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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Strong Dollar Makes for Some Weak Earnings -- The Week in Dividends, 2014-10-24

Third-quarter earnings reports dominated the week's news for the stock market, and in the aggregate these results pushed the S&P 500 to its best weekly gain since the first week of 2013. As usual, though, I prefer to lead off with my favorite kind of development--dividend increases--of which we had two this week.

Top Harvest holding Magellan Midstream MMP continues to raise its quarterly cash distribution at a scorching pace. The $0.6675 a unit payment announced on Wednesday, which exactly matched my expectations, is up 4.3% from last quarter and 19.7% from a year ago. Such rapid growth helps justify a low yield (3.3%) by historic standards for midstream master limited partnerships; an attractively conservative risk profile assists on that count as well.

With the price of crude oil on a downswing of late, it's worth noting that Magellan has very little direct sensitivity to crude oil prices in the near term. If anything, lower prices for refined petroleum products should encourage consumption, which could actually benefit pipeline volumes and revenues. However, much of Magellan's recent expansion has involved projects that transport crude oil. If oil prices remain depressed for an extended period of time, drilling activity could decrease, and so could profitable expansion opportunities for midstream partnerships. This is a risk worth noting for Magellan and many of its midstream peers, but I continue to believe that Magellan's most significant source of earnings--its refined petroleum products system--is also the most attractive thanks to the relatively steady volume of products consumed and the automatic, inflation-linked tariff increases such pipelines enjoy. I continue to view Magellan as a core holding, and it qualifies as a buy up to our fair value estimate of $90 a unit.

Earlier in the week, American Electric Power AEP chipped in with the 6.0% dividend increase I've been expecting all year. On Thursday, the utility also reported an 8% drop in third-quarter operating earnings per share from a year ago; the decline was due mainly to a planned increase in maintenance costs and unusually cool summer weather. Even so, AEP maintained its outlook for full-year EPS growth (up 7% at the midpoint of management's range) and over the next several years (4%-6% a year). Against this backdrop, I'm confident AEP can deliver annual dividend increases averaging 6% for at least several more years as the payout ratio moves from a likely 59% for 2014 into the middle of the company's target range of 60%-70%. The only drawback I see for AEP is the stock price, which closed Friday at a 5% premium to our $54 fair value estimate. However, on any retreat below that level, I would consider AEP a buy.

As for the rest of the week's earnings reports, they contained no especially adverse surprises from my point of view, but we have seen negative macroeconomic trends take a toll on near-term profits as well as our valuations. In the wake of third-quarter results, we reduced fair value estimates for three Builder holdings: Coca-Cola KO (down $2 a share to $42), McDonald's MCD (down $3 to $95) and Unilever UL (down $2 to $44). The common themes here are a weak global economy, particularly as it pertains to consumer spending, and the persistent rise of the U.S. dollar versus other currencies. For many of our holdings--including most in the Builder--dollar strength has become a formidable headwind for earnings growth in a period where there are few tailwinds to speak of. Then again, each of these three companies has its own story.

In Coke's case, I think this week's sharp selloff creates a decent buying opportunity, and I'm again thinking about adding to the Builder's position. The proper context for the stock's 6% drop on Tuesday is the market-beating gain of almost 13% it had between our purchase on April 3 of this year and Monday, Oct. 20. Apparently investors had bet, at least implicitly, on a strong showing in Coke's third quarter. Instead, global volume growth ticked down to 1%, and the bears came roaring back. Operating income and EPS (excluding unusual items and currency effects) rose 5% and 6%, respectively, only moderately below what I view as the company's long-term trend. In particular, 6% growth in per-share earnings and dividends strikes me as respectable, if not attractive, in light of a highly reliable dividend that now yields 3.0%. But with currency posing a growth headwind of six percentage points in the year-over-year comparison, core EPS did not grow at all.

Coke currently anticipates that 2015 will be similar to 2014: mid-single-digit core EPS growth, most or all of which could be offset by continued currency depreciation. The firm also softened its long-term financial targets a bit, though the goal of high-single-digit EPS growth excluding currency effects is still on the table. Management seems to understand that the business isn't performing up to its full potential, though they're resisting the kind of bold, slash-and-burn cost cutting that some critics are demanding. Still, it seems to me that Coke is drawing too much fire given that its single largest problem--negative currency effects on earnings--is far beyond its ability to control. Up until this week, sentiment had grown too bullish; now (as I thought in April) it's too bearish again.

I don't know at what point the dollar will level off or weaken, and I don't like to think of stocks like Coke (let alone Philip Morris PM) as being currency plays rather than operating businesses. It's fair to guess that unless currency trends quickly reverse themselves, the annual dividend increase we get from Coke next year could be quite small. Yet with adequate margins of safety to protect our dividends as well as the long-term growth potential provided by exposure to foreign economies, I think currency risk is one generally worth accepting--at least for a one-of-a-kind wide-moat business like Coke.

Unilever falls in the same category as Coke. Its sales hit something of a rough patch during the third quarter as emerging market growth slowed, retailers' inventories buckled in China, and currency headwinds failed to let up. The latter accounts for the bulk of the drop in our revenue growth forecast for 2014 (from +1% to -2%) and the $2 an ADR drop in our fair value estimate. As with Coke, we have to live with currency risks even as they can't help but affect dividend growth rates from year to year. Yet the company remains a solid operator with a balanced strategy of optimizing volume gains, pricing, and costs, and the quality of its brand and product portfolio continues to improve. With the 3.2% drop in the ADR price this week driving its current yield up to 3.7%, Unilever has become one of the most attractive candidates for new money in the Builder--though the account's already-huge weighting in consumer staples remains a hurdle for add-on buys in the sector.

Then there's McDonald's, whose results were awful, but where the long-sagging share price and dour sentiment at least limited the stock's drop on Tuesday to 0.6%. Several one-off items combined to drive third-quarter EPS down 28%, though in this period currency wasn't among them. But even though certain declines could be rationalized away by management, there's no hiding from the 3.3% drop in global same-store sales. The $3 a share cut to our fair value estimate rests mainly on lower anticipated revenues and margins in key markets including the U.S., Germany, and Japan; previous reductions had already reflected troubles in Asia. Meanwhile, management's conference call featured an awareness of the company's problems and plans for lots of small-bore improvements in the restaurants' offerings, but nothing that seems likely to twist same-store sales back into positive territory overnight.

While I have no problem admitting that my November 2012 purchase of McDonald's was a mistake, it's harder to tell what to do from here. I still have no fear of the dividend being cut: The company's cash flow and balance sheet remain very strong, so there's no reason for management to divert its cash elsewhere. Some elements of McDonald's wide economic moat rating--the value of its brand, for example--are being called into question by recent financial trends, but others are not, such as its enormous scale and leverage with suppliers. A 3.7% yield is nothing to sneeze at, either: It presently exceeds the average of the U.S. utility sector. Perhaps the stock wouldn't be cheap if there were obvious ways to fix the company's problems, but if McDonald's can't return to positive same-store sales growth within a year, it'd become hard to argue that the stock actually is cheap here. All in, I'd say that McDonald's is currently our most frustrating holding. I'm not ready to give up, but the clock is ticking, and I have no plans to buy more.

As it happens, the two other most-frustrating holdings (out of our current roster of 31 stocks) reported results this week too, and neither provided me with incremental heartburn. In fact, GlaxoSmithKline's GSK third-quarter results provided a welcome bit of relief. Pressure on Glaxo's respiratory drugs continues but should abate into 2015. The company has also started chopping away at costs. In other words, compared to the truly dreadful showing in the second quarter, it seems the ship is no longer sinking--and the 4.9% gain in the stock price this week suggests I'm not the only person holding that view.

Glaxo also has a reasonably good story to tell in terms of changes to its wide-ranging portfolio of operations. Next year Glaxo will complete a three-way transaction with Novartis NVS that will substantially enlarge Glaxo's vaccines and consumer products units in exchange for its oncology business and a pile of cash--much of which will be paid out as a special dividend. After these deals are done, Glaxo's pharmaceutical business will shrink to only 60% of total revenue. Additionally, the company is also looking to sell off some of its mature product lines and exploring a possible initial public offering for ViiV, a HIV-focused business that might be valued more highly by investors as a separate entity than buried inside the huge conglomerate as it is today.

However, Glaxo also announced that it will hold its dividend rate flat through next year: No dividend increase was issued along with third-quarter results as had been the case each year since 2006 (I had figured that the rate of growth would at least be halved). With a payout ratio elevated by (1) several years of dividend growth exceeding EPS growth, (2) operational problems, especially in respiratory drugs, and (3) yet another case of a massive currency headwind for stated results, I judge that Glaxo has enough room to maintain its current dividend rate as it maneuvers a lot of moving parts through the end of next year. However, an increase might have been a bit too much--rather than viewing it as a sign of confidence, it might instead have looked as though management was simply out of touch. I also have no doubt that Glaxo desires to restart consistent dividend growth as soon as it can, though with an elevated payout ratio any dividend increases really need to be funded by growth in earnings, and 2016 seems like the earliest timeframe in which we might see Glaxo's dividend rate rise again.

This is another stock that, like McDonald's, I'd rather not have bought. Still, I am more comfortable coming away from Glaxo's third-quarter results than I was going in. We reaffirmed our fair value estimate at $48 an ADR (it was reduced from $51 last week to reflect recent currency changes). One quarter of stability does not a favorable trend make, but with a 5.6% current yield--the second-highest of any DividendInvestor holding--I am content to continue holding the Harvest's small position as I await confirmation that Glaxo's performance has bottomed out.

The week's other earnings reports were not particularly noteworthy. Like its global staples peers, Procter & Gamble PG is feeling some heat from negative exchange rate trends, but its operational turnaround remains on track. P&G also announced plans to split off Duracell as an independent entity next year, which underscores the company's determination to shrink the quantity and enhance the quality of the brands in its wide-ranging portfolio. Though the stock rose 2.3% in Friday's trading, P&G is still in buy territory with a 3.0% yield. Separately, United Parcel Service UPS reported solid growth and improved profitability in the third quarter even as it prepares for another surge of package volumes in December. The company remains one of my favorite cyclicals but I wouldn't buy it at today's price--it closed Friday with a 2.7% yield and at a 6% premium to our $95 fair value estimate.

Finally, AT&T T and Rogers Communications RCI showed stability but few signs of overall growth in their third-quarter results. With AT&T closing Friday slightly below our $34 fair value estimate, both stocks qualify as buys in our framework. However, I continue to worry that there is so little growth to be had in this industry that even generous yields (5.4% for AT&T, 4.2% for Rogers) will not be enough to drive adequate long-term total returns. Our allocation of capital to the telecom industry is small and will almost certainly remain that way.

Earnings season will peak next week, at least for the DividendInvestor portfolios, as 10 of our holdings release results. Wednesday we'll hear from Kraft Foods KRFT and Southern Company SO; Thursday will bring word from Altria MO, Public Service Enterprise Group PEG, Realty Income O, Shell RDS.B and Xcel Energy XEL; and Friday's calendar shows Chevron CVX, Clorox CLX and Magellan Midstream.

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.

Josh's Video of the Week: Are These 3 Dividend-Payers Still on Track?
Sizing up the disappointing results from McDonald’s and Coke, and GE’s nice surprise.

News and Research for Builder and Harvest Portfolio Holdings

American Electric Power AEP
Analyst Note 10/23/2014 | 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 it reported third-quarter ongoing earnings of $1.01 per share, in line with our expectations. This quarter's earnings were down from $1.10 in the third quarter of 2013. Management narrowed its full-year EPS guidance to $3.40-$3.50 from the previous $3.35-$3.55 range.

AEP recently increased its quarterly dividend to $0.53 per share from $0.50, reaffirming our view that management’s 4%-6% long-term earnings growth target will drive similar dividend growth.

At the company’s vertically integrated utility segment, earnings declined $0.11 per share to $0.45, primarily due to shifting future plaint maintenance into 2014, as management previously indicated. Additionally, the impact of cooler weather reduced quarterly earnings by $0.05 per share. The company reported 9.5% systemwide earned return on equity, which should improve from rate changes allowed in recent rate case decisions. Industrial sales grew an impressive 3.8%, partially offset by weak residential sales.

Transmission continued to perform well, reporting year-to-date earnings of $0.23 up from $0.11 supported by continued transmission investments. For the year, management expects to earn $0.30 at the segment. Transmission assets now stand at $2.4 billion, an 83% increase from the same year-ago period. AEP Generation’s future remains in flux, as management awaits key rulings in Ohio, particularly on the company’s requested Ohio PPA.

At our meeting with AEP's management during the upcoming Edison Electric Institute Financial Conference, we expect an update on further transmission opportunities, regulated growth within the vertically integrated utility segment, and cost plan, all of which should support management’s 4%-6% long-term earnings growth target.

Analyst Note 10/23/2014 | Michael Hodel, CFA

AT&T's wireless results have evened out as the shift away from traditional wireless device subsidies has slowed. More than half of the firm’s postpaid customer base has made the transition to the cheaper no-subsidy plans, but the pace of migration slowed during the third quarter. Average service revenue per postpaid wireless customer increased sequentially, a welcome sign after sharp sequential declines during the first half of the year. With the worst of the initial financial impact of this transition in the past, AT&T should be in a position to reap the benefits of lower phone subsidy costs over time. Also, the firm’s decision to quickly move customers to lower-priced plans continues to produce strong customer loyalty, with customer defections remaining at a record low level. We believe AT&T remains worthy of a narrow economic moat rating and we don’t plan to materially change our fair value estimate.

Reported wireless revenue grew 4.9% year over year and 2.3% sequentially during the third quarter. AT&T’s pricing actions continued to mitigate the impact from a noisy competitive environment, as the firm added 785,000 net postpaid connections during the quarter, including around 335,000 new phone customers. AT&T didn’t make as big a push in the tablet market as rival Verizon, but otherwise customer growth between the two firms during the quarter. AT&T’s revenue growth also continues to benefit from up-front recognition of Next installment revenue, with 3.4 million smartphones sold under the program. We had expected Next sales to be even stronger, though management indicated that inventory shortages (presumably for the latest iPhones) constrained sales. With 20 million smartphone customers currently on no-subsidy rate plans but not yet on Next, upgrade activity could be very heavy during the fourth quarter.

The benefits of Next accounting and relatively modest upgrade activity thus far in 2014 have buoyed wireless profitability. The reported wireless EBITDA margin held steady year over year and sequentially at 42% of wireless service revenue. We estimate that absent the upfront equipment revenue recognition that Next accounting prescribes and excluding costs associated with the Leap acquisition, the EBITDA margin would have fallen about 2-3 percentage points year over year. This decline comes despite a likely drop in smartphones purchased during the quarter versus a year ago (AT&T reported a small increase in smartphones activated on its network, but the firm also indicated that a growing percentage of customers are choosing to bring their own device rather than take a subsidy or enroll in Next). As we’ve mentioned previously, we believe the benefit of this hit to underlying profitability will materialize over time as upgrade activity and subsidy levels diminish.

The fixed-line business turned in respectable results during the quarter, with residential customer metrics showing some signs of improvement. AT&T lost 173,000 residential customers during the quarter, far better than the 474,000 it lost a year ago, and the firm added 64,000 residential Internet access customers, the strongest third quarter result since 2010. Residential revenue growth held steady at 3% year over year. Revenue in the business and wholesale services unit declined 2.0% year over year, the slowest pace of decline in two years. Fixed-line profitability remains an area of concern, however, as the segment's margins continue to contract.

Free cash flow continues to reflect the impact of the Next program and higher capital spending. AT&T continues to sell off Next receivables, but not at the same pace as new Next sales. Free cash flow has totaled $8.6 billion year to date, down from $11.1 billion at this point a year ago. Increased capital spending accounts for about half of the decline in free cash flow, but management continues to target total spending for the year at $21 billion, roughly flat with 2013. Going forward, AT&T should have an opportunity to reduce capital spending somewhat as it completes Project VIP initiatives, especially on the fixed-line side of the business.

Coca-Cola KO
Analyst Note 10/21/2014 | Adam Fleck, CFA

We are likely to trim our $44 fair value estimate for wide-moat Coca-Cola about $1 or $2 to reflect near-term concerns, but overall we believe the company’s revisions to its 2020 vision only delay rather than prevent the long-term high-single-digit earnings growth potential of the business.

The firm reported top-line challenges in its third quarter, with adjusted 1% year-over-year revenue growth reflecting slowing price/mix and volume growth and further foreign currency headwinds. We're encouraged that the company continued to enjoy positive, rational pricing in the core North American sparkling beverage market, and that profitability again improved, but we caution that further top-line headwinds look to threaten this year-over-year margin improvement in the fourth quarter. As such, we continue to forecast Coke’s adjusted earnings per share (including negative currency translation) to be roughly flat versus 2013. Similarly, management estimates that currency-neutral 2015 EPS growth will also be in a mid-single-digit range.

That said, the company reiterated its long-run high-single-digit EPS growth target, which is in line with our own forecast, though the structure has changed slightly. The firm now expects net revenue growth in the mid-single-digit range (versus about 6% previously). Although we believe our current long-run 5.5% forecast captures the new guided midpoint, we will probably lower our projections given continued top-line uncertainty.

Mitigating this factor, management also extended its annual savings target to $3 billion by 2019 (and $2 billion by 2017) from a prior expectation of $1 billion by the end of 2016. These updated initiatives include restructuring the firm’s North American manufacturing footprint and streamlining operations for additional back-office cost savings. While some of these savings will be reinvested into the business, we nonetheless expect slightly higher long-term operating margins than we previously forecast.

In all, we think management is working to control what it's able given the low-growth environment of nonalcoholic beverages, but we’re also encouraged that the firm will install revenue growth targets as a measurable goal for incentive pay. Local managers will be measured on both a volume and price basis, depending on geography (skewed more toward price for developed markets and more toward volume for emerging ones). While growing at a profitable rate will remain Coke's ultimate goal, we believe setting up top-line goals also incentivizes the company’s management to be proactive with bottling partners, and to spend marketing dollars more effectively (an area of recent focus).

Beyond focusing on owned operations, Coke also moved its 6%-8% long-term earnings growth goal to focus on earnings before taxes rather than operating income. While some critics may surmise that this alteration implies interest-expense engineering will drive much of the growth, we believe instead that the move is meant to capture increasing equity income, which is slated to climb materially as the firm increases its partnership with Monster Beverage (which will remove energy drinks from Coke's consolidated operations); in fact, we wouldn't be surprised to see additional similar partnerships struck over the coming years.

In the near term, however, Coca-Cola noted that cash flow is likely to be a bit softer than originally expected at the beginning of the year largely because of negative currency translation, and the company now targets repurchasing approximately $2.5 billion of shares--at the low end of its prior guidance. Because we view shares as currently undervalued, we'd prefer to see increasing levels of buybacks.

Coca-Cola: Valuation 10/21/2014
We've lowered our fair value estimate to $42 per share from $44. Although we still expect long-run earnings per share growth in the 7% to 8% range, we forecast a longer period of lower bottom-line gains due to end-market volume weakness (both developed and emerging market), European price competition, and productivity and marketing initiatives planned for 2015. Our fair value estimate implies a 19.3 times price/earnings ratio (based on our updated estimated 2015 earnings per share) and a 14.8 times enterprise value/EBITDA. We continue to expect the firm to face developed-market carbonated beverage volume challenges in the near term, although we expect positive pricing, gains in emerging markets, and still-beverage growth to drive low-single-digit revenue growth in 2015 compared with the prior year. Longer term, we expect top-line gains of about 5%, lower than our prior 5.5% forecast due to secular volume headwinds in North American and Europe. That said, this growth projection remains a bit ahead of competitor PepsiCo, driven by Coke’s dominant presence in developing markets, its ability to drive positive pricing, and further gains in noncarbonated drinks; we still view volume and price contribution as relatively equal contributors to this growth. Although we've lowered our long-run revenue outlook, we now believe operating margins can climb north of 24.5% over the next five years from about 22% in 2013, about 30 basis points higher than our prior forecast due to an incremental $2 billion in productivity-related savings versus the company's previous outlook (for a total of $3 billion on an annual run rate by 2019). While some of these savings will be reinvested into the business, we nonetheless expect higher margins to result. As such, we continue to expect EPS growth to outpace both sales and operating-income gains because of Coca-Cola’s commitment to additional share repurchases. Our revenue and income growth targets are roughly in line with management’s long-term forecasts for mid-single-digit yearly top-line growth and pre-tax income gains of 6% to 8% annually.

GlaxoSmithKline ADR GSK
Analyst Note 10/22/2014 | Damien Conover, CFA  

Glaxo reported third-quarter results largely in line with our expectations and those of consensus, but the poor pricing environment for respiratory drugs is putting pressure on the firm's wide moat. Based on the results, we don't expect any changes to our wide moat rating or GBX 1,510 fair value estimate ($48 for the ADR) as we believe the stock looks slightly undervalued despite significant challenges ahead for the company.

We expect the declining pricing power in respiratory drugs seen over the past three quarters will continue, but at a decelerating rate, into 2015. Representing over one fourth of sales and likely more than one third of profits, the respiratory decline in pricing power is weighing on growth, profitability, and the company's wide moat. However, we expect the decline to slow in 2015 as new respiratory drugs gain traction and new contracts begin with Express Scripts (top drug Advair will be removed from the "exclude" list in 2015) and Caremark (competing drug Symbicort will be added to the "exclude" list). While we are concerned about the poor initial sales of the new respiratory drugs Breo and Anoro, increasing formulary acceptance should help in 2015. Further, management expects a return to growth in respiratory drug sales by 2016, which is encouraging, but we don't expect growth until 2019.

Cost-cutting is preserving margins and showing the resilience of Glaxo's wide moat. In the quarter, SG&A costs were lower than expected as the firm is adapting its cost structure to the poor respiratory market, and we expect further cost-cutting will help it mitigate these headwinds.

Outside of respiratory, emerging market and HIV drug sales boosted overall results. Partly helped by the annualizing of the Chinese investigation into improper business practices, emerging market sales jumped 12% year over year. In addition, with strong HIV drug sales, management is exploring an IPO of this business, which we expect would garner strong interest by the market.

McDonald's MCD
Analyst Note 10/21/2014 | R.J. Hottovy, CFA

Although expectations for McDonald's were low following recent U.S. comparable sales trends and external issues in international markets (food supplier issues in China, geopolitical issues in Russia), the third-quarter update paints a picture of a company struggling to keep pace with evolving consumer tastes and a competitive global restaurant landscape. The comparable sales decline of 3.3% (-3.3% U.S., -1.4% Europe, -9.9% APMEA) was in line with our expectations, though combined operating margins were a bit worse than forecast (29.7%, a decline of 330 basis points) due to temporary external factors. With management's outlook for negative comparable sales in October (which we expect to extend well into 2015), it's clear that recent menu and marketing initiatives have not had the success management anticipated.

To confront these issues, management unveiled a new global approach "to increase its relevance with customers and drive guest traffic," including a modernized restaurant experience and a comprehensive digital ordering, payments, and marketing strategy. McDonald's also outlined new initiatives designed to improve U.S. operations, including a more nimble organization with decisions made closer to the customer; revamped marketing emphasizing food quality; and a simplified yet customizable menu balancing core items and locally relevant choices. While we view each of these initiatives as appropriate, execution and timing remain questions and we believe investors should not expect an overnight turnaround.

We'll wait for additional details regarding turnaround plans before finalizing our model, but third-quarter results will likely result in a slight reduction to our $98 fair value estimate. We're also planning to review the brand intangible asset component of our wide moat and stable trend rating as well as our Exemplary equity stewardship rating, which factors in three-year cash return targets of $18 billion-$20 billion, but not recent execution issues.

McDonald's: Investment Thesis 10/23/2014
After an impressive eight-year run from 2004 to 2011 highlighted by average annual global comparable sales growth of 5.6% and roughly 1,500 basis points of operating margin expansion to north of 31%, McDonald's fundamentals have weakened in recent years amid increased competition, self-inflicted product pipeline and marketing issues, a tepid macro environment, and evolving consumer tastes. To confront these issues, management has unveiled a new global approach "to increase its relevance with customers and drive guest traffic," including a modernized restaurant experience and a comprehensive digital ordering, payments, and marketing strategy. McDonald's also outlined new initiatives designed to improve U.S. operations, including a more nimble organization with decentralized decisions made closer to the customer; revamped marketing emphasizing food quality; and a simplified yet customizable menu choices balancing core items and locally-relevant options.

While we view each of these initiatives as appropriate, execution and timing remain questions, and investors should not expect an overnight turnaround. This is particularly true in "priority markets" such as the U.S., Germany, and Japan, and we anticipate negative comparable sales trends to persist into 2015. We believe the company can gradually return to the lower end of its longer-term goals (3%-5% system sales growth, 6%-7% operating income growth, returns on incremental invested capital in the high teens) based on a wide economic moat rating stemming from a widely recognized brand intangible asset, convenient restaurant locations, a cohesive franchisee system, and significant bargaining and advertising scale. These qualities have kept McDonald's among industry leaders with respect to average unit volumes ($2.5 million per restaurant compared with the QSR industry average just north of $1 million) and operating margins (31.2% in 2013, compared with industry averages in the high teens). Nevertheless, the pace of improvements in the company's priority markets has become a concern and indicates that McDonald's brand equity may be under pressure amid industry promotional activity and fast-casual competition.

McDonald's: Economic Moat 10/23/2014
Nonexistent switching costs, intense industry competition, and low barriers to entry make it difficult for restaurant operators to establish an economic moat. Although we acknowledge that McDonald's has faced increased competition, self-inflicted product pipeline and marketing issues, a tepid macro environment, and evolving consumer tastes in recent years, we believe the company still possesses a wide moat. Our moat rating is based on a mix of structural and intangible competitive advantages, including widely recognized brand, cohesive franchisee system, and meaningful economies of scale. These qualities were instrumental in helping McDonald's to build the largest restaurant system in the world and leading market share in the majority of countries in which it operates (with the notable exception of China). McDonald's generated $89 billion in sales at its company-owned and franchised restaurants during 2013, representing 4% of the $2.3 trillion global restaurant industry (using Euromonitor estimates). This more than doubles Yum Brands' systemwide sales of $40 billion and dwarfs Subway's $12 billion.

With strong brand recognition, consistent customer experience, convenient restaurant locations, and a uniform value-priced menu that balances core classics with locally relevant menu choices, McDonald's is among the few restaurant concepts to be successfully replicated across the globe. McDonald's average trailing 12-month sales of around $2.5 million per restaurant easily trumps the quick-service restaurant industry average of just over $1 million per location. Additionally, we believe exterior and interior restaurant decor upgrades, more-efficient kitchen and drive-through configurations, and an Innovation Center (a 38,000-square-foot facility where the company can simulate new restaurant prototypes across a wide range of configurations, technologies, dayparts, and guest count volume) can help to drive improved restaurant productivity metrics in the years to come.

Menu innovation has also historically played a central role in enhancing McDonald's intangible asset moat source with introduction of several margin-accretive products like McWraps and the McCafe beverage platform. Management has acknowledged executional issues with its product pipeline during the past several years, but menu innovation plans appear more robust over the next several years with launches planned across multiple dayparts, menu categories, and pricing tiers. We're also intrigued by the rollout of high-density kitchen prep tables in the U.S. during 2014, which are designed to offer increased customization for core menu items, facilitate the "Create Your Taste" customized premium burger platform, and allow for more locally relevant customer preferences across all regions.

Management has emphasized new sales layers across protein categories (primarily beef and chicken) and reiterated the tremendous opportunity that still exists for the breakfast daypart across the entire system; breakfast represents approximately 25% of system sales in the U.S., but only 13% in Asia Pacific, Middle East, and Africa and roughly 5% in Europe. Each of these core categories (beef, chicken, breakfast) represent an incremental sales opportunity of more than $2 billion in the years to come, which should be accretive to comparable-restaurant sales trends and average unit volumes.

We also remain optimistic about McDonald's global potential in the beverage category, which could represent a $3 billion incremental sales opportunity and could help to expand the McDonald's brand beyond its restaurant locations. Coffee is the most significant opportunity within the beverage category, and management has laid out a game plan to build market share in the $65 billion global informal eating out coffee category through new beverage product innovations, further rollout of blended iced coffee beverages, a grocery packaged coffee partnership with Kraft (to build greater awareness of the McCafe brand), and additional McCafe restaurant locations and kiosks. Management estimates that it accounts for 13% of the IEO coffee market (suggesting $8.3 billion in coffee sales or roughly 9% of McDonald's $89 billion in systemwide sales during 2013), and we believe there is an opportunity to increase this number to exceed 15% over time. More important, coffee not only represents an opportunity to drive incremental traffic and drive restaurant margins, but also it can be employed as a loss leader to help developing the breakfast daypart (and by extension, the brand intangible asset) in the Europe and Asia Pacific, Middle East, and Africa segments.

In our view, McDonald's brand intangible asset is enhanced by its cohesive franchisee and affiliate system, which collectively operates more than 80% of the chain. This structure allows the company to expand its brand reach with minimal corresponding capital needs while also providing an annuitylike stream of rent and royalties, even during challenging economic times. As a result, McDonald's generates excellent free cash flow and returns on invested capital in the mid- to high teens. These results are even more impressive when considering that the firm owns 45% of the land for its restaurants (more than $5.8 billion in land assets), meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains. We believe considerable land assets provide an additional competitive buffer that most other restaurant firms cannot match.

As the world's largest restaurant chain in terms of systemwide sales, McDonald's wields tremendous economies of scale relative to its QSR peers. The firm can exert a significant amount of bargaining power over its suppliers, many of whom owe their existence to McDonald's, thus ensuring access to food and other raw materials at predictable, competitive prices. The McDonald's brand is also one of strongest in the world, aided by an unrivaled advertising budget of more than $800 million in 2013.

McDonald's: Valuation 10/23/2014
We are trimming our fair value estimate to $95 per share from $98 based on a modest reduction to near-term revenue and operating margin forecasts in the company's struggling priority markets (including the U.S., Germany, and Japan). Our updated fair value implies 2015 price/earnings of 18 times, enterprise value/EBITDA of 10 times, and a free cash flow yield of 4%. At 17 times forward earnings and 9 times forward EBITDA, the shares trade at a discount to restaurant industry averages (22 and 12 times) and our fair value estimate. McDonald's has reiterated its long-range growth objectives of 3%-5% annual sales growth, 6%-7% average annual operating income growth, and return on invested capital in the high teens, the low end of which aligns with the later years of our discounted cash flow forecast period. With persistent global macroeconomic headwinds, increased competitive pressures, and the food quality and safety concerns in Asia, we expect a modest revenue decline during 2014, as contribution from 1,400 new restaurant openings worldwide will be offset by a 2% decline in comparable sales (compared with a three-year historical trend of 3% growth). Over a longer horizon, we expect low- to mid-single-digit revenue growth for the consolidated company, driven largely by international unit openings and a return to traffic and ticket growth through new menu innovations, modernized customer experience, and inflationary price increases. Our model assumes 1%-2% top-line growth in 2015, but we believe comps may take several months to accelerate against aggressive industry promotional activity and limited price increase opportunities. While McDonald's will fall short of its 6%-7% operating income growth target in 2014, we believe it can return to margin expansion over a longer horizon because of its bargaining clout with suppliers and strong franchisee system. We expect company-owned restaurant margins will contract almost 150 basis points this year (from 17.5% in 2013) amid elevated payroll costs and expense deleverage stemming from soft global sales trends, but gradually improve toward 18%-19% over our 10-year explicit forecast period. Over the next 10 years, our model assumes operating margins reach 33% (compared with expectations of 29.5% in 2014), driven by higher franchisee rent and royalty agreements, increased emerging-market franchises, and margin-friendly menu additions, but tempered by labor and occupancy cost inflation.

McDonald's: Risk 10/23/2014

Even the best-operated restaurant chains are susceptible to cyclical headwinds, including high unemployment rates and volatile commodity, labor, and occupancy costs. We expect restaurants to increasingly compete on price and product differentiation in the years to come, including Burger King/Tim Hortons, Chick-fil-A, Subway, and Yum Brands, fast-casual competitors like Panera and Chipotle, and specialty burger chains like Five Guys, In-N-Out Burger, and Smashburger. If heightened competition were to cause a material decline in restaurant productivity metrics, it could impair McDonald's brand intangible asset and its intrinsic value.

With 57% of total operating profits coming from its Europe and APMEA segments, McDonald's is sensitive to economic fluctuations in these regions, including currency movements, increased labor costs, and negative publicity tied to food quality concerns. Additionally, we believe the company will face increasing competition from other quick-service and fast-casual restaurant rivals as they expand globally.

While its size affords McDonald's scale advantages, questions about the agility of its supply chain have surfaced recently. Although we agree with management that it possesses an "infrastructure positioned for growth," there have been instances when rivals brought new products to market more rapidly than McDonald's because of raw material procurement constraints. We believe McDonald's can improve speed to market through better communication with its key vendors and franchisees, but believe these supply chain changes will take time to enact.

We believe the company's brand and scale advantages make it better positioned to weather global macro pressures and increased competition than most QSR peers, but the sluggish pace of strategic initiatives in its priority markets makes near-term free cash generation less visible.

Philip Morris International PM
Valuation 10/20/2014 | Philip Gorham, CFA, FRM

After a solid third quarter that slightly surprised on the upside, we are maintaining our $90 fair value estimate for Philip Morris. Our valuation implies a 2015 P/E multiple of 18.5 times and a 2015 EV/EBITDA multiple of 12.9 times. It also implies a 2015 dividend yield of 4.0%, which is around the middle of the pack for the international tobacco manufacturers. Our fair value estimate is based on three key valuation drivers: volume, pricing, and margins. We have again lowered our 2014 estimates to account for the strengthening U.S. dollar, and now expect revenue to fall by 4.5% and operating income by 12.0% this year. We forecast a fairly solid rebound in 2015 (assuming no further currency impact) with revenue growth of 4.3%. Beyond 2015, we hold revenue growth in the mid-single digits for the remainder of our explicit forecast period. Our revenue assumptions are driven primarily by pricing, as global volumes continue to decline, albeit slower than the 3% drop in 2013. As Europe recovers, we expect the European Union to provide the greatest revenue growth from price increases (6% per year), alongside Eastern Europe, the Middle East, and Africa, where we expect trading up to accelerate with the recovery. We believe the 2013 gross margin of 66.7% is a fair assumption for the long term. Revenue growth is being driven by pricing, not volume, so the procurement advantage of growing scale is limited. In the absence of acquisitions, and given that raw tobacco prices are fairly stable, we see little opportunity for Philip Morris to expand its gross margin on a sustained basis. However, we do believe there is an opportunity at the operating margin for greater profitability. We forecast Philip Morris' operating margin to grow by 120 basis points over the 2013 margin of 44.2% (and 20 basis points above its 2012 peak of 44.4%), mainly driven by cost leverage from pricing, but also because we believe there is some operational fat to trim. This is a key variable in our scenario analysis. Despite higher costs of borrowing in the later years in our forecast period, we model an average of 10.4% EPS growth (after a 9.4% drop this year on currency) driven by earnings growth and share buybacks in roughly equal measure. We make similar assumptions for dividend growth, with an average 8.6% growth rate over our five-year forecast period.

Procter & Gamble PG
Analyst Note 10/24/2014 | Erin Lash, CFA  

Even though competitive pressures around the globe persist, wide-moat Procter & Gamble’s first-quarter results offered the first signs that broad-based promotional spending may be subsiding, and new products could be gaining some traction at the shelf. Sales rose a modest 2%, entirely reflecting higher prices and favorable mix. We think this performance provides evidence of the firm’s brand strength, but it will take a few more quarters, and a positive volume contribution, before we can view this as sustainable. Management held the line on its full-year forecast--which calls for low-to-mid single digit organic sales growth and mid-single-digit underlying earnings per share growth--and we don’t anticipate making any changes to our $93 fair value. At nearly a 10% discount to our fair value and 19 times our fiscal 2015 earnings estimate, we contend P&G is attractively valued.

We continue to believe that efforts to focus on its core brands will aid financial performance without sacrificing scale and negotiating leverage with retailers. As such, we welcomed P&G’s also decision to exit the battery business, likely in a split of Duracell which was acquired as part of the Gillette deal in 2005. We previously surmised could be in the cards, given the highly competitive nature of the category; however, until the exact form of the separation is determined, we will refrain from adjusting our valuation.

P&G’s commitment to shedding costs should enable the firm to further invest behind its brands. And in that light, profitability in the quarter was modest, with adjusted gross margins up 20 basis points to 49.7% and adjusted operating margins down 20 basis points to 19.9%. Our forecast calls for operating margins of 20.1% in fiscal 2015 (compared with 19.4% in fiscal 2014), and we expect operating margins to improve to nearly 23% by the end of our 10-year explicit forecast.

From a category perspective, health care (with 6% underlying sales growth) and the baby, feminine, and family care businesses (up 4%) were the highlights. However, its other segments were more of a mixed bag. Beauty remains a challenge, with flat organic sales relative to a year ago. Management noted that Olay struggled, although Pantene generated mid-single-digit organic sales in the quarter. Despite this, we suspect the performance in this category could prove lumpy given the fierce competitive dynamics of the U.S. hair care space.

We are attending the firm's analyst day in Cincinnati next month and hope to get additional details on P&G's product rationalization plans, as well as its cost-cutting efforts. In addition, we will be looking to get a better sense of the depth of the firm's management bench. We still believe CEO A.G. Lafley’s appointment and subsequent tenure give 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. Ultimately, we think the person who will be named to the CEO role will have a good grasp of P&G's vast product and geographic footprint, and maybe more important, will be someone who is able to rally the troops around the world, which has been lacking over the past several years.

Rogers Communications RCI
Analyst Note 10/23/2014 | Michael Hodel, CFA  

Rogers Communications’ delivered mixed third-quarter results that showed modest improvements on the wireless revenue front despite a slight uptick in postpaid churn. Group revenue rose roughly 1% year over year to CAD 3.3 billion ($2.9 billion), in line with expectations. We plan to maintain our $44 fair value estimate and narrow moat rating, and the stock looks modestly undervalued.

Wireless revenue rose 1.8% from the year-ago period, boosted by a slowing decline in prepaid subscribers and a 1.1% rise in postpaid subscribers. Postpaid churn rose slightly (1.31% versus 1.23% a year ago), but management stressed improved retention of higher-value customers, evidenced by the firm’s highest quarterly blended ARPU since 2012. We believe this serves as further evidence that Rogers’ focus on disciplined pricing and promotions is starting to take hold. Wireless profitability remained very strong during the quarter, with the EBITDA margin holding steady at 51% of network revenue.

Revenue in the cable segment declined 1.0%, primarily as a result of increased competition for television customers. Cable profitability remains relatively steady, with the segment EBITDA margin dropping less than a percentage point on increased NHL promotion. The NHL agreement also pressured profitability in the media segment. However, we think the NHL package will help drive growth in the media business in the coming quarters, with some carry over to Rogers’ other businesses as well.

Rogers reiterated its full-year guidance, though management signaled the firm would likely fall near the lower end of its operating profit and free cash flow expectations. We still think CEO Guy Lawrence’s Rogers 3.0 plan needs time to be properly evaluated, but Rogers has shown modest progress in the early innings despite some fits and starts.

Unilever PLC ADR UL
Analyst Note 10/23/2014 | Erin Lash, CFA  

While Unilever’s third-quarter trading update marked a retreat for a fairly consistent operator, we don’t suspect this indicates a deterioration in the firm’s brand intangible asset (which in combination with its cost advantage form the basis of our wide moat). We’re modestly adjusting our fair value estimates for the firm’s shares to EUR 33 per share (from EUR 34), $44 per ADR (from $46), and GBX 2,863 (from GBX 2,758) to reflect a slight pullback in our expectations for the firm’s fiscal 2014 top-line performance; however, we’re holding the line on our long-term forecast (which calls for nearly 5% annual sales growth and operating margins just shy of 16%). With shares trading at a modest discount to our valuation, we’d suggest investors keep this wide-moat name on their radar.

Organic sales ticked up just 2.1%, almost entirely driven by price (up 1.8%) as volumes were lackluster (up just 0.3%). Despite this, we don’t believe Unilever has wavered from its commitment to bring value-added new products to market. Rather, a portion of this pronounced slowdown reflects trade destocking in Chinese hypermarkets, driving sales in the country (which represents about EUR 2 billion in annual sales or 4% of its total) down a whopping 20%. While this is far from a positive, management stressed this wasn't reflective of consumer demand. However, we note emerging markets (57% of sales) have decelerated over the past few quarters (increasing just 5.6% in the past three months, down from 9% in 2013). As we've highlighted, emerging-market consumers spend a disproportionate amount of their income on food (in some case close to half, where prices have trended higher partly because of increased protein and dairy costs), leaving them less to spend in other categories. Further, developed markets (down 2.5% in the quarter) are likely to remain challenging, as price competition (among retailers and manufacturers) persists in both Europe (down 4.3%) and North America (up a mere 0.6%).

Personal care (up 3%) and home care (up 5.7%) drove the bulk of Unilever’s sales in the quarter, as food (down 0.5%) and refreshments (up 0.5%) were again muted. The majority of this weakness reflects declining margarine category sales and soft ice cream performance in Europe, as the summer weather was particularly cool. Improving its spread brands has been a focus for Unilever’s management group for the past 18 months, and while the firm cites improving category share as evidence its investments are working, we ultimately question whether Unilever could look to shed this underperforming business given its penchant to trim its food portfolio in order to focus its resources on the highest return opportunities. Ultimately, we expect Unilever will continue to actively manage its brand portfolio in line with actions taken over the past six years, during which the firm shed EUR 2.5 billion in sales (mostly food brands), while completing nearly EUR 3 billion in acquisitions (primarily in personal care).

Unilever: Valuation 10/23/2014
After reviewing our discounted cash flow model, we're reducing our fair value estimate to $44 from $46, which implies forward fiscal 2015 price/earnings of 20 times, enterprise value/EBITDA of 13 times, and a free cash flow yield of 5%. The fair value decrease reflects more modest fiscal 2014 top-line expectations. Our fair value estimate is based on the 12-month rolling average exchange rate, which is $1.35 per EUR 1 as of Oct. 23. Because of Unilever's global business, our fair value estimate will continue to fluctuate with the exchange rate. Left unhedged, depreciation in the euro will lower the value of a dollar-denominated investment in the firm's ADRs.

Slowing global demand is taking a toll on Unilever--given its vast geographic footprint--foreign currencies have been a notable dark spot, constraining reported sales by around 7% through the first nine months of the year, and as such, we now expect sales to slip nearly 2% in 2014 (versus our prior forecast for growth of 1%). However, we view longer-term concerns related to this as overblown. Unilever's underlying performance, which excludes any foreign currency impact, is more indicative of its long-term trajectory, and we expect foreign currency rates will ebb and flow. In addition, while negative foreign currency movements disproportionately weigh on emerging markets, we still expect these regions will outpace more mature markets over the near to medium term, reflecting austerity measures in Europe and high unemployment levels and intense competitive pressures, particularly in mature developed markets. Overall, we think Unilever's grasp of consumer trends and investments related to bringing new products to market and marketing spend will ensure that challenges in emerging markets are ultimately resolved. We forecast sales growth of 1.2% in fiscal 2014, but longer term we expect annual sales growth will approximate 5%, reflecting the benefits of new products as well as higher prices. The commodity cost environment is more benign than years past, but we don't suspect this will persist longer term, given increasing demand for raw materials in emerging markets. While we're encouraged by the company's commitment to wring additional savings from its cost structure by leveraging its massive scale, we suspect it will continue to reinvest in its business. As a result, our forecast assumes that operating margins approach 16% by 2022, about 140 basis points above fiscal 2013 adjusted operating margins.

United Parcel Service UPS
Analyst Note 10/24/2014 | Keith Schoonmaker, CFA  

UPS hauled 6.9% greater average daily packages than in the year-ago period, but revenue per package declined about 1% due to growth of cheaper services outpacing that of premium offerings. For example, B2C shipments constituted 45% of domestic revenue, and the higher cost to deliver to residences suppresses margin. Despite the mix headwind, UPS improved operating margin 40 basis points to 13.7%. We maintain our wide moat rating and expect to increase our fair value estimate by $2-$4 due to the time value of money and volumes slightly exceeding our 2014 projections, though year-to-date margins are in line with our 12.5% projection for 2014.

Management expects an 11% increase to December volumes, on top of the volume that last December stretched UPS’ capacity. UPS is investing $500 million of capex and plans $175 million of additional operating expense to deal with peak season. The firm is adding a full operating day, has expanded 47 facilities, and improved its World Port and Chicago sorting facilities, among other steps. Clearly the firm is investing capital and effort to contend with an anticipated massive wave of B2C demand this holiday season.

Bigger picture, we think contending with challenges raised by ever-increasing online fulfillment is the greatest operational issue the firm faces. Of course the firm wields price to offset higher costs, with annual average 2%-3% improvement in realized rates, but we think the firm may need to move to even steeper peak surcharges to get paid for accomplishing the incredible and to give incentives to customers to distribute volume over additional days. That said, after a tough 2013 peak season, this is probably not the year to press too hard. Dimensional pricing on all Ground shipments is effective near year end. This should help, as should full implementation of the Orion route planning software. We expect to hear more about Access Point lockers and other plans to preserve margin at the Nov. 13 investor meeting.


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