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
Generous or Burdensome? -- The Week in Dividends, 2014-07-25

Nine DividendInvestor portfolio holdings released results this week, and whatever the trend may be for the market in general, this is shaping up to be one of the least inspiring earnings seasons for our stocks since the last recession ended in 2009. While the individual stories varied from on-track to legitimately concerning, there were no material surprises to the upside, and the market responses to our reports were almost uniformly negative. It is not without irony that only Rogers Communications RCI eked out a tiny price gain this week--thanks to the low expectations created by weak performance during the past several quarters.

As I have been from the launch of DividendInvestor in 2005, I am focused on fostering a large and growing stream of income from our portfolios. This approach won't always be popular, and our portfolio results show it clearly hasn't been since mid-May. Even so, I'm confident that it will deliver consistent, practical cash returns in the here and now as well as capital appreciation in the long run. This being my underlying objective, it is also the strategic lens through which I view quarterly earnings results, which in turn helps me organize this week's events.

Only one of the week's reports was truly concerning: that of Harvest holding GlaxoSmithKline GSK. The stock price tells a grim tale: A 6.0% plunge right after Wednesday's report, followed by another 3.0% after a major brokerage firm slapped a sell rating on the stock on Friday, bringing the week's loss to 9.5%. Ordinarily I don't comment on research that is published by other firms, but it was reported in the media that this particular analysis raised questions about the sustainability of Glaxo's dividend--certainly not the kind of issue we can ignore.

The sunniest spin that can be put on Glaxo's second-quarter results--excluding the effects (all negative) of currency movements, divestitures and one-off items--is that revenue declined 4% and earnings per share shrank 12%. Advair, which at about 20% of revenues is Glaxo's top product, is facing more competition and reimbursement price pressure than we (or the company) expected. Worse, Breo and Anoro--the new respiratory treatments meant to offset Advair's decline--produced only GBP 16 million in sales in the second quarter to Advair's GBP 1.1 billion, and much of the blame for this debut to an empty house rests on poor management execution. As a result, Glaxo's goal of 4%-8% core EPS growth this year has been replaced with the expectation of EPS "broadly similar" to 2013 on an ex-currency, ex-divestitures basis.

Perhaps this would not be so bad if Glaxo's dividend wasn't already so generous-- generous to the point where "burdensome" might be a more accurate word. When I initiated the Harvest's position in May 2013, I figured Glaxo was paying out about two-thirds of its core EPS. That was more than top-tier peers like Johnson & Johnson JNJ and high enough to limit the EPS growth that could be sourced from share repurchases, but not so lofty that it triggers concerns about dividend safety. Since then, the dividend has been raised another 6%, but EPS has been hurt by weak operational performance as well as the rise in the British pound. (Glaxo reports results and pays its dividends in sterling, but only a small portion of its profits are earned in the U.K.) Based on the most recent Reuters consensus estimate, Glaxo's payout ratio is now in the neighborhood of 83%.

Glaxo itself doesn't seem to be panicking even if some shareholders are. Management indicated on its conference call that the dividend policy has not been changed--and I assume by "policy" they mean not just the current annualized payout (GBP 0.80 an ordinary share; about $2.73 an ADR) but the practice of GBP 0.01 increases to the quarterly dividend rate that have been issued each year in October since 2006. If the payout ratio was in the 50s, or even the 60s, it wouldn't be such a stretch to see Glaxo keeping its dividend policy intact through a few choppy, transitional years until consistent growth resumes. Unfortunately, Glaxo has already used up much of the safety margin it started with, and after updating our forecasts we don't see much (if any) growth for EPS over the next few years. Our fair value estimate is now $51 an ADR, down $3 from our previous report and $5 since April.

It would help if Glaxo's balance sheet held as much or more cash as it had debt, like a number of its peers, but instead the company has rather more debt than cash (net debt is 1.7 times EBITDA). It might also be a plus if Glaxo had an abundance of costs to cut, but it's already been trimming expenses for years, and right now it's more important for the firm to raise its outlays for late-stage product development and new product launches. This isn't a pretty picture, and a quick revival seems unlikely--no quick fixes are in sight, at least none that wouldn't make the company's long-term problems even worse. And unless Glaxo's financial trends start to improve soon, my best guess is that the quarterly dividend rate will be held flat in October rather than being raised.

All in, my sense is that Glaxo's dividend is not in imminent jeopardy, but the risk of a dividend cut has risen to a level where I am not prepared to commit more capital to the stock. For reference, Glaxo represents a below-average 3.5% of the Harvest's value and only 1.9% of the Builder and Harvest on a combined basis. With dividend safety metrics that are weaker than I typically require even for economically defensive businesses and a poor outlook for dividend growth, I can't say I would be interested in buying the stock if I didn't already own it.

However, I'm not prepared to cut the Harvest's position loose just yet--at least not without a suitable replacement. I think the odds are still strongly against a dividend cut, though not overwhelmingly so. Glaxo is now under a lot of pressure to demonstrate that it can deliver better profits and shore up the reliability of the dividend, and the market sentiment around the stock is just dreadful. Very few companies of any size offer dividend yields in the range of Glaxo's 5.6%, and we've come to a point where anything short of a dividend cut ought to allow for better (that is, decent) stock performance over the next couple of years. The situation reminds me a bit of Royal Dutch Shell RDS.B, where investors were quick to seize on signs of improvement as a reason to return to its high-yielding shares. I realize that by hanging on to Glaxo I run the risk of a larger loss than the negative 2.5% total return we have to date, but for now I prefer the wait-and-see approach.


In addition to Glaxo, Coca-Cola KO and McDonald's MCD landed in the market's doghouse, though I suspect the 3.4% drop in Coke's share price this week has more to do with market expectations that rose after a strong first-quarter showing. I didn't find any reason to be disappointed with the company's 3% global volume growth, including a 2% gain for carbonated beverages, and 5% growth in core operating income. Take away the currency headwinds, troubles in a few individual markets like Venezuela, and the impact of bottler divestitures, and Coke really doesn't look that far off its long-term track. I still consider the stock a buy, and if the price slips under $40 (which would imply a yield above 3.0%), I may add to the Builder's position.

McDonald's, on the other hand, is clearly trying investors' patience. Its second-quarter results were virtually flat on any metric as its stagnant stretch shows no sign of ending soon, and it doesn't seem that management knows what to do about it yet. I assume a lack of EPS growth will again take a toll on dividend growth this year, yet the dividend yield of 3.4%--while nice--is not so high that we can afford to wait indefinitely for adequate growth to resume.

I'm still of the view that McDonald's will eventually return to modest growth: low-single-digit comps, a few more stores, a bit of margin expansion, and some share repurchases are still a workable formula for high-single-digit dividend growth. But the longer this weak patch lasts, the more cause we may have to question just how formidable the company's competitive positioning is. The stock still qualifies as a buy at Friday's 9% discount from our fair value estimate, which we reaffirmed at $105. However, I do not plan to add more shares to our stake, which is currently 5.2% of the Builder's total value.

The other six reports this week--Altria Group MO, American Electric Power AEP, AT&T T, Realty Income O, Rogers Communications and Unilever UL--were all fairly consistent with our expectations. Rogers was notable only because it showed stable revenue and EBITDA on a year-over-year basis. That level of performance won't cut it long-term, but better than Rogers has turned out in a while, and I continue to hold the Builder's shares. You'll find more details on Rogers and all our other firms' results in the analyst notes below.


This week's news was almost all about second-quarter earnings reports, but not quite. On Thursday, star Harvest holding Magellan Midstream Partners MMP raised its quarterly cash distribution to $0.64 a unit, up 4.5% from last quarter and 20.2% from a year ago. This bumped the units' current yield back over the 3.0% mark, which I appreciate quite a bit--loath as I am to trim our position, it's not easy for the Harvest's largest position to yield less than most of the stocks in the Builder. Still, Magellan's rapid distribution growth (though bound to slow eventually), high-quality assets, conservative finances and disciplined management make me comfortable with our current position. Magellan is scheduled to report its second-quarter results on August 5.

Next week the pace of earnings reports will crest as a full dozen of our portfolio holdings are scheduled to release results. This batch will be heavy on energy and utilities; I'm sure Shell will get a fair bit of scrutiny after last quarter's improvement in financial performance and subsequent bounce in the stock price. With Shell ADRs trading well above our fair value estimate, I hope expectations haven't gotten out of hand, but in any event I have no immediate plans to change the Harvest's position. Procter & Gamble PG may be another candidate for market drama as it too is something of a turnaround story, but in this case an attractive valuation (11% below our $89 fair value estimate) provides a more comfortable backdrop both short- and long-term.

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: My Favorite Long-Term Dividend Pick
Planned consolidation should contribute to better pricing power in this shrinking industry, but one name stands out among the rest.
http://www.morningstar.com/cover/videocenter.aspx?id=656828

News and Research for Builder and Harvest Portfolio Holdings

Altria Group MO
Analyst Note 07/22/2014 | Philip Gorham, CFA, FRM

There were few surprises in Altria's second-quarter earnings report. The firm narrowly missed our sales estimate, but a one-time benefit at the gross margin from an adjustment relating to the master settlement agreement kept earnings on track to meet our full-year forecast. We are maintaining our $39 fair value estimate and wide moat rating. Management announced a new $1 billion share-repurchase program, to be completed by the end of 2015, and tightened 2014 earnings per share guidance to a range of $2.54-$2.59, up slightly from $2.52-$2.59. Our full-year EPS estimate is at the midpoint of the new guidance. We regard Altria as slightly overvalued at today's price, and while we continue to like the firm's competitive positioning, we think there are opportunities with more attractive valuations in our consumer defensive coverage.

Second-quarter cigarette revenue fell 1.2%, driven by a 5.0% decline in volume. Notably, the premium category is underperforming the discount category, with Altria's Marlboro and other premium volume down 4.9% and 10.3%, respectively, while discount volume declined just 1.3%. Volume trends appear to be improving, with industry declines of 4.5% converging on the approximate 4.0% longer-term rate, but we believe a further decline in U.S. unemployment will be required before Altria's price/mix algorithm will fully offset volume declines.

The combined retail share of Copenhagen and Skoal reached 51.1% in the second quarter, its highest level since Altria's acquisition of the brands in 2009. The repositioning of Skoal is still ongoing, however, with trade inventory liquidation driving a 6.1% decline year over year in shipments of the brand. Adjusting for these temporary impacts, we believe Altria's smokeless portfolio should be able to contribute mid-single-digit revenue growth in the medium term, driven by balanced volume and pricing growth, making it a valuable contributor to earnings.

American Electric Power
AEP
Analyst Note 07/25/2014 | Andrew Bischof, CFA  

American Electric Power reported $0.80 in earnings per share for the second quarter, up from $0.73 in the second quarter of 2013. Management reaffirmed its $3.35-$3.55 EPS guidance for the full year, in line with our estimates. Management also reaffirmed its 4%-6% long-term earnings growth target, which we think can drive dividend growth above the utilities sector average. We are reaffirming our $53 fair value estimate and narrow economic moat and stable moat trend ratings.

The transmission business accounted for the bulk of the year-over-year earnings growth in the second quarter, up to $0.10 EPS from $0.04 EPS. Management reported that systemwide earned return on equity is 10.1% on a trailing 12-month basis, a healthy return that offers solid support for earnings and dividends. The generation and marketing segment also posted higher earnings, to $0.20 per share.

Total usage in all customer segments was down 0.5% in the quarter with similar weather conditions, partially offsetting the 1.5% year-over-year increase in usage during the exceptionally cold first quarter. We expect AEP will face another tough year-over-year usage comparison in the third quarter based on the mild summer weather so far in its service territories. Weak usage trends could weigh on earnings and dividend growth.

AT&T T
Analyst Note 07/24/2014 | Michael Hodel, CFA

AT&T's second-quarter results were messy, resulting from the aggressive shift away from traditional wireless device subsidies. The benefits of this transition were clear, as the firm posted strong customer growth, especially relative to Verizon, on record-low customer defections. On the other hand, wireless revenue was hit harder than we had expected. Nearly a third of AT&T's smartphone customer base has shifted to cheaper no-subsidy rate plans without enrolling in the Next handset financing plan. We continue to view the move away from subsidized rate plans as an overall positive for AT&T. However, the full financial benefit of this shift will take time to materialize, in the form of lower phone subsidy costs or, for those customers who ultimately enroll, higher Next revenue. Changing customer behavior could create bumps, especially around cash flow, during the remainder of 2014 as phone upgrade activity ramps up, but we believe AT&T remains well positioned. Our narrow economic moat rating and $34 fair value estimate are unchanged.

Reported wireless revenue grew 3.7% year over year, down from 7.0% during the prior quarter. Revenue again benefited from up-front recognition of Next installment revenue, as AT&T sold 3.1 million smartphones under the program (versus 2.9 million during the first quarter). But the rapid movement to no-subsidy plans, and a full quarter's impact from this shift, caused average monthly service revenue per postpaid customer to drop more than $5 year over year and $4 sequentially to about $62. Going forward, management expects to make up much of this lost service revenue via equipment installment revenue. The good news, in our view, is that if this replacement revenue doesn't materialize, the corresponding benefit is lower device expenses. Phone upgrade activity has been muted thus far in 2014, and the wireless EBITDA margin held roughly steady year over year at 42% as a result.

The fixed-line business turned in modestly disappointing results. AT&T lost 55,000 Internet access customers during the quarter, with the shift to U-verse slowing. Television customer growth (190,000 customers added) dropped to the slowest pace in two years. The impact of past price increases appears to be waning, as consumer revenue growth slowed to 3.0% year over year from 4.3% last quarter. Revenue in the business services unit declined 2.9% year over year, in line with recent experience. Fixed-line profitability is also becoming an area of concern, with the segment's EBITDA margin dropping nearly 3 percentage points versus a year ago to 26.9%, another new low.

Free cash flow was weak during the quarter, dropping to $2.1 billion from $4.0 billion a year ago. Year to date, free cash flow has totaled $5.1 billion, down from $7.9 billion at this point in 2013. Capital spending is up 20% year over year, but management has front-loaded projects this year and continues to expect spending for the year will be roughly flat with 2013 at $21 billion. Financing Next handset sales has also hit cash flow, though AT&T has started selling off these receivables. With more than $4 billion in proceeds generated from the sale of America Movil shares, net leverage declined $3.5 billion during the quarter to $72.7 billion, or about 1.7 times EBITDA. Cash on hand stands at $11.3 billion, which management plans to use to meet near-term debt maturities and prepare for the upcoming spectrum auctions.

Coca-Cola KO
Analyst Note 07/22/2014 | Adam Fleck, CFA

We're keeping our $44 fair value estimate and wide moat rating for Coca-Cola following second-quarter results. The firm continued to see revenue decline year over year, but this was due entirely to currency headwinds and structural changes in the business (largely the firm's refranchised bottling operations); concentrate volume grew 2% and price and mix added 2% to the top line.

Although the shifting Easter holiday benefited the second quarter this year versus last, recent marketing efforts also seem to be taking hold, as systemwide unit case volume increased 2% during the first half of 2014. This figure falls at the low end of our long-run forecast, but we're encouraged that Coke seems to be making a concerted effort to drive better pricing in the North American market. As evidence, the core carbonated soft drink business saw price/mix increase 3%--following a 2% increase in the first quarter--alongside market share gains, and the region's weakness in juice stemmed from major price hikes to offset increased commodity costs. Volume growth was relatively solid in other geographies, with share gains in Eurasia and Africa, stabilized performance in Europe, and 9% volume growth in China.

With improved volume and pricing, gross margins rose to 61.7% from 60.9% a year ago. Some of this increase was reinvested in marketing, but adjusted operating income still increased 5% year over year, outpacing sales gains. We project operating profit climbing at a 6%-7% clip over the long run as volume and pricing growth continues.

Management offered a slightly weaker outlook for the second half of 2014 as a result of issues in Venezuela (where the government has limited corporate profitability), partially offset by lessened currency translation headwinds and a lower tax rate. Still, at an estimated negative earnings per share hit of just $0.02 (versus our current full-year EPS forecast of $2.10), we see minimal impact to our valuation.

In the second half of 2014, the firm plans to launch its naturally sweetened Coca-Cola Life product in the United Kingdom and the United States, following the initial offering in Argentina and Chile. Management noted this quarter that Diet Coke sales in North America were soft--a continued trend from last year given consumers' backlash against artificial sweeteners such as aspartame. Coke Life uses sugar and Stevia, a plant-based sweetener, to achieve its "natural" description and lower calorie count than a regular soda. We expect marketing efforts to support this product in the near term, and if recent other innovative products (such as Dr Pepper Snapple's 10 lineup) are any indication, there is potential to recapture lapsed soda drinkers. That said, we don't expect this product to completely stem declining per capita carbonated soft drink consumption in developed markets, given continued concerns about high amounts of sugar and calories and the likelihood that Coca-Cola Life could partially cannibalize other offerings.

Nonetheless, we remain encouraged by Coke's cash flow and share-repurchase plans. Free cash flow through the first six months of 2014 stands at about $3.4 billion, up from $2.9 billion over the same period a year ago. Management noted that it remains on track for full-year net share repurchases of $2.5 billion-$3.0 billion; at the current market quote, we believe these investments are attractive.

GlaxoSmithKline ADR GSK
Analyst Note 07/23/2014 | Damien Conover, CFA

GlaxoSmithKline reported challenging second-quarter results that fell below both our expectations and those of consensus, largely because of continued weakness with top drug Advair. Based on the poor performance, we expect to slightly lower our fair value estimate. However, we don't expect any changes to Glaxo's wide moat rating. Further, the structural changes previously announced (adding Novartis' vaccine and consumer units while selling oncology assets) should better position Glaxo in therapeutic areas where the company holds strong critical mass. Nevertheless, the quarter's weakness in the respiratory unit is concerning and likely led to the company's lowered full-year 2014 guidance (flat earnings growth down from 4-8% growth).

Leading the overall sales contribution at 28% of total sales, the respiratory group's fall of 8% year over year was the primary factor in the company's total sales fall of 4% on the top line and 12% on the bottom line. We believe Advair's high margins caused the amplified decline on the bottom line. Aggressive formulary management largely in the U.S. has pushed Glaxo's respiratory drugs off key insurance platforms, leading to the poor respiratory performance. We expect this trend to continue for the remainder of the year. However, a key outcomes study called SUMMIT should report within a year, and a positive mortality benefit with Glaxo's next-generation respiratory drug Breo would help offset the weakness to Advair. Further, Glaxo's other next-generation drug Anoro has shown statistically significant improvements relative to blockbuster Spiriva, creating another avenue to offset declining Advair sales.

Outside of the respiratory unit, the remaining results in the quarter were largely in line with our expectations. However, marketing expenses were ahead of our expectations and we believe the increased costs are largely supporting the next-generation respiratory drugs.

GlaxoSmithKline: Investment Thesis 07/24/2014
As one of the largest pharmaceutical companies, GlaxoSmithKline has used its vast resources to create the next generation of medicines. The company's innovative new product lineup and expansive list of patent-protected drugs create a wide economic moat, in our opinion.

The magnitude of the company's reach is evidenced by a product portfolio that spans several therapeutic classes, as well as vaccines and consumer goods. The diverse platform insulates the company from problems with any single product. Additionally, the highest revenue generator, Advair, represents close to 20% of total revenue. However, the complexity in approving a generic version of an inhaled drug like Advair will likely hold off significant generic competition well past the drug's 2010 patent expiration, especially in the U.S., where approvals for generic inhaled drugs are particularly difficult. Further, the company's advancement of its next generation respiratory drugs should help the company's maintain its entrenchment in both asthma and chronic obstructive pulmonary disease.

On the pipeline front, Glaxo has shifted from its historical strategies of targeting slight enhancements toward true innovation. The benefits of this strategies are showing up in Glaxo's strong pipeline of respiratory drugs. We expect this focus will improve both approval rates and pricing power.

From a geographic standpoint, Glaxo is strategically branching out from the developed markets into emerging markets. Glaxo's consumer and vaccine segments well positions the firm in these price sensitive markets. While this strategy will likely create some challenges like the potential legal violations that arose in early 2013 in China, we believe the fast-growing emerging markets will help support long-term growth and diversify cash flows beyond developed markets.

Turning to the bottom line, Glaxo continues to implement cost savings initiatives. Since 2012, the company has identified over GBP 3 billion in potential annual cost savings, which should be achieved by 2014-16. The improved productivity should help mitigate pricing pressure in both the U.S. and Europe.

GlaxoSmithKline: Economic Moat 07/24/2014

Glaxo holds a wide economic moat on the basis of patents, a powerful distribution network, economies of scale, and diverse operations. Similar to its peer group, Glaxo's branded drugs hold patent protection that keeps competitors at bay for several years, while the company can charge prices that enable returns on invested capital above its cost. The delay in competition also enables the company to develop the next generation of patent-protected drugs to evergreen its pricing strategy. Not only does Glaxo's powerful distribution network attract small biotech companies that need help marketing drugs, but also very large firms such as Amgen and Roche have partnered with Glaxo for its marketing heft. Glaxo's strong cash flows enable the firm to support the $800 million on average needed to bring a drug to the market. Finally, Glaxo's operations in vaccines and consumer health care products augment its strong competitive advantages in branded drugs, with cost advantages in vaccines and branding power in consumer drugs providing the key moat sources in these smaller business lines.

GlaxoSmithKline: Valuation 07/24/2014
We are reducing our fair value estimate to $51 from $54 per share based on lower projections for Advair. Pricing pressure and increased competition in the respiratory area is leading us to reduce our forecasts for this key drug. The reduced sales outlook has an amplified impact on earnings given Advair's high margins. Post the completion of the restructuring with Novartis (2015), we forecast average annual sales growth of 2% during the next decade, with new products offsetting patent losses. Further, growth in emerging markets should mitigate the patent losses in developed markets, as brand names are more important in emerging markets and give products a much longer life cycle. Also, steady growth from vaccines and consumer health-care products should reduce the volatility from patent losses in the prescription drug business. We expect steady operating margins over that period as cost-cutting efforts help to offset expansion into lower-margin geographies and lost sales from the high-margin drug Advair. For the discount rate, we estimate Glaxo's weighted average cost of capital at 8%, in line with the company's peer group. The fair value estimate for this share class is derived using a model in the firm's reporting currency, and applying the applicable exchange rate for the share. Any differences between the fair value estimate shown in the valuation section and the fair value displayed elsewhere in this report is a function of a more recent exchange rate.

GlaxoSmithKline: Risk 07/24/2014
Like all pharmaceutical companies, Glaxo faces risks of drug delays or nonapprovals from regulatory agencies, an increasingly aggressive generic industry, and competition in the pharmaceutical industry. However, specific to Glaxo, generic competition could come at any time for the company's leading drug Advair, which could be detrimental to the company as the drug represents over 20% of the top line and a higher portion of the bottom line because of the drug's high margins.

McDonald's MCD
Analyst Note 07/22/2014 | R.J. Hottovy, CFA

We believe McDonald's is taking appropriate steps to drive more consistent traffic through menu innovation/customization, improved marketing messaging and reach, enhanced value platforms, and use of consumer-driven insights, but the company's execution speed is becoming a concern. Our model had assumed a modest comp decline in the U.S. and nominal growth in Europe and APMEA during the back half of the year. However, June comp declines across each region and management's outlook for a continuation of first-half trends into the second half (including negative global comps in July) raise questions about whether industry and macro headwinds have longer-lasting implications than we've assumed. McDonald's profitability remains healthy despite sluggish top-line trends--operating margins were down just 50 basis points to 30.5%--and suggests that the franchise system and scale advantages behind our wide moat rating are still valid. However, if traffic trends continue to lag, it could indicate McDonald's brand equity may be waning amid industry promotional activity and fast-casual competition, potentially putting our stable moat trend rating at risk.

There is no change to our $105 fair value estimate, as modest reductions to our near-term estimates will be offset by cash generated since our last update. For 2014, we now expect 2% top-line growth versus prior expectations of 3%. Our model also assumes 40 basis points of operating margin contraction (versus 31.2% last year) due to customer-engagement efforts and expense deleverage. Looking beyond 2014, we expect a return to low- to mid-single-digit top-line growth and operating margins in the 31%-32% range, which balances refranchising efforts with industry competition and labor cost increases. We find shares modestly undervalued and view buybacks/dividend, refranchising, and cost control plans as positives. Nevertheless, without more tangible comp improvement starting in 2015, our longer-term estimates could prove aggressive.

We continue to view management's customer-engagement and planning efforts as most critical in the U.S., where comps declined 1.5% during the quarter (including a 3.5% decrease in June) and guest traffic declines more than offset 3% contribution from menu price increases. Management reiterated its optimism for a number of current initiatives, including a "reset" of employee staffing and scheduling to maximize capacity during peak hours while eliminating inefficiencies elsewhere. We also remain encouraged about the potential for the McDonald's high-density preparation tables, which have been rolled out across much of the U.S. system. These tables are designed to incorporate new ingredients and facilitate greater customization while maintaining speed of service. This could create new menu innovation opportunities while also helping to enhance McDonald's brand intangible asset. Management's updated second-half outlook confirmed our thoughts that investors shouldn't expect much of a comparable sales lift from this investment in 2014, but we still believe this helps to drive a steady improvement in traffic beginning in 2015. However, we also recognize that the continued gravitation toward fast-casual restaurant chains among McDonald's more affluent customers could neutralize some of the benefits from these initiatives. We believe we have captured the give and take of these factors with our longer-term U.S. comp outlook in the low single digits, but will continue to monitor's management's efforts for reengaging with customers for changes to our longer-term assumptions.

McDonald's: Analyst Note 07/23/2014

Several restaurant and food-service firms have cut ties with meat supplier OSI this week amid a China Food and Drug Administration investigation into OSI subsidiary Shanghai Husi Food for allegedly supplying expired beef and chicken to Yum Brands, McDonald's, and other food-service firms across China and other Asian markets. OSI believes the Husi incident was an isolated event, and we do not view this development as indicative of structural supply chain issues at any of the restaurant chains affected. Nevertheless, the negative publicity could adversely affect top-line and operating margin results for Yum's China and McDonald's APMEA divisions in the back half of the year.

We plan to trim our same-store sales outlook for Yum China to mid-single-digit growth for the back half of the year (KFC China is lapping negative comps in the third and fourth quarters amid last year's poultry supplier issues), falling short of guidance calling for high-single-digit growth. We still believe 18% restaurant margins are achievable for Yum China based on first-half trends and continued margin benefits from the recent menu revamp and store portfolio mix changes. These changes will not be enough to affect our $82 fair value estimate, however, and we still expect 20% EPS growth for the year.

For McDonald's, we now expect APMEA segment comps to decline slightly during the back half of the year and consolidated operating margins of 30%-31%. We plan to trim our $105 fair value estimate by a dollar or two to account for these changes.

Historically, restaurant companies have been able to bounce back from food quality issues (in China and other markets) through new menu innovations and food quality marketing campaigns. But given that this situation comes on the heels of other food quality scares in the region, we will continue to monitor consumer response for more severe brand impairment issues, which could have implications for our valuation assumptions and economic moat ratings.

Realty Income O
Analyst Note 07/25/2014 | Todd Lukasik, CFA  

Realty Income reported second-quarter results that largely reflect a continuation of the favorable environment it has been enjoying of late. We're maintaining our narrow moat rating and $44 fair value estimate.

For the quarter, on a year-over-year basis, revenue and adjusted EBITDA (excluding merger expenses, which can vary from quarter to quarter) increased 23% and 24%, respectively, both driven by recent acquisitions. On a per-share basis, adjusted EBITDA increased 10%, reflecting the incremental equity Realty Income has issued to help fund its recent property purchases. With same-store rents (a measure of internal growth) increasing 1.4% in the quarter, the vast majority of the growth in adjusted EBITDA per share was driven by acquisitions, the environment for which continues to remain favorable to Realty Income.

Specifically, Realty Income continues to source near-record volumes of deal flow (more than $6 billion in the quarter), allowing it to be choosy about the assets it eventually acquires ($405 million). Although pricing remains high on an absolute basis by historical norms (with cap rates as low as 6% for the best assets), investment spreads (that is, the difference between the capitalization rate that Realty Income pays to acquire properties and its accounting cost of funds) remain wide, at 215 basis points in the quarter. Making investments at such wide spreads to its accounting cost of funds allows the firm to realize excess cash flow that can be used to support future dividend increases.

Realty Income's dividend in the quarter represented 85.5% of adjusted funds from operations, a level at which the firm has been very comfortable historically. The firm generally contemplates a fifth dividend increase near this time of year (in addition to its four small quarterly increases throughout the year). The next "extra" increase will be the first since the firm boosted its dividend significantly at the start of 2013 in conjunction with its acquisition of ARCT, which we believed pulled dividend increases forward from future years. Given recent acquisition activity, cash flow has grown and its 85.5% AFFO payout ratio puts Realty Income is in a position where it can consider a fifth increase again this year. Even if it passes on a fifth increase again this year, we expect its payout ratio to be low enough by this time in 2015 that a fifth dividend increase then will be a near-certainty.

Rogers Communications RCI
Analyst Note 07/24/2014 | Imari Love  

Rogers Communications posted solid yet underwhelming second-quarter earnings results, with revenue and EBITDA in line with expectations. Group revenue was flat year over year at CAD 3.21 billion ($3 billion), as the firm was unable to generate any meaningful top-line traction in its wireless, cable, and media businesses.

Wireless revenue actually fell 1% from the year-ago period, as the slight increase in its subscriber base was offset by a small decline in blended average revenue per user. That said, the 1.4% decline in postpaid ARPU was much better than the 4.9% drop in the first quarter. The sequential improvement is a function of a more disciplined approach to pricing and promotions as well as the firm starting to lap the year-over-year comparisons on some of the international roaming packages launched last year (the nonroaming network revenue growth was up 2% in the quarter). Looking into the second half, we expect roaming pressures to ease a bit, which should improve the trajectory for ARPU. Despite the lack of revenue growth, Rogers was able to grow its EBITDA by 1% and improves its margin by 20 basis points to 40.9%. We remain encouraged by the firm’s ability to cut postpaid churn (down 4 basis points to 1.13%) while simultaneously cutting retention spending (down CAD 35 million year to date). This dynamic sets the stage for profitable long-term growth and signals that the competitive intensity in the sector has abated.

Looking ahead, Rogers reiterated its full-year guidance (despite a somewhat sluggish first half), which implies the firm sees better days ahead in the coming quarters. Although we plan to update our model to reflect the firm’s operational progress, we do not plan to revise our $44 fair value estimate at this time.

We are only eight weeks into new CEO Guy Laurence’s Rogers 3.0 plan, and the firm has already slashed 15% of its upper management positions and plans to restructure thousands more in order to make the company leaner and more cost efficient. While the regulator’s continued push for a fourth national player looms as an overhang for the sector, we believe the well-entrenched economic moats of the major incumbents have formed a virtual barrier to entry to any new carrier that strives to be profitable on national scale. All in all, we expect the shares to react favorably to these results and at a price/fair value ratio of 0.9, we believe the shares are undervalued.

Unilever PLC ADR UL
Analyst Note 07/24/2014 | Erin Lash, CFA  

Unilever is not immune to the pressures of unfavorable foreign currency movements, which hurt reported sales by more than 8%, and slowing growth in emerging markets. However, we contend that second-quarter results show that strategic efforts to realign the firm's business away from slower-growing food brands and toward faster growing personal-care brands and reinvest behind core brands are gaining traction. Underlying sales jumped nearly 4%, equally split between higher prices and volume. We think this balanced growth is evidence of the strength of Unilever's product set, supporting the intangible asset source of the firm's wide moat.

The dichotomy of faster-growing emerging markets and more-mature developed markets was pronounced, as emerging markets (57% of sales) jumped 6.6% (which although favorable was a marked slowdown from the 10% recorded in the year-ago period), while developed markets (43%) edged up just 0.3%. Management highlighted that while conditions in Europe remain challenging (down 0.8% in the quarter), the firm realized improved pricing in several Southern European countries, including Spain, Greece, and Italy, pointing to further stabilization in the region.

Through the first half of 2014, underlying operating margins popped 30 basis points to 14.3%, which is notable, considering Unilever's brand investments. We think this signals the firm is leveraging its global scale and subsequent cost advantage (which also contributes to our thinking regarding Unilever's competitive positioning) to generate enhanced profitability. Results through the first half of the year are tracking in line with our expectations, and we don’t anticipate a material change to our EUR 33, GBX 2,748, and $44 fair value estimates. Although the stock strikes us as fairly valued, we'd probably recommend investment if it traded down on concerns surrounding unfavorable foreign currency movements or slowing emerging-market growth, similar to late last year.

From a category perspective, Unilever delivered fairly robust growth across home care (up 6.2%), personal care (4.5%), and refreshments (4.5%); food was the only laggard, posting underlying sales growth of just 0.7%. While this is far from a positive, we recognize that 60% of the firm's food sales are derived through slower-growing developed markets, which is probably hindering the top-line growth of this segment. Further, we expect that Unilever will continue to actively manage its brand portfolio in line with actions taken over the past six years, during which the firm shed EUR 2.5 billion in sales (mostly food brands), while completing nearly EUR 3 billion in acquisitions (primarily in personal care). Given Unilever's vast portfolio, we think it's essential that its resources--both financial and personnel--are focused on the highest-return opportunities, and we applaud these strategic actions.

 

 
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