About the Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.

Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio. Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor.

Peters holds a BA in economics and history from the University of Minnesota Duluth and is a CFA charterholder. He is also the author of a book, The Ultimate Dividend Playbook, which was released by John Wiley & Sons in January 2008.

 
Investment Strategy

Dividends are for everyone regardless of age. The outcome of owning dividend-yielding stocks is the key variable-higher-yielding stocks with safe payouts being less risky while affording investors who don't need current income the ability to reinvest/reallocate the capital.

The goal of the Dividend Select Portfolio is to earn annual returns of 9% - 11% over any three-to-five year rolling time horizon. We further seek to minimize risk, as defined by the probability of a permanent loss of capital. For our portfolio as a whole, this goal is composed of:

3% - 5% current yield
5% - 7% annual income growth

 
 
May 22, 2015
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Josh Peters, CFA
Equities Strategist and Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio.
Featured Posts
Staying on the Grid -- The Week in Dividends, 2015-05-22

Both news and trading activity have been quiet in the stock market for the last couple of weeks, but at least we've enjoyed a steady drumbeat of dividend increases to keep things interesting. On Thursday, National Grid NGG provided the latest bump to our income.

The final dividend for the 2014/15 fiscal year (which ended in March) will be paid on August 5, and the rate rose 2.3% to GBP 0.2816 for the London-listed ordinary shares. This translates to $2.16 an ADR at current exchange rates. Combined with the interim dividend that was paid in January, National Grid will dish out GBP 0.4287 for the full fiscal year, a year-over-year improvement of 2.0%. This exactly matches the change in the average level of the U.K. Retail Price Index, a measure comparable to the U.S. Consumer Price Index, in line with the company's policy of providing dividend growth at least equal to inflation.

Over time we think Grid can grow its dividend faster than inflation, but we're not surprised that the company is taking a conservative approach to dividend growth right now. In fiscal 2013/14, Grid's payout ratio reached 79%--a pretty high level even for a fully-regulated utility--just as it entered the new eight-year RIIO regulatory settlement in the U.K. The good news is that Grid performed well within its new framework; earnings per share rose 9% to GBP 0.581. In addition to demonstrating its profit potential under RIIO, this advance trimmed Grid's payout ratio to a more comfortable 74%.

Though dividend growth (in nominal terms) may be hindered again in the next year or two by very low inflation readings in the U.K., we think Grid's dividend growth can improve based on its own operating performance. The ADRs are trading at a premium to our reaffirmed fair value estimate of $63, but they're still priced for a 4.6% yield, which is better than we find among most fully-regulated utilities in the U.S. I also like the built-in hedge against inflation offered by regulatory treatment in the U.K., which automatically indexes National Grid's business model to inflation. (Though we naturally seek such hedges in dollars, there's been a reasonably strong correlation between inflation in the U.K. and the U.S. over the last few decades.) I haven't ruled out swapping Grid for the strikingly similar PPL Corporation PPL once PPL completes its upcoming spinoff of Talen Energy, but at the moment I don't see a large enough advantage to make such a swap worthwhile.

On the research front, we raised our fair value estimate for longtime core holding Realty Income O by $6 to $50 a share. Like many of the fair value changes we've seen for our portfolio holdings this year, this reflects new assumptions within our updated cost of equity methodology. In Realty Income's case, like more than half of our current holdings, we now expect shareholders to demand long-term total returns averaging 7.5% a year rather than 8.0%. While many investors feel threatened by the potential for rising interest rates, our cost of equity framework correlates to long-term inflation averaging 2.0%-2.5% a year and a long-term average yield for the 10-year Treasury bond around 4.5%. This leaves a lot of room for interest rates and inflation to move higher from current levels without hurting Realty Income's long-term value proposition, which helps form a margin of safety for buyers.

With this new appraisal, I am considering adding to our stake in Realty Income--even though I presume interest rates are bound to rise at some point. The stock, like most REITs, may trade like a bond in the short term, but a well-demonstrated capacity to grow its dividend while maintaining a conservative risk profile gives it the best attributes of both a stock and a bond. Very few other businesses of any kind are positioned to meet our portfolio's income, risk, and long-term total return objectives as nicely as this one.

It looks like a couple more quiet weeks are on tap. Our streak of weekly dividend growth has probably ended; our next hike--one of Realty Income's routine quarterly bumps--isn't due until the middle of June. Our next round of earnings reports are more than a month away.

Wishing you and yours the best this Memorial Day weekend,

Josh Peters, CFA
Director of Equity-Income Strategy
Editor, Morningstar DividendInvestor

Disclosure: I own all of the holdings of the Dividend Select portfolio in my personal accounts.


News and Research for Builder and Harvest Portfolio Holdings

The Impact of E-Cigs on Tobacco Companies' Moats May Be Overstated
Analyst Note 05/20/2015 | Philip Gorham, CFA, FRM

The emergence of e-cigarettes is one of the most controversial issues in the tobacco space today and the single-most disruptive force since cigarettes were declared to be harmful to public health. Investors are concerned that e-cigs may threaten the competitive advantages and cash flows of the large tobacco manufacturers and accelerate the decline of cigarette volume. Our analysis, however, shows that not only are there significant risks to the current growth trajectory of e-cigs, but that only in the most bullish outcome for e-cig growth will they materially dent the cash flows and valuations of the Big Tobacco firms. We are reiterating our wide economic moat and stable moat trend ratings for global tobacco players British American Tobacco, Imperial Tobacco, and Philip Morris International. Given the limited impact we expect from e-cigs, we are also maintaining our fair value estimates for all three firms. We continue to regard Philip Morris International as the pick of the group on valuation and competitive positioning.

To estimate the growth path of e-cigs based on the functionality of the products, we have used the Rogers qualitative model and the Bass quantative model and have concluded that it is likely to be two decades before e-cigs at least partially displace cigarette consumption for all smokers in developed markets. Only in our most bullish scenario, in which e-cigs benefit from favourable tax and regulatory treatment, do e-cigs achieve full adoption in 10 years and have a material negative impact on the tobacco group. With cigarette makers becoming dominant in some e-cig categories, and given our belief that e-cig adoption will be slower going forward, we believe the shift to e-cigs could be less painful than many investors believe.

With this overhang in perspective, our pick in the global tobacco space is Philip Morris International, a high-quality business trading at a discount to our valuation due to short-term cyclical issues.

National Grid ADR NGG
Analyst Note 05/21/2015 | Travis Miller

We are reaffirming our GBX 815 per share ($63 per ADR share) fair value estimate and narrow moat and stable moat trend ratings for National Grid after the company reported fiscal-year operating earnings up 9% year over year to GBX 58.1 per share. This was slightly lower than our forecast, but we are maintaining our long-term outlook so the adjustment to fiscal 2014-15 results doesn't have a material impact on our fair value estimate.

In the first year of the new RIIO regulatory construct, National Grid was able to take advantage of the plan's financial incentives to post remarkable returns far greater than any other regulated utilities we cover. Management reported earning a 14.0% return on equity at its U.K. electric transmission business and a 14.2% return on equity at its U.K. gas transmission business. These businesses combined contributed 43% of Grid's operating profit for the year, helping offset lower earned returns on equity at its other businesses.

The most upside continues to be at its U.S. regulated utilities, which underperformed their allowed returns again this year. Part of the business plan this year is to achieve rate increases that will boost those returns. Although regulatory conditions are improving in Grid's Northeast U.S. service territories, we remain skeptical that this business will be able earn much more than the 9%-10% returns on equity that most other U.S. regulated distribution utilities earn, diluting the attractive U.K. business.

Management reaffirmed its long-term dividend policy and capital investment plans, all in line with our forecasts. Management recommended a GBX 28.16 per share final dividend, resulting in a 2% increase from fiscal 2014 and in line with management's inflation-growth target. If Grid continues achieving returns like it did in the U.K., we think dividend growth should accelerate.

Public Service Enterprise Group PEG
Analyst Note 05/19/2015 | Travis Miller

We are reaffirming our $37 per share fair value estimate, narrow moat rating, and positive moat trend for Public Service Enterprise Group after meeting with senior management at the American Gas Association Financial Forum in Palm Desert, CA.

PSEG recently energized its $790 million Susquehanna-Roseland transmission line after nearly a decade in the making. PSEG's ability to bring that project online gives us confidence it can achieve its $6.7 billion transmission investment plant through 2019, a key leg of our 8% annual earnings growth forecast at the utility. Another key growth area for the utility is the $1.6 billion gas system modernization program it has proposed. We think there is a high probability regulators will approve most of that program based on other utilities' experiences in other states.

PSEG's operating agreement with Long Island Power Authority is giving it a seat at the table as New York goes through a long review of the state's energy policy. PSEG also is a stakeholder on the power generation side with its New York plants. We don't foresee any immediate implications, but we think PSEG's involvement in New York could put it in position to participate in cross-state transmission projects, M&A or other investments that a new state energy plan might envision. Expanding to New York through investment or M&A could be the next leg of growth for PSEG after it completes its current five-year plan.

At PSEG Power, we remain relatively neutral on the impact from PJM's Capacity Performance product expected in this year's capacity auction. CP should be all upside for PSEG given its fleet's good reliability profile, but we don't think it will be much--if any--upside to the base auction this year. We continue to forecast midcycle fleetwide capacity revenues only slightly higher than those implied in the most recent auctions.

Realty Income O
Investment Thesis 05/21/2015 | Todd Lukasik, CFA

Realty Income remains one of our favorite real estate investment trusts, but the changing environment is likely to present the firm with unique challenges relative to its first 20 years as a public company. Nonetheless, the potential for higher interest rates may present an opportunity to add shares of this quality firm at a reasonable margin of safety.

After riding a decades-long tailwind of falling interest rates and rising consumer spending, Realty Income is positioning its portfolio for a more challenging environment, leading it to investment-grade tenants and nonretail assets. Relative to its traditional non-investment-grade retail tenants, investment-grade tenants should be even more likely to honor lease commitments during the initial lease term, but we think the nonretail tenants may present greater risk when leases expire because there is often not the same direct economic incentive to re-lease Realty Income's property as opposed to another. If we're right, this might lead to higher re-leasing costs or more vacancies longer term than Realty Income has experienced historically, although we wouldn't expect this to play out until the nonretail tenant leases begin expiring, which is still a few years away. Furthermore, the firm has beefed up its re-leasing team to address the unique challenges these new asset types may present, so we don't expect meaningful disruption from these potential challenges.

The potential for rising interest rates may weigh on investment spreads on new acquisitions, although we expect management to adhere to its historically disciplined approach and only consummate deals with positive spreads. Size becomes an increasing challenge as well. Realty Income will require an increasingly large deal flow to close enough transactions to have a meaningful impact on its cash flow. Meanwhile, competition in the net-lease space has intensified. Nonetheless, we think the pool of potential properties is large enough to provide acquisition growth for years to come, and we expect the firm to remain disciplined such that future acquisitions support a growing dividend, leading to greater firm value over time.

Realty Income: Economic Moat 05/21/2015
Realty Income owns and manages free-standing, single-tenant properties, with retail properties constituting roughly 80% of its portfolio. When making property purchases, Realty Income applies the same Warren Buffett- and Benjamin Graham-inspired investing principles that Morningstar espouses, and its narrow moat stems from its successful implementation of these conservative investing principles. We attribute its moat to customer switching costs associated with the long-term, triple-net leases the firm signs with tenants, which are favorable to Realty Income. Furthermore, Realty Income owns retail properties in locations where its tenants can operate profitable stores, resulting in very high levels of occupancy and tenant demand, resulting in cash flow that is sustainable beyond the initial decade-plus lease terms.

The firm builds a margin of safety into its retail property purchases by demanding that its retail tenants generate sufficient cash flow to more than cover rent payments, allowing for some deterioration in store performance before its rental stream could be compromised. Furthermore, Realty Income requires many of its retail tenants to supply it with property-specific financial information that allows the firm to monitor each property's rent coverage over time and dispose of assets if the tenant's operating fundamentals suggest rent coverage has become insufficient. By using conservative underwriting practices when acquiring properties and then actively monitoring and managing its operating properties, Realty Income has been able to maintain impressively high average occupancy exceeding 98% since 1970. Its occupancy rate has never dipped below 96%.

For all its properties (both retail and nonretail) the firm signs triple-net leases with its tenants, which leaves the tenants--and not Realty Income--responsible for property taxes, insurance, and maintenance, resulting in recent average property income margins above 98%. The leases' initial terms generally run between 15 and 20 years and require regular, albeit modest, increases in rent. The combination of high occupancy, low operating expenses, and long-term leases with rent bumps results in a reliable cash flow stream that should increase modestly over time. And the leases impose customer switching costs on tenants, because they are obligated to pay rent over the entire lease term.

Realty Income has ventured into nonretail property types over the past few years, including industrial space, manufacturing and distribution facilities, and suburban office properties. We like the competitive dynamics of this nonretail portion of its portfolio relatively less. In our opinion, the nonretail properties lack many desirable characteristics of Realty Income's retail portfolio. Specifically, Realty Income does not get property-level financial information on nonretail assets. There is no obvious equivalent property-specific metric for rent coverage. The money the tenant earns is not necessarily linked strategically or specifically to the particular property. And, consequently, there doesn't seem to be as strong a tie between the tenant and the particular Realty Income property it leases. We also expect the nonretail assets to exhibit greater operational and cash flow variance, given their relatively higher exposure to economic cyclicality, and we think they have more risk around lease expiration. The firm also appears to recognize potential differences between its traditional retail assets and recently introduced nonretail ones, as reflected by its early 2014 hiring of an executive with industry experience in industrial and distribution properties to focus on these nonretail property types.

Despite our preference for Realty Income's retail properties, the nonretail assets enjoy the same benefits of the long-term, triple-net leasing structure Realty Income has used for decades. And the firm's foray into nonretail property types has added diversification benefits--away from the American consumer, into other property types, and up the credit curve to investment-grade tenants. Furthermore, the company plans to keep at least 70% of its portfolio in retail properties (it recently had roughly 80% exposure to retail assets).

Realty Income: Valuation 05/21/2015
We are increasing our fair value estimate to $50 per share from $44. While we have made minor modifications to our forecasts, we mainly attribute this increase to the incorporation of a lower cost of equity (now 7.5% versus 8.0% previously), consistent with changes we are making across our research coverage.

Our $50 fair value estimate implies a 5.7% cap rate on our 2016 net operating income forecast, an 18 times multiple of our 2016 AFFO forecast, and a 4.6% dividend yield, assuming a $2.28 per share payout. This would put the dividend at roughly 84% of our 2015 forecast for adjusted funds from operations, a level from which we think dividend growth can track with growth in cash flow going forward.

Over the longer term, we assume Realty Income will achieve rent growth of 1.5% with long-term occupancy of 97.5%, lower than its historical average, which reflects our concern that the nonretail assets into which it is diversifying carry higher operational variance and risk at lease expiration than its traditional retail assets.

The firm's triple-net leases have effectively made tenants responsible for the majority of property expenses. As a result, we expect long-term net operating income margins near 98% and long-term EBITDA margins near 90%. We also expect maintenance capital expenditure requirements to increase slightly longer term to reflect the risk of greater re-leasing costs associated with nonretail assets. Although the acquisition environment has been very favorable for Realty Income recently, we expect volume to slow later in our forecast.

We ran upside and downside forecasts to reflect potential future environments that are either more or less favorable, respectively, than our base-case expectations. Our upside fair value estimate is $62 and our downside fair value estimate is $37.

Realty Income: Risk 05/21/2015
Realty Income's long-term leases can be canceled if a tenant files for bankruptcy or rewritten via bankruptcy or during times of tenant distress, and roughly half its tenants are non-investment-grade credits. Recently, the firm derived 10% of its revenue from convenience stores, 10% from drugstores, 9% from dollar stores, 8% from restaurants, 7% from health and fitness centers, and roughly 5% each from theaters and transportation facilities. Many of these types of industries could suffer from any slowdown in consumer spending, although the firm has been focusing its portfolio on retail areas with a value, service, or necessity focus.

Realty Income's customer concentration is high, with its top 20 customers providing 54% of revenue and its top five tenants contributing 4%-6% each, which is higher than many other retail landlords we cover. Rent recovery on tenant bankruptcies has historically been around 80%, but some bankruptcies have been--and could be in the future--worse.

Because Realty Income's tenants' rent bumps are usually capped, it could take years for the firm's rental revenue to reflect market rates when inflation is high. Moreover, there are new risks with Realty Income's move into nonretail assets (including industrial, office, distribution, and manufacturing properties); the underwriting is different from its traditional retail base, and the strategic shift adds uncertainty, mainly at lease expiration, in our opinion.

Competition for the types of triple-net-leased assets Realty Income likes has intensified since the global financial crisis, which may pressure future investment returns.

We view a potential rising interest rate environment as a valuation risk for Realty Income, although we would expect the firm to maintain its acquisition discipline, focusing on cash-flow-accretive transactions.

Spectra Energy Partners SEP
Analyst Note 05/19/2015 | Jason Stevens

We are reaffirming our fair value estimates and wide moat ratings for Spectra Energy and Spectra Energy Partners after meeting with senior management at the American Gas Association Financial Forum in Palm Desert, California. Spectra Energy's management reaffirmed its five-year growth plan, which should help it keep a leading market share of takeaway capacity in the Eastern United States and a prime foothold in high-demand population centers like New York City, Boston, and the East Coast. This supports our wide moat rating.

Spectra management told us it doesn't expect to merge with Spectra Energy Partners anytime soon. Spectra Energy owns 80% of SEP, making a merger less tax-advantaged than the recent deals involving Williams and Kinder Morgan. In addition, SEP is relatively young, so it doesn't have the incentive distribution rights burden that Williams and Kinder faced. Management still has plans for some $6 billion of investment at SEP, giving it plenty of growth opportunities.

We are awaiting an announcement from management by October regarding its plan to create a financial structure that would increase investors' comfort with the variable cash profile of DCP Midstream and DCP Midstream Partners.

Management thinks liquids takeaway capacity from the Marcellus is an area of possible growth investment. Natural gas liquids increasingly are acting as a constraint on dry gas production. Spectra is in a good position to leverage its existing infrastructure to handle liquids as well as dry gas. However, under current NGL pricing it may be difficult to attain shipper commitments for additional projects at this time, in our view.

 

 
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