One of the reasons why I like studying companies that have been growing their dividend by a rate of 7% or more annually for the past ten years is that, not only am I finding businesses that are returning more and more cash to their owners over time, but I am also getting a firsthand glimpse into what the leaders of the company are projecting about the future cash flows for the business. It cuts through all the BS you see on the first few pages of a company’s annual report and tells you what those with the innermost knowledge of a company really think—after all, if you’re running a company that is anticipating trouble growing profits in the next couple of years, are you going to give shareholders a 10% raise in the payout? Probably not, because it’s a lot easier to deal with a few years of 1% or 2% increases than a year of a 10% increase followed by a cut.
Likewise, when a company with a record of raising dividend payments suddenly stops doing so, you should take a hard look at the company and re-evaluate your position. I’m not saying you should sell—there are plenty of great companies that have to work through problems (that is particularly true in the commodities industry, particularly oil) and it would be foolish to sell after a dividend freeze or a dividend cut because you’d be engaging in the act of selling low. That said, contemplating a fair price at which you’d exit wouldn’t be unwise.
Let’s walk through a real-life company to show you what I have in mind—say, Eli Lilly. From 1995 through 2009, with the exception of 2003-2004, Eli Lilly raised its dividend. A payout that was $0.26 quarterly in 2000 grew to $0.49 in 2009. If not excellent, it’s certainly nice: you almost doubled your payout in a little less than a decade, and you get a pay raise during the 2nd worst recession of the past century. At a time when even some of the Coca-Cola heirs were being sent into bankruptcy due to bad real estate bets, owning a cash-generating asset that was raising its payout to you was a nice place to be.
But then something worthy of attention happened: Eli Lilly kept the payment static in 2010. That should have made you scratch your head a little bit: After all, Eli Lilly grew its profits that year from $4.42 to $4.74. The dividend payout was declining from 44% to 41%. If profits were growing, why wasn’t management sharing more of those profits with owners? Sure, it could have been post-recession shock, and a new era of fiscal conservatism washed over the company, or it could have been something else. If you pulled up the company’s statement, you would have seen that Cymbalta was about to go off-patent. Hmmm, the leading drug responsible for much of the company’s profits was about to lose its special patented protection.
What’s interesting, though, is this: The stock was trading at only 7x profits. It was in the $30s. If you had been a part owner of the stock for five years or less, and didn’t buy it during the selloff in 2008-2009, you probably paid in the $40s, $50s, and $60s. It wouldn’t have seemed wise to sell, because the stock was so cheap. In other words, even if you correctly realized that the company’s earnings power was set to decline, it didn’t make sense to sell the stock because the price of the stock had gotten cheaper than the amount of the earnings power decline. And after all, this is still a company making $5 billion in annual profit, and collecting $1.96 in cash per share is no great hardship.
Still, aware of what was happening to Eli Lilly’s earnings power, you decided you would get out of the stock if it saw a price in the $50s, and then set your eyes towards greener pastures (by the way, this is a part of investing that is more art than skill—you could have some very intelligent ladies and gentlemen that would disagree as to whether the fair value exit price would be $45, $55, or $65).
When 2011 came along, it was more of the same: the dividend remained at $1.96, but the earnings came down a bit to $4.41. The price of the stock peaked a bit into the low $40s. Even recognizing the trouble with the core business, I still wouldn’t have yet been interested in selling: the price of $40 would still be too cheap for me to be interested in leaving (note: you should keep in mind that we are talking about a struggling but ultimately solvent and profitable company here—if we were talking about a company facing the prospect of bankruptcy, you cut your losses, hopefully learn something and have a sense of humor as best you can about it, and then move on—the rules are different when the waiting game could lead to 100% wipeout which is not the case here).
By 2012, earnings continued to get worse than expected with Cymbalta going off patent and losing 69% of its sales, with profits going down to $3.39. The stock, meanwhile, crossed the $50 threshold and hit a high of $54. Somewhere between $47 and $50, I personally would have left. It was a price that would let me leave a business struggling to grow profits (heck, struggling to maintain profits) without selling low.
The dividend, meanwhile, stayed at the $0.49 quarterly rate throughout all of this. 2009, 2010, 2011, 2012: the quarterly payout remained the same. In this case, the frozen dividend was a signal that the management team did not see earnings growing, and they were right. You get happy that you’re given the opportunity to exit Eli Lilly at a good price, and move on.
Now interestingly enough, the stock has since crossed into the mid-$60s, going for $66.96 at the time of my writing. If I sold around $50 in 2012, I’d have no remorse about “missing out” on the subsequent $15+ price appreciation because it’s illusory; the stock is overvalued, the pipeline is generally weak (compared to the loss of Cymbalta), and the dividend continues to eat up a substantial amount of profits. When I talk about stocks generally being overvalued to the tune of 20% or so, companies like Eli Lilly are stereotypes I have in mind.
This is where a superficial reading of the Peter Lynch quote “buy what you know” can get you into trouble. A lot of people have heard of Eli Lilly. It’s huge; it’s been around a while. It sounds vaguely blue-chippy. But unless the stock gets more overvalued, or some unanticipated blockbuster drugs come through the pipeline, or Trulicity becomes an even more lucrative source of long-term profits in the fight against diabetes than even optimistic projections suggest, then you will get disappointing returns.
Eli Lilly has earned $2.49 in the past twelve months. The dividend, which is still at $0.49 quarterly, accounts for 78% of the company’s profits now. The $66 price of the stock amounts to a 26x earnings ratio, which is only tolerable when you expect a very high likelihood of 12% annual growth or more for 5+ years. Maybe $66 per share would be a fair price to pay if Cymbalta profits were still rolling in and had five years before going off patent. This current valuation is in no way connected to value investing—to do well, you need higher than expected growth to happen for a while.
The good news is, if you’ve been owning the stock, now isn’t a bad time to get out. The good news is that Eli Lilly has a good balance sheet. The only carry $5 billion in debt and have over $5.1 billion in cash assets. Humalog is the only drug in the entire portfolio growing sales at a rate over 10% (in the case of Humalog, the growth rate is 11%).
My guess on what is likely the next five years? Eli Lilly will grow profits a bit, perhaps up to the $3.50-$3.75 range from the current base of $2.50. But the P/E ratio will contract significantly, probably somewhere around 16x profits. In other words, I anticipate the journey from 26x profits to 16x profits will be a headwind to a larger extent than profit growth will be a tailwind, and you will see the stock trading at $60 five years from now ($3.75 in profits x P/E multiple of 16=$60). I’m not saying Eli Lilly is a terrible company. I’m not guaranteeing there aren’t scenarios under which it could be a good investment. But I am saying there is a significant NEGATIVE margin of safety in the current stock price, and total returns will lag the growth of the firm in the coming years. And given that I think Eli Lilly will grow at a single-digit rate in the coming years, the P/E compression could very well wipe out most of your gains. Given that we only have to make one investment at a time in a world of 15,000 publicly traded securities, I’m not sure there is wisdom in putting Eli Lilly on your current shopping list.
Originally posted 2014-11-07 15:03:25.
