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
Magellan, Rogers Raise Our Pay -- The Week in Dividends, 2015-01-30

It's been a long time since we had such a busy week in terms of news flow. To cut through the clutter, I always like to lead off with dividend increases when we've got them, and this week two DividendInvestor portfolio holdings raised our pay.

The first was top holding Magellan Midstream Partners MMP, which on Tuesday delivered on its goal of 20% distribution growth for 2014. The quarterly distribution payable on Feb. 13 will be 0.695 a unit--up 2.75 cents (4.1%) from the preceding quarter and 18.8% from a year ago. Including this final quarterly payment based on 2014's results, Magellan will distribute $2.615 a unit, up 19.8% from $2.1825 in 2013. The partnership's most recent goal for distribution growth in 2015 was 15%, implying quarter-over-quarter increases of 2.25 cents a unit over the next four quarters. However, with distribution coverage probably having jumped past 1.4 times for 2014, there's a lot of upside to Magellan's 2015 distribution growth objective on excess coverage alone--something we may hear more about when the partnership reports its year-end results next week. In the meantime, I continue to view the units as a buy.

The other dividend increase was the 4.9% bump from Rogers Communications RCI, which also reported year-end financial results this week. There are two dimensions to this story, the first of which is Rogers' own fundamental position. The company posted essentially flat revenue and EBITDA last year, but higher depreciation, amortization, and interest charges led core earnings per share to a 13% decline. At CAD 2.96 a share, though, core EPS still provided decent coverage for dividends totaling CAD 1.83 a share in 2014--a 62% payout ratio is arguably low by telecom standards. This gives management room to continue raising the dividend at a modest pace while new CEO Guy Laurence tries to reorient the business away from price-based competition. A rise in average revenue per wireless user in the fourth quarter offers a sign that these new efforts are bearing some fruit. In all, we held our local-currency fair value estimate flat at CAD 48 a share.

Unfortunately, there is another dimension to the Rogers story: the 18% plunge in the Canadian dollar since I bought our shares in May 2013. This has hammered the market value of our investment, its fair value (which dropped $6 a share to $38 in our most recent update, solely due to currency), and the dividend income we're collecting (down nearly 10% from what we initially stood to earn despite 10% cumulative dividend growth in Canadian dollars). The stock still trades at a small discount to our updated fair value estimate, but despite some signs of operational progress, I'm not sufficiently convinced of Rogers' ability to deliver adequate long-run dividend growth to consider buying more.

Our other holding in telecom, AT&T T, reported earnings this week too--or, more accurately, a $4 billion loss in the fourth quarter of 2014. This reflected a massive mark-to-market adjustment for the firm's pension plans, which in turn is the product of plunging interest rates: As the interest rate used to discount future pension outlays goes down, the present value of the liability goes up, and AT&T is one of several large companies that have adopted annual "big bath" accounting entries for actuarial swings. If interest rates rise in the future, the pension could result in comparable gains--but if rates stay low for many years to come, AT&T could be forced to dump a lot more cash into its pension plans.

Setting aside the pension issue, core earnings of $2.51 a share rose only a penny from the previous year, a big disappointment relative to the mid-single-digit gain AT&T forecasted at the beginning of 2014. Competition is largely to blame, as T-Mobile TMUS in particular is trying to steal AT&T customers. We don't believe T-Mobile (or Sprint S) can keep up their discounting indefinitely, but against the current backdrop it's hard to put a lot of faith in AT&T's prediction of even low-single-digit EPS growth in 2015. Worse, just as ordinary capital spending was about to fall and provide better dividend coverage (free cash flow only barely exceeded dividend payments last year), AT&T reported this afternoon that it spent $18.2 billion to acquire additional spectrum in the just-closed AWS-3 auction. AT&T needs more spectrum as customers take up more wireless bandwidth, but the industry hasn't shown much ability to charge customers more for improved service, making this spectrum purchase look like a giant exercise in maintenance, not growth. I don't believe any of AT&T's recent or pending moves are improving the likely rate of dividend growth, and the risk profile of the business is worsening. As with Rogers, I have no plans to add to our stake here.

Chevron CVX and Royal Dutch Shell RDS.B were prominent among the week's earnings reports as well and, as you might expect, they're feeling the effects of the oil price plunge. Even with planned cuts in capital spending and other costs, neither company will generate free cash flow sufficient to fund their dividends fully at current commodity prices. If you extend crude oil prices below $50 a barrel off into the indefinite future, then neither dividend is safe. But if we are correct in our view that the marginal cost of supply (the most expensive barrel needed to satisfy world demand) is a lot higher than $50, then what we're dealing with is mostly a timing issue. And that's what safety margins are for: Both Chevron and Shell have long maintained very strong balance sheets and moderate dividend payout ratios in preparation for stressful points in the cycle. If necessary, they've got the capacity to increase debt over the next few years so that dividends can be preserved while most (though not all) new development projects stay on track.

Our analysts indicated that Shell's fair value will hold steady for now at $70 an ADR while our appraisal of Chevron is likely to come down when our update is complete. At this point I view both stocks as buys, but I believe we hold enough of each stock already in light of the risk that commodity prices stay low enough for long enough that we might have to question the reliability of their dividends. If I add to our exposure in the group, my most likely move would be to add super-strong ExxonMobil XOM to the fold.

Separately, Procter & Gamble PG stands to be a beneficiary of falling oil prices at some point, but for now the strong dollar is more than offsetting a decent rate of core EPS growth. We respect the operational progress the firm is making, and excluding currency our investment thesis appears to be on track, but currency effects took our fair value estimate down $4 a share to $90. The stock had a rough week, but its dividend yield has crossed back above the 3% mark, making it an attractive purchase here.

Rounding out the week's earnings reports were uneventful releases from Altria Group MO and American Electric Power AEP. Our fair value estimate (currently $44) for Altria may increase as the company's 2015 earnings outlook is a bit better than we'd forecast; our appraisal for AEP held steady at $54 a share. Both companies are operating right in line with their medium-term goals for earnings growth, which supports solid dividend growth as well. Perhaps more importantly in this touchy environment, they don't operate abroad or produce oil, which makes them safe havens from the macro storms of the day. Their cash flows are also highly reliable, funding above-average dividend yields. These days, such features add up to lofty premiums to our fair value estimates. I have no plan to sell either position--Altria remains a core holding, and AEP is on the fringe of being core. Their strong dividend prospects should drive adequate total returns even from today's prices. At the same time, I have no reason to expect additional capital appreciation in the near term, and I'm aware of the risk of short-term drops in their stock prices if interest rates turn higher.


As if all that wasn't enough news to digest, several other items bear notice. The first of these, and one of the biggest business headlines of the week, was Don Thompson's departure from the corner office at McDonald's MCD. That the stock rallied on this news, gaining 3.2% in a week during which the S&P fell 2.8%, is not necessarily easy to justify. Clearly the firm's directors, as well as franchisees, are very eager for improved financial performance. Their willingness to act is a plus. But if anything McDonald's has been trying lately was working, it seems unlikely to me that Thompson would be out the door--he's only 51 years old and has only been CEO for two and a half years. From this I deduce that the company is still wandering around in the dark looking for its keys (probably under the lamppost, as the joke goes, because that's where the light is).

Our fair value estimate for McDonald's was not affected by the news; we still think the shares are worth $95 each based on a slow recovery to modest growth in same-store sales and operating income over the long run. An ample dividend yield is helping support the stock price at a level that the firm's current financial performance probably wouldn't merit on its own. It's only for the continuing reliability of the dividend--and, critically, a lack of compelling opportunities elsewhere--that I've been willing to put up with this frustrating situation. But given a workable alternative, I'd be willing to move on.

Uncharacteristically given the market selloff, our worst performer on Friday was fully-regulated regional utility Southern Company SO. The stock dropped nearly 4% on official word that the construction of new nuclear units at Plant Vogtle is now delayed with hundreds of millions of dollars of additional costs being likely. We expect to learn more when the company issues year-end financial results next week, though our valuation already includes $1 a share of Vogtle cost overruns borne by shareholders. The bigger problem is a relatively rich stock price, which left no margin of safety for construction challenges in this massive project. It helps greatly that Georgia is a friendly regulatory environment for Southern, and the company secured strong support before starting the project. I don't believe the delays and costs announced thus far threaten the trajectory of the dividend, but it may put off an eventual acceleration from the roughly 3% annual dividend growth we expect in the near term. I plan to continue holding our position.

Rounding out company-specific developments, our review of United Parcel Service UPS after last Friday's earnings warning led us to drop our fair value estimate by $2 to $95 a share. That's a much smaller impact than the $11+ plunge in the stock's price that day, but the elevated costs in the fourth quarter of 2014 and the weak outlook for earnings growth in 2015 off a lower-than-expected base had a modestly negative impact on our view. I still like this wide-moat stock for the long haul, and if we get the 7.5% dividend increase I'm looking for next month, the UPS would yield a tad over 3% at our updated fair value. That in turn would make it a strong candidate for an add-on buy.

With earnings season approaching the halfway point, it's becoming clear that the pickup in economic activity in the U.S. is not correlating to better earnings for most companies. Perhaps that pickup will prove to be short-lived too, as the government's initial estimate of fourth-quarter GDP growth came in at a disappointing 2.6%. Between crummy economic conditions abroad, falling non-dollar currencies, and plunging commodity prices, lots of companies are being hurt. Worse, from my point of view, is that other companies--those that dodge the triple threat of foreign economic sensitivity, currency translation, and commodity prices--are almost all too expensive to buy!

I can look at one group of our holdings and feel like a recession is under way, while another is priced for near-perfection. Don't let the major U.S. stock market indexes, which are still within striking distance of all-time highs, create an impression that everything ought to be okay--and that if a company isn't doing well, it must be the company's fault. Things are tough out there and getting tougher, and we had best be prepared for a rough ride in the months ahead. As always, I expect the heavy defensive tilt of our portfolio holdings to serve us well.


Earnings season for DividendInvestor holdings will crest next week with 10 reports: Emerson EMR and UPS on Tuesday; Clorox CLX, GlaxoSmithKline GSK, Southern, and both Spectra Energy SE SEP entities on Wednesday; and AmeriGas Partners APU, Magellan, and Philip Morris PM on Thursday.

Of these, I'm keenest to hear from Philip Morris. Given that its operations are entirely outside the U.S., it's in line to feel some of the worst currency-related pain of any big American company. In particular, currency is putting a lot of upward pressure on the company's dividend payout ratio--pressure that would be far more manageable if the company reported its financials and paid its dividends in euros rather than U.S. dollars. I'll be curious to see if the recent surge in the dollar prompts management to consider a switch like this, even though it would mean U.S. shareholders would have to bear currency variations directly in their dividend payments. That would be unfortunate, but less bad than a dividend cut forced by some massive additional spike in the dollar down the road.

Just to be clear, I'm not yet concerned for the safety of Philip Morris' dividend, and I still view the stock as a buy. But the interplay between uncontrollable currency movements and the generous income this stock provides--plus the threat of plain packaging rules to premium brands (see our analyst note below)--makes this stock one of the "hot spots" I'll be monitoring very carefully as 2015 unfolds.

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.


News and Research for Builder and Harvest Portfolio Holdings

Altria Group MO
Analyst Note 01/30/2015 | Philip Gorham, CFA, FRM  

Altria's full-year 2014 results were modestly above our estimates on the top line because of higher-than-expected gains on asset sales at Philip Morris Capital, but the core business performed in line with our forecast. The company provided 2015 guidance that is above our estimates, so we may raise our $44 fair value estimate modestly. We are reiterating our wide moat and stable moat trend ratings, as these results show that Altria's strong portfolio of brands retains its pricing power. The company also announced the retirement of long-serving COO Dave Beran.

From the standpoint of total returns, it was another strong year for Altria shareholders in 2014, with returns outpacing the S&P Food, Beverage & Tobacco Index as well as the broader market. The stock increased 30% in the calendar year, and the firm paid $2 in dividends, a yield of almost 4% at the current market price. From a fundamental standpoint, however, we are finding the market valuation increasingly difficult to justify. On a positive note, revenue grew by almost 2%, despite falling cigarette volumes, but the firm suffered margin erosion due mostly to increased spending on the eCig business and higher overhead. Although diluted EPS grew by 13%, this was driven by lower losses on the early extinguishment of debt. Adjusting for this nonrecurring item, pretax income fell by 3%.

The core cigarettes business performed in line with our medium term expectations in 2014. Revenue net of excise taxes grew by 2%, despite a volume decline of 3%. We think this is indicative of the firm's pricing power, the source of its wide moat that we believe remains intact. However, we are somewhat concerned about the implications of the transactions involving Lorillard, Reynolds American, and Imperial Tobacco. Not only will Altria face a strong No. 2 player in Reynolds with a volume share of around 36%, but also Imperial Tobacco could become aggressive on price in an effort to turn around the Winston and Salem brands.

American Electric Power AEP
Analyst Note 01/28/2015 | Andrew Bischof, CFA  

We are reaffirming our $54 per share fair value estimate, narrow economic moat, and stable moat trend ratings after AEP reported full-year ongoing operating earnings of $3.43 per share, compared with $3.23 last year.

Management reaffirmed its 2015 earnings guidance range of $3.40-$3.60 and 4%-6% three-year earnings growth target, in line with our forecasts. We think management's focus on its regulated growth plan and its large capital spending budget make it highly likely AEP will achieve this target. A higher systemwide earned ROE in 2015 also should help earnings growth after management pulled forward some one-time operating expenses in 2015.  

We continue to anticipate a strategic decision on AEP Generation, but management said it is waiting for key rulings in Ohio. A ruling on the company's contentious OVEC PPA request remains outstanding. A recent commission hearing continues to support our belief the commission will reject the capacity request, based on the legality of PPA support payments. In our view, a negative ruling would result in a quick decision to sell the no-moat merchant business, leaving investors with an attractive regulated business with above-average dividend growth potential. Key PJM capacity proposals also play into the divestment decision, but we believe this is secondary to the OVEC PPA decision and any positive developments would increase the business' value, rather than drive management's ultimate decision.

Looking to 2015, rate filings in West Virginia, Ohio, and Kentucky should help boost earned returns. Additionally, continued industrial growth in the company's shale service territories will likely support modest load growth. Continued attractive wide-moat growth opportunities in transmission and cost efficiency gains should support earnings growth. These initiatives will help offset material headwinds at AEP Generation, notably lower PJM capacity prices and low power prices.

AT&T T
Analyst Note 01/28/2015 | Michael Hodel, CFA  

AT&T struggled to handle the competitive pressures in the wireless business during the fourth quarter. Though the firm reported a 50% increase in net postpaid wireless customer additions versus a year ago, lower-value tablet customers fueled this growth. By our estimate, the firm posted a net loss of about 400,000 core phone customers during the quarter, losing market share to Verizon and T-Mobile. We continue to believe, however, that the current level of price competition in the industry is unsustainable and that AT&T’s long-term competitive position remains sound.

We don’t plan to change our fair value estimate, but the ongoing wireless spectrum auction is clearly an elephant in the room. Participants are not allowed to discuss bidding until the auction closes, but AT&T did provide some guidance with respect to financial leverage that likely places a ceiling, albeit a high one, on the amount the firm will end up spending. Until we have clarity around the auction, though, we aren’t certain how large an impact it will have on our fair value estimate. That said, we don’t expect to reduce our fair value estimate more than 10%, leaving the shares fairly valued.

AT&T’s wireless metrics provided little to cheer about. The pace of postpaid customer defections (churn) ticked up to the highest level in several years, which management blamed on T-Mobile’s ability to offer the iPhone for the first time around a major product refresh. We don’t believe this explanation provides comfort, though, as T-Mobile continues to aggressively target AT&T’s large base of iPhone users. AT&T’s relatively weak customer performance is a source of concern given that the firm has made several moves over the past year to counter the increase in competitive pressure. We expect AT&T’s performance will improve over the next year or so, though, as competitive intensity abates, the firm’s legacy base of dissatisfied iPhone customers shrinks, and recent network improvements gain recognition.

As with Verizon, the biggest wireless negative during the quarter was weak revenue per customer, a direct reflection of the promotions and discounts AT&T has used to retain share. Average revenue per postpaid phone customer declined 11% year over year, accelerating from an 8% decline each of the past two quarters. Viewed sequentially, this metric declined more than 2% after showing signs of stability last quarter. Even if Next phone installment plan billings are included, the decline in revenue per customer worsened during the quarter.

Reported wireless revenue growth accelerated to 7.7% year over year, reflecting the impact of accounting for Next installment plans. About 58% of smartphone activations during the quarter utilized the Next plan, pushing Next activations up fivefold year over year. The upfront revenue recognition of Next payments also benefits profitability, but AT&T still reported a decline in wireless EBITDA to 34.8% of services revenue from 37.4% a year ago. Fixed-line profitability, an area of concern recently, showed nice improvement, with the segment’s margin showing meaningful sequential improvement for the first time in two years.

Free cash flow continues to reflect the impact of the Next program and higher capital spending. AT&T continues to sell off Next receivables, but not at the same pace as new Next sales. Free cash flow totaled $9.9 billion during 2014, just covering $9.6 billion of dividend payments. For 2015, management continues to expect capital spending will decline to about $18 billion from $21.2 billion in 2014, allowing free cash flow to grow. The DirecTV acquisition, assuming it closes, should also provide additional dividend coverage in 2015.

AT&T ended the year with $73.5 billion of net debt, just less than 1.8 times trailing EBITDA. Management indicated that this ratio will likely head above 2.0 times after the DirecTV and Nextel Mexico transactions close. Management also indicated that leverage could move as high as 2.5 times once the dust settles around all of the firm’s strategic initiatives, including the spectrum auction. By our calculation, this figure leaves $18 billion of incremental debt capacity based on year-end figures. As a result, we suspect that AT&T will acquire, at most, half of the spectrum currently on auction.

Chevron CVX
Analyst Note 01/30/2015 | Allen Good, CFA  

Along with reporting fourth-quarter earnings, Chevron announced the suspension of its share-repurchase program and a reduction of its capital spending program for 2015. We expected both actions, given the decline in cash flow in the current oil price environment and the company's desire to maintain its balance sheet health and support the dividend. Part of the purpose of the share-repurchase program, as opposed to greater dividends, is its flexibility. The magnitude of the capital spending increase was a positive surprise, given the amount of capital the firm currently has committed to projections under construction. The updated guidance reflects about a $5 billion decrease or 13% from last year's level. Though management didn't provide 2015 guidance previously, it did indicate spending would probably be flat. Spending could be lowered further if conditions worsen later in the year. We still expect Chevron to fall well short of covering its capital spending and dividend this year, however.

Despite the reduced spending, Chevron still expects production growth to be flat to 3% higher in 2015, depending on asset sales and entitlement impacts. It is also maintaining its 2017 production target of 3.1 million barrels of oil equivalent per day, since most growth projects are well under construction. The longer that oil prices remain depressed, however, the greater the risk to that target. More detail should be available in March at the company's annual analyst day. By 2017, Chevron expects cash flow to cover the dividend, although that would require an improvement in oil prices as well. That said, we do not see any threat to the dividend, given that it remains a priority and capital flexibility will increase with time.

We plan to update our forecast with the latest guidance and updated oil price deck, which will probably result in a decrease in our fair value estimate.  Our moat rating is unchanged.

The sharp decline in oil prices hasn't changed our thesis. While Chevron's long-term growth outlook is intact, we continue to prefer Exxon. While Exxon holds less growth potential, we anticipate greater free cash flow growth and margin improvement relative to Chevron. In fact, the decline in oil prices only enforces our view on the importance of relative free cash flow growth.

McDonald's MCD
Analyst Note 01/28/2015 | R.J. Hottovy, CFA  

McDonald's announcement that CEO Don Thompson will retire March 1 should not come as a surprise given its struggles to adapt to an increasingly competitive landscape and evolving consumer preferences. We view incoming CEO Steve Easterbrook as a suitable replacement, given his focus on customer engagement as McDonald's chief brand officer, as well as CEO roles at U.K.-based restaurant chains PizzaExpress and Wagamama between 2011 and 2013. However, we believe the company would benefit from additional outside perspective in its efforts to modernize customer experience and develop a more nimble organization.

As McDonald's USA President Mike Andres outlined at an investor event in December, we believe there are three primary challenges facing the U.S. business today (which we believe also pertain to other struggling markets such as Germany and Japan). These include a pricing gap between its value and premium products that has become too wide; slow reaction times to changing taste preferences at a local and regional level, a more pronounced consumer shift toward more healthful foods (real or perceived), and the fast-casual category reaching critical mass; and too much menu complexity. Based on his presentation at its November 2013 analyst day, we believe Easterbrook recognizes these challenges and will develop a blueprint for global consumer engagement improvements. Nevertheless, we'd still like to see Easterbrook surround himself with some outside restaurant and financial industry talent, especially when rivals have found success adapting to industry changes in recent years.

There is no change to our $95 fair value estimate, wide moat, or Standard stewardship rating. We continue to believe 2015 will be a challenge, but with local decision-making and Experience of the Future investments positioning McDonald's for modest top-line and margin improvement in 2016. However, we'll revisit our assumptions as we get additional color on Easterbrook's strategic initiatives.

In addition to Thompson's retirement, McDonald's also announced that CFO Pete Bensen will be appointed to the newly created role of chief administrative officer, overseeing a number of the company's operational functions. Corporate Controller Kevin Ozan will succeed Bensen as CFO. We are generally supportive of these moves, as they should allow Easterbrook to focus on McDonald's more pressing consumer engagement issues while allowing someone with a solid understanding of the company's entire operations like Bensen to focus on operational improvements (which are likely to include supply chain improvements and coordination among key suppliers, regional management, and franchisees).

Philip Morris International PM
Analyst Note 01/26/2015 | Philip Gorham, CFA, FRM  

We believe the announcement by the U.K. government that it will press ahead with legislation to introduce plain cigarette packs in England will have limited impact on the names under our coverage. However, we regard the spread of plain pack legislation as a significant negative for the industry, and we would probably revise our pricing assumptions for the global players if similar legislation spreads to other markets. Until we gain more visibility into governments' strategies, however, we are retaining our wide moat and stable moat trend ratings for the tobacco multinationals we cover.

Following around two years of consultation, culminating in last year's Chantler report that recommended the introduction of plain packs, the U.K. government has announced that it will put legislation to Parliament by May that will propose the introduction of standardized packaging on tobacco products in England. We believe the bill has a strong chance of passing. A poll by Cancer Research UK (admittedly an organization with a vested interest) indicates that 72% of U.K. voters favor such legislation. The largest opposition party also takes a firmly anti-tobacco stance, which should tip the balance toward enactment.

We believe plain packs would be a significant negative for the industry because the legislation could cause trading down by smokers and/or erode the pricing power of premium brands over lower-priced competitors. In an industry that already has limited opportunities to communicate with its core consumer, plain packs would eliminate trademarks and packaging branding, some of the few remaining marketing tools available to cigarette manufacturers. In turn, we believe this could lead to trading down to cheaper brands by consumers less able to differentiate among brands. Differences in taste and perceived quality are likely to offset trading down, however, particularly at the higher end where smokers tend to be more brand loyal.

Evidence on the impact of standardized packaging from Australia, the only other market to have introduced the legislation, is mixed. Retail World supermarket sales data showed that volume of mainstream and premium brands fell 8%-9% in 2013, but value brands increased 12.9%, indicating that trading down is occurring. Plain packs were introduced in 2012, along with a large excise tax increases of 12.5% every year for four years. This has muddied the waters for measuring the impact of plain packs, as Australia is already one of the highest-price-point cigarette markets in the world, and the change in consumption patterns could be driven by the increasing price points rather than economizing.

In the United Kingdom, the major manufacturers have well-laddered product portfolios, and all have lower-priced brands that could capture market share in the event of trading down. However, we think the migration of consumers to lower price points represents a risk for those with the largest market share. Imperial Tobacco is the market leader in the U.K., with a volume share of around 45%. Its product portfolio ranges from Davidoff and Embassy at the high end of the pricing spectrum to Lambert & Butler and JPS at below-average price points. Japan Tobacco (not covered) has a share of around 40% and could have the most to lose. Through Benson & Hedges and Silk Cut, the firm has a heavy presence in premium price categories. For British American Tobacco and Philip Morris International, however, the U.K. is a relatively small market. Both firms possess volume shares in the high single digits and will be less affected than Imperial and Japan Tobacco. Nevertheless, the Marlboro brand is positioned at the premium end in the U.K. and Philip Morris International could suffer share losses as a result.

Procter & Gamble PG
Analyst Note 01/27/2015 | Erin Lash, CFA  

While Procter & Gamble’s headline second-quarter results were bleak (with sales down 4% and earnings before tax off 8%), we haven’t swayed from our view that the firm’s underlying business is gaining traction. As such, P&G’s wide moat, which stems from its expansive scale and brand power, is firmly in place. However, in light of the negative impact foreign currency is having on current-year results, we’re taking our fair value estimate down to $90 per share, from $94. We now expect sales to slip 3.7% this year (which compares with 1.7% growth previously), and operating margins to approximate 19.4% (versus 20.1% previously). The profit impact is more pronounced, as the firm isn't manufacturing in the locations it is selling, a challenge that is unlikely to abate, but is not indicative of the firm’s fundamentals. Shares are off around 3%, and at a slightly larger discount, we’d contend that the stock would be an attractive investment in a sector where discounts are few and far between.

Excluding foreign currency rates and one-time charges (including a $0.26 per share impairment related to its battery business), sales ticked up 2%, driven by higher prices and favorable product and geographic mix, and operating margins contracted 60 basis points to 20.2%. We still believe efforts to bring new products to market that prove valuable to consumers are paying off. In fact, Kimberly-Clark recently noted that it suffered share losses at the hand of P&G in both U.S. diapers and adult incontinence. This commentary runs in line with P&G’s disclosure at its investor conference in November 2014 that Pampers (P&G’s largest brand, with $10 billion in annual sales) had overtaken Huggies and now controls around 38% share of the U.S. diaper market, about 300 basis points above the level held by Kimberly.

From a category perspective, fabric and home care and baby, feminine, and family care proved bright spots, with underlying sales up 3% and 4%, respectively. However, beauty remains a challenge; segment organic sales ticked down 1%. As such, we view the recent appointment of David Taylor to the helm of this business (while he also continues to run the global health and grooming operations) favorably--a fresh perspective might be just what is needed to put this business on more stable ground. Olay is still a struggle, though Pantene continues to improve, posting seven straight months of market share gains. We aren’t blind to the fact, though, that the performance in this category could prove lumpy given the fierce competitive dynamics of the U.S. hair care space.

P&G also disclosed that to date, 35 brands (including the pet-care and battery business) have been sold or discontinued or will be consolidated, out of the 90-100 it plans to shed. We continue to believe that P&G's efforts to focus on core brands will aid financial performance without sacrificing scale and negotiating leverage with retailers. We hope to garner additional perspective on these efforts when we attend the Consumer Analyst Group of New York conference next month.

Procter & Gamble: Valuation 01/27/2015
We're taking P&G's fair value estimate down to $90 per share, from $94, after accounting for the drag unfavorable foreign currencies are expected to have on both the top (negative 5%) and bottom lines (negative 12%) this year. We now expect sales to slip 3.7% this year (which compares with 1.7% growth previously), and operating margins to approximate 19.4% (versus 20.1% previously). The profit impact is more pronounced as the firm isn't manufacturing in the locations it is selling, a challenge that is unlikely to abate. Our long-term expectations for P&G's consolidated operations (annual top-line growth above 4% and nearly 23% operating margins) remain in place. Our revised valuation implies fiscal 2016 price/adjusted earnings of 21 times, enterprise value/adjusted EBITDA of 15 times, and a free cash flow yield of 4%.

We had already incorporated the impact of the Duracell sale to wide-moat Berkshire Hathaway for its $4.7 billion in P&G shares (52.8 million shares, a transaction that is slated to take place in the second half of calendar 2015) into our valuation. P&G is set to inject $1.8 billion of cash into the battery business before the close, which lowers the deal value to $2.9 billion or 1.3 times fiscal 2014 sales and 7 times fiscal 2014 adjusted EBITDA.

We contend the decision to shed more than half of its brands over the next 18 months stands to enhance its focus on the highest-return opportunities. Deteriorating economic conditions in the U.S. and Europe combined with moderating growth in emerging markets will constrain P&G's near-term growth prospects, but our outlook for a top-line increase above 4% long-term remains in place. Globally, P&G's categories grow roughly 3% annually, so to reach the 4% annual sales growth pace we've modeled, the firm would have to grow 1%-2% faster than the markets and categories in which it competes, which we view as achievable, particularly in light of recent strategic efforts. The firm has growth opportunities for its brands in many overseas markets, and in developed markets it remains the share leader in many of its categories.

Even though we're encouraged P&G is realizing some margin improvement from its ambitious initiative to shave $10 billion from its cost structure, we ultimately think the firm will need to reinvest a portion of these savings to maintain its competitive positioning. Our long-term forecast calls for operating margins to improve to nearly 23% by the end of our 10-year explicit forecast.

Rogers Communications RCI
Analyst Note 01/29/2015 | Michael Hodel, CFA  

Rogers Communications posted mixed results that were essentially in line with our expectations despite subscriber declines in postpaid wireless and across the cable business. Group revenue rose roughly 3.8% from the prior-year period to CAD 3.36 billion ($2.66 billion), meeting management’s fiscal 2014 guidance. At this time, we do not foresee any changes to our CAD 48 fair value or narrow economic moat rating, and shares look mildly undervalued at current levels.

Wireless revenue rose 2.5% from the year-ago period, as heightened equipment sales offset declines in postpaid subscribers and revenue per customer. The fourth quarter typically yields the highest subscriber turnover, and 2014 was no exception. Postpaid churn rose to 1.46%, the highest rate in three years. However, postpaid ARPU rose 1.6% to CAD 67.43, as management remains committed to minimizing discounts and retaining higher-value customers. Rogers activated 836,000 smartphones in the fourth quarter (likely boosted by Apple’s iPhone 6 and 6 Plus models), its highest rate in two years. We believe there is still runway for growth in terms of smartphone activations, which should continue to drive data demand that will necessitate increased capacity and higher-quality networks, which should play to Rogers’ strengths. The wireless operating margin expanded roughly 90 basis points to 42.6% of network revenue.

Cable revenue remained flat year over year as the firm withstood modest net subscriber losses across Internet, television, and phone services. However, the media business posted a strong fourth quarter, with revenues rising 20% on the back of the firm’s NHL licensing agreement, a trend we expect to continue. We think Rogers should be able to use the NHL package to aid growth across other portions of its business as well, while Rogers’ strong reputation for network reliability should ultimately drive growth over the longer term.

Management is calling for flat to modest EBITDA growth in 2015, which will depend primarily on the effectiveness of CEO Guy Lawrence’s strategy of trading wireless subscriber additions at any cost for higher-value customers that will maintain long-term relationships with Rogers. While we believe Rogers has the assets to take this stance in terms of network performance and reliability, there is an element of risk that customers will ultimately defer to the best rates versus network quality. The fourth quarter marked the firm’s first year-over-year growth in postpaid ARPU in nearly two years, so there is evidence that the strategy has merit, but management acknowledged there could be some bumps over the course of the next year.

Rogers Communications: Valuation 01/30/2015
We are lowering our fair value estimate to $38 per share from $44 to account for weakness in the Canadian dollar versus the U.S. dollar. We project Rogers to increase revenue at a 3% compound annual rate through 2019. Although smartphone activations continue to increase, the weak economic backdrop is having negative effects on roaming and out-of-plan usage. We expect ARPU and margins to largely remain flat as the benefits from heightened smartphone service plan pricing (and the lower postpaid churn it should produce) are offset by stiff competition and retention spending. At our fair value estimate, the 2014 P/E ratio would be roughly 15 times, in line with historical norms. Our blended cost of capital is 8%.

Royal Dutch Shell ADR RDS.B
Analyst Note 01/30/2015 | Stephen Simko, CFA  

Of the European integrateds, Shell is currently the best-positioned to withstand prolonged cheap oil given its relatively robust financial health. Still, there’s no question 2015 is going to be a very challenging year for the firm. With a capital outlay budget that is set to approach $35 billion and a $12 billion annual dividend payout, Shell is set to burn more than $13 billion in free cash flow based on current oil price futures. It’s possible that the capital expenditure cuts and asset sales could each reduce cash burn by a few billion dollars, but as of today it appears very likely that 2015 will be a year where the company is forced to increase its balance sheet leverage to withstand the challenging operating environment. The firm’s gearing ratio is currently 12%, so Shell has plenty of financial resilience with which to both increase leverage and protect its dividend. At $50 Brent, we believe Shell’s dividend would not be at risk until at least 2017.  

That said, we were surprised that the company didn’t give a clearer outlook of how spending could be curtailed if oil prices do not recover. Instead, management focused on the notion that it believes current oil price weakness will prove relatively short lived. Even so, about 30% of the company’s 2016 capital outlay has yet to be firmly committed. If oil prices don’t recover in the coming quarters, Shell could still plausibly make major adjustments to its long-term spending plans in relatively short order.

Regarding its near-term outlook, management provided guidance that each $10 per barrel change in oil prices equates to a roughly $3.3 billion change in cash flow and reported earnings. That implies that if oil prices are in the $50 range for all of 2015, Shell could see its upstream profitability collapse towards breakeven after generating $16.5 billion in adjusted earnings during last year.

After reviewing our forecasts, Royal Dutch Shell's fair value estimate and economic moat ratings are unchanged.

Southern Company SO
Analyst Note 01/30/2015 | Mark Barnett  

We maintain our $46 fair value estimate for Southern Company after management announced a schedule overrun notification from the E&C consortium constructing the Vogtle nuclear project. This is no surprise following SCANA's public acknowledgement of delays at its V.C. Summer project using the same Westinghouse AP1000 design. The projects have experienced similar hitches, and struggle with quality control of equipment and supplies, a problem which Southern's sizable QA facilities onsite testify to.

In its release, management cited a $10 million per month increase in its capital cost for the project that investors are likely to bear. Given the 18-month extension, this could put the increased total cost at roughly $620 million. However, we expect management to clarify whether this figure fully applies to current owner's costs from today through completion on a monthly basis or whether that increase is limited to a more specific period.

Management provided a reminder that the project carries a $30 million per month financing burden. Financing is often overlooked in industry presentation of the cost of new nuclear units. The delays could represent an incremental $500 million or so in finance costs to complete the units. We have already assumed that shareholders bear incremental costs of a total of $775 million (2014 dollars) for the project, representing $1 per share off of our fair value estimate.

Summary numbers are far from certain, and don't represent the potential for costs the consortium will try to pin on Southern to protect themselves. Most large projects end up with some litigation. We consider Southern to have a strong upper hand, as jurisdiction over another dispute with the consortium lies in Georgia, and we expect slipperiness around contract language and cost responsibility could be interpreted in Southern's favor. It is however the largest variable in fair value impact from any overrun figure.

An announcement like this is merely a formal published recognition of the potential numbers involved with owner's cost overruns and extra financing costs associated with a longer funding timetable to complete construction. The U.S. and global nuclear supply chain--particularly for newer designs like the AP1000 and Areva's EPR--had not been vibrant and growing when these projects were decided, so it's no surprise to have some serious complications. The issue is regulatory support for recovery of additional costs incurred.

We believe Georgia's regulators will push hard to support Georgia Power's legal protection from consortium costs, and it is quite likely that management's endorsement of the strength of the wording of its contract in terms of fixed total delivery costs is coming from a genuine place. Westinghouse and other contractors were desperate for these projects to be approved to keep their flailing nuclear businesses alive and fed. Southern's consistency in public comment on this issue stands in contrast to SCANA's management commentary which has not been nearly as strong. However, South Carolina regulators have been similarly supportive of the project there in public and SCANA enjoys a similar, constructive regulatory environment for cost recovery of its project.

United Parcel Service UPS
Investment Thesis 01/25/2015 | Keith Schoonmaker, CFA

UPS is the colossus among global parcel shipment companies, and we consider its economic moat to be the widest among all freight transportation firms. The company crafted its moat by assembling an integrated global shipping network that's unlikely to be matched by any but a few global players. Despite its extensive unionization and asset intensity, UPS produces returns on invested capital about double its cost of capital and margins well above its competitors'; we credit the firm's leading package density and outstanding operational efficiency, enhanced by extensive technology investment. UPS and its competitors have turned to Asia and developing nations for growth, and we think UPS has ample runway left to build speed. Even existing operations have revenue expansion potential via pricing power, because UPS operates within a somewhat rational oligopoly in its largest market, U.S. high-service parcel delivery.

UPS earns higher margins than its peers, by its mix (FedEx has expanded ground operations, but still earns a majority of its revenue in its low-margin express segment) and by funneling substantially greater package volume through its efficient assets. In the U.S. parcel market, FedEx's express and ground units together handled about 10.7 million average parcels daily in fiscal 2014, but UPS moved 14.4 million in calendar 2013. Within this total, the disparity is even greater in U.S. ground, where UPS moved on average over 12 million parcels per day and FedEx on the order of half of that: 6.8 million including SmartPost. Another aspect of UPS' margin advantage lies in its use of integrated assets to transport U.S. urgent and ground shipments through the same pickup and delivery network. In contrast, FedEx uses parallel networks of drivers and trucks to separately handle ground and express shipping. In addition to the greater efficiency of UPS' single system, clients appreciate the convenience of using the same driver to handle both express and ground packages. However, during periods of tremendous volume volatility, FedEx ground's variable cost model shows merit.

United Parcel Service: Economic Moat 01/25/2015
UPS earns its wide economic moat from efficient scale, cost advantage, and the network effect. Extensive express, ground, and freight networks demand a huge quantity of trucks, trailers, terminals, sorting equipment, IT systems, and skilled labor. Replicating these assets in the absence of sufficient package flow would be costly, and few entities would endure the financial losses during the necessary density-building phase. As evidenced by DHL's worthy effort, such a project would require at least a decade of effort. Even a global shipping powerhouse like DHL failed to displace UPS and FedEx on their massive home turf--these two competitors comprise the efficient scale in high-service U.S. domestic parcel delivery. In this high-fixed-cost business, the substantial parcel volume handled by the incumbents provides a cost advantage that makes competing at market prices difficult for low-volume entrants. Compared with FedEx, UPS produces superior margins via greater package volume, concentration on high-margin ground shipping, and use of a single network rather than parallel air and ground operations. The firm produces attractive ROICs averaging around 15% (excluding the 2007 pension withdrawal expense) despite its intensely asset-based operations. The firm does have substantial asset-light operations in its freight forwarding and contract logistics operations, and the former boast network effects typical of this model--additional offices make the entire system more valuable to shippers. We believe with near certainty that the firm will outearn its cost of capital for the next 10 years, and consider excess normalized returns more likely than not two decades from now; we consider UPS' economic moat to be one of the widest in the transportation universe.

United Parcel Service: Valuation 01/25/2015
We've lowered UPS's fair value estimate to $95 from $97 per share as we incorporate actual 2014 earnings that were lower than we previously modeled, and management's expectations for 2015 growth below its stated long-run target of 9% to 12% per annum. We assume that the firm achieves long-run 13.5% consolidated margins as early as 2016 (previously we assumed this would happen 2015), up from 12.7% in 2013. Our margin estimates in three operating segments--14% in domestic package, 16% in international package, and 8% for supply chain and freight--drive consolidated margin projections. We expect continued strength in global industrial production actual reports and optimistic near-term expectations. UPS' performance is tied to the health of the global economy, and we believe shipping volume will not recover for several quarters. In the long run, however, we believe overall global parcel shipping market expansion and consistent price increases will enable UPS to increase its top line at about a 5% compound annual rate during the next five years. The firm expects to expand international package shipping faster than the broader market through internal growth and by adding assets. UPS generated an impressive high-teens average return on invested capital during the past five years and produced tremendous free cash flow of 5%-11% of sales. The firm reinvests heavily (in the long run, we model about 4% of sales) and earns consistently high returns on its assets.

United Parcel Service: Risk 01/25/2015
Rapid changes in shipping demand during the recent recession demonstrate that the cone of uncertainty surrounding modeling estimates can widen quickly because of macroeconomic factors. UPS derives nearly a fourth of its total revenue from international sources, but it still relies heavily on the U.S. market. The UPS driver team is unionized, but UPS recently minimized the risk of service disruption by signing the current labor contract well before the expiration of the previous agreement.

 


 

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