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

 
 
Sep 04, 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
Southern to Buy AGL -- The Week in Dividends, 2015-08-28

By week's end, the change in the general level of stock prices--a 0.9% gain for the S&P 500--was really nothing to write home about. What happened between last Friday and today was probably best ignored by serious investors … and probably still is.

Under the common definition, the market did have its first correction since late 2012. At Monday's panicky open and again at Tuesday's close, the S&P 500 had pulled back more than the customary 10%--actually more than 12%--from its all-time high. But as a practical matter, the opportunity was largely chimerical. The intraday volatility on Monday and Tuesday was so great that you could hardly trust the quoted prices, and by Friday the S&P had regained more than half of its loss between Aug. 14 and Aug. 25. I suspect that only the nimblest and luckiest of speculators--or, perhaps, their robots--made any hay out of this. Worse, I don't think we learned anything about the economy or corporate earnings that we didn't already know. My best guess is that the market was simply playing catch-up: The S&P had traded in such a narrow range for such a long time that when that range broke, we experienced six months' worth of pent-up volatility in less than two weeks.

There may yet come a time when buyers will be offered some unusually attractive choices long enough for humans to react. In the meantime, I'm always looking for swaps that might upgrade the income, income growth, quality, and/or valuation characteristics of our holdings. But when everything plunges in tandem, such opportunities rarely materialize--particularly in a timeframe that allows for proper research and consideration. To the extent any unusual stock-specific opportunities remain after the rebound on Wednesday and Thursday, I'd call out a few of our most defensive stocks--mostly utilities and real-estate investment trusts--that ranked among the biggest losers in our portfolio this week. To cite a few names, Duke Energy DUK, Ventas VTR, Health Care REIT HCN, and American Electric Power AEP all dropped more than 4% on the week even as the S&P closed in positive territory. But my single best idea--yesterday, today, and tomorrow--is our whole portfolio, not any individual stock or industry group. At Friday's closing prices, the Dividend Select account pays a current yield of 4.3%, offers an income growth rate I estimate at 6.0% a year, and trades at an 11% discount to the aggregation of our fair value estimates.


The only major fundamental development for our portfolio holdings this week was Southern Company's SO offer to acquire AGL Resources GAS for $66 a share in cash. I have a mixed view of the deal--slightly negative, but it doesn't change my overall thesis for owning Southern long-term.

On the one hand, $66 is much higher than our $49 standalone fair value estimate for AGL. AGL's operations in Georgia will remain a standalone subsidiary of Southern rather than being integrated with Georgia Power, and even if there were major efficiencies to be had, the bulk of the benefits would go to ratepayers rather than shareholders. I also like to look at acquisitions in terms of whether the acquirer is acting out of strength or weakness, and I suspect this case reflects more of the latter. Capital expenditures are the principal driver of earnings growth for regulated utilities, and before adding AGL, Southern's spending was set to slump over the next few years. Adding AGL to Southern's asset base also dilutes the potential risks associated with the Kemper County and Vogtle construction projects (though of course buying AGL also introduces integration risks).

On the other hand, our admiration for AGL had grown in recent years as it successfully integrated its own acquisition of Nicor in 2011. In addition to attractive assets, Southern is also getting a platform from which to grow further into the transportation and delivery of natural gas. Southern should be able to extract at least some cost savings from the combined firm, and by financing a disproportionate amount of the purchase with low-cost debt, the transaction should benefit from a low cost of capital.

The net of these considerations is a new fair value estimate of $46 a share for Southern, down by $1 even though the company lifted its long-term earnings per share growth target to 4%-5% a year (up from 3%-4%) with an allusion to faster dividend growth too. I think of it this way: The acquisition premium is a known cost that comes out of our pockets, but the benefits are less certain. Even so, the company's overall risk profile remains acceptable for our strategy, and as long as I see no real threat to Southern's existing dividend growth trajectory, the stock is likely to remain in our portfolio as well as a buy at prices below fair value.

As for AGL, it was my recommended substitute for master limited partnership AmeriGas Partners APU in tax-deferred accounts. The stock scored a big gain, but still ended the week at $60.56 a share, an 8.2% discount from Southern's offer. I suspect this wide deal spread reflects the general volatility in the stock market of late, but also some more specific concerns regarding the firms' ability to complete the deal. By coincidence, the Public Service Commission of the District of Columbia rejected Exelon's EXC proposal to acquire Pepco Holdings POM this week simply because regulators didn't think customers would benefit. (Other state regulators involved in the deal behaved in the more traditional manner of requiring service enhancements, more investment, and/or rate givebacks from the combined entity.) Neither Southern nor AGL need their merger to be approved by the D.C. commission in particular, but this still represents a shot fired across the bow of the entire industry--not least because Pepco shares instantly lost the premium valuation Exelon offered.

So: Hold or fold AGL? Continuing to hold, let alone buying, represents a straightforward bet on the deal getting done on the terms currently proposed. We think there is a 90% chance of this, helped by the business-friendly nature of the states involved, though Illinois is a potentially unpredictable exception. But rather than being a buyer of AGL here--either on a standalone basis or as a stand-in for AmeriGas--I think PPL PPL offers a more attractive long-term opportunity. I haven't bought PPL mostly because two-thirds of its business is in the U.K., which means it would be a near-duplicate of our position in National Grid NGG. But while Grid looks modestly overvalued, PPL looks moderately undervalued, and its yield of 4.8% nearly matches Grid's 4.9%. In taxable accounts I'd still prefer AmeriGas to PPL, but in a tax-deferred setting that matched our portfolio's weightings in individual stocks, our stake in Grid is small enough (2.5% of the account's value) that adding PPL to the mix doesn't lead to what I consider excessive concentration in the U.K. utility sector.

Finally, Ventas VTR has released taxable cost basis allocations for its own shares and those of recent spinoff Care Capital Properties CCP on the investor relations section of its website. This link will take you directly to the site: http://www.ventasreit.com/investor-relations/dividend-information/form-8937-organizational-actions.

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

Southern Company to Buy AGL Resources at a 35% Premium to Fair Value, Upside Can't Justify Price
Analyst Note 08/23/2015 | Mark Barnett

After reviewing Southern Company's all-cash offer for AGL Resources of $66 per share announced Aug. 24, we will be lowering our fair value estimate for Southern to $46 per share from $47 per share and increasing our fair value estimate for AGL to $64 per share from $49 per share. We maintain stable narrow moat ratings for both. The fair value impacts assume a 90% chance of deal close, with the primary obstacle being state-level regulators as Southern's shareholders won't have an opportunity to vote on the deal given the all-cash payment. We have assumed roughly $0.70 per share in value from potential synergies from the deal, though this estimate is preliminary as neither management team has commented on expected synergies. Without synergies, our Southern fair value estimate would fall to $45 per share. The companies expect to close mid-2016, though year-end 2016 may be a more conservative goal.

The deal is very favorable for AGL shareholders as it significantly overvalues its cash flows, representing a 35% premium to AGL's fair value and valuing the company at 10.2 times 2015 EBITDA, 2 times book value, and 22.4 times 2015 EPS by our estimates, premiums to its peers. The deal implies a nearly $12 billion enterprise value for AGL. We would recommend that shareholders approve the deal as offered.

For Southern, we believe that AGL's system certainly represents a strategic fit given the largest utility by rate base is in Georgia, a state where Southern has navigated regulation extremely well. Further, AGL's diverse gas infrastructure and presence across regional gas markets has enabled the company to participate in large Federal Energy Regulatory Commission, or FERC, -regulated pipeline projects even with its relatively small balance sheet. We expect that Southern's size combined with its own need for new gas infrastructure within the Southeast to facilitate an ongoing shift from coal generation to gas generation and could bring some material growth opportunities.

We would be cautious projecting this deal onto other gas local distribution company, or LDC, valuations, which are among the highest in our coverage universe and which remain in our view substantially overvalued. Without the regional overlap, slowing growth opportunities from the acquirer's own system, and the excellent business fundamentals that we see in AGL Resources, a deal at this size of a premium would represent much clearer value destruction for an acquiring utility.

Further, we believe that AGL stood out from its peers in quality of earnings growth and valuation, with earnings and cash flow growth being driven primarily by regulated utility and FERC pipeline investment and with shares trading at a material discount to peers' valuations. AGL had been the only gas LDC trading below or around fair value so far throughout 2015 and was the best available target in our view.

AGL Resources GAS
Investment Thesis 08/24/2015 | Mark Barnett

AGL's purchase of Nicor Gas led to a dilution of what we considered one of the most appealing dividend-producing regulated utility businesses out there, but thus far AGL has managed to materially improve its regulatory environment in Illinois without a formal rate case, securing a large rider-based capital expenditure program and some changes in regulatory accounting that better reflect the cash generation of the utility. We're still concerned about regulatory risk in a formal rate case, but it looks to be at least 2017 before any meaningful changes could take place. We are not the only ones with a bullish view on AGL's fundamentals, evidenced by Southern Co.'s $66 per share offer to buy AGL outright. We currently forecast a 90% chance of the deal closing and expect resolution by mid- to year-end 2016.

Shifting gas flows due to a huge jump in production from the Marcellus had hamstrung the company's gas marketing business during the past few years and rendered its storage investments much less attractive. This was a drag on results until the extreme winter in 2014 led to an enormous trading windfall, highlighting the option value of that business, which was again demonstrated during a cold 2015 winter season.

AGL's utility footprint is still a healthy cash flow machine, and despite the possibility of a setback in the next Illinois rate case we believe it will produce a healthy growing stream of cash to support a dividend that provides a relatively appealing yield in today's low-interest-rate environment. Pipeline investment riders mean AGL's capital expenditure now closes to earnings faster than most of its peers. Outside of the utility, investments in new Federal Energy Regulatory Commission-regulated pipelines will bring healthy new earnings streams at returns above state-regulated distribution investments if they proceed to completion in the face of competing projects.

If AGL can manage regulatory relations successfully in Illinois and see a return to profitable storage operations, we project that earnings could grow 7.0% on average from 2014 ex-wholesale to 2019 with 4.5% growth in dividend payouts.

AGL Resources: Economic Moat 08/24/2015
Service territory monopolies and efficient-scale advantages are the primary moat sources for regulated utilities like AGL. California and federal regulators grant AGL exclusive rights to charge customers rates that allow it to earn a fair return on and return of the capital it invests to build, operate, and maintain its generation, transmission, and distribution electricity and gas networks. In exchange for its service territory monopoly, regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow AGL to achieve at least its cost of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. The risk of adverse regulatory decisions prevents regulated utilities from earning wide economic moat ratings. However, the threat of material value destruction is low, and normalized returns exceed costs of capital in most cases, leaving us comfortable assigning AGL a narrow moat. We project that AGL will earn a small but consistent spread over its cost of capital for the foreseeable future.

The nonregulated marketing and retail gas businesses do not have economic moats, in our view, but investments in FERC-regulated pipelines will offset this as we believe these assets typically have narrow to wide moats due to the generally long-term contracted nature of pipeline revenue and the inefficiency of duplicating large capital projects like these. Altogether, the preponderance of utility cash flows and returns on invested capital over weighted average cost of capital continue to support a narrow moat.

AGL Resources: Valuation 08/24/2015
We're increasing our fair value estimate for AGL Resources to $64 per share from $49 as we believe Southern's $66 per share all-cash offer for AGL has a 90% chance of closing as proposed. We are reaffirming our $49 per share stand-alone fair value estimate. On a stand-alone basis, we forecast 4% annual gross margin growth from 2015 to 2019, trailing regulated rate base growth. This growth is driven by $4.3 billion of investment at the regulated utilities. Growth could be lumpy, depending on the timing of rate case filings, though infrastructure riders help smooth the closing of capital expenditures to rates and reduce lag. Falling storage profits have cut AGL's growth outlook significantly, though activity could rebound in 2016-17. We forecast 17% average operating margins after an exceptional 2014. We think AGL could increase the dividend as much as 5% annually while still maintaining an average payout ratio. Our fair value estimate assumes that AGL's business mix remains relatively stable, with the gas utilities generating a consistent 70%-80% of EBIT until FERC-regulated pipelines come on line. We assume a 5.5% weighted average cost of capital and 7.5% cost of equity in our discounted cash flow valuation. This is lower than the 9% rate of return we expect investors will demand of a diversified equity portfolio, reflecting AGL’s lesser sensitivity to the economic cycle and low degree of operating leverage.

AGL Resources: Risk 08/24/2015
The primary risk that AGL faces is regulatory. The company's outlook is heavily influenced by its ability to maintain and improve its relationships with regulators in the six states it serves. Although AGL has had some disappointments in recent rate cases, most of its rate mechanisms are favorable and we think they outweigh its below-average allowed returns. We think that AGL could have a rough experience when it finally files a full rate case in Illinois, though regulation there has improved significantly already. At its nonregulated businesses, SouthStar faces the risk that it could continue to lose market share to competitors. AGL also could continue to realize substandard returns on the hundreds of millions of dollars it has invested in gas storage if rates remain weak.

Southern Company SO
Investment Thesis 08/25/2015 | Mark Barnett

Southern's total return proposition remains appealing for patient investors in a world of few decent income alternatives, though we believe management is overpaying for the AGL Resources acquisition, despite our bullish view of that firm's fundamentals and our high opinion of its business model. On a standalone basis, this giant Southeast utility enjoys some of the best regulation in the United States, with strong, consistent regulatory relationships in its key service territories of Alabama and Georgia. The company is entrenched in a huge investment program aimed at phasing out or retrofitting its massive coal fleet, building a low-carbon coal unit in Mississippi, and constructing the first new nuclear plant in the U.S. (in Georgia) after a freeze of more than 30 years. Management is interested in gas infrastructure, and we view the AGL deal as a bold stroke to establish a beachhead in midstream on top of that company's high-quality gas local distribution company, or LDC, assets.

While regulatory risk in the current cycle is high--as evidenced by ongoing cost and rate uncertainty in Mississippi and cost overruns and disputes at the Vogtle nuclear project in Georgia--earnings and cash flow growth should improve as expenditures close to rates, driving 4% earnings and dividend growth through 2019. Although economic growth in the firm's four service territories might not remain above average, capital investment remains our growth forecast's primary engine, and much of it closes to cash returns annually, keeping cash lag below many peers'. The company is also developing an appetite for large-scale solar development, though this business will remain a small contributor relative to the traditional utilities.

Southern has more upside to economic improvement than most peers and has traditionally traded at a premium to the sector. While that premium has shrunk with uncertainty around Kemper and Vogtle, investors shouldn't underestimate Southern's constructive regulatory structure, despite above-average recovery risk during this investment cycle. Favorable and supportive regulation is a key driver behind the company's huge construction program and above-average returns.

Southern Company: Economic Moat 08/25/2015
We think Southern's narrow economic moat arises from the nature of the regulatory compact between its four utilities and state regulators. In return for its allowed monopoly in its service territory, regulators allow the utilities to recover their investments in the system with a reasonable return on and of their capital. The company's transmission and distribution assets would be extremely difficult and costly to replicate, which in the U.S. has traditionally served to justify its monopoly. These factors are balanced by the effective cap on returns provided by regulation.

Among its peers, Southern's regulatory environment stands out as the strongest and is supported by above-average economic fundamentals in its key regions as well. These factors contribute to the premium returns Southern has earned and have led to a constructive working relationship with its regulators, the most critical component of a regulated utility's moat. We expect returns on invested capital to remain at a modest but consistent spread above Southern's cost of capital for the foreseeable future.

Southern Company: Valuation 08/25/2015
We are lowering our fair value estimate to $46 from $47 per share to incorporate a 90% chance of closing the $66-per-share takeover offer for AGL Resources. We assume roughly $1 per share in offsetting value from estimated synergies between the two businesses, though our expectation could be conservative on this front. Without synergies, we believe the deal would represent roughly $2 per share of value dilution for Southern's shareholders. Our standalone fair value estimate remains $47 per share, and incorporates cost overrun figures from the Vogtle nuclear project and the Kemper coal project.

We continue to incorporate a 75% chance that Southern settles with Chicago Bridge & Iron on the Vogtle cost dispute, assuming that shareholders could bear roughly $375 million in a settlement. We also include an incremental $750 million in owners' costs at Vogtle. However, it's possible that Southern could pass any settlement costs to customers or win a fully litigated case in court, neutralizing the impact on investors.

Our standalone forecast for total capital investment from 2015 to 2019 is roughly $24.5 billion, and this incorporates expenditures to meet coal plant emission limits in the federal air toxics rule and revised costs for the Kemper plant and Vogtle project. We forecast that this spending can deliver 4% average annual gross margin growth through 2019. We expect Southern's regulated utilities to continue earning close to the company's industry-leading allowed returns on a standalone basis, though we project modest declines in allowed returns on equity and invested capital through the current rate cycle. We believe the AGL deal could also weigh on ROICs unless material synergies above our forecast can be realized.

We forecast average power demand growth of a conservative 1% for Southern's utilities from a strong 2014 through 2019. During the next five years, we assume that standalone consolidated operating margins average 25.5%. We anticipate that Southern will increase its dividend 4% annually during the next few years, largely in line with management's projections. With AGL in the fold, management is guiding toward a slightly higher growth rate in earnings, and guided on its update call that its steady $0.07 per share dividend increases could move to $0.08 per share before synergies with AGL in the fold.

We use a 7.5% cost of equity and 5.7% weighted average cost of capital in our discounted cash flow valuation.

Southern Company: Risk 08/25/2015
We think the prospects of success with the AGL acquisition are very high, and have estimated an offset of roughly $1 per share to the value dilution from the high deal price from synergies. However, these efficiencies are not guaranteed, and furthermore could be clawed back by the Georgia regulator, in particular in exchange for deal approval. If the burden became too high, we expect Southern could call off the deal.

Although we are bullish on this company's standalone prospects overall, some uncertainties remain, including the impact of nuclear cost overruns, possible emissions legislation, and other fossil fuel regulations. However, compliance measures could prove to be less painful to shareholders than some might expect; regulators will allow Southern to pass most of the incremental costs on to customers, preserving the firm's long-term earnings power.

The biggest threat that Southern faces is a deterioration of its regulatory relationships in its four retail service territories. Much of the company's success hinges on the relationships it has built through years of low power prices and excellent customer service. While the Kemper facility has been a financial setback, we don't believe it has any long-term impact on Southern's regulatory relationships in Mississippi, and certainly not elsewhere. The risk of declining customer usage has increased, although Southern's best-in-class regulation should help mitigate the effects.

Nuclear construction expenses are approved twice yearly, but there is still a risk that additional expenses might not be recovered. Cost overruns could also lead to further stranded capital at the new coal gasification plant or at the new nuclear plants, though a revised process in Georgia eases the burden of approval for new costs. If tough federal environmental regulations further raise investment needs and costs for customers, regulators might be less willing to support above-average allowed returns on equity.

 

 
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