2023-08-04 07:35:00 ET
Summary
- "Rome wasn't built in a day" - Li Proverbe au Vilain.
- Everyone talks about Warren Buffett’s success, but understand that it took decades of diligent investing.
- We discuss two deeply discounted +8% yields for steady retirement income.
Co-authored with “Hidden Opportunities.”
Warren Buffett is the undisputed king of patient investing; after all, his relentless focus on profitability and excess cash flows through economic turmoil has led to the amassment of a fortune that most of us can only dream of.
From time to time, markets will be irrational, and quality stocks can sell off. That doesn’t mean every cheaply priced stock is an opportunity; studying the company’s fundamentals and examining the profitability and cash flows is critical. It is our job as investors to find the diamond in the rubble. Just because you found the gem doesn’t immediately mean the markets will accept it immediately. Investors need control over their emotions and patience to succeed in the markets.
"No matter how great the talent or efforts, some things just take time. You can't produce a baby in one month by getting nine women pregnant." – Warren Buffett.
Today we discuss discounted securities where profitability remains strong, and management is keen to pay growing dividends to shareholders. Yet, these trade at deep bargain prices due to the market’s unfounded assumptions about the business and its ability to survive economic pressures. Guess what, both companies have been around for over 50 years and have been great dividend stewards. While Mr. Buffett may not own these firms, he appreciates quality businesses with terrific pricing power.
"The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business." – Warren Buffett.
Let us examine two inelastic businesses with excellent pricing power to lead us through these tough economic conditions.
Pick #1: BTI – Yield 8.8%
British American Tobacco p.l.c. ( BTI ) is the 3rd largest global tobacco company (behind China National Tobacco and Imperial Brands) with an FY 2022 revenue of $34.2 billion. The company (which refers to itself as BAT ) operates and sells its products in over 180 countries and has a portfolio of some of the most popular cigarette brands, such as Kent, Lucky Strike, and Dunhill.
Like other Big Tobacco companies, BAT is heavily focused on growing its portfolio of reduced-risk products, or non-combustibles, and has secured market leadership in the United States and 15 E.U. markets. The company has successfully converted its traditional cigarette customers towards these new products and reached more than 23 million consumers in this new category.
Combustible smoking (often seen as a declining business) represents the lion's share of BAT’s top line. Yet, the company projects 3% - 5% organic constant currency revenue growth for FY 2023 due to its heavy exposure to Europe, the Middle East, Asia, and South America, where combustibles are still a modestly growing business.
Inflation and recession-resistant product line
Tobacco is a unique business where inflation costs are the easiest to pass to customers without impacting their loyalty to the brand. Notably, BAT’s peer Altria recently put in effect a 3rd price hike in 2023 for its Marlboro line of cigarettes.
This business has a unique ability to perform well during recessions, as individuals tend to consume more of its products during difficult economic situations. Notably, the monthly sale of cigarettes rose 47% during the pandemic years.
"I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty." – Warren Buffett.
Valuation
Despite being a leader in non-combustibles in key global markets, BAT is the cheapest among its peers – Altria ( MO ) and Philip Morris International ( PM ). Not only is the company valued attractively by P/E and EV/EBITDA, but its dividend yield is also currently the highest while enjoying the best EPS coverage.
Author's Calculations from company data
Note: BAT is a U.K. corporation that declares and pays dividends in GBP. U.S. investors owning NYSE:BTI will receive a USD dividend amount that is variable due to USD-GBP price variations.
Author's Calculations
BAT remains committed to returning excess profits to shareholders while maintaining a modest 65% payout.
"We want to give continuous focus on strong and consistent cash delivered and the leverage of the company. We understand the importance of cash returns for our shareholders. We are committed to 65% of dividend payout over the long term." – Tadeu Marroco, CEO .
BAT’s current quarterly dividend of 57.72p ($2.97 annually) calculates to a healthy 8.8% annualized yield and comes at a modest 62% payout ratio (using FY 2022 EPS). Management indicates mid-single-digit EPS growth in 2023, further improving the payout ratio. This shows high safety and sustainability through the company’s self-funded transformation into the non-combustible segment.
BAT’s current valuation presents an attractive opportunity to buy into its big, well-covered yield. Up to 8.8% yields from this recession-resistant business with one of the widest moats in the modern economy.
Pick #2: TDS Preferred Shares – Yields 11%
Telephone and Data Systems, Inc ( TDS ) is a Fortune 1000 company that delivers high-speed Internet, TV entertainment, and phone services to rural and suburban communities in several states. TDS has 1.2 million connections in 32 states, and the telecom company is also a majority shareholder (84%) of US Cellular ( USM ), the fourth-largest telecom company in the U.S. Altogether, TDS provides communication services to 6 million Americans. Like T and VZ, TDS shares also sold off aggressively following the Wall Street Journal investigation revealed that U.S. phone companies have left behind a network of cables covered in toxic lead
TDS assessed its communications network nationwide and located approximately 10 miles of lead-sheathed cables. The company is currently identifying the following steps to address the minimal amount of lead cabling it has estimated is in its network. TDS will have to bear the removal costs and face potential litigation for health effects and environmental damage, it is too early to estimate the charges, but it will be minimal and manageable for the company that just deployed fiber in 25,000 service addresses during Q1 2023. For FY 2023, TDS has guided $260-290 million in Adj. EBITDA. Worst case, we may see the numbers land closer to the lower end of this range.
TDS has been an annual dividend grower for 49 years, and the financial headwind from the lead sheathing issue will not come in the way of the company becoming a Dividend King. TDS remains well-positioned to achieve this rare milestone in 2024.
Despite a rebound later in the week following the panic-induced sell-off, TDS preferred shares continue to present attractive bargains at current price levels, offering up to 80% upside to par value.
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Telephone and Data Systems 6.625% Deposit Shares, Series UU Cumulative Redeemable Perpetual Preferred ( TDS.PU )
- Telephone and Data Systems 6.000% Deposit Shares, Series VV Cumulative Redeemable Perpetual Preferred ( TDS.PV ).
Both preferreds present similar opportunities, with a whopping ~11% qualified yield and significant upside to par value.
Trailing Twelve Months, excluding the USM operations, TDS spent $69 million on preferred dividends and only $7 million on interest expenses. Both these expenses were adequately covered by the company’s $277 million Adj. EBITDA for the period. Even at the low end of the annual Adj. EBITDA guidance of $260 million, the preferreds enjoy adequate dividend safety.
The company also reported over $100 million in cash and cash equivalents at the end of the quarter (including USM; the figure comes to $259 million, but TDS doesn’t have direct access to USM’s cash assets).
Author's Calculations
TDS announces Q2 2023 results Friday morning, August 4th.
Considering higher Capex due to 5G and fiber rollout and elevated interest payments (TDS has a 50-50 exposure to fixed/floating rates), will TDS common dividend be cut, maintained, or raised? We don’t know. While we would be happy to see the company enter the exclusive Dividend King club, it doesn’t matter to us as the investors of its cumulative preferreds.
TDS preferred shares enjoy adequate dividend coverage and present a safer income opportunity in the beaten-up telecom sector. The lead sheath issue will cost TDS some money, no doubt. But it will be manageable and paid out over the years, and telecom companies can easily charge the customer a modest fee to recover the costs. We don’t see a material impact on TDS financials or their operations and will sit back and collect our adequately covered dividends and patiently wait for a massive upside.
Conclusion
Investors must understand the type of business they have invested in, its position in the market, its competitive advantage, and the sensitivity of its goods or services to weaker economic conditions. And patience is a crucial virtue for an investor. You can’t buy quality companies and expect them to soar immediately. Value gets unlocked over time, and we believe in getting paid to wait for the upside.
Warren Buffett is a living example of the power of patience when it comes to succeeding in the financial market. In his 80+ year investing career, The Oracle of Omaha has always focused on the slow and steady approach to wealth building and never swung for the fences.
"The stock market is a device to transfer money from the ‘impatient’ to the ‘patient.’" – Warren Buffett.
We have a lot to learn from Mr. Buffett's experience through varying economic climates, interest rates, and political landscapes. While we don’t exactly buy what he does, and vice versa, we seek to learn from his emotional prowess in investing.
Recession-resistant goods and services fortify both BTI and TDS' business models, and these companies are well-positioned to maintain operational stability through turbulent times. We are seizing these discounted prices and will collect big dividends through market volatility. Remember, fortunes favor patient and steadfast investors. Happy investing!
For further details see:
Buffett Says Be A Long-Term Investor: 2 Dividends For A Rich Retirement