The Dividend Mailbox

Telecom & Tobacco: Analyzing the Legal Liability That Could Limit Returns

July 18, 2023 Greg Denewiler Season 1 Episode 25
The Dividend Mailbox
Telecom & Tobacco: Analyzing the Legal Liability That Could Limit Returns
Show Notes Transcript

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Even though dividend growth stocks typically have a high degree of predictability, that doesn’t mean you can’t end up with surprises. Outside dividend cuts, some of the most significant surprises can come from legal liability - often arising from the distant past. Companies routinely face challenges in the courtroom and are well-equipped to handle their cases, but occasionally they are forced to cut a check with a lot of zeros. The problem for investors is that there is no quantifiable way to know what legal liabilities might be lingering out there.

 

This episode is packed with specific companies as Greg dives into two stocks from the tobacco industry and two from the telecom sector. He examines the legal history of British-American Tabacco ($BTI) and Altria ($MO), alongside the potential future liability of AT&T ($T) and Verizon ($VZ). In doing so, he also breaks down their performance as companies and gives you a snapshot of how we analyze dividend growth candidates. 

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This is Greg Denewiler, and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.

 

Welcome to episode 25 of The Dividend Mailbox. So last month we had a listener send us a question about a stock, and I thought it would be good to use this as an example because on the surface it actually does have some appeal to it. So today we're going to look at: is this a good investment or not, from our standpoint of dividend growth? We're going to go over how we evaluate ideas and whether we want to look at something as a potential investment. I think you'll find it helpful because we're also going to contrast it to another business in the same industry, that has been a great investment. 

Then we're going to switch to the telecom area. Since some of these are widely held, it's probably going to be worth your time to listen because some of the big legacy communication companies have been great dividend stories in the past, but things are changing there. 

So, the common theme for today is that all these companies that we're going to talk about have very attractive dividends, but there's just more to the story than just the dividend. The hope here is that it helps you get some ideas as far as how this whole dividend growth strategy evolves over time.

 

The interesting thing I think about this listener question is there are some pieces of this that, again, on the surface do look somewhat enticing. So, the question is, what is your opinion about British American Tobacco? It has an 8% dividend yield. It trades at about 80% of book value, (which means theoretically its assets are worth more than the stock price), it has a PE of not quite nine, (which means it's trading at about half the valuation of the market), and the profit margin is 24%, (which is relatively attractive). And then Zack's has a buy on it, they've got it rated AT&Two. So just on the surface, this looks like maybe it is an attractive stock to look at for a good dividend.

Now if you've listened to our previous podcast, of course 8% is extremely attractive, but you know that right away when we see a big dividend, that's a big yellow flag for us. There are things behind thAT&That create the 8% yield, which is really giving you an idea thAT&There are some issues here. So right away the first question is, okay, is this going to be a dividend growth story or not?

So what I would like to do is, first of all, just go through and look at some of the numbers on BTI, which is the symbol. Let’s take a look at it and see, is this really a candidate? Is this something we should spend time on or not? 

The current PE is around eight, so the stock is very cheap. As far as the balance sheet goes, the debt situation actually has been improving. Back in 2013, 10 years ago, the debt was about 170% of equity, and now it's down to 55%, which is a positive, and especially the trend is positive. If you look at operating margins, in 2013, they were 36%. They've actually climbed to 55%, so that's a good number. The EBIT margin, which is earnings before interest and taxes— in 2013, it was 42%, and right now it's 39%. A slight drop but you have to look AT&That and say that's a decent number too. And then finally, let's just take a quick look at earnings. Right now, they are $3.60 and the estimate for 2024 is $4.40. So you've got some earnings growth there. Of course, to grow a dividend at some point you have to grow earnings. So that on the surface looks pretty good. 

But now we're going to go a little bit deeper to see, okay, what else is behind this story? Well, if you look at earnings and you go back to 2013, 10 years ago, they earned $3.20, and as I just mentioned, in 2022, there were $3.60. So the earnings have grown very little. The dividend back in 2013 was $2.21 and now it's $2.65. Well, right there, that pretty much takes it out of our screen because that puts BTI’s dividend growth rate at about 2% a year, which obviously is a much smaller number than 7.2%. So right away we have a big problem. There's really not any dividend growth here and the fact that earnings haven't grown is pretty much the reason why. If they get to $4.40, that will indicate, okay, maybe it will start growing a little bit. However, even if the dividend was growing relatively successfully, if they can't continue to grow earnings then eventually the dividend's going to peak out.

You could say, well, you know, I don't need that much dividend growth when I've got an 8% yield from day one. Just the compounding of that is going to make up for the lack of actual dividend growth. I can reinvest that somewhere else and I can get it from another investment. 

Well, here's another piece that becomes a much bigger problem. The return on the balance sheet— which we use return on invested capital— if you go back 10 years, it was running around 20%. Now it's down to 6%. So, the balance sheet is really not that profitable for them. It's hard for them to reinvest in their business, and you just can't get an attractive return. So that right there is giving you an indication thAT&This thing, very likely, is going to struggle going forward. The chances of it doubling its dividend in 10 years is just not very high. In fact, it's probably not going to happen.

Then finally what I want to say is over the last 10 years, the total return which includes that 8% dividend, has been 1% a year. Basically, whAT&ThAT&Tells you is the stock price has gone down over 10 years and all the return has come from the dividend. A big piece of that is just the fact that you've had some PE contraction and investors are just not willing to pay any more for the earnings. We're going to go over probably the big reason why here in a minute. 

So, you have to look AT&This thing and say, if you are going to, or you were thinking about considering it, you really have to try to figure out whAT&The catalyst is and maybe the business is about to change. But for us, this is not one that we would look at.

 

What I would like to do now is just compare it to Altria, which is another tobacco business. Let's just look AT&The difference of if I had to pick one of the two, which one would it be? Starting out with the PE for Altria, it's around nine. It trades a little bit more expensive, but not much. The dividend yield is also around 8%. So, if you're just looking at dividend yield, you would want the higher quality company of the two, debt to equity. This gets complicated because Altria actually has negative shareholders equity, and I'm not going to get into that whole story because in this case, I don't think it's going to make that much difference, but operating margins in 2013 were 45%. They've actually gone up, now they're up to 57%, so that's a strong trend. The EBIT margin is currently 40%, 10 years ago it was 45%. It declined, but not by much, and it is about as profitable as British American Tobacco. If you look at earnings, the earnings estimates for next year are $5.26, and last year 2022, they were $3.20. Here's the big key difference between these two stories. In 2013, Altria earned $2.26, and now they're up to $3.19, so, they've had some decent earnings growth. The dividend has gone from $1.84 to $3.72. So Altria's dividend did grow by basically 7.2% a year. It doubled in 10 years, which normally is exactly what we're looking for as far as a dividend growth stock. And with the $5.20 plus estimate for next year, there's an argument thAT&There is still some dividend growth there. Finally, let's just look AT&The return on invested capital for Altria. 10 years ago, it was 25% and currently, it's 23%, so they have continued to manage their balance sheet fairly well, and they continue to be able to maintain profitability in the business.

From a financially successful standpoint, it's really a whole different story. The 10-year total return from Altria is 8.8% a year, so you've done okay with it. And if you go back farther and you go back 50 years, as I've mentioned in previous podcasts, this thing is one of the big winners of the S&P 500, and a lot of it is really just due to that dividend and thAT&They've been able to maintain and grow it, even though the business itself has actually declined. So, if you look AT&This thing, you could actually say, maybe I should be looking at Altria. 

Well, look, everybody knows smoking kills you. Of course, everybody that smokes thinks that it's not going to kill them, which is kind of the way, I guess, human nature is. But if people want to smoke, they should probably be allowed to smoke, and I'm not going to make a judgment of whether anybody should own a tobacco stock or not. It's totally up to you. We don’t because there's one piece left in the tobacco story. If you haven't thought about it or been thinking about it as I've described these businesses, you know, this is the big elephant in the room.

If you look AT&The litigation liability of these companies in the past few decades, I mean, the numbers just are astounding. It really is like these things have big targets on their backs and everybody wants to sue them. Part of it is the states, they've gone after these companies really to help partly fund some of their state budgets. It's, I guess, obvious why because they will potentially kill you. A lot of the major legal settlements that have occurred really started in the 90s, when they started to really pick up. And as I read these out, some of these are specific to companies, and some of them are industry-wide, but the point is obvious, there's just a lot of litigation here.

You've got a $145 billion settlement back in ‘91, $206 billion in ‘98. Texas versus big tobacco was $15 billion. $28 billion in 2002, $10 billion in May of ‘14. And then one thing I will mention about British American Tobacco, the number's not real big here, but you just kind of look at and say, okay, you know, what are these guys willing to do for business? Just recently in April of 2023, they had a $630 million settlement, and they actually pled guilty to selling and manufacturing products in North Korea in violation of US sanctions and bank secrecy laws. That just does not look good. 

So, when you look AT&Tobacco overall, it is an unknown. They keep trying to settle the cases, they keep trying to move the business away from it. And yeah, Altria has been able to manage this landscape and continue to move forward but they thought vaping was going to be a part of their answer and now they've run into problems there. The big takeaway here is, are you going to get a dividend that doubles in the next 10 years? To me, it's just a huge unknown. It's not something that you can really quantify, and for me and for what we do, it's just something we're going to stay away from.

I probably have gone over enough on the tobacco story. I hope that gives you a little idea of how we look at something as far as an investment, and I can't stress enough, really, the North Star should be, it has to be a gross stock to grow the dividend. I can't really say that one enough. 

 

So, we're going to switch gears a little bit, but it's going to end up being somewhat of the same problem. So now what I'd like to do is just take a quick look at AT&T and Verizon. These companies come up occasionally. They've been great dividend growth stories in the past, but I think the scenarios have changed.

Their businesses, especially AT&T, have been around for a long time. The telephone was first invented in 1876, and you probably already know it was Alexander Bell, hence the original Bell Operating Companies and AT&T was basically called the Bell System. Actually, AT&T is the old Southwestern Bell, and what ended up happening was back in the eighties, they broke up AT&T into either seven or eight operating companies. There was the Southwestern Bell, Atlantic Bell, and Pacific Bell— a total of either seven or eight of them. Then what happened as soon as they broke it up, they all started merging back together. They bought other pieces of business and Southwestern Bell then became SBC and eventually was back to AT&T. Verizon was also one of the Bell operating businesses. 

So, what you have here is an industry and it has changed everything. The big turning point in the 1800s was really the railroads. Then you had the Wright brothers and the whole airline industry. You had the automobile. These huge industry innovations or disruptors really changed how America grew. Well, communication is a huge piece of that puzzle that helped build the economy, and the Bell system was probably the major contributor to that. So, you had AT&T out there, they started to wire really the world, and it was a great long-term, steady, income-producing stock for a long period of time. It was just consistent, and it always came through. But then, probably two or three decades ago, things really started to change when the cellular telephone was invented.

So that's probably a long-winded version of getting to AT&T now and Verizon. Both of these are 7% dividend yields and both AT&T and Verizon trade at a multiple of about six, so they are extremely cheap. But one of the problems with these things is AT&T has a $400 billion asset base, and you've got Verizon coming in just a little bit less than that, they have a $377 billion asset base. The total debt for AT&T is $140 billion and Verizon is $150 billion. So, one of the problems here is these debt costs have gone up and they have to roll their debt over. You've got an issue there where their interest costs are really going to start going up. And with technology constantly changing, these companies spend a lot on CapEx. They really are constantly having to reinvent their network. You go from 3g, then you go to 5g— there's always something out there that's faster. It's really hard for these guys to have a return on their balance sheet that's very attractive at all. And when you look at AT&T, right now their return on invested capital is 5% and they've struggled to do that in the last several years. Verizon is kind of a similar story, although it has been a little bit more profitable. Their return on invested capital is, is 9%. A big part of that is Verizon just didn't do the acquisitions that AT&T has done in the last few decades, so they've been able to not dilute their equity as much.

Here's where I think you get into a real problem with these. Of course, AT&T just went through a spinoff a few years ago, so this is really not apples and apples. Number one, the dividend has struggled to grow any, and 10 years ago when you look at Verizon, earnings have grown well from $1.20 to $4.80, but in the last few years, basically they've stalled out.. You've got a dividend for Verizon that's gone from $2.09, to 10 years ago $2.60. There you have very little dividend growth, and again, our big mantra is total return. Our dual mandate is to grow the dividend and to also see growth in the stock price. We want the entire value of your account growing. In Verizon's case, the total return, which includes the dividend, has only been 1.2% a year for the last 10 years. AT&T's a little more complicated because it's spun off several businesses that it purchased a few decades or a decade ago. That story's more complicated, but it's also the reason why their return on capital is down in the mid to low single digits. It’s because they paid too much for businesses trying to find growth, but they just weren't very successful at it.\

And then finally here's, I think, one of the biggest problems going forward from an investment standpoint. You had a Wall Street Journal article that just came out on the 10th, and it talks about all the cable that's been laid by the legacy Bell companies. Everything's gone to fiber now pretty much, but several decades ago they used copper and they insulated some of it with lead. Well, there's a huge problem with that lead starting to decompose and it's getting into the water system. It's created toxic levels that are way above the EPA recommendation. Everybody knows that lead is toxic, you do not want it in your body. So the writing is on the wall and the lawsuits are going to come out fast and furious on this as this begins to get more publicity. The big issue is going to be when did they know and when could they have done something about it or started to do something about it. 

This is one of the problems with investing in general, and then when you're looking at dividend growth investing, you're always going to potentially have some situations out there where lawsuits can become a big issue. Tobacco litigation is one thing, a lot of people will smoke their entire life and it will appear that it just doesn't really affect them. Well, still everybody knows that smoking is just not a good thing. Lead is a whole other story, you do not want lead in your system, it's that simple. So now you've got a case where they've had cables that have been laid for decades and the litigation that is probably coming on this stuff is going to really create a headwind for these companies. I'm not saying that it's going to put them out of business, but when you've got legacy businesses that are having a hard time growing currently and have huge CapEx problems, I don't think the 7% dividend is worth it. It's just not going to cover the challenges that these companies have. I'm not suggesting that the stocks can't go up 25-50% from here. Whatever the number, it really doesn't matter to me because I just can't see where they're going to get any kind of significant dividend growth going forward. With the debt problems and the litigation hanging out there, it may even be hard for them even just to maintain their dividend.

Personally, I would stay away from anything that's a legacy communication company. I don't know we'll see about the litigation. A lot of companies have litigation, it's really common and some have more than others. Unfortunately, it's just the way that our society is. Litigation is a big problem in the drug industry, and a lot of drug stocks are good dividend payers, especially some of the larger ones. You look at Coke and Pepsi, there you've had California try to restrict the size of soft drinks. Clearly, sugar is a problem and it's a huge contributor to diabetes. A lot of these snack foods have high salt content. If there's any kind of where you can connect the dots, litigation seems to follow. 

So you want to make sure you have profitable businesses. If you don't have as high debt levels, they're more able to sustain, and in the end, cash flow is just key because it helps resolve some problems. But you also have to realize that you're not going to be perfect at this. To some degree, litigation is unavoidable, but it's another great reason why you want to have a diversified portfolio. You are going to hit some that just don't work so well, or that hit you with surprises. When you have a diversified portfolio and you're sticking to that growth mantra, then that's what helps cover the mistakes. I really is where the compounding kicks in on the ones that work, and that's what leads you to where you get the dividend growth that you're looking for long-term. 

 

So to wrap up: A) don't let the dividend seduce you. That's probably the biggest thing. And then B) it's looking at these businesses and one of the things that does come up is litigation. 

This episode was a little bit, well, not a little— it was a lot about things to watch out for. AT&T and Verizon have been big dividend stocks and a lot of people own them. So I hope maybe it helped give you an idea there as far as why we don't own them, and I can't emphasize enough, this is not about predicting whether these stocks are going to go up or down or what they're going to do in the next six months, or over a year. We're just saying that they're going to have an extremely hard time growing the dividend much at all, and for the reasons that we've already mentioned, they may possibly be dividend-cut ideas.

You just want to look at the story. You want to have some idea. If you're going to buy individual stocks, then you need to make sure you understand the business model because it's not simple. Things are constantly evolving. And we try not to move the portfolio much, but once you get into a situation where the growth is not there, you really have to make a decision, and usually, it's just better to move on.

If you let the dividends seduce you into either buying something or hanging onto it, you're giving up the dual mandate of not only dividend growth but earnings growth, which tends to lead eventually to price growth. If you give up that earnings growth just trying to hang onto the dividend, you're going to have a huge hit in total return when you go out five, 10 years out.

 

If you enjoyed today's podcast, please leave us a review and subscribe. If you would like more information regarding dividend growth or our investment strategy. Please visit growmydollar.com. There you will find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com

Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.