MARKET DIGEST ARGUS. Independent Equity Research Since DJIA: 19, MONDAY, SEPTEMBER 11, 2017 SEPTEMBER 8, DJIA 21, UP 13.

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1 ARGUS Independent Equity Research Since DJIA: DJIA: 19, MONDAY, SEPTEMBER 11, 2017 SEPTEMBER 8, DJIA 21, UP Good Morning. This is the Market Digest for Monday, September 11, 2017, with analysis of the financial markets and comments on Fortive Corp., Walt Disney Co. and Wal-Mart Stores Inc. IN THIS ISSUE: * Growth Stock: Fortive Corp.: Looking for better-value entry point for stock (Jasper Hellweg) * Growth Stock: Walt Disney Co.: Shares fall after Iger comments (Joseph Bonner) * Value Stock: Wal-Mart Stores Inc.: Raising FY18 estimate (Chris Graja) MARKET REVIEW: Stocks were mixed on Friday, with declines of 0.6% for the Nasdaq Composite and 0.2% for the S&P 500, but a fractional rise for the Dow Jones Industrial Average. For the week, geopolitical concerns and a second hurricane approaching U.S. shores only a few weeks apart weighed on sentiment, with the major benchmarks ending lower by 1.2% for the Nasdaq, 0.9% for the Dow and 0.6% for the S&P 500. Year-to-date gains are now 18.2% for the Nasdaq, 10.3% for the Dow and 9.9% for the S&P 500. Bond yields and the U.S. dollar continued to drift lower, as expectations for a third increase in short-term rates from the Fed in 2017 look less likely. Even before hurricane season began, the federal funds futures market was factoring in a declining chance of a rate hike in the second half of the year. Coupled with a dip in the inflation rate (in part reflecting lower oil prices), concerns about consumer spending and business investment, and additional uncertainties for energy prices in the wake of hurricane activity, the Fed is likely to remain on hold. In addition, bond sales or unreplaced maturing bonds from the Fed s balance sheet unwinding are a tightening of monetary policy, and we suspect the central bank will not want to complicate matters with an additional interest rate hike. The 10-year Treasury yield ended the week at 2.05%, down from 2.17% in the prior week. Meanwhile the U.S. Dollar Index (DXY) fell 1.6% for the week and is now down 10.8% for the year. While the second quarter included no real currency benefit to corporate earnings, we think that will change based on the significant year-to-date weakening in the dollar. Corporate earnings should see a meaningful dollar-related tailwind beginning in 3Q17, strengthening in 4Q17 and carrying into Led by industrial and precious metals, the stocks of commodity producers have resumed a rally that began after the U.S. election. Initially that rally occurred even though the U.S. dollar rose sharply in November and December. Disappointment about the prospects for a major infrastructure program may have contributed to the pause in commodities in April and June, despite a falling dollar, but the resumption of a commodity rally coincides with the renewed decline of the dollar that began in late June. Among our market indicators, our technical composite held above zero following its best two-week advance in NYSE breadth since late last year. Net advances/declines were down slightly, but net up/down volume improved. On CBOE trading measures, there was a moderate decline from last week s sharp rise in the put/call ratio. The strategic composite was little changed for the week but slipped back from midweek highs. Market internals saw a small dip as relative strength in transports & energy offset by relative weakness in Financials, Industrials & Technology and buying of defensive Consumer Staples and Healthcare. External indicators also saw little change as relative strength in crude oil versus industrial materials matched weakness in credit spreads and emerging market versus developed markets. At 2,460, the S&P 500 stands about 1% above fair value, based on our Fisher inflation-based valuation model. At recent highs above 2475, the index was never more than 2% above fair value. We note that market peaks since 1960 have not occurred until the S&P 500 was 8%-17% above fair value. In this week s economic calendar, the Labor Department s JOLTS report for July will be released on Tuesday. Wednesday brings the Treasury budget and the PPI-final demand for August. On Thursday, the consumer price index for August will be released. Friday will bring business inventories for July, retail sales and industrial production for August, and preliminary consumer sentiment and the empire state manufacturing survey for September. Last week, Argus analysts upgraded Palo Alto Networks Inc. (PANW) to BUY from HOLD. Argus also initiated coverage of Anheuser-Busch In Bev SA/NV (BUD), the world s largest beer brewer by volume, with a BUY rating. The average stock in the Argus universe gained 0.6% last week. The largest percentage gainers were AbbVie Inc. (ABBV; BUY; +15.5%), Chicago Bridge & Iron Co. (CBI; HOLD; +12.7%) and AstraZeneca PLC (AZN; BUY; +10.3%), while the largest percentage decliners were Equifax Inc. (EFX; BUY; -12.9%), CIENA Corp. (CIEN; BUY; -10.5%), and United Technologies Corp (UTX; HOLD; -8.4%). (Stephen Biggar) 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 1 Y - N E W Y O R K, N. Y ( ) LONDON SALES & MARKETING OFFICE TEL / FAX

2 FORTIVE CORP. (NYSE: FTV, $66.45)... HOLD FTV: Looking for better-value entry point for stock * FTV shares have outperformed over the last three months, rising 4.6% compared to an advance of 1.2% for the broad market. * The company recently reported 2Q EPS that topped expectations, and management raised guidance. * The company has recently started to grow by acquisition a good sign. * We view FTV shares as fairly valued at current levels, and would look for a nonfundamental selloff to the lower $60s as a potential upgrade trigger. ANALYSIS INVESTMENT THESIS We are maintaining our HOLD rating on Fortive Corp. (NYSE: FTV), a spinoff of BUY-rated Danaher Corp. Fortive provides professional and engineered products, software and services for a variety of end markets. It began trading as an independent company on July 5, Fortive is a diversified industrial company with an experienced management team and several strong businesses; however, like former parent Danaher, it will rely heavily on management s ability to make attractive acquisitions and to improve margins and earnings at acquired companies. Many investors believe that Fortive is today in a similar position to that of Danaher more than a decade ago, before a long upturn. But we think that Fortive, with its relatively high leverage, will find it difficult to duplicate Danaher s record of growth through acquisitions, and believe that it could itself become an acquisition target. We also believe the current FTV share price fails to account for the cyclicality of the company s businesses and the likely difficulty of improving near-record margins. We view the shares as fairly valued at current levels, and would look for a nonfundamental selloff to the low-$60s as a potential upgrade trigger. RECENT DEVELOPMENTS Fortive Corp. began operating as an independent company at the start of 3Q16, and all reported results prior to 3Q16 were carved out from Danaher s accounting records. Its shares have outperformed over the last three months, rising 4.6% compared to an advance of 1.2% for the broad market. Over the past year, its shares have outperformed the market with a gain of 27%, compared to a 13% increase for the S&P 500. The company recently reported results that topped consensus expectations. On July 27, Fortive reported 2Q17 adjusted diluted earnings of $0.71 per share. EPS beat the consensus of $0.69 and rose 11% year-over-year. Sales rose a sequentially stronger 5.4% on a core basis to $1.6 billion, with growth in all of the six platforms. For the first half of the year, the company has earned $1.31 per share. Along with the 2Q results, management provided guidance for 3Q17 and FY17. For the third quarter, management expects adjusted diluted EPS of $0.66-$0.70. For all of 2017, management once again raised its adjusted diluted EPS guidance to $2.72-$2.80 from $2.68-$2.78. In addition to organic growth, Fortive has a growth-by-acquisition strategy. On September 6, Fortive announced that it will spend $770 million to acquire Landauer (NYSE: LDR), a global provider of subscription-based technical and analytical services to determine occupational and environmental radiation exposure, as well as a domestic provider of outsourced medical physics services. Landauer generated annual revenues of $143 million in Upon closing of the acquisition, Landauer will become part of Fortive s Field Solutions platform (comprising Fluke, Qualitrol and Industrial Scientific) within Fortive s Professional Instrumentation segment. Earlier in 3Q, the company closed its acquisition of Industrial Scientific, which manufactures portable gas detection equipment and provides safety-as-a-service solutions. EARNINGS & GROWTH ANALYSIS Fortive has two business segments, Professional Instrumentation (53% of revenue) and Industrial Technology (47%). The Industrial Technologies segment performed well in 2Q, with 4.7% revenue growth, 5.4% core revenue growth, and a 20.9% operating profit margin. Acquisitions contributed approximately 1.1% growth, while currency translation had a negative impact of 0.9%. Looking ahead, we expect organic growth in the mid-single digits in this segment, along with margin improvement. Professional Instrumentation revenues grew 4.8%, with 6.6% core revenue growth offset by 140 basis points of currency headwinds and 4 basis points related to the separation from Danaher. The professional instrumentation segment posted a 24.4% operating margin, with 200 basis points of core operating margin expansion as a result of favorable volume and amortization. Turning to our EPS estimates, we expect 3Q earnings of $0.68. Reflecting our expectations for better top-line growth, we are raising our 2017 estimate to $2.76 from $2.72 and our 2018 estimate to $3.05 from $2.92. Our long-term earnings growth rate projection is 6%

3 FINANCIAL STRENGTH & DIVIDEND Our financial strength rating on Fortive is Medium, up from Medium-Low. Moody s rates the company s senior unsecured debt as Baa1/stable and Standard & Poor s rates it as BBB/stable. The company scores below average on debt load, but above average on interest coverage and return of equity. At the end of 2Q17, it had roughly $3.2 billion in total debt, with a long-term debt/capitalization ratio of 50%. The company had cash and equivalents of $968 million. During the quarter its interest coverage ratio was 16.0-times. The company pays a quarterly dividend of $0.07 per share. Our dividend estimates are $0.30 for 2017 and $0.34 for MANAGEMENT & RISKS Fortive President and CEO James Lico draws on years of experience at Danaher. He became VP of operations at Danaher in 1996 and eventually became executive vice president. Prior to Danaher, Mr. Lico held management positions at Allied Signal and General Motors. Danaher Co-Founder Mitchell Rales serves on Fortive s board. Mr. Rales was also Danaher s president from 1984 to There are risks to owning FTV shares. Investors face the risk that Fortive could overpay for acquisitions or have difficulty integrating acquired businesses. In addition, the company has a relatively high debt/cap ratio and its high capital requirements create significant liquidity risk. COMPANY DESCRIPTION Based in Everett, Washington and recently spun off from Danaher Corp., Fortive provides professional and engineered products, software and services for a variety of end markets. The company has two business segments: Professional Instrumentation and Industrial Technologies. VALUATION FTV shares appear fairly valued at current prices near $67. Over the past year, the shares have ranged between $47 and $67. From a technical standpoint, the shares are in a bullish pattern of higher highs and higher lows that dates to July On the fundamentals, the shares are trading at 22-times our 2018 EPS estimate, above the industry average multiple. The current yield of about 0.5% is below the industrial sector average. We will look for a nonfundamental selloff in FTV to the low $60s as a potential upgrade trigger. On September 8, HOLD-rated FTV closed at $66.45, down $0.88. (Jasper Hellweg, 9/8/17) WALT DISNEY CO. (NYSE: DIS, $97.05)... BUY DIS: Shares fall after Iger comments * The market reacted negatively to CEO Bob Iger s comments at an investor conference, driving DIS shares down 4% on the day on Thursday. * The market s negative reaction may have been due to Mr. Iger s remarks that Disney s earnings growth will be flat in FY17 (ending in September). * Management had previously warned that it expected only modest growth in FY17. It also looks for FY17 to be an anomaly in the company s earnings growth trajectory due to tough comps and other issues. * We are lowering our FY17 EPS estimate to $5.78 from $5.86 and maintaining our FY18 forecast at $6.47. ANALYSIS INVESTMENT THESIS We are maintaining our BUY rating on Walt Disney Co. (NYSE: DIS) to a target price of $129. Disney is preparing to launch its own over-the-top streaming ESPN video service, as well as a Disney-branded streaming service, leveraging its investments in Major League Baseball s BAMTech platform. While this may not end the debate over ESPN s place in the emerging/converging cable/ott distribution landscape, we see the BAMTech deal as a step in the right direction and as a hedge against further traditional cable subscriber losses. We also like Mr. Iger s reassurance that ESPN is getting the same (high) persubscriber rates from new OTT distributors that it gets from its traditional cable-affiliated distributors. Although increased investment in Shanghai Disneyland and other projects has weighed on earnings, Disney is also positioning itself for long-term growth. However, Disney has now warned that it expects FY17 earnings growth to be flat. We think the market may have overreacted to this slight change in guidance. Disney looks for FY17 to be an anomaly in the company s earnings growth trajectory due to a tough prior-year comparison and other issues Disney s 2017 summer selloff has made valuation metrics more attractive

4 RECENT DEVELOPMENTS CEO Bob Iger made some newsworthy announcements on September 7. The market reacted negatively to Mr. Iger s comments driving DIS shares down 4% on the day. The market s negative reaction may have been due to Mr. Iger s remarks that Disney s earnings growth will be flat in FY17 (ending in September). Management had previously mentioned that a balloon payment for NBA television rights and a tough compare between FY17 s Rogue One and FY16 s Star Wars: The Force Awakens, would lead to only modest earnings growth in FY17. Mr. Iger s lowered outlook comes on the heels of Hurricane Irma-related cancellations at Disney World in Orlando, Florida and cruise itinerary cancellations. We think the market may have overreacted to this slight change in guidance. In August along with its 3Q17 results, Disney announced that it will launch its own ESPN-branded multi-sport digital video streaming subscription service in early 2018, pushed back from late 2017, and a new Disney-branded streaming subscription service in Mr. Iger got more specific about the new over-the-top services in his presentation. Disney now expects to launch the ESPN service in spring Pay TV subscribers will be able to continue authenticated access though the ESPN app to content on the current ESPN linear channel feeds. The new OTT service will be accessed through the same ESPN app but be considered a plus or premium service, as yet unnamed, which will include 10,000 additional sporting events not already broadcast on ESPN in sports including Major League Baseball, the National Hockey League, Major League Soccer, tennis and various college sports. Mr. Iger expects the ESPN OTT service to morph into something akin to an itunes platform where viewers can pick and choose sports that they want to watch. With the advent of online streaming, it looks like a la carte viewing choice will finally become a reality. ESPN already has an audience of 23 million monthly unique mobile users. The new Disney-branded OTT service is expected to launch in late 2019 and will include Disney s hit first-run film content as well as movies, TV shows, and short-form content originally produced for the new service itself. Mr. Iger announced that Disney has now decided to put its core film product, Star Wars and Marvel movies on the new service. Disney will also sever its film output arrangement with Netflix, effective 2019, in order to redirect content to its new streaming service. While Disney is likely foregoing hundreds of millions in licensing from Netflix, having its core branded movie content on the new service should provide a powerful attraction to new subscribers. Disney plans to increase its investment in digital streaming technology company BAMTech, LLC by an additional 42%; it will then have a controlling 75% stake. Disney will pay $1.58 billion for the additional 42% after paying $1 billion for its original 33% interest in August The difference in these prices implies that the value of BAMTech has appreciated by 24% since August Mr. Iger reiterated that BAMTech s technology is critical to powering the launch of the new ESPN- and Disneybranded digital direct-to-consumer subscription services as well as other new digital initiatives. Disney expects that its BAMTech investment will be modestly dilutive to earnings over the next two years. EARNINGS & GROWTH ANALYSIS We are lowering our FY17 EPS estimate to $5.78 from $5.86 and maintaining our FY18 forecast of $6.47. We note that Disney expects its BAMTech investment to be modestly dilutive to earnings over the next two years. Our forecasts imply 6.5% EPS growth over the next two years. Our long-term earnings growth rate forecast is 10%. MANAGEMENT & RISKS The FCC and consumer advocates had pushed for smaller, more selective cable channel bundles for years, but had little success in the face of industry opposition. However, skinny bundles from both legacy cable distributors and new-entrant internet streaming providers may be the wave of the future. Disney s plans to join the OTT fray are simply a recognition of the building relevance of this emerging form of content distribution to viewers. At the very least, digital streaming will be an addition to, if not an outright replacement for, traditional large multichannel cable bundles. ESPN, as the most valuable cable channel, could be saddled with expensive long-term sports contracts, without a reliable affiliate revenue stream, if it is unable to generate the kind of revenue from these new forms of distribution that it has generated from traditional cable bundles in the past. Skinny bundles could also take a toll on Disney s other cable and broadcast channels. We think that CEO Robert Iger deserves much of the credit for making alliances and catapulting Disney to the top of the media industry. Mr. Iger wooed Steve Jobs and Pixar first into an alliance to distribute Disney/ABC television content through Apple s itunes store, then arranged Disney s acquisition of Pixar. In 2009, Disney signed on to the Hulu joint venture to distribute content over the internet, and announced an agreement with the Chinese government for a new park in Shanghai, which opened in June In 2010, it acquired Marvel Entertainment and agreed to distribute some ABC television content through Netflix. In December 2012, Disney acquired Lucasfilm, with its iconic Star Wars intellectual property. Mr. Iger remains under contract through July 2, COO Tom Staggs, the presumed heir-apparent, resigned in April 2016, and the board must now find a new candidate to succeed Mr. Iger, perhaps from outside the firm. The succession issue adds a level of uncertainty for Disney

5 Disney investors face numerous risks. A drop in consumer spending businesses can impact businesses across its portfolio. The company can fight back with discounts, especially in the Parks division, though this hurts profitability. The company has recently benefited from price increases, even in the face of a continued slow-growth economy. Another financial or other crisis could be a blow to consumer confidence. All of these factors could reduce travel and spending at Disney locations. Disney has also increased its economic sensitivity through the reacquisition of Disney retail stores in North America and Japan. The Studio Entertainment and Media Networks divisions, like all creative content producers/distributors, depend on advertising spending, which is a major component of revenue for the networks and makes their revenue highly sensitive to cyclical fluctuations. These divisions must also deal with the hit-or-miss nature of the media business, as studios try to anticipate the changing tastes of a fickle public. The studios must also try to contain the high costs of producing entertainment content. We note that media audience fragmentation and the secular shift in advertising dollars away from broadcast television and toward digital/ internet platforms have magnified the above-mentioned risks. Of course, Disney is in the forefront of adapting to the new digital delivery platforms, and has at times shortened distribution windows to the consternation of its theatrical exhibition partners. COMPANY DESCRIPTION Walt Disney Co. is a global entertainment company with four divisions: Media Networks, Parks and Resorts, Studio Entertainment, and Consumer Products & Interactive Media. The company owns and leverages well-known brands, ranging from Mickey Mouse and Frozen to ESPN and ABC. Disney acquired the animated movie producer Pixar Animation Studios in 2006, comic book and movie producer Marvel Entertainment in 2010, and Star Wars originator, Lucasfilm, in Disney derives 23% of its revenue from outside of North America and 12% of its revenue from Europe. VALUATION Our valuation methodology is multistage, including peer analysis, a multiple-analysis matrix applied to our proprietary forecasts, and discounted cash flow modeling. DIS shares have traded between $90 and $116 over the past year, and are currently below the midpoint of that range. The shares have fallen 6% year-to-date on a total-return basis, compared to a 12% gain for the S&P 500 and a 4% gain for the S&P Media Index. DIS is trading at a trailing enterprise value/ebitda multiple of 10.2, near the peer median. Disney s forward enterprise value/ebitda multiple of 9.2 is 4% below the peer average, compared to an average premium of 3% over the past two years. Our rating remains BUY with a target price of $129. On September 8, BUY-rated DIS closed at $97.05, down $0.01. (Joseph Bonner, CFA, 9/8/17) WAL-MART STORES INC. (NYSE: WMT, $78.88)... HOLD WMT: Raising FY18 estimate * We are maintaining our HOLD rating on Wal-Mart. Our thesis is simple. We believe that Wal-Mart must significantly improve its return on invested capital to become a multiyear outperformer. * We are raising our FY18 adjusted earnings estimate to $4.37 per share from $4.35. We are maintaining our FY19 EPS estimate of $4.55 which represents an increase of approximately 4%. * The trailing 12-month return on capital declined to 15.0% in 2Q18 from 15.5% in the prior-year period. This downtick was the result of a 1.2% decrease in adjusted operating income. Average invested capital was up 2.2%. * WMT shares trade at an enterprise value of about 12.2-times trailing EBIT, versus a five-year average of 11. We think the current multiple is fair given WMT s market position, financial strength, and earnings challenges. 12-times is a multiple that we use to value high quality retailers, because takeovers in the sector often occur near this level. ANALYSIS INVESTMENT THESIS We are maintaining our HOLD rating on Wal-Mart Stores Inc. (NYSE: WMT). Our thesis is simple. We believe that Wal- Mart must significantly improve its return on invested capital to become a multiyear outperformer. Home Depot provides a useful road map for potential improvement at WMT. Based on Bloomberg data, Wal-Mart ended FY11 with an ROIC of 14.6% and FY17 with an ROIC of 12.2%. By contrast, Home Depot ended FY11 with an ROIC of 12.8% about 180 basis points lower than WMT but ended FY17 with an ROIC of 30.3%, more than twice as high as WMT. Over the last five years, the S&P 500 has delivered an annualized return of 13.75%. Wal-Mart has underperformed, with an annualized return of 4%. By contrast, HD has nearly doubled the return of the index, with an annualized return of 25.4%. (We did not tinker with the date range; we simply used the Bloomberg comparative returns screen as it is configured.) It is hard to be confident of many things on Wall Street, but we are confident that WMT will outperform if it can consistently boost ROIC

6 What exactly does WMT have to do? Very simply, the retail giant has to grow income faster than sales and sales faster than its capital base. The implication is that it is not enough to simply boost earnings by opening more mildly profitable stores or to boost comp sales by stuffing stores with more inventory. Since the end of FY11, WMT has increased square footage by 18%. During this period, sales have declined to $420 per square foot from $436, and EBIT has declined to $20 per square foot from $26, according to Bloomberg data. Meanwhile, HD has increased square footage by less than 1% over the same period. But HD sales have increased to almost $400 per square foot from $289, and EBIT has more than doubled from $25 per square foot to $57. Our intent isn t to be judgmental. We simply want to show that megacap retailers have the potential to outperform if they follow the route taken by HD, and get operating and capital efficiency on track. We thus believe that WMT has a significant opportunity to improve. The trailing 12-month return on capital declined to 15.0% in 2Q18 from 15.5% in the prior-year period. This downtick was the result of a 1.2% decrease in adjusted operating income. Average invested capital was up 2.2%. Asset growth has declined and we will be looking for that to continue. We will be looking for continued capital discipline. On the income side, WMT s success in driving traffic and comp sales in last year s important fourth quarter were certainly positive factors that gave us optimism regarding the shares. We are optimistic about the company s plan to invest more in its staff. Based on the stores we visit, the company has a significant opportunity and need to provide better in-store service, have the shelves better stocked, and have faster checkout times. The challenge for management will be to make sure that a better shopping experience translates into attractive returns on incremental investments. To his credit, the new head of the U.S. stores has made it a priority to fix the basics, and we are seeing progress in some of the stores we visit regularly. While we have not seen it across the board, one New Jersey store we visited posted cell phone numbers for the store manager and a regional manager with instructions to call if the rest rooms were not clean. We like the level of accountability. We are also pleased by the company s recent plan to close stores. We want to see management more focused on the productivity of the U.S. big-box stores. While the closings are an encouraging step, we believe that they represent only about 1% of sales. Our bias is for upgrading the shares. Rather than speculate on whether a surge in ROI will actually occur, we want to see tangible results. In the event of an upgrade, WMT might make most sense for income-oriented equity portfolios. WMT has a dividend yield of 2.5% and the company has boosted its dividend for 44 consecutive years. On the negative side, we remain concerned that it will be hard to raise margins in a world where Amazon seems obsessed with lowering prices to gain market share. That said, Kroger has thrived by offsetting lower gross margins with greater efficiency, suggesting that there is a similar opportunity for WMT. RECENT DEVELOPMENTS On August 17, Wal-Mart reported second-quarter GAAP earnings from continuing operations of $0.96 per share, which includes $0.17 in after-tax costs for the extinguishment of debt offset by a $0.05 per share gain from the sale of a business in Mexico. On an adjusted, non-gaap basis, WMT earned $1.08 per share in 2Q18, which was up from an adjusted $1.07 in 2Q17, and above our estimate and the StreetAccount consensus of $1.07. With positive comp sales and traffic, WMT s important U.S. division illustrated that it is still one of the strongest and most relevant U.S. retailers. WMT provided 3Q18 adjusted EPS guidance of $0.90-$0.98, compared to $0.98 in the third quarter of last year and a prerelease consensus of $0.97. Our prerelease estimate had also been $0.97. The company provided full-year adjusted EPS guidance of $4.30-$4.40 for FY18. Management previously said that it expected adjusted earnings of $4.20-$4.40. The pre-release consensus was $4.39. In the second quarter, comparable sales at Wal-Mart U.S. were up 1.8% excluding fuel. This was in line with the StreetAccount consensus. CEO Doug McMillon said that the U.S. stores team is doing a better job of serving customers. Based on our store visits, we agree that stores are looking neater and better organized. Our personal opinion and admittedly anecdotal observation is that checkout times vary significantly from store to store. In some cases we have seen little or no improvement with very few cashiers and insufficient staffing and line management at the self-checkout stations. Having one person serve eight self-checkout stations surely reduces costs, but that isn t always enough staffing. We have heard guests say that they feel disrespected. In other cases, we have seen very significant improvements including multiple open express lines that make it easy and convenient to make an after-work stop. We have said this in other reports, but Target does an excellent job with product returns

7 Same-store sales at Sam s Club were up 1.2%, excluding fuel. The StreetAccount consensus called for a 1.3% increase. Traffic was up 2.1% in the quarter. Average ticket was down by 0.9%. Total revenue of $123.4 billion (which includes membership fees) rose 2.1%. Membership fees and other fees decreased 3% to $1.4 billion. In 2Q16 membership fees and other included a $535 million gain from selling assets from a Chinese e- Commerce business. In this year s 2Q, the company had a smaller gain of $387 million from the sale of the Suburbia business in Mexico. Comparable traffic was up 1.8% and the average ticket was up 1.3% at Wal-Mart U.S. E-commerce growth helped Wal- Mart U.S. comps by an impressive 70 basis points in the third quarter. Second-quarter e-commerce sales rose about 60% (including acquisitions) in the U.S. which is encouraging given that WMT must compete with Amazon. Management expects 3Q18 comps at U.S. Wal-Mart stores to be up 1.5%-2%. Sam s Club posted a 2.1% increase in comp traffic and a 0.9% decrease in the average ticket. e-commerce added about 80 basis points to comp growth. For 3Q, Sam s expects comp sales (excluding fuel) to be up about 1% to 1.5%. Full-company operating income of $5.97 billion was down 3.2% in 2Q on a GAAP basis. Excluding the $387 million gain on the Mexican business, adjusted operating income was $5.58 billion, slightly above our estimate of $5.55 billion. The adjusted operating margin of 4.54% was just above our estimate of 4.5%. The StreetAccount consensus was also 4.5%. Sales (not including membership fees) rose 2.1% for the quarter, to $121.9 billion. Our estimate was $122.8 billion. Without the currency impact, sales would have increased 3%. International sales decreased 1%, to $28.3 billion, but were up 2.5% on a constant currency basis. Comp sales were positive in 9 of 11 International markets. U.K. comps reversed their 1Q decline, rising 1.8% on a 0.6% increase in traffic and a 1.2% increase in ticket. U.K customers seemed to respond to price reductions, although promotions weighed on gross margin. Total company gross margin decreased by 11 basis points, to 25%. Our estimate was 24.4%. The StreetAccount consensus was 25.3%. WMT is seeing some benefit from better logistics, offset by price reductions and online sales of lower margin items. As a percentage of sales, selling, general and administrative expenses were 21.2%. This is an increase of 10 basis from the prior-year quarter. Our estimate was 21%. The StreetAccount consensus was 21.1%. Digging a bit deeper, we note that the expense rate for U.S. stores rose by 13 basis points because of investments in e-commerce. Net interest expense was $575 million, nicely below our forecast of $645 million. Cash flow from operations was $11.4 billion in 1H18 versus $14.9 billion in 1H17. Net income was lower this year and inventories were a smaller source of cash this year. The trailing 12-month return on capital declined to 15.0% in 2Q18 from 15.5% in the prior-year period. This downtick was the result of a 1.2% decrease in adjusted operating income. Average invested capital was up 2.2%. We will be watching to see if WMT can grow earnings by making existing stores more productive, as Home Depot has done so effectively. WMT s return on capital has fallen significantly from 18.1% in FY13. One challenge in improving ROIC is that the Walton Family controls about half of the shares. The company may need to approach future repurchases in a thoughtful way to prevent a situation where the family s ownership becomes even larger and dissuades outside investors. EARNINGS & GROWTH ANALYSIS We are raising our FY18 adjusted earnings estimate to $4.37 per share from $4.35. There are just two changes. The second-quarter adjusted profit was $0.01 higher than we expected and we are raising our 4Q sales-growth estimate by about 100 basis points to 3%, which raises our EPS estimate to $ Q consensus is about $1.34. Our 3Q estimate remains at $0.97. Management s 3Q guidance is $0.90-$0.98 and consensus is $0.97. WMT s updated non-gaap guidance, for the year is $4.30-$4.40. This differs from the GAAP guidance by $0.12 per share. This excludes both the $0.17 per share loss on the extinguishment of debt in 2Q and the $0.05 gain on the sale of the business in Mexico in 2Q. Our FY18 estimate of operating margin remains at approximately 4.6%. We are maintaining our FY19 EPS estimate of $4.55 which represents an increase of approximately 4%. We are modeling about a 2% increase in sales and increase of about 5 basis points in operating margin that reflects a lower expense rate, partly offset by lower gross margin as a result of price investments and growing mix of online sales. We are expecting additional share repurchases. The current consensus is $4.63. If this number starts to rise on higher operating income, it could be a catalyst for higher ROI and for us to boost our rating. Our five-year earnings growth rate estimate is 2%. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating for Wal-Mart remains Medium-High, the second-highest rank on our five-point scale. The credit agencies give the company ratings in the AAs, and outlooks are stable. The company s commercial paper ratings are top - 7 -

8 tier, A1/P1. We believe this is a real advantage at times when the credit market is jittery, although we don t think Wal-Mart is likely to have any difficulty borrowing money. WMT had $6.5 billion in cash and equivalents on the balance sheet at the end of the second quarter. Total debt/capital was about 35%, which is slightly below the company s target, and just below prior-year levels. WMT s market position, earnings stability and real estate ownership are all very solid even allowing for a couple of difficult years. Moreover, we think the company s sales of food and medicine, which tend to depress margins, add to earnings stability as well as inventory turnover and store traffic. In our opinion, it might be difficult for a competitor to topple a low-cost, high-volume retailer like WMT or Costco because it is so hard to get the inventory management and logistics right. It also takes considerable capital to build the necessary computer systems, distribution centers, transportation and stores. Amazon seems primed for the challenge, but we believe that there are a lot of retailers that will get squeezed before Wal-Mart does. Margins at WMT are lower than we would normally look for in a company with a High financial strength rating, and WMT s debt is not exceptionally low. Amazon is certainly making a move to grab more general merchandise business, but WMT is fighting back. It will take time for WMT to earn the confidence that AMZN has deservedly won as an online seller, but there is a convenience to being able to place an online order and pick it up in a local store, and there is certainly a benefit to being able to do an in-store return. Wal-Mart said in the annual report that 90% of the U.S. population lives within 10 miles of a Wal-Mart store. Wal-Mart owns about 86% of its domestic discount stores, supercenters and neighborhood markets and 85% of Sam s Clubs locations. This is a high percentage relative to many other retailers we follow. In some additional cases, WMT owns the building and leases the land. The company has a combination of owned and leased properties outside the U.S. We believe that approximately one-third of those properties are owned. The balance sheet lists the value of property and equipment at about $108 billion net of depreciation, down from $109 billion a year earlier. We believe that about 70% of the pre-depreciation value is in land and buildings. Treating operating leases as debt, we estimate that the present value of leases at about $12.5 billion, which puts adjusted debt at approximately 40% of capital, which is below average for retailers we follow. We estimate that lease-adjusted debt was about 2-times EBIT plus depreciation and rent at the end of FY12 and FY13. It was about 1.9-times in FY11. This is a very solid level relative to other retailers we follow. Adjusted debt was approximately 2.1-times in FY14 and 1.8-times in FY15 and FY16. The ratio was also approximately 1.8-times for FY17. We believe that investors are going to hold management s feet to the fire to make sure that the company uses its capital as productively as possible. Trailing ROI 15.2% in FY17, 15.5% in FY16, 16.9% in FY15, 17% in FY14, 18.1% in FY13, 18.6% in FY12 and 19.2% in FY11. It does appear that management is looking much harder at capital investments. The company paid dividends of $0.95 in FY09 and $1.09 in FY10. WMT raised the quarterly dividend to $ per share from $ in March. Dividend payments totaled $1.21 per share in FY11, $1.46 in FY12, $1.59 in FY13, $1.88 in FY14, $1.92 in FY15, $1.96 in FY16 and $2.00 in FY17. In the 4Q17 release, the company announced a dividend increase to $2.04 for FY18. According to management, Wal-Mart has increased its payout every year since it first declared a dividend in We are maintaining our FY18 dividend estimate of $2.04 per share. Our FY19 estimate is $2.12 per share. The company repurchased about $7.3 billion of its stock in FY10, $14.8 billion in FY11, and $6.3 billion in FY12. In FY13, it repurchased $7.6 billion. WMT repurchased $6.7 billion of its stock in FY14, $1 billion in FY15, and $4.1 billion in FY16. In October of calendar 2015, WMT authorized a new $20 billion repurchase plan. At the end of FY17, the company had a remaining authorization of $10.8 billion. We believe that WMT ended 3Q with an authorization of approximately $4.8 billion after repurchasing about $2.2 billion of shares in 1Q. MANAGEMENT & RISKS Even Wal-Mart faces intense competition from Amazon and online retailers. This is especially true in categories like entertainment and electronics. But Wal-Mart s size, distribution capabilities, focus on low prices and emphasis on food and other low-margin consumer products leave it better positioned than most retailers. WMT and other retailers have recently been under pressure because of fear that Amazon s proposed purchase of Whole Foods will hurt grocery margins and move Amazon closer to customers. Amazon is a powerful competitor that is willing to operate at very low margins. AMZN s entry into groceries is somewhat unconventional. We d normally expect a big player to enter a fragmented, high margin sector like local pet shops, or small-town hardware stores. In acquiring Whole Foods, Amazon is entering an industry with razor-thin margins that is served by three very efficient competitors in WMT, Kroger and Costco. While it will clearly be desirable for AMZN to have a brick-andmortar presence in the busy high-income cities and suburbs where Whole Foods operates, we believe that Amazon will need to significantly lower prices and improve the supply chain at Whole Foods. We think that will be very good for core Whole Foods shoppers. A challenge for Amazon will be that margins on dry groceries are already very thin and Whole Foods gets about two thirds of its sales from fresh and prepared foods which involve a different kind of supply chain than the one Amazon operates so - 8 -

9 well. While Whole foods has lowered some prices, we d cite the example of an organic lemonade brand. A local Whole Foods cut the price from $3.19 to $2.79. That is still above the $2.50 for Stop & Shop customers with a loyalty card and the everyday price of $2.00 at Wal-Mart. In late June 2010, Bill Simon became president and CEO of Wal-Mart U.S. He had a number of accomplishments at the company, including the $4 generic program. In July of calendar 2014, Mr. Simon was replaced by Greg Foran who had been President and CEO of Wal-Mart Asia. Mr. Foran seems to be devoting a lot of attention to Shopkeeping 101, or the very basics of running a retail store, which we commend. Based on a lot of store visits, we believe he is making progress. We believe that stores generally look cleaner and the shelves appear better stocked. We shop WMT regularly and we believe that there are far too many instances where checkout times are unacceptably long because there are not enough registers open. Self-checkout lines do help, but they are inconvenient for many types of products and there are often back-ups because shoppers need assistance. Over the last few years, Wal-Mart has made a significant effort to improve its image in the U.S., which was somewhat marred by the allegations of bribery in Mexico that were published by the New York Times. Then CEO Mike Duke said that the company was working to determine what happened and would take aggressive action if violations of the law or company policies occurred. The company is also aware of allegations related to violations of the Foreign Corrupt Practices that may have occurred in Brazil, China and India. WMT incurred $157 million of costs in FY13, $282 million in FCPA expenses in FY14 and $173 million in FY15. Management does not believe that the issue will have a material adverse impact on the business. Materiality is obviously a high bar for a company with over $480 billion in annual sales, almost $7 billion of cash, and $200 billion of assets. Doug McMillon replaced Mr. Duke as CEO. Mr. McMillon started as an hourly associate in 1984 and has since served as CEO of Sam s and the International business. We believe that the company s response to natural disasters, the initiative to cut medicine prices, programs to be more environmentally conscious, the settlement of class-action lawsuits, and a new plan to hire military veterans are all steps toward improving the company s image. WMT also took a very active role following the earthquake and tsunami in Japan. Wal-Mart has taken very visible steps to improve healthcare for its employees and to become more environmentally friendly. The recent initiative to increase training and wages should also help. We believe that the banking and financial crisis probably improved WMT s image. The company has created jobs as other companies fired workers and it continued to grow as financial firms went bankrupt or required billions in public money. The company is involved in a range of litigation including various suits that allege unfair treatment of female employees. These issues are discussed in the annual report. As the company continues to expand, market saturation and ongoing cannibalization within and among Wal-Mart s various formats in its main U.S. market pose significant risks. That said, we believe that the company will be much more disciplined in opening stores. We have previously been critical of the company s store environment, which can be cluttered. It appears that customers liked the stores with less merchandise in the aisles, but they don t necessarily buy more. We still believe that WMT as a whole has room to improve if it is to reach the level of in-store execution as the Target stores we visit. Several years ago we walked a Nordstrom store with Blake Nordstrom. He was very quick to recognize that the competition is no longer made up of just immediate brick-and-mortar peers. Shoppers compare any experience with that available from a range of best-in-class companies. For Wal- Mart, these may include, Amazon, Zappos, L.L. Bean and Whole Foods. A risk related to international expansion is that the company may not be embraced warmly in some overseas markets; it may also have to deal with unfamiliar regulations and is likely to face volatile currency fluctuations. We believe that there is also a risk that the company may not be able to gain the scope to maximize profits in some markets. The counter point is that everyone likes to save money and WMT has the potential to use its buying power and logistical expertise to offer low prices on items that are relevant and desired in markets outside the U.S. Currency fluctuation is an ongoing risk. A strong dollar hurts earnings as foreign profits are translated into fewer dollars. A weak dollar might be a bigger long-term threat because it could cost Wal-Mart more to purchase the large number of items it imports from Asia. The economy is a risk for all retailers because of their sensitivity to changes in consumer discretionary spending. Wal- Mart has often been somewhat insulated from downturns in consumer spending, given its low-price leader status and the growing number of food items that it sells. However, the discounters have been hit harder by price hikes for gasoline and other commodities, which disproportionately affect the discretionary income of lower-income consumers. Deflation can also be a challenge as it can reduce unit revenue on selected products such as groceries. An additional risk is that management may simply stumble in executing one or more of its various strategies, from realestate acquisition to cost control, product mix and employment practices

10 Despite a range of risk factors, we don t think Wal-Mart is affected by a very important risk for retailers irrelevance. A great many retailers could easily be replaced or vanish completely, but we believe that there is a need for Wal-Mart. It plays an important role in the economy. Its buying power, inventory management and logistical prowess represent a real barrier to entry. The Walton family controls approximately half of the company s outstanding shares. COMPANY DESCRIPTION Wal-Mart is the world s largest retailer. In the fiscal year ended January 31, 2017, sales were $481 billion. The company has three segments: Wal-Mart Stores, which accounted for about 63% of sales; Sam s Club, a membership warehouse chain, which comprised 12% of revenue; and the International segment, which generated 25% of sales. The company, based in Bentonville, Arkansas, ended fiscal 2017 with about 11,700 retail units in about 28 countries. Groceries are the largest produce category in the U.S. market, at approximately 56% of sales. E-commerce sales were over $12 billion in FY16. VALUATION Over the last year, Wal-Mart shares have returned about 12%. The shares are currently trading at about 18-times our FY18 EPS forecast and 17.4-times our FY19 forecast. The current-year multiple is in line with the S&P 500 s multiple of 18-times our calendar 2017 estimate. We believe this is reasonable. Wal-Mart is a mature business and is facing earnings pressure as it raises employee wages and invests in e-commerce capabilities. The company still has a strong balance sheet and solid cash flow generation. On a relative trailing basis, WMT is trading at a 15% discount to the S&P 500 s trailing multiple, which is consistent with the five-year average of a 15% discount. We believe that the company will need to improve ROI and further improve comparable sales to see higher multiples on an absolute and relative basis. WMT trades at a forward-four-quarter P/E of 17.6, which is slightly above the 17.2 median of its mass-merchant peers. We believe that the company s financial strength argues for a premium multiple, but a soft earnings outlook suggests a discount until the market sees an inflection point. The company s consensus, five-year, growth rate of 5.1% is now well below the group median of about 11.5%. WMT has raised its dividend every year since it initiated a payout in Over the last five years, the company has raised the dividend at an annual rate of 5.4%, but we expect slower growth over the next few years. WMT s indicated dividend yield is 2.5%. We believe this is attractive at a premium to the 10-year Treasury yield of 2.05%. Based on a simple discounted earnings model that assumes that EPS hits our estimate of $4.55 in FY19 and grows by 5% per year in the following three years, EPS would grow to $5.25 per share. We are assuming that the shares trade at a terminal multiple of 18, which is unchanged from our previous note. The shares would be worth about $95 in 4.5 years. Using a discount rate of 7.5%, which is 150 basis points below the rate we use for most of our universe, the shares would be worth about $70. WMT shares trade at an enterprise value of about 12.2-times trailing EBIT, versus a five-year average of 11. The range for the period is 9-to 13-times. We think the current multiple is fair given WMT s market position, financial strength, and earnings challenges. Based on WMT s financial strength, it could move higher, though it will likely be constrained until earnings growth accelerates. 12-times is a multiple that we use to value high quality retailers, because takeovers in the sector often occur near this level. On September 8, HOLD-rated WMT closed at $78.88, down $1.19. (Christopher Graja, CFA, 9/8/17)