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
GE, J&J, Philip Morris Report Q2 Results -- The Week in Dividends, 2014-07-18

Despite geopolitical turmoil and tragedy, corporate earnings retained the spotlight on Wall Street, which kept stock prices close to all-time highs. Among our portfolio holdings, three companies reported results this week, two of which I regard as buys.

* Johnson & Johnson JNJ weighed in on Tuesday with impressive growth for its pharmaceutical business. However, the device and consumer businesses lagged well behind, and while overall second-quarter results beat consensus expectations, management's full-year outlook implies less business momentum going into the second half of 2014. The stock dropped 3.1% for the week but remains slightly above our reaffirmed $99 fair value estimate. I plan to continue holding the Builder's position but would consider the stock a buy again at or below $99.

* Philip Morris International PM reported results on Thursday that were roughly consistent with the information provided at the company's analyst meetings on June 26-27. Management still sees operating, currency-neutral earnings per share growth between 6% and 8% this year, and the stock finished the week with a gain in line with the overall market. However, relative to recent trends, there were positive signs in many of the company's operating regions. Moreover, the underlying strength of Philip Morris' financial model was on display as well: Volumes shrank 2.7%, but excluding currency and other one-off items, net revenue grew 4.5%, core operating profits advanced 9.5%, and earnings per share improved a whopping 20.0%.

This impressive performance is unlikely to be repeated in the second half of 2014 as year-over-year comparisons become more difficult, but in general the quarter's results reaffirmed our thesis for the stock as well as our $90 fair value estimate. Philip Morris is my top buy recommendation at its current price.

* General Electric GE wrapped up the week's earnings reports on Friday with second-quarter results that were in-line with market expectations. However, the backlog for the industrial business advanced only slightly from the previous quarter, and the stock slipped a bit on Friday despite the market's broad rally.

What I found most interesting is the accelerating shift in the mix of GE's profits. Between the pending acquisition of Alstom's power business, the planned split-off of the Synchrony consumer finance operation, and other strategies that are now in place, GE now expects 75% of total earnings in 2016 to come from its industrial business. This represents a dramatic swing from the years leading up to the financial crisis, in which financial services accounted for more than 50% of overall profits. Of course, GE is a gigantic enterprise, and a shift of this magnitude necessarily takes years--perhaps too many years for Wall Street to appreciate properly. But since we can be paid a 3.3% dividend yield to wait, GE is my second-best buy idea after Philip Morris right now; we reaffirmed our fair value estimate at $29.

Earnings season has only just begun. Next week I expect 9 DividendInvestor portfolio holdings to release second-quarter results, followed by another 12 during the week of July 28.

The only other development of note this week comes from the domestic tobacco industry, where the long-rumored merger of number-three Lorillard LO into number-two Reynolds American RAI has finally been struck. In addition, Reynolds plans to sell the assets of the combined entity that it doesn't want (including, surprisingly, Lorillard's blu e-cigarette business) to U.K.-based Imperial Tobacco ITYBY.

Our portfolios don't have any direct stake in this merger. I've long avoided Reynolds for its weak overall market share trends and Lorillard for its dependence on mentholated cigarettes, which are at risk of additional regulation (or possibly an outright ban). But any change in the landscape has to affect industry leader Altria Group MO, and from the standpoint of an Altria shareholder, my sense is that the Reynolds-Lorillard tie up is a net positive. First, the domestic industry is shrinking from five meaningful players (including Imperial and tiny Vector Group VGR) to four. Second, while Imperial will get a lot bigger, it is buying brands with entrenched declines in market share--most likely it will milk them for cash just as Reynolds did. Third, Reynolds isn't changing its generous dividend policy, but it is taking on additional debt--affirming my view that a price war is unlikely because it is unaffordable. Fourth, while Reynolds will retain Vuse, its internally-developed e-cigarette product, the merger on the whole represents a double-down bet on traditional tobacco products--and that in turn may suggest that the e-cigarette phenomenon isn't living up to the hype.

Altria shares fell this week in sympathy with (but not nearly as much as) Lorillard and Reynolds as the merger terms apparently didn't meet investors' fevered expectations. Despite this, Altria still looks a bit overvalued, closing Friday at an 8% premium to our $39 fair value estimate. I plan to continue holding the stock in the Harvest.

Separately, after digesting second-quarter results from Builder holding Wells Fargo WFC, we raised our fair value estimate by $1 to $50 a share. I'd like to raise the Builder's stake in Wells if offered the opportunity--especially if the stock fell into the $46-$47 area, at which point it would yield more than 3%.

Best regards,

Josh Peters, CFA
Director of Equity-Income Strategy
Editor, Morningstar DividendInvestor

Disclosure: I own the following stocks in my personal portfolio: AEP, APU, CLX, CVX, EMR, GE, GIS, GSK, HCN, JNJ, KO, KRFT, MCD, MMP, NGG, O, PAYX, PEG, PG, PM, RCI, RDS.B, SE, SEP, SO, UL, UPS, WFC, XEL.

News and Research for Builder and Harvest Portfolio Holdings

Reynolds-Lorillard Synergies Cloudy, but Imperial's Purchase of Blu is an Unexpected Positive
Industry Note 07/15/2014 | Philip Gorham, CFA, FRM

We are raising our fair value estimate for Lorillard to $69 per share after the announcement that it is to be acquired by Reynolds American at that price. In connection with the deal, Imperial Tobacco will acquire cigarette and electronic cigarette assets from the combined Reynolds-Lorillard entity for $7.1 billion. Strategically, we believe this is a sound move, although at 12 times EBITDA, Reynolds has paid a full price to grab Newport, one of the crown jewels of the U.S. tobacco industry. We are maintaining our narrow moat rating for Reynolds at this time, but may consider revising it as we think this deal significantly improves Reynolds' competitive positioning. The deal is also transformative for Imperial Tobacco, and although we will review the assumptions in our model, we doubt the deal will have a material impact on our valuation. British American will retain its 42% holding of Reynolds by providing $4.7 billion of funding for the deal, an investment we do not expect to move the needle on our fair value estimate.

The deal values Lorillard at $27.4 billion, or 12 times 2013 EBITDA, although given that we believe Reynolds stock, which will make up 27% of the funding, is currently 50% overvalued, we estimate the underlying valuation to be 11.2 times EBITDA. The headline valuation is in line with historical deals in mature tobacco markets, which have averaged 12.5 times since Imperial acquired Reemstma for 12.7 times EBITDA in 2002, and we think it represents solid value for Lorillard shareholders. Although we are skeptical that the use of menthol will be banned by the U.S. Food and Drug Administration, and view the menthol risk factor as minimal, the risk still exists and we believe this valuation prices Lorillard at a level that overlooks that risk.

For Reynolds, this is a strong strategic move, in our opinion. Around 90% of the firm's cigarette portfolio will now consist of Pall Mall, Camel, and Newport, with the remaining 10% taken up by smaller brands such as American Spirit and Doral. Imperial Tobacco will purchase the Kool, Salem, Winston, and Maverick brands, and will become the third-largest player in the U.S. industry, with a share of about 10%. While we expect regulators to take a close look at the deal, we think the announced divestitures will be sufficient to allow the deal to pass, particularly as we estimate Reynolds' market share will increase only by around 7% to 36%.

Management estimated synergies in the deal of $800 million over two years, above our $400 million-$500 million estimate. We are skeptical that the combined Reynolds-Lorillard company can achieve this, though, since Lorillard's 2013 selling, general, and administrative expenses were only $709 million in total, and we estimate total noninput costs amount to little more than $1 billion.

The biggest surprise in today's announcement, in our opinion, was the acquisition by Imperial of Lorillard's Blu e-cig business. Blu is the market leader in the U.S., with a share of around 50% of the market in convenience stores, and has established intellectual property in a fast-emerging category in which customers are still in trial mode. We regard this acquisition as a positive for Imperial, which we believe lagged competitors in establishing a footprint in e-cigs, but we believe Blu was the sweetener to persuade Imperial to take the cigarette brands Reynolds wanted to dispose of rather than one of its marquee brands Camel or Pall Mall.

While we believe the acquisition of Blu is a positive for Imperial, we are also impressed that the firm is assuming the infrastructure of Lorillard, which will give it a much stronger presence in the U.S. However, the brands it is acquiring are third-tier and lack the brand loyalty and pricing power of leaders Marlboro (Altria) and Newport (Reynolds-Lorillard) and even second-tier brands such as Camel and Pall Mall. Although, at an EBITDA multiple of less than 9 times, we believe the firm has picked up these brands at an attractive valuation, we suspect Imperial will be the clear price taker and that the U.S. industry will operate more as a duopoly. We recommend long-term investors take long positions in the tobacco names with the strongest competitive advantages, including Philip Morris International, which is currently trading at a modest discount to our fair value estimate.

General Electric GE
Analyst Note 07/18/2014 | Daniel Holland  

General Electric delivered operating earnings of $0.39 per share, up nearly 10% from the prior year. The company’s performance in the quarter was on pace with our expectations for the firm and does not alter our wide economic moat rating. The company’s year-over-year organic growth rate of 8% and order growth rate of 4% reflect healthy growth in the core business. The diversity of GE’s industrial businesses helped stabilize overall growth as strength in the power and aviation businesses offset tepid demand in the U.S. health-care markets. Consolidated industrial operating margins improved 20 basis points versus the prior year. Our current financial forecast is predicated on continued improvement in operating margins due to overhead cost reductions and integration of recent acquisitions in the oil and gas and aviation segments. We reiterate our $29 fair value estimate.

The quarter’s result was overshadowed somewhat by updates on portfolio moves by the company regarding Synchrony and Alstom. GE expects to formally spin off Synchrony by the end of July, though the company will retain an 85% stake in the business. As previously indicated, all of the proceeds from the initial spin will be reinvested in Synchrony, giving the company resources to begin to operate as an independent organization. GE received signed approvals from the French government and the Alstom board of directors to proceed with its acquisition of Alstom’s power assets and controlling interest in three additional joint ventures in nuclear energy, renewable energy, and grid infrastructure. The deal is expected to close in mid-2015. Both the Alstom and Synchrony transactions are consistent with GE’s longer-term strategy of increasing the exposure to industrial businesses in the overall earnings mix. The company is now targeting 75% of earnings from industrials by 2016, a stark contrast to the prerecession earnings mix.

Johnson & Johnson JNJ
Analyst Note 07/15/2014 | Damien Conover, CFA

Johnson & Johnson reported strong second-quarter results that exceeded both our and consensus expectations largely because of stronger-than-expected pharmaceutical sales. In particular, sales of hepatitis C drug Olysio significantly outperformed expectations. Despite the strong quarter, we do not plan to change our $99 fair value estimate, as Gilead and AbbVie are set to launch new competitive hepatitis C drugs by the end of the year, diminishing the strength of J&J's competitive positioning in that disease. Nevertheless, the overall strength in the high-margin pharmaceutical division continues to support our wide moat rating on the company.

In the pharma segment, total sales increased 21% year over year, boosted by Olysio as well as several strong product launches. While we expect this growth will moderate in 2015 as competition arrives, J&J is still in the launch phase for several new potential blockbusters, including diabetes drug Invokana, cardiovascular drug Xarelto, and cancer drug Imbruvica. Further, J&J's near-term patent losses involve complex injectable drugs (Invega Sustenna and Risperdal Consta for neuroscience indications) as well as a biologic (Remicade for immunology disease), which lead us to project smaller market share losses to generic competition relative to typical generic competition.

J&J's device division continues to struggle (up 1% year over year) while the consumer group is rebounding (up 4% year over year) from manufacturing issues. We believe continued low medical utilization is weighing on the medical device segment as higher cost sharing with patients seems to have slowed the typical rebound in health-care spending coming out of a recession. While we expect minor improvement in growth for the medical device segment, we expect the structural change of increased cost sharing and more price-sensitive payers is likely to lead to long-term growth of 3%.

Philip Morris International PM
Analyst Note 07/17/2014 | Philip Gorham, CFA, FRM  

Philip Morris International reported second-quarter results that beat consensus estimates both on the top and the bottom lines, and the report contained several positives that suggest our investment thesis and wide moat rating remain intact. We are reiterating our $90 fair value estimate. Despite the transformative transactions announced in the industry this week, we continue to regard Philip Morris International as the pick of the tobacco group both on long-term competitive positioning and valuation. Turnarounds in Europe and Asia are the upside catalysts to the stock, in our opinion, and while there is still work to do on both fronts, particularly in Indonesia, second-quarter results showed some green shoots of improvement.

Europe and Asia are two of the most important geographies for Philip Morris, and both regions reported a strong performance in the second quarter. Organic revenue in the European Union, which is likely to be a critical driver of the turnaround in business performance, grew 2.7%, with contributions from both volume and pricing. Although top-line growth remains slightly below our long-term assumption of 3.0%, it is a significant improvement from the 0.4% decline in organic revenue in the first quarter and could be a sign that some of the troubled Southern European markets are finally stabilizing. We see mixed read-throughs for Imperial Tobacco's European business from management's commentary. In Spain, where Imperial is the market leader, the total market declined 1.2%, a sequential improvement from the 3.6% decline in the first quarter. On the other hand, management cited slower trading out of cigarettes and into roll-your-own tobacco, a category in which Imperial also leads, as a contributor to the improving volume performance in the EU.

Although the company's Asia segment is far from out of the woods, there were some encouraging signs in the second quarter. We regard Asia as a long-term growth driver, and a recovery is important to our investment thesis. However, organic revenue in the region fell 3.6%, driven by a tax increase in Japan on April 1. We expect Japan to remain a drag on results for the next three quarters as Philip Morris' price increases along with the tax hike were muted.

On a more positive note, the market in Indonesia increased 4.9%, rebounding strongly from a 1.0% decline in the first quarter, and Philip Morris' volume increased 1.3%. However, the firm's market share fell by a further 1.2 percentage points, as the kretek category continued to take share of the overall market. Indonesia is Philip Morris' single-largest market by volume and had been a key driver of its strong financial performance until 2012. With a strong distribution platform (the firm remains the market leader in Indonesia with a 34.9% share, although the local players are close behind), we believe Philip Morris has a wide economic moat in the Indonesian market, and we anticipate it will use its platform to respond to the shift in tastes and preferences by taking steps to further penetrate the kretek category.

With the exception of Indonesia, we regard Philip Morris' operational problems--namely a strong U.S. dollar, macroeconomic weakness in parts of Europe, and predatory pricing practices by a competitor in the Philippines--as mostly temporary in nature. We still regard the firm as the best-positioned business in the global tobacco industry, as we believe it possesses a wide economic moat through a cost advantage over local manufacturers and strong brand loyalty to Marlboro in developed markets. For investors who can accept the risk of the spread of plain packs, we continue to recommend building a position when the stock trades at an attractive discount to our fair value estimate.

Philip Morris: Valuation
After a strong second quarter that slightly surprised on the upside, we are maintaining our $90 fair value estimate for Philip Morris. Our valuation implies a 2015 P/E multiple of 17.5 times and a 2015 EV/EBITDA multiple of 12.0 times. It also implies a 2015 dividend yield of 4.3%, which is around the middle of the pack for the international tobacco manufacturers.

Our fair value estimate is based on three key valuation drivers: volume, pricing, and margins. We have lowered our 2014 estimates slightly to account for the strengthening U.S. dollar, and now expect revenue to fall by 5.2% and operating income by 9.9% this year. We forecast a fairly solid rebound in 2015 (assuming no further currency impact) with revenue growth of 4.3%. We hold revenue growth in the midsingle digits throughout our five-year explicit forecast period, but we assume 4% top-line growth in our final year of 2018 as this is a more realistic balance of pricing and volume in the long term. Our revenue assumptions are driven primarily by pricing, as global volumes continue to decline, albeit slower than the 3% drop in 2013. As Europe recovers, we expect the European Union to provide the greatest revenue growth from price increases (6% per year), alongside Eastern Europe, the Middle East, and Africa, where we expect trading up to accelerate with the recovery.

We believe the 2013 gross margin of 66.7% is a fair assumption for the long term. Revenue growth is being driven by pricing, not volume, so the procurement advantage of growing scale is limited. In the absence of acquisitions, and given that raw tobacco prices are fairly stable, we see little opportunity for Philip Morris to expand its gross margin on a sustained basis. However, we do believe there is an opportunity at the operating margin for greater profitability. We forecast Philip Morris' operating margin to grow by 40 basis points over the 2013 margin of 44.2% (and 20 basis points above its 2012 peak of 44.4%), mainly driven by cost leverage from pricing, but also because we believe there is some operational fat to trim. This is a key variable in our scenario analysis.

Despite higher costs of borrowing in the later years in our forecast period, we model an average of 8.1% EPS growth (after a 4.3% drop this year on currency) driven by earnings growth and share buybacks in roughly equal measure. We make similar assumptions for dividend growth, with an average 8.3% growth rate over our five-year forecast period.

Wells Fargo & Company WFC
Valuation 07/14/2014 | Jim Sinegal

We are raising our fair value estimate to $50 per share, up $1 since our last update owing primarily to the time value of money, offset by a decrease in our near-term net interest margin estimates. Our fair value estimate represents 1.6 times book value per share as of June 30 and 12 times our 2015 earnings per share estimate. In our base-case scenario, we expect the net interest margin to average 3.4% by our calculation over the next five years. The valuation is quite sensitive to this parameter, which has varied by more than 2 percentage points over the last 10 years. We expect the bank's efficiency ratio to fall gradually to 52% by the end of our forecast period, as operating costs are reduced and mortgage-related expenses taper off. We expect net charge-offs to average just under 0.6% of loans in the long run. All in, we foresee a long-run return on average assets of 1.6%, at the top end of the company's current goal. We use a 10% cost of equity for the bank, reflecting its relatively stable operating results.


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