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
Dividend Hikes from Philip Morris, Realty Income -- The Week in Dividends, 2014-09-12

Leading off the week's news--in addition to the two add-on purchases I made this morning--are a pair of dividend increases from core DividendInvestor holdings.

The first was the routine 0.2% hike announced by Harvest holding Realty Income O on Tuesday, which runs the company's streak of uninterrupted dividend growth to 68 quarters. Last week I noted that I was a bit disappointed that Realty Income didn't provide us with a bigger once-a-year dividend hike in August, in line with past practice. But after receiving an intriguing tip from a DividendInvestor subscriber, I decided to investigate the matter a bit further with investor relations officer David Butterfield. I learned that with recent changes in management, no one could remember why the extra dividend increase of a year was contemplated in August--as opposed to December, by which time the projecting and planning for the upcoming year would be finished. So, starting this year, Realty Income will consider its extra dividend boost for the year in December rather than August.

Based on the recent growth in Realty Income's adjusted funds from operations (AFFO, the best metric of cash generation by a real estate investment trust) and what should be a payout ratio nicely below the company's 85% target by the fourth quarter of this year, I'm guessing that the dividend increase for 2014 as a whole will be in the range of 4%. This outcome would be right in line with my long-term estimate and rounds out an attractive total return prospect from the stock's current price, which has lately slipped back below our $44 fair value estimate and now yields 5.2%.

The other dividend increase was one of the year's most important: Philip Morris International PM is the only stock held in both our Builder and Harvest portfolios, and on a combined basis it's our second-largest position after Magellan Midstream MMP. A variety of factors are conspiring to hurt Philip Morris' earnings this year, most notably negative currency trends. That's why I've been expecting a much smaller dividend increase in 2014 than the 12.7% average hike since Philip Morris was spun off from Altria Group MO in 2008. Yet I had no real doubt that Philip Morris would still raise our pay; such is the devotion of both Philip Morris and Altria to reward their shareholders through large and growing dividends. In the end, Philip Morris' 6.4% dividend increase was nicely ahead of my 4.3% forecast.

Thanks largely to this dividend hike, Philip Morris shares now yield 4.8%, and they remain one of my top buy recommendations at Friday's 7% discount to our $90 fair value estimate. In addition to the extra income, which always comes in handy, I read this dividend increase as a positive signal for future financial performance. The company could have kept its streak of annual dividend growth alive with a much smaller hike. Moreover, with the payout ratio above management's long-term target of 65% even before this raise, I doubt many investors would have complained. We might interpret the size of this year's dividend increase we actually received in one of two ways. Perhaps Philip Morris is comfortable with a payout target of 75% rather than 65%, which would testify to the underlying resilience and profitability of the business (though the press release offered no comment along these lines). Or maybe management expects a rebound in earnings per share within the next few years in addition to an underlying growth rate in the high single digits--the combination of which would drive the payout ratio back down while still providing for solid dividend growth. I suspect both factors are at work: Philip Morris sees a rebound coming as well as the capacity for a higher payout ratio. Either way, this dividend increase affirms my thesis for holding the shares, which remain in buy territory and now offer a highly attractive 4.8% yield.

Turning to this morning's trades, the Harvest is finally closing in on fully-invested status. To deploy the rest of its cash, I'm encouraged by the possibility that new-purchase candidates Enterprise Products EPD or Ventas VTR could get a bit cheaper, and I'm also eyeing a potential add-on purchase for Spectra Energy Partners SEP. However, the pickings for the Builder remain extremely thin. Even among add-on buys, the positions I'd be most interested in boosting are almost all in the consumer staples sector, which already accounts for over 35% of the Builder's value. I'm starting to wonder if I will have to either set my sights a little lower in terms of yield (2.75% or 2.5% instead of 3%?) or growth in order to deploy its 4.6% cash weighting in full. At least without a break in market prices, I can see my work is still cut out for me.

In other news, Builder holding McDonald's MCD revealed another rotten month for sales. Global same-store sales fell 3.7% year-over-year, led by a 14.5% drop in the Asia Pacific/Middle East/Africa region that was hurt by a food safety scare. Management forecasted a hit to third-quarter profits as well. This fresh data led us to trim our fair value estimate by another $2 to $98 a share. Yet the market price of the stock held up well this week, actually gaining 0.3%. I don't and can't know when McDonalds' sales trends will finally turn around, but perhaps investors have discounted the bad news. Or, possibly, more bad news could be interpreted as good news if it is seen forcing a dramatic change in leadership. Certainly the company's recent strategies aren't working that well, but we still believe the organization's long-term competitive advantages remain intact.

Based on the pattern of recent years, McDonald's is also due to raise its dividend in the next week or so. With a streak of uninterrupted yearly dividend growth dating to 1976, I'm sure we'll get a little extra pay, even if the raise proves disappointingly small. But while I remain frustrated with the company's funk, lately I've been thinking about what price I might actually add a few shares to the Builder's position. Its 3.5% yield is backed by a very strong financial position and provides ample compensation for our patience--though by now I'm under no illusions about just how much patience might be required here.

Food also featured in another notable development this week, with Builder holding General Mills GIS agreeing to acquire leading organic packaged food concern Annie's BNNY for about $800 million. The premium Annie's shareholders will enjoy is enormous--52 times trailing earnings!--but a low cost of capital, likely operating synergies, Annie's rapid growth rate, and General Mills' history of successful integration of acquisitions suggest the financial and strategic benefits should justify the cost. (Furthermore, it's also fairly small in relation to General Mills' market value of $32 billion.) I'm sure we'll learn more about this transaction next week as the company is scheduled to report fiscal first quarter results on Wednesday, but I expect it will remain my favorite company in the packaged food field. I also remain interested in adding to our stake at prices below our fair value estimate (currently $52).

Meanwhile, Builder holding General Electric GE will get a bit smaller, inking a deal to sell its well-known appliance unit to Electrolux ELUXY for $3.3 billion. This drew a lot of media attention, but the transaction value pales in relation to GE's market value of some $260 billion, and should have little or no effect on future dividends. The stock remains a core holding as well as an attractive purchase at its current 3.4% yield.

On the macro front, a bit of nervousness is bleeding into the rosy consensus the U.S. stock market has enjoyed of late. The geopolitical environment remains fraught, with the United Kingdom--of all places--adding to uncertainties with Scotland's referendum on independence next Thursday. I don't expect any material fundamental impact on our U.K.-domiciled portfolio holdings; for more, see the Morningstar.com video we created on the topic. The Federal Reserve is also on the market's calendar with a two-day meeting set to conclude on Wednesday. Fears that short-term interest rate will rise sooner and faster than expected have already created a selloff in longer-dated Treasuries that has hurt high-yielding common stock values as well.

I actually wouldn't mind if these different threats (real or perceived) conspire to create more attractive valuations for stock buyers, and I don't see any reason to change our basic strategy. Even changes that would affect long-term security values--major movements in interest rates, for example--can't really be predicted or timed with any accuracy. As I've said in the past, we can't avoid taking interest rate risk if we want to generate a meaningful amount of income in our portfolios. However, in exchange for embracing interest rate risk within our strategy, we get (1) the practical benefits of the income itself, (2) long-term growth of income that can't be had from bonds, and (3) less sensitivity to the vagaries of economic growth, since most high-yielding companies are economically defensive as well. This tradeoff is what enables me to buy or add to high-yield holdings like Health Care REIT HCN and Southern Company SO even when interest rates are rising.

It is a sound practice, and indeed an essential one, that we base our investment decisions on the idea that both short- and long-term interest rates will be higher in the future than they've been in the last few years. Fortunately, the cost of equity that we use to discount future free cash flows for individual companies (8% at a minimum) already foots to what I view as a more-or-less normalized environment for interest rates: We haven't let unusually low rates inflate our fair value estimates. When rates are on an upward swing, our portfolio holdings may well pass out of favor for a time. However, if we select our individual companies carefully and look to large, reliable and growing streams of income to drive our total returns over decades rather than days, we may simply excuse ourselves from Wall Street's interest-rate guessing games. Now that's my idea of relief!

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: Don't Be Scared by Scotland
The U.K. will remain a good hunting ground for dividend-paying stocks even if Scotland decides to become independent.

News and Research for Builder and Harvest Portfolio Holdings

FCC Chairman Pulls No Punches With the Wireless Industry
Industry Note 09/10/2014 | Michael Hodel, CFA

Federal Communications Commission Chairman Tom Wheeler, speaking to the wireless industry at trade group CTIA’s annual show, was very direct in addressing several key issues, including competition, the "open" Internet, and the upcoming wireless spectrum auctions. His positions reinforce our view that industry giants AT&T and Verizon have only managed to create narrow economic moats, despite their massive scale relative to competitors, and that smaller rivals Sprint and T-Mobile do not currently possess long-term competitive advantages. Our fair value estimates are unchanged, and we view the shares of each of these firms as roughly fairly valued. The chairman’s comments also cast some doubt on his views on the proposed Comcast/Time Warner Cable and AT&T/DirecTV mergers, particularly the latter. We would avoid the shares of both target firms at current prices.

Wheeler first addressed the topic of competition, stating that he believes the FCC must protect competition where it exists today, and encourage competition where it needs support. On the former point, the chairman stated that the FCC and the Justice Department must stand ready to defend competition, remaining skeptical of the consumer benefits of consolidation despite the economic efficiencies gained with additional scale. Wheeler cited the commission’s explicit rejection of the AT&T/T-Mobile merger and subsequent implicit rejection of the rumored Sprint/T-Mobile tie-up. In short, the current structure of the wireless industry, with two sub-scale players desperate to gain share, will likely remain firmly in place for the foreseeable future. We also note that direct competition currently exists between AT&T and DirecTV across roughly a quarter of the U.S. where AT&T’s U-Verse television service is offered.

The chairman then highlighted the role that competition plays in preventing Internet access providers from leveraging their control of the network to hinder the "open" Internet. However, he also believes that competition alone is inadequate in this case, as the "walled gardens" that sprouted up in the early days of wireless data services demonstrate. As such, the U.S. needs assurances that network providers will consistently adhere to open Internet principles. The public comment period on the FCC’s open Internet proceeding has yet to close, but Wheeler has already begun the process of evaluating the record. It appears that he now believe wireless networks should receive the same treatment as fixed-line networks. The original open Internet principles the FCC outlined in 2010 and the rough proposal the commission outlined earlier this year called for an exemption for wireless networks. Wheeler specifically condemned throttling of data speeds for customers on "unlimited" data plans without transparently disclosing this practice.

In addition, we believe issues like the open Internet, the difficulty the FCC has had in crafting acceptable policies, and the potential challenging of enforcing future policy violations could color the commission’s view of the Comcast/TWC merger. The deal would result in Comcast controlling more than a third of the Internet access market, providing the firm heavy influence over the market. However, a panel session later in the day with the remaining four FCC commissioners showed that two members of the board clearly aren’t in favor of imposing open Internet policies given that problems for consumers have yet crop up and additional regulation could discourage additional network investment. The commission’s position on open Internet rules and the potential influence of a giant like the proposed Comcast/TWC still aren’t clear.

Lastly, the chairman spoke on the matter of spectrum policy. In fact, much of the CTIA show’s first day revolved around the industry’s need for additional wireless spectrum and the challenges the FCC faces in successfully completing the broadcast spectrum auction slated for 2015. The National Association of Broadcasters has filed suit against the FCC recently, challenging the commissions proposed broadcast spectrum auction rules, threatening to delay the auction process. Wheeler believes that the broadcasters aren’t confident that the auction will raise adequate proceeds to make selling their spectrum worthwhile and he implored the wireless industry to join AT&T in pledging broad, aggressive participation. Lastly, Wheeler indicated that a successful broadcast spectrum auction is critical to paving the way for similar auctions in the future.

AT&T has indicated that it could see spending more than $9 billion in the broadcast auction, in addition to any amount spent at the AWS-3 auction scheduled later this year. These purchases would serve to further erode AT&T already mediocre returns on invested capital unless consumers are willing to pay significantly more for wireless service in the future. Given the maturity of the wireless industry and the limited room left to run on smartphone adoption, we don’t expect wireless revenue and profit growth to accelerate over the next few years.

Clorox CLX
Investment Thesis 09/09/2014 | Erin Lash, CFA

Clorox competes in categories with high levels of private-label penetration and derives the bulk of its revenue from mature, developed markets. Despite this, we think its strong brands (more than 80% of which are number one or two in their respective categories) and relative cost advantages--the basis for its wide economic moat--are driving healthy results. The strength of Clorox's brand portfolio is evident in the fact that since 2005, the firm has taken 66 price increases (mostly to offset the recent runup in commodity costs), of which an impressive 64 remain in place.

We regard Clorox as one of the more innovative firms we cover, which enhances its ability to raise prices. Management anticipates garnering three points of growth from new products again in the current fiscal year and longer term, which should help the firm maintain its competitive positioning throughout varying operating landscapes. We've long believed Clorox’s brand equity and investments in product innovation and marketing support are a plus (in aggregate representing about $600 million of spending annually, or 11% of consolidated sales). Our thinking seems to be supported by management's commentary that shipments of its Glad premium trash bag products (which includes Glad OdorShield and trash bags with Febreze) have held up, indicating to us that consumers are still willing to pay up where they see added value.

While the firm competes in the household and personal-care markets against significantly larger rivals, its focus on niche categories has served it well, and its lean cost structure has resulted in operating margins in the midteens, comparable with those of leading industry peers like Procter & Gamble. Beyond maintaining a tight focus on its cost structure, we think Clorox's efforts to expand into adjacent product categories--with the aim of reducing its dependence on product lines like food containers, where consumers are probably more inclined to shop on price--are paying off and helping it stand out from the competition. From our perspective, this type of expansion can smartly leverage a strong brand like Clorox or Glad, while also boosting margins.

Clorox: Economic Moat 09/09/2014
We assign Clorox a wide economic moat because we think the household and personal-care company will generate excess economic profits for at least the next 20 years. Despite its more focused geographic and product platform, Clorox operates with strong brands and a relative cost advantage, which in combination allow the firm to sustain leading market share and generate solid returns and excess cash flow for shareholders. Clorox's brand strength is undeniable, as more than 80% of its portfolio (which includes leading brands such as Clorox, Glad, Hidden Valley, Kingsford, and Brita) hold the number-one or -two spot in the aisle. The brand equity inherent in its product lineup is further evidenced by the fact that since 2005, the firm has taken 66 price increases across its business, and 64 of those are still in place--a 97% success rate. Even when the firm isn’t actively increasing prices to offset higher commodity costs, new products tend to come with a higher price tag, and in general, volumes have not come under pressure for an extended period of time. We also think Clorox is a valuable partner for retailers, as its brands (like Clorox bleach and Kingsford charcoal, which compete in categories where private-label offerings maintain substantial share) drive traffic in stores--a characteristic that value offerings can't tout.

Further, Clorox ensures its strong competitive position remains intact by investing significant resources behind its brands and this spending is yielding market share gains. For instance, in the trash bag market (a category where private-label offerings hold the top spot with nearly 40% share), management cites that Clorox's value share increased from roughly 26% when it acquired the Glad brand in 1999 to approximately 33% in 2013, which is notable (and even more impressive given that Clorox was able to reverse nearly 10 years of deteriorating share trends), in our view.

Clorox has also amassed scale and subsequently is able to garner a lower cost per unit than its smaller peers. In fact, Clorox's margins (at north of 17%) are not out of whack compared with those of its significantly larger peer, Procter & Gamble (around 19%). Clorox has worked to enhance the efficiency of its sourcing efforts--the household and personal-care firm co-owns mines to obtain specific clay for its cat litter products and garners the main raw material for charcoal (charred wood) from mills located close to its manufacturing facilities. In addition, Clorox isn’t just bringing new products to market that cost more to manufacture, as several new products (like compacted bleach, light-weight charcoal, and lower-resin trash bags) are value-added but also come with reduced cost. These factors, combined with the fact that Clorox boasts returns on invested capital (which have averaged 23% over the past five years) far in excess of our 7.7% cost of capital estimate, support our stance that the firm maintains a wide economic moat.

Clorox: Valuation 09/09/2014
After reviewing the assumptions underlying our discounted cash-flow model, we're maintaining our $96 per share fair value estimate, which implies fiscal 2015 price/earnings of 21 times, enterprise value/EBITDA of 13 times, and a free cash flow yield of 5%. The benefit from additional cash generated since our last update was offset by a slightly more muted near-term sales and profit outlook; however, our long-term forecast for 4%-5% annual top-line growth (consistent with Clorox's 3%-5% long-term target) and operating margins approaching 19% over our 10-year explicit forecast remain intact. Persistent economic challenges and price controls in Venezuela and Argentina have taken a toll on the firm's international business. In addition, elevated levels of unemployment at home will probably keep a lid on consumer spending over the near term. Despite this, we anticipate that over our 10-year explicit forecast, Clorox will ultimately benefit from its solid brand portfolio as well as investments in new products (as evidenced by our forecast for mid-single-digit annual sales growth longer term). However, in light of these near-term headwinds, we now forecast top-line growth of just south of 1% in fiscal 2015 (down from 3% previously) and 2.4% in fiscal 2016 (down from 3.7% previously). Input cost inflation has made margin expansion difficult to come by over the past few years. However, we think the firm's cost-management efforts should lead to modest profit improvement during our forecast period. While we think that a portion of any savings generated will be reinvested in the business in the form of advertising spending and product innovation, we forecast operating margins will expand to 19% by fiscal 2024, more than 150 basis points above the average margin generated over the past five years. Throughout the next 10 years, we expect return on invested capital to average 27%, well in excess of our 7.7% cost of capital estimate, supporting our opinion that Clorox maintains a wide economic moat. We place a low degree of uncertainty around our fair value estimate for the shares, as we think projections of the company's cash flows fall within a fairly narrow range.

Clorox: Risk 09/09/2014

Clorox is influenced by the commodity-driven nature of its business, which can impact profitability. Further, adverse weather has challenged the firm's sales (like cold weather hindering charcoal sales). Private-label penetration is high in many of the company's categories, and heightened competitive pressures persist. As such, Clorox has stepped up its merchandising efforts and is investing behind its brands, which we view as an appropriate response, but promotional spending isn't a sustainable long-term strategy. Forty-five percent of total revenue is concentrated with only five retailers (26% from Wal-Mart alone), indicating Clorox maintains significant exposure to retailer consolidation, which could weaken Clorox's pricing power.

We can't ignore that Clorox derives about 1% of annual sales from the volatile market of Venezuela. But Clorox no longer seems committed to its operations in the region, stating it is considering all options with regards to the business, given the erratic market conditions combined with the fact that two thirds of its portfolio has been under price controls for the past three years (so while manufacturing costs have more than doubled, the firm has been unable to price to offset these headwinds).

While Clorox has looked to acquisitions to build out its product and geographic footprint, the timing of the Burt's Bees deal was poor; at 2008 prices, management had to write down $258 million in goodwill in 2011 when the optimistic projections underpinning the purchase price failed to materialize. However, we don't disagree with the aim of product diversification or the focus on the natural or organic niche. The issue is more about growth, and as Clorox has come to realize with its Green Works brand, consumers are willing to pay for natural or organic products, but not necessarily the premium that was once expected. Despite this and in light of the stability of its profitability and cash flows, we assign Clorox a low uncertainty rating.

General Electric
Analyst Note 09/08/2014 | Barbara Noverini

On Sept. 8, GE announced the intention to sell its home appliances business to Swedish manufacturer Electrolux for approximately $3.3 billion in cash. In our opinion, the strength of the GE appliances brand combined with favorable expectations for a rebound in housing at this point in the economic cycle both garnered support for a valuation of nearly 8 times trailing 12 month EBITDA. As the deal closes in 2015, GE expects to net a gain of approximately $0.05-$0.07 per share.

In our opinion, the deal makes sense for both parties. Adding GE’s storied brand to its portfolio of higher-end appliances broadens Electrolux’s reach in the U.S., where it competes head to head with Whirlpool. For GE, shedding the cyclical appliance unit monetizes a valuable consumer-oriented brand, while allowing the company to focus on supporting business segments that serve faster-growing industrial end-markets. We plan to analyze the impact this impending sale will have on our current fair value estimate of $29 per share; however, we don’t intend to alter our wide moat rating for GE based on this news.

General Mills GIS
Analyst Note 09/08/2014 | Erin Lash, CFA  

Highlighting the muted growth prospects within the packaged food landscape, General Mills intends to acquire natural and organic manufacturer Annie’s for $46 per share (just north of $800 million in total and a 36% premium to its prior close) in an all-cash deal. While the addition is not significant in terms of General Mills’ consolidated business (at 1% of sales and operating income), the purchase price (around 4 times sales and 29 times on an enterprise value/trailing-12-month EBITDA basis) strikes us as quite rich at first blush.

It is unclear how General Mills will finance the transaction (details we hope to garner during its earnings conference call next week), but with more than $850 million of cash on its balance sheet, it is possible it will not be required to assume the entire amount as additional debt. We also wouldn’t be surprised to see the firm ratchet down its share repurchase activity over the near term, which we forecast at $1 billion in fiscal 2015. As such, depending on means used to finance the deal, we may revisit our issuer credit rating (which currently stands at A, with the possibility for a slight downgrade). Further, we intend to review our discounted cash-flow model and our $52 fair value estimate, but we don’t anticipate material changes at this juncture.

Overall, we think the addition of Annie’s will be a positive, nearly doubling the sales General Mills garners from natural and organic products. We view this as particularly attractive given the growth prospects of the category, which is growing more than three times as fast as overall grocery sales according to industry sources. We also think the added distribution channels through which Annie’s products are sold could open new doors for General Mills. Management has proved to be prudent acquirers in the past, and we don’t expect this deal to be any different. Our narrow moat, based on the firm’s solid brand portfolio and expansive global network, remains in place.

McDonald's MCD
Analyst Note 09/09/2014 | R.J. Hottovy, CFA

McDonald's August sales update provided additional color on the magnitude of recent food supplier issues in China, its impact across the APMEA region, and its ongoing struggles in the U.S. The August comp decline of 14.5% in APMEA supports our outlook for double-digit segment comp declines over the balance of the year, and management's guidance that the supplier issue will dilute third-quarter earnings by $0.15-$0.20 per share confirms that segment restaurant margins are likely to fall to the high-single-digit or low-double-digit range the next few quarters (compared with 14% in the first half of the year). That said, we continue to assume some improvement in segment comps in 2015, as the company puts a greater emphasis on value offerings to stimulate traffic and likely engages in food-quality marketing campaigns. Longer-term, we continue to view mid-single-digit revenue growth as a reasonable assumption for APMEA.

More troubling are the continued comp pressures in the U.S., which fell 2.8% despite facing easier comparisons than July's 2.5% decline. Admittedly, McDonald's efforts to drive more consistent traffic through menu innovation/customization, reduced operating complexity, and enhanced value platforms are only in early stages, but we plan to trim our near-term comp outlook for this region based on current trends as well as transition to new leadership. We still view our wide moat rating as valid based on a strong franchise system and scale advantages and believe current menu initiatives can be accretive longer-term, but concede that the brand intangible asset component of our stable moat trend may be at risk if traffic declines persist.

We're planning to shave a dollar or two from our fair value based on updated 2014 and 2015 assumptions. Although shares look inexpensive using traditional valuation metrics (and still offer a dividend yield north of 3%), we believe investors must have some patience with this name given the aforementioned struggles.

McDonald's: Valuation 09/10/2014

We are cutting our fair value estimate to $98 per share from $100 based on a modest reduction to near-term estimates stemming from recent food scare concerns across Asia, which will have negative implications for comparable sales and margins in McDonald's APMEA region. Our updated fair value implies 2015 price/earnings of 17 times, enterprise value/EBITDA of 10 times, and a free cash flow yield of 4.4%. At 16 times forward earnings and 9 times forward EBITDA, the shares trade at a discount to restaurant industry averages (19 and 11 times) and our fair value estimate. McDonald's has reiterated its long-range growth objectives of 3%-5% annual sales growth, 6%-7% average annual operating income growth, and return on invested capital in the high teens, which is roughly consistent with the later years of our discounted cash flow forecast period.

With persistent global macroeconomic headwinds, increased competitive pressures, and the food quality and safety concerns in Asia, we expect essentially flat revenue during 2014, as contribution from 1,500-1,600 new restaurant openings worldwide will be offset by a 1%-2% decline in comparable sales (compared with a three-year historical trend of 3% growth). Over a longer horizon, we expect low- to mid-single-digit revenue growth for the consolidated company, driven largely by international unit openings and a return to traffic and ticket growth through new menu innovations and inflationary price increases. Our model assumes 1%-2% top-line growth in 2015, but we believe comps may take several months to accelerate against aggressive industry promotional activity and limited price increase opportunities.

While McDonald's will fall short of its 6%-7% operating income growth target in 2014, we believe it is well positioned for longer-term margin preservation because of its bargaining clout with suppliers and strong franchisee system. We expect company-owned restaurant margins will contract about 130 basis points this year (from 17.5% in 2013) amid elevated payroll costs and expense deleverage stemming from soft APMEA region sales trends, but gradually improve toward 19% over our 10-year explicit forecast period. Over the next 10 years, our model assumes operating margins reach 33% (compared with expectations of 29.9% in 2014), driven by higher franchisee rent and royalty agreements, increased emerging-market franchises, and margin-friendly menu additions, but tempered by labor and occupancy costs.


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