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Morningstar Equity Analyst Report | Pricing: 06 Sep 2013 | Rating: 06 Sep 2013 | Trading Currency: USD | Page 1 of 7

Banco Santander SA SAN (XNYS)
Morningstar Rating

Last Price

Fair Value Estimate

Price/Fair Value

Dividend Yield %

Market Cap (Bil)

Industry Group

Stewardship

QQQ

7.30

9.00

0.81

8.50

78.91

Banks - Global

Standard

Morningstar Pillars

Analyst

Quantitative

Economic Moat
Valuation
Uncertainty
Financial Health

Narrow
QQQ
Very High
BBB

Narrow
Undervalued
High
Strong

SAN
USA
y

Price/Intrinsic Value
Price/Earnings
Forward P/E
Price/Cash Flow
Price/Free Cash Flow
Dividend Yield %

Investment Thesis

profitability through loan losses in the short term.

Morningstar Analysts 20 March 2013

Quantitative Valuation

Undervalued

Santander Profits Fall 13% Sequentially in 2Q

Fairly Valued

Overvalued

Current

5-Yr Avg

0.85
21.9
14.5

11.8
8.50


12.6

0.5
5.8
7.30

Sector Country

0.99
12.4
10.4
8.0
18.7
2.89

0.97
15.3
10.7
6.8
11.9
2.48

Bulls Say
OSantander is a well-diversified financial
institution, whose wide reach has helped it stay
profitable during this downturn.
OThe bank has proved to be a good acquisitor,
capable of controlling costs and maintaining an
acceptable efficiency ratio.
OSantander has top positions in several
promising Latin American markets, which should
help profitability.
Bears Say
OAlthough Santander seems to have avoided
problems in Spain and the U.K. somewhat better
than its peers so far, these countries' recessions
could catch up with Santander, prompting
additional credit losses.
OThe bank's nonperforming loan balances may
not show the full picture, hiding potentially bad
loans. If that were the case, loan losses could rise
dramatically, and hinder profitability for several
quarters.
OAlthough Santander's business is diversified
well beyond Spain, its home country's
creditworthiness could have an adverse indirect
impact through elevated costs of debt and equity,
in our view.

In its 150-plus years of existence, Banco Santander has
come a long way, from being a trade bank in its namesake
town in northern Spain, to one of the world's largest
financial institutions. Although we are not keen on growth
for growth's sake, the firm has a good record of profitable
expansion. We like its outlook and think the banking
behemoth has weathered the storm well compared with
its peers. However, it is not out of the woods yet, and very
severe short-term risks remain that could impair returns
and cripple capital, in our view.
As with peer Banco Bilbao Vizcaya Argentaria BBVA, we
think geographic diversification is one of the main reasons
for Santander's resilience. Like its forefathers did in the
16th century, management has looked west toward Latin
America to expand Santander's franchise (roughly half of
earnings), where it is among the top banks in each of its
markets. The bank also has a sizable stake in the U.K.
(around 15% of profits) and a foothold in the U.S. Indeed,
its native Spain, whose severe recession has put regional
banks under brutal stress, accounts for less than one
fourth of the company's operations, cushioning the
country's adverse impact on profitability. In contrast, we
think bright prospects in Brazil (about 30% of profits) have
helped and will continue to help the firm maintain
profitability during this economic downturn and beyond.
In addition, we think the company's strategy of floating
part of its stakes in some of its regional operations has
been a good source of capital, like Santander Brasil's and
Santander Mexico's IPOs in 2009 and 2012, respectively.
Santander has also shown an outstanding aptitude for
managing credit risk, in our opinion. Having learned from
multiple crises throughout the bank's history (with a little
help from the Bank of Spain), management prides itself
on maintaining stringent underwriting standards and has
largely avoided the worst impacts of Spain's recession
thus far. Despite a meaningful spike in recent quarters,
overall nonperforming loans have remained in check, at
around 4.5% of loans. In our view, loan losses are bound
to rise, however, since the bank relies heavily on retail
operations, which typically churn out higher losses than
wholesale businesses. Further, we think pressure is
building in its Spanish retail arm and in the bank's Latin
American subsidiaries, which will take a bite from

Santander has been a successful acquisitor, but we are
wary that this may change. Even after conducting very
sizable purchases to expand its reach, the company has
done a good job of controlling costs, in our opinion.
Efficiency (noninterest expense/revenue) has averaged
less than 60% in the last five years, which we see as
adequate, given that oftentimes mergers tend to eat up a
lot of resources. However, we worry that management's
appetite for growth could be too big, making it overpay for
targets or making the entity too large to be effectively
managed. Either case could prove detrimental to
shareholder wealth.

Analyst Note
Erin Davis 30 July 2013

Santander Profits Fall 13% Sequentially in 2Q
Spain's Banco Santander reported profits of EUR 1,050
million for the second quarter, down from EUR 1,205
million in the first quarter, as revenue fell in the difficult
economic environment. The bank's 2013 earnings are well
ahead of our full-year expectations, but we continue to
think that more asset write-downs may be ahead given
the ongoing deterioration in Spain's business
environment.

Across segments, Santander's performance was largely
in line with our expectations. In Continental Europe,
revenue and expenses were flat with the trailing quarter,
but a 10% rise in provisions caused profits to fall 19% to
EUR 250 million. We think results are likely to continue to
deteriorate; non-performing loans rose 121 basis points
sequentially to 7.8% of loans, while provisions for loan
losses slipped to cover just 63% of NPLs compared with
71% in the first quarter. Return on fell to 3.4% from 3.9%,
and remains well below the bank's 13% estimated cost
of equity. In Latin America, profits were down 12%
sequentially, to EUR 868 million, on the back of slow
economic growth in the region. Brazil, the biggest driver
of this segment, saw profits fall 16% sequentially to EUR
420 million. We're pleased that credit performance
improved and that non-performing loans fell 18 basis
points to 5.26% of loans, but worry that this could reverse
if growth does not improve. Still, we're reassured by the

© 2013 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information contained
herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without
written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

?

Morningstar Equity Analyst Report |Page 2 of 7

Banco Santander SA SAN (XNYS)
Morningstar Rating

Last Price

Fair Value Estimate

Price/Fair Value

Dividend Yield %

Market Cap (Bil)

Industry Group

Stewardship

QQQ

7.30

9.00

0.81

8.50

78.91

Banks - Global

Standard

Close Competitors

Currency (Mil)

Market Cap

TTM Sales

Operating Margin

TTM/PE

HSBC Holdings PLC HBC

USD

205,138

82,885

18.78

12.90

Citigroup Inc C

USD

149,679

73,371

16.37

15.17

Barclays PLC BCS

USD

59,545

45,391

-1.98

0.00

Deutsche Bank AG DB

USD

45,340

47,884

-3.52

0.00

fact that the bank continued to generate capital despite
the difficult environment, and improved its core Tier 1 ratio
by 44 basis points to 11.1%. We plan to maintain our fair
value estimate for the narrow-moat bank.

Economic Moat
20 March 2013

In spite of being welldiversified geographically,
Santander is not immune to its
home country's weakening
creditworthiness.

We think Banco Santander has a narrow moat. Santander
is Spain's largest lender and one of the biggest financial
institutions in the world. As with most banks, Santander's
narrow moat is due in part to its deposit base. Deposits
allow banks to fund loans below the risk-free interest rate,
augmenting the spread between the interest on the money
they loan and what they pay depositors. In addition,
customers' deposits are "sticky," meaning that, despite all
the fees banks charge, clients tend to remain with them,
especially if they use several of the firm's services. Indeed,
roughly half of Santander's revenues come from fees,
which reduce the company's reliance on interest rate
movements. Throughout the years, management has
proven to be focused on cost control both in its legacy
businesses and in the many acquisitions the firm has
undertaken in the past. Hence, the bank's efficiency ratio
(noninterest expense/revenues) has averaged less than
60% in the last five years. Moreover, we think Santander's
geographical diversification is another reason behind its
moat. Having revenue streams originating both in
developed and in emerging economies has proven to be
invaluable for the bank. While many of its pure-play
Spanish peers are struggling, Santander's returns have
remained positive even during these troubling times.

Valuation
20 March 2013

We are leaving Santander's fair value estimate at $9 per
ADR.
In our view, Santander still has to face plenty of loan
losses, with net charge-offs of around 1.7% and 1.3% of
loans in 2013 and 2014, respectively (versus 1.5% in late
2012). In the long term, we expect the bank's loan losses
will hover around 0.7% of loans. This is slightly higher
than the 0.5% historical average because of the bank's

increased focus on emerging markets and loans to
individuals. We think this exposure to the developing
world can afford it an above-average internal asset growth
rate of 7%-8% per year in the future. Still, we anticipate
expansion will be somewhat muted in the next couple of
years. We think the bank will keep its efficiency ratio
below 60%. Elevated charge-offs in the next few years
will command high provisions for loan losses, which will
put a damper on the bottom line and hinder profitability.
Lower earnings could make it difficult for Santander to
generate enough equity to fund future acquisitions and
maintain very strong capital ratios at the same time. Thus,
we think there could be an equity offering to boost the
company's capital position. In the long run, however, we
expect the bank will outearn its 13% estimated cost of
equity with relative ease.
Our downside scenario incorporates more severe loan
losses and the need for much more capital given
significantly slimmer earnings. These factors trim roughly
50% off our base-case fair value.
Our sovereign distress scenario incorporates a meaningful
haircut on Santander's sovereign debt securities on top of
the downside scenario conditions. By our estimates,
Spanish sovereign debt makes up around 70% of the firm's
core equity. Thus, we think that any write-downs on these
holdings would surely mar Santander's capital position.
As a result, the bank would likely be forced to raise equity
at a distressed price, which would prove quite dilutive, in
our view.
We weigh our base-case fair value of EUR 10 (1.30 times
book value) at 50%, the downside fair value of EUR 5 (0.65
times book value) at 20%, and our sovereign distress fair
value of EUR 3.5 at 30%. Using an exchange rate of $1.30
per euro (as of March 20, 2013) and a 1 to 1 ADR conversion
factor, our weighted-average EUR 7 per share fair value
(0.9 times book value) equates to $9 per ADR.

Risk
20 March 2013

Santander's widespread geographical reach, while
beneficial, is not riskless. Although the bank has navigated
Spain's downturn better than the country's regional banks,
its native country had a colossal construction boom that
both inflated real estate prices dramatically and employed
vast numbers of people. Now, Spain's high unemployment
and falling asset prices pose a threat to Santander's credit

© 2013 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information contained
herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without
written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

?

Morningstar Equity Analyst Report |Page 3 of 7

Banco Santander SA SAN (XNYS)
Morningstar Rating

Last Price

Fair Value Estimate

Price/Fair Value

Dividend Yield %

Market Cap (Bil)

Industry Group

Stewardship

QQQ

7.30

9.00

0.81

8.50

78.91

Banks - Global

Standard

quality, and losses may exceed our expectations. Although
slightly less dramatic, the same is true for the U.K. and
the rest of Europe. Finally, the bank is also exposed to
Latin America, which, despite recent signs of
stabilization--namely in Brazil and Chile--could face
economic upheaval. Another risk that we see is
Santander's insatiable appetite for acquisitions. We
worry that management could get ahead of itself and
overpay for its purchases, or fail to realize meaningful cost
synergies.
In spite of being well-diversified geographically,
Santander is not immune to its home country's
deteriorating creditworthiness, in our view. The bank
faces the prospect of tighter regulation which may require
higher capital ratios. If Santander's acquisitions drain
more capital than what it can earn internally, management
could opt to conduct an equity offering. Should the bank
have to tap the capital markets to raise funds, we think
Santander could find itself issuing very costly debt and/or
very dilutive equity, especially if the bank were forced to
apply haircuts to its European sovereign debt holdings,
which are mostly Spanish. To be sure, write-downs on
Santander's Spanish sovereign securities (which are
equal to roughly 70% of its core capital) could wipe out a
meaningful portion of the bank's equity base.

necessary experience, it may not prevent the firm from
being run as a family business. Finally, we think senior
management's remuneration system could improve.
Although we like that the variable portion of salary makes
up about 60% of the total, we think using only two
measures of performance, share return and earnings per
share growth, may not be appropriate. While we
acknowledge that management's actions will ultimately
be reflected in the share price and bottom line, we think
credit quality and return metrics would enhance the bank's
compensation scheme. Thus, on balance, we think
Santander's management team is a standard steward of
shareowner capital.

Management
Morningstar Analysts 20 March 2013

We think Santander's top brass has done a good job of
expanding the bank's reach and controlling operating and
credit costs, and thus has put shareowner capital to good
use. Santander has withstood several crises from which
it has learned the indispensability of sound underwriting
standards and diversification, in our view. We think
Santander's growth has served shareholders well thus far.
However, we are worried that management, in its
apparently insatiable appetite for expansion, could
overpay for future acquisitions or fail to realize synergies,
either of which could destroy shareholder value.
We're also concerned about the Botin family's influence
on the decision-making process. In our opinion, the family
may be too focused on expanding Santander's empire,
and its interests may not always be aligned with those of
minority shareholders. Chairman Emilio Botin represents
the third generation of Botins at the bank's helm, and his
daughter, Ana Botin (who currently heads Santander UK),
is on track to succeed him. Although she may have the

© 2013 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information contained
herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without
written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

?

Morningstar Equity Analyst Report |Page 4 of 7

Banco Santander SA SAN (XNYS)
Morningstar Rating

Last Price

Fair Value Estimate

Price/Fair Value

Dividend Yield %

Market Cap (Bil)

Industry Group

Stewardship

QQQ

7.30

9.00

0.81

8.50

78.91

Banks - Global

Standard

Analyst Notes Archive
Santander Profits Fall 13% Sequentially in 2Q
Erin Davis 30 July 2013

Spain's Banco Santander reported profits of EUR 1,050
million for the second quarter, down from EUR 1,205
million in the first quarter, as revenue fell in the difficult
economic environment. The bank's 2013 earnings are well
ahead of our full-year expectations, but we continue to
think that more asset write-downs may be ahead given
the ongoing deterioration in Spain's business
environment.

earlier when he had worked for Banesto, one of
Santander's predecessors. After a number of legal battles,
the central bank recently opened hearings into the matter.
Saenz will be replaced by Javier Marin, who had served
as managing director of the bank. This transition at the
top comes as little surprise, as Saenz, who is 70, was likely
to step aside in the coming years for one reason or another,
in our opinion. We think Marin, a 22-year veteran of the
bank, is likely to make only modest changes to the
company's strategy.
Santander's First-Quarter Profit Benefits Lower
Provisions
Erin Davis 26 April 2013

Across segments, Santander's performance was largely
in line with our expectations. In Continental Europe,
revenue and expenses were flat with the trailing quarter,
but a 10% rise in provisions caused profits to fall 19% to
EUR 250 million. We think results are likely to continue to
deteriorate; non-performing loans rose 121 basis points
sequentially to 7.8% of loans, while provisions for loan
losses slipped to cover just 63% of NPLs compared with
71% in the first quarter. Return on fell to 3.4% from 3.9%,
and remains well below the bank's 13% estimated cost
of equity. In Latin America, profits were down 12%
sequentially, to EUR 868 million, on the back of slow
economic growth in the region. Brazil, the biggest driver
of this segment, saw profits fall 16% sequentially to EUR
420 million. We're pleased that credit performance
improved and that non-performing loans fell 18 basis
points to 5.26% of loans, but worry that this could reverse
if growth does not improve. Still, we're reassured by the
fact that the bank continued to generate capital despite
the difficult environment, and improved its core Tier 1 ratio
by 44 basis points to 11.1%. We plan to maintain our fair
value estimate for the narrow-moat bank.
Saenz Steps Down as Santander CEO
Erin Davis 29 April 2013

On Monday, Banco Santander SAN announced that
Alfredo Saenz has resigned as CEO ahead of a decision
by Spanish regulators that would have effectively decided
whether his criminal conviction should disallow him from
working in banking. Until recently, Spain's rules had
prevented anyone with a criminal conviction from holding
a senior position in banking. Saenz was convicted in 2009
of making false criminal acquisitions against clients years

In the first quarter of the year, Spain's largest bank, Grupo
Santander SAN, earned EUR 1,205 million, up significantly
from the EUR 401 million it earned in the trailing quarter.
Most of this increase was due to the non-recurrence of
special loan loss provisions in the fourth quarter; excluding
this, earnings were up 18% sequentially, but down 26%
from the year-ago quarter because of the weaker
economic environment. We had already factored in the
roll-off of these extraordinary provisions and we are
leaving our fair value estimate at EUR 7 per share. For the
moment, we are also leaving our $9 per ADR and GBX 570
per British share fair value estimates unchanged, but we
will monitor exchange rate movements. If the euro keeps
up its recent strengthening streak we would make a
positive adjustment to our dollar-and pence-denominated
fair value estimates.
Credit quality remains the main headwind for Santander,
in our view. Overall, the group's nonperforming loans rose
to 4.8% of the portfolio (versus 4.5% in at year-end).
Notably, in the Spanish core portfolio, NPLs rose to 4.12%,
up from 3.8% at year-end. In the run-off Spanish portfolio,
NPLs rose 220 basis points to a whopping 56.2%. After
being nudged up in 2012, coverage fell in the first quarter.
Loan loss provisions cover 70.9% of NPLs compared to
72.4% at year-end. We see no indication yet that a peak
in dud loans is nigh. Thus, after fully complying with
government-mandated reserves, we expect to see regular
provisions for loan losses run close to EUR 3 billion per
quarter, or around 1.7% of loans.

© 2013 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information contained
herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without
written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

?

Page
Page
5 of1 7of 1

Quantitative Equity Report | Release Date: 06 September 2013 | Reporting Currency: EUR | Trading Currency: USD

Banco Santander SA ADR SAN
Last Close

Quantitative Fair Value Estimate

Market Cap (Mil)

Sector

Industry

7.30

8.48

78,153.4

y Financial Services

Banks - Global

Banco Santander SA offers retail, commercial, private banking
and asset management services. The company operates in
Spain, the UK, Portugal, Europe, Brazil, Latin American
countries and the US.

Quantitative Scores

Country of Domicile
ESP Spain

Price Versus Quantitative Fair Value
2009

2010

2011

2012

2013

2014

Sales/Share
Forecast Range
Forcasted Price
Dividend
Split

20
16

Scores

Momentum:

Standard Deviation: 36.91

All Rel Sector Rel Country

Quantitative Moat
Narrow
Valuation
Undervalued
Quantitative Uncertainty High
Financial Health
Strong

94
75
74
78

91
86
55
68

12

92
83
64
85

Quantitative Fair Value Estimate
8

Total Return

6.31

52-Wk

8.86

4.77

5-Yr

17.51

4
SAN
ESP
y

Undervalued

Fairly Valued

Overvalued

Valuation

Sector
Median

Country
Median


12.6

0.5
5.8
7.30
0.9
1.4

0.99
12.4
10.4
8.0
18.7
2.89
1.0
2.3

0.97
15.3
10.7
6.8
11.9
2.48
1.2
0.9

Current 5-Yr Avg

Sector
Median

Country
Median

10.2
1.3
508.0

9.8
3.0
281.8

Current 5-Yr Avg

Price/Quant Fair Value
Price/Earnings
Forward P/E
Price/Cash Flow
Price/Free Cash Flow
Dividend Yield %
Price/Book
Price/Sales

0.85
21.9
14.5

11.8
8.50
0.8
1.1

Profitability

Return on Equity %
Return on Assets %
Revenue/Employee (K)

3.7
0.2
277.8

10.0
0.6
265.5

Score
100

Quantitative Moat

80
60
40
20
0
2006

2007

2008

2009

2010

2011

2012

Financial Health
Current 5-Yr Avg

Distance to Default
Solvency Score
Assets/Equity
Long-Term Debt/Equity

2013

Sector
Median

Country
Median

0.7
490.0
5.0
0.4

0.5
755.2
2.9
0.4

0.7

17.0
0.2



16.7
0.4

1-Year

3-Year

5-Year

10-Year

-0.6
-85.2
-63.3
32.5
-15.9
5.5

10.0
-34.1
-39.9
-7.2
-5.3
-9.9

11.7
-41.0
-29.7
-1.6
-3.7
-7.7

12.1
-12.7
-7.3
7.8
5.0
4.7

Growth Per Share
Revenue %
Operating Income %
Earnings %
Dividends %
Book Value %
Stock Total Return %

82.5
54.1
5.36
11.1
2.1

-31.3
-48.1
6.03
8.5
1.7

-24.2
-25.8
7.35
9.7
1.0

19.7
3.5
7.88
28.1
1.1

-5.0
-23.4
8.50
21.9
1.1

Total Return %
+/– Market (Morningstar US Index)
Dividend Yield %
Price/Earnings
Price/Revenue
Undervalued
Fairly Valued
Overvalued

Monthly Volume (Million Shares)
Liquidity: High

35

Financials (Fiscal Year in Mil)
Revenue
% Change

2008

2009

2010

2011

2012

TTM

40,956
32.7

47,989
17.2

42,049
-12.4

54,124
28.7

53,577
-1.0

51,892
-3.1

11,230
0.3
9,332

7,458
-33.6
9,412

3,963
-46.9
8,181

7,939
100.4
5,351

801
-89.9
2,205

1,447
80.6
2,711

Operating Income
% Change
Net Income

15,827
-3,488
6,309
15.4

-18,036
-3,223
-4,833
-10.1

51,874

4,994
11.9

35,995
-3,398
3,955
7.3

24,322
-3,887
3,965
7.4



5,049
9.7

Operating Cash Flow
Capital Spending
Free Cash Flow
% Sales

1.19
-14.4
1.26

1.02
-14.4
-0.79

0.92
-9.9
0.75

0.59
-35.9
0.56

0.22
-62.5
0.53

0.25
13.6
0.62

EPS
% Change
Free Cash Flow/Share

0.62
11.23
8,229

0.62
11.96
8,329

0.47
11.98
9,077

0.38
10.90
10,539

0.50
9.37
10,810

0.47
8.73
10,810

16.6
1.0
22.8
0.04
18.2

14.6
0.9
19.6
0.04
15.5

11.1
0.7
19.5
0.04
16.2

7.1
0.4
9.9
0.04
16.4

2.9
0.2
4.1
0.04
17.0

3.7
0.2
5.2
0.04
17.2

Profitability
Return on Equity %
Return on Assets %
Net Margin %
Asset Turnover
Financial Leverage


27.4
38,873


15.5
36,805


9.4
30,475


14.7
22,992


1.5
18,238


2.8


Gross Margin %
Operating Margin %
Long-Term Debt

57,587
4.6

71,832
5.5

75,018
4.2

76,414
4.3

74,654
4.4

71,299
4.4

Quarterly Revenue & EPS
Revenue (Mil)
Mar
Jun
Sep
Dec
Total
2013
10,290.0 10,319.0



2012
10,911.0 16,179.0 10,270.0 21,707.0 53,577.0
2011
10,302.0 11,835.3 10,563.0 20,870.0 54,124.0
2010
2,807.0 22,474.2 9,544.0 11,830.3 42,049.3
Earnings Per Share
2013
0.11
0.10



2012
0.17
0.01
0.01
0.03
0.22
2011
0.23
0.15
0.18
0.00
0.59
2010
0.25
0.25
0.25
0.20
0.92

Dividends/Share
Book Value/Share
Shares Outstanding (Mil)

Total Equity
Fixed Asset Turns

Revenue Growth Year On Year %
76.4
36.7
10.7

5.9

4.0
-2.8

-5.7
-36.2

-47.3
2011

2012

©2013 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information
contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution
is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

2013

®

ß

Morningstar
Morningstar Equity
Equity Analyst
Analyst Report
Report |Page 6 of 7

Morningstar Equity & Credit Research Methodology
Fundamental Analysis
At Morningstar, we believe buying shares of superior
businesses at a discount and allowing them to compound over time is the surest way to create wealth in
the stock market. The long-term fundamentals of businesses, such as cash flow, competition, economic cycles, and stewardship, are our primary focus. Occasionally, this approach causes our recommendations to
appear out of step with the market, but willingness to
be contrarian is an important source of outperformance and a benefit of Morningstar’s independence.
Our analysts conduct primary research to inform our
views on each firm’s moat, fair value and uncertainty.

Fundamental Economic
Fair Value
Moat Rating Estimate
Analysis

Uncertainty
Assessment

QQQQQ
QQQQ
QQQ
QQ
Q
Star
Rating

Economic Moat
The economic moat concept is a cornerstone of Morningstar’s investment philosophy and is used to distinguish high-quality companies with sustainable competitive advantages. An economic moat is a structural
feature that allows a firm to sustain excess returns
over a long period of time. Without a moat, a company’s profits are more susceptible to competition. Companies with narrow moats are likely to achieve normalized excess returns beyond 10 years while wide-moat
companies are likely to sustain excess returns beyond
20 years. The longer a firm generates economic profits,
the higher its intrinsic value. We believe lower-quality
no-moat companies will see their returns gravitate to-

ward the firm’s cost of capital more quickly than companies with moats will. We have identified five sources of
economic moats: intangible assets, switching costs,
network effect, cost advantage, and efficient scale.

Fair Value Estimate
Our analyst-driven fair value estimate is based primarily on Morningstar’s proprietary three-stage discounted
cash flow model. We also use a variety of supplementary fundamental methods to triangulate a company’s
worth, such as sum-of-the-parts, multiples, and yields,
among others. We’re looking well beyond next quarter
to determine the cash-generating ability of a company’s
assets because we believe the market price of a security will migrate toward the firm’s intrinsic value over
time. Economic moats are not only an important sorting
mechanism for quality in our framework, but the designation also directly contributes to our estimate of a
company’s intrinsic value through sustained excess returns on invested capital.

Uncertainty Rating
The Morningstar Uncertainty Rating demonstrates our
assessment of a firm’s cash flow predictability, or valuation risk. From this rating, we determine appropriate
margins of safety: The higher the uncertainty, the wider
the margin of safety around our fair value estimate before our recommendations are triggered. Our uncertainty ratings are low, medium, high, very high, and extreme. With each uncertainty rating is a corresponding
set of price/fair value ratios that drive our recommendations: Lower price/fair value ratios (<1.0) lead to positive recommendations, while higher price/fair value

Economic Moat
C O M PE T I T I V E F O R C E S

WIDE

Moat Sources:

Intangible
Assets

NARROW

NONE

Switching
Costs

COMPANY PROFITABILITY

Network
Effect

Cost
Advantage

© 2013 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information
contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is
prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Efficient
Scale

Morningstar
Morningstar Equity
Equity Analyst
Analyst Report
Report |Page 7 of 7

Morningstar Equity & Credit Research Methodology
ratios (>1.0) lead to negative recommendations. In very
rare cases, the fair value estimate for a firm is so unpredictable that a margin of safety cannot be properly
estimated. For these firms, we use a rating of extreme.
Very high and extreme uncertainty companies tend to
have higher risk and volatility.

Quantitative Economic Moat: The quantitative moat
rating is analogous to Morningstar’s analyst-driven
economic moat rating in that both are meant to describe the strength of a firm’s competitive position.
Financial Health: Financial health is based on Morningstar’s proprietary Distance to Default calculation.

Credit Rating
The Morningstar Corporate Credit Rating measures the
ability of a firm to satisfy its debt and debtlike obligations. The higher the rating, the less likely we think the
company is to default on these obligations.

Quantitatively Driven Valuations
To complement our analysts’ work, we produce Quantitative Ratings for a much larger universe of companies.
These ratings are generated by statistical models that
are meant to divine the relationships between Morningstar’s analyst-driven ratings and key financial data
points. Consequently, our quantitative ratings are directly analogous to our analyst-driven ratings.
Quantitative Fair Value Estimate (QFVE): The QFVE is
analogous to Morningstar’s fair value estimate for
stocks. It represents the per-share value of the equity
of a company. The QFVE is displayed in the same currency as the company’s last close price.
Valuation: The valuation is based on the ratio of a company’s quantitative fair value estimate to its last close price.
Quantitative Uncertainty: This rating describes our level of uncertainty about the accuracy of our quantitative
fair value estimate. In this way it is analogous to Morningstar’s fair value uncertainty ratings.

Understanding Differences Between Analyst
and Quantitative Valuations
If our analyst-driven ratings did not sometimes differ
from our quantitative ratings, there would be little value in producing both. Differences occur because our
quantitative ratings are essentially a highly sophisticated analysis of the analyst-driven ratings of comparable companies. If a company is unique and has few
comparable companies, the quantitative model will
have more trouble assigning correct ratings, while an
analyst will have an easier time recognizing the true
characteristics of the company. On the other hand, the
quantitative models incorporate new data efficiently
and consistently. Empirically, we find quantitative ratings and analyst-driven ratings to be equally powerful
predictors of future performance. When the analystdriven rating and the quantitative rating agree, we find
the ratings to be much more predictive than when they
differ. In this way, they provide an excellent second
opinion for each other. When the ratings differ, it may
be wise to follow the analyst’s rating for a truly unique
company with its own special situation, and follow the
quantitative rating when a company has several reasonable comparable companies and relevant information is flowing at a rapid pace.

Uncertainty Rating
Price/Fair Value
2.00
Q

1.75

175%

1.50
1.25
1.00
0.75

155%
125%
95%

QQ

135%

80%

125%

115%

110%

105%

QQQ

90%

85%

80%

70%

QQQQ

60%

0.50

50%
QQQQQ

0.25
Low
Uncertainty Rating

Medium

High

Very High

© 2013 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information
contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is
prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.


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