About the Editor

Michael Hodel is the editor of Morningstar DividendInvestor, a monthly newsletter that focuses on dividend income investment strategy. For illustration purposes, issues highlight activities pertaining to a Morningstar, Inc. portfolio invested in accordance with a current income and income growth from stocks strategy.

Michael is portfolio manager for Morningstar Investment Management LLC, a federally registered investment adviser and a wholly-owned subsidiary of Morningstar,Inc. At Morningstar, Mike was a technology strategist for Morningstar, responsible for telecommunications research. He also served as chair of Morningstar's Economic Moat Committee, a group of senior members of the equity research team responsible for reviewing all Economic Moat and Moat Trend ratings issued by Morningstar. He joined Morningstar in 1998.

Hodel holds a bachelor's degree in finance, with highest honors, from the University of Illinois at Urbana-Champaign and a master's degree in business administration from the University of Chicago Booth School of Business. He also holds the Chartered Financial Analyst® designation.

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 Portfolios is to earn annual returns of 8% - 10% 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
4% - 6% annual income growth

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Michael Hodel, CFA
Editor, Morningstar DividendInvestor
Portfolio Manager, Dividend Select Portfolios
Michael Hodel is the editor of Morningstar DividendInvestor, a monthly newsletter that focuses on dividend income investment strategy. For illustration purposes, issues highlight activities pertaining to a Morningstar, Inc. portfolio invested in accordance with a current income and income growth from stocks strategy.
Featured Posts
A Raise for Magellan -- The Week in Dividends 2017-07-21
DividendInvestorâ„  focuses on the activities of portfolios of Morningstar, Inc. that are invested in accordance with the Dividend Select strategy. These portfolios are managed by Morningstar Investment Management LLC, a registered investment adviser, who manages other client portfolios using these strategies.

From the DividendInvestor news file this week:

Magellan Midstream Partners
MMP boosted its quarterly payout by 2%, bringing its forward yield to 5.1% as of today's close. And five other Dividend Select holdings -- Alliant Energy LNT, Johnson & Johnson JNJ, Coca-Cola KO, Public Service Enterprise Group PEG, and Southern SO -- announced dividends this week that were unchanged from their previous respective payouts.

As earnings season continues, several Dividend Select holdings released quarterly results this week. Please see new Morningstar analyst notes below for General Electric GE, Genuine Parts GPC, Johnson & Johnson, and Philip Morris International PM.

Also below is a general note on the efforts to repeal and replace the Affordable Care Act (several portfolio holdings were tagged) and an update on Procter & Gamble PG and the efforts of Nelson Peltz to gain a seat on the firm's board. Finally, news about the Atlantic Coast Pipeline resulted in the Morningstar analyst reaffirming the current fair value estimates for Dominion Energy D, Duke Energy DUK, and Southern.

And if you missed yesterday's alert, the new August issue of DividendInvestor is available for download here.

Best wishes,

David Harrell
Managing Editor, Morningstar DividendInvestor

News and Research for Dividend Select Portfolio Holdings
Atlantic Coast Pipeline Receives Constructive EIS from FERC; Dominion's Dividend Increases on Track
by Charles Fishman, CFA | Morningstar Research Services LLC | 07-21-17

We are reaffirming our fair value estimates for Dominion Energy ($85), Duke Energy ($86), and The Southern Company ($50) after staff of the Federal Energy Regulatory Commission released its final Environmental Impact Statement for the proposed Atlantic Coast Pipeline, or ACP.

FERC staff concluded that the ACP would have some adverse effects, but we expect remediation costs to be immaterial. Dominion management indicated to us that its initial review of the recommendations was favorable and attention would now shift to the FERC’s Final Order to Proceed. FERC has 90 days to issue the Final Order, or by Oct. 19.

A minor concern is that the FERC commissioners, who must approve a Final Order, still lack a quorum. Acting Chairman Cheryl LaFleur (D) was the only commissioner remaining as of June 30. President Donald Trump has nominated four new commissioners, but all need Senate approval. We think it is likely at least two will be confirmed, creating a quorum and allowing quick ACP approval.

We expect the ACP to be completed in late 2019. For Dominion Energy, we expect dropdowns into Dominion Midstream Partners beginning in 2020, following the Cove Point dropdowns. We estimate these dropdowns and the ongoing DMP distributions will raise about $7.5 billion of cash for Dominion Energy, allowing for annual dividend increases exceeding 8% during the next five years.

The $5 billion-plus ACP will be a natural gas transmission line with a capacity of 1.5 bcf/day, running from West Virginia to North Carolina, passing through Virginia. Partners in the ACP are Dominion (48%), Duke Energy (47%), and The Southern Company (5%). The pipeline will serve two huge natural gas-fired power plants, one under construction, owned by Dominion. ACP could be expanded to 2 bcf/day to support new gas generation for Duke or Southern as they continue to replace retiring coal plants. Dominion Energy will construct, operate, and manage the ACP.

Better Second Quarter Free Cash Flow, but Near-Term Uncertainty Weighs on GE's Shares
by Barbara Noverini | Morningstar Research Services LLC | 07-21-17

Industrial free cash flow turned positive in GE’s second quarter at over $700 million, a welcome result following the negative $2.2 billion reported in the first quarter. However, management’s increasingly cautious tone regarding resource-rich markets in the Power segment, ongoing weakness in the Oil and Gas segment, and a possible delay in closing the Industrial Solutions sale all contribute to the swirl of near-term negativity that we’ve seen overhanging the stock. Management reiterated its $12 billion to $14 billion target in industrial cash from operations for 2017. Meeting the low end of this range will require GE to generate approximately $1 billion more in industrial CFOA than it did in second-half 2016. With GE’s cash generation typically back-half loaded, we still believe the guided range is achievable; however, persistent weakness in energy-related segments could make this an uphill battle. We intend to trim our near-term earnings and cash flow estimates to the low end of management’s guidance; however, we do not expect this to materially impact our $32 per share fair value estimate. We see recent weakness in shares as more symptomatic of near-term uncertainty rather than deterioration in GE’s longer-term prospects.

Although GE’s consolidated top line declined 12% year over year on a reported basis, industrial sales increased 2% when excluding the impact of divestitures. Power, Renewables, Healthcare, and Energy Connections and Lighting each grew revenue organically year over year by 5%, 13%, 5%, and 2%, respectively. This more than offset ongoing weakness in Oil and Gas and Transportation, which reported organic sales declines of 3% and 13%, respectively. Industrial operating margin increased year over year by 10 basis points to 13.2%, contributing to over 70 basis points of year-to-date improvement in margins, only 30 basis points shy of its 100 basis points year-end 2017 target. We continue to believe incremental improvement is happening at GE.

On-Track Second-Quarter Results Leave Our Outlook for Genuine Parts Intact; Shares Attractive
by Zain Akbari, CFA | Morningstar Research Services LLC | 07-20-17

We do not plan a large change for our $94 per share valuation after narrow-moat Genuine Parts reported second-quarter earnings (5% sales increase, diluted EPS of $1.29) that leave it on pace to meet our 2017 targets. Management updated 2017 guidance to 3%-4% sales growth and $4.70-$4.75 diluted EPS (sales outlook was unchanged, but the prior EPS target was $4.75-$4.85 per share), in line with our 3.5% and $4.75 respective marks. Our long-term forecast (4% top-line growth, 8% adjusted operating margin) is intact. We see the shares as attractive, largely on account of a slump in the automotive parts retail industry that we believe is cyclical in nature rather than structural.

The industrial segment (30% of 2016 sales) led performance, with quarterly sales up 7%. Management lifted its full-year segment revenue growth guidance to 4%-5% from 3%-4%, versus our 4.5% mark. A recovering energy sector as well as strong performance from clients in the iron and steel and lumber industries boosted the segment, which is recovering from revenue shortfalls in 2015 and 2016. We see the unit as competitively advantaged, combining quick access to mission-critical components with purchasing advice from trained sales personnel to provide service levels that subscale competitors cannot match economically.

The automotive unit saw 4% quarterly sales growth, not far from our 3% full-year segment expectation. The division, which accounted for 53% of the firm’s 2016 sales, saw first-half margins contract by about 25 basis points, near our roughly 30-basis-point forecast 2017 dip. We see the industry slump as cyclical, with weather conspiring with slowing miles driven growth to depress sales. Our view contrasts with year-to-date investor and media attention on Amazon’s increased interest in the space. We see those fears as overblown due to the service levels customers demand and their price insensitivity, with AutoZone and Advance as the best means for patient investors to capitalize.

J&J Posts Largely In-Line 2Q as Blood Cancer Drugs Help Offset Generics, but Growth Concerns Remain
by Damien Conover, CFA | Morningstar Research Services LLC | 07-18-17

Johnson & Johnson reported second-quarter results largely in line with both our and consensus expectations, and we don’t expect any major changes to our $114 fair value estimate based on the results. We continue to view J&J as slightly overvalued, with concerns about the slowing sales growth across its divisions. Nevertheless, the firm’s strong wide moat looks intact, buoyed by a diverse lineup of patent-protected drugs and well-entrenched devices and consumer goods.

In the quarter, excluding acquisitions and divestitures, operational sales grew 1% year over year, as prior favorable period adjustments hurt sales growth by 4%, but we expect slowing sales growth for J&J over the next three years. The drug segment is facing increased generic pressure, with immunology drug Remicade down 5% operationally year over year. We believe both branded and biosimilar pressures are weighing on Remicade’s sales and expect this pressure will increase as Samsung/Merck’s biosimilar Renflexis (approved by the U.S. Food and Drug Administration in April) launches later in the year, joining Pfizer’s biosimilar Inflectra in the U.S. Given Remicade’s high contribution to profit margins, sales declines will have an amplified impact on J&J's cash flows. We expect additional generic pressure on cancer drugs Velcade and Zytiga as well as neurology drugs Concerta, Risperdal Consta and Invega Sustenna over the next three years. Offsetting some of this pressure, the company’s blood cancer drugs continue to post solid gains, and we are bullish on Imbruvica and Darzalex, as both drugs have shown excellent relative efficacy and hold first-mover advantages.

Turning to J&J's remaining divisions, operational sales at consumer and devices fell 1% and grew 1%, respectively, year over year, highlighting our view of continued weakness in these groups. While new product launches should help improve this growth over the next three years, we still project modest growth of 3% annually for both segments.

Another Miss Highlights the Frothy Expectations Around PMI
by Philip Gorham, CFA, FRM | Morningstar Research Services LLC | 07-20-17

For the second consecutive quarter, Philip Morris International missed consensus forecasts but remains on track to meet our full-year forecasts, which remain within the lowered guidance range. We still believe the competitive advantages underpinning our wide economic moat rating are transferable to the emerging RRP portfolio, but we think expectations have become too lofty, and we view the stock as overvalued. Although we have modestly lowered our near-term estimates to reflect unfavourable currency movements, this is immaterial to our valuation, and we are reiterating our $95 fair value estimate.

The greatest negative impact in the quarter came from currency, although on an underlying basis, volumes across the board appeared slightly soft. In Asia, in particular, volumes did not improve sequentially as we had expected, falling 9.8%, with PMI citing excise-tax-driven price increases and an increase in illicit trade as the drivers. This trickled through the income statement, and currency-neutral operating income growth slowed to 6%, down from 11% in full-year 2016.

In an environment of very sluggish consumer staples growth, this was still a decent performance, and although the company may not be meeting the market's aggressive expectations, there are several reasons not to panic. First, the U.S. dollar has weakened against the euro in recent weeks, which should provide some respite from currency headwinds in the second half of the year. Second, much of the volume shortfall appears to have been driven by the economy end of the market, which has limited impact on profitability. Third, sales of HeatSticks are picking up some of the slack. The company reported 6.3 billion in HeatStick shipments in the second quarter, up 43% sequentially from the first quarter. The impressive uptake rates iQOS has generated since last year supports our thesis that heated tobacco has a strong chance of gaining critical scale.

Peltz Vies for Board Seat at P&G in Effort to Accelerate Change
by Erin Lash, CFA | Morningstar Research Services LLC | 07-17-17

After announcing an ownership stake earlier this year of more than $3 billion, or around 1% of shares outstanding, activist investor Nelson Peltz is now seeking a board seat at Procter & Gamble. We don’t intend to alter our $94 fair value estimate (which calls for operating margins to expand more than 300 basis points to nearly 25% by 2026 and 4% annual sales growth in the longer term) based on this news. With the shares trading a touch below our valuation, we’d suggest investors interested in the space, where discounts are few and far between, keep an eye on this name.

As we said in February, we believe P&G is taking prudent steps to right its ship, although we’ve long held these investments would take time to yield improvement. Management just closed the book in October on a meaningful multiyear brand rationalization, shedding more than 100 brands from its mix; this leaves it with just 65 brands, which we think positions P&G to benefit from more focused brand spending and hence an ability to more effectively tap into and respond to evolving consumer trends. We think these investments stand to drive accelerating sales and volume growth across the company's mix and, in the process, aid the brand intangible asset source of its wide moat.

Beyond bolstering its top line, P&G is also eyeing further efficiency gains, targeting to extract another $10 billion of costs by reducing overhead, lowering material costs, and increasing manufacturing and marketing productivity. We believe these efforts are unlikely to meaningfully boost margins but rather fuel product innovation (including improved packaging) and advertising (as well as increased sampling to prompt trial) to reignite the company's top-line prospects. As such, we forecast P&G will allocate 3% of sales to research and development and 11.5% of sales to marketing annually, up from historical levels of less than 3% and around 11%, respectively.

Political Reality too Much for GOP Healthcare Overhaul; Mixed Impact for Our Healthcare Coverage
by Vishnu Lekraj | Morningstar Research Services LLC | 07-18-17

The political reality of scaling back healthcare coverage for millions of constituents was too much for the U.S. Senate GOP to overcome in passing a major overhaul of the Affordable Care Act. With the loss of more than two “yes” votes for both the initial and revised Senate Republican plan, Senate majority leadership was unable to push a measure that would be appealing to both the moderate and libertarian wings of its caucus. Thus, we believe the probability of a substantive “repeal and replace” plan becoming law is now extremely low. On balance, we find this development positive for both the managed care and hospital sectors as volume increases due to expanded coverage will remain in place. On the other end of the spectrum, the elimination of various ACA fees and taxes for pharmaceutical and device companies is now off the table. Even though this development maintains a status quo operating environment, it does take away a potential positive financial impact for these firms.

From here we believe the Senate will take a step toward shoring up a weak public exchange marketplace in order to maintain a functioning private individual insurance market over the near term. This will likely require some meaningful level of bipartisan negotiation in both chambers of congress. Despite the rhetoric of letting these marketplaces fail, we believe it will be politically untenable for Republicans to allow this scenario to playout given they control every branch of the federal government and a significant percentage of affected voting districts are either Republican or tossup leaning. Additionally, we believe congressional GOP leadership is keen to move on from the political minefield of healthcare legislation and toward initiating a major overhaul of U.S. tax code.

Bottom line, we believe the ACA will likely remain in place for some time to come and its dominant affect upon healthcare-related firms will continue. However, we also believe there will need to be legislation to address long-term issues and concerns related to certain aspects of the law. Chiefly, lawmakers will have to formulate a long-term plan to stabilize the public exchange/individual markets (which comprise approximately a quarter of the private insurance space) in order to keep premium costs in check, incentivize robust health insurance company participation, and prevent a death-spiral scenario from developing.

©2017 Morningstar, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. The information contained in this document is the proprietary material of Morningstar, Inc. Reproduction, transcription, or other use, by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited. All data presented is based on the most recent information available to Morningstar, Inc. as of the release date and may or may not be an accurate reflection of current data.  There is no assurance that the data will remain the same.

The commentary, analysis, references to, and performance information contained within Morningstar® DividendInvestorâ„ , except where explicitly noted, reflects that of portfolios owned by Morningstar, Inc. that are invested in accordance with the Dividend Select strategy managed by Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc. References to "Morningstar" refer to Morningstar, Inc.

Opinions expressed are as of the current date and are subject to change without notice. Morningstar, Inc. and Morningstar Investment Management LLC shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use.  This commentary is for informational purposes only and has not been tailored to suit any individual. 

The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided as of the date written, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment.

This commentary contains certain forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Investments in securities are subject to investment risk, including possible loss of principal.  Prices of securities may fluctuate from time to time and may even become valueless.  Securities in this report are not FDIC-insured, may lose value, and are not guaranteed by a bank or other financial institution. Before making any investment decision, investors should read and consider all the relevant investment product information.  Investors should seriously consider if the investment is suitable for them by referencing their own financial position, investment objectives, and risk profile before making any investment decision. There can be no assurance that any financial strategy will be successful.

Common stocks are typically subject to greater fluctuations in market value than other asset classes as a result of factors such as a company's business performance, investor perceptions, stock market trends and general economic conditions.

All Morningstar Stock Analyst Notes were published by Morningstar, Inc. The Week in Dividends contains all Analyst Notes that relate to holdings in Morningstar, Inc.'s Dividend Select Portfolio. Morningstar’s analysts are employed by  Morningstar, Inc. or its subsidiaries.  In the United States, that subsidiary is Morningstar Research Services LLC, which is registered with and governed by the U.S. Securities and Exchange Commission.

David Harrell may own stocks from the Dividend Select and Dividend Select Deferred portfolios in his personal accounts.
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