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
O Boy, Our First Dividend Hike of 2015 -- The Week in Dividends, 2015-01-23

The biggest macro news of the week was the European Central Bank's long-awaited embrace of quantitative easing. Similar to the now-concluded QE of our Federal Reserve, the ECB will now print EUR 60 billion a month to purchase fixed-income securities through September 2016. Financial markets leapt as a result, but I find it more useful to think about this in terms of currency becoming less valuable relative to stocks rather than stocks becoming more valuable in an absolute sense. With a potentially unlimited supply of money and, to be sure, a much more finite quantity of corporate cash flows to support stock prices, it's the cash flows that are properly characterized as scarce. But while QE certainly has inflated the quoted value of stocks and other securities, its effect on the cash flows that must ultimately provide returns is, well ... "negligible" seems like a fair word. Investors may feel wealthier when they open their brokerage statements, but the rest of the month they'll still be starved for income.

I think it's important to be aware of what's happening on the global macroeconomic stage, at least up to a point, but I also believe there's more value to be added to our portfolios by paying attention to what goes on at the level of individual companies. I can't make the stock market serve up lower-priced and therefore higher-yielding stocks for us to buy, but at least the ones we already own almost always enhance our income over time through dividend increases.

Considering the marquee role it has played for the DividendInvestor strategy over the years, I'm delighted that Realty Income O has provided our first dividend increase of 2015. On Tuesday, the company bumped up its monthly dividend rate to $0.189 a share, an increase of 3.0% from last month and 3.8% from a year ago. Also, though only a cosmetic part of the change, I'm glad that the rate itself has gone from a number requiring seven decimal points to one with just three. I hope this will characterize the routine quarterly hikes going forward as well, and there's at least some room for those increases to be a bit larger than the 0.2% they've been in recent years. The stock is overvalued--credit or blame for that goes to central banks and the bond market--but it still yields a decent and highly reliable 4.2%. Additionally, I'm looking forward to dividend growth for all of 2015 in line with my long-term estimate of 4% to 5% annually.

We had four corporate earnings reports roll in this week. Here are the key facts, highs, lows, and conclusions from my point of view.

* Johnson & Johnson's JNJ core earnings came in at $5.97 a share for 2014, up 8.2% from the prior year on a 4.2% rise in revenue. This strikes me as solid performance from such a large enterprise (total revenue reached $74.3 billion last year). Unfortunately, the company faces several headwinds in 2015, the biggest of which is currency. With 53% of sales earned outside the U.S., the strong dollar stands to be upward of a 6 percentage point headwind to the top line. Moreover, growth in the pharmaceutical unit--last year's star performer with sales advancing 14.9%--will tail off sharply as recently-launched drugs (most notably hepatitis C treatment Olysio) face stronger competition. The device and consumer businesses aren't yet positioned to pick up the slack.

All told, Johnson & Johnson predicts core earnings per share to be in the range of $6.12 to $6.27 in 2015. This represents a 2.5%-5.0% improvement on last year, but only because of a change in the way management plans to calculate core EPS. Without that maneuver--worth $0.42 a share--J&J's 32-year streak of yearly increases in core EPS would probably come to an end.

(As an aside, I'm often annoyed by having to use adjusted, core, operating, or pro-forma EPS as a yardstick, particularly when it seems there are material adjustments almost every single year. That said, this is the number Wall Street cares about the most. In this case, it also helps that Johnson & Johnson's core EPS has historically been more strongly correlated with free cash flow than GAAP earnings. And since core EPS also seems to be the most relevant statistic management uses in setting the dividend, I won't protest too much.)

The stock had a tough week, losing 1.8% amid a 1.6% gain for the S&P 500. But while there's nothing to be done about the currency headwind facing J&J and all other U.S.-based multinationals, we expect operational growth in sales and EPS to bounce back in 2016 and beyond. Based on management's profit outlook, my best guess is that J&J's dividend will rise from its current quarterly rate of $0.70 a share to $0.74 or $0.75, an increase of 5.7% or 7.1%. Obviously I'd prefer the latter, especially as the stock's dividend yield hasn't been above 3% for some time now. Over the long run, though, I think 7% is still a realistic expectation for dividend growth. Our fair value estimate remains $99 a share, and I expect to maintain our stake in this core holding despite its modest overvaluation.

* Unilever UL ended 2014 on a bit of a sour note as global volume turned negative, due in part to retailer inventory movements in China. In general, though, the company is still doing a good job balancing volume and price across a wide array of brands, product categories and economic regions. Currency, of course, has been the chief headwind of late (4.6 percentage points on the top line) as total revenue declined 2.7% in the year. But operating margins improved a bit, allowing core EPS to rise 1.9% despite an 8.9 percentage point currency hit for profits.

The company's outlook for 2015 was a bit vague. Management doesn't expect any improvement in the economic backdrop, but does hope to score further enhancements to the operating margin. With Unilever reporting its financial results and paying its dividends in euros, the impacts of currency changes on the business aren't as bad as they would be in dollars--for example, the strong dollar actually increases the profit contribution from Unilever's U.S. operations. Reuters' consensus estimate for 2015 anticipates an 8% gain in core EPS, and with a payout ratio near 70% but capital spending likely to moderate over the medium term, I figure the dividend ought to rise to EUR 0.30 a share (up 5.3%) or perhaps a bit more when the next quarterly payment is declared in April.

The bad news for U.S. investors is that the strong dollar/falling euro will almost certainly overwhelm whatever Unilever's dividend increase turns out to be. To catch up with these rapid currency changes, we now translate our fair value for Unilever using the latest spot exchange rate rather than a moving average. This meant that while our fair value estimate for the ordinary shares held steady at EUR 33, we now value the U.S.-listed American Depository Receipts at $38, down $6 from our last update. On this basis the stock is now moderately overvalued, like many of its staples peers, and its dividend yield (at 1.12 euros to the dollar) has slipped to just 3.0%. But without any ready replacements for Unilever, I plan to hold our position.

* It seems the funk at McDonald's MCD is far from over. Considering how lousy the company's same-store sales performance was during 2014, it's surprising that core EPS dropped only 1% (that is, excluding charges for foreign tax matters, the estimated impact of supplier issues in Asia, and a small but negative currency effect). That's one of the virtues of the franchise model, at least from shareholders' point of view: The franchisees are on the front line being squeezed the hardest. But currency (yet again) is poised to exact a much larger toll on EPS this year, and we expect same-store sales will fall again in 2015--with declines hopefully moderating as the year wears on and year-over-year comparisons get easier. Our fair value estimate remains unchanged at $95.

About the only positive development in the release is that McDonald's will reduce capital expenditures this year, helping support free cash flow. Management's three-year goal of returning $18-$20 billion of cash to shareholders through dividends and buybacks remains on track. However, the key to this turnaround is getting consumers to feel like McDonald's is a place they want to eat. Management is very busy developing and launching strategies meant to do just that, but if the tide doesn't turn soon, we may have to consider the possibility that changes in the industry have dealt the firm a blow that will last longer and cost more than recent management missteps. Some appeal remains thanks to the stock's 3.8% dividend yield, which I continue to view as safe, but I'm starting to think of McDonald's as being the AT&T T of the restaurant business (that is, essentially no merit beyond the plump yield).

* General Electric GE provided our best earnings report of the season to date, helping carry the shares to a 3.8% gain on the week. For the year, the shrinking financial side of GE reported core EPS of $0.69, down 10%, but the industrial side--well on its way to accounting for 75% of total profits in 2016 as planned--scored a 10% gain to earn $0.96 per GE share. The company is quickly reducing costs in response to plunging oil prices and associated pressure on its oil & gas equipment segment, and once GE Capital Services is done shrinking to its targeted size, total growth in EPS should be sufficient to drive long-term dividend growth in the 8% range. Yielding 3.8% at Friday's closing price and still available at an 18% discount to our reaffirmed fair value estimate of $30, I regard GE as my single most attractive buy recommendation at present.

It would have been better if the week's earnings news ended here, but United Parcel Service UPS nosed its way in on Friday morning with an earnings warning--one that led to the stock's biggest one-day decline in the eight years we've owned our stake. In the fourth quarter of 2013, a surge in package volume and bad weather led to disappointing profits. This year, UPS turned out to be over-prepared, leading to excess costs.

On one level, I don't mind--in fact, I actually prefer--that the company sacrifice short-term profits when it is necessary to provide the best possible service to customers. Such choices reinforce the company's brand, the loyalty of customers, and provide a long-term payback. The bigger problem is that this doesn't seem to be just another one-quarter fluke: Not only did UPS take down its expectation for profits in 2014, but management indicated that EPS growth in 2015 (now off a smaller base) would fall short of its long-term goal of 9%-13%.

The near-10% drop in UPS' stock price seems like an overreaction; the news didn't lead to a change our fair value estimate of $97 a share. But the stock had been rising, and by Thursday's close it was quoted at an 18% premium to our appraisal--leaving it far more vulnerable to short-term disappointments like this one than if it was priced at an 18% discount.

With valuations high in most sectors of the market--particularly in some dividend-rich areas like staples, utilities and real estate investment trusts--this creates a lot of tension. Should we sell stocks at lofty prices even when there's no place to put the proceeds and they'll earn nothing as cash? Or should we hang on to keep collecting dividends, even though multiple years' worth of dividends can evaporate if the wrong piece of news hits the stock price? As I wrote last week, all I can promise is a measured approach. But even if I conclude that some stocks should be sold without immediate replacements, I will still look to continue growing our portfolios' total income in 2015.

UPS isn't among those potential sale candidates--especially now. I still consider this wide-moat giant to be a core holding for the long haul, and I'm looking for a decent-sized increase to the dividend (something in the high single digits) in a few weeks. And if the stock falls below our fair value estimate, I am ready to consider adding to our stake.

Next week earnings season picks up with seven of our holdings reporting: Procter & Gamble PG and AT&T on Tuesday, American Electric Power AEP on Wednesday, Rogers Communications RCI and Royal Dutch Shell RDS.B on Thursday, and Altria Group MO and Chevron CVX on Friday. As usual I have no specific predictions about short-term earnings, but I'm sure that currency headwinds will feature in P&G's outlook, and it will be interesting to see how our two supermajors plan to cope with sub-$50/barrel oil. I do not fear for either stock's dividend at this point, based in large part on the idea that oil prices will be much higher a few years out, but I will be listening closely for anything that might shake my assumptions.

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.

Josh's Video of the Week: What Impact Will a Rising Dollar Have on Dividend Payers?
More than likely, it will mean smaller-than-usual dividend increases from companies with global footprints.

News and Research for Builder and Harvest Portfolio Holdings

Shift Toward Ancillary Services Not Dilutive to Paychex's and ADP's Moats
Industry Note 01/22/2015 | Brett Horn  

In the most recent quarter, Paychex saw 4% year-over-year growth in its core payroll processing business and 14% year-over-year growth (adjusting for an accounting change) in its ancillary human resources products. We saw similar results at ADP, with the company seeing 18% year-over-year growth for its professional employer organization business and 7% growth in its employer services segment. The growth in employer services appears to be heavily tilted toward ancillary services, as employee counts in its core payroll services were up only 3% year over year. This trend is nothing new, as the two companies' payroll services have relied heavily on growth in ancillary services to prop up modest growth in the payroll area, and we expect this to continue.

Given that our wide moat ratings have historically been primarily driven by the two companies' dominance in the scalable and sticky payroll processing business, the shift away from this business could have negative implications for the companies' moats at first glance. But, in our view, this trend is actually additive to the companies' moats. While these ancillary services are not nearly as moaty on a stand-alone basis, we think they provide an avenue for ADP and Paychex to further monetize their payroll relationships, and we believe there are significant synergies implicit in cross-selling additional services. Further, we think payroll customers who purchase multiple services from Paychex and ADP could ultimately prove to be more sticky than payroll-only customers. We don't believe either company is particularly advantaged in exploiting this trend. We think Paychex's small-business customer base is more likely to rely on only one provider for its general human resources needs, but ADP's large-business customer base would presumably have a greater need for a wider variety of services.

While we don't expect ADP and Paychex to dominate every area of the human resources services industry, we do think their established customer bases and ability to offer a common platform across different services will give them a leg up over single-service providers in the long run. In our view, the two companies are moving toward a model that resembles leading bank technology providers like Fiserv, which has leveraged its captive core processing relationships to cross-sell ancillary products to the point where these ancillary products make up the majority of revenue, while maintaining strong profitability and its wide moat. We think the strong results Fiserv has generated during this transition point to the positives of this approach.

General Electric GE
Analyst Note 01/23/2015 | Barbara Noverini

GE’s industrial portfolio delivered a solid quarter of growth as ongoing momentum in several U.S. end markets more than offset weakness in the energy sector. Industrial revenues grew organically by 9% year over year to $32.2 billion in the quarter, reflecting robust equipment sales in Power & Water, shipment and services growth in Transportation, and ongoing improvement in Health Care. Strength in these segments offset weakness in Oil & Gas, which managed to hold sales flat on an organic basis amid challenging industry conditions. The quarter’s results closed 2014 with about $108 billion of industrial revenues, reflecting a 7% year-over-year organic growth rate.

Industrial segment operating margin improved 50 basis points year over year to 18.8% in the quarter, as cost reduction efforts intensified companywide. Oil & Gas, in particular, stepped up efforts to rationalize the cost base as segment order growth slowed, anticipating the need to operate a leaner footprint in the near term. For 2014, industrial operating margins expanded 50 basis points to 16.2%, as business mix skewed toward lower margin equipment sales; however, analytics expanded service margins an impressive 220 basis points to 32%, underscoring the attractiveness of growing services as a percentage of GE’s revenues over time.

In our opinion, wide-moat GE’s resilience in the face of uncertain global macroeconomic conditions supports our belief that despite increased concentration on industrials, the portfolio’s end markets and geographic exposure are well diversified. Persistent weakness in oil prices will likely continue to affect order growth and sales in the Oil & Gas segment; however, we’ve built near-term weakness into our discounted cash flow model, and remain optimistic that demand in Power & Water, Aviation, Transportation, and Health Care will continue to produce solid results for GE in 2015. As such, we reiterate our fair value estimate of $30 per share.

Johnson & Johnson JNJ
Analyst Note 01/20/2015 | Damien Conover, CFA  

Johnson & Johnson reported fourth-quarter results largely in line with our expectations, and we don't expect any changes to our $99 fair value estimate or wide moat rating. While the pharmaceutical segment continues to post robust growth, up 14% year over year in the quarter, we expect increased generic and branded competition and continued sluggish sales from consumer (up 1%) and medical devices (up 4%) to lead to overall 2015 sales growth of 1%, excluding foreign exchange rate changes. Also, the headwind in changes in currency as the dollar has strengthened will likely hurt 2015 top-line growth by close to 600 basis points.

Many recently launched drugs continue to buoy the pharmaceutical group, but increasing competition should weigh on growth over the next few years. In particular, the very robust sales growth from immunology drug Stelara, hepatitis C drug Olysio, and oncology drug Zytiga will likely fade significantly as new competitors emerge with more effective drugs. Further, generic competition will likely emerge for neuroscience drug Invega in 2015. While the company lacks a robust late-stage pipeline, we expect early-stage pipeline drugs along with the redeployment of J&J's war chest of cash to gain external pipeline drugs will help mitigate competitive pressures over the long term.

While J&J is signaling an expected improvement in the consumer and medical device segment growth in 2015 to help offset slowing drug sales, we remain skeptical. We don't see enough innovation in either group to lead to accelerating growth. For the past several years, the lagging performance of these divisions has been offset by a strong drug division, but the magnitude of strong drug sales growth will likely fade over the next few years.

On the bottom line, a better than expected tax rate helped to offset lower-than-expected operating margins. As the company's drug division slows, we expect an amplified impact on the bottom line given the drug group's higher margins.

Analyst Note 01/23/2015 | R.J. Hottovy, CFA  

As McDonald's looks to move past a 2014 highlighted by increased competition, evolving consumer preferences, and unexpected geopolitical and supplier issues, the question becomes whether the company has developed an appropriate game plan to improve its relevance with consumers and when investors can expect to see results. Breaking down key priorities for 2015, including more menu and marketing decisions made at the local/regional level, a streamlined menu structure, and a comprehensive Experience of the Future plan emphasizing the "Create Your Taste" personalization platform and digital engagement, we see a number of positives. In particular, we remain constructive about local and regional decision-making, as we believe this will be one of the most important steps in making the McDonald's system a more nimble organization capable of responding to a quick-service restaurant customer demanding constant menu innovation.

We are maintaining our $95 fair value estimate and wide moat rating, as recent results and management's directional guidance for 2015 align with our model. We believe shares are modestly undervalued using our long-term discounted cash flow approach, but we agree with management's assessment that the market should not expect changes overnight. U.S. comparable sales growth of 0.4% in the U.S. in December is a positive, but likely more a function of easier comparisons and broader restaurant spending than turnaround plans in place (though management noted that it is seeing some customer experience improvements in some markets). We continue to believe 2015 will be a challenge, but with local decision-making and Experience of the Future investments setting the firm up for a modest reversal in top-line and margin trends in 2016. However, we'll monitor the pace of improvements in priority markets, as further fundamentals degradation would likely signal more serious structural issues at play and a weakening of McDonald's brand intangible asset moat source.

Taking a closer look at McDonald's in 2015, our model continues to call for negative global comparable sales growth (though returning to flat territory by the back half of the year), low-single-digit declines in revenue (including foreign currency headwinds) and roughly 50 basis points of operating margin contraction (implying operating margins around 28.5%). We'll have greater visibility about the impact of local decision-making and Experience of the Future initiatives as the year progresses, but our model currently assumes a return to low-single-digit comparable sales growth and operating margin expansion in 2016, albeit at more modest levels than the company saw in the late 2000s. Longer term, our model still assumes that the company can return to the lower end of its longer-term goals (3%-5% system sales growth, 6%-7% operating income growth, and returns on incremental invested capital in the high teens).

As we wait for McDonald's customer-facing initiatives to come into focus in 2015, we are encouraged by a number of other potential shareholder-enhancing activities. First, we believe management's decision to pare back store openings in more challenged markets--which is expected to result in a $700 million reduction in capital expenditures to $2.0 billion in 2015--is prudent, and could free up capital for other consumer experience and infrastructure upgrade projects. Although management remains committed to its plans refranchising an additional 900 locations globally over the next two years (on top of the 400 refranchised in 2014), we're encouraged by CFO Pete Bensen's comments about the ability to look at a more heavily franchised system over an extended horizon, which could provide upside to the free cash flow estimates in the later years of our explicit forecast period. Finally, we're comforted that the company remains on track with its goal of returning $18 billion-$20 billion to shareholders between 2014 and 2016, as it reinforces the strength of the McDonald's franchisee system--a major piece of the intangible asset source behind our wide moat rating--even as it attempts to refine its platform for increased industry competition and changing consumer preferences.

Unilever PLC ADR UL
Analyst Note 01/20/2015 | Erin Lash, CFA

Intense competitive pressures and tepid consumer spending persist, as evidenced by Unilever’s results, but we contend the firm’s brand intangible asset and cost edge (which form the basis of our wide moat) remain firmly in place. While we aren’t adjusting our EUR 33 fair value estimate, we’re now incorporating spot exchange rates (as opposed to the one-year average rate previously) to value its other share classes, which drives our fair value estimate changes to GBX 2,492 (down from GBX 2,683) and $38 per ADR (down from $44). This will enable us to more appropriately account for the present environment, and our fair value estimates will continue to ebb and flow with spot rate changes.

For the quarter, organic sales rose 2.1%, reflecting higher prices as volumes slipped 0.4%. Emerging markets (57% of sales) have slowed significantly from a year ago (up just 5.7% for fiscal 2014 compared with 8.7% growth in fiscal 2013). However, we believe the firm’s tenure in these regions (which dates back more than 50 to 100 years in some instances) and its subsequent grasp of consumer trends, combined with investments in new products and marketing will ensure Unilever is well positioned when growth resumes. North America posted 2% underlying sales growth (driven by a balanced contribution from price and volume), though we aren’t blind to the fact that this compares to a weak period last year, when sales fell 2.4%. Given management’s commentary that promotional spending in U.S. hair care and deodorants is running rampant, it will take a few more quarters before we view this uptick as sustainable.

Unilever’s efficiency initiatives appear to be gaining traction, as core operating margins expanded 40 basis points to 14.5%. The company noted that 20%-25% of its EUR 20 billion cost base is at least partly affected by oil prices, which should prove a low-single-digit tailwind in the 2015. We still expect operating margins to improve to around 16% over our 10-year explicit forecast.

Emerging markets were again weighed down by trade destocking in Chinese hypermarkets, hampering sales in the country (which represents about EUR 2 billion in annual sales or 4% of its total) by around 20%. The impact is likely to be felt through the first quarter of 2015, given the tough comparison from a year ago. Management still expects growth to resume over the course of the year, though, as consumer demand has not subsided to the same degree, which we perceive to be reasonable.

Food remained a weak spot, with underlying sales down 0.6% in fiscal 2014. Spreads (about 7% of consolidated sales and 10% of operating income) has been Unilever’s Achilles’ heel within this business, with underlying sales falling more than 3% in fiscal 2013 and down a similar level through the first nine months of this year (management didn’t quantify the decline in the fourth quarter but we don’t suspect it materially improved). In December, Unilever disclosed its intentions to separate its developed market spreads business into a standalone segment (which will be 100% owned by the parent company); however, we don't think this will meaningfully change the business’ prospects. Rather, we think this news signals the business is noncore (despite management’s commentary to the contrary) and could eventually lead the firm to cut ties with this flagging segment, in line with recent efforts.

Unilever PLC ADR: Valuation
After reviewing our discounted cash flow model, we're reducing our fair value estimate to $38 from $44, which implies fiscal 2015 price/earnings of 20 times, enterprise value/EBITDA of 13 times, and a free cash flow yield of 5%. The fair value decrease reflects the fact that we’re now incorporating a spot exchange rate of $1.16 per EUR as of Jan. 20 (as opposed to the one-year average rate previously). This will enable us to more appropriately account for the present environment, and our fair value will continue to ebb and flow with spot rate changes. Left unhedged, depreciation in the euro will lower the value of a dollar-denominated investment in the firm's ADRs.

Slowing global demand is taking a toll on Unilever, given its vast geographic footprint (with nearly 60% of sales resulting from emerging markets). And while foreign currency rates turned modestly positive (to the tune of 1.6%) in the fourth quarter of fiscal 2014, we aren't expecting this to materially aid reported sales in fiscal 2015. We forecast sales growth just north of 1% this year. Unilever's underlying performance, which excludes any foreign currency impact, is more indicative of its long-term trajectory, and we expect foreign currency rates will ebb and flow. In addition, while negative foreign currency movements disproportionately weigh on emerging markets, we still expect these regions will outpace more mature markets over the near to medium term, reflecting austerity measures in Europe and high unemployment levels and intense competitive pressures, particularly in mature developed markets. Overall, we think Unilever's grasp of consumer trends and investments related to bringing new products to market and marketing spend will ensure that challenges in emerging markets are ultimately resolved. Longer term we expect annual sales growth will approximate 5%, reflecting the benefits of new products as well as higher prices. The commodity cost environment is more benign than years past, but we don't suspect this will persist longer term, given increasing demand for raw materials in emerging markets. While we're encouraged by the company's commitment to wring additional savings from its cost structure by leveraging its massive scale, we suspect it will continue to reinvest in its business. As a result, our forecast assumes that operating margins approach 16% by 2022, about 150 basis points above fiscal 2014 adjusted operating margins.

United Parcel Service UPS
Analyst Note 01/23/2015 | Keith Schoonmaker, CFA

Wide-moat UPS indicated on Jan. 23 that it anticipates fourth-quarter adjusted EPS to be flat from the prior-year period and full-year adjusted EPS growth to be just 3.9% (on a GAAP basis: $3.28 in 2014 versus $4.61 in 2013). The miss was chiefly due to high peak expenses in the domestic segment, though volume and revenue were in line with management’s expectations. Our take is that UPS simply refused to repeat 2013’s weak holiday service and brought on personnel to ensure this did not recur. Management estimates that inefficiencies led to $200 million of excess cost; while certainly not a positive, we expect this to exert little pull on our DCF-derived fair value estimate.

International missed management targets due to $30 million of nonrecurring expenses and negative currency comparisons, but details were sparse; Supply Chain and Freight performed in line with guidance. The firm took a $670 million mark-to-market aftertax pension charge (noncash) and recent contract ratification resulted in recognition of $22 million aftertax charges related to a transfer of health-care liabilities to multi-employer plans. Excluding these, UPS anticipates $1.25 quarterly diluted EPS (flat to the year-ago quarter).

Management expects 2015 EPS growth to be offset somewhat by pension and currency headwinds to below the stated 9%-13% long-term target. UPS will counter uncertain e-commerce demand timing using yield management more assertively in peak season (especially ground residential and SurePost), and we note dimensional pricing goes into effect on smaller non-Sure Post) parcels this year. FedEx also implements dim pricing on small parcels this year, and took the time today to helpfully reaffirm its fiscal 2015 EPS guidance of $8.50-$9 (30% over fiscal 2014 at the midpoint). Both firms need to get paid for accomplishing the incredible; it seems in 2014, UPS still did not meet this goal in line with its expectations. Truth be told, we're always a bit surprised when UPS stumbles.


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