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
Earnings Season, Week 3 -- The Week in Dividends, 2014-10-30

This week's update comes a day early as I'll be traveling tomorrow, though most of the week's earnings reports have already rolled in. I'm pleased to report there has been a lot less drama than we saw last week--perhaps because three of our reports have come from the utility industry.

Though its third-quarter results were otherwise as expected, Harvest holding Southern Company SO took yet another charge for its Kemper County coal gasification project in Mississippi. Already delayed well past expectations, the in-service date for the gasification and gas recovery systems was pushed back again to the first half of 2016. Fortunately the generating part of the project, which (with the benefit of hindsight) is the only part of the plant that should have been built, is already running on pipeline-delivered natural gas. Like a rock in a shoe, these charges and delays have been annoying and a bit painful, but Southern is so large and financially resilient that the safety and growth of its dividend hasn't been affected to any material degree. Our fair value estimate remains $45 a share; if the stock falls below that level, it would return to buy territory within our strategic framework with a yield of 4.7% or better.

Harvest holding Royal Dutch Shell RDS.B continues to recover from the dreadful financial results it reported in 2013; its third-quarter operating earnings per share improved 30% from the year-ago period. I appreciate the progress Shell is making in the areas it can control, and these improvements should provide a bigger cushion for cash flow if the oil price stays depressed for a while. I'm comfortable continuing to hold the stock here; Shell's balance sheet is strong enough to endure a few years of depressed energy prices before I would develop concerns about our income. However, for new money in the energy sector, I think Chevron CVX offers significantly better long-term dividend growth prospects that more than compensate for a lower current yield (3.7% to Shell's 5.1%).

The rest of the week's results to date--those from Altria Group MO, Kraft Foods Group KRFT, Public Service Enterprise Group PEG, Realty Income O and Xcel Energy XEL--came in close to our expectations with no immediate changes to our fair value estimates. (Details are included in the analyst notes below.) All five of these stocks are trading above our current fair value estimates, but four are unlikely candidates for sale. Altria and Realty Income are core holdings: proven dividend-paying champions that, while never to be taken for granted, I would let go only with the greatest reluctance. PSEG's rapid transformation into a predominantly regulated and highly attractive business is moving it closer to core territory. Kraft's overall appeal is adequate without being particularly attractive; its main advantage within the Harvest is to add to the account's diversification outside the energy, utility and real estate sectors. That leaves Xcel, which closed Thursday at a 16% premium to our $29 fair value estimate, as a possible source of funds for new purchases in the Harvest. For better or worse, there is very little on the horizon by way of new ideas, so I have no immediate plans to sell Xcel.

On the research front, we raised our fair value estimate for United Parcel Service UPS by $2 to $97 a share, mainly reflecting the time value of money since our last update. The company is one of my favorite cyclicals and I plan to continue holding, but I won't be adding to our position at a current price around $103 and a dividend yield well below 3%.

As for the rest of earnings season, Chevron, Clorox CLX and Magellan Midstream MMP are scheduled to report tomorrow (Oct. 31), followed by Emerson Electric EMR and Health Care REIT HCN on Tuesday, the Spectra Energy SE SEP entities on Wednesday, National Grid NGG next Friday, and AmeriGas Partners APU on Nov. 13.

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

Altria Group MO
Analyst Note 10/30/2014 | Philip Gorham, CFA, FRM  

Altria's third-quarter results demonstrated that the firm is on track to meet our full-year forecasts. Our two major takeaways from the quarter are that the U.S. cigarette industry is declining at a below-trend rate of about 3%, and Altria is a distant third in the e-cigarette category. We are reiterating our $39 fair value estimate and wide economic moat rating. Management reiterated full-year EPS guidance of $2.54 to $2.59, which represents adjusted EPS growth of 7% to 9%, and we remain at the higher end of that guidance.

Altria kept track with the U.S. cigarette industry in the third quarter, with a volume decline of less than 3%. Higher prices more than offset the volume contraction, with revenue net of excise taxes growing by almost 3%. This level of volume decline is below our estimate of the long-term structural consumption contraction, which is closer to 4% per year. The cigarette industry is a defensive one, and the addictive nature of the product usually leads to lower volume volatility than the rest of the consumer staples space. There is a cyclical element to demand, however, and consumption can be affected by economic factors, particularly those affecting low-income consumers. In the third quarter, we believe lower gas prices and improving employment were the driving forces behind the below-average decline in consumption, and we expect this modest tailwind to continue in the very near term. Despite the drop in volumes, profitability in Altria's cigarette segment remained steady, while the overall reported operating margin slid 210 basis points to 31.8%. Margins were hindered by a one-time adjustment to the Master Settlement Agreement payments and due to elevated promotional activity in the smokeless segment.

Although it did not break out results for its new e-cig product, management stated that national expansion of MarkTen is continuing. The product is now sold in about 80,000 retail stores, mostly in the western half of the U.S., and distribution will continue to be rolled out in the eastern half. However, MarkTen's retail volume market share is only about 9%, according to IRI, much less than the 24% share achieved by Reynolds American in a comparable number of points of sale with Vuse, its vapor product. This could indicate lower consumer trials for MarkTen, but it could also imply that heavier promotional discounts will be required for the brand to gain greater trial penetration. With the regulatory backdrop remaining relatively light, we expect the e-cig category to remain competitive.

Kraft Foods Group KRFT
Analyst Note 10/30/2014 | Erin Lash, CFA  

While Kraft operates with a solid brand mix as well as a vast distribution network on its home turf (driving our narrow economic moat), the firm has been plagued by soft consumer spending, intense competition, and volatile commodity costs, particularly within dairy and meats. Organic sales ticked up a modest 1%, as 2% higher prices were offset by lower volumes. In response to the rampant cost inflation in the cheese, meat, and coffee categories, Kraft has put through significantly higher prices; however, the firm was unable to offset the profit hit given the lag in the benefit, as the adjusted gross margin tumbled 180 basis points. These challenges are unlikely to abate, but we’re encouraged by management’s repeated references to new products and brand spending, as we believe this is what will ultimately reignite the firm’s business.

We don’t anticipate making any changes to our $53 per share fair value estimate, as results through the first nine months of the year are tracking in line with our expectations. Over the longer term we forecast that annual sales growth will amount to 3%-4% (despite the fact that its operations will exclusively focus on the mature North American market where outsized growth is unlikely), driven by new products and higher prices. Because we think that the company's ability to realize further cost savings--half of which Kraft intends to reinvest in the business, half of which will be returned to shareholders--should persist for some time, we forecast that operating margins will expand to more than 19% by fiscal 2017 (up from a midteens operating margin historically). Shares trade at a slight premium to our valuation, and as such, we’d suggest investors await a more attractive entry point before initiating a position in the stock.

Ensuring its products are stocked where consumers are shopping remains a focus for the management group. More specifically, Kraft maintains less penetration within alternative channels (like club and dollar stores) relative to the rest of the industry, which management pegged at 10%-15%. The firm has been vigilant in adjusting its packaging and product set to cater to these channels, and as such, realized 8% growth in these outlets in the quarter. However, we doubt Kraft has fully tapped this opportunity, and we anticipate expanding its presence in these channels will be a focus for the company for some time.

On a broader scale, we have yet to see any meaningful signs that the consumer spending landscape is improving. Promotional spending appears to be running rampant throughout the consumer goods space; although, 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 in the quarter). As we’ve said in the past, we think value-added new products that win with consumers across the store are ultimately what is going to turn the tide and reignite category growth rates.

Public Service Enterprise Group PEG
Analyst Note 10/30/2014 | Travis Miller  

We are reaffirming our $37 per share fair value estimate, narrow moat and positive moat trend for Public Service Enterprise Group after it reported third-quarter operating earnings of $0.77 per share, up slightly from $0.76 per share in the third quarter of 2013. Management tightened its full-year earnings per share guidance to $2.60-$2.75, in line with our estimate. PSEG's business diversity remains the source of its positive moat trend and that continues to show up in its financial performance.

Growing earnings at the utility--PSE&G--continue to offset lower earnings at PSEG Power, as we expected. PSE&G year-to-date earnings are up 21% from the same period in 2013, in part due to a $0.10 per share benefit it has gotten through nine months from its transmission investments. During the third quarter, PSE&G filed with the Federal Energy Regulatory Commission for a $182 million transmission rate increase effective 2015, in line with our expectations and likely representing more than $0.10 per share of additional earnings.

PSEG Power's year-to-date earnings fell 7% from the same period last year, in line with our expectations. Lower energy and capacity prices, lower hedged margins, and cool weather hurt earnings. PSEG made no material changes to its 2015 hedges during the quarter, remaining 65%-70% hedged at an average $50/MWh. It hedged approximately an additional 5% of its expected 2016 generation, dropping its average hedged price to $49/MWh from $51/MWh given the weaker midyear markets. This doesn't have a material impact on our forecasts or fair value estimate.

Realty Income O
Analyst Note 10/29/2014 | Todd Lukasik, CFA  

We're maintaining our overall opinion of Realty Income, including our narrow economic moat rating and $44 fair value estimate, following another solid quarter. Recent acquisitions, combined with 1% to 2% internal growth in its legacy portfolio drove 17% revenue growth, 20% adjusted EBITDA growth (before merger expenses), and 6% adjusted EBITDA per share growth, the latter reflecting dilution associated with the equity funding component of recent deals. We also monitor adjusted EBITDA less interest expense on a per share basis, which increased nearly 11% in the quarter, reflecting a favorable debt funding environment. Portfolio operating metrics also came in fine, with a 1.4% increase in same-store rents, occupancy improving 20 basis points to 98.3%, and re-leasing efforts maintaining rent parity between the expiring and new aggregate rents.

Dividend coverage metrics have improved meaningfully after peaking most recently in early 2013 following its ARCT acquisition. Then, the dividend represented more than 92% of reported adjusted funds from operations, or AFFO, per share versus less than 86% in the most recent quarter. Historically, Realty Income has considered a fifth, more meaningful increase to its annual dividend (in addition to its four traditional quarterly hikes) in the August timeframe. However, our conversations with management suggest that the board may begin considering the fifth potential dividend increase near the end of the year instead, to better coincide with its annual internal planning efforts. With its latest, 86% dividend payout ratio and management's expected 4% to 6% increase in 2015 AFFO per share, we think a fifth hike will likely be announced between now and the end of January. But even if a fifth bump doesn't come in the near term, that should set the stage for even better dividend coverage in 2015, which should justify a fifth bump next year, at the latest.

On the surface, it appears that management reduced its funds from operations, or FFO, guidance for 2014, the one-time negative $0.03 hit to FFO from charges related to the recent redemption of some of its preferred shares more than accounts for the revised guidance range. Moreover, the firm introduced 2015 guidance that falls near our own expectations. One wildcard is acquisitions. While it appears the acquisition environment remains attractive in terms of opportunities sourced (more than $7 billion in the quarter), we note a sharp drop-off in consummated deals in the third quarter ($182 million in the quarter versus more than $1 billion in the first half of the year), and we suspect Realty Income is becoming choosier on the deals it closes as market conditions adjust. Still, the implied run rate of roughly $350 million for the second half 2014 suggests an annual run rate of $700 million, not far from our $1 billion target for 2015. Even if Realty Income falls short on actual acquisitions versus our expectations, it may exceed our assumptions in other regards, such as higher initial yields on deals, better tenant credit profiles, longer initial lease terms, or other factors.

Southern Company SO
Analyst Note 10/29/2014 | Mark Barnett  

Southern Company reported third-quarter EPS on Oct. 29 that was once again hit by charges at the Kemper IGCC in Mississippi, as delays and projected start-up costs led to a $0.29 per share charge, bringing the year-to-date EPS impact to $0.55. Excluding charges, results were flat at $1.09 per share versus $1.08 per share in the third quarter of last year. Guidance stands at $2.72-$2.80 per share for the full year, excluding the Kemper charges. Our current EPS forecast excluding Kemper remains $2.76. We are maintaining our stable narrow moat rating and $45 per share fair value estimate.

While Kemper remains frustrating, our attention is focused on economic activity in the company's footprint and on the progress and regulatory treatment of the new Vogtle nuclear plant in eastern Georgia. Management projected a continuing 3% growth trend in GDP in its footprint. While GDP isn't a perfect measure, we do expect demand in Southern's service territories to grow above the national average for the foreseeable future. However, residential and commercial weather-adjusted demand in third-quarter 2014 was not promising, with residential down 0.3% and commercial down over 1%. Both gauges remain flat to modestly down for the full year. The bright spot was industrial demand, which improved 5% year over year and stands at a 3.6% positive delta year to date.

On the Vogtle front, management played down the potential for delays at the site, given concerns after SCANA announced significant delays and cost overrun expectations. The terms of the project agreement are different as Southern's project is fixed-price turnkey. However, we believe delays are likely. We believe Southern will be able to recover most cost overruns, but we continue to project a 75% chance of $500 million in overruns for investors.

United Parcel Service UPS
Valuation 10/26/2014 | Keith Schoonmaker, CFA

We have increased our fair value estimate for UPS to $97 per share from $95 primarily because of the time value of money since our last update and as we trued up results for volume growth in the third quarter that slightly exceeded our expectations performance (price per package was below our projections, but margins year-to-date are in line with our annual projection). We assume that the firm achieves long-run 13.5% consolidated margins as early as 2015, up from 12.7% in 2013. Our margin estimates in three operating segments--14% in domestic package, 16% in international package, and 8% for supply chain and freight--drive consolidated margin projections. We expect continued strength in global industrial production actual reports and optimistic near-term expectations. UPS' performance is tied to the health of the global economy, and we believe shipping volume will not recover for several quarters. In the long run, however, we believe overall global parcel shipping market expansion and consistent price increases will enable UPS to increase its top line at about a 6% compound annual rate during the next five years. The firm expects to expand international package shipping faster than the broader market through internal growth and by adding assets. UPS generated an impressive high-teens average return on invested capital during the past five years and produced tremendous free cash flow of 5%-11% of sales. The firm reinvests heavily (in the long run, we model about 4% of sales) and earns consistently high returns on its assets.

Xcel Energy XEL
Analyst Note 10/30/2014 | Travis Miller  

Xcel Energy management reported third-quarter earnings and initiated 2015 guidance consistent with its 4%-6% annual long-term earnings target, in line with our estimates, and supporting our $29 per share fair value estimate. We are reaffirming our narrow moat and stable moat trend. Management tightened its full-year earnings guidance range to $1.95-$2.05 per share.

Xcel remains on track to achieve our full-year earnings outlook after earning $0.73 per share in the third quarter. This is down from $0.77 per share Xcel earned in the third quarter of 2013, however much of that difference is due to a $0.07 per share swing in weather-related usage. Adjusting for weather impacts, earnings are up 4% year to date.

Xcel raised its 2014-18 capital investment plan by $500 million and announced a plan to spend $2.85 billion in 2019, bringing its 5-year spending plan to $17.5 billion. This spending plan relies on constructive regulatory outcomes, particularly in Minnesota and Colorado where Xcel has pending rate increase requests. We assume Xcel receives $240 million of rate increases in Minnesota for 2014-15, including recovery of a portion of Monticello nuclear plant project overspend. We assume regulators approve a $100 million rate increase in Colorado. A punitive decision in any of Xcel's pending rate cases would have a material impact on our earnings forecasts and potentially our fair value estimate.


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