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

Oct 08, 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
More MLP Mayhem -- The Week in Dividends, 2015-10-02

On Thursday, we got our first distribution increase from Enterprise Products EPD, which joined our Dividend Select portfolio on Aug. 12. Limited partners will receive $0.385 a unit on Nov. 6, up from the $0.38 that was paid in August. Consistent distribution growth is nothing new for Enterprise: This was the 45th straight quarterly increase, with the last dozen being a half-cent bump from the preceding quarter.

Of course, this steady performance stands in stark contrast with the way Enterprise and other energy master limited partnerships have been trading lately. The Alerian MLP Index registered one-day declines near 6% on both Monday and Tuesday, bringing the benchmark to a loss exceeding 48% from the all-time high of August 2014. It's hard to find anything specific to explain these latest plunges; it seems that an already-panicky level of selling simply gave way to more panic. Then, on Wednesday, the index rocketed almost 9% higher--its best one-day gain since November 2008.

This kind of action can be unsettling even for long-term holders, and it would be overly optimistic to dismiss its relevance out of hand. On one hand, indiscriminate dumping of MLPs does not suggest the sellers are giving much thought to the fundamental qualities of individual partnerships. On the other, there are some genuine weaknesses out there--not every MLP is the "toll road" bulls like to believe, and judging by an abundance of thin distribution coverage ratios across the sector, few seem to have prepared themselves for a serious industry downturn.

Fortunately, I believe the long-haul, consumption-driven assets represented by Magellan Midstream MMP, Spectra Energy Partners SEP, and most of Enterprise's portfolio are well placed to thrive even in this environment. Better yet, these entities entered this stressful period with strong balance sheets and plenty of excess distribution coverage. I expect these three partnerships (as well as AmeriGas Partners APU) to continue raising their distributions even as much weaker MLPs halt growth or are forced to trim payouts.

The market will eventually separate the wheat from the chaff. My view of our MLP holdings has not changed: All four continue to meet my criteria for distribution safety, long-term distribution growth, fundamental quality, and risk characteristics--and all four also trade at meaningful discounts to our fair value estimates. If I didn't own them already, I'd be a willing buyer up to the weightings we currently hold. We should expect volatile prices for even well-placed holdings such as ours, but I don't believe it is necessary to react to volatility, especially of the day-by-day kind. One of the great luxuries of our strategy is that, by focusing on income, we can maintain an even keel in rocky waters. I certainly don't need to sell just because others are selling, but I also don't need to buy more if I'm already satisfied with my position.

In other news this week, core holding Paychex PAYX put up another round of strong results for its first fiscal quarter (which ended in August). Revenue rose 8%, operating margins improved, and core earnings per share jumped 11% from the year-ago period. The report was in line with our expectations and we reaffirmed our $45 fair value estimate. I continue to like Paychex a great deal, but while the underlying business generates large and steady free cash flows, the stock price is often volatile--primarily reflecting the unpredictable nature of employment growth and interest rates. I'm crossing my fingers that future volatility will serve up a good opportunity to boost our stake.

Also, one of our long-tenured holdings has a new name: Health Care REIT is now known as Welltower HCN. The ticker symbol remained the same. I think the new name is a bit of an improvement--the old one had a generic quality to it. Of course, it doesn't change our take on the stock (which remains favorable) or my preference for Ventas VTR (whose valuation I find more favorable still).

Best regards,

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

Disclosure: I own all of the holdings of the Dividend Select portfolio in my personal accounts.

News and Research for Dividend Select Portfolio Holdings

American Electric Power AEP
Analyst Note 10/02/2015 | Andrew Bischof, CFA

We are reaffirming our $60 fair value estimate and narrow economic moat and stable moat trend ratings for American Electric Power after the company sold its unregulated commercial barge transportation subsidiary, AEP River Operations, to privately held American Commercial Lines for $550 million.

Management said in March that it was considering strategic alternatives for the unit. We consider the price appropriate for a business that contributed less 3% of consolidated 2014 earnings. AEP will net $400 million after debt and book a $125 million gain in the fourth quarter for the subsidiary, which it purchased in 2001. We like that management has designated proceeds for regulatory investments and believe the additional capital may be used to bring forward moaty transmission investments, much as management did in 2014.

What we believe is more telling is management's indication that the strategic review of the no-moat competitive generation business--a review that began in 2014--is ongoing. Management has received some information required for the review, mainly PJM capacity results, but is waiting for outcomes from the company's outstanding Ohio power purchase agreement request. Given the Ohio commission's lukewarm response to FirstEnergy's request, we view approval of AEP's PPA request as unlikely. We ultimately believe that management will wisely decide to sell the no-moat unit, although the timing is uncertain as power market volatility may have depressed the unit's near-term attractiveness and marketability.

Coca-Cola KO
Analyst Note 09/29/2015 | Adam Fleck, CFA

Keurig Green Mountain on Tuesday officially launched its Keurig Kold beverage system, with partners Cola-Cola (which has invested more than $2 billion in Keurig Green Mountain) and Dr Pepper Snapple offering several key brands on the single-serve platform. While we believe there is potential upside for this market should consumers flock to the many flavor choices and smaller serving sizes, we hold major reservations--mainly a lack of convenience or price advantage over alternative at-home soda consumption methods--that cause us to not include any associated revenue or earnings in our forecast for either Coke or Dr Pepper. While this opinion is potentially negative for Coca-Cola, given its direct investment in Keurig Green Mountain, we also note that the total investment makes up less than 1% of our valuation for Coke, or less than a $1 per share hit even if the entire outlay were written off. As such, we plan to maintain our $43 fair value estimate for wide-moat Coca-Cola and our $60 fair value estimate for narrow-moat Dr Pepper Snapple.

The Keurig hot coffee system has proved successful in the United States, installed in roughly 20 million households, but we don't expect nearly the success rate for Kold. Competing at-home cold-beverage provider SodaStream has seen its penetration level off at a much lower rate of less than 2 million households domestically. While we see problems with SodaStream's offering that Kold solves (including Kold brewing a single-serving size and not requiring carbonation capsules), the economics of at-home cold beverage brewing simply don't add up for us. As such, we see the ultimate penetration much closer to SodaStream than Keurig hot.

We believe Keurig hot has been successful because it solves three major issues experienced by many single-serve coffee drinkers: convenience, price, and variety. Before Keurig and other single-serve coffee brewers, consumers who wanted a single cup of coffee had the option to either brew a whole pot of coffee and dispose of the remainder, or brew a smaller amount, which required some (admittedly basic) math regarding water/coffee ratios and a disproportionate amount of cleanup. While a K-Cup costs more per serving than a pot of coffee, it's substantially less than a cup at Starbucks or another premium coffee shop. And Keurig has proved successful signing several major manufacturers to its platform, while also supporting many of its own proprietary brands and flavors.

Kold appears to score positively on only one metric: variety. It's hard to argue with the convenience of opening a can of Coke from the refrigerator, and even Kold's smaller serving size (8 ounces versus a can's 12 ounces) is answered by recent packaging innovations such as 7.5-ounce cans. Keurig has set each 8-ounce pod at $1.25 each, significantly more expensive than a can of Coca-Cola (roughly $0.25-$0.30 apiece as part of a 12-pack) or even fountain drinks at major fast food chains or gas stations (often less than $1 for 20 ounces or more).

There are probably some consumers who will greatly value the ease of use and variety of product offerings (including potential new flavor combinations that won't be available widely in stores), but we view the extremely wide price discrepancy as evidence that the product will be incredibly niche. Keurig management targets Kold users brewing nearly two 8-ounce pods per day At $1.25 each, this puts weekly spending at $17.50, monthly spending at roughly $75, and yearly expenditures at more than $900--all before the $370 up-front cost of the machine itself. If a consumer wanted to purchase this amount of soda in traditional 12-packs of 12-ounce cans, he would need to purchase 41 packages; at about $3.73 per pack (per Beverage Digest), this would work out to $152 in annual spending, or more than $750 in annual savings.

While we aren't optimistic about Kold's prospects in driving substantial growth, there could be some minor incremental benefits to Coke and Dr Pepper. Even if the system only penetrates 2 million households, we estimate that at two 8-ounce servings brewed daily, split evenly between Coke and Dr Pepper brands, the system could add nearly 1% to Coke's U.S. carbonated soft drink volume and about 2% to Dr Pepper's. Moreover, while the royalty payment structure remains uncertain, we estimate that the higher price point of the product would drive a stronger improvement in revenue and operating earnings. For Coca-Cola, even at a mid-single-digit percentage of North American earnings, this boost would only move our fair value estimate 1%-2%, since the segment is just one fourth of operating profits. The impact for Dr Pepper would be more meaningful, given the firm's higher exposure to the U.S. market, but we caution that we also believe Keurig Kold will partially cannibalize current soda sales, leading us to keep our valuation unchanged at present.

Duke Energy DUK
Investment Thesis 09/30/2015 | Andrew Bischof, CFA

Duke Energy is the largest utility in the United States. Management wisely continues to transform Duke into a pure regulated utility, recently agreeing to sell its 7.5-gigawatt Midwest commercial generation fleet to Dynegy.

Duke's regulated distribution businesses make up about 85% of consolidated earnings. In recent years, Duke's utilities have been able to win higher customer rates from regulators, translating into higher profits. In 2015-19, we anticipate cumulative capital expenditures of $42 billion, of which nearly $30 billion is growth capital. These investments include new power generation, infrastructure, and environmental upgrades supporting our 4.5% earnings growth estimate in line with management's 4% to 6% guidance.

We anticipate that Duke will be able to recover these costs through constructive regulatory outcomes, particularly in the Carolinas and Florida. This regulatory support is a key reason for Duke's narrow moat. These constructive relationships formed by management should also help protect Duke in a higher interest rate environment.

We believe the unregulated international segment has been investors' biggest concern. However, the unit historically contributes just 10% to total earnings, and we think it faces manageable challenges. Brazil's low-cost hydroelectric generation represents more than half of the segment's total operating revenue. Duke has historically benefited from a highly contracted business with market-based rates and annual inflation adjustments, but recent drought conditions have depressed profits as regulators have dispatched thermal generation before hydroelectric generation. Low electricity demand, anemic economic growth, and foreign currency volatility have also pressured near-term international segment results.

The other unregulated subsidiary is commercial power, which consists of high-quality renewable assets backed by long-term contracts with commercial and industrial customers. The unit represents only 5% of earnings, but management has identified renewables as a growth area and we wouldn't be surprised if Duke pursued more projects with utility-like contracted earnings.

Duke Energy: Economic Moat 09/30/2015
Service territory monopolies and efficient-scale advantages are the primary moat sources for regulated utilities such as Duke. State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on and return of the capital they invest to build, operate, and maintain their distribution networks. In exchange for regulated utilities’ service territory monopolies, state and federal regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow regulated utilities to achieve at least their costs of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. Intuitively, utilities should have an economic moat based on efficient scale, but in some cases regulation offsets this advantage, preventing excess returns on capital. The risk of adverse regulatory decisions precludes regulated utilities from earning wide economic moat ratings. However, the threat of material value destruction is low, and normalized returns exceed costs of capital in most cases, leaving us comfortable assigning narrow moats to many regulated utilities.

We believe Duke's international energy segments are no-moat businesses, as they lack long-term competitive advantages based on their exposure to commodity markets. We assign a narrow moat to Duke's commercial power unit, which is supported by long-term wind and solar PPA with creditworthy borrowers. Overall, given the relative size of the regulated and commercial power segments, we believe a narrow moat rating is appropriate for Duke.

Duke Energy: Valuation 09/30/2015
Our fair value estimate for Duke is $83 per share. We estimate it will invest about $42 billion in capital expenditures through 2019, most of this at its regulated utilities, and continue to receive constructive regulatory recovery of those expenditures. Based on this investment budget, we anticipate consolidated rate base could grow as much as 6% annually, on which the company is allowed to earn modest returns. We expect 4.5% long-term normalized earnings growth, as regulated earnings driven by rate base growth is partially offset by weakness at the company's international unit. We forecast 1% average power demand growth for Duke's Carolina, Indiana, and Ohio subsidiaries, and 1.5% for Florida from 2015 through 2019, alleviating the need for any near-term rate relief even with Duke's huge investment plan. We anticipate that Duke will increase its dividend 4% annually during the next few years, largely in line with management's projections and at the midpoint of management's targeted 65%-70% payout ratio. We discount our cash flows using a 5.8% weighted average cost of capital, which is based on a 7.5% cost of equity, 2.25% inflation, and a 4.5% normalized risk-free rate.

Duke Energy: Risk 09/30/2015
Regulatory risk remains the key uncertainty for Duke Energy, particularly given its aggressive investment plans during the next several years. Much of the company's success hinges on the relationships it has built through years of low power prices and excellent customer service. Duke's regulatory exposure is diversified due to operations in six state jurisdictions and its federal-regulated transmission projects. Duke should benefit from favorable regulation in the Carolinas, Florida, and Indiana, partially offset by more challenging regulatory environment in Ohio. We don't forecast any major near-term rate cases. Duke might file for a rate increase in Florida in 2018.

Another potential risk for Duke shareholders is the decline in power prices due to decreasing electricity demand or falling natural gas prices. The company has a significant ongoing development program that is subject to potential cost overruns and political and regulatory risk. Tightening environmental compliance regulations could require significant capital investment or added operating costs that may have uncertain cost recovery through traditional regulated rates.

As with all regulated utilities, Duke faces the risk of an inflationary environment that would raise borrowing costs and make other investments more attractive for income-seeking investors.

Paychex PAYX
Analyst Note 09/30/2015 | Brett Horn

Paychex maintained its recent momentum in its fiscal first quarter. Revenue increased 8% year over year, with Payroll Services revenue up 5% and Human Resource Services revenue up 15%. Paychex continues to see much of its growth come from cross-selling ancillary HR services into its payroll customer base. We expect this trend to continue and see this situation as a way for the company to maintain strong growth despite its established position in its core business. We are encouraged by the fact that growth in the Human Resource Services segment appears to be spread across multiple product types, which suggests to us that this trend could have a long tail and is not dependent on a favorable situation for any particular product, although healthcare reform is likely providing a little bit of a boost in the current environment. Operating margins for the quarter came in at 41.0%, compared with 40.1% last year. We think there is room for Paychex to sustainably improve its already ample margins over time based on the scalability of the business model. We will maintain our $45 fair value estimate and wide moat rating.

Low interest rates remain as an impediment to Paychex’s profitability, but the effect seems to be flattening out. The yield on client funds remains muted at 1.1%, but it held steady compared with last year. We would note that Paychex has significant leverage to any increase in interest rates and in particular to short-term rates given its investment strategy. By our estimate, a 1-percentage-point increase in the yield on the portfolio would increase operating income by about 4%. For comparison, yields in the pre-crisis period were about 2 percentage points higher than current levels.

Welltower HCN
Analyst Note 09/30/2015 | Todd Lukasik, CFA

Health Care REIT has changed its name to Welltower, but our opinion of the firm is unchanged. We are maintaining our $80 fair value estimate and narrow moat rating. Along with the rest of our health-care REIT coverage, Welltower’s shares appear attractive, trading at a 15% or so discount to our estimate of value. We think the firm’s new name effectively conveys its position within the health-care landscape, but its strategy is unchanged. Welltower will continue to provide capital to health-care service providers and operating companies, mainly to fund their real estate needs, as the health-care industry evolves to focus more acutely on wellness, quality outcomes, and value. Welltower’s common stock will continue to trade under the same ticker used previously, HCN.


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