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.
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AmeriGas, McDonald's, P&G in the News -- The Week in Dividends, 2014-11-14

Equity markets continue to calm down after last month's shakeup, and while there weren't any major developments for our portfolios, there were a few minor ones worth noting.

On Monday, McDonald's MCD reported another fall in same-store sales, though a global decline of only 0.5% now qualifies as relatively good news. The year-over-year drop in the Asia/Pacific, Middle East and Africa segment ebbed to 4.2%, showing the worst effects of the food safety scare earlier this year are wearing off. Both the U.S. and Europe remain in marginally negative territory without such a clear excuse. Perhaps more interestingly, the activist investment fund Jana Partners reported a stake in McDonald's at the end of the third quarter. Though it then held only a comparatively tiny block of shares, it may be that Jana had only started to build its position, and this news was enough to give the stock a lift in Friday's trading.

In fact, McDonald's shares are now quoted slightly above our fair value estimate of $95--which, I hasten to add, we've repeatedly reduced in the last four months. This being the case, I certainly wouldn't mind replacing McDonald's with another business, preferably one that didn't seem so clueless about how to solve its problems. Unfortunately, this observation is simply a variation on the same discouraging theme we've dealt with all year--a lack of high-quality, high-payout businesses at even reasonable prices, let alone bargain ones. After all, I still haven't found a way to deploy the almost $10,000 of cash that is sitting in the Builder. It follows that the only way I am likely to sell or trim existing positions at this point is if I think the stock is likely to be worse to own than zero-yielding cash over a 3-to-5 year timeframe. McDonald's may be frustrating to own, but it's hard to prefer cash to the stock's 3.5% yield.
On Thursday, earnings season finally came to an end when Harvest holding AmeriGas Partners APU reported results for the quarter and fiscal year that ended in September. The results held few surprises after a preannouncement last week in advance of the partnership's analyst meeting, though the distribution coverage ratio of 1.23 times for 2014 was just a bit thinner than I'd like--I hope to see a return to the historical average of 1.3 on a long-term average basis. Even so, AmeriGas continues to thrive by raising its per-gallon margins, carefully controlling costs and making bolt-on acquisitions. Together, these forces more than offset the decline of propane volumes across the industry, and I remain confident the partnership can meet its goal of 5% annual distribution increases for many more years to come. We reaffirmed our fair value estimate of $47 a unit, keeping AmeriGas in buy territory with a 7.8% yield--the highest of any DividendInvestor holding by far. No other equity security that I know of offers a comparable yield yet provides an adequate level of financial strength as well as solid long-term growth potential.

Thursday also brought an interesting move by Builder holding Procter & Gamble PG, which will sell its Duracell business to Berkshire Hathaway BRK.B in exchange for P&G shares that Berkshire owns. This provides both sides with some nifty tax advantages, but beyond that it's a bit of a head-scratcher. Widely considered one of P&G's weakest divisions, Duracell operates in a commoditized corner of the consumer products industry where brands don't gather much pricing power. We don't have access to detailed financial data for the business, but it's hard to imagine Duracell being the kind of wide-moat business favored by Warren Buffett. Then again, P&G isn't getting a terribly attractive price--just seven times EBITDA. P&G will retire about 2% of its outstanding shares with the transaction, but based on the company's disclosure of $0.12-$0.14 a share of 2014 earnings that will shift from continuing to discontinued operations, Duracell seems to have accounted for about 3% of total earnings.

We see the Duracell transaction as a net plus for P&G over the long run. Consistent with the strategic emphasis announced in July, this will shift capital toward more productive uses and tighten management's focus. It appears our fair value estimate will rise $1 a share to $94 as a result. However, at least initially, it will probably dilute coverage of the dividend slightly. This is often a problem with asset sales: The businesses a company like P&G wants to get rid of usually have little growth potential, poor margins and low valuation multiples when sold, but they punch above their weight in terms of free cash generation. All in, I think P&G is on the right track, but with many more divestitures planned, it may take several years for earnings per share and dividend growth to accelerate. In the meantime we enjoy a healthy and still well-covered yield of 2.9%, though I wouldn't consider adding to positions at yields less than 3.0%.

Rounding out the week's developments are two increases to our fair value estimates. The larger-than-expected dividend hike issued by Builder holding Spectra Energy Corp. SE last week lifted our fair value estimate by $1 a share to $44. The stock closed Friday at an appealing 13% discount to our appraisal and offers a 3.9% yield--metrics that offer strong fundamental appeal, especially for investors who want midstream energy exposure but can't or don't want to own master limited partnerships.

Separately, in a routine update described below, our fair value estimate for Builder holding Paychex PAYX rose $2 a share to $39. The stock price is still well ahead of our new valuation, but I still consider Paychex a core holding for (1) a wide economic moat borne out of scale economies and customer switching costs, (2) an dividend policy that is exceptionally well-suited to the resilient, cash-rich nature of the business, and (3) the positive exposure it provides to faster employment growth and rising interest rates.

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

President Obama's Net Neutrality Support May Embolden FCC
Industry Note 11/11/2014 | Michael Hodel, CFA  

President Obama's call on the Federal Communications Commission to introduce strong open Internet (or "net neutrality") principles may embolden chairman Tom Wheeler to take a more aggressive policy stance as the commission formulates its new rules on the matter. We believe investors are best served by remaining level-headed, as these issues will continue to be debated at the FCC, among industry participants, and in the courts. In addition, we don't believe the actions taken at the FCC meaningfully alter the competitive landscape in the industry, and we aren't changing our moat ratings or fair value estimates at this time. We continue to believe that an unfavorable outcome for U.S. Internet access providers would amount to a lost opportunity rather than radical change to current business practices. A favorable outcome, on the other hand, could provide modest upside to our fair value estimates.

The president called on the FCC to adopt the "strongest possible" policies to protect net neutrality, including reclassification of consumer Internet access as a Title II service (a common carrier utility). Title II reclassification would give the FCC the legal leeway needed to fully regulate Internet access services, including pricing. The president, however, supported the idea that the FCC should forbear from elements of Title II not relevant to net neutrality principles, a position reclassification opponents fear will provide a slippery slope toward the type of regulation traditionally imposed on phone companies. While we don't believe a dramatic slide into heavy-handed regulation is a likely outcome, this threat is always a long-term risk in this industry, regardless of the outcome of any one debate.

Wheeler initially opposed reclassification, favoring instead to use existing regulatory authority to craft policies that ensure an open Internet without running afoul of the Court Of Appeals decision last January that struck down prior FCC rules. Public comments filed with the FCC since May have clearly colored the chairman's position, as the FCC has recently begun exploring various forms of reclassification. In addition, Wheeler has recently strengthened his position on wireless net neutrality, indicating that he now believe wireless networks should receive the same treatment as fixed-line networks. The president explicitly supported this position.

Wheeler also commented last May that the net neutrality debate is about open access networks and not peering or network interconnection. We were skeptical at the time that this bifurcation would remain in place, as the implications of slowing traffic within the network or at peering points are largely the same to consumers. Obama called for increased transparency surrounding interconnection agreements to avoid special treatment for certain content or services. Cutting to the heart of the matter, the president stated that no service should be stuck in a "slow lane" for failing to pay a fee, regardless of the manner in which that slow lane is created. We suspect that the president's support on this issue will embolden Wheeler to formally bring interconnection into the FCC's open Internet policies. A hybrid approach, with interconnection receiving Title II treatment while consumer Internet access is excluded, could become a compromise.

American Electric Power AEP
Analyst Note 11/12/2014 | Andrew Bischof, CFA  

We are reaffirming our $54 per share fair value estimate, narrow economic moat, and stable moat trend ratings for American Electric Power after discussing the company's 4% to 6% earnings growth target and moaty transmission and regulated investment opportunities with senior management during the Edison Electric Institute Financial Conference in Dallas, Texas.

Through 2017, AEP forecasts a $14.5 billion increase in its regulated rate base from a 2012 year-end base of $33.2 billion, an implied 7.5% annual growth rate that should support management's 4% to 6% growth rate off its 2014 original guidance. These growth opportunities should allow for above-average dividend growth. The company’s $12.0 billion capital plan from 2015-17 focuses on regulated spending.

At the core of the program is building out the company’s moaty regulated and competitive transmission business, focusing on regional projects to support plant retirements, local reliability projects, replacing aging infrastructure, and customer-driven projects. For management’s base case, which includes all approved projects or projects not requiring regulatory review, management predicts rate base growing to $6.4 billion by 2018, from a 2012 base of $800 million. Incremental transmission opportunities could drive that growth to $8.2 billion. The plan excludes any additional opportunities from FERC Order 1000 competitive transmission projects. We think AEP is well positioned to benefit from any additional opportunities.

AEP Generation's future remains in flux, as management awaits key rulings in Ohio, particularly on the company's requested OVEC PPA as well as the company's Ohio PPA request for a portion of its statewide fleet. If the state commission votes down the capacity request, we think the management will smartly sell its no-moat merchant business, allowing it to focus on its core regulated operations.

AmeriGas Partners APU
Analyst Note 11/14/2014 | Mark Barnett

After reviewing AmeriGas' fiscal 2014 performance and participating in management's call, we are maintaining our $47 fair value estimate and stable narrow moat rating. During the fiscal year, AmeriGas realized a healthy increase in EBITDA and earnings per common unit despite a challenging operating environment during the past winter when regional supply shortages and cold weather could have severely disrupted a less flexible, smaller operator.

Year over year, EBITDA excluding mark-to-market impacts rose nearly 8% to $665 million from $618 million in 2013. Earnings per common unit rose nearly 32%. We had projected EBITDA of $669 million and earnings per common unit of $2.98 for the fiscal year. The difference between our estimates and earnings doesn't have a material impact on our fair value estimate.

A 1.7% increase in total propane gallons sold on cooler temperatures combined with an impressive 6% increase in per-gallon gross margin drove the year-over-year EBITDA growth. Lower depreciation expense and a smaller share of profits to the general partner helped widen the growth in earnings. Volumes sold were roughly 3% below our projections for the year, but AmeriGas managed to put up stronger-than-expected per-gallon margins despite the difficulty of acquiring emergency supplies at moments of peak demand in the winter.

Investors who took advantage of the slump in AmeriGas' shares after the extremely mild winter weather of 2012 have done well, highlighting the mispricing that can occur when investors focus too much on near-term performance that's unrelated to AmeriGas' moaty business model, underlying cash flow, and earnings potential. The company still faces long-term challenges in declining propane demand, but we think the performance of the business in 2014 should remind investors that AmeriGas is still a high-ROIC, finely oiled distribution machine.

Analyst Note 11/7/2014 | Michael Hodel, CFA

AT&T has finally found an international investment, agreeing to purchase Mexican wireless carrier Iusacell for $2.5 billion, including the assumption of debt. The firm also introduced 2015 capital spending expectations for its existing U.S. business of $18 billion, down from roughly $21 billion spent over the past couple of years. AT&T has wrapped up several of its Project VIP initiatives, including expansion of LTE network coverage to 300 million people. We had expected capital spending to decline in 2015, though not to the same degree management has forecast. These announcements are relatively small and in isolation don't materially change our view of AT&T's fair value estimate or competitive position. However, we are looking for additional detail regarding the firm's commitment to Mexico, including the potential for additional acquisitions, such as the assets America Movil plans to spin off. Absent an acquisition, AT&T will likely need to inject additional capital into Iusacell to enable the firm to grow and reach viability. We believe the venture into Mexico creates the potential for AT&T to destroy value, albeit on a relatively small scale. Still, combining this move with the Directv acquisition, which we believe was overpriced, 2014 is shaping up to be a poor year for capital allocation, in our view.

Iusacell has a long and checkered history, at one time operating as a subsidiary of Verizon. Grupo Televisa is currently in the process of selling its 50% stake in Iusacell to Grupo Salinas, which owns the remaining half of the firm. Once the Televisa deal closes, AT&T will buy Iusacell in its entirety from Salinas. Today, Iusacell serves 8.6 million customers, less than 10% of the Mexican wireless market, making it a far smaller rival to America Movil (70% markets share before divestitures) and Telefonica (about 20% market share). Scale is critical in the wireless business and it appears that Iusacell currently operates only marginally above break-even at the EBITDA level. The firm's network covers about 70% of the country, though it holds wireless spectrum nationwide. AT&T has pledged to expand the network to cover "millions" of additional people. Wireless penetration in Mexico stands at around 85%, about 20 percentage points lower than in the U.S., but the Mexican market is growing less than 1% annually.

AT&T clearly plans to invest in Mexico to boost Iusacell's scale, which probably means stealing or acquiring customers from a rival. As it happens, America Movil plans to divest around 20 million customers to bring its market share below 50%. Based on media reports, these assets could fetch between $10 billion and $15 billion, depending on how competitive bidding becomes. If AT&T succeeds in acquiring the America Movil spinoff, it would then become the second-largest player in the market with around 28% share. However, we question the return this investment would produce. If we assume AT&T ends up spending $12.5 billion to acquire assets in Mexico, it would need to generate more than $1.5 billion in EBITDA to bring the multiple on these purchases down to 8 times. In a market where total wireless spending runs at about $17 billion annually and where average revenue per customer hasn't shown much growth despite smartphone adoption, that seems like a tall order. For additional context, Telefonica has generated
EBITDA in Mexico of about $330 million over the past year (this figure will grow somewhat as a result of changes in Mexican regulation).

Kraft Foods Group KRFT
Investment Thesis 11/12/2014 | Erin Lash, CFA

With a solid brand portfolio (Kraft and Oscar Mayer each generate more than $1 billion in annual sales, and another 10 brands each generate more than $500 million) and substantial economies of scale on its home turf (with more than $18 billion in annual sales), we think Kraft has garnered a narrow moat. However, several of the firm's brands had been under invested in for years, and Kraft's innovation track record, which had been dismal, reflected this uninspiring level of investment. But Kraft contends it has made significant strides as an independent organization, focusing its resources on smaller but higher-impact product launches (rather than dozens of items), and more than doubling its spending to hype each new product.

In addition, ensuring its products are stocked where consumers are shopping remains a focus for the firm. 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 third quarter. However, we doubt Kraft has fully tapped this opportunity, and anticipate expanding its presence in these channels will be a focus for some time.

Despite the brand equity inherent in its portfolio, Kraft continues to take a hard look at its cost structure. Even before becoming an independent operator, Kraft announced initiatives to improve its efficiency by realigning its U.S. sales organization, consolidating domestic management centers, and streamlining the corporate and business unit organizations. In light of the fact that some production facilities haven't had the benefit of an infrastructure update since the 1950s, we think further cost savings are in the cards (half of which management has committed to reinvesting in the business while returning the other half to shareholders). Management is also pursuing opportunities related to strategic sourcing initiatives, maintenance optimization, and supply chain simplification--showcasing its stringent cost management focus.

Kraft Foods Group: Economic Moat 11/12/2014
Operating with a portfolio of powerful brands that span the grocery store, we believe Kraft has garnered a narrow economic moat. Kraft maintains significant scale despite splitting from the global snack operations in fall 2012, with annual revenue of more than $18 billion. In fact, Kraft is North America's fourth-largest food and beverage company, with two brands that generate annual revenue of more than $1 billion each (Kraft and Oscar Mayer) as well as another 25-plus brands that produce sales of more than $100 million every year, making it a key supplier for retailers. According to management, Kraft products account for 4%-6% of every American grocery store's sales. However, the firm falls short of a wide economic moat, in our view, because some of the categories in which it competes--like packaged meats and cheeses that account for almost half of annual sales--have become commodified, as consumers are less willing to pay up for the company's brands.

Kraft Foods Group: Valuation 11/12/2014
After reviewing the assumptions underlying our discounted cash flow model, we're maintaining our $53 per share fair value estimate, which implies fiscal 2015 price/earnings of 16 times, enterprise value/adjusted EBITDA of 11 times, and a free cash flow yield of 6%. 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, we think the firm is on its way to demonstrating the appeal of a more focused domestic foods business. From our view, 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. As a result, 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 outsize growth is unlikely), driven by new products and higher prices. However, the degree to which investments were lacking previously extends to its manufacturing and supply chain network. As an example, management has disclosed that some of its factories haven't been invested in since the 1950s, signifying the level of efficiencies possible. 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). 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 11/12/2014
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 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 will turn the tide and reignite category growth rates.

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 43% 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 of late, Kraft has put through significantly higher prices; however, the firm was unable to offset the hit to profitability given the lag in the benefit. Even in light of the tough operating environment, we think that Kraft will remain a formidable player in the domestic food space.

National Grid ADR NGG
Analyst Note 11/12/2014 | Travis Miller  

We are reaffirming our GBX 810 per share fair value estimate, narrow moat, and stable moat trend for National Grid after discussing the improving prospects for its U.S. utilities with senior management during the Edison Electric Institute Financial Conference in Dallas.

Management told us that any thoughts of selling the U.S. utilities are off the table, a change from discussions as recently as two years ago. Aggressive regulatory activity since then has improved returns and turned them into moderate growth contributors to consolidated earnings. The next key regulatory milestone in the U.S. is a likely filing for new rates at Massachusetts Electric in 2015. The U.S. utilities contributed GBP 307 million of operating profit in the first half of fiscal 2014-15 of GBP 1.6 billion consolidated operating profit.

Management is projecting 8.5%-8.9% earned returns on equity at the U.S. utilities, but that figure could be higher if not for abnormally high costs related to the extreme 2013-14 winter weather. We expect earned returns can hit mid-9% range after the Massachusetts Electric rate case assuming a constructive outcome. Returns could also improve if National Grid is able to convert some of the 1 million customers in its service territories who still use heating oil instead of natural gas.

Shareholders also should benefit from a GBP 1.5 billion RPI-linked loan National Grid received from the European Investment Bank in early November. Although the coupon rate is not public, we surmise it is less than the nearly 6% allowed cost of debt National Grid can collect through regulated rates. Even excluding this issue, managers told us they have been able to lower the company's delivered cost of debt to 4.5% during the first half of the fiscal year from 5.2% during the first half of fiscal 2014, nearly all of which will accrue to shareholders.

National Grid: Analyst Note 11/7/2014
We are reaffirming our GBX 810 per share fair value estimate, narrow moat, and stable moat trend for National Grid after management said operational and financial performance was in line with its expectations through the first half of its 2015 fiscal year. Management reaffirmed its fiscal 2014-15 guidance, long-term dividend policy, and capital investment plans, all in line with our forecasts.

National Grid announced a GBX 14.71 per share interim dividend, up 1.5% from its fiscal-year 2014 interim dividend paid last year. We think management will approve a final dividend next year that implies a higher growth rate near 3%, in line with its policy to grow the dividend at least in line with RPI inflation.

We think results through the first half of the year support our outlook that National Grid can earn 10% consolidated returns on equity this year. National Grid reported operating income up 2% to GBP 1.6 billion for the first half of fiscal year 2015. Lower financing costs helped boost earnings per share 16% to GBX 23.40 per share. Management said it plans to invest GBP 3.1 billion-GBP 3.3 billion this fiscal year, down from the GBP 3.4 billion it spent during the 2013-14 fiscal year but still producing similar 5% regulated asset growth, in line with our expectations.

Paychex PAYX
Investment Thesis 11/12/2014 | Brett Horn

While Paychex core payroll business is still highly profitable, it has struggled a bit to find growth in recent years. Paychex's business is exposed to macroeconomic conditions and its focus on serving small businesses magnifies the effect. A pullback was understandable during the recession, but payroll client growth has been fairly meager even as this headwind has abated. In our view, the company has reached a point of maturity in payroll processing that will limit its growth compared with years' past.

Fortunately, the company has other factors working in its favor. Its growth in recent years has come mainly through cross-selling ancillary services centered around human resources, employee retirement plans, and insurance. Further, we think the company's PEO services, a model that helps small businesses better negotiate employee benefit plans, is positioned to expand as health-care costs rise. We expect the company's growth to continue to shift in this direction, and believe that its small business focus is a benefit as the limited resources available to small businesses should make them more likely to look for bundled solutions like those offered by Paychex, as opposed to searching out best-of-breed applications. Paychex, with its broad product portfolio and dominant position in the small-business space, is best-positioned to exploit this trend. As such, we think the company can maintain healthy earnings growth even as the addition of new payroll clients begins to diminish.

Paychex should have another factor working in its favor in the coming years, although the timing is difficult to predict. Its payroll business generates float income, and the low interest rate environment has hampered profitability on this side. Although its float income is small in relation to total revenue, it drops almost completely to the bottom line, and we estimate that 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.

Paychex: Economic Moat 11/12/2014
Paychex has a wide economic moat due to high customer switching costs, and cost advantages due to scale within its small business niche. Paychex is the second-largest player within the payroll outsourcing market (based on revenue), and its scale has allowed the firm to leverage its 580,000 clients to spread out costs associated with its servicing infrastructure. Switching from one payroll processing vendor to another is a difficult task, and a customer's unwillingness to do so has allowed Paychex to build a sticky client base. Annual client retention rates are about 80%, with most attrition due to client failures. Paychex's retention rates are similar to those experienced by ADP in the small business space.

Paychex is dwarfed by its larger competitor, ADP, which generates about 5 times as much revenue in the payroll area, but we think Paychex's small client focus is a positive from a moat standpoint. More than 80% of its clients have fewer than 20 employees, which lowers their bargaining power, and Paychex holds a leading market position in the small-business segment (employers with fewer than 50 employees). The difference can clearly be seen in operating margins, with Paychex generating margins close to 40%, compared with a high-teens level for ADP. So although ADP has a scale advantage across the entire payroll processing market, we think Paychex has dug out a strong position in the most profitable area.

Paychex: Valuation 11/12/2014

We are increasing our fair value estimate to $39 from $37 per share due to the time value of money since our last update and some modest changes to our long-term profitability assumptions. Our fair value estimate equates to a fiscal 2015 price/earnings multiple of 21.1 times and a fiscal 2015 EV/EBITDA of 10.9 times. Lackluster client growth has impeded Paychex's growth in recent years, but the situation has been improving modestly, and we expect this to continue. But we believe that growth in ancillary lines will continue to be the main engine in coming years. Further, an increase in interest rates should allow float income to bounce back over time. Adding these factors together, we project an 8% revenue CAGR over our projection period, with a 5% CAGR in the payroll segment and an 11% CAGR in ancillary services. We expect margins to improve over time, as a result of higher float income and some modest scale benefits, and project operating margins to improve from 39% in fiscal 2014 to 43% by the end of our projection period. Roughly half of this improvement comes from improved yields on the float portfolio. Although our projected margins are higher than the company's historical range, we would note that the company achieved significant margin improvement prior to the recession and the drop in interest rates, and we expect a bounceback as these headwinds recede. We use a cost of equity of 10%.

Paychex: Risk 11/12/2014
Paychex is exposed to macroeconomic conditions. Its results can take a hit during periods of high unemployment, and its concentration in the small-business market exposes it to increased client failures during recessions. The management of client funds could create problems if the company were to experience material impairments in its portfolio. The company handles sensitive information and its brand could be damaged if its systems were breached. Regulatory changes could also pressure margins and revenue.

Procter & Gamble PG
Analyst Note 11/14/2014 | Erin Lash, CFA

We walked away from Procter & Gamble's analyst day, held in Cincinnati on Nov. 12-13, with a more comprehensive take regarding the firm's pipeline for product innovation, which we view as a crucial intangible asset in light of the competitive environment in which it competes, as well as its prospects for growth at home and abroad. We continue to regard P&G as a wide-moat giant that enjoys the benefits of scale with an extensive global manufacturing and distribution network and unprecedented brand reach.

After incorporating the impact of the Duracell sale to wide-moat Berkshire Hathaway for its $4.7 billion in P&G shares (52.8 million shares, a transaction that is slated to take place in the second half of calendar 2015), we plan to take our P&G fair value estimate up by $1, to $94 per share. P&G expects to incur $0.28 per share in a goodwill impairment charge and is set to inject $1.8 billion of cash into the battery business before the close, which lowers the deal value to $2.9 billion or 1.3 times fiscal 2014 sales and 7 times fiscal 2014 adjusted EBITDA. Despite the lower valuation relative to other deals in the consumer product space (which tend to approximate high-single- to low-double-digit EBITDA multiples), we think the price paid seems fair, as price is more important to consumers than brands in batteries, with research and development spending critical just to stay ahead of the competition. In addition, the growth prospects for Duracell's core battery business are limited longer term, given the growth of electronic devices with their own rechargeable batteries. Our long-term discounted cash flow expectations for P&G's consolidated operations (annual top-line growth above 4% and nearly 23% operating margins) remain in place.

Beyond the sale of the battery business, P&G also disclosed that to date, 28 brands (including the pet-care business earlier this year and Duracell) have been sold, discontinued, or will be consolidated, out of the 90-100 it plans to shed. Prospective buyers are conducting due diligence on another 10 brands; however, management refrained from offering any other specifics regarding the brands that have been cut or any price received for the assets. When asked, CEO A.G. Lafley called out the fragrance space as one that had gotten too broad, saying, "We were performing better in the fragrance business when we were very focused on three or four, Hugo Boss and Lacoste, Dolce & Gabbana and Gucci, than when we ended up with an assortment of 20-plus." As such, we won't be surprised to see additional pruning of the firm's mix in this category.

While we've been of the opinion that P&G's pricing and brand power have come under pressure following a stream of lackluster innovation, we now think the reignited focus on winning with innovation could be gaining some traction. For instance, P&G has operated as the number-two player in the U.S. diaper market for the past 20 years. However, as a result of new product launches and efforts to get in front of new moms early on with increased sampling in hospitals, Pampers (P&G's largest brand with $10 billion in annual sales) has overtaken Huggies (a Kimberly-Clark brand) and now controls around 38% share of the U.S. diaper market, about 300 basis points above the level held by its leading competitor. The success of its recent innovation has been particularly evident in its Swaddlers product line (which now is sold in sizes 1-6, up from just 1-3 previously), accounting for more than $600 million in annual sales, up from less than $200 million 10 years ago and equating to a 10% value share of the category.

The firm is also realizing an improved share position in the U.S. laundry category; it now controls about 62% of the market, up from less than 60% the past several years. Tide, P&G's second-largest brand, has been a beneficiary, garnering 42% of the market, up from less than 40% over the past few years. We think this reflects the success of its single-dose laundry pod launch. As a segment, single-dose laundry now makes up about 12% of the overall U.S. laundry space, with P&G maintaining 75% of this niche (accounting for $750 million in annual sales). Management has called attention to the fact that single-dose laundry is even winning with dollar store consumers, despite the fact it sells at a 20% premium to base Tide, given the convenience it affords (it is easier to take a pod or two to the laundromat than a jug of liquid detergent). We think this showcases that consumers are willing to pay up for a product when they perceive added value.

We walked away from the meeting with the sense that management remains laser focused on removing excess costs from its operations and enhancing its cost advantage. For one, CFO Jon Moeller told us how the extension of common manufacturing platforms around the world is proving particularly advantageous for its diaper business, a product that had been manufactured in disparate forms but is a sizable opportunity. The company was manufacturing diapers with different materials in multiple geographies around the world, which inherently limited the negotiating leverage it could garner over suppliers. However, as the firm has worked to streamline its manufacturing and production of diapers (using the same inputs on a global basis now), we expect it to exploit its purchasing leverage and ultimately enhance its cost edge. Partly as a result of these efforts, we forecast gross margins will expand by around 200 basis points over the next 10 years to 51%, about 100 basis points above its average gross margin over the past five years.

With regards to the firm's management structure, we still believe Lafley's appointment following the abrupt resignation of former CEO Bob McDonald in May 2013 and subsequent tenure gives credence to our prior concerns that P&G, which tends to promote from within, may not have anyone ready to fill the top spot, since several senior executives headed for the exits during McDonald's time at the helm. While we expect that Lafley will continue to lead the organization until a permanent successor--possibly from outside the organization--is named, we anticipate that this time he will stay on (possibly in the chairman role) to ensure a smooth transition, unlike when he handed over the reins in July 2009. P&G tends to be an organization in which individuals move up from within the ranks, but we were encouraged by Lafley's reference in response to a question the importance of bringing in outside talent to the organization, as we think fresh perspectives can prove highly valuable.

Public Service Enterprise Group
Analyst Note 11/11/2014 | Travis Miller  

We are reaffirming our $37 per share fair value estimate, narrow economic moat, and positive moat trend ratings for Public Service Enterprise Group after discussing its growth opportunities with senior management at the Edison Electric Institute Financial Conference in Dallas, Texas. We think the utility's growth will be the key driver of dividend growth in the coming years.

The $1 billion Energy Strong program will contribute a full year of earnings in 2015. There could be additional growth upside with the gas main replacement program in 2016 and beyond depending on the outcome of a potential rate filing in mid-2015. PSEG expects to complete the $350 million gas main replacement portion of Energy Strong by the end of 2015 and could petition New Jersey regulators to extend the program.

Another key part of our growth forecast is the utility's $6.8 billion planned transmission investment during the next four years. New rates tied to its transmission investments contributed about $0.10 per share of incremental earnings this year and should contribute a similar amount in 2015 based on its $182 million mid-October rate increase request. We expect similar transmission revenue and earnings growth for several more years.

The risk to the transmission growth is a potential cut in its base allowed return on equity. Unlike in other regions, no one has filed a complaint with the Federal Energy Regulatory Commission challenging PSEG's allowed ROE. We think a complaint is unlikely given PSEG's systemwide average allowed ROE is 11.4%, which is within the range of reasonableness that FERC set earlier this year in what we think will be a precedent-setting ruling involving utilities in the Northeast.

Spectra Energy Corp. SE and Spectra Energy Partners SEP
Analyst Note 11/10/2014 | Jason Stevens

Spectra Energy and Spectra Energy Partners delivered strong third-quarter earnings, on par with expectations. While we're not making any changes at this time to our fair value estimate for Spectra Energy Partners (which we raised just before earnings), we are increasing our fair value for Spectra Energy by $1 to $44 per share, largely in recognition of a faster-than-anticipated dividend hike. Our wide moat ratings for both firms are intact.

Spectra Energy Partners' core U.S. Transmission business reported EBITDA of $352 million for the quarter, up 11% from $318 million last year. The liquids segment posted $60 million in EBITDA, up from $40 million a year ago. Total distributable cash flow for the quarter came in at $247 million, or $0.84 per unit, providing 1.46 times coverage of the declared $0.57625 per unit distribution.

Spectra Energy posted quarterly net income of $201 million, or $0.30 per share, down from last year's $263 million. Relative weakness at field services was the primary culprit, though a weaker Canadian dollar also contributed. EBITDA only decreased 6% year over year, and we continue to expect full-year EBITDA of $3.1 billion.

During the quarter, Spectra added four new projects to its list, worth $700 million. Year to date, Spectra has moved more than $3 billion of projects into execution, a pace we expect it to keep up for the foreseeable future.

Spectra Energy Corp.: Investment Thesis 11/10/2014
Spectra is a pure play on natural gas demand and infrastructure. Its operations stretch across all links in the natural gas value chain, with the exception of riskier exploration and production. With positions in gathering, processing, transportation, storage, and distribution, Spectra collects a large portion of the economic rents paid to move gas to end users.

About a third of Spectra's earnings, depending on commodity prices, come from gathering and processing natural gas. The Empress processing plant in western Canada conducts fee-based gathering and processing, but the bulk of gathering-processing cash flows come from Spectra's 50% ownership of DCP Midstream, a joint venture with Phillips 66. While there is significant commodity exposure here, DCP's considerable position in six producing regions and its natural gas liquids business provide some diversification. We're much bigger fans of the company's U.S. transmission segment, long-haul pipelines, and storage facilities that move about 12% of gas consumed in North America. Nearly half of the company's earnings stem from stable, long-term contracts for firm capacity across this system. Canadian distribution subsidiary Union Gas makes up the balance of Spectra's earnings and supplies natural gas to 1.3 million customers in Ontario. Earnings fluctuate somewhat with the weather, as the primary uses for natural gas are winter heating and, increasingly, summer cooling.

Growth opportunities for Spectra remain compelling, thanks to its large, diverse, and well-positioned asset base. Pipelines and fee-based processing opportunities in the U.S. and Canada offer low-risk, bite-size, bolt-on growth opportunities backed by firm contracts. Also, DCP, the largest natural gas liquids player in the midstream industry, has its hands full trying to build out new infrastructure to support surging NGL production in the Eagle Ford, Permian, and Mid-Continent. Overall, Spectra and DCP are currently executing on $9 billion in approved projects that will enter service between now and 2016. More than $20 billion in additional identified projects will ensure longer-term growth prospects.

Spectra Energy Corp.: Economic Moat 11/10/2014
We think Spectra Energy has a wide economic moat. As one of the largest natural gas transportation and distribution companies in North America, Spectra can bring its impressive scale and experience to bear across multiple markets. Its core strategy is to own and operate natural gas assets with local monopolies, effectively maximizing switching costs and yielding consistently attractive returns on invested capital. We think each of Spectra's various businesses has a moat, though we believe that Union Gas only deserves a narrow moat, given its limited ability to increase regulated returns. We're particularly interested in Spectra's pipeline assets, which consist of long-haul interstate pipelines that run from the Gulf Coast to Midwest, Northeast, and Florida markets and from northeastern British Columbia to Vancouver. Spectra's strong positions in the Marcellus, Horn River, and Montney shale plays provide particularly attractive long-term growth opportunities. As Spectra continues to devote most of its growth capital to a variety of internal pipeline and storage projects, we think it can achieve economies of scale by flowing incremental volumes through its existing system, connecting North America's major natural gas resource plays with its prominent demand centers.

Spectra Energy Corp.: Valuation 11/10/2014
Our fair value estimate for Spectra Energy is $44 per share after accounting for third-quarter earnings and updating our model. We continue to expect that Spectra will be able to increase revenue by 10% and EBITDA by 8% a year on annual investment of around $3 billion. Because of the cash flows from Spectra's general and limited partner stakes in SEP, we agree with management's expectations of faster dividend growth, which we model at $0.12 per year. We expect U.S. Transmission (or SEP) and Western Canada do deliver around 11% annual EBITDA growth, while Union Gas slightly trails the full company and DCP sees 4%-5% annual gains. For our fair value estimate, we average the results of a discounted cash flow model and a dividend discount model. Our discounted cash flow model values Spectra at $49 per share, while our dividend discount model yields $37 per share. Our $44 fair value estimate implies a 12.5 times forward EBITDA multiple and a 3.1% forward yield.

Spectra Energy Corp.: Risk 11/10/2014
While roughly 80% of cash flows are fee-based, low commodity prices destroy margins for the remaining 20%, and a sustained low-price environment could stunt growth across the board by keeping producer drilling at bay. Through DCP, Spectra is exposed to the spread in natural gas liquids and natural gas prices; as natural gas prices increase, while NGL prices decline, processing margins at DCP deteriorate, reducing cash available for distribution to Spectra. We worry somewhat about access to capital in the event of a market collapse and note that rising interest rates could raise costs of refinancing debt and send investors into other yield vehicles. Other risks include changes to regulatory safety requirements, environmental exposures, leaks, spills, or fires.

Spectra Energy Partners: Valuation 11/10/2014
We are maintaining our $62 per unit fair value estimate for Spectra Energy Partners after incorporating third-quarter results in our model. We continue to forecast steady growth at both of SEP's segments. We model $1.4 billion in EBITDA for U.S. Transmission in 2014, climbing to $1.9 billion in 2018. For SEP's liquids segment we model $224 million in 2014 EBITDA, increasing to $383 million by 2018. All told, we expect SEP EBITDA to increase roughly 10% a year throughout our five-year horizon, supporting distribution growth of 8% a year. Our fair value estimate is based on the average of two valuation methodologies. Our discounted cash flow model values SEP at slightly less than $62 per unit, while a dividend discount model implies a value just shy of $63 per unit. Our valuation implies an 18 times multiple on 2015 EBITDA and a 3.6% forward distribution yield, measures we believe are justified by the combination of growth and stability offered by SEP.


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