

Walgreen has historically done an excellent job of selecting store locations. We believe that the company has only hadto close a small number of recently opened stores due to poor sales. We believe that reducing the pace of store openings is likelyto improve the productivity of new and existing stores. Readers of our work know our concern that the U.S. has too many storesof all types. Anyone who has driven down a busy road knows that drugstores are no exception. In defense of acquiring Rite Aidstores, the deal doesn’t add to the sector’s aggregate store count, it just consolidates more stores under WBA and likely gives thema presence in new geographies.

We believe that WBA’s U.S. retail division is benefiting from its’ third-party distribution agreement withAmerisourceBergen, but we do see some risks in having one distributor for branded and generic medicines. WBA now ownsapproximately 26% of the Amerisource as a result of exercising warrants.

Walgreen’s shares have historically been less volatile than the S&P 500, as indicated by the company’s beta.Another risk to the stock is a “double whammy” faced by all growth stocks. If growth slows, the stock price could be

hurt both by the potential for lower future earnings and by a decline in the earnings multiple. Such declines can be severe.COMPANY DESCRIPTIONWalgreens Boots Alliance Inc. based in Deerfield, Illinois, is a holding company created in December 2014 when

Walgreen completed its purchase of privately held Alliance Boots. The combined pharmacy, beauty and healthcare distributioncompany generated $118 billion in FY17 sales through its presence in more than 25 countries. About 75% of revenue is from thePharmacy USA division. The company has more than 13,200 stores in 11 countries, including 8,100 in the U.S. and 4,700 in theUK and internationally, under the Walgreen, Duane Reade and Boots names. Alliance Healthcare distributes Pharmacy productsto over 230,000 stores, clinics and hospitals in more than 19 countries. WBA owns 26% of AmerisourceBergen.

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The FY15 financials aren’t comparable with previous years and they aren’t comparable with FY16. The FY15 resultsinclude Alliance Boots on a fully consolidated basis for eight months and include equity income from Walgreen’s 45% interestin Alliance Boots for four months. FY16 includes a full 12 months of consolidated results.

Retail USA business generated about 70% of sales in FY16. Retail International generated about 10% and Pharmaceuticalwholesale generated about 20% of sales. One thing that is notable is the Retail International has a 41% gross margin, while USAis about 26% and wholesale is about 9%. In terms of contribution, USA contributed 74% of adjusted operating income dollars,Retail international contributed about 16% of operating income dollars and Wholesale, less than 10%. We believe theconcentration in the U.S. and UK will increase during the winter because of cold and flu season in the U.S. and because we believethat the Boots stores in the UK get a lot of holiday gift business.

We believe the International Pharmacy business has higher gross margin because it has a higher front-of-store mix thanthe U.S., including company-owned cosmetics brands such as Boots.

VALUATIONWBA shares have slipped approximately 13% over the last 12 months. At current prices, the shares trade at 12.9-times

our FY18 estimate and at 11.75-times our FY18 estimate.Over the last five years, the shares have traded at an average of 14-times the average analyst estimate for the next four

quarters. The current level is 15.5.CVS is Walgreen’s closest competitor. CVS is trading at 11.5-times forward-four-quarter earnings estimates, compared

to a five-year average multiple of 15.5. We currently prefer CVS to WBA because CVS has focused on its transformation as ahealthcare company and in developing proprietary programs and analytical tools to reduce healthcare costs and improve theefficacy of patient care. That said, we believe CVS is trading at a below-average multiple because it has lost business to some ofWBA’s preferred networks.

As a framework for valuing the company, the five-year average enterprise-value multiple is about 12-times trailing EBIT,a level were M&A deals often occur. CVS is trading at 10-times. At a multiple of 11, and using our EBIT forecast for the nextfour quarters, of approximately $8.5 billion, the shares would be worth approximately $66 in about a year. At 12-times, the shareswould be worth $74. We are maintaining our HOLD rating.

On November 16, HOLD-rated WBA closed at $71.30, up $1.10. (Christopher Graja, CFA, 11/16/17)

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