AMM Dividend Letter Vol. 7 ~ Return of the King of Beers

This is from the AMM Dividend Letter released May 3, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

In a recent interview with 60 minutes about his new book “Flash Boys”, Michael Lewis declared the stock market “rigged” (see the clip here: http://www.cbsnews.com/videos/is-the-us-stock-market-rigged/). Flash Boys is about the world of High Frequency Trading (HFT), and the “edge” that some traders have been able to achieve by using very fast computers to “see” market data ahead of their competitors. While this is disconcerting for short-term traders and speculators, we don’t think these concerns are relevant to long-term investors.

Carl Richard in the New York Times sums up this view rather succinctly:

“Now, if you’re a trader who spends every day making trades for a living, you’ll be interested in the conversation about whether there’s a system in place for front-running your trades that costs you a bit each time you buy or sell. And if you’re a concerned citizen, you’ll care whether people are breaking the law. But as an investor, high-frequency trading doesn’t matter because you’re focused on the boring work of buying good things and owning them for a long time.”

First and foremost our goal is to invest (i.e. take an ownership position) in high-quality businesses. We describe high quality as the ability to invest incremental capital at a high rate of return on the shareholder’s equity. Unlike traders/speculators who seek to buy a stock and then flip it for a profit a short time later, we seek to become long term shareholders in a business that can provide us an attractive return over time.

If the stock market is “rigged”, perhaps it is in favor of the investor that has the patience to own high-quality businesses and who ignores the day-to-day, week-to-week, and month-to-month fluctuations of the stock market. Wealth will compound at a surprising rate for the patient investor who lets high-quality businesses generate high rates of return on capital over many years.

Interestingly, this approach seems to be the exception and not the rule to investing today. A casual glance at the “Investment” section of the local Barnes & Noble shows a heavy weighting toward books on trading, charting and generally trying to game the market. A much smaller section is dedicated to actual investment analysis.

Price is What You Pay, Value is What You Get

The second pillar of our process is to pay a fair price for our investment. Traditional financial theory defines the value of any assets as the sum of all future cash flows discounted back to present day at an appropriate discount rate. This creates a present day or intrinsic value, the price we are willing to pay today for future returns. Buying below present value generates higher returns while paying too much leads to lower returns. If we pay significantly above fair value for an asset it may even lead to negative returns over time, even for a high quality company. Ideally we seek to invest at prices below our conservative estimate of intrinsic value to provide both a margin of safety and the opportunity for higher long-term returns.

Ultimately we want to buy businesses that provide a good or service that consumers will want well into the future. Estimating future cash flows for these types of companies is much easier than for companies with new or untested products. It becomes even easier if the company makes a product consumed by mankind since the dawn of civilization. We can safely assume this product will be desired well into the future.

Anheuser-Busch InBev (BUD) is a perfect example.

Dividend Stock in Focus

Anheuser-Busch InBev (BUD): $106.28*
*price as of the close May 2, 2014

The 2008 merger between Anheuser-Busch and InterBrew resulted in Anheuser-Busch InBev (BUD) which is now the largest brewer of a 12,000 year old consumer staple.

The first humans out of Africa were nomadic hunter-gatherers. When they stepped foot into the Fertile Crescent their nomadic lifestyle ceased as they now had access to an abundant source of cereal grains, a new food source that humans could store and provide an unexciting but reliable meal when needed. Families took root, built permanent settlements, and banded together with other families. The building blocks of modern civilization were set.

All harvested grain was stored together in one easily defended central location; however the vessels used to store the grain were not water tight. When water mixed with the grains, especially barley, the mixture turned into a sweet tasting gruel. Left alone for a few days the gruel underwent a further transformation becoming slightly fizzy and pleasantly intoxicating. Mankind had discovered beer!

The first beer had low alcohol content but was rich in suspended yeast, a strong source of vitamins and protein. The higher levels of B vitamins helped compensate for the decline in meat consumption as man began to farm more and hunt less. The first beers weren’t filtered requiring the use of straws to drink. Also, the beer was stored and served in containers too large for personal consumption. Sharing a beer was an offer of sustenance and friendship. 12,000 years later sharing a drink is still a universal symbol of friendship.

A Mesopotamian pictograph of two people drinking beer
A Mesopotamian pictograph of two people drinking beer

Beer consumption has survived the rise and fall of many governments and civilizations, and we see no reason why it will not continue to survive and grow as long as mankind exists. As the global leader of a timeless consumer staple, Anheuser-Busch InBev (BUD) is in an enviable position.

Dividend History:

Shares for Anheuser-Busch InBev (BUD) started trading in the U.S. in 2009. Since then management has grown the dividend at an annual rate of 38.7%.

Data from S&P Capital IQ
Data from S&P Capital IQ

The chart is a little misleading. After buying Anheuser-Busch, the new mega-brewer slashed its dividend to pay off its new debt as fast as possible. The management team has proven themselves to be skilled deal makers, willing to cut dividends and sell assets if the net positive is a stronger and more valuable business. There is always a chance management cuts the dividend again if they can scoop up another global brewer, like SABMiller Plc. We would expect the dividend to come back once the deal is complete and the balance sheet restored.

Catalysts for Dividend Growth and Price Appreciation

Acquisitions

Anheuser-Busch InBev’s management team is adept at acquiring other larger brewers, cutting costs, and creating value for its shareholders. This goes back to the merger between Brazil’s two largest breweries, Brahma and Antarctica, to create Ambev. Then Interbrew, at the time Europe’s leading brewer, merged with Ambev to form InBev. Then InBev bought Anheuser-Busch to form Anheuser-Busch InBev.

To complete the Anheuser-Busch transaction, InBev had to sell assets, including South Korea’s largest brewer, Oriental Brewery. The sale of Oriental Brewery included a buyback clause. Earlier this year, Anheuser-Busch InBev exercised this right and bought Oriental Brewery back from KKR.

Anheuser-Busch InBev also purchased the rest of Grupo Modelo that it did not own. Management targeted $1 Billion in cost savings from the deal. The cost savings are expected to be delivered ahead of schedule in 2015.

Craft Beer Boom! (Then Bust)

Craft beer currently represents 10.2% of the domestic beer market. Bart Watson, an economist with the Brewers Association, thinks it could reach 15% in the near future. In Oregon, craft beer accounts for 47% of all beer consumed. While trends never move in an orderly fashion (there are typically booms and busts along the way), right now we are amid a craft beer boom.

According to the Denver Post, Colorado added 56 new permitted breweries in 2013 pushing the state’s total to 217, double that of 2012. Across the nation 1,528 new breweries opened in 2013. That’s on top of the existing 2,043 craft brewers.

The craft beer market is still dominated by a handful of breweries like Boston Beer Co. (SAM), Sierra Nevada Brewing Co., New Belgium Brewing Co., and Deschutes Brewery. The remaining craft brewers are fighting for tap and shelf space in a crowded market. It is only going to get tougher. For the breweries that are under capitalized the fight will be brutal.

Anheuser-Busch InBev has the capital, the scale, and the distribution network to help any established craft brewer ramp up and survive the coming fight. In 2011 Anheuser-Busch InBev purchased Chicago’s Goose Island for $40 million. Anheuser-Busch InBev started a national roll out strategy and Goose Island’s sales increased significantly. In 2013 alone Goose Island’s volume increased “more than 70%”. The chart below compares Goose Island’s sales volume growth to its closest competitors as of October 2013. Shock Top is an Anheuser-Busch InBev beer too.

Chart from Anheuser-Busch InBev’s November 2013 Investor Seminar
Chart from Anheuser-Busch InBev’s November 2013 Investor Seminar

In February Anheuser-Busch InBev bought Blue Point Brewery. Blue Point is a 15 year old company and produces about 60,000 barrels a year. Their flagship beer is the Toasted Lager, a 2006 World beer Cup Gold Medal Winner. The company needs capital to compete and expand on a national scale. We expect Anheuser-Busch InBev to do for Blue Point what they did for Goose Island.

The craft beer boom has also played a part in lagging U.S. sale sales volumes for Anheuser-Busch InBev. Buying and investing in craft brewers can offset U.S. Volume declines. Craft beer is also premium priced beer which combined with management’s ability to increase distribution and cut costs is a recipe for higher profits.

China

Performers at Qingdao 2013 Beer festival
Performers at Qingdao 2013 Beer festival

China is still one of the fastest growing beer markets in the world and is Anheuser-Busch InBev’s fastest growing market. For 2013 the company’s beer volume sales grew 8.9% with only a 14.1% market share. The Chinese beer market is fragmented and the bulk of the beer consumption growth has come from low-end beers. This is a strong opportunity for Anheuser-Busch InBev. The company’s high-end brands can gain market share through organic growth, acquisitions, and partnerships.

Deleveraging

The merger of Anheuser-Busch with InterBrew left the new company with a highly leveraged balance sheet. Except for the small dividend it paid out, all excess cash flow was used to deleverage the balance sheet (i.e. pay down debt). The ultimate target was a Net Debt to EBITDA ratio of 2x. Anheuser-Busch InBev reached this target and is now returning excess cash to shareholders. On top of the year-end dividend, Anheuser-Busch InBev paid out its first interim dividend since the merger last year. Management wants the dividend yield to be in-line with its consumer staples peers. The goal is a dividend yield of 3-4%.

Management also stated that cash will be returned to shareholders through share buybacks too.

Another Mega Deal

Anheuser-Busch InBev wants more exposure to the faster growing emerging markets of Africa. Its largest competitor SABMiller Plc has solid exposure to these markets, and that company’s CEO has gone on record that an Anheuser-Busch InBev buyout of SABMiller is a workable deal. He then declined to say if any discussions between the two companies have taken place. According to Bloomberg, an acquisition of SABMiller would add over $7 billion in revenue from Africa and $4 billion in Asia. Bloomberg also estimates a combined Anheuser-Busch InBev and SABMiller to have over 50% of the “global beer profit pool”. A combined company is a large opportunity for Anheuser-Busch InBev’s management to generate a lot of value through scale and cost cutting.

Conclusion:

“A great business at a fair price is superior to a fair business at a great price.” – Charlie Munger

Anheuser-Busch InBev is a great business. The company is the leading global brewer and brews 7 of the world’s top beer brands: Bud Light, Budweiser, Corona, Skol, Stella Artois, Brahma, and Beck’s. Anheuser-Busch InBev also has a large, if not the largest, market share position in many key markets including Brazil (69%), Argentina (77%), Canada (41%), U.S. (48%), Belgium (57%), and Ukraine (36%). The company sports industry leading margins too. Our discounted cash flow model puts Anheuser-Busch InBev’s fair value at $106 per ADR. When the stock dipped below $100 we started buying as we viewed this as an opportunity to buy a great business at a fair price.

Chart courtesy of Stockcharts.com
Chart courtesy of Stockcharts.com

Further Reading:

Books

For more on beer and the early development of human civilization, plus how 5 other major drinks help shape civilization read.
A History of the World in 6 Glasses

From colonial days to the craft beer boom, the history of beer in the United States.
Ambitious Brew: The Story of American Beer

Flash Boys: A Wall Street Revolt by Michael Lewis

The behind the scenes story of the how the Brazilians were able to wrestle Anheuser-Busch away from the Busch family.
Dethroning the King: The Hostile Takeover of Anheuser-Busch, an American Icon

Links

Why Carlos Brito, the CEO of Anheuser-Busch InBev, is one of the most effective CEOs…. Frugality (Joe Kusnan’s Blog)

Dividend growth investing provides inflation protection (AMM Dividend Letter)

The stock market has been “rigged” since day one (The Reformed Broker)

The next big thing in craft brewing Introducing Samuel Adams Heli-Yum

Apple (AAPL) hits one of its catalysts (AMM Dividend Letter)

No matter how full life gets there is always room for a couple beers with a friend (Balanced Action)

All past letters are archived here.

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

AMM Dividend Letter Vol. 6 ~ A Growth Opportunity from a 254 Year Old Company?

This is from the AMM Dividend Letter released March 29, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

This is the sixth edition of the AMM Dividend letter and we hope it has been both informative and entertaining (at least in as much as an investment letter can be entertaining). Our primary goal for this letter is to provide current investors in our firm’s dividend strategy with a “closer look” at some of the investments that we have made on their behalf.

If you have enjoyed reading this letter and know any family or friends that would enjoy it too, please feel free to share it. Alternatively, If you did receive this letter from a family member or friend and you would like to receive our future letters you can join our mailing list by clicking the link below.

Join Here!

As always, don’t hesitate to call or email if you have any feedback regarding our letter, or if you want to discuss your portfolio investments in greater detail.

Thank you,
Your Portfolio Management Team

Dividend Stock in Focus

Lorillard, Inc. (LO): $53.35*
*price as of the close March 28, 2014

Early History**:

Lorillard, originally known as P. Lorillard & Co., is America’s oldest tobacco company. While the company’s public shares have only been trading since 2008 when it was spun off fully from Loews Corp., it was originally founded in 1760. In fact, some of North America’s first tobacco advertisements were run by P. Lorillard & Co. in Ben Franklin’s newspaper. Below is an ad from 1789.
Lorillard_hogshead,_1789

The early history and founding of the United States was heavily influenced by tobacco. If not for two key tobacco related moments it is quite possible the United States of America would have never been.

1. King James’ Hatred of Tobacco:

King James (I of England & VI of Scotland) despised many things: witches, burning up to 400 per year; sex with women, the nickname Queen James is self-explanatory; and especially tobacco smokers, who he viewed on par with Devil worshipers. In 1604 King James raised the duty on Tobacco by 4,000 percent.

The increased duty made the push for a New World tobacco supply even stronger. In 1607 The Virginia Company landed in the Chesapeake Bay and founded the Jamestown colony. This third English colony seemed destined to fail like the previous two, that is, until John Rolfe planted Nicotiana Tabacum seeds.

Over several seasons John Rolfe perfected his growing, harvesting, and curing to create the unique Virginia tobacco. Demand took off. Immigration rose to meet the need for labor. Sadly, most of the new labor came in the form of slavery. Life expectancy abounded. Disposable incomes grew to the point that a ship in 1619 arrived carrying “young maids to make wives priced at one hundred and twenty pounds of the best leaf tobacco”. Births finally out paced deaths.

The Jamestown experiment and the future American colonies would succeed, in part, because of tobacco.

2. War Allies:

It was the French Navy that prevented Lieutenant General Lord Cornwallis from escaping Yorktown as George Washington and his army pressed forward. Leading to the surrender of Cornwallis and prompting the British Government to negotiate an end to the Revolutionary War.

It is said that the French help, troops and a loan, was secured by the Patriots’ win at the battle of Saratoga and by the charisma of Ben Franklin, who served as Minister to France during the war. What is not often discussed was the vital role tobacco played.

Five million pounds of Virginia tobacco served as the collateral for the loan Ben Franklin negotiated that helped the patriots defeat one of Europe’s most potent nations. Securing the independence declared by the colonies on July 4, 1776 and still celebrated 238 years later.

** The information in this section is from the book: Tobacco: A Cultural History of How an Exotic Plant Seduced Civilizationby Ian Gately.

Dividend History:

Once spun off from Loews Corp., Lorillard immediately started paying a quarterly dividend of $0.30667 per share. In February of this year Lorillard increased its quarterly dividend again by 12% to $0.615. This is the sixth increase in 6 years, doubling the initial payout. This represents a 13% compound annual growth rate since August 2008.

Data from S&P Capital IQ
Click to enlarge. Data from S&P Capital IQ

Lorillard’s policy is to return 70-75% of its earnings to shareholders in the form of a dividend. The company’s current payout ratio is 70%.

Catalysts for Dividend Growth and Price Appreciation

Electronic Cigarettes:

Civilization’s love affair with smoking is waning. The harm is just too great. Enter the electronic cigarette (eCig), a device focused on harm reduction and renewing man’s love affair with nicotine.

An eCig is a battery powered device that converts liquid nicotine, not tobacco, into a vapor that is inhaled by the user. There is no fire, smoke, or ash.

Image courtesy of Howstuffworks.com
Image courtesy of Howstuffworks.com

In April 2012 Lorillard purchased Blu eCigs for $135 million in cash. Sales have grown from $61 Million in 2012 to $230 million in 2013 per Lorillard’s latest 10-K filing. Utilizing Lorillard’s well established distribution network Blu eCigs have already captured 50% of the U.S. electronic cigarette market. The market share gains are even more impressive when we consider that Blu eCig’s have so far only been available in approximately 1/3 of the retail locations that comprise Lorillard’s distribution network. As Lorillard fills out its distribution network, we would expect Blu eCigs’ strong sales growth to continue.

During the 4th quarter of 2013 Lorillard also purchased SKYCIG, a leading U.K. electronic cigarette maker. The acquisition gives Lorillard an entrance into the U.K. market and Western Europe. The company has announced plans to rebrand SKYCIG, unifying Lorillard’s global electronic cigarette brand under the Blu eCig banner.

While Blu eCig’s operating and profit margins are well below the margins of traditional cigarettes, there is reason to believe this situation may reverse itself in the future. Cigarette sales are subject to excise taxes and part of the revenue goes to funding legacy legal settlements while sales of e-cigarettes do not. Goldman Sach’s research department estimates that eCigs as a whole could generate profit margins in excess of 50%. Traditional cigarettes currently generate around 30% profit margins and Lorillard’s trailing twelve month profit margin is at 23%. Sales growth and margin expansion driven by expanding market share and greater adoption by the consumer should be positive for Lorillard’s stock price in the year’s to come.

Market Leader in Menthol Cigarettes:

Cigarette sales for tobacco companies are declining. Over the last 3 years the total volume of sales for domestic cigarettes has declined at a compound annual rate of -2.31%. In comparison, Lorillard’s total sales volume has declined at a much slower rate, -0.59% compounded annually over the last 3 years. This is due to Lorillard’s Newport brand of cigarettes, a menthol flavored cigarette. As seen in the chart below, Newport’s represent the bulk of Lorillard’s sales and the brand continues to gain market share.

From Lorillard's 2013 10-K
Click to enlarge. From Lorillard’s 2013 10-K

Lorillard’s management has more than offset any volume declines with price increases. Since becoming a fully independent company in 2008, Lorillard has grown revenue at a compound annual rate of 6%.

Data from S&P Capital IQ
Click to enlarge. Data from S&P Capital IQ

Potential Merger:

Lorillard and Reynolds American surged earlier this month on the rumored news that Reynolds would make a bid for Lorillard. The rumored bid is expected to be north of $20 billion. Rather than an outright buyout of Lorillard the deal would most likely be a merger and involve an equity offer from Reynolds.

There are significant hurdles for this deal to be completed. Reynolds and Lorillard are the number 2 and 3 U.S. tobacco companies. A combined entity would control about 92% of the U.S. market and 67% of the U.S. menthol market. Additionally, British American Tobacco owns 42% of Reynolds and controls five board seats. Any equity Reynolds issues that would dilute shareholders by 5% or more needs approval from British American Tobacco.

Right now the deal is a rumor along with the speculation that Imperial Tobacco or Japan Tobacco would make counter-bids for Lorillard. We were happy to hold Lorillard for the long-term when we first bought it in the $47-49 range and the failure of a bid to materialize will not change our thinking.

Capital Efficiency:

Lorillard is an extremely capital efficient company generating Return on Assets (ROA) over 30% and Return on Capital (ROC) over 90%.

Data from S&P Capital IQ
Click to enlarge. Data from S&P Capital IQ

Return of Capital:

Besides rewarding shareholders with a growing dividend, Lorillard has also bought back a lot of shares. Since it’s spin-off in 2008 Lorillard has reduced total shares outstanding at a compound annual rate of -5.35%.

Data from S&P Capital IQ
Click to enlarge. Data from S&P Capital IQ

Conclusion:

Cigarette sales across the U.S. are in decline, making an investment in this industry somewhat contrarian. However, due to Lorillard’s leadership in the menthol category, the company has seen below average declines in sales volumes, and management has more than offset these declines with price increases. Total revenue has grown at a compound annual rate of 6% since 2008. Assuming a fairly conservative growth rate of 3%, a discount rate of 12.5%, long-term average margins, and accounting for share buybacks we derive a fair value of $55 per share. Fair value represents the price we would be willing to pay to generate a return commensurate with a particular stock’s risk (i.e. it does not represent a “target” or static price objective). For a company like Lorillard we estimate this return objective to be 12-15% annually. Additionally, our fair value estimate gives little weight to the eCig business which we feel could provide significant upside.

Chart courtesy of Stockcharts.com
Chart courtesy of Stockcharts.com

Further Reading:

For more on the history of civilization’s love/hate relationship with tobacco read
Tobacco: A Cultural History of How an Exotic Plant Seduced Civilization

Rich Man, Poor Man (Dow Theory Letters)

Choose dividend growth over highest yield (Alliance Bernstein)

How to Generate an 11% Yield on Cost in 6 Years (Dividend Growth Investor)

All previous AMM Dividend Letters are archived here.

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

AMM Dividend Letter Vol. 5 ~ Growing Wealth Like Grace Groner With Abbvie (ABBV)

This is from the AMM Dividend Letter released February 28, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

You’ve probably never heard the story of Grace Groner but it’s an important one.

Grace lived in Michigan, worked as a secretary, wore secondhand clothes, never owned a car, and lived in a modest one bedroom house. Upon her death, this woman of modest means left Lake Forest College an estate of over $7 million to establish internships and study abroad programs. The donation is expected to generate over $300,000 a year for the college.

How was a woman of such modest means able to give away over $7 million upon her death?

After graduating from Lake Forest College in 1931, Grace started working for Abbott Labs (ABT) as a secretary. She worked at Abbott Labs for 43 years. The key to her wealth was a simple decision she made early in her career. At age 26 she took her savings, about $180, and bought 3 shares of Abbott Labs at $60 per share and then never sold.

Along its way to becoming a global pharmaceutical/medical device behemoth Abbott split its shares a dozen times, paid dividends, and grew its dividend year-in and year-out. Living below her means Grace didn’t have a need for the dividends, instead she reinvested them. Her initial $180 investment compounded into $7 million, 39,000 times her original investment, a compound annual growth rate slightly over 15%.

Yes, Grace was very fortunate in making an early investment in one of the great health-care and dividend growth companies of the 20th century. While Grace’s wealth may be considered a happy accident her investment strategy, dividend growth and reinvestment, is a proven way to build wealth over a long period of time.

According to Longrundata.com, a nifty website with a dividend reinvestment calculator, if you had bought $1,000 worth of Abbott Labs 20 years ago (January 1, 1994), well after Grace Groner’s initial purchase, you would now have $10,667 as of February 27, 2014. That’s over 10x you’re original investment and an annualized return of 12.46%. Because of Abbott Labs commitment to growing its dividend, the yield on your original purchase would now be around 24%.

Spending less than you earn, investing in dividend growth companies, and reinvesting those dividends is a tried and true path to building wealth over the long-term. Just like Grace Groner.

Sincerely,
Your Portfolio Management Team

Dividend Stock in Focus

AbbVie (ABBV): $50.91*

*price as of the close February 28, 2014

In late 2012 Abbott Labs, in an effort for investors to better evaluate its two distinct business lines, spun-off its biopharmaceutical division, Abbvie, to existing shareholders in a tax-free corporate restructuring. Abbvie is an example of a “Restructuring/Special Situation” (as described in the last letter) that we feel has an opportunity to eventually become a dividend stalwart.

Following the spinoff, shares of ABBV declined in to the low $30 range on fears of Abbvie’s largest drug Humira losing its patent in 2017. Our opinion at this time was that these fears were overblown and that the market was mis-pricing the risk of the patent loss. The essence of this mis-pricing is related to the difference between a chemically synthesized drug (which is easier for generic manufacturers to develop and bring to market) vs. a biologic like Humira which is more complicated and costly to develop in generic form. More on this below.

Our initial time frame for an investment in a spin-off is at least one year. This allows us time to evaluate the new stand alone business as it pertains to management, strategy execution, and dividend policy. Additionally, research has shown that corporate spin-offs in general continue to outperform the broader stock market for 2-3 years following the spin-off. During our initial holding period if our outlook for the new stand alone company improves and our valuation estimate continues to increase we may continue to buy shares in the new company.

The strong growth and cash flow from Humira, the continued development of their drug pipeline, and management’s commitment to returning capital to shareholders through dividends has increased our estimate of fair value for the company and changed our holding period from one year to multiple years.

Catalysts for Dividend Growth and Price Appreciation:

Biologic vs. Chemical Compound:

Abbvie’s near term fortunes are heavily dependent on the blockbuster drug Humira. Over 50% of Abbvie’s sales and over 70% of their profits come from Humira. The main concern surrounding Abbvie is the loss of Humira’s patent in 2017 in the U.S. followed by the loss of its European patent in 2018. Once “off patent” there is a risk that generic drug makers will start selling their own form of Humira for much less than Abbvie, stealing market share and hurting Abbvie’s profitability. As discussed above, however, the fact that Humira is a biologic rather than a chemically synthesized drug provides a layer of protection or “moat” to help protect it from would be generic competition.

Chemically synthesized drugs are produced through a combination of chemical processes that can be repeated in a predictable and highly dependable way. Well known examples of these kinds of drugs include Tylenol, Lipitor and Viagra.

When a chemically synthesized drug goes off patent it is easier for a generic drug maker to get FDA approval for its version. The generic drug maker does not have to put its generic drug through clinical trials, it only has to prove that their drug is equivalent to the name brand drug and therefore will produce the same data as when the name brand drug went through its trials.

Unlike these drugs, biologics are proteins currently too large and complex to be created chemically. Instead, scientists enroll the help of microorganisms (plant or animal cells) by splicing the necessary DNA sequence coding the protein/biologic into the microorganisms’ DNA. Then the microorganisms produce the targeted biologic.

In contrast to chemically synthesized drugs it is difficult, and sometimes impossible, to characterize a complex biologic by testing methods available in the laboratory. Some of the components of a finished biologic may even be unknown.

In short, for biologics the product is the process. Manufacturers must ensure product consistency, quality, and purity by ensuring that the manufacturing process remains substantially the same over time. In contrast, a chemical drug manufacturer can change the manufacturing process extensively and analyze the finished product to establish that it is the same as before the manufacturing change.

The trouble with creating generic or “follow-on” biologics is that any deviation from the process in producing the original pioneering biologic, whether it be different cell lines, purification techniques, etc., can cause vast differences between the original biologic and the follow-on biologic. This can have dangerous consequences.

For example, Epogen and Eprex are both proteins of identical structure, Epotein, focused on treating anemia due to Kidney failure. However, they are each produced by two slightly different methods. The slight difference in productions leads to a dangerous reaction in patients taking Eprex. Patients taking Eprex began producing antibodies at a much higher rate than patients taking Epogen. Eprex patients experienced an allergic reaction to Epotein so severe that they also became allergic to the Epotein produced naturally by their own body. Instead of improving medically, Eprex patients became more ill.

As discussed above in the case of Epogen and Eprex, the potential differences between the original biologic and the follow-on biologic means the follow-on must undergo testing for efficacy and safety too. Per new regulations, the potential follow-on biologic must have animal toxicity tests performed and possibly animal immunogenicity tests if there are elevated concerns about impurities and excipients.

It is more than likely that follow-on biologics will be required to undergo clinical studies. The scope of these clinical trials will depend upon the uncertainty surrounding the biosimilarity after structural and functional characterization and animal studies.

More tests mean more time and more costs to develop a generic biologic. Humira is way too profitable a drug to not have potential competition but the complexity of production and the costs associated with bringing a generic competitor to market make it that much harder for generic drug makers to immediately cut into Abbvie’s Humira profits.

Pipeline:

Hepatitis C: Abbvie has an extremely effective HCV combo being developed to treat Hepatitis C. The SVR12 rates (the undetectable amounts of virus RNA at 12 weeks after stopping treatment) in the early phase III trials are around 96%. While they will face strong competition from both Merck and Gilead, Abbvie is still looking to grab $2-3 billion in peak sales in the very attractive HCV market.

Leukemia: Abbvie is in partnership with Roche to develop ABT-199, a treatment for Chronic Lymphocytic Leukemia (CLL), one of the most common forms of Leukemia. It targets the Bcl-2 protein that prevents the CLL cell from dying. ABT-199 switches off the Bcl-2 protein allowing CLL cells to die naturally and making them more susceptible to chemotherapy.

In a recent Australian clinical trial people with an extremely poor prognosis achieved an 84% response rate and the bone marrow cancer was cleared in 23% of the people. From Anthony Steele the Head of Support Services for the Leukemia Foundation of Australia.

This drug means people with an incurable cancer, who undergo many periods of intensive treatment, periods of remission and with an expectation that the disease will relapse, now have hope that a treatment will be made available to end this life-long cycle.

Endometriosis: Elagolix is focused on the treatment of endometriosis and is currently in phase III trials. Compared to the standard care for endometriosis, Elagolix is as effective with less side effects, goes into effect quicker, and easily reversed. Ovulation returns after the first month of cessation, a key aspect for women who want to get pregnant. It is also a once day oral tablet versus an injection for the current methods. Elagolix is also in phase II trials for uterine fibroids, an indication that could be larger than endometriosis. JP Morgan Equity Research potentially sees a $1 billion combined market for Elagolix.

Conclusion:

Abbvie is a company whose story is still lead by Humira but the narrative is turning into one about its pipeline. However, when calculating fair value we can’t base it on potential. We have to calculate fair value on what we can currently account for. Our estimate of fair value has risen over the year and currently sits at $58 per share.

Chart courtesy of Stockcharts.com
Chart courtesy of Stockcharts.com
The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

AMM Dividend Letter Vol. 4 ~ Apple: A New Dividend Payer for Your Portfolio

This is from the AMM Dividend Letter released January 31, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

Dividend oriented investors often focus too much on current yield (i.e. how much the company pays the investor today), which, by extension, leads to a portfolio of mature slower growth businesses like regulated utilities or telecommunications service companies. These companies may offer relatively high current yields, yet their growth prospects are low. We aren’t against investing in these industries; however we don’t think an investor seeking long-term wealth creation should necessarily overweight their portfolio in these kinds of businesses.

When we developed the AMM Dividend Strategy we decided to focus on overcoming the current yield dilemma (high payout, low growth) in dividend investing. To build a more growth oriented dividend portfolio we focus on three core types of dividend payers as the building blocks of our portfolios.

1) Dividend Stalwarts: Companies that have strong dependable market positions, that pay a reasonable dividend (~2-3%), and have shown an ability to grow their dividends over a long period of time at a pace far faster than inflation. While the current yield is modest, we expect the growth in the dividend payout to provide a more robust yield (on original cost) in the future.

2) Restructuring/Special Situations: Companies undergoing a restructuring, spin-off, or other special situation. Volume 1 of the AMM Dividend Letter highlighted such an investment, the upcoming spin-off of SLM Corp. (SLM) into two companies. If we see value in the restructuring and the parent company pays a reasonable dividend we will invest. Our initial time frame for these investments is one year but if, after the restructuring, one of the companies’ appears to offer good odds of becoming a dividend stalwart we may hold our investment for a longer time frame.

3) New Dividend Payers: Companies that have recently initiated a dividend policy. While these companies do not have the long history of paying and growing their dividend like the stalwarts, they do have a strong market position and the cash flow to become a stalwart in the future. And sometimes they’re just so cheap that you have to buy them like the subject of our latest letter, Apple Inc. (AAPL).

Dividend Stock in Focus

Apple, Inc. (AAPL): $500.60*

At the turn of the millennium, before the iPad and iPhone revolutions, Apple was in the early stages of a business turnaround. The key people that would help drive Apple’s future growth, like founder Steve Jobs and lead designer Jony Ive, were already in place. The candy colored iMac was out and people were talking about Apple again. The iMacs were a start but they weren’t the blockbuster Apple needed.

Then came 2001.

Original-Apple-iPod

The introduction of the iPod represented more than just another high tech, high priced gadget. In reality the iPod represented three products: the iPod (the device), iTunes (personal data manager), and the iTunes store (the digital store). The beginning of Apple’s closed ecosystem.

Apple became extremely successful with its closed ecosystem. Ironically Apple’s success might not have happened were not for the critical decision to open up iTunes to the PC market. While Steve jobs wanted to keep the iTunes software solely on apple devices, Senior Vice President’s Phil Schiller and Jon Rubinstein saw the value in opening up iTunes to PCs. From Design Crazyby Max Chafkin:

“We argued with Steve a bunch [about putting iTunes on Windows], and he said no. Finally, Phil Schiller and I said ‘we’re going to do it.’ And Steve said, ‘F*** you guys, do whatever you want. You’re responsible.’ And he stormed out of the room. In October 2003, iTunes was introduced for Windows. Apple would sell two million iPods that year. The following year, with the release of the iPod Mini, the figure would increase five fold. Once it was on the PC, that’s when it took off”.

The majority of computer users had PCs and they could finally buy an iPod. Their first iPods turned into their first iPhones. Their first iPhones turned into their first iPads. They saw how easy it was to upgrade the software and how well the software worked with the hardware. They soon realized how much easier it would be to be fully a part of the Apple ecosystem propelling Apple past Coca-Cola and being awarded Interbrands’ title as World’s Most Valuable Brand for “revolutionizing the way we work, play, and communicate”.

Dividend History:

At first blush Apple may appear an unusual choice for a strategy focused on dividend growth; however Apple is a great example of the “New Dividend Payer” concept discussed earlier. The company initiated a $2.65 quarterly dividend in 2012, in part due to pressure from shareholders who argued that the company should return a portion of their fast growing cash hoard to shareholders. Last year Apple increased the quarterly payout by 15% to 3.02 per share. This represents a current yield of approximately 2.4% at current price levels. The payout ratio stands at 30%. Given the firm’s leading position, rock solid balance sheet, and an ever-growing activist shareholder base, we expect the dividend hikes to continue.

Chart from S&P Capital IQ.
Chart from S&P Capital IQ.

Catalysts for Dividend Growth and Price Appreciation:

Aspiration Brand:

“But the bottom Line is that there are people who can afford iPhones and iPads, and people who can’t” – John Gruber of Daring Fireball

A lot of digital ink has been spilled lately about how Apple needs to introduce a cheaper iPhone or face market share loss to Android based smart phones. Competing for market share with cheaper phones is a surefire way to destroy margins and free cash flow.

Apple is a luxury brand. Apple builds its smart phones and other hardware at relatively the same cost as its competitors, however because of its brand recognition and the quality it infers, Apple can charge a higher price. Think Rolexes not Timexes.

Apple is hyper focused on elegant designs and operating systems that are known for simplicity, intuitiveness, and reliability. Focusing on quality products for their customers is what drives Apple. Not market share. A market will build around highly-desirable high-quality products. As a luxury brand, Apple can charge more for its products, maintain higher operating margins, and generate excess cash per sale.

China:

Over 80% of cell phones in China are still connecting to a 2G network. China is still in the early stages of growth for its 3G and 4G networks. It wasn’t until faster and more robust wireless networks like 3G came along in the U.S. that smartphone use took off. We have a similar situation developing in China.

Smart phones sales in China have reached an all-time high. About 9 of every 10 handsets sold in China is a smartphone and the Chinese consumer tends to buy a new phone every 15 months.

Chart courtesy of Counterpoint Technology Market Research.
Chart courtesy of Counterpoint Technology Market Research.

While it was expected to happen, it was crucial that Apple gain a larger exposure to China. China Mobile, the largest Chinese wireless network operator, started carrying the iPhone this year because they were losing subscribers to competitors who did. Apple now has access to China Mobile’s 760+ million customers.

China has the largest growing group of people that can afford iPhones and iPads.

iTunes:

In June 2013 Apple reached 575 million iTunes accounts. According to Horace Dediu of Asymco, that averages out to 500,000 new iTunes accounts per day. With year-over-year revenue growth of 38% and 25% for 2012 and 2013 respectively, iTunes is growing into another major source of revenue for Apple. With over $16 billion in sales in fiscal year 2013, iTunes accounts for 9.4% of total sales.

Per account, Apple generates more revenue per user than even Amazon.

Chart courtesy of Morgan Stanley Research.
Chart courtesy of Morgan Stanley Research.

And not surprising Apple produces more free cash flow per account than each company mentioned in the graph above.

There is a lot of leverage in iTunes. The more Apple devices in consumers hands the more iTunes accounts. This leads to more purchases of apps, music, movies, books, software, and a lot more revenue and cash flow for Apple. Content purchases, like music and movies, also keeps people tied to Apple’s ecosystem.

Looking to the future every iTunes account is linked to a credit card or debit card and it’s easy to see how Apple could lead the way in digital wallets.

Cash Flow:

For the trailing twelve months Apple (AAPL) has generated about $40 billion in normalized free cash flow. Without factoring in any growth or margin expansion/contraction in 12 years Apple could buyback all of its shares outstanding just using existing free cash flow. This is a very basic example and doesn’t account for items like repatriation taxes on the large amount of cash that is being generated overseas. Nevertheless, it shows that Apple is a cash flow machine. Apple’s cash flow yield, essentially what would be your cash return if investing today, is over 8%.

Return of Capital:

Amidst the push by activist investors like David Einhorn of Greenlight Capital and Carl Icahn, Apple has initiated a $100 billion plan to return more capital to shareholders. $60 billion has been earmarked for share buybacks. As of Apple’s most recent 10-K, $23 billion has been used leaving $37 billion left to buy more shares. At Apple’s current share price over 8% of their shares outstanding could be bought back under the plan.

Of the remaining $40 billion of capital to return to shareholders $10 billion was used to increase Apple’s quarterly dividend to $3.05, providing another $30 billion of capital to be returned to shareholders on top of the $37 billion in share buybacks.

Conclusion:

Apple exists at the crossroads of technology and industrial design. Two categories that are highly dependent on the changing tastes of its customer base. Due to this inherent risk in their business model, we use a higher discount rate (12.5%) than we would typically use for a company of this size and financial strength when valuing Apple. We also built out our cash flow model using a 25% operating margin (below Apple’s trailing twelve month operating margin of 28%), estimated growth over the next five years at 6% vs. the average analyst estimate of 16%, and excluded share buybacks. Even with our modest assumptions we arrive at a fair value of $605 per share for Apple.

* Price as of the close January 31, 2014

Chart courtesy of Stockcharts.com.
Chart courtesy of Stockcharts.com.
The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

AMM Dividend Letter ~ Vol. 3: Qualcomm’s Growing Dividend

This is from the AMM Dividend Letter released December 31, 2013. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

Dividend Stock in Focus

Qualcomm (QCOM): $74.25*

Profile:

Qualcomm was founded in San Diego in 1985 by former UC San Diego Professor and MIT alumnus Irwin M. Jacobs along with 7 others.

The majority of Qualcomm’s revenue comes from the design of computer chips for cell phones and tablets. Open up any smartphone today and you are more than likely to see a Qualcomm based processing chip. In fact, Qualcomm is the sole chip supplier for Apple Inc.’s iPhones and iPads.

While Qualcomm’s lead position in mobile chipset design makes it the premier mobile chip company in the world, even more attractive in our view is the company’s network licensing business. Interestingly, this is a business built off of a technology first thought up of by one of Hollywood’s most attractive people.

Old Hollywood’s Role in Today’s Wireless Networks:

Hedy Lamarr was a contract star for MGM through the 1930s and 1940s and was considered one of the most beautiful people of her time. Hedy is probably most remembered for her then extremely controversial role in the 1933 movie “Ecstasy”, a movie with brief nude scenes of Ms. Lamarr and close up shots of Hedy’s face during a sex scene. While tame by today’s standards the movie caused a big controversy at the time.

Ms. Lamarr was much more than a pretty face, and should really be remembered for her contribution to modern communication. In 1942 she and composer George Antheil were granted a patent for frequency hopping. In the early 1940s torpedoes operated on one frequency and could very easily be jammed with overwhelming interference at the right frequency. George’s and Hedy’s technology based on the 88 keys of a piano would have the torpedoes hop between 88 frequencies avoiding the interference. Frequency hopping could prevent Allied torpedoes from being jammed. Well… it would have if the U.S. Navy didn’t sit on the technology until 1960.

Hedy and George’s technology would eventually become the basis for today’s wireless communication. Qualcomm’s CDMA technology, the backbone of today’s 3G wireless networks, is based on Hedy Lamarr’s original frequency hopping.

The companies that make the hardware for 3G and 4G wireless networks and the companies that own the wireless networks all use Qualcomm’s designs and all of them pay Qualcomm royalty fees (~ 3-5% on almost every smartphone sold globally), essentially making them a toll booth to the global 3G wireless network.

Dividend History:

Qualcomm may at first appear to be an odd choice for a portfolio focused on dividends. While the current dividend yield is only 1.9%, Qualcomm has aggressively grown its annual dividend payout over the last 10 years from $0.19 per share to $1.20 for a compound annual growth rate of more than 20%. We expect Qualcomm to continue its policy of high dividend growth well into the future.

Data from S&P Capital IQ.
Data from S&P Capital IQ.

Catalysts for Dividend Growth and Price Appreciation:

3G & 4G Wireless network Growth:

While the U.S. and other developed countries are moving onto 4th generation markets the rest of the world is still connecting through 2nd generation networks. 80% of connections in China, and 90% in India are still 2G**. The growth in 3G connected devices in these developing markets over the next few years will be huge. From GSMA Intelligence:

3G and 4G technologies will account for half of all global mobile connections in five years, according to Wireless Intelligence forecasts.

We calculate that 3G/4G connections combined will account for about 4.25 billion of the 8.5 billion connections forecast by 2017, or 50 percent (40 percent 3G + 10 percent 4G). This is up from a combined 1.7 billion of the 6.5 billion total this year (26 percent).

Chart courtesy of ©GSMA Intelligence 2013
Chart courtesy of © GSMA Intelligence 2013

In their recent analyst day Qualcomm said that they expect around 3.4 billion 3G/4G connections by 2017. Qualcomm stands to collect a lot of royalty payments as the rest of the world migrates from 2G to 3G.

Even as the more developed markets like the U.S. move onto the 4th generation wireless networks, the newest 4G smartphones will still need to be backwards compatible with 3G networks. The highest estimate for 4G connected devices by 2017 is 10%.

4G networks are still in the early stages of their development and there is a wide array of standards for it unlike the 3G network. It is a safe bet that Qualcomm will be a leader in 4G too. According to Barron’s, Qualcomm has a 3 year lead over its competitors when it comes to the 4G-LTE network.

The top two patent holders for 4G-LTE networks are Samsung with 9.36% of all patents and Qualcomm with 5.65%. Qualcomm also has the greater share of seminal 4G-LTE patents.

Table courtesy of iRunway: Patent & Landscape Analysis of 4G-LTE Technology
Table courtesy of iRunway: Patent & Landscape Analysis of 4G-LTE Technology

Of those seminal patents Qualcomm holds ~10% of the patents related to network coverage and key patents in the categories that are essential to better and smoother inter-network transition.

Return of Capital:

Since FY 2003 Qualcomm has returned over $26 billion to its shareholders in the form of increased dividends and share buybacks. In fiscal year 2013 alone, Qualcomm bought back over $4.6 billion worth of stock reducing shares outstanding by 4%***.

Chart from Qualcomm's analyst Day presentation
Chart from Qualcomm’s analyst Day presentation

Paul Jacobs, the current CEO of Qualcomm, recently announced that going forward the company will return 75% of its free cash flow and increase the dividend by more than its earnings growth. Qualcomm is expected to grow its earnings over 10% in 2014. With almost $8 per share in cash on it balance sheet, Qualcomm has the ability to conduct further share buybacks.

Conclusion:

Qualcomm is the toll booth to the 3G wireless data super highway right as the 3G network is about to explode with increased traffic. We would expect Qualcomm’s free cash flow to grow right along with it allowing for increased dividends and share buybacks. We estimate QCOM’s fair value at $95 per share, approximately 30% above the current share price.

* Price as of the close December 31, 2013
** GSMA Intelligence
*** Barron’s

Image courtesy of Stockcharts.com
Chart courtesy of Stockcharts.com
The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.