About the Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.

Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio. Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor.

Peters holds a BA in economics and history from the University of Minnesota Duluth and is a CFA charterholder. He is also the author of a book, The Ultimate Dividend Playbook, which was released by John Wiley & Sons in January 2008.

 
Investment Strategy

Dividends are for everyone regardless of age. The outcome of owning dividend-yielding stocks is the key variable-higher-yielding stocks with safe payouts being less risky while affording investors who don't need current income the ability to reinvest/reallocate the capital.

The goal of the Dividend Select Portfolio is to earn annual returns of 9% - 11% over any three-to-five year rolling time horizon. We further seek to minimize risk, as defined by the probability of a permanent loss of capital. For our portfolio as a whole, this goal is composed of:

3% - 5% current yield
5% - 7% annual income growth

 
 
Mar 30, 2015
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Josh Peters, CFA
Equities Strategist and Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio.
Featured Posts
Heinz Merger Boosts Kraft's Fair Value -- The Week in Dividends, 2015-03-27

Josh is away from his post this week due to family obligations, so once more his loyal stand-in is at the helm. It certainly turned into an interesting week to oversee the Dividend Select Portfolio! On Wednesday, Kraft Foods Group KRFT caused a stir in an otherwise fairly relaxed week in dividends with an announced merger plan with privately-held Heinz. I'm going to leave it to Josh to share his deeper thoughts on the transaction and on what comes next, but Morningstar analyst Erin Lash believes the deal could deepen Kraft's narrow economic moat and lead to a substantial improvement in the profitability of its operations, both material positives for shareholders. We include Lash's full take in our summary below. With that, here's the week in dividends!

Best regards,

Mark Barnett
Equity Analyst, Utilities

Disclosure: I own none of the holdings of the Dividend Select portfolio in my personal accounts.

 


News and Research for Dividend Select Portfolio Holdings

 

Kraft Foods Group KRFT
Analyst Note 03/27/2015 | Erin Lash, CFA

After incorporating the pending merger with Heinz, we've raised our fair value estimate for Kraft to $93 per share, which implies fiscal 2016 price/earnings of 18 times and an enterprise/EBITDA multiple of 12 times. We assume that the deal closes at the end of the third quarter of fiscal 2015, which is in line with management's expectations for a second-half close, and as such, we include one quarter of Heinz's results in our current fiscal-year forecast. Following the transaction, Kraft shareholders are poised to receive a $16.50 per share special dividend and own 49% of the combined firm. Over our 10-year explicit forecast, we anticipate that returns on invested capital will exceed our cost of capital estimate, supporting our take that Kraft maintains a narrow economic moat.

As a result of the firm's focus on investing behind bringing new products to market that resonate with consumers, combined with the potential to extend the distribution of Kraft's brands over Heinz's global distribution network, we forecast that annual sales growth will amount to 3%-4% longer term. Further, Kraft has continued to take a hard look at its cost structure by realigning its U.S. sales organization, consolidating domestic management centers, and streamlining the corporate and business unit organizations, and we think these efforts will be accelerated when it combines with Heinz. The company plans to cut $1.5 billion in costs from its operations, representing 10% of Kraft's annual cost of goods sold and operating expenses. While high, this is likely quite achievable, given the success Heinz has realized--its EBITDA margins soared to 26% in fiscal 2014 from 18% pre-deal in mid-2013. In light of these efforts, we believe the firm is poised to generate operating margins exceeding 21% over our 10-year explicit forecast, well above the midteens its peers tout.

Kraft Foods Group: Investment Thesis  03/26/2015
From our vantage point, Kraft's deal with Heinz stands to boost the competitive positioning of the combined entity (of which Kraft shareholders will maintain a 49% ownership). Kraft-Heinz would leapfrog Coca-Cola to become the third-largest food and beverage firm in North America behind PepsiCo and Nestle, boasting more than $22 billion in sales in 2014 ($29 billion on a consolidated global basis). Further, brand strength would be sound, with eight brands generating more than $1 billion in annual sales and another five garnering $500 million-$1 billion in sales each year.

Despite the opportunity to extend the distribution of Kraft's fare across Heinz's vast global distribution platform (which derives 60% of sales outside North America, including 25% in emerging and developing markets), we suspect a fair amount of brand pruning could also be in the cards, similar to the actions 3G has taken since owning Heinz (which shed Shanghai Long Fong Foods in China and its domestic foodservice dessert business in 2013). For one, we've thought for some time that Jell-O, which continues to falter despite multiple stabs at putting it on more stable ground, could be axed in favor of allocating more capital to faster-growing categories such as organics, or even pursuing a tie-up outside the United States. These actions strike us as likely under new management.

Kraft has continued to take a hard look at its cost structure (by realigning its U.S. sales organization, consolidating domestic management centers, and streamlining the corporate and business unit organizations), and we think these efforts will be accelerated when it combines with Heinz. It plans to cut $1.5 billion in costs from its operations (representing 10% of Kraft's annual cost of goods sold and operating expenses), which while high is likely quite achievable given the success Heinz has realized--its EBITDA margins soared to 26% in fiscal 2014 from 18% pre-deal in mid-2013. As a result of these efforts, we believe the firm is poised to generate operating margins exceeding 21% over our 10-year explicit forecast, well above the midteens its peers tout.

Kraft Foods Group: Economic Moat  03/26/2015
In our view, the planned tie-up with Heinz will enhance Kraft's narrow economic moat, which is derived from the firm's solid brand intangible asset and economies of scale on its home turf. As a combined firm, Kraft-Heinz will leapfrog Coca-Cola to become the third-largest food and beverage firm in North America behind PepsiCo and Nestle, boasting more than $22 billion in sales in 2014 ($29 billion on a consolidated global basis). Kraft's offerings already span the grocery store, but as a merged business, brand strength could prove even sounder, with eight brands generating more than $1 billion in annual sales (including Kraft cheeses, dinners, and dressings; Oscar Mayer meats; and Philadelphia cream cheese, among others) and another five (including Kool-Aid, Capri Sun, and Ore-Ida) garnering $500 million-$1 billion in sales each year. We further believe the enhanced scale afforded by the deal stands to beef up negotiating leverage with retailers that depend on leading brands to drive traffic in their stores. According to management, Kraft products account for 4% to 6% of every American grocery store's sales, highlighting the strength of its brand set. While we intend to revisit the moat as we get a better understanding about the company's brand portfolio going forward, the firm still falls short of a wide economic moat at this time, in our view, because some of the categories in which it competes--like packaged meats and cheeses--have become commodified, as consumers are less willing to pay up for the company's brands. This is a particular challenge given that switching costs are nonexistent in the consumer products industry. However, if the combined organization steers away from these commodified categories, we may raise our rating to wide.

Kraft Foods Group: Valuation  03/26/2015
After incorporating the merger with Heinz, we're raising our fair value estimate to $93 per share, which implies fiscal 2016 price/earnings of 18 times and an enterprise/EBITDA multiple of 12 times. We assume that the deal closes at the end of the third quarter of fiscal 2015, which is in line with management's expectations for the deal to close in the second half of the year, and as such, we include one quarter of Heinz's results in the current fiscal year. Kraft shareholders are poised to receive a $16.50 per share special dividend, as well as own 49% of the combined firm.

Kraft has been challenged as an independent organization, given the ultracompetitive operating environment, combined with rampant cost inflation and soft consumer spending at home, which has been exacerbated by the recent reduction in the federal food-stamp program. However, Kraft's brands had been under invested in by its previous owners, and we think that by expending resources to tout its product set in front of consumers (both in terms of product innovation and marketing support) the firm should realize a decent level of top-line growth. We also surmise that revenue synergies are attainable, as Kraft, the bulk of whose sales come from the United States and Canada, can now sell its fare across Heinz's vast global distribution platform, which derives 60% of sales outside North America, including 25% in emerging and developing markets. As a result, over the longer term we forecast that annual sales growth will amount to 3%-4%, driven by new products and higher prices.

Management further anticipates beefing up the efficiency of its business, similar to the success Heinz has realized--its EBITDA margins soared to 26% in fiscal 2014 from 18% predeal in mid-2013. It plans to do this by cutting $1.5 billion in costs from its operations (representing 10% of Kraft's annual cost of goods sold and operating expenses). Because we think that the company's ability to realize further cost savings should persist for some time, we forecast that operating margins will expand to nearly 20% by fiscal 2017 (200 basis points above fiscal 2014) and to more than 21% by fiscal 2024. Over our 10-year explicit forecast, we anticipate that returns on invested capital will exceed our cost of capital estimate, supporting our take that Kraft maintains a narrow economic moat.

Kraft Foods Group: Risk  03/26/2015
Kraft's planned tie-up with Heinz could encounter a number of pitfalls. The integration could prove more difficult to digest than the firm anticipates, particularly as management attempts to extract a significant amount of costs from the business. Further, attempts to extend the distribution of Kraft's products through Heinz's international network may fall flat with consumers.
Beyond the challenges that could arise as a result of the merger, promotional spending appears to be running rampant throughout the consumer goods space as packaged food firms (both other branded players and lower-priced private-label products) battle to garner more of consumers' reduced discretionary budgets. However, Kraft cites limited participation in this activity, highlighting mac and cheese as well as desserts as areas where it looked to defend its share position over the past few quarters.

In addition, consumers perceive a few of the categories in which Kraft competes--namely cheese and packaged meats--as commodified, meaning they are more likely to consider price rather than brand when making purchase decisions. Further, Kraft generates 26% of its sales from Wal-Mart and 42% from its five largest customers. As such, Kraft's bargaining power also could be diminished, as the base of retail outlets consolidates and market share shifts to mass merchants and warehouse clubs at the expense of traditional grocery stores.

Furthermore, bouts of unfavorable weather, as well as increased demand in emerging markets, could place upward pressure on raw material prices (for products such as dairy, coffee beans, meat, wheat, soybean, nuts, and sugar) longer term. In response to the rampant cost inflation in the cheese, meat, and coffee categories in the recent past, Kraft has put through significantly higher prices. However, the firm has been unable to fully offset the hit to profitability given the lag in the benefit.

Paychex PAYX
Analyst Note 03/25/2015 | Brett Horn

Paychex’s fiscal third-quarter results largely showed a continuation of recent trends. Revenue was up 8% year over year, with growth in ancillary human resources services buoying modest growth in the payroll processing business. The human resources segment was up 19% year over year, or 14% excluding the effect of an accounting change. This strong growth bolsters our opinion that the company has substantial opportunities to cross-sell ancillary services into its core payroll processing customer base. Further, we believe that this shift is not dilutive to the wide moat Paychex has dug in its legacy operations, but rather represents a way for the company to further exploit its competitive advantages.

We think the company's small-business focus plays to its advantage in this respect, as we believe small businesses are more likely to lean on one provider for all of their needs. For the quarter, operating margins came in at 37.5%, compared with 38.5% last year, as growth in employee compensation slightly outstripped top-line growth. Paychex is tracking roughly in line with our expectations for the full year, and we will maintain our fair value estimate.

 

 

 
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