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
Last Dividend Hikes of 2014 -- The Week in Dividends, 2014-12-19

If you're feeling a bit whipsawed of late, you're certainly not alone. After suffering its largest weekly decline in two and a half years, the S&P 500 recovered nearly all of last week's drop with a gain of 3.4%. As often seems to be the case in recent years, the bulk of the bounce can be credited to the Federal Reserve, which after its latest policy meeting gave no sign that a rise in short-term interest rates is imminent. The plunge in oil prices eases pressure on inflation--not that there were many signs of accelerating inflation to begin with--and that gives the Fed more leeway to hold rates at rock bottom.

I think policymakers are right to be concerned with the threat of outright deflation. Surely they don't want to halt what little economic growth we have by raising interest rates too soon. But as time wears on, I find it harder to see what real economic purpose is served by keeping interest rates so low, and I find it easier to see the cost in the form of inflated financial asset values. That's been the trouble with this whole exercise in extreme monetary policy: It's been much more effective in stimulating stock and bond prices than real economic activity.


Barring any unusual, last-minute changes by our portfolio holdings, the two final dividend increases of the year rolled in this week.

Realty Income's O was the year's fourth routine quarterly hike of $0.0003125 a share; for 2014 as a whole, the monthly dividend rate increased a total of 0.7%. This subpar rate of growth comes after the best-ever 20.0% increase during 2013, which temporarily lifted Realty Income's payout ratio (using adjusted funds from operations, or AFFO) above a long-term target range in the mid-80%. This year AFFO has grown much faster than the dividend, reducing the payout ratio and setting the stage for faster dividend growth soon. However, the board--which had already deferred consideration of a larger dividend increase from August in past years to December--appears to have put the decision off until January instead.

A small shift in timing doesn't alter my highly favorable view of the business and I plan no change to the Harvest's position. I still think 4% is a good long-term expectation for annual dividend growth; for reference, Realty Income has already projected 4%-6% growth in AFFO per share in 2015. Still, the stock does look a bit expensive here relative to our fair value estimate of $44 a share, and a transition to higher interest rates--whenever it happens--stands to be bumpy for all real estate investment trusts.

The other came from what I often consider our most annoying portfolio holding, AT&T T. I'll credit the firm with now raising its dividend for 31 years in a row, but for a seventh straight year, the quarterly dividend rate rose by a mere penny--an increase of just 2.2%. As it happens, I'm more grateful for this penny than I have been in past years. The telecom industry is still economically defensive, and dividend yields are certainly high, but beyond that there's little to like. Customer growth in wireless service is drying up, and while providers collectively spend tens of billions of dollars on their networks every year, they haven't been able to charge customers more for the explosion in data usage. Instead, a price war has broken out. Of course, this being AT&T we're talking about, questionable acquisitions (Directv DTV and Mexico's Iusacell) are also part of the story, and I cringe to think how much the company could be in the process of spending in the not-yet-closed spectrum auction. Against this backdrop, even a 2.2% dividend hike has a reaffirming quality to it. The absence of one--and, with that, an end to such a long streak--would have come close to being a sell signal all on its own.

This week also brought quarterly earnings reports from two Builder holdings that have non-standard fiscal calendars:

* General Mills GIS had already reduced its near-term profit outlook during this tough time for the domestic packaged food industry, so uncharacteristically weak results weren't a surprise: a 4% year-over-year drop in earnings per share excluding non-recurring items on a 3% drop in sales (both figures include a small headwind from currency). We continue to expect much better performance over the long term, and our fair value estimate held steady at $52.

* Paychex PAYX turned in another solid quarter with a 9% increase in EPS, but while the bottom line exceeded consensus expectations, Wall Street seemed less than impressed and as the stock price dropped 3.1% after the Friday morning release. Perhaps there was also some hope for an increase in fiscal year guidance, which management left unchanged. Though the stock often overreacts to its quarterly financial reports and still trades at a large premium to our fair value estimate, it remains a core holding for its wide economic moat, steady and abundant free cash flow, and unusually generous dividend policy.

Elsewhere in a surprisingly active week in terms of company news, Coca-Cola KO and General Electric GE both weighed in with analyst conferences this week. Coke's presentation was relatively uneventful, as management had already indicated that (1) 2015 would be no better than 2014 in terms of core earnings growth and (2) unfavorable currency trends are likely to negate what core growth the company can generate. I assume these dynamics, plus a relatively high (60%) payout ratio by historic standards, will lead to a below-trend dividend increase early next year: I'm currently expecting a hike around 5%. We're still confident that Coke's global business can generate better growth over the long run, though. We've reaffirmed our fair value estimate of $42 a share, and with a yield near 3% and the likelihood of long-term dividend growth in the high single digits, I'm willing to be patient through Coke's current slow patch.

GE is another story that still involves patience, though in my view a long-awaited inflection point is finally in sight. The company offered earnings guidance for 2015 that fell a bit short of Wall Street views. EPS from the industrial side of the company are expected to grow at a double-digit rate despite a slowdown for the oil and gas segment, but as GE Capital Services shrinks, its contribution to profits does as well, and this headwind will likely persist into 2016. This helps explain last week's relatively disappointing dividend increase of 4.5% for next year. However, by 2016, 75% or more of GE's total earnings will come from its industrial infrastructure operations, creating a more profitable and more valuable business as a whole. Yielding 3.6% at Friday's closing price, I think we're being nicely rewarded to wait through the balance of GE's long-running transformation.

Finally, Kraft Foods Group KRFT announced an unexpected retirement for CEO Tony Vernon; his title will be assumed by current chairman John Cahill. The stock's sharp reaction--a 6.4% gain in Thursday's trading--suggests that investors expect more aggressive management of Kraft's wide-ranging brand portfolio, presumably including divestitures and/or acquisitions. Though the shakeup suggests the board believes there is room for better financial performance, the stock's leap strikes me as overdone. It was already trading above our fair value estimate of $53 a share, and we don't know enough about possible changes in strategy to change our valuation yet. As a result, Kraft is now the most overpriced holding in the Builder or the Harvest on a price/fair value basis. Though I still think the company's long-term prospects are decent, it isn't such a proven or prodigious creator of value that I consider it a core holding, so the stock could be a source of funds in the Harvest if better opportunities arise.

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.


News and Research for Builder and Harvest Portfolio Holdings

Coca-Cola KO
Analyst Note 12/16/2014 | Adam Fleck, CFA

We plan to maintain our $42 per share fair value estimate and wide moat rating for Coca-Cola following details gleaned from the firm’s business update call, though we will likely lower our near-term projections to account for ongoing currency headwinds. Following up on the cost savings plan announced in October, there are several additional transactions that will take place in 2015 with both positive and negative impacts; these include the continued refranchising of some of Coke’s wholly owned North American distribution assets, the sale of the firm’s energy drink portfolio to Monster Beverage, and the inclusion of Monster’s non-energy drinks. The key takeaway is that the combined impact is minimal for 2015--the company estimates that the headwind from giving up distribution rights will lead to a 1% hit to the top line and EPS, but Monster’s moving parts will drive revenue up 1% to 2% while not affecting the bottom line.

Over the long run, the company aims to complete half of its bottling refranchising by 2017 and the remainder by 2020, with a low-single-digit percentage headwind to EPS due to sacrificed gross margin in product sales from the additional layer formed between Coke and retailers. The revenue impact is also minimal (about 5% of sales, per management guidance for $2 per case impact and our forward estimates), since Coke plans to structure the agreements as sub-bottling contracts rather than outright sales, and will therefore receive a portion of the lost selling price back in quarterly payments.

In all, based on management’s outlook, operating margins should rise as a result of this transaction--this also makes sense considering that Coke’s historical business pre-bottling acquisition (in 2010) was higher margin. Importantly, ROICs should also increase. The company will shed $5 billion in assets by 2017, or nearly 10% of our estimated future invested capital base for the company, a rate higher than the low-single-digit reduction in earnings.

At first blush, the end financial results of the refranchising appear to offer Coke minimal return on its initial investment. The company acquired the North American bottlers in 2010 for about $12 billion, and spent an additional $1 billion for rights to distribute several of Dr. Pepper Snapple’s brands. On top of the $5 billion in assets the firm will shed by 2017, management estimates that the remaining business to be refranchised by 2020 will be another $5 billion, and the manufacturing arm (which, for now, will stay with Coke) is worth roughly $2 billion. The company also estimates the total efficiency savings (including those planned for the manufacturing piece) at about $1 billion, good for a total of $13 billion--equal to the original purchase price.

That said, we believe there are benefits to having owned the bottlers, including enhanced product development (such as 8-ounce cans and 1-liter plastic bottles in North America) that helped increase price per ounce and offset substantial commodity cost inflation, better national account management, and improved employee incentives to drive growth across the systems. Admittedly, it’s worth questioning whether Coke needed to own the bottlers outright in order to enact these changes, but ultimately we think the future gains from increased package development, cost-cutting initiatives, better price/volume management, and variable incentive pay from the sub-bottlers (allowing Coke to capture some of the future growth upside) will help drive higher returns for the firm.

We also remain encouraged by management’s updated goals to again focus on its core beverage business, with plans to drive top-line growth back to the mid-single-digit level (such as incremental marketing spend and improved pricing in North America) while also cutting costs by 8% per year. In all, we’re still comfortable with our long-run forecast for 7% to 8% annual earnings per share growth.

Coca-Cola: Valuation 12/19/2014
We've maintained our $42 fair value estimate, but we've lowered our near-term revenue and earnings forecast due to the negative impact from currency translation and structural changes to the business. We still expect long-run earnings per share growth in the 7% to 8% range, but we anticipate a lower bottom-line gain in 2015 due to these factors, combined with end-market volume weakness (both developed and emerging market), European price competition, and productivity and marketing initiatives planned for the year. Our fair value estimate implies a 20.6 times price/earnings ratio (based on our updated estimated 2015 earnings per share) and a 15.7 times enterprise value/EBITDA.

We continue to expect the firm to face developed-market carbonated beverage volume challenges in the near term, and although we expect positive pricing and still-beverage growth in 2015, the strong U.S. dollar will probably trim about 3 percentage points from the top line, driving only about 1% total gains. Moreover, we've lowered our revenue outlook roughly 0.5% to 1% annually from 2016 through 2018, as the firm plans to divest a portion of its North American distribution business. Longer term, we still expect top-line gains of about 5%, ahead of competitor PepsiCo, driven by Coke’s dominant presence in developing markets, its ability to drive positive pricing, and further gains in noncarbonated drinks; we still view volume and price contribution as relatively equal contributors to this growth. Offsetting the near-term pressures on Coke's revenue, we now believe operating margins can climb to nearly 25% over the next five years from about 22% in 2013, about 40 basis points higher than our prior forecast due to the positive mix shift from shedding the lower-margin distribution assets. We also note that management recently added an incremental $2 billion in productivity-related savings versus its previous outlook (for a total of $3 billion on an annual run rate by 2019). While some of these savings will be reinvested into the business, we nonetheless expect higher margins to result. As such, we continue to expect EPS growth to outpace both sales and operating-income gains because of Coca-Cola’s commitment to additional share repurchases. Our revenue and income growth targets are roughly in line with management’s long-term forecasts for mid-single-digit yearly top-line growth and pre-tax income gains of 6% to 8% annually.

General Mills GIS
Analyst Note 12/17/2014 | Erin Lash, CFA

Soft consumer spending continues to be a challenge, but these headwinds aren't unique to General Mills, and we still believe the firm's solid brand portfolio, when combined with its global distribution platform, warrants a narrow moat. We aren't making any changes to our assumptions or our $52 fair value estimate, which is based on 3%-4% long-term annual sales growth and mid-single-digit operating profit growth, and we view the shares as fairly valued.

Second-quarter organic sales slipped 1%, as higher prices and improved mix only partially offset lower volume. U.S. retail sales were lackluster, down 4%, almost entirely because of sluggish volume. While we're encouraged by the performance of yogurt (up 1%) and snacks (up 2%), cereal (down 5%), meals (down 7%), and baking products (down 5%) were laggards. Promotional spending has been running rampant as the industry has attempted to prop up center-of-store sales, although we've never viewed this spending as a wise strategic move for the longer term. As such, General Mills' admission that volume sold on promotion was off 1%-2% in the quarter is favorable and supports its commentary that innovation (with a focus on catering to consumers' desire for convenience and health and wellness offerings) is what will ultimately drive profitable category sales longer term.

Adjusted gross margins slipped 80 basis points to 34.9%, while the adjusted operating margin ticked down 40 basis points to 17.0%. However, in light of the firm's commitment to extract costs from its operations and streamline its North American manufacturing footprint, we still expect the firm will expand operating margins to 17% over our five-year explicit forecast, while investing behind its brands. Further, we forecast annual average operating income growth of 5% and adjusted earnings per share growth of 7% over our five-year forecast, which is consistent with the company's mid-single-digit and high-single-digit forecast, respectively.

Kraft Foods Group KRFT
Analyst Note 12/18/2014 | Erin Lash, CFA

In a surprise move, Kraft announced that CEO Tony Vernon, 58, will step down from his post at the end of December and will be succeeded by chairman John Cahill, 59. Vernon has headed the North American grocery business since it was spun off from the global snacking operations. From our perspective, Cahill possesses significant experience in the food and beverage industry after spending about 20 years at Pepsi Bottling Group and PepsiCo, which should benefit the company and its shareholders. We view Kraft's stewardship of shareholder capital as standard, and we doubt it will veer from optimizing shareholder returns with a new leader at the helm. Further, we don’t anticipate this change will affect our $53 fair value estimate, which incorporates our expectations for 3%-4% sales growth and operating margins of more than 19% longer term. We still believe Kraft operates with a portfolio of powerful brands that span the grocery store, resulting in a narrow economic moat.

While we've long viewed Vernon as an adept leader, we think this leadership change could signal that Kraft may eventually look to take more aggressive actions to shed underperforming brands. As independent organization, Kraft has reignited several lackluster products that had been underinvested in previously (like Kraft mayonnaise). However, despite multiple stabs at putting the Jell-O brand on more stable ground, for instance, the business continues to falter, and we think management may now opt to reallocate investment dollars toward more profitable initiatives. We don't expect to garner any insights into Cahill's strategic direction for the firm for another few months, though, and will refrain from making any changes to our take until such time.

 

 
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