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

 
 
Aug 02, 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
P&G Tries Our Patience -- The Week in Dividends, 2015-07-30

The rush of second-quarter earnings results continued this week with another six of our holdings reporting through Thursday. Coming into this week, I worried that GlaxoSmithKline GSK might kick our shins again, yet the stock actually generated a nice gain so far this week--even if merely by failing to produce incremental bad news. I'm still disinclined to hold our small Glaxo position for the long term, but I appreciate this rebound in the share price as well as the opportunity to continue evaluating our alternatives carefully. It's not as though clearly higher-quality businesses with yields near 6% are falling out of trees.

Instead, it seems that Procter & Gamble PG, a onetime stalwart of reliability, may hand us our worst earnings result of the season, at least as measured by the market's reaction--the stock traded down 4% on Thursday. Wall Street has clearly lost patience with macroeconomic excuses for falling sales and earnings per share. P&G goes to some length to isolate its operational performance from currency changes, divestitures and the like, but even on that basis the firm's underlying performance has still flagged. We're also heading into another CEO transition: P&G veteran David Taylor will soon take the reins from A.G. Lafley, even though Lafley is hardly heading back into semi-retirement on a high note.

A vast restructuring and simplification drive is not producing any quick fixes. After P&G inked a deal to sell most of its beauty lineup to smaller rival Coty COTY, I was relieved that the year-long reshaping of the company's brand and product portfolio is effectively complete. But in the guidance management revealed for the new fiscal year, we can see the near-term cost of the restructuring and a mismatch between P&G's short-term performance and Wall Street expectations. On the surface, P&G appeared to beat estimates with core earnings per share of $4.02 for fiscal 2015. However, this baseline drops to $3.77 once the businesses P&G plans to dispose of are classified as discontinued operations. Worse, off that 6% smaller base, P&G expects EPS growth to range between a mid-single-digit percentage increase and a slight drop--opening up an even larger gap between Wall Street estimates for fiscal 2016 and the company's forecast. Since stocks are conventionally valued on a price/earnings basis, and few investors are eager to pay richer P/Es for flagging financial performance, today's drop in P&G's stock price isn't at all hard to understand.

We've owned P&G for more than four years now. At least on my initial purchase, we've managed to earn an annualized total return in the high single digits. That's only about half the return produced by the S&P 500, and my subsequent add-on buys for P&G at higher prices have fared even worse. So why am I still hanging on?

* The firm's dividend retains a lot of appeal, backed by a strong balance sheet, abundant free cash flow, and an economically defensive risk profile. After Thursday's decline, P&G's current yield stands at 3.4%.

* Dividend growth has slowed sharply to just 3% this year, but continues on an annual basis as it has for 59 years. We expect growth to accelerate in future years as earnings growth permits--the board's commitment to a growing dividend hasn't changed. But with the yield where it is, double-digit EPS and dividend growth is no longer necessary to drive adequate long-run total returns; a mid-single-digit pace would do.

* The company's wide economic moat remains intact, in our view. P&G did fall behind some in certain product categories and regions. But even if its turnaround plan has been slow to bear fruit in the form of faster sales growth, the company's wide moat has been able to at least preserve high profit margins and returns on capital through one of the more difficult periods in P&G's history.
 
My patience is not infinite, and I too am tired of excuses, but I'm still willing to give P&G at least one more year to shine. Though all of the deals are in place to finish its portfolio rationalization, many of those deals have yet to close, and P&G hasn't yet had the opportunity to reallocate capital elsewhere. We don't expect a large change in our fair value estimate (currently $90), which pegs P&G as one of the cheaper stocks we own on a price/fair value basis. Furthermore, if P&G goes ahead with the split-off of the stake it will own in Coty as planned, its share count will drop substantially in fiscal 2017, which in turn will aid earnings per share.


All of our earnings reports in the week thus far are covered in the notes below; in particular I'd note that we expect a $2 or $3 increase to our fair value estimate for Altria Group MO based on improving revenue trends. Additionally, a routine update to our model added $1 to our appraisal of American Electric Power AEP, which we now value at $60 a share.

I'll be out of the office on Friday, so this week's update comes a day early. Unless something unexpected warrants immediate attention, I'll include our analyst notes for tomorrow's scheduled reports (Chevron CVX and Public Service Enterprise Group PEG) in next week's update. In addition, Clorox CLX is due to report on Monday; AmeriGas Partners APU, Emerson Electric EMR and Health Care REIT HCN on Tuesday; Spectra Energy Partners SEP on Wednesday; and Magellan Midstream Partners MMP on Thursday.

Best regards,

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 Dividend Select Portfolio Holdings

Altria Group MO
Analyst Note 07/29/2015 | Adam Fleck, CFA

We are maintaining our wide moat rating on Altria, but will likely raise our $51 fair value estimate by $2 to $3 after updating our near-term projections for a stronger than expected 2015. Smokeable products enjoyed a very strong second quarter with revenue excluding excise tax up 7.8% on better volume and pricing based on a stronger U.S. tobacco consumer. However, management of both Altria and Reynolds (which reported earlier in the week) confirmed our view that the back half of 2015 is likely to be weaker as consumers lap lower gas prices from a year ago, inventory movements even out, and excise tax increases go into effect in several states. Smokeable adjusted operating income growth was even stronger (up 15.8%) than revenue growth, partially due to higher revenue, but supported by the end of the federal tobacco buyout. The firm will lap the end of the buyout in the fourth quarter, which is likely to suppress margin growth in the back half and we forecast smokeable reported margins of 44.5%, down from first-half levels. Our adjusted 2015 EPS expectation is $2.79, within management’s raised guidance of $2.76-$2.81. With shares trading near our fair value estimate, we would recommend investors wait to build a position in the name.

While tobacco industry volumes have declined just 0.5% in the first half of 2015, we expect long-term volume to decline 3%-4%. We expect Altria’s share to remain stable (volume declines will mirror the industry), but our wide moat rating is based on the brand intangibles behind the Marlboro brand, which will support better pricing allowing the smokeable segment to capture 1% annual revenue growth over our explicit forecast. Nonetheless, total firm revenue should grow faster as more tobacco users experiment with alternatives to cigarettes, supporting growth in both the e-cig category and in smokeless products where Altria has the strong Copenhagen brand, which boosted volumes nearly 5% and boosted retail share 0.8% in the quarter.

Looking at the innovative tobacco segment, Altria continues to work on rolling out its Mark Ten XL and Green Smoke products nationally. The firm also expanded its strategic framework with Philip Morris International in the quarter to jointly develop innovative products. While Altria continues to be behind key U.S. competitor Reynolds on e-cig market share and likely profitability as Altria mentioned these products were still in development mode--though Reynolds recently pulled back on its expectations of VUSE operating profitability by the second half of 2015--its PMI partnership should allow it access to market research globally, which could lead to better product development. In that vein, the firm is expected (following FDA approval) to introduce the next-generation heat-not-burn iQOS product in the U.S. As we published in our recent report (“Not Up in Smoke Yet: E-Cigs’ Threat to Tobacco Moats is Limited”) we believe HNB will have the most solid runway in the U.S. innovative tobacco industry given its more similar feel to traditional cigarettes, and the product could eventually help Altria overthrow Reynolds as the leading large tobacco player in the innovative space.

American Electric Power AEP
Valuation 07/27/2015 | Andrew Bischof, CFA

We are increasing our fair value estimate to $60 per share from $59 after second-quarter 2015 results that were in line with our expectations. The increase in our fair value estimate is the result of time value appreciation since our last update.

At the regulated utilities, we estimate $12.3 billion of planned infrastructure investments in 2015-17, in line with management forecasts, and consistent regulatory treatment leading to 9% regulated earnings growth. But power plant closures and customer switching weigh on unregulated earnings. On a consolidated basis, we project 5% average annual earnings growth through 2018.

Primary growth investments at the regulated utilities include environmental controls on AEP's power plants and large interstate transmission projects. Higher average returns on its capital investments should help earnings as transmission projects become a larger share of its regulated asset mix. We assume a normalized energy demand growth rate of 1%.

We project regulated earnings will account for approximately 85% of consolidated earnings in 2015, down from roughly 95% in 2013-14, as we assume Ohio Power fully deregulates and we account for forecast plant closures. Incorporating management's guidance, we assume Ohio Power divests 8.9 gigawatts of competitive generation, adjusting for the 2.4 GW transfer to the Kentucky and Appalachian utilities and 3.1 GW of planned plant closures. We assume management divests the unregulated unit in 2016.

We use a 6.0% weighted average cost of capital and 7.5% cost of equity in our discounted cash flow valuation.

GlaxoSmithKline ADR GSK
Analyst Note 07/29/2015 | Damien Conover, CFA

We are holding firm to our fair value estimates of $47 and GBX 1,510 (ADR/local) for Glaxo after it reported in-line second-quarter results. Further, we continue to believe that Glaxo holds a wide moat, balanced by strong new drug launches offsetting increased competition to the company’s core respiratory franchise. Strong brand power in the consumer group and cost advantages with the vaccine segment further solidify Glaxo’s moat.

With the leading contribution to sales, the pharmaceutical group posted mixed results in the quarter (up 2% year over year), which we expect to continue for many more quarters. While respiratory drug Advair (16% of total sales) is showing some signs of stabilization and the new HIV drugs Tivicay and Triumeq are gaining better than expected traction, the new respiratory drugs Anoro and Breo still struggle to gain market share. We expect Advair to continue to show weakness over the next several years as branded competitors have capitulated on pricing and generic launches are likely after 2016. While the HIV drugs continue to post solid gains, we believe the new respiratory drugs will need to gain traction before the drug segment can post strong growth. We expect positive data from the Summit study in the third quarter, which should help Breo differentiate against Advair on a mortality benefit. This data combined with better positioning on drug formularies should accelerate Breo’s growth.

Outside of the drug group, the vaccine group (down 5%) and consumer health care (up 6%) posted offsetting growth. We expect growth in the vaccine group to improve with the broader product offerings acquired from Novartis and a strong pipeline of new vaccines. Further, we expect both the vaccines and consumer group to improve profitability over the long term as the firm has made a commitment to expand the margins of these segments by over 800 basis points, which we think the company will come close to achieving by 2020.

Procter & Gamble PG
Analyst Note 07/30/2015 | Erin Lash, CFA

Despite Procter & Gamble’s lackluster sales, which ticked up 1% organically in fiscal 2015, but 2% when excluding the brands to be divested, we believe the firm is taking prudent steps to position it for profitable growth longer term. Beauty remained a laggard, with segment sales off 1% versus last year. However, health care (up 4%) and baby, feminine, and family care (up 3%) were bright spots. We contend the market share gains achieved in U.S. laundry, U.S. diapers, and adult incontinence signal the potential that can be realized across its mix when innovation and marketing are on target, supporting the firm's brand intangible asset, although these investments take time to yield measurable gains. In addition, P&G’s efforts to drive out excess costs are notable, and ultimately should provide the fuel to reignite its brands. Excluding the impact of unfavorable foreign exchange, adjusted gross margins increased 80 basis points to nearly 50% and adjusted operating margins rose 130 basis points to the high teens/low 20s.

We suspect the market fails to share our view that P&G can return to posting mid-single-digit annual sales growth and maintain its percentage of sales spent on R&D,  which stands at roughly 2.5% of sales and is in line with peers. In that light, shares fell at a mid-single-digit rate following the earnings release. Despite this, we think P&G's strategic endeavor to right-size its brand mix is a wise course, and shows the firm aims to become a more nimble and responsive operator. Further, we think this should enable it to inclrease its focus (from both a financial and personnel perspective) on the highest-return opportunities, which is critical in the intensely competitive environment in which it plays. However, we’ve long thought these initiatives would play out over the next few years rather than a couple of months. As such, we don’t expect to materially alter our $90 fair value estimate, and view wide-moat P&G as an attractive undervalued investment.

Globally, P&G's categories grow roughly 3% annually, so 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. Further, we contend that the firm possesses growth opportunities for its brands in many overseas markets (such as within the liquid laundry and diaper pant categories in China), as it works to tailor its mix to meet the preferences of local consumers. We're also encouraged that P&G is realizing some margin improvement from its ambitious initiative to shave $10 billion from its cost structure, while investing behind its core brands, and think more improvement is likely in the cards. Beyond reinvesting in the business, we expect dividends will remain a priority of cash--the firm has paid a dividend to its shareholders consistently for more than 120 years--and we forecast mid- to high-single-digit dividend increases over the next 10 years.

It was announced earlier this week that David Taylor--a 35-year company veteran, who has headed up the health-care business since 2013 and was recently tapped to bring beauty care and grooming into his fold--is poised to assumed the top spot in November. We had anticipated hearing his initial take on the firm’s competitive positioning during the earnings call, but this was not in the cards. Despite this, we still don’t foresee Taylor veering from the strategy (that is enhancing the efficiency of its operating model and propping up sales growth) that has been laid out. Further, we don’t think this change in the management suite will shift the firm’s standard stewardship of shareholder capital.

Procter & Gamble: Analyst Note 07/29/2015
After more than two years back at the helm, Procter & Gamble announced CEO A.G. Lafley will step down in November, and David Taylor--a 35-year company veteran, who has headed up the health-care business since 2013 and was recently tapped to bring beauty care and grooming into his fold--will be assuming the reins. Lafley will continue to serve as executive chairman to ensure a smooth transition. We weren’t surprised Lafley would look to step down from running the day-to-day operations as P&G closes the chapter on strategic efforts put in place a year ago to shed more than half of its brand portfolio. From an internal perspective, Taylor struck us as the heir apparent, given his grasp of P&G’s vast product and geographic footprint.

We expect Taylor to continue implementing the playbook P&G has been operating under the past few years--maintaining a stringent eye on extracting costs from its operations, while fueling investments behind product innovation that resonates with consumers and marketing. Beyond articulating and implementing the firm’s strategic efforts, we think the onus will be on him to ensure P&G’s large global employee base remains engaged in its strategic direction (unlike a few years ago).

This announcement doesn’t have an impact on our $90 fair value estimate, which already took into account the planned brand sales announced last year and incorporates our expectations for 4% annual top-line growth--with a more balanced contribution from price and volume--and 23% operating margins by the end of our 10-year explicit forecast. Despite efforts to slim down, we don't think P&G will sacrifice its scale edge (maintaining around 90% of its sales base, or more than $70 billion in annual sales), but will better focus its resources (personnel and financial) on its highest-return opportunities, enhancing its brand intangible asset and cost edge. Wide-moat P&G stands out as undervalued, and we'd suggest investors consider building a position in the name.

Realty Income O
Analyst Note 07/30/2015 | Todd Lukasik, CFA

Realty Income delivered solid second-quarter results, consistent with the steady cash flow generation of its legacy assets combined with incremental growth from acquisitions. The firm is on track to meet our expectations for the year, and we’re maintaining our $50 fair value estimate and narrow moat rating.

For the quarter, on a year-over-year basis, revenue increased 11% while EBITDA rose 9%. On a per-share basis, EBITDA increased 4%, reflecting the incremental shares the firm has issued to fund external growth investments.

Realty Income had a very productive quarter with acquisitions and developments, funding $721 million at an initial yield of 6.3%. This second-quarter volume was near the high end of the range the firm had initially provided for 2015 in its entirety, and Realty Income has increased its acquisition guidance assumption yet again to $1.25 billion for full-year 2015. This still may prove conservative, as the firm has already closed $931 million year-to-date. Although initial yields are very low in the current environment relative to historical levels, the potential total return of roughly 7.5% (that is, the 6.3% initial yield plus perhaps 1%-1.5% annual cash flow growth) still looks acceptable relative to our roughly 7% estimate for its long-term cost of capital. Plus, nearly half of the quarter’s investments were with investment-grade-rated tenants, including Walgreens, which command higher prices (that is, lower initial yields), due to the lower risk that they’ll default on rent payments over the initial lease term of 18.2 years, on average.

Porfolio operating metrics remain strong. Occupancy was 98.2%, while rents on new versus expiring leases increased 5.7%. Same-store rents (a measure of internal growth) increased 1.5%, near our long-term expectation for Realty Income’s portfolio.

We’ve tweaked our forecasts, and we now expect AFFO per share to come to $2.73 in 2015, at the top end of management’s increased guidance range of $2.69-$2.73.

Southern Company SO
Analyst Note 07/29/2015 | Mark Barnett

We maintain our $47 per share fair value estimate and stable narrow moat rating after Southern Company reported second-quarter 2015 earnings showing a modest but healthy pickup in weather-adjusted power demand.

Southern remains one of the cheapest regulated utilities in our coverage universe, trading near an 8% discount to our fair value estimate. Long-term EPS growth remains at the middle of the pack, but we believe upside from above-average economic growth remains higher than for many of Southern's large- and mid-cap utility peers, and investors collect a nearly 100-basis-point premium on the dividend in the meanwhile.

This is the first time since 2004 that all three customer classes--residential, commercial, and industrial--have shown weather adjusted growth in two consecutive quarters. Earnings for the quarter rose 4.5% to $0.71 per share from second-quarter 2014 EPS of $0.68, excluding a $14 million aftertax charge for cost overruns at the Kemper coal facility in Mississippi and a $4 million charge for a 2009 legal settlement. We expect full-year 2015 EPS of $2.80 excluding these items.

The Kemper project, which has weighed on results over the past few years and remains a concern in many minds, will see a more tangible rate treatment decision sometime during the third quarter. This should allay some of the uncertainty that has surrounded that project. We don't expect a material change from the previous settlement there.

During the quarter, stronger weather was a $0.03 per share boost to performance. Weather-adjusted consolidated adjusted EPS would have been flat with the prior-year period. Still, we're encourage by growth across all three key customers classes in Southern's service territory as many utilities commercial demand in particular has remained stagnant. The numbers are modest improvements, and we're not ready to update our forecasts for stronger expected growth yet.

United Parcel Service UPS
Analyst Note 07/28/2015 | Keith Schoonmaker, CFA

UPS improved second-quarter normalized operating margin by 8%, including bettering profitability in all three reporting segments. Most significantly was the greater than 17% EBIT improvement in both the International Package and Supply Chain and Freight segments. While UPS’ top line declined 1.2% due to currency effects and lower fuel surcharges, the firm improved its bottom line 10%. We maintain our wide moat rating and fair value estimate.  

Results were solid underneath movements in currency and fuel. In volume, UPS grew U.S. domestic 1.8%, led by strong 15% growth in deferred packages. International volume gained 3.6% from the prior-year period, most notably in 5.5% growth of export packages, and shipments within Europe expanded a robust 8.5%. In price, average revenue per piece slid 2% overall, including steep declines of 7% in the aforementioned fast-growing deferred segment and 10% in the international segment. Excluding currency effects however, consolidated average revenue per piece decreased just 0.6%, and excluding currency and fuel surcharge effects, revenue would have expanded nearly 4% from prior-year levels.

Quarterly margins somewhat exceeded those we project for the full year. Domestic margins improved to 13.6% on pricing and Orion technology improvements, and international delivered an impressive 18.1% EBIT margin. Supply Chain and Freight served up a 9.2% operating profit.

We're not surprised to see UPS investing in service expansion, this quarter via capacity improvement in a Germany hub, in a New Hampshire distribution center for aircraft engine maker Pratt & Whitney, and in rolling out UPS Access Points to more than 100 U.S. cities. By year-end UPS plans to offer Access Points delivery to 8,000 locations in the U.S. and 22,000 in total. The intent is to serve peak season and reduce attempts to deliver, but we're a little skeptical and suspect this model may work better abroad than in the U.S., due to expectations of residential delivery.

 

 
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