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 of DividendInvestor's model dividend portfolios, the Dividend Harvest and the Dividend Builder. 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

The goal of the Builder Portfolio is to earn annual returns of 11% - 13% 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:

2% - 4% current yield
8% - 10% annual income growth

The goal of the Harvest 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:

6% - 8% current yield
2% - 4% annual income growth

About Josh Joshs Photo
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, and manager of DividendInvestor's model dividend portfolios, the Dividend Harvest and the Dividend Builder.
Featured Posts
Clorox, Paychex in the News -- The Week in Dividends, 2014-09-26

Though the stock market has had a bit of the jitters of late thanks to global worries in general and the more specific fear of higher short-term interest rates at home, the flow of company-specific news is still light.

Our biggest mover this week was Builder holding Clorox CLX, which jumped 7.4% in Monday's trading. A small part of that rise can be attributed to the company's decision to exit the Venezuelan market. The unit, which accounted for only 1.4% of total sales last year but produced a $23 million operating loss, was squeezed between the government's absurd controls on selling prices and rapidly inflating manufacturing costs. We're not surprised to see Clorox fold its tent in Venezuela under such circumstances, and in the absence of this drag going forward, I suspect the company can produce a bit more earnings growth than we've seen since 2010.

However, the main cause of Monday's rally was a rumor, reported by the New York Post, that Clorox has recently turned down a takeover offer at a 20% premium to where the stock had been trading. But even though I would not buy this stock (or any stock) on takeover hopes, we believe Clorox's current valuation is justified by a wide-moat collection of niche consumer brands and a highly efficient manufacturing base. Our fair value estimate remains $96 a share, and while near-term dividend growth is likely to be modest, I still like the company's generous dividend policy and current yield over 3%. It will be interesting to see if anything materializes on the merger and acquisition front, but I think it's more likely that Clorox will be a buyer of brands from Procter & Gamble's PG non-core asset sales rather than a seller. I plan to continue holding the Builder's shares.

We also received the first earnings report of Builder holding Paychex's PAYX 2015 fiscal year, which included 5% year-over-year growth in operating income and a 7% improvement in earnings per share. Results came in slightly ahead of expectations, which investors rewarded with a 3.5% gain in the stock price on Wednesday, though the company's full-year outlook remains intact. Our fair value estimate held steady at $37 a share, which pegs the market price at a roughly 18% premium. That's more than what I think of as a rounding error, and I don't expect much by way of near-term capital appreciation from here, but I still consider the stock a core long-term holding for the Builder. Its merits include a wide economic moat based on customer switching costs and scale, abundant and resilient free cash flows, upside leverage to both employment and short-term interest rates, and uniquely generous dividend policy. Conceivably, I could replace Paychex with something cheaper, but it would be very difficult to replace the stock with something that was also better suited to our strategic purposes.

The next week or two should continue being fairly light as far as company-specific developments go, though I am looking forward to a dividend increase by Harvest holding Kraft Foods Group KRFT. My best guess is that Kraft will raise its quarterly dividend rate by $0.025 a share, the same as last year, for a new rate of $0.55. In percentage terms this would be a 4.8% increase, which isn't bad in the context of a yield in the upper 3% range, though over the next few years I hope to see annual dividend growth accelerate into the 6% area. The stock isn't a buy at its current price--like Paychex, it's trading at a premium to our fair value estimate--but I have no plans to sell.

Best regards,

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

Disclosure: I own the following stocks in my personal portfolio: AEP, APU, CLX, CVX, EMR, GE, GIS, GSK, HCN, JNJ, KO, KRFT, MCD, MMP, NGG, O, PAYX, PEG, PG, PM, RCI, RDS.B, SE, SEP, SO, UL, UPS, WFC, XEL.

Josh's Video of the Week: 4 Dividend Payers for a Higher-Rate World
Trying to time interest-rate increases is less important than choosing companies with a good margin of safety that you can hold through thick and thin.

News and Research for Builder and Harvest Portfolio Holdings

Capacity Performance Scheme Could Boost Earnings, Value for Mid-Atlantic Utilities
Industry Note 09/25/2014 | Travis Miller

Exelon could be a big winner if the Mid-Atlantic transmission grid operator PJM moves forward with its proposed performance capacity product. Other winners could include owners of large coal and nuclear generation fleets such as Public Service Enterprise Group and FirstEnergy. PJM still must finalize the plan and the Federal Energy Regulatory Commission must approve it, so we're not explicitly including it in our fair value estimates or cash flow forecasts for any utilities. We are reaffirming our $40 fair value estimate and wide moat and stable moat trend ratings for Exelon.

The proposal would reward utilities that have power plants that can run even in extreme weather conditions, like the winter 2014 polar vortex. This primarily includes nuclear and hydro plants, but it also could include fossil fuel plants that have a history of good operating performance and have secured firm or on-site fuel sources. As the largest nuclear operator in the Mid-Atlantic region, Exelon is best positioned to benefit. Public Service Enterprise Group and FirstEnergy also have large nuclear fleets that would benefit.

The PJM Market Monitor recently estimated capacity performance prices could range from $85.80/MW-day to $234/MW-day, nearly doubling the current capacity revenue for most Mid-Atlantic utilities. At $100/MW-day, we estimate Exelon would realize $200 million of additional pretax earnings and it could be worth $5 per share of long-term value. The impact would be smaller but still positive for utilities like Public Service Enterprise Group and FirstEnergy.

PJM proposed procuring 85% of peak load as capacity performance, so we expect prices will clear at generators' costs of securing firm gas transportation rights or storing oil on site since nuclear and hydro capacity make up far less than 85% of the region's peak load.

Clorox CLX
Analyst Note 09/22/2014 | Erin Lash, CFA  

In a move we anticipated, Clorox announced that it would cease operating in Venezuela, a region that represented around 1.4% of fiscal 2014 sales. As a result, the firm expects to incur $60 million in aftertax costs this year and an additional $10 million to $15 million over the next three fiscal years. When the firm reported fourth-quarter results in August, we got the sense that management was no longer committed to its operations in Venezuela, saying that it was considering all options with regards to that business. The volatile nature of the market combined with the fact that two thirds of its portfolio has been under price controls for the past three years (indicating that while manufacturing costs have more than doubled, the firm has been unable to price to offset these headwinds) made operating in the region a drain on the overall business. We ultimately think an exit of this unprofitable venture will favorably prop up both sales and profits, while also enabling the management group to focus on the highest return opportunities.

Management held tight to its outlook for fiscal 2015, which targets 1%-3% underlying sales growth (versus our 0.9% forecast) and earnings per share of $4.35-$4.50 (versus our $4.45 estimate). Given the relatively small size of its Venezuelan operations, we don't anticipate a material change to our $96 fair value estimate. After trading up nearly 6% after a New York Post report that Clorox rebuffed a takeover offer earlier this year, the shares now trade in line with our fair value. However, given the consistent cash flows the firm generates year after year, we wouldn't require a material margin of safety to recommend the shares. We still think Clorox's brand intangible asset (combined with the firm's cost advantage) supports our wide moat rating.

Clorox: Analyst Note 09-22-2014
The New York Post reported Saturday that over the past three to six months, Clorox has rebuffed a takeover offer that valued the firm at a 20% premium to its stock price, or between $105 and $110 per share. This implies a 9%-15% premium to our $96 fair value estimate, 2.5-3 times sales, and around 14 times trailing 12-month EBITDA. Potential suitors named were Church & Dwight, Jarden, Procter & Gamble, and Unilever. We've long believed Clorox was not a likely acquisition target in the consumer product space, given that activist investor Carl Icahn's attempts to sell the firm in 2011 ultimately fell on deaf ears, but we recognize that in a landscape of lackluster growth and lagging profits, Clorox's brand portfolio may be an attractive addition to beef up the financial prowess of others in the space.

From our vantage point, Unilever is the most likely of the four companies named to have made an approach to acquire the U.S.-centric household- and personal-care firm. Following the deal to acquire Alberto Culver four years ago (which came at a price of more than 2 times sales and nearly 15 times trailing EBITDA), Unilever has shown it is willing to pay up for growth. The Unilever management group has done a commendable job taking Alberto's mature North American hair-care brands and extending them into faster-growing emerging markets, and this could have been a motivation behind any deal to poach Clorox, given that Clorox derives around 80% of its sales from North America and has shown little desire to expand its geographic footprint in markets where it doesn't believe it has a competitive edge. We will not be making any changes to our fair value estimates or wide moat ratings for Clorox or Unilever based on this speculation, given that it is very unclear whether a deal will ever materialize. We will update our analysis if more details come to light.

The other three potential suitors seem less likely, in our view. For one, we doubt P&G would have made a bid for Clorox, as it is embarking on a path to refocus its business on its most profitable brands, with plans to shed more than half of its brand portfolio over the next two years. Further, after striking a deal in the 1950s to acquire Clorox, P&G was ultimately forced to unwind the transaction 10 years later, and we doubt management would subsequently pursue the firm again. Church & Dwight (with more than $3 billion in sales and a $9 billion market capitalization) also seems doubtful, given its muted size compared with Clorox (with around $5.5 billion in sales and a nearly $12 billion market cap). Jarden, a leading household product firm with a diverse portfolio that includes Rawlings, Crock-Pot, and Yankee Candle, has proved to be a serial acquirer in the past, but Clorox's product mix doesn't strike us as the most desirable, given Jarden's current portfolio set.

Paychex PAYX
Analyst Note 09/24/2014 | Brett Horn

Paychex’s fiscal first-quarter results contained no major surprises and were largely a continuation of recent trends. Revenue increased 9% year over year. While the payroll segment continued to record only modest growth of 4%, Paychex saw 17% growth in ancillary human resources services. This growth was partially driven by an accounting change in its PEO business, which accounted for 3 percentage points of this growth. But in our view, the strong results in this area demonstrate that these ancillary services remain a material growth engine for the company. We’ve seen similar trends at Paychex’s larger peer, ADP, and we are pleased to see these companies exploiting the opportunity to cross-sell these services and effectively expand the moat around their traditional payroll business. While these ancillary services are not as moaty as the payroll business on a stand-alone basis, in our opinion, the trend is not dilutive to the company’s moat due to the significant synergies inherent in providing a broader range of services. We expect these services to make up an increasing portion of revenue over time.

Interest income ticked up slightly year over year, and management pointed out that it believes the pressure on yield has bottomed out. While the timing of any improvement in interest rates is uncertain, we estimate that a 1 percentage point increase in yield would increase Paychex’s operating income by 4%, providing significant leverage to any improvement in this area. For reference, yields in the precrisis period were about 2 percentage points higher than the current level. Operating margins in the quarter fell to 40.1% from 41.6% last year, but this was primarily driven by the accounting change. We will maintain our fair value estimate and wide moat rating.

Procter & Gamble PG
Analyst Note 09/23/2014 | Erin Lash, CFA

Procter & Gamble on Sept. 23 announced the sale of its European pet-care business, which it has been looking to shed since Mars acquired the bulk of its pet-care operations earlier this year, to Spectrum Brands. Annual sales amount to just $200 million, and although financial terms of the deal weren’t disclosed, we aren’t making any changes to our $93 per share fair value estimate because of this news given the relatively small size of the business within P&G’s portfolio.

This news follows P&G's announcement last month that it intends to shed 90-100 brands--more than half of its existing brand portfolio--to become more nimble and responsive in the global consumer products arena. We view this as particularly important given the stagnant growth in developed markets and the slowing prospects from emerging regions. Even a slimmed-down version of the leading global household and personal-care firm will still carry significant clout with retailers, and we think these actions will only enhance P&G's brand intangible asset and its cost advantage, which form the basis for our wide moat rating.

Philip Morris International PM
Analyst Note 09/24/2014 | Philip Gorham, CFA, FRM  

Two new regulations proposed in the U.K. and France pose a threat to Big Tobacco profitability. Both are far from being implemented, however, and we are retaining our wide economic moat ratings and fair value estimates for the tobacco firms under our coverage until we see evidence of the probability of implementation growing.

At the Labour Party conference yesterday, opposition leader Ed Miliband announced a plan to provide additional funding for the U.K.'s National Health Service in part through a tax on tobacco companies' net profit in the event of his party winning the general election, scheduled for May 2015. The tax should generate around GBP 150 million in annual incremental revenue. As the U.K. leader with a share of around 44%, Imperial Tobacco would be the hardest hit by such a tax, and would contribute GBP 60 million to 65 million per year, followed by Japan Tobacco (not covered) with GBP 57 million. We estimate that this would negatively impact our fair value estimate for Imperial Tobacco by GBP 7 per share, or 8%.  Both Philip Morris International and British American Tobacco have high single digit volume shares in the U.K., and our valuation would likely not be materially impacted by the tax.

In another threat to the tobacco industry, the newspaper Les Echos this morning reports that the French government is considering the introduction of standardized packaging. We regard plain packs as the single most dangerous regulatory threat to tobacco profitability, and we would reconsider our wide moat ratings in the event of adoption in more major markets. Philip Morris would be most affected by such a measure, as it holds a volume share of around 41% in France, and its portfolio is more vulnerable to trading down. However, we believe the risk to the government's tax revenues keeps the probability of implementation well below 50/50 at this stage, and unless we see evidence to the contrary, we will reiterate our wide moat rating and $90 fair value estimate.


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