Another pair of dividend increases graced our portfolio this week, courtesy of Builder holding Clorox CLX and Harvest holding National Grid NGG. Clorox surprised me on the upside, raising its quarterly dividend by 10.9% to $0.71 a share. I had no doubt that our pay would grow; Clorox has now raised its annual dividend payments in each of the last 37 years. With per-share earnings on track to grow only about 5% in the fiscal year that will end in June, I was looking for a hike more on the order of 6.3%. However, there's no reason that Clorox--whose free cash flow often exceeds reported profits--can't support a payout ratio in the 60% range. I read this hefty hike as a signal of (1) management's determination to reward shareholders through dividends and (2) the likelihood of faster per-share earnings growth in the years ahead.

National Grid's story is a bit more complicated. The final dividend for its 2012/2013 fiscal year, which will be paid in August, rose 4% in local currency. However, the company declined to give a firm target for dividend growth in the year ahead, as it has done in the past. Instead, management reaffirmed its commitment to dividend growth exceeding the U.K. Retail Price Index (a measure of inflation comparable to our Consumer Price Index). The interim dividend (payable in January 2014) will stay flat with the January 2013 payment, and it looks like National Grid will wait until this time next year for the next dividend increase--presumably to see how fast inflation runs.

Two other modestly negative factors will affect our dividend from National Grid. The first is the decline of the British pound relative to the dollar: Although the August dividend will be up 4% year-over-year, this growth will be offset by the falling pound. Furthermore, National Grid will now allow the administrator for its American Depository Receipts to collect a fee out of our dividend income. This cost is not unusual--a fee is deducted out of the dividends we receive from Vodafone Group VOD--but it hasn't been clipped from National Grid's dividends in the past. (It looks like the ADR administrator, Bank of New York Mellon BK, decided it wasn't making enough money by creating and redeeming National Grid's ADRs and so sought permission to charge shareholders for merely collecting dividends.) Whatever the rationale, this will trim another $0.02 an ADR from the fiscal year's final dividend payable in August. If the fee levied on our Vodafone dividends is any indication, another $0.01 an ADR will be taken out of the smaller interim dividends paid in January.

I'm not exactly thrilled with these details. Based on where RPI inflation has been running, I figure next year's dividend increase will be about 3%, but I'd rather have a firm target. I'm even more annoyed by the imposition of fees on our dividends, though I am optimistic that exchange rates will recover once the British economy firms up. However, these are issues that I'm willing to put up with. I've incorporated the exchange-rate effects and new dividend fees in my calculation of National Grid's dividend rate (now $3.08 an ADR), but the ADRs still yield close to 5%. Even if the dividend is unlikely to grow as fast as it has in the past, the successful conclusion for its U.K. rate cases means that National Grid now has eight years of clarity that includes the ability to pass inflation through to customers and keep the dividend flat or rising in real terms. That's not a bad deal, particularly in this environment.

Separately, we also got a bit of good news from the Kinder Morgan family. Based on the expected benefits of Kinder Morgan Energy Partners' KMP acquisition of Copano Energy, KMP raised its 2013 distribution target to $5.33 a unit, up $0.05 from its previous goal, while general partner Kinder Morgan Inc. KMI lifted its 2013 dividend target to $1.60 a share, up $0.03. The challenges of Kinder Morgan's immense size are considerable, and growth will eventually slow, but I have to admire the ability of Rich Kinder and his team to find new ways of keeping our pay on the rise without losing focus or taking too much risk.

The only other news on the dividend front involves Vodafone, which will receive $3.15 billion in June from its 45% stake in Verizon Wireless. Only two weeks ago, Verizon Communications VZ CEO Lowell McAdam floated the idea that Verizon Wireless might not make any distributions to its two owners at all this year: an empty threat that investors rightly ignored. Vodafone has said--credibly, in our view--that it can pay its current dividend without receiving any cash from Verizon Wireless. Verizon, on the other hand, cannot.

Vodafone is scheduled to report results for its 2012/2013 fiscal year on Tuesday. I assume that the year's final dividend will include a 7% year-over-year increase, but the key issue for us will be the rate of dividend growth going forward--this has been the last fiscal year of Vodafone's 7% dividend growth target. Now that the dividend most likely accounts for about 90% of the free cash flow Vodafone collects from its other businesses, I expect a lower rate of dividend growth for a while. I'm also prepared for the possibility that Vodafone might opt to hold its dividend flat until economic conditions improve in Europe. If that happens, I would be at least a little less enthusiastic about holding the stock. However, I think management is strongly disposed to continue raising its dividend when circumstances permit, and I would not want Vodafone to start relying on Verizon's fickle generosity to raise its dividend further. So while next week's report stands to be an interesting one, I don't think a temporary halt in dividend growth alone would lead me to consider selling.

In the past week we published three increases to fair value estimates for our portfolio holdings. Late last Friday, after my weekly update was released, our fair value for top Harvest holding Magellan Midstream Partners MMP rose $2 to $47 a unit on the likely benefits of its Bridgetex joint venture and a recent acquisition. Magellan still looks a bit overpriced right now, but with double-digit distribution growth lining up for several more years, I'm very comfortable leaving the Harvest's hefty position as-is.

A smaller ($1 a share) increase took effect for fellow Harvest holding Public Service Enterprise Group PEG on a combination of the time value of money--the natural drift upward of our fair value estimates as cash flows are realized in line with our forecast--as well as higher commodity prices. We now think PSEG shares are worth $34 apiece, not far below their current price.

Over in the Builder, our single largest position received a fairly large boost. After updating our forecasts nine months into General Mills' GIS fiscal year, we now value the shares at $48 each, up $7 a share. Although I paid only $38.53 a share when buying the Builder's first 200 shares on June 22, 2012 and the stock price has rallied 30.7% in just 11 months, we've also had the benefit of two dividend increases totaling 24.6% (8.2% announced on June 26, 2012 and 15.2% on March 12, 2013) to help justify the move north. I remain a big fan of General Mills and its potential to continue providing long-term dividend growth averaging 7%-9% a year. While our new Dividend Buy price shakes out at $45.60 (up from $39), this is a stock I have no trouble calling a buy all the way up to our new fair value estimate.

One final note: The June 2013 issue of DividendInvestor has been released to our website; you can download the issue by clicking here. In addition to profiles of Air Products & Chemicals APD, AT&T T, Microsoft MSFT, Nestle NSRGY and Spectra Energy SE, I offer a few thoughts about the temptation to sell our stocks at what may seem like lofty prices. Given the lack of appealing alternatives, I feel no temptation to make sweeping changes to our portfolios right now. Capital gains are bound to come and go, but a large and growing dividend is a gift that should keep on giving. That being said, I am considering a few small trades that could come as early as next week, so stay tuned.

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, BMR, CLX, CVX, EMR, GE, GIS, INTC, KMI, KMR, KRFT, MCD, MMP, NGG, O, PAYX, PBCT, PEG, PM, RDS.B, SE, SYY, UPS, VOD, WFC.

News and Research for Builder and Harvest Portfolio Holdings

Utilities Building Competitive Advantages in Transmission and Generation Fleet Diversity
Industry Note 05-15-2013 | Travis Miller

At the Electric Power Conference that we attended in Rosemont, Ill., regulators and utilities executives highlighted the critical role that gas and electric transmission systems and generation fuel diversity will play as utilities adapt to low natural gas prices, renewable energy, and environmental regulations. We think transmission and generation fleet diversity are key sources of competitive advantage for utilities today.

These issues are most acute in the Northeast, as low gas prices drive oil-to-gas residential heating conversions and increasing gas-powered generation. The region's gas supply constraints could force gas curtailments during harsh winters. We think Northeast Utilities NU and National Grid NGG are best positioned to benefit from more gas demand and power transmission needs in the Northeast. We forecast 8% earnings growth for Northeast Utilities and 4% earnings growth for National Grid during the next five years based on expanding customer bases and several billion dollars of individual and joint transmission investments. We give both companies narrow moats and stable moat trends.

Fleet diversity and flexibility also are key. We think Public Service Enterprise Group PEG and NRG Energy NRG have the best-positioned fleets to benefit from volatile markets and respond to changing public policy. Both have fleets that include low-cost coal and nuclear generation, high-efficiency natural gas plants, peakers, and renewables in the tight Northeast and Texas markets. We give PSEG a narrow moat and positive moat trend because it also has $5 billion of planned high-return transmission investment during the next five years to address electricity constraints in northern New Jersey.

Regulators and executives also highlighted the Midwest region as an area in need of transmission investment as low gas prices and environmental regulations force coal plant retirements. We assign ITC Holdings ITC a wide moat based on its dominant transmission presence in the Midwest. We forecast 12% annual earnings growth the next five years on a stand-alone basis, given the growth opportunities the company has to support renewable energy development and the shift away from coal generation.

American Electric Power AEP
Analyst Note 05-15-2013 | Andrew Bischof

As part of the Electric Power Conference we attended in Rosemont, Ill., on Tuesday, American Electric Power generation executive vice president Mark McCullough gave a presentation highlighting the shifting nature of AEP's generation portfolio, in which coal currently accounts for 66% of generation capacity but could fall to 50% by 2020. McCullough also highlighted the need for generation flexibility amid low natural gas prices.

Overall generation from the company's natural gas fleet fell 34% in the first quarter from the year-ago quarter, while coal generation notched a 9% gain. In the first quarter of 2013, the average natural gas price was $3.49 per thousand cubic feet compared with $2.45/mcf in the year-ago quarter, highlighting the sensitivity of AEP's generation mix to changes in natural gas prices. AEP expects long-term natural gas prices to remain between $4 and $6/mcf. We are reaffirming our $48 fair value estimate, narrow moat, and stable moat trend.

McCullough stressed the complications of incorporating renewables into its generation portfolio, which provide an intermittent generation source often requiring backup generation (usually natural gas) to support grid reliability. Significant transmission investments are also needed to transmit energy from rural generation facilities, which we believe is an attractive growth opportunity for AEP. Transmission investments are generally provided forward-looking rate treatment and higher allowed returns on equity. AEP plans to increase transmission assets to $2.8 billion by 2015, from $700 million at year-end 2012.

General Mills GIS
Investment Thesis 05-14-2013 | Erin Lash, CFA

Intense competition and erratic changes in commodity prices have weighed on the performance of firms across the industry. Further, because consumers have balked at the higher prices packaged food firms have sought to charge, volumes throughout the space have come under pressure. We don't expect an immediate reversal in these headwinds, but we believe that with a portfolio of market-leading brands and an expansive global distribution network, General Mills should continue generating solid cash flows over the longer term.

General Mills manufactures and markets cereals and other convenience foods (such as baking items, snack foods, vegetables, soups, ice cream, and yogurt) across the world. In our opinion, the firm has garnered leading market share in many categories by continuously investing in product innovation and marketing for its core brands. For example, after rolling out several product line extensions, Pillsbury now controls nearly 70% of the refrigerated baked goods category, while Cheerios is the number-one ready-to-eat cereal franchise, accounting for 13% of the category's sales. We believe General Mills should continue to enhance its market share position as new products seek to take advantage of emerging consumer trends, such as health and wellness, with launches that include Nature Valley Protein Bars, Fiber One Nutty Clusters, and new varieties of Yoplait Light yogurt (which is being endorsed by Weight Watchers). While we've been encouraged by General Mills' brand investments, total marketing spending has been weighed toward in-store promotional support over the last several quarters. We understand that this spending is essential as it brings a rash of new products to market, but we hope that this trend reverses before long. From our perspective, promotional spending is not a sustainable or profitable long-term strategy, and we'd prefer to see General Mills invest behind the advertising support of its brands.

We are impressed by the international distribution network the firm is developing. For more than two decades, through its Cereal Partners Worldwide joint venture, General Mills, along with Nestle NSRGY, has expanded into more than 130 countries, including 35 key developing and emerging markets, such as China and Eastern Europe. Additionally, General Mills sells its Haagen-Dazs ice cream brand in at least 60 markets, and Nature Valley bars are sold in nearly 80 markets. We contend that the firm should be able to leverage this platform to expand the distribution of other leading brands. In addition, General Mills has been actively putting its excess cash to use with the acquisition of a stake in the international Yoplait brand a few years back, which was followed by the acquisition of Yoki (a privately held Brazilian foodmaker whose portfolio of products spans the snack, seasoning, and convenient-meal aisles). From our perspective, acquiring local firms or taking part in joint ventures with native companies that understand the domestic market helps to minimize the risk inherent in international expansion, and we wouldn't be surprised to see the firm pursue similar agreements as it looks to build out its operations around the world.

However, General Mills has its share of challenges, namely persistent cost pressures and soft consumer spending. For instance, after incurring mid-single-digit cost inflation in fiscal 2011 (for commodities such as energy, dairy, and grains) followed by 10% inflation in fiscal 2012, the company expects 2%-3% higher costs in fiscal 2013. Despite this more muted forecast, unfavorable weather conditions in the U.S. and Russia weighed on raw material prices last year, and as such, commodity costs could continue to hinder profitability into fiscal 2014. Further, offsetting cost pressures with higher prices may continue to constrain sales volume growth, if consumers balk at these higher prices--particularly in places where unemployment remains stubbornly high and austerity measures are constraining discretionary spending. As a result, we think a focus on improving efficiency will be crucial. In light of these pressures, General Mills plans to eliminate 850 positions from its global workforce (roughly 2% of its total employee base), in an effort to further improve its cost structure. Despite these challenges, from our perspective, its portfolio of market-leading brands and its intense focus on driving costs out of the business should ensure the packaged food firm navigates the challenging environment relatively unscathed.

General Mills: Valuation
After reviewing General Mills' results through the first nine months of fiscal 2013, we're bumping up our fair value estimate to $48 per share from $41, which implies fiscal 2014 price/adjusted earnings of 17 times, enterprise value/EBITDA of 11 times, and a free cash flow yield of 5.7%. Recent acquisitions (including Yoki and Yoplait Canada) help near-term results. However, volume weakness, as well as aggressive competition, is taking a toll on firms throughout the industry, and General Mills is no exception. We continue to believe the packaged food firm's expansive global distribution platform, as well as a solid brand portfolio, should ensure it generates solid returns for shareholders longer term. Consumers' response to General Mills' higher prices may hinder volume growth, but we believe investments behind new product launches and increased prices on its products will prop up the firm's sales growth. We forecast 6% sales growth in fiscal 2013 (driven by recent acquisitions), but longer term, average annual revenue growth of about 3%-4% seems more reasonable to us (which is in line with management's long-term forecast for low-single-digit annual sales growth). Unfavorable weather last summer in the U.S. and abroad drove raw material costs higher. Despite this, management expects cost inflation will moderate this year to just 2%-3% (which is down from a 10% increase in fiscal 2012--the highest level the firm experienced in more than three decades). Notably, grain makes up just 5%-10% of its overall purchases. According to management, General Mills hedged the bulk of its exposure for the remainder of this fiscal year, but its costs could obviously increase into fiscal 2014 if drought conditions fail to improve. As such, we forecast operating margins of 16.6% in fiscal 2013 and 16.8% in fiscal 2014 (which are below the firm's five-year average operating margin of 17%). We expect that General Mills' stringent focus on cost management and increased scale in developing markets should enable it to expand margins to 18% by fiscal 2016. Further, we forecast annual average operating income growth of 6.7% and adjusted earnings per share growth of 8.5% over our five-year explicit forecast, which is consistent with the company's mid-single-digit and high-single-digit forecast, respectively.

General Mills: Risk
Despite falling from unprecedented highs, input costs (such as oats, wheat, corn, soybean, and oil) have proven volatile, weighing on General Mills' profitability. The firm is charging higher prices for its products to offset elevated input costs, but this has pressured volume as consumers continue to maintain a tight grip on their purse strings. This volume pressure has been particularly pronounced in the domestic yogurt aisle, where it led on pricing and its competitors failed to follow. As a result, the firm is surgically adjusting prices to ensure that its products remain competitive. Further, with nearly 30% of its consolidated sales generated by international operations, General Mills is exposed to currency rate fluctuation. General Mills generates 22% of its sales from Wal-Mart WMT and 54% from its five largest customers, potentially putting the firm in a vulnerable bargaining position.

Magellan Midstream Partners MMP
Investment Thesis 05-10-2013 | Connie Hsu, CFA

Magellan Midstream Partners is an independent transportation and storage service provider with an attractive asset base that has yielded stable cash flows, returns, and distributions since 2001. Given its record, clear strategic direction, and conservative management, we expect this trend to continue despite declining demand for refined petroleum products. Magellan's asset footprint, fee-based contract structures, and internal growth opportunities should generate cash flow growth in almost any economic scenario.

Magellan's asset positioning is its main competitive advantage, providing extensive reach and proximity to regions of high demand and supply. Its 9,600-mile refined product pipeline is the longest network in the United States, providing access across the Midwest to more than 40% of U.S. refining capacity, while marine storage and inland distribution terminals span the Gulf Coast and Southeast, with major hubs in Cushing and Houston. Magellan's ammonia pipeline runs directly from supply sources in Texas and Oklahoma to serve agricultural demand across the Midwest.

These pipelines and terminals typically secure long-term fee-based contracts, in which customers pay to reserve capacity or ship certain volumes. Rates are often directly regulated by the Federal Energy Regulatory Commission, which dictates annual rate increases based on changes to the fixed goods Producer Price Index (8.6% currently). These contracted annual price adjustments provide inflation protection and allow Magellan to increase profits even with flat to slightly declining volumes for the next several years. Like most master limited partnerships, Magellan does not take title to the products that it transports and stores, so commodity exposure is very limited. It does, however, participate in butane blending and transmix fractionation, which require holding inventory. These activities generate about 15% of Magellan's operating margins each year. The company hedges about 80% of its inventory to mitigate price risk; importantly, Magellan says it does not engage in these activities when the pricing dynamics are not favorable.

This enviable asset profile fosters both steady cash generation and a healthy slate of growth opportunities. In particular, Magellan's central presence in key trading hubs and near Gulf Coast refineries provides ample opportunity for internal growth projects and acquisitions of midstream assets, giving the partnership a slight edge over its peers. From 2009 to 2011, Magellan spent about $1.2 billion on a very attractive set of growth projects and acquisitions that have paid off handily, most notably the BP BP pipelines between Houston and Texas City and Cushing storage facilities.

The expansion outlook is strong as well. Through 2014, the partnership plans to spend $700 million, with 70% of capital going toward crude oil investments and 30% toward refined products. This is a significant deviation from the current asset footprint, which generated 75% of operating margins from refined products in 2012. Major projects include the Longhorn pipeline reversal and conversion to crude service, which will bring crude oil from the Permian Basin to Houston, as well as a pipeline joint venture that will transport condensate to Corpus Christi customers. The Permian crude line is especially promising, as the company has already increased its planned capacity to 225,000 barrels per day from 75,000 due to strong customer demand. Additionally, Magellan continues to build and lease storage at attractive rates, which we think will remain an important growth driver, given our tepid outlook for refined product volume growth. Beyond these projects in the works, Magellan is also monitoring $500 million of potential opportunities, mostly on the crude side.

Magellan's cost of capital is among the lowest in refined products and broader MLPs. While some competitors are following Magellan's example by reducing or eliminating their incentive distribution rights, we still expect its financing costs to remain among the lowest in class. Its conservative balance sheet management and record warrant its high credit ratings, in our view. This could prove a meaningful advantage as organic and acquisitive expansion opportunities continue to arise. Thus, we see solid growth prospects for Magellan as long as the U.S. remains reliant on crude oil.

Magellan operates one of the most simple, straightforward business models in the midstream sector. Its capital structure is free of general partner economic considerations, the company does not participate in any commodities trading/marketing activity that brings commodity price volatility, and management has a consistent set of criteria for capital allocation and balance sheet management. We think this is the ideal combination for an MLP, which exists to provide stable distribution growth for its investors.

Magellan Midstream Partners: Valuation
We are updating our fair value estimate to $47 per unit from $45 to give Magellan credit for the Bridgetex crude pipeline joint venture with Occidental Petroleum and a pending refined products pipeline acquisition. Our fair value estimate implies 2013 price/earnings of 22 times, enterprise value/EBITDA of 16 times, and a free cash flow yield of 4.7%.

In our base case, we assume healthy volume growth of crude, while refined products demand remains flat, based on crude projects coming on line and Energy Information Administration forecasts. With greater pipeline flow from the midcontinent to the Gulf, we're confident that Magellan's plumbing in the East Houston refining complex will see strong utilization and attractive expansion opportunities. Incremental volumes from the oil sands, Eagle Ford, and Permian can only improve its competitive position.

We model generous pipeline tariff rate increases in the new crude segment, as the partnership's new long haul pipelines begin shipping at about $2-3 per barrel for committed capacity and $3.50-$3.68 per barrel for spot volumes, in contrast to the lower short haul rate of $0.31 per barrel that Magellan currently charges to ship from Houston to Texas City. In refined products, we assume rates increase at a slight discount to projected FERC increases (3%-4% annually). 

Capital expenditures of $700 million in 2013 and $320 million in 2014 follow management guidance, and we assume Magellan continues to pursue growth at historical spending rates thereafter. New projects produce returns of 7-8 times EBITDA in the out years of our explicit period, with more attractive returns on current projects with greater visibility, such as the Crane-Houston crude pipeline conversion.

Distributable cash flow over our forecast period increases at a 12.6% compound annual rate, while distributions grow at a 12.5% CAGR from $1.88 in 2012 to $3.34 in 2017. We expect management to use excess cash flow for organic growth, acquisitions, or distribution increases.

Our 7.8% weighted average cost of capital assumes a 10% cost of equity and 5.8% cost of debt. In our terminal value, we use 3% growth in perpetuity. At our fair value estimate of $47 per unit, Magellan's units would yield 4.4% on our 2013 distribution projection. We cross-check our cash flow model with a distribution discount model which values Magellan at $45 per unit, respectively.

Magellan Midstream Partners: Risk
Magellan's greatest risk stems from potential changes in regulations. Pipelines are heavily regulated in terms of the rates that they can charge, environmental guidelines, and the tax-favored status of the MLP form of business. While the partnership has diversified its refined product customer base in recent years, the ammonia pipeline still depends on just three customers. Magellan's refined products and crude oil throughput are also reliant on third-party refineries and pipelines, so any disruption in service (due to turnarounds or weather conditions, for example) could reduce volumes and hence cash flow. Additionally, as with all midstream operators, fires, spills, leaks, and changing regulations can affect operations, profitability, and reputation. Finally, rising interest rates would probably weigh on unit prices of all MLPs at a certain point, though Magellan's cost of debt would remain fairly stable thanks to primarily fixed-rate debt and distant maturities.

McDonald's MCD
Investment Thesis 05-15-2013 | R.J. Hottovy, CFA

McDonald's remains resilient despite an increasingly challenging environment for restaurant operators. Although it's unlikely that the firm duplicates the almost 1,500 basis points of operating margin expansion it posted during the last five years, we are optimistic that it is capable of generating superior returns on invested capital over an extended horizon. Our confidence stems from unrivaled scale advantages, an incredibly strong brand, a cohesive franchisee system, and ample international growth opportunities. Despite a few self-inflected product pipeline and value-menu management missteps during 2012 as well as industry competition that remains fierce, we don't expect McDonald's strong competitive positioning to abate anytime soon and we believe the company possesses the widest economic moat in the restaurant category.

With average trailing-12-month sales of around $2.6 million per restaurant, McDonald's restaurant productivity easily trumps the quick-service restaurant industry average of just over $1 million per location. We attribute this outperformance to a number of factors, including brand strength, convenient restaurant locations, and a consistent customer experience across the globe. Menu innovation also has played a role in McDonald's productivity. During the last several years, the company has introduced a number of new, margin-accretive products, such as McWraps and premium burgers. We also have been impressed by the firm's beverage initiatives, including the McCafe specialty coffee menu and real fruit smoothies. Management has acknowledged a few executional issues with its product pipeline during 2012, but we believe that the menu innovation efforts appear more robust in 2013 with several new products across multiple dayparts, menu categories, and pricing tiers. In the U.S., this includes an expanded U.S. launch of the McWrap (a larger variation of the successful snack wrap product), new breakfast products (including the Egg White Delight McMuffin and Steak and Egg Burrito), a wider assortment of Quarter Pounder varieties, as well as new chicken entree and beverage product launches later in the year. Additionally, exterior and interior restaurant decor upgrades, more-efficient kitchens and drive-thrus, and free wireless Internet access should keep McDonald's ahead of the competition and help attract incremental customer traffic.

As the world's largest restaurant chain in terms of systemwide sales, McDonald's wields tremendous economies of scale relative to its quick-service restaurant peers. The firm can exert a significant amount of bargaining power over its suppliers, many of whom owe their existence to McDonald's, thus ensuring access to food and other raw materials at predictable, competitive prices. The McDonald's brand is also one of strongest in the world, aided by an unrivaled advertising budget of $788 million in 2012.

Another underlying strength is McDonald's cohesive franchisee and affiliate system, which collectively operates more than 80% of the chain. This structure provides the firm an annuitylike stream of rent and royalties even during challenging economic times with minimal corresponding capital needs. As a result, McDonald's generates excellent free cash flow and returns on invested capital in the mid- to high teens. These results are even more impressive when considering that the firm owns 45% of the land for its restaurants (more than $5.6 billion in land assets), meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains.

Despite these competitive advantages, even the best-operated restaurant chains are susceptible to cyclical headwinds, including high unemployment rates and volatile commodity, labor, and occupancy costs. McDonald's also faces broad competition from a number of global quick-service restaurant chains, including Burger King BKW, Subway, and Yum Brands YUM--many of which have recently adopted variations of McDonald's products--as well as fast-casual restaurant competitors like Panera PNRA, Chipotle Mexican Grill CMG, and specialty burger chains like Five Guys and In-N-Out Burger. However, we do not believe McDonald Corp.'s rivals pose enough of a threat to its wide economic moat, and we expect the firm to weather economic pressures more effectively than the competition. In fact, there are indications that McDonald's renewed emphasis on value-menu advertising has been effective in broadly driving traffic across the globe. We believe protecting and growing traffic is key for McDonald's because it will ultimately encourage trade-up and add-on purchases as the global macroeconomic picture improves (and boosting the average transaction size in the process).

McDonald's: Valuation
Our fair value estimate is $105 per share, which implies 2013 price/earnings of 18 times, enterprise value/EBITDA of 11 times, and a free cash flow yield of 4.2%.

Even with persistent global macroeconomic headwinds and increased competitive pressures, we expect the top line to grow approximately 4% during 2013 due to 1%-2% comparable sales growth (owing to modest menu price increases and flattish restaurant traffic) as well as contribution from approximately 1,000 net new restaurants worldwide. We believe U.S. comps will finish the year in low 2% range (compared to three-year historical trend of 4%), as uneven consumer spending patterns are partly countered by a tactical shift to emphasize value menus and a stronger product pipeline. Reimaging efforts, coupled with additional menu developments across all price tiers and daypart expansion should be additive to comps across other regions, though macroeconomic pressures across much of the eurozone and food supplier and quality concerns China could keep comps in check over the near term. Over a longer horizon, we expect mid-single-digit revenue growth for the consolidated company, driven largely by international unit openings and higher traffic and ticket through new menu innovations and inflationary menu price increases.

Although we've adjusted our near-term margin assumptions due to the company's increased emphasis on value, labor cost inflation, and reimaging and throughput capacity technology investments, we believe McDonald's remains one of the better-positioned restaurant chains for operating margin preservation because of its tremendous bargaining clout with suppliers. We expect company-owned restaurant margins to contract 40 basis points this year (compared with 18.1% in 2012) amid elevated and payroll and occupancy costs. However, we expect a more modest contraction in consolidated operating margins in 2013 (forecasting 31.0% compared to 31.2% in 2012) due to a reduction in event-driven SG&A costs. Over the next 10 years, our model assumes operating margins reaching 33%, driven by higher franchisee rent and royalty agreements, greater scale in emerging markets, and increased sales contribution from margin-friendly menu additions. We project ROIC to remain in the high teens over time, well ahead of our 9% cost of capital assumption, providing additional support to our wide moat rating.

McDonald's: Risk
Rivalry among quick-service restaurants appears to be on the rise, with chains increasingly competing with one another on the basis of price and product differentiation. Additionally, a number of U.S.-based specialty hamburger concepts have posted strong growth in recent years, including Five Guys and In-N-Out Burger. If increased competitive threats were to cause a material decline in franchise sales, it would alter McDonald's intrinsic value. Volatile food, energy, and labor costs could affect profitability. Restrictive credit markets could impede franchisees' abilities to add new restaurants, perform renovations, or purchase equipment. McDonald's also faces increasing competition from Yum Brands and other rivals as it expands internationally.

National Grid NGG
Analyst Note 05-17-2013 | Travis Miller

National Grid's adjusted operating profit grew 4% for fiscal 2012-13 and earnings per share grew to GBX 56.10, up 13% adjusted for storms and timing differences. This is in line with our projections, and we are reaffirming our GBX 715 fair value estimate, $53 ADR fair value estimate, narrow moat, and stable moat trend rating. We continue to believe National Grid can increase earnings 4% annually the next four years based on its investment plan and approved customer rate increases.

Driving the earnings growth in 2012-13 were higher customer rates related to a 7% increase in Grid's U.K. regulatory asset value and a 5% increase in its U.S. regulatory asset value. We expect its U.K. earnings base to continue growing at a similar clip as Grid invests GBP 2 billion-3 billion annually in the United Kingdom, in line with its approved regulatory budget.

Management reaffirmed its intent to increase the dividend at least in line with inflation for the foreseeable future, but it did not give any specific growth targets as it's done in the past. It plans to pay a GBX 40.85 per share full-year dividend for 2012-13, a 4% increase from 2011-12. It also said it plans to recommend a GBX 14.49 per share interim dividend for 2013-14, flat with the 2012-13 interim dividend. We expect this means management plans a substantial raise in its full-year 2013-14 dividend payment next year if results are in line with expectations. We forecast full-year dividend growth in line with our 4% earnings growth projection the next few years.

Public Service Enterprise Group PEG
Investment Thesis 05-14-2013 | Travis Miller

Public Service Enterprise Group's even split of earnings between its regulated distribution utility and its wholesale generation fleet gives it an attractive business profile for investors who want a dose of steady cash flows and moderate commodity exposure. A significant improvement in New Jersey utility regulation now offers the utility significant growth opportunities at attractive regulated rates. At the generation unit, PSEG's diverse fleet is showing its competitive advantage as gas and power prices plumb decade-low levels. This makes the stock one of our top utility picks at the right price for long-term investors.

Power market deregulation is critical to PSEG's wholesale generation business. Limited power supply and high demand in the New Jersey and Northeast markets where PSEG operates makes its plants' energy and capacity more valuable than many other utilities' fleets. We don't see this changing for many years.

PSEG has one of the most balanced and diverse generation fleets of any U.S. utility. It has ultra-low-cost nuclear plants, coal plants that benefit when gas prices rise, high-efficiency gas plants that benefit when gas prices fall, and small plants that can run when demand peaks. In the oast decade, PSEG has improved the performance at its three nuclear plants, two of which it owns with world-class operator Exelon EXC. Capacity factors consistently top 90% now, up from 80% before 2004. As a result, returns on capital have nearly doubled.

Short-term power demand and pricing volatility could swing profits, but as long as PSEG remains an efficient operator, the generation business should continue to provide value in any commodity market environment. The company's ability to hedge most of its generation margin through New Jersey's three-year forward power auction and regional capacity markets should help reduce earnings volatility. Furthermore, the company should benefit from tighter federal environmental regulations, given its low-emissions profile.

Regulated earnings have improved because of lower overhead costs and the opportunity to invest billions of dollars in infrastructure upgrades. Regulators have proved tough but fair, as the state embarks on a huge environmental push. Three base-rate increases since 2006 and a chance to earn 10%-12% returns on equity on new projects provide a good foundation for earnings. The most recent rate increase totaling $100 million went into effect in mid-2010 and many of its new growth projects will flow into rates with minimal lag.

Public Service Enterprise Group: Valuation
We are raising our fair value estimate to $34 per share from $33 after updating our forecasts to reflect higher current forward commodity prices and time-value appreciation. We previously incorporated results from the 2013 New Jersey Basic Generation Service Auction conducted in early February that were above our expectations.

Based on current forward power prices and PSEG's hedge position as of March, we expect earnings to hit a trough in 2013 and recover to near $2.50 in 2014 and 2015. Higher earnings at the regulated utility should offset lower earnings at PSEG Power. We continue to drive our midcycle power price assumptions based on a $5.40 per thousand cubic feet midcycle natural gas price and midcycle heat rates 15% above current 2015 forwards. We estimate this could support $2.0 billion EBITDA at PSEG Power, a 66% jump from our 2015 mark-to-market EBITDA estimate.

We expect PSE&G earnings will overtake PSEG Power segment earnings by 2014, up from just 20% of consolidated earnings as recently as 2009. The key earnings growth driver for PSE&G is the $6 billion of investment we assume between 2013 and 2016 in approved transmission and distribution projects. We assume PSE&G recovers $680 million of rate increases during that time period. We do not include the utility's 10-year, $5.4 billion Energy Strong proposal. On a consolidated basis, we think the company can achieve $3.45 earnings per share on a normalized midcycle basis.

We use a 10% cost of equity and 7.8% cost of capital in our discounted cash flow valuation.

Public Service Enterprise Group: Risk
Volatile power markets provide the biggest source of uncertainty in our fair value estimate. New Jersey power prices doubled from 2004 to 2008, then fell more than 50% through mid-2013. If prices stay at 2012 levels through 2014 and beyond, our earnings and fair value estimates could be significantly lower. PSEG's diversified sources of generation revenue--New Jersey's basic service contracts, hedges, open-market sales and capacity payments--as well as dispatch diversification help offset some of that risk. Rising fuel costs and operating costs also provide a source of uncertainty. At the utility, regulatory uncertainty, inflation, and demand shifts are the key risks.

Sysco SYY
Investment Thesis 05-14-2013 | Erin Lash, CFA

Sysco is the leading food-service distributor in the United States and Canada, with about a 17.5% share of this $225 billion market. Although food distribution is generally a low-margin, capital-intensive business, economies of scale have allowed Sysco to post returns on invested capital that have consistently exceeded our estimate of its cost of capital. The firm distributes more than 400,000 traditional food and nonfood products, serving 400,000 customers in various industries, and has expanded into other profitable niche segments, such as health care, education, and lodging. In an effort to solidify customer relationships, Sysco has made it a priority to consult with clients on how they can drive sales and minimize costs (an advantageous undertaking, given that about 80% of its sales are derived from smaller customers). We think its expansive distribution network and extensive product offering afford Sysco a wide economic moat.

Over the past 40-plus years, Sysco has actively participated in the industry's consolidation, completing more than 150 deals, and management's hunger for deals has yet to subside, with acquisitions expected to contribute around 1% of sales growth each year. While smaller local and regional distributors (sales of $10 million-$400 million) remain the most likely prospects, Sysco's openness to pursuing deals outside its home market is in contrast to its stance just a short time back. When we asked CFO Chris Kreidler about this apparent shift in strategy last year, he said that although scale is not possible in Europe the way it is in North America (due to different legal and regulatory environments in each country), the firm is still able to leverage the knowledge and experience it's gained, such as in brand management and customer service. In our view, the biggest challenge related to any deal would result from constraints on personnel rather than financial resources. However, given the firm's preference to complete smaller deals and management's exemplary stewardship of capital, we don't anticipate potential deals to materially affect our fair value.

Despite being a low-cost operator, Sysco is keenly focused on trimming additional fat from its already lean operating structure, by working to improve its supply chain by more efficiently routing deliveries, as well as optimizing its product sourcing and supplier relationships. However, what has been most impressive to us is the pace at which Sysco is rolling out this vast undertaking. The firm has spent more than four years designing and testing these new processes and procedures, and after some performance issues surfaced, Sysco extended the testing phase in order to minimize problems on a broader scale--a wise move, from our perspective. The firm took another step back in the fall of 2012 when additional challenges arose following its first simultaneous launch at two separate facilities. Management still expects the cost savings from this project to amount to around $600 million over the next few years, and we forecast operating margins to improve to 5.3% by fiscal 2017 (up from 5.0% adjusted operating margins in fiscal 2012). In our view, the potential for higher customer retention, the ability to better serve customers, and improved reporting should prop up revenue and limit unnecessary expenses. That said, because the project is still in the very early stages, we don't forecast any meaningful benefit over the near term.

Sysco is not immune to headwinds, including lackluster restaurant traffic and food cost inflation, but some underlying positive trends support our thesis that an expansive distribution network will enable the firm to remain the dominant player in the category, generating strong cash flows and outsize returns for shareholders longer term. Food cost inflation, while still a challenge, remains moderate at just 2%-3%, which is ideal for Sysco. Historically, the company has been able to pass along these higher costs to its customers, but double-digit inflation in categories such as meat and produce makes this pass-through more challenging. And we recognize that unfavorable weather conditions (similar to the drought experienced throughout the U.S. Corn Belt last summer) could once again drive food costs higher. In addition, case volume performance had been trending higher, but the third quarter of fiscal 2013 (historically one of the firm's smallest with regards to sales and profits) was a marked contraction, as underlying case volume fell 0.2%. We anticipate that volume will remain lumpy; however, the fourth fiscal quarter tends to be particularly strong for Sysco in light of Mother's Day--which is usually one of the busiest days for restaurants during the year--and as a result, we expect to garner a better read on the overall economic climate over the coming months.

Sysco: Valuation
After reviewing Sysco's results through the first nine months of fiscal 2013 and the assumptions underlying our discounted cash flow model, we're maintaining our $36 fair value estimate, which implies forward fiscal 2014 price/earnings of 19 times, enterprise value/EBITDA of 10 times, and a free cash flow yield of 5.1%. Given the fragile state of today's consumer, we expect that restaurant traffic and ultimately consumer spending levels could remain lumpy, hindering near-term sales, but that food cost inflation, as well as the firm's string of recent acquisitions, props up sales growth, offsetting the pressures created by soft consumer spending. As a result, we forecast that sales will increase 5.5% in fiscal 2013 compared with the year-ago period. Longer term, we forecast that Sysco will benefit as consumer spending picks up, resulting in just north of 4% annual sales growth through fiscal 2017. Looking out through fiscal 2015, management thinks the firm will expand its underlying business at a 4%-6% rate, which seems reasonable, in our eyes. This assumes that there will be little to no real industry growth and nominal sales growth of 4%-6%.

While the firm's business transformation efforts are taking longer and costing more than its initial plans (similar to other firms that have undertaken such an endeavor), we view the measured pace of the rollout (which should prevent a major service disruption on a larger scale) as a plus. In our view, the constant focus on improving its cost structure will enable Sysco to offset volatile input costs. By fiscal 2017, we forecast operating margins of 5.3% (about 30 basis points above the firm's average operating margin over the past five years). We expect returns on invested capital to average 15% compared with our 8.5% cost of capital assumption during the next five years, providing support to our opinion that Sysco maintains a wide economic moat.

Sysco: Risk
If global economic headwinds persist and food inflation accelerates, Sysco's financial results could be pressured. Furthermore, given that around 60% of sales result from the restaurant industry, the firm depends on the strength of consumer spending, which has been fragile, partly as a result of high unemployment. Because input costs (such as food and fuel) are a significant component of Sysco's cost structure, high commodity costs can also weigh on results. Finally, Sysco's business transformation is taking longer and costing more than its initial plans, similar to others that have undertaken such an effort. While this is far from a positive, we've been encouraged that management is taking a measured approach to the implementation of this initiative, which should ensure that it avoids a major service disruption on a larger scale. As a result, we assign Sysco a medium uncertainty rating.