About the Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.

Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio. Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor.

Peters holds a BA in economics and history from the University of Minnesota Duluth and is a CFA charterholder. He is also the author of a book, The Ultimate Dividend Playbook, which was released by John Wiley & Sons in January 2008.

 
Investment Strategy

Dividends are for everyone regardless of age. The outcome of owning dividend-yielding stocks is the key variable-higher-yielding stocks with safe payouts being less risky while affording investors who don't need current income the ability to reinvest/reallocate the capital.

The goal of the Dividend Select Portfolio is to earn annual returns of 9% - 11% over any three-to-five year rolling time horizon. We further seek to minimize risk, as defined by the probability of a permanent loss of capital. For our portfolio as a whole, this goal is composed of:

3% - 5% current yield
5% - 7% annual income growth

 
 
Apr 26, 2015
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Josh Peters, CFA
Equities Strategist and Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio.
Featured Posts
Three Hikes Right on Target -- The Week in Dividends, 2015-04-24

Despite the steady drumbeat of first-quarter earnings reports, three dividend increases lead off our review of the week's news for our Dividend Select portfolio. All three precisely matched my expectations.

* Johnson & Johnson JNJ raised its dividend for a 53rd straight year. At $0.75 a share, the new quarterly rate is a 7.1% improvement on the old one, roughly in line with the 7.3% average hike of the previous six years. Though consistent double-digit growth for J&J is a thing of the past, I'm encouraged that the company is able to keep growing its dividend at this pace--particularly as earnings face considerable currency headwinds as well as increased competition for its key pharmaceutical unit. The stock's yield has returned to the 3.0% area, and I plan to maintain our present stake. Even if earnings per share may stagnate for a few years, a payout ratio that is still below 50% provides room for adequate dividend growth in the mid- to high-single digits.

* Magellan Midstream Partners' MMP forthcoming cash distribution of $0.7175 a unit marks a modest but expected deceleration in growth--it's up 2.25 cents from the previous quarter, compared to a 2.75 cent pace of increase in the preceding five quarters. Even so, Magellan is on track to hit management's target of total distribution growth of 15% for 2015 ($3.005 a unit in the four quarters starting with the just-declared payment versus $2.615 a unit over the prior year). With a new Morningstar analyst assuming coverage of Magellan this week, our fair value was reduced slightly ($2 a unit to $88), but we continue to expect strong distribution growth in the 10%-15% range as well as healthy cash-flow coverage over the next several years.

* Southern Company SO raised its dividend for a 14th straight year and, for the eighth year in a row, the annualized dividend rate rose by $0.07 a share. The dividend rate is now $0.5425 a share quarterly, or $2.17 on a yearly basis. I remain somewhat concerned by the delays and cost overruns associated with two large construction projects: This is why, despite a yield near 5% and an above-average (4%) weighting in our portfolio, I see Southern in a supporting role rather than as a core holding. Fortunately, the fact that Southern's dividend remains on a gentle but steady trek upward suggests the challenges at the Kemper County gasification plant and the nuclear expansion at Plant Vogtle remain manageable. (Had Southern opted to hold its dividend rate flat, I might have drawn the opposite conclusion.) I'm looking forward to updates regarding Kemper and Vogtle in next Wednesday's conference call.

As for earnings reports, the six portfolio holdings releasing quarterly results this week provided few surprises, and none resulted in changes to our fair value estimates. Currency took a predictable toll on the stated results of Coca-Cola KO and Procter & Gamble PG, but both companies continue to show signs of operational improvement that should outlast this unusual period of dollar strength. P&G's report was not well received by the market; its stock was the only one of the six to register a meaningful price decline this week. However, we continue to think the shares are worth $90 each, and Friday's close at $81 gives the stock an attractive 10% discount as well as a 3.3% current yield. Details for each company are provided in the analyst notes below.

In other news, after reviewing the results released by Wells Fargo WFC last week, we raised our fair value estimate by $6 a share to $58. This reflects the change in our cost of equity methodology (Wells is now valued with a 9% average annual required return for shareholders rather than 10%) as well as cash flows realized since our last update. I hope to boost our relatively small weighting in this core holding someday, but while the shares now look somewhat undervalued, I'd rather wait for a yield of at least 3%. Separately, in addition to its healthy first-quarter results, Ventas VTR released a name--Care Capital Properties--as well as an initial SEC registration statement for the planned spinoff of nursing home assets later this year. Though I can't yet say whether this new entity will remain in our portfolio for the long haul--that will depend on valuation in addition to many other fundamental considerations--I'm comfortable calling Ventas a buy in advance of the spinoff.

Lined up to report quarterly results next week are Kraft Foods KRFT and United Parcel Service UPS on Tuesday; Southern on Wednesday; Realty Income O on Thursday; and Chevron CVX, Clorox CLX, and Public Service Enterprise Group PEG on Friday. I don't expect much drama from this lot, and Kraft won't even hold a conference call due to its upcoming merger with Heinz. Also, based on past practices, I expect our annual distribution increase from AmeriGas Partners APU, and I hope that Chevron will continue to raise its dividend--even if only slightly--as the firm deals with lower energy prices.

Best regards,

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

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


News and Research for Builder and Harvest Portfolio Holdings

Google Announces Wireless Service
Industry Note 04/23/2015 | Rick Summer, CFA, CPA

Google has formally announced Project Fi, a new wireless service in the United States that will provide mobile voice, messaging and data services. It's currently available via invitation only. Although we find the service intriguing, from a technology perspective, we are skeptical the service will attract a material number of subscribers, at least from what we understand at this point. As we noted in our analyst note on January 23, we believe Google will need to provide something beyond connectivity and cheaper pricing to disrupt the industry. We are sticking with our wide economic moat rating and $715 fair value estimate at this time. In spite of our caution about Project Fi, Google remains one of the more attractive investment opportunities in the technology sector.

Project Fi is priced cheaply, as compared to traditional U.S. mobile operators. Plans start at $20 for voice and messaging, and $10 for each gigabyte of mobile data, even when traveling internationally. Currently, only the Google Nexus 6 is supported. The phone will seamlessly roam on the mobile networks of Sprint, T-Mobile and free wi-fi hotspots that Google claims to have verified as high quality. On an optimistic note, we believe the service could potentially increase consumer expectations about 1) ubiquitous wireless broadband connectivity, and 2) cheaper pricing, which would continue to drive increases in mobile data usage, where Google and large ad-supported Internet players could benefit.

The long-term effects are still dubious, in our opinion. Lack of control over mobile assets (sufficient spectrum, wireless infrastructure) may be the ultimate limiter for Google. Sprint and T-Mobile U.S. may be willing to resell excess capacity to Google, but we think this contract is unlikely to support tens of millions of MVNO subscribers. The last thing Sprint or T-Mobile wants, in our view, is to build network capacity to serve customers loyal to a powerful brand like Google only to face unreasonable terms or outright loss of the business at contract renewal time. Regardless, we think the move is shrewd, and relatively low-risk for Google.

Altria Group MO
Analyst Note 04/23/2015 | Philip Gorham, CFA, FRM

Altria's first-quarter results revealed a company executing well amid an improving operating environment. We intend to raise our near-term assumptions to reflect the solid mid-single-digit revenue growth, but we doubt this will materially affect our $51 fair value estimate. We are reiterating our wide moat and stable moat trend ratings, as these results show that Altria's strong portfolio of brands retains its pricing power.

Reported net revenue growth of 6.5% was in line with that reported by Reynolds American and Lorillard in the first quarter. This represents one of the strongest quarters Altria has delivered since its split from Philip Morris International in 2008, and we think lower gas prices are filtering through to the spending of low income consumers. Cigarette volume increased 1.6%, well above the historical decline rate of 3%-4% and in spite of higher prices. Marlboro grew volumes by 1.2%and added 30 basis points to its market share, but it was at the lower end of the price spectrum that volumes improved most. Altria's discount cigarette volume increased 8.6%.

Management reaffirmed its full-year earnings guidance of $2.75 to $2.80. We currently estimate EPS at the high end of that range, and suspect there may be upside to it if gas prices remain low throughout the year. Nevertheless, we believe Altria's stock is fully priced. In spite of the addictiveness of the product, cigarette volumes are somewhat cyclical and sensitive to the purchasing power of the low income consumer. We believe, therefore, that industry volumes are growing at an above-trend pace on a sustainable and mid-cycle basis. Furthermore, the industry profit pool could come under pressure if Imperial Tobacco becomes aggressive on price when it acquires brands including Winston and Salem from Reynolds American. Marlboro's strength and premium positioning is likely to give it some protection, however, and we expect Reynolds' Pall Mall to be most affected by any uptick in price competition.

American Electric Power AEP
Analyst Note 04/23/2015 | Andrew Bischof, CFA

We are reaffirming our $59 per share fair value estimate, narrow economic moat, and stable moat trend ratings after AEP reported first-quarter ongoing operating earnings of $1.28 per share, compared with $1.15 in the same year-ago period. Management reaffirmed its 2015 earnings guidance range of $3.40-$3.60 and 4%-6% three-year earnings growth target, in line with our forecasts.

Regulated investments continued to pay dividends for AEP, driving 7% regulated revenue growth for its vertically integrated utilities, transmission and distribution utilities, and transmission. Management plans to spend 70% of the company's $12.2 billion three-capital plan on distribution and transmission, moving the company more toward a fully regulated utility. We believe these investment opportunities, particularly capital investments in wide-moat transmission, and cost efficiency gains will support earnings growth. AEP's $227 million rate increase request in West Virginia and $70 million rate increase request in Kentucky could lift earned returns as soon as mid-2015.

Management highlighted the negative impact it has felt from low oil prices given its significant operations within shale counties. Industrial sales within shale counties still increased 14%, down notably from the 30% increase in the same year-ago quarter. Growth in shale counties helped offset a 0.6% drop in industrial sales in non-shale counties.

AEP Generation notched a good quarter due to favorable pricing and lower plant outage and maintenance expense. Management continues to undergo a strategic review of the unit. We continue to believe indecision in Ohio on the company's PPA requests and uncertainty in PJM, including capacity performance, will ultimately lead to a decision to divest the no-moat business. While no set decision date has been set, management noted it would wait for the upcoming PJM capacity auction and further Ohio PPA rulings before making a final decision, likely later this year.

Coca-Cola KO
Analyst Note 04/22/2015 | Adam Fleck, CFA

We’re maintaining our $43 fair value estimate for Coca-Cola after first-quarter results, as the firm is on track to meet our full-year expectations. While underlying revenue growth during the quarter was the strongest in several years (up 8% year over year, excluding a 6-point currency headwind and a point of negative M&A effects), we attribute most of this outperformance to the timing of concentrate shipments, which outpaced end-market unit case volume gains (5% growth versus 1%, respectively) due to several extra shipment days. Given management’s expectation that concentrate and unit case volume shipments should finish the year roughly in line, we anticipate slowing quarterly top-line growth. Nonetheless, Coke maintained its full-year outlook for mid-single-digit currency-neutral EPS growth, and we believe continued productivity enhancements and growth opportunities should support high-single-digit earnings growth over the long run.

Although unit case volume slowed in the quarter versus 3% gains in the fourth quarter, we remain encouraged that the firm saw growth in both sparkling and noncarbonated drinks. Within sparkling, China was a particular standout, growing 6% in the quarter, while the Eurasia and Africa segment saw 4% sparkling gains and India enjoyed double-digit growth. Despite declines in Russia, we believe the positive growth trajectory for Coke in emerging and developing markets remains intact.

Price and mix also contributed positively in the quarter, climbing 3% versus the prior year, the strongest pace since early 2012. While we attribute some of these gains to rate hikes in the face of increased inflationary pressure and positive geographic mix, and we note that comparisons will become more difficult over the rest of 2015, we think the overall consolidated volume growth despite this positive pricing and mix (including a 1% gain in trademark Coca-Cola globally), speaks to the brand intangible assets that buoy our wide economic moat rating.

With this higher revenue, Coke enjoyed slight adjusted operating margin improvement, climbing 20 basis points to 23.4% from 23.2% a year ago, even with a double-digit percentage increase in marketing spending. The firm also continues to invest in productivity programs, and spent about $90 million during the quarter on such investments, compared to $86mm in last year’s first quarter; while we expect spending here to continue over the remainder of 2015, we believe the firm’s long-run profitability will benefit as a result, with operating margins climbing above 24% within the next five years.

Beyond its own cost structure, Coke continues to restructure its U.S. distribution system, and has now divested or signed letters of intent to shed 15% of the country’s volume to third-party partners. The firm remains on-track to complete two-thirds of the process by 2017, and the remainder by 2020, which should help both profitability and returns on invested capital. Management commented that the company is also likely to divest other bottling and distribution assets, including its German operations; beyond also boosting profitability (the Bottling Investment Group remains Coke’s lowest margin business), we think proceeds garnered from any transactions could be used to increase investments in higher returning endeavors (such as the upcoming Monster Beverage minority stake), boost distribution in other emerging regions, or return to shareholders.

We also remain encouraged by Coca-Cola’s free cash flow, which increased 71% year-over-year to $1.1 billion in the quarter. The firm announced a small $400 million acquisition recently (China Culiangwang Beverages), and we expect further bolt-on acquisitions to continue. However, we note that the firm’s dividend payout—which increased about 8% for 2015—now represents a payout ratio versus adjusted earnings north of 60%, above the firm’s historical average in the mid-50% range. As such, although we expect dividend growth to mirror earnings growth over the long run, we caution that the firm could lift its payout at a slower rate over the next several years in the interim.

Magellan Midstream Partners MMP
Investment Thesis 04/23/2015 | Peggy Connerty

MMP is primarily a fee-based business with margins generated by low-risk transportation- and storage-related activities making up 85% of total margin. Margins on most of MMP’s pipeline and storage systems are underpinned by long-term contracts and FERC-indexed tariff escalators. In general, growth in Magellan’s base business is steady while organic growth projects and third-party acquisitions add an extra layer of growth.

MMP has an investor-friendly partnership structure with one of the lowest costs of capital among energy partnerships. Since MMP’s general partner does not receive incentive distributions, or IDRs, growth is unburdened by a heavy general partner share of the cash flow, which afflicts many other MLPs. This should prove advantageous going forward as management pursues acquisitions.

Limited commodity exposure insulates MMP somewhat from volatile swings in commodity prices. Approximately 85% of MMP’s operating margins are fee based without direct commodity price exposure while the remaining 15%, the butane blending business, is hedged to minimize the impact of swings in the spread between gasoline and butane. During periods of strong commodity spreads MMP uses the “windfall” from this business to enhance coverage on the cash distribution rather than increasing the growth rate of the distribution. We estimate growth in cash distribution in the 10%-15% range with solid coverage levels that provide a cushion during periods of commodity and economic volatility.

Through 2016, the partnership plans to spend more than $1 billion on organic growth projects. Major projects include the Saddlehorn pipeline, which is 50/50 joint ventures with Plains and will transport crude from the Niobrara to Cushing and the Corpus Cristi Condensate Splitter, which is due to start up in the second half of 2016. Additionally, Magellan continues to build and lease storage at attractive rates, which we think will remain an important growth driver, given our tepid outlook for refined product volume growth. Beyond these projects in the works, Magellan is also monitoring $500 million of potential opportunities, mostly on the crude side.

Magellan Midstream Partners: Economic Moat 04/23/2015
Overall, given the regulated nature of the pipeline industry along with Magellan’s stable fee-based operations, its annual PPI-indexed tariff escalators, the long-term contracts underpinning many of its pipelines and facilities, and its lack of general-partner incentive distribution rights, Magellan should continue to consistently generate returns on invested capital well in excess of its cost of capital. As the incumbent with a solid asset footprint in a business with high barriers to entry, Magellan has the ability to continue investing in incremental assets at high rates of return to further strengthen its position, making it a formidable opponent to potential new entrants and deserving of a wide moat rating. The source of Magellan’s moat is efficient scale.

Extensive regulatory oversight of MMP's pipelines acts as gateway for new entrants with many federal, state, and local agencies involved in permitting, siting, pipeline rate setting/increasing, pipeline new-build and abandonment, and power of eminent domain. FERC oversight or approval is needed to determine rates and annual rate increases on pipelines. MMP's liquids pipelines face light-handed regulation from FERC plus extensive environmental regulations, state regulatory oversight, and permitting requirements. FERC (natural gas pipelines) and state agencies (liquids) determine common carrier status and thus grant power of eminent domain to common carrier pipelines.

Importantly, Magellan has near monopoly status for many of its refined product pipelines. Its refined product pipeline system is the largest in the U.S. and supplies 40%-54% of demand for products in seven of the 15 Midwestern states they serve. Volumes on their refined product systems are stable and in line with EIA projections while tariffs generally increase annually in their markets.

Annual rate increases tied to PPI plus productivity escalator (currently 2.65%) provides five-year line of sight to MMP's rates on pipelines regulated by FERC. This adds both inflation protection and stability to returns for the five-year cycle. The current escalator (2.65%) is in effect until July 2016, at which point a new factor (to be determined) will be effective through July 2021. The FERC index method of increasing rates is designed to allow pipeline operators to recover increases in costs incurred each year without having to file a burdensome cost of service rate case filing. Approximately 40% of MMP’s refined product pipeline systems are interstate and thus are regulated by FERC, and are entitled to an annual escalator of PPI index +2.65%.

For the remaining 60% of its pipelines, which are either intrastate pipelines or deemed to be in competitive markets (i.e., in the Houston market), MMP uses market-based rates that are adjusted at MMP’s discretion based on competitive factors. MMP has indicated that it often increases market-based rates using the FERC index methodology. On the crude oil side, MMP’s pipeline systems are all intrastate pipelines and therefore also use market-based rates that are adjusted annually based on competitive factors.

MMP secures volume commitments from anchor shippers through binding open seasons on new pipeline projects, thus providing critical revenue support before it begins project construction. Before a pipeline is built, an open season is held in which potential customers are given the chance to sign up for part of the new pipeline’s capacity rights. This stage usually lasts for one to two months. If interest is insufficient the project often does not move forward. This procedure ensures that capital is being prudently allocated and demonstrates that new pipeline projects are required for “public convenience and necessity.” Magellan’s open season on the Little Rock products pipeline allowed it to secure committed volumes on this pipeline before proceeding with the project.

Long-term contracts underpin many existing and new pipeline and storage facilities, adding resilience during periods of volatility (BridgeTex, Little Rock Pipeline). Furthermore, many facilities (including existing and facilities under construction--inland storage, marine terminals, condensate splitter) are fully subscribed with take-or-pay contracts on a long-term basis. MMP has indicated that as of December 31, 2014, approximately 47% of shipments on its refined product pipeline system were subject to volume or term commitments, or both, in exchange for reduced tariff rates, with the average remaining life of these contracts at approximately four years.

MMP’s condensate splitter, which is due in service in 2016, is fully contracted with long-term take-or-pay agreements. For the crude oil segment as of December 31, 2014, approximately 50% of the shipments were subject to long-term agreements with the average remaining life of these contracts at four years. Also, 100% of MMP’s crude storage is under contract with an average remaining life of approximately two years. On the marine terminal side, approximately 77% of usable storage capacity is under contracts. The average remaining life of their storage contracts is approximately three years. Given the long-term growth potential for North American crude oil production, we are confident that these assets will typically be highly utilized for the foreseeable future.

MMP does not take title to volumes being transported and simply charges a fee to the shipper for transporting the volumes on the pipeline. These “fee-based margins” help maintain stability of earnings during periods of declining commodity prices. MMP’s business is primarily fee based, and underpinned by long-term contracts. In total, 85% of operating margin is generated from transportation and storage activities while the remaining 15% is tied to more commodity-sensitive businesses (primarily butane blending), which it hedges.

Magellan Midstream Partners: Valuation 04/23/2015
Our fair value estimate for MMP is $88 and is based on a standard discounted cash-flow model that includes an average cost of debt of 6.5% and a cost of equity of 7.5%. This gives a weighted average cost of capital of 7.0%. Given MMP’s estimated cash distribution of $3.01 for 2015 and its yield of 3.7%, the total 12-month return proposition is 12%. We check our estimate with a distribution discount model that uses a 10-year horizon and the same assumptions regarding distribution growth, implying an $89 per share valuation. Our fair value estimate implies 2015 enterprise value/EBITDA of 23.2 times and a distribution yield of 3.4%.

Going forward, management has indicated that it expects to increase the cash distribution by 10% in 2016 and beyond; however, given its historical conservatism, we would not be surprised if this ends up being a bit higher as management locks in additional fee-based projects.

Magellan Midstream Partners: Risk 04/23/2015
Magellan's uncertainty rating is low, in our opinion. The partnership earns approximately 85% of its cash flows from steady, fee-based revenues on its pipelines and storage terminals. However, Magellan has 15% of its operating margin derived from commodity-sensitive businesses, primarily butane blending. Management has provided guidance on this segment for 2015, indicating that its earnings will be lower by approximately $100 million in 2015 versus 2014. Longer-term, if a lower commodity price environment persists, the butane blending segment will likely continue to face headwinds.

Since MMP is a yield-oriented investment, it is sensitive to interest rates. While interest rates are expected to remain relatively low in the near future, if this changes due to stronger economic conditions, MMP and the MLP sector in general could begin to experience some headwinds.

Magellan also faces regulatory risk as pipelines are heavily regulated in terms of the rates that they can charge, environmental guidelines, and the tax-favored status of the MLP form of business. Legislation changes affecting MLPs and other pass-through securities could affect MMP’s ability to attract investors and ultimately to raise capital and execute its growth strategy. Over the years there has been talk of potentially taxing MLPs with income over a certain level as corporations, thereby eliminating their tax-efficient status. However, currently there is no legislation under discussion to make any changes to the tax status of MLPs.

If the current low crude oil price environment persists for an extended period of time, it is probable that the opportunity set available to MMP (and other MLPs) will shrink and ultimately lead to lower capital expenditures, reduced cash distribution growth, and lower coverage levels.

Magellan's throughput is also reliant on third-party refineries and pipelines, so any disruption in service (e.g., due to turnarounds or weather) could reduce volumes and hence cash flow.

Procter & Gamble PG
Analyst Note 04/23/2015 | Erin Lash, CFA

Tepid top-line performance again plagued wide-moat Procter & Gamble in the fiscal third quarter, even absent an 8-point negative foreign exchange hit, as organic sales ticked up just 1%. Beauty remained a laggard, with segment sales off 3% relative to the year ago. However, grooming (up 9%) and health care (up 6%) were standouts. We contend that the market share gains management called out in U.S. laundry, U.S. diapers, and adult incontinence showcase the potential that can be realized across its mix when innovation and marketing are on target, supporting the firm's brand intangible asset.

In addition, the improvements P&G is posting on the cost side are encouraging; after excluding the impact of unfavorable FX movements, adjusted gross margins increased 90 basis points to nearly 50% and adjusted operating margins popped 170 basis points to the high teens/low 20s. But these savings aren't just being realized on its home turf, as management highlighted that it increased core earnings at 4 times the level of sales in emerging markets last year and anticipates earnings growth jumping to 6 times sales in these regions in fiscal 2015, supporting P&G's cost edge.

The impact of FX headwinds is slightly more pronounced, with the firm now expecting FX to hamper full-year sales by 6%-7% versus 5% previously. But when including the impact from our recalibrated cost of capital assumptions, which now better align with the returns that debt and equity investors will demand long term, we're holding the line on our $90 fair value estimate. We contend P&G's strategic endeavor to rightsize its brand mix is a wise course and should enable the firm to focus its resources (both financial and personnel) on the highest-return opportunities, which is critical in the intensely competitive environment in which it plays. With the shares trading below our valuation, we'd recommend investors give this wide-moat name a look in an industry where discounts are few and far between.

Although absent from today's discussion, we think the topic of succession will receive increasing airplay over the course of the year. CEO A.G. Lafley has been back at the helm for nearly two years, and we wouldn't be surprised if he chose to step down from running the day-to-day operations in due course. From an internal perspective, it appears that David Taylor--who has headed the health-care business since 2013 and was recently tapped to bring the beauty-care and grooming businesses into his fold--strikes us as the heir apparent. While P&G tends to be an organization in which individuals move up from within the ranks, we were encouraged by Lafley's recent reference regarding the importance of bringing in outside talent, as we think fresh perspectives can prove highly valuable. Even when a permanent successor is named, we anticipate that Lafley will stay on (possibly in the chairman role) to ensure a smooth transition, unlike when he handed over the reins the first time in July 2009. Ultimately, we think the person who will be named CEO 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.

Procter & Gamble: Investment Thesis 04/23/2015
Procter & Gamble is working to right its ship. The firm previously entered too many new markets (particularly emerging markets, where competitors already have a leg up) too quickly, and new products failed to resonate with consumers, as evidenced by its languishing market share position. However, P&G's announcement that it intends to shed around 100 brands--more than half of its existing brand portfolio, which in aggregate posted a 3% sales decline and a 16% profit reduction the past three years--indicates it is parting ways with its former self, looking to become a more nimble and responsive player in the global consumer products arena. We view this as a particularly important trait given the stagnant growth emanating from developed markets and the slowing prospects from emerging regions.

Even a slimmed-down version of the leading global household and personal care firm will still carry significant clout with retailers, and we think these actions stand to enhance P&G's brand intangible asset and its cost advantage, which together form the basis for our wide moat. The 65 brands it will keep (including 23 that generate $1 billion-$10 billion in annual sales, and another 14 that account for $500 million-$1 billion in sales each year) already account for 90% of the firm’s top line and 95% of its profits. As such, we don't anticipate P&G will sacrifice its scale edge but will be able to better focus its resources (both personnel and financial) on its highest-return opportunities.

These actions build on the firm's $10 billion cost-saving initiative designed to lower costs through reduced overhead, lower material costs from product design and formulation efficiencies, and increased manufacturing and marketing productivity. Overall, we think the combination of these efforts will enable P&G to up its core brand spending (behind product innovation and marketing support), which is critical given the ultra-competitive landscape in which it plays, while at the same time driving improved profitability. We forecast margin expansion at the gross (up around 200 basis points to 51%) and operating income line (up 350 basis points to 23%) over our 10-year explicit forecast.

Procter & Gamble: Economic Moat 04/23/2015
P&G is the leading consumer product manufacturer in the world, with around $80 billion in annual sales. Its wide moat derives from the economies of scale that result from its portfolio of leading brands, 23 of which generate more than $1 billion in revenue per year and another 14 of which generate between $500 million and $1 billion in sales annually. Given the dominant market positions P&G maintains in its categories (over 30% of baby care, 70% of blades and razors, more than 30% of feminine protection, and in excess of 25% of fabric care), we contend that retailers rely on P&G's products to drive traffic in their stores. Further, the size and scale P&G has amassed over many years enable the firm to realize a lower unit cost than its smaller peers, resulting in a cost advantage. From our perspective, P&G supports its competitive advantages by investing in research and development ($2 billion annually or 2.5% of sales) and marketing ($9 billion each year or 11% of sales) for core brands (which is comparable to the approximately 2% and 11%-13% of sales spent on research and development and marketing, respectively, by wide-moat peers Colgate and Unilever).

P&G's announcement last year that it intends to shed about 100 brands--more than half of its existing brand portfolio, which in aggregate posted a 3% sales decline and a 16% profit reduction the past three years--indicates it is parting ways with its former self, looking to become a more nimble and responsive player in the global consumer products arena. Even a slimmed-down version of the leading global household and personal care firm will still carry significant clout with retailers, and we think these actions will support P&G's brand intangible asset and its cost advantage. The 65 brands it will keep already account for 90% of the firm’s top line and 95% of its profits. As such, we don't anticipate P&G to sacrifice its scale edge but will be able to better focus its resources (both personnel and financial) on its highest-return opportunities. Overall, we forecast returns on invested capital (including goodwill) to average 12% over the next five years, well in excess of our 7.1% cost of capital, solidifying our take that P&G maintains a wide economic moat.

Procter & Gamble: Valuation 04/23/2015
We're maintaining our $90 per share fair value for P&G, which implies fiscal 2016 price/adjusted earnings of 21 times, enterprise value/adjusted EBITDA of 15 times, and a free cash flow yield of 4%. We've accounted for the drag unfavorable foreign currencies are expected to have on both the top (negative 6%-7%) this year. We now expect sales to slip 5.7% this year (which compares with a 3.7% decline previously). We’ve also recalibrated our capital cost assumptions to better align with the returns equity and debt investors are likely to demand over the long run. We now assume a 7.5% cost of equity, down from 9.0%. This is lower than the 9% rate of return we expect investors to demand of a diversified equity portfolio, reflecting P&G' lower sensitivity to the economic cycle and low degree of operating leverage. Our pretax cost-of-debt assumption rises to 5.5% from 2.3% as we move to incorporate a normalized long-term real rate environment into our model. Our long-term expectations for P&G's consolidated operations (annual top-line growth above 4% and nearly 23% operating margins) remain in place. We contend the decision to shed more than half of its brands over the next year months stands to enhance its focus on the highest-return opportunities. Deteriorating economic conditions in the U.S. and Europe combined with moderating growth in emerging markets will constrain P&G's near-term growth prospects, but our outlook for a top-line increase above 4% long-term remains in place. Globally, P&G's categories grow roughly 3% annually, so to reach the 4% annual sales growth pace we've modeled, the firm would have to grow 1%-2% faster than the markets and categories in which it competes, which we view as achievable, particularly in light of recent strategic efforts. The firm has growth opportunities for its brands in many overseas markets, and in developed markets it remains the share leader in many of its categories. Further, we're encouraged P&G is realizing some margin improvement from its ambitious initiative to shave $10 billion from its cost structure, but we ultimately think the firm will need to reinvest a portion of these savings to maintain its competitive positioning. Our long-term forecast calls for operating margins to improve to nearly 23%% by the end of our 10-year explicit forecast.

Procter & Gamble: Risk 04/23/2015

Like others, P&G has fallen victim to weak and volatile consumer spending combined with persistent cost inflation that has yet to fully abate. At the same time, promotional spending over the past several years has conditioned consumers to expect lower prices, and lackluster innovation has, in some instances, failed to prompt consumers to pay up for its new products. Further, with more than 60% of its sales derived outside the U.S., P&G is exposed to foreign exchange rate fluctuations, which could have a negative impact on sales and profitability.

Slowing growth rates around the world, competitive pricing, and unfavorable foreign exchange trends have played a part in Procter & Gamble's woes, but we think the problems run deeper, as the firm might have overextended itself in its endeavors to build out its product portfolio and geographic footprint. While P&G was slow to react, management has responded with a massive $10 billion cost-saving initiative to dramatically reduce head count and ultimately free up funds to reinvest in its business. More recently, the firm has followed these cost cuts with plans to halve its brand portfolio to better focus its resources, which we view positively.

From a category perspective, despite some of the gains the firm is realizing within the U.S. diaper and laundry categories, beauty remains a challenge, as organic sales remain at the level of a year ago. Management has noted that Olay in particular continues to struggle, although Pantene appears to be gaining some traction, posting mid-single-digit organic sales and growing its share base over the past several months. Despite this, we suspect the performance in this category could prove lumpy given the fierce competitive dynamics of the U.S. hair care space, and it will take a few more quarters until we can get a sense whether this improvement is sustainable.

Ventas VTR
Analyst Note 04/24/2015 | Todd Lukasik, CFA

Our favorable view of narrow-moat Ventas was reinforced by the release of solid first-quarter results, and we plan to maintain our $81 fair value estimate. Trading at a 10% discount to our estimate of value, Ventas looks like a relative bargain in an overall real estate investment trust coverage universe that looks 10% or so overvalued to us.

Following robust growth over the past few years predicated on occupancy and rental rate gains, Ventas' senior housing operating portfolio's rate of internal growth slowed markedly, with same-store profits increasing just 0.9%. Although this would have been higher (at 2.7%) if not for some favorable real estate tax credits in the prior-year period, overall internal growth here has reduced noticeably from the mid- to high-single-digit levels achieved since the economy began emerging from the downturn. We expect this more moderate rate of growth to persist, as the easy cash flow gains from higher occupancy and recovering rental rates appear to be in the rearview mirror. Nonetheless, we think Ventas' quality senior housing operating portfolio is likely to remain a relatively robust performer with slightly faster growth than its overall portfolio, on average, in the coming years.

Ventas' triple-net and medical office building portfolios performed well, with same-store net operating income increasing 4.8% and 2.2%, respectively. We expect total portfolio same-store net operating income to expand 3.2% in 2015, near the upper end of management's 2.5%-3.5% guidance range.

Overall financial results reflect Ventas' solid portfolio management and external growth investments. Our reckoning of revenue and adjusted EBITDA (from which we exclude interest income and merger-related expenses) both increased 18%, with adjusted EBITDA per share growth of just 6%, reflecting the impact of incremental share issuances to fund external growth. Normalized funds from operation per share increased 8%. Despite the divergence between total and per-share growth metrics, we continue to think that Ventas' relatively lower dividend payout ratio enables it to use relatively more retained cash flow to fund external growth, supporting higher levels of per-share growth relative to many peers.

Ventas has already made $3.6 billion in new investments in 2015, with its further $1.75 billion acquisition of Ardent still pending. Ventas' exemplary management team has proved an adept allocator of capital over the years, converting balance sheet growth into per-share cash flow and dividend growth at a rate that exceeds many peers'. We continue to think Ventas will find plenty of future external growth opportunities, benefiting from favorable industry trends including a growing and aging population, more insureds as a result of the Affordable Care Act, and occasional consolidation opportunities resulting from the fragmented ownership of health-care real estate.

Verizon Communications VZ
Analyst Note 04/21/2015 | Michael Hodel, CFA

Verizon's performance overall remained solid during the first quarter despite continued intense wireless competitive pressure, including T-Mobile’s effort to start the year off quickly and Sprint’s “cut your bill in half” promotion. The competitive environment is most noticeable in the growth of average revenue per customer, which continues to slow despite massive increases in wireless data consumption. Offsetting this pressure, Verizon customer loyalty remains exceptionally strong, which is a significant component of its industry-best profitability. We believe the firm is still the best-positioned wireless carrier in the industry, worthy of a narrow economic moat rating. We don't expect to make a material change to our fair value estimate at this time, leaving the shares modestly undervalued currently. While we would prefer to wait for a better price before investing in Verizon, we’d note that we believe the stock is attractive relative to other large cap telecom peers like AT&T and Comcast.

Wireless customer growth during the first quarter looked very similar to a year ago. Verizon added 565,000 net postpaid connections (phones, tablets, and other devices) during the quarter, up about 5% year over year, but tablet activations continue to boost this figure. Digging deeper into this figure, the firm lost 100,000 net postpaid accounts during the quarter, resulting in the loss of 138,000 core postpaid phone customers. Both figures were only slightly worse than a year ago (22,000 and 91,000 lost, respectively). On the positive side, the pace of customer defections (churn) slowed versus both the prior quarter and a year ago. Given the significant shifts in the competitive environment and the fact that the first quarter is the slowest seasonal period of the year by far, these customer metrics are solid in our view. In short, the firm is doing a good job of holding on to its customers while its share of new customer decisions (gross adds) has likely slipped modestly.

Slowing growth in average revenue per account remains the biggest negative in Verizon’s wireless business. Adjusting for the adoption of Edge phone installment plans, average billings per postpaid account increased this metric increased 1.5% year over year, down 3.5% growth last quarter and around 8% growth during the first half of 2014. Verizon is currently lapping tough comps, as the firm was slow in late 2013 and early 2014 to adjust to pricing in response to the increase in competition. Still, the mismatch between revenue growth and increasing consumption is an area that bears careful watching. Average data usage per postpaid account increased 54% year over year, an acceleration versus the recent experience.

Verizon plans to launch wireless video services later this year in an effort to better monetize wireless data traffic, but we remain skeptical that carrier driven services will prove competitive versus the offerings of more nimble competitors. More critical, we still expect the level of competitive intensity will ease in the medium term as T-Mobile and Sprint shift their focus to profitability from growth.

Wireless profitability was very strong during the quarter. An increasing number of customers are opting for the Edge phone installment plan, which benefits reported wireless margins. On a reported basis, the wireless EBITDA margin improved nearly 4 percentage points year over year and 14 percentage points sequentially to 56% of services revenue, by far the strongest level on record. Excluding the Edge impact, margins likely would have been roughly flat year over year, which we again view as very strong given the competitive environment.

On the fixed-line side of the business, Verizon again showed modest improvement in the residential business versus the recent past. FiOS Internet access and television customer growth accelerated year over year for the second quarter in a row. Price increases and the migration to higher service levels continue to drive solid consumer revenue growth, which has topped 4% year over year for 11 straight quarters. Currency pressures hurt the enterprise business, with revenue declining 6% year over year. Absent the currency issue, management stated revenue would have declined at the same pace seen in the second half of 2014 (4.5%). The enterprise business continues to struggle with competitive pressure, which has hammered pricing for certain services. Even strategic enterprise services haven’t been immune to this pressure, with strategic revenue declining 1% versus year ago.

Fixed-line profitability was again a bright spot during the quarter. The segment’s EBITDA margin expanding 0.2 percentage points year over year, the seventh consecutive quarter of expansion. Verizon has steadily improved the efficiency of this business, reducing headcount consistently over the past several years. The fixed-line unit now employs 75,500 people, down from 80,900 a year ago and 91,800 at the end of 2011. With the planned sale of fixed-line properties to Frontier, the segment will again decline in importance to Verizon overall but we believe the firm’s remaining fixed-line assets in the northeast will prove strategically valuable to the wireless business over time.

The sale of wireless towers to American Tower closed during the quarter, juicing Verizon’s reported cash flow: About $2.4 billion of tower proceeds were included in operating cash flow. Still, adjusting for this transaction, cash flow was very strong during the quarter at $4.2 billion, up from $3.0 billion a year ago. Nearly half of this increase was the result of lower capital spending, which is a timing issue as Verizon still plans to spend slightly more in 2015 than it did in 2014. Verizon also received $1.3 billion in proceeds from the securitization of Edge receivables.

Verizon competed payment for the AWS-3 spectrum it won at auction and funded a $5 billion accelerated share repurchase during the quarter. As a result, net debt increased $6.3 billion to $108.5 billion, or 2.5 times EBITDA. Leverage is now flat versus the level hit immediately after the Vodafone transaction closed. Verizon reiterated that it expects to regain its A- credit rating over the next three years or so.

Verizon Communications: Investment Thesis 04/21/2015

Verizon has focused relentlessly on network quality over the years, cementing its reputation with customers and its position as the premier U.S. carrier in terms of customer loyalty and profitability. This position has enabled the firm to weather increased competitive intensity well.

Verizon Wireless is a good business and the best of the U.S. carriers. The firm has been the most consistent of the industry's major players over the past decade, investing steadily in its networks and approaching the market with a consistent brand message. Verizon Wireless has consistently captured more than its share of growth among higher-value postpaid customers. Only AT&T can match Verizon Wireless' scale, but we believe Verizon has several advantages relative to its primary rival, notably a more robust network built around uniform spectrum blocks and a more loyal customer base built around network and brand reputation rather than more ephemeral qualities (such as past iPhone exclusivity).

Both T-Mobile US and Sprint are now fighting for a sustainable place in the wireless market. T-Mobile has emerged as the stronger competitor, revitalizing its brand image and customer growth recently. Sprint has also begun competing more aggressively, but it continues to be haunted by past missteps. Regardless of the actions these firms take, we don't believe either has the resources to compete aggressively over the long term. We expect that both will ultimately price services within close proximity to AT&T and Verizon as they attempt to drive the cash flow needed to reinvest in their networks.

Verizon's fixed-line business is locked in a battle with the cable companies to capture Internet access, phone, and television customers. Verizon has invested heavily in its networks, which has enabled solid consumer revenue growth and provided a largely future-proof network. But, returns on this investment have been poor, as we calculate fixed-line asset turnover and margins trail most peers. We believe Verizon's position in the market providing services to large businesses and other carriers, which constitutes more than half of fixed-line sales, is stronger than in the residential market.

Verizon Communications: Economic Moat 04/21/2015
We base our narrow moat rating for Verizon on the strength of its wireless business (70% of revenue and more than 80% of EBITDA), which we believe is the best in the United States. Verizon Wireless and AT&T dominate the U.S. wireless industry, with about 60% of the retail market between them. These firms both generate solid cash flow while simultaneously investing heavily in marketing and network improvements that other rivals can't match. As evidence of the firm's scale, we estimate that Verizon Wireless serves more than 1,300 customers per employee; T-Mobile serves around 1,000 customers per employee; and U.S. Cellular, the nation's fifth-largest carrier (and similarly focused on the postpaid market), serves about 700 customers per employee. Verizon Wireless also spends roughly half as much per customer on advertising as U.S. Cellular despite spending 9 times as much in absolute terms. Verizon's wireless EBITDA margins are the class of the industry, typically running in the mid-40s as a percentage of service revenue versus about 40% at AT&T and 20%-25% at Sprint and T-Mobile.

Following the acquisition of Alltel in early 2009, Verizon Wireless also offers the most comprehensive geographic coverage of any wireless carrier in the nation, a position that would be very difficult for any other carrier to match. In addition, Verizon Wireless has had a decade to build its brand and reputation around the strength of its networks without interruption. Although not as strong an advantage as its scale, this unbroken stretch stands in stark contrast to every other major wireless carrier in the U.S. We believe Verizon Wireless' continued strong customer loyalty indicates that a large percentage of customers choose the firm for attributes it controls directly, including its network reputation.

One of the biggest detriments to the competitive position, in our view, is U.S. spectrum policy. The AWS-3 spectrum auction demonstrates the extremely high prices spectrum can fetch given that the U.S. government ultimately determines how and when additional spectrum is made available to the industry. We believe Verizon showed more discipline than AT&T did during the AWS-3 auction, but it still spent more than $10 billion, at very high prices relative to recent past purchases. This spending will constrain future returns on invested capital, which we estimate only modestly exceed the firm's cost of capital.

We aren't as enamored with the fixed-line side of the business. About 40% of this unit's revenue comes from the residential market, where cable and wireless companies have been stealing customers. We estimate Verizon now serves less than 40% of the households in its territory, down from nearly 60% five years ago. We believe that losing customers will make it difficult for Verizon to earn a solid return on FiOS network spending or justify network upgrade spending beyond where FiOS already exists.

Business and wholesale services generate the remainder of fixed-line revenue. We believe Verizon is well positioned in these markets because of the capabilities of its networks, especially the local reach it has within its traditional service territory. Few firms have the expertise to deliver the complex networking services Verizon can offer. We do expect increasing competition for small business customers, however.

Verizon Communications: Valuation 04/21/2015
Our $50 per share fair value estimate assumes very modest wireless revenue growth set against continued high wireless capital spending needs. While phone subsidies have pressured wireless profitability in recent years, Verizon Wireless has done a solid job of controlling costs. The cost of providing service to customers has steadily declined from about 13% of service revenue in 2011 to less than 10% recently. The pace of customer phone upgrades ebbs and flows each year, with heavy concentrations during the fourth quarter. Upgrades accelerated in 2014, causing wireless margins to fall modestly relative to the record level recorded in 2013. The drop in margin would have been more dramatic absent the benefit from phone installment-plan accounting, which calls for Verizon to book all future payments up front. We think margins will move higher in the future, as phone installment plans provide an accounting lift while also better matching phone device revenue and cost over time. Verizon Wireless has expanded its customer base at an impressive pace in recent years, taking share from rivals. We expect customer growth to remain solid, though we now expect wireless service revenue to increase only about 1% annually, on average, through 2019. The accounting for phone installment plans hurts service revenue growth, as a portion of revenue previously considered service shifts to equipment sales. On the fixed-line side, weakness in the enterprise business has offset continued strength in the consumer market recently. FiOS has shown progress in stemming fixed-line phone customer losses, and the firm has pushed through price increases that have significantly boosted consumer revenue growth. Any pickup in employment should give enterprise revenue a boost, but we expect this business will again shrink in 2015. The wholesale business is likely to remain in decline for the foreseeable future, but should shrink at a slower pace over the next few years. We believe revenue will stabilize over the next couple of years, which should allow fixed-line margins to expand modestly. Fixed-line capital spending peaked in 2008 and has tapered off nicely since. We expect spending will hold fairly steady through 2019.

Verizon Communications: Risk 04/21/2015
The buyout of Vodafone's stake in Verizon Wireless eliminates a source of uncertainty. But, the deal also adds leverage at the same time that the wireless business is reaching maturity, with smartphone growth slowing. Verizon Wireless and its rivals are turning to new services and devices to spur growth, but the revenue opportunity in these areas may not prove adequate to maintain the current rate of growth across the industry. If smaller carriers such as Sprint and T-Mobile aren't able to stabilize market share and grow revenue, one or both may turn to increasingly irrational pricing in attempt to reach stability. Anything that cuts into wireless cash flow over the next couple years will hinder Verizon's ability to repay debt. Another expensive spectrum acquisition would likely also reduce Verizon's balance-sheet strength.

On the fixed-line side of the business, cable companies and wireless substitution continue to steal residential customers in large numbers despite Verizon's network-upgrade efforts. Predicting when phone customer losses will slow is difficult, and the firm will likely need to win customers back to generate a decent return on its investment in FiOS. If consumer revenue growth stalls or if the enterprise market continues to struggle, Verizon may have trouble expanding fixed-line margins as planned.

Wells Fargo & Company
WFC
Valuation 04/24/2015 | Jim Sinegal

We are raising our fair value estimate to $58 per share from $52 per share based on the time value of money and a reduction in our assigned cost of equity as we update our cost-of-capital methodology. Our fair value estimate represents 1.6 times book value per share as of Dec. 31, 2014, and 12 times our 2016 earnings-per-share estimate. In our base-case scenario, we expect the net interest margin to average 3.5% by our calculation over the long run. The valuation is quite sensitive to this parameter, which has varied by more than 2 full percentage points over the last 10 years. We expect the bank's efficiency ratio to fall gradually to 53% by the end of our forecast period, as operating costs are reduced and mortgage-related expenses taper off as revenue increases. We expect net charge-offs to average just over 0.5% of loans in the long run. All in, we foresee a long-run return on average assets of 1.6%, at the top end of the company's current goal.

 

 
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