These 3 High-Yield Blue Chips Are Very Strong Buys

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About: Bristol-Myers Squibb Company (BMY), BTI, CELG, CVS
by: Dividend Sensei
Summary

I'm a huge proponent of buying blue-chip dividend stocks at fair value or better. Sometimes the market offers quality companies at VERY large discounts to intrinsic value.

Today British American Tobacco, CVS Health and Bristol-Myers are trading at mouth-watering valuations, due to mispriced risks that are likely overblown.

I'm confident enough in each of these blue-chips to either own all of them in my retirement portfolio (where I keep 100% of my life savings).

At today's 28% to 43% discounts to intrinsic value, each is likely to deliver safe and rising dividends plus 13% to 25% CAGR total returns over the next five to 10 years.

Just remember that all investing is probabilistic, so always use proper diversification and the right asset allocation for your individual risk tolerance.

(Source: imgflip)

Long-time readers will know that I'm a passionate value investor, always looking to buy quality companies for my retirement portfolio (100% of my life savings) at discounts to fair value.

Because as Buffett famously said, "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." But to also quote Frasier Crane "if less is more, than think how much more more is."

In other words, if buying a wonderful company at a fair price is good, then buying it at a wonderful price is likely much better.

However, while deep value investing is potentially highly lucrative, it's also easier said than done. As Peter Lynch, the second best investor in history behind Buffett (29% CAGR total returns from 1977 to 1990 growing Fidelity Magellan Fund's assets from $20 million to $14 billion) pointed out

In this business, if you're good, you're right six times out of ten. You're never going to be right nine times out of ten... I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction...The typical big winner in the Lynch portfolio generally takes three to ten years to play out...Time is on your side when you own shares of superior companies." - Peter Lynch (emphasis added)

In other words, there is a big difference between value traps and good deep value investments. If you know what blue-chips to buy when they are most despised, then you can get them at a low enough price to create both a high margin of safety (due to very low expectations that are easy to beat) as well as lock in private equity-style returns, but in a low-risk package. Or at least you can most of the time since all investing is probabilistic and even the greatest investors of all time are wrong frequently (which is where good risk management comes in).

I've created a three-factor quality scoring system (11 point scale) based on dividend safety, business model, and management quality. Anything with a score of 8 or higher is a "blue-chip" and companies with 9 or higher ratings are "SWAN" stocks (sleep well at night, or extra high-quality blue-chips). This scale and systematic rating system are designed to avoid recommending higher risk/lower-quality companies that are more likely to possibly prove to be value traps.

Following the market dip, created by the escalating trade war (-4.6% from ATH at Monday's low) I wanted to point out three deep value blue-chips that I'm confident are going to deliver safe and growing dividends over time, and potentially blockbuster annualized total returns over the next five to 10 years.

These companies are British American Tobacco (BTI), CVS Health (CVS) and Bristol-Myers (BMY). I personally own all of these companies, with British American being my latest addition (initial position of 67 shares at $37.48 with a $0.36 commission).

First I'll explain why the market is so pessimistic about each company, as well as why I consider those fears likely overblown and these dividend blue-chips to be worthy of consideration to add to your diversified income portfolio today.

That's because each is trading at a 28% to 43% discount to intrinsic value, which means that each is capable of delivering between 13% and 25% CAGR total returns over the next five to 10 years (Buffett and Lynch-like returns from low-risk blue-chips).

British American Tobacco: The Most Undervalued Big Tobacco Company You Should Consider Buying

British American Tobacco is my latest retirement portfolio buy because it checks many boxes in terms of portfolio goals

  • highly attractive safe yield (above my portfolio yield on cost of 5.3%)
  • VERY deep discount to fair value (near an eight-year low)
  • diversifies me by holdings (my 27th company)
  • diversifies me by sector (consumer staples)

(Source: Ycharts)

But why exactly is the stock trading 44% below its all-time high? That would be two main reasons, the first of which is fears over increased regulatory pressure to accelerate the secular decline in smoking rates.

The biggest short-term risk for BTI is in the EU, which accounts for over 20% of its revenue.

  • Asia-Pacific: 22%
  • Western Europe: 21%
  • US: 21%
  • Eastern Europe, Middle East, and Africa: 20%
  • Americas: 16%

A 2016 menthol ban will go into effect in Europe in May 2020. What's more, the FDA has also said it plans to ban menthol cigarettes in the US, though this might take many years (management estimates up to nine years or 2027 until this goes into effect). The FDA also plans to eventually cut nicotine levels in the US by 66%, in an attempt to make them nonaddictive.

55% of BTI's US cigarette sales in 2018 were menthol showing how badly it could be hurt by a US ban (potential 21% reduction in US sales or about 4% company-wide revenue decline). And of course, a drastic reduction in nicotine could greatly accelerate the decline in US smoking rates (which has been a secular trend since the early 1960s).

Throw in menthol bans being passed (or expected to be passed) in Canada, Turkey, and Brazil and you can see why Wall Street is nervous about this company's future.

That's especially true given that vaping, part of the reduced risk movement the industry hopes can extend its ability to grow its bottom line (and dividends) for many years is the largest disruption to tobacco in decades. Vaping products, while growing rapidly, tend to have less brand loyalty and thus might potentially generate lower margins in the future.

But while many of those risks are shared by other tobacco giants (like Philip Morris International and Altria) British American also has one other big risk which is a heavily levered balance sheet.

Company Yield TTM Payout Ratio Simply Safe Dividends Safety Score (Out of 100) Sensei Dividend Safety Score (Out of 5) Sensei Quality Score (Out of 11)
British American Tobacco 7.2% 64% 45 (borderline safe = average) 4 (safe) 8 (Blue-Chip)
Safe Level (by industry) NA 85% or less 61 or higher 4 or higher 8 or higher

(Sources: Simply Safe Dividends)

That's the big reason that both I, and Simply Safe Dividends (where I'm an analyst) rate its dividend safety lower than it otherwise would be based on the stability of its earnings and cash flow.

Over the past year, BTI has paid out 64% of its earnings as a dividend. This is a reasonably safe payout ratio for tobacco companies and leaves BTI with cushion to pay the dividend should business conditions unexpectedly worsen. According to analysts, BTI's payout ratio over the next year is expected to be 65%, which is fairly consistent with its level today and suggests the safety of the company's dividend won't change much in the near future." - Simply Safe Dividends (emphasis added)

Management has a long-term adjusted EPS payout ratio target of 65%, which is where the payout now sits. But SSD rates the dividend safety as borderline (average compared to most US companies) due to its debt levels. Now it should be noted that "borderline" doesn't mean unsafe, merely only as safe as the average company's.

BTI's net debt-to-EBITDA ratio... is nearing the high side of what we prefer to see (the lower, the better). Overall BTI's debt levels look decent and unlikely to pose a threat to the dividend...BTI's dividend looks to be about as safe as the average company's. While BTI is likely a source of reliable dividend income, conservative investors often prefer to have most of their portfolios invested in companies whose dividends appear safer than average. " - Simply Safe Dividends (emphasis added)

As I'll soon explain, I'm less concerned about the debt, but agree that it certainly needs to come down.

In 2015 R.J Reynolds bought US menthol king Lorillard for $27.4 billion (gaining #1 market leader Newport). Then in 2017 BTI bought out the remaining 58% of R/J Reynolds for $49.4 billion in a mostly debt-funded deal that resulted in sky-high leverage.

The Reynolds deal was priced at 10X EV/EBITDA which is a fair price for the wide moat and cash-rich assets it got. Newport is a crown jewel for British American, enjoying not just slower volume declines relative to the industry average, but also commanding mid-single-digit pricing power (annual price hikes that offset volume declines and keep sales growing).

Of course, with menthol now under regulatory pressure around the globe, the strategic acquisition of Reynolds means that BTI took on a lot of debt to increase its regulatory risk, which is a major reason the stock has been so battered over the past 18 months.

Company Net Debt/EBITDA Interest Coverage Ratio S&P Credit Rating Average Interest Cost Return On Invested Capital
British American Tobacco 4.2 6.2 BBB+ 3.5% 8%
Safe Level 3.0 or below 8 or above BBB- or higher below ROIC 15% or higher

(Sources: Simply Safe Dividends, F.A.S.T Graphs, Gurufocus, Morningstar)

That massive increase in invested capital (debt + equity) means that BTI's return on invested capital (a proxy for good management) fell from a healthy 18% in 2016 to 6% in 2017, and it's been slowly rising over time as the company digests its largest acquisition in history.

The good news is that BTI's free cash flow margin of 36% means it has the ability to easily service that debt, which has a very low-interest-rate thanks to its strong credit rating (and borrowing in Europe where rates are lower than in the US). It also means the company can afford its sky-high dividend while deleveraging quickly over time, which it's been doing since the Reynolds deal closed.

(Source: Simply Safe Dividends)

The average debt maturity is 9.2 years, with no single year representing more than 14% of its total debt. With a historical FCF/adjusted EPS conversion ratio of 80% that should allow BTI to pay off debt at a rate of $2 to $2.5 billion per year (2.5% to 3% of debt each year) and steadily improve the dividend safety over time via deleveraging (debt declined 2.7% in 2018). All while growing the dividend at a low to mid-single digit rate (4% in 2018). (Source: BTI Investor Presentation)

Management's long-term plan is to eventually hit a net debt/adjusted EBITDA ratio of 3.0 (which would be the upper end of the safe range for tobacco companies). At the end of 2018, the leverage ratio was 4.0 and would have been 3.6 if not for negative currency effects (putting the company well on its way to achieving its leverage guidance).

To get there BTI expects about $400 million in synergistic cost savings by 2020 (from the Reynolds acquisition) plus other cost savings programs will drive 0.5% to 1% margin expansion. While such cost savings are far from guaranteed BTI's historical margin expansion rate is 1.5% per year, so I consider its deleveraging plan, based on more conservative cost-cutting assumptions, to be reasonable.

But I'm sure you're wondering how long the tobacco industry's standard business model of raising prices faster than volumes are declining can continue. After all, at some point, high pack prices (made worse by high tobacco taxes) mean consumers simply can afford to smoke anymore right?

Actually, believe it or not, the end of big tobacco might be many decades away. Morningstar's Philip Gorham has modeled how long BTI can likely continue steadily raising prices to the point where volumes start declining at similar rates as in Australia (where cigarette prices are the highest in the world at $17.50 per pack). Using data on price elasticity from various industry sources (and pricing data from the WHO), he concludes that

it will be 2051 before global pricing reaches levels at which price elasticity increased in Australia. This is comfortably longer than 20 years, the benchmark period that we expect wide-moat companies to continue generating economic rent." - Morningstar (emphasis added)

How can we tell if BTI bulls are right and not being delusional? By looking at the company's actual results. As its newly retired CEO recently said

“BAT performed well in 2018, exceeding our target of high single figure adjusted constant currency EPS growth, whilst continuing to invest in long-term sustainable returns.

For fiscal 2018 (the most recent quarterly results) BTI posted solid growth including

  • 25% sales growth (3.5% adjusted for Reynolds acquisition)
  • 7% price hikes last year (the highest in the industry and the strongest pricing power for BTI in 5 years)
  • 8.5% revenue growth in core combustibles (brands representing 80% of cigarettes)
  • 11.8% adjusted EPS growth (constant currency and adjusted for Reynolds acquisition)
  • Gross margins up 6%
  • operating margins up 5% (to 38%)
  • +0.4% market share in combustibles
  • 3.5% volume declines (2.7% in core markets, 0.4% better than industry)
  • 95% growth in vaping and reducing risk product revenue
  • deleverage balanced sheet to net debt/adjusted EBITDA of 4.0 (down from 5.3 in 2017, would have been 3.6 if not for currency fluctuations)
  • raised dividend 4% (while improving safety via planned debt pay down)

Risks are what might go wrong, the fundamentals (all of the above) are the facts that matter far more to long-term investors. The objective truth is that BTI remains a modestly fast-growing company that doesn't deserve to trade at its fire sale price.

Furthermore, the CEO (who retired on April 1st, 2019) explained that the company remains confident in its ability to keep growing earnings and the dividend in 2019 and long beyond, despite all the regulatory hurdles.

We recognize that the proposed potential regulatory changes in the US have created some investor uncertainty. We have a long experience of managing regulatory developments, a track record of delivering strong growth while investing for the future and an established multi-category approach. I am confident that my successor, Jack Bowles, will continue to deliver a similar level of sustainable long-term returns as we accelerate our Transforming Tobacco agenda. Looking into 2019 we are confident of another year of high single figure adjusted constant currency earnings growth and this confidence is reflected in our Board’s proposal to increase the dividend by 4%.” - fomer CEO (emphasis added)

Jack Bowles, the new CEO is the former COO of international operations, meaning the guy responsible for the company's strong historical cost-cutting and managing its complex supply chain to generate great economies of scale and those impressive FCF margins. I'm confident that he will continue its track record of steady (and safe) dividend growth.

(Source: BTI investor presentation)

That's because, while the tobacco market is in decline, the global nicotine market (in BTI's 40 largest countries) is expected to grow about 25% over the next five years. That's actually a slight acceleration over the past seven years, in terms of industry revenue.

(Source: BTI investor presentation)

British American is investing heavily in the new product categories that it believes will be able to drive about 4% long-term sales growth, even as cigarette volumes decline due to increased regulatory pressure.

(Source: BTI investor presentation)

Management believes it can convert that 4% sales growth into high single digit (7% to 9%) adjusted EPS growth. And since the payout ratio is at its long-term target of 65%, that also means about 8% long-term dividend growth could be coming once deleveraging is complete in about three years (leverage falls under 3).

Why do I trust management's guidance? Because of the company's track delivering steady earnings and dividend growth despite rising regulatory risks is excellent.

(Source: BTI investor presentation)

Basically, while the age of big tobacco will eventually end the age of nicotine can likely replace it meaning British American still has the potential to become a "buy and hold forever" dividend stock.

And for now, British American's shares are trading dirt cheap, which creates the potential for about 20% long-term total returns.

(Source: F.A.S.T Graphs)

The PE ratio only has to return to its 20-year average of 14.3 for investors to enjoy 19% CAGR total returns. Even low single-digit multiples would still make BTI one of the best high-yield blue-chips to own over the next five years.

Basically, when it comes to British American, the fears over the company's inability to grow in the future are outweighed by the objective truth that the company is in fact growing, has a plan for continuing to grow at about 8% over the long-term, and is executing well on its plan to deleverage within three years (creating a very safe dividend in the process that can then grow at double the current rate).

That is why I just bought the stock and am willing to put up to 5% of my life savings into this company (four more buys via limit orders) should the market offer me this quality tobacco giant at even more attractive valuations.

CVS Health: A Bold Bet On Vertical Integration Could Pay Off Handsomely

While both healthcare and the broader market are in a pullback/dip right now, CVS is in a severe bear market and trading at five-year lows (which is why I recently bought it for my retirement portfolio three separate times at prices between $51.91 and $53.91).

(Source: Ycharts)

Part of that decline is due to fears of healthcare regulatory changes (discussed in the Bristol section) but the largest reason shares have crashed is concerns over the $78 billion mega acquisition of Aetna (which the company possibly overpaid for to the tune of about $20 billion), the 5th largest health insurer in America.

Big debt-funded M&A is very risky, and about 80% of such deals fail to be accretive to long-term EPS. Big strategic moves by CVS are not new for investors with the company spending much of the last 12 years vertically integrating itself (and exposing itself to potentially greater regulatory risk) via a shift into pharmacy benefit management, long-term healthcare, and now health insurance.

  • 2006's $21 billion purchase of Caremark RX (which made it into one of America's largest pharmacy benefit managers)
  • 2015's $12.7 billion purchase of Omnicare, another PBM that also gave it exposure to long-term care (senior housing)
  • 2018's $78 billion (including debt) acquisition of health insurer Aetna, its largest deal ever

In 2018 CVS had to take two write-downs on its Omnicare acquisition, representing about 50% of what it paid in 2015, due to challenges in long-term care. That understandably has investors nervous about how the Aetna integration will go. Even if the higher margin business (Aetna's final full year net margins were double CVS's pre-merger) boosts CVS's overall cash flow growth, there is still a risk of a $10 billion to $15 billion write-down in CVS's future. That would crush that year's EPS, which is what Wall Street likes to obsess over.

And of course, we can't forget that CVS, prior to buying Aetna, had an impressive 14-year dividend growth streak that made it a favorite among DGI investors.

(Source: Simply Safe Dividends)

But thanks to taking on $40 billion in debt to fund that deal, the dividend has been frozen (and buybacks suspended) while the company wisely focuses on deleveraging.

(Source: CVS Investor Presentation)

However, the bearish thesis on CVS is based on the idea that the company's integration of Aetna will go poorly and its other segments will suffer (including from the so-called "retail apocalypse").

Q1 results not just beat top and bottom line expectations, but management also raised its adjusted EPS guidance by 1%. The company posted good sales growth in all its segments

  • Pharmacy services: 3.1% growth
  • Retail/LTC (what the retail apocalypse was supposed to hurt): 3.3% growth
  • Healthcare benefits: $17.8 billion (700,000 net membership growth YTD thanks to medicare advantage expansion).

CVS's units are almost all performing well with prescription growth of 6.7% YOY following 2018's 9.1% growth (and far better than Walgreen's weak results). Similarly retail is posting positive same-store sales growth and Aetna's membership growth is accelerating. The only cause for concern may be a decline in PBM retention rates from 98% to about 95% for 2019's guidance. This is something to watch closely in the future since CVS's big growth strategy over the past decade (prior to buying AET) was focused on becoming the nation's largest PBM.

More importantly, operating cash flow (from which free cash flow is generated that funds dividends and debt repayments) guidance was unchanged at $10.05 billion. Remember that in order for CVS to live up to its bullish investment thesis the company needs to execute well, deliver on guidance, and pay down debt at a steady clip.

(Source: CVS earnings presentation)

$8 billion in free cash flow guidance for 2019 has to pay $2.6 billion in dividends which leaves about $5 billion to repay debt. Since the Aetna merger closed the company has repaid $4 billion in debt (10% of what it took on to close the deal) including $875 million in Q1. Keep in mind that CVS closed on the Aetna merger in late November of 2018, meaning it's paid off $4 billion in bonds in about six months.

This year the company expects to repay about $4.4 billion in total debt, or $3.5 billion more (bringing total debt repayment since the AET deal closed to $7.5 billion or 19% of the total) by the end of 2019. Income investors should definitely cheer that management is attacking that mountain of debt with a vengeance, and delivering on its promises to reduce the company's risk profile significantly and quickly.

There's also good news when it comes to Aetna integration. Management is now saying that Aetna synergistic cost savings will come in at the high end of its $300 million to $350 million guidance this year and the company now claims to be on track to exceed the initial $750 million cost savings target by 2020.

(Source: CVS investor presentation)

What's more, the company is now launching an expanded cost savings program called the enterprise modernization initiative. This is focused on delivering $1.5 billion to $2 billion in annual cost savings by 2022. In other words, CVS thinks that not just can it exceed its initial AET cost savings targets, but also cut another $1 billion in annual costs in 2021 and 2022.

Remember that execution risk for large M&A is high. Since CVS has never played in the health insurance space before, whether or not management could deliver good integration and cost savings (which are the only way CVS can possibly justify the price it paid for AET) was a major reason the stock has taken a pounding for so long. However, thus far the Aetna merger appears to be going better than expected.

(Source: CVS earnings presentation)

That increases the chances that the company will hit its deleveraging target of repaying about $17 billion in maturing debt over the next three years, purely with retained free cash flow. That would likely get CVS to management's targeted low 3s leverage ratio and allow it to once more start raising its dividend and repurchasing stock (at highly accretive prices should shares languish that long).

That's not just important due to rising recession risk (when credit markets tighten the last thing a company wants is a bloated balance sheet) but also should preserve its dividend safety.

Company Yield TTM FCF Payout Ratio Simply Safe Dividends Safety Score (Out of 100) Sensei Dividend Safety Score (Out of 5) Sensei Quality Score (Out of 11)
CVS Health 3.8% 36% 69 (safe) 4 (safe) 8 (Blue-Chip)
Safe Level NA 40% or less 61 or higher 4 or higher 8 or higher

(Sources: Simply Safe Dividends)

CVS not only offers a mouth-watering yield double that of the S&P 500, but the payout is safe, courtesy of a low payout ratio and manageable balance sheet.

Company Net Debt/EBITDA Interest Coverage Ratio S&P Credit Rating Average Interest Cost Return On Invested Capital
CVS Health 5.4 3.6 BBB 4.2% 6%
Safe Level 3.0 or below 8 or above BBB- or higher below ROIC 15% or higher

(Sources: Simply Safe Dividends, F.A.S.T Graphs, Gurufocus, Morningstar)

At first glance, that leverage ratio seems frightening and indeed if it were to remain that high forever CVS's dividend safety would suffer. But as you can see below, not just are debt levels falling but analysts expect the net leverage ratio to drop by 24% in 2019 alone.

(Source: Simply Safe Dividends)

That's based on management's 2019 cash flow guidance, which the company remains on track to hit.

That's despite investing heavily into refurbishing its nearly 10,000 US pharmacies to replace lower margin retail space (about 20% of it) with minute clinics which now number 1,100.

(Source: CVS/Aetna merger presentation)

The company is also testing out a new concept called HealthHub in Houston.

Ross Muken of Evercore has seen one and on the conference call said it was "a pretty impressive new institution." These new types of neighborhood clinics are designed to provide people with integrated and data-driven healthcare that is part of the company's long-term vision of streamlining the US healthcare system to drive down costs by about $65 billion per year (while keeping a small sliver of the billions in savings for itself).

CVS intends to open HealthHubs at 15% of its Houston locations and at the upcoming investor day will clarify how it plans to start rolling these out nationwide later in 2019 and 2020.

(Source: CVS investor presentation)

CVS's grand long-term vision is to leverage its industry-leading scale, which now includes 23 million health insurance members and #1 market share in all its pharmacy business segments, and turn itself into a healthcare juggernaut that can withstand any regulatory changes that might be coming down the road (lower risk through sheer size and industry magnitude).

(Source: CVS factsheet)

Now CVS's great quarter and strong Aetna execution so far don't mean CVS has become a risk-free stock, far from it. All companies face various challenges over the short to long-term and CVS is still going to face numerous growth headwinds, such as reimbursement pressures, lower generic drug launches this year, and rising labor costs.

(Source: CVS earnings presentation)

But all of that is baked into management guidance, which the company just showed it's on track to meet. If CVS lives up to the modest growth expectations analysts have (6.5% long-term cash flow growth) then deleveraging is expected to be complete by the end of 2021 (some analysts think 2020) with dividend growth of about 6.5% beginning in 2022.

Morningstar's Jake Strole expects about 10% EPS growth beyond 2022 when the debt repayments have reduced interest costs and aggressive buybacks can resume. If that forecast proves accurate than CVS could potentially deliver 10% long-term dividend growth which would almost guarantee a much higher PE ratio.

And should the stock return to its 20-year average PE of 16.3, then even this slow-growing blue-chip could deliver Buffett/Lynch-like returns of more than 20% CAGR over the next five years.

(Source: F.A.S.T Graphs)

What if CVS's PE doesn't return to 16.3? Well, even a far more modest multiple expansion to 13.4 would see investors enjoy a 20% CAGR total return, which would almost certainly crush the broader market. All while owning a safe dividend-paying blue-chip that is already the 7th largest company in America by revenue (and recession-resistant to boot).

That's the power of buying a quality blue-chip at five-year lows, that continues to grow its cash flow (what all stock prices are ultimately based on) at a modest rate. In other words, modestly growing dividend blue-chips can potentially become blockbuster winners if you buy them when they are most hated and thus trading at high margins of safety and ridiculously attractive valuations.

Bristol-Myers Squibb: Celgene Merger Creates Large Opportunities For Long-Term Profit

Bristol's shares have been badly hurt not just due to overall fears over potentially drastic changes to US healthcare policy (like the Democrats proposed Medicare-for-All single-payer system), but also the complexity and execution risk surrounding the $90 billion (including debt) acquisition of Celgene (CELG), the largest its ever attempted.

(Source: Ycharts)

Since the acquisition was announced Bristol has badly underperformed the broader healthcare sector, which itself has significantly lagged the broader market. And despite the defensive (recession-resistant) nature of healthcare during economic downturns, the recent trade war dip (created by rising recession risk) has failed to help healthcare stocks in general, and Bristol in particular.

When it comes to political/regulatory risk (like single payer) this is a valid, if likely overblown concern. Due to numerous hurdles that stand in the way of such sweeping legislation passing, I, and most analysts consider this a low probability (though long-tail) risk. Democratic control of all three branches would be required (including a filibuster-proof 60 votes in the Senate), which not just takes time (since Supreme Court turnover is very slow), but also there is no guarantee that more conservative Democratic Senators would vote for a proposal that is sure to be extremely controversial.

A February Harris polls showed most people (71% including 53% of Republicans) say they want the government to ensure universal coverage.

However, just 13% support straight up single payer (like in the UK) and 45% support single payer with private insurance remaining a supplemental option. As Gallup's editor-in-chief, Mohamed Younis, explains

"Folks are clearly saying the system is still sort of broken to some degree, but there isn't a lot of consensus around how to fix it in one way or another."

And you can bet that big pharma in particular, and healthcare industries in general, are going to have a significant influence in DC courtesy of their rivers of lobbying cash.

Lobbying By Industry 1998 to 2018

(Source: Opensecrets)

Over the past 20 years, the healthcare segment has spent $8.4 billion or about $420 million per year on lobbyists. That's more than any other industry or segment of the economy.

Does that mean that the long-tail risk of sweeping healthcare reform is zero? Of course not, however, politicians have been talking a big game about "sticking it to greedy healthcare companies" for decades, and the latest populist rhetoric was to be expected as the 2020 election season heats up.

Anyone who isn't comfortable with headline regulatory risk (which is weighing on healthcare stocks today) shouldn't invest in this industry/sector. It's never going away, but will often create high price volatility that leads to attractive long-term buying opportunities like we're seeing today.

What about the Celgene merger and company-specific risks? It's certainly true that big mergers come with big risks, as the Harvard Business Review's meta-analysis of M&A indicates.

However, I need to point out that certain industries, such as tech and pharma, are naturally M&A heavy (so merger risk is also table stakes investors need to be comfortable with).

(Source: Wikipedia)

M&A is something that both Bristol and Celgene have proven adept at, as you can see by the company's strong returns on invested capital (a proxy for good capital allocation) over time.

(Source: Simply Safe Dividends)

The low price Bristol is paying for Celgene means this deal is likely to prove highly profitable for current investors and management thinks it can squeeze out $2.5 billion in cost savings via synergies.

(Source: Bristol-Myers merger presentation)

And given that Celgene is focused purely on higher margin specialty drugs (Bristol has also shifted to a pure patented drug focus in recent years), that likely explains why management's guidance over the next three years is for about 30% FCF margins (up from 19% in 2018).

30% FCF margins are near the upper end of this industry and only exceeded by top tier biotechs like AbbVie (37% in 2018).

Company Yield TTM Payout Ratio Simply Safe Dividends Safety Score (Out of 100) Sensei Dividend Safety Score (Out of 5) Sensei Quality Score (Out of 11)
Bristol-Myers 3.6% 51% (26% post-merger) 79 (safe) 4 (safe) 9 (SWAN)
Safe Level NA 60% or less 61 or more 4 or more NA

(Sources: Simply Safe Dividends)

That kind of cash-rich business model is why, despite the debt Bristol is taking on, its dividend remains safe, both considering its FCF payout ratio and its post-merger balance sheet.

Company Net Debt/EBITDA Interest Coverage Ratio S&P Credit Rating Average Interest Cost Return On Invested Capital
Bristol-Myers 0 36.3 A+ 2.6% 31%
Safe Level 3.0 or below 8 or above BBB- or higher below ROIC 15% or higher

(Sources: Simply Safe Dividends, F.A.S.T Graphs, Gurufocus, Morningstar)

Today Bristol enjoys a pristine balance sheet (and about $3 billion in net cash), however, it plans to take on $52 billion in new debt as part of the Celgene acquisition.

(Source: merger presentation)

That means its net leverage ratio is going to jump to double the industry average when the deal closes in Q3 2019.

Company Pro-Forma Debt/EBITDA Ratio Pro-Forma Interest Coverage Ratio Pro-Forma S&P Credit Rating

Pro-Forma Average Interest Rate

Bristol-Myers 4.0 15.1 A 3.1%
Industry Average 2.0 NA NA NA

(Sources: management guidance, Morningstar, Simply Safe Dividends, Gurufocus, Fast Graphs, credit rating agencies)

That is going to mean much higher leverage and borrowing costs (Celgene has a lower credit rating and so higher-yielding bonds). Moody's, Fitch and S&P have announced they will consider downgrading the company's credit rating one or two notches over the higher leverage.

Similarly, Simply Safe Dividends and I have downgraded the dividend safety rating from a very safe 99/100 to 79 and 5/5 to 4/5. Both still represent safe levels, as does Bristol's post-merger A credit rating. Why are most analysts (including myself) not worried about Bristol's debt?

That's because Bristol is paying such a low price for Celgene (at the merger price CELG is the 6th most undervalued biotech in America) that management expects the merger to be incredibly accretive (40+% EPS boost 12 months after closing).

But while Wall Street might focus on earnings, dividend and bond investors care about cash flow (what actually pays dividends and services debt). And fortunately, a Bristol/Celgene combo is going to generate a river of free cash flow that will make rapid deleveraging relatively easy. That's based on what its CFO told analysts at the merger conference call.

From a balance sheet perspective, we will remain in a very strong position. We project substantial free cash flow in excess of $45 billion in the first three years, which provides us with the flexibility to delever and maintain a strong investment-grade credit rating. It also supports our continued commitment to our dividend as evidenced by our announcement a month ago on our 10th consecutive annual increase, which will benefit shareholders from both companies." - CFO Charles Bancroft (emphasis added)

Post-merger Bristol's slow growing dividend (usually grows 2% per year in between larger hikes) will cost $3.9 billion, vs $15 billion average annual FCF. That translates into the FCF payout ratio declining from 51% (over the past 12 months) to just 26% and allowing the company to retain about $11.1 billion annually that can repay its merger debt. Within three years net leverage could fall to 2.3 and within five years potentially zero if management wants to return to a pristine balance sheet.

In other words, as management points out, the merger isn't likely to significantly threaten its credit quality or dividend safety.

Meanwhile, Bristol's fundamentals remain solid with Q1 results coming in better than expected on both its top and bottom line

  • revenue growth 14%
  • adjusted EPS growth: 16.6%
  • 2019 adjusted EPS guidance reiterated at $4.15 (4.3% growth)

The reason that Bristol's earnings growth guidance for full year 2019 is weaker than its impressive EPS growth this quarter is likely due to Opdivo facing stiffer competition from key rivals like Merck's (MRK) Keytruda. The cancer blockbuster also recently suffered a drug trial setback, which is always a risk for any drug maker (approved drug indication expansions are key to maximizing peak sales).

However, even factoring in that trial result and increased competition Morningstar's Damien Conover estimates peak Opdivo sales of $10 billion within a few years. For context in 2018, Bristol's entire annual revenue was $22.6 billion.

Bristol is also facing generic competition pressure from several virology drugs which recently went off patent. But despite that I and most analysts expect the company to be able to continue growing sales and cash flow in the years to come.

That's courtesy of the combined development pipelines it will own when the Celgene merger closes.

(Source: Bristol-Myers merger presentation)

Not just will Bristol be #1 in high margin oncology, as well as cardiology (combined a $48 billion global drug market), but it will also be a leader in immunology. Analyst firm EvaluatePharma estimates that oncology and immunology combined will represent $270 billion in global drug sales by 2024.

(Source: EvaluatePharma)

Bristol's new and improved drug pipeline is expected to be one of the best in the industry including

  • 50 total early-stage drugs in development (41 oncology and Immunology)
  • six late-stage blockbuster drugs (four oncology, two immunology) which alone are expected to generate $15 billion in peak annual sales

Those new drugs will combine with nine $1+ billion blockbusters that the larger Bristol will own upon the merger closing.

That means that, by 2024, Bristol could become the second biggest drugmaker in the world (about $50 billion annual sales), second only to Novartis's (NVS) $53 billion.

And while sustaining long-term growth is always a challenge for drug makers (due to patent cliffs) Bristol's CEO is confident about the long-term growth outlook, based on what he said at the Q1 conference call

The combined company is expected to have sales and earnings growth every year through 2025, despite the erosion of Revlimid. This growth will be fueled by Bristol-Myers Squibb's strong foundational products, Celgene's current product portfolio, our life cycle management programs, and our six potential launch opportunities. Looking to the second half of the next decade, our marketed portfolio has the potential to be earlier in its life cycle and more diverse within our areas of focus. Our early pipeline will have matured giving us the next set of registrational opportunities. We expect to have a strong balance sheet with continued flexibility to invest in innovation valuable and expanded technology capabilities and complementary platforms, such as cell therapy and protein homeostasis." - CEO Giovanni Caforio (emphasis added)

Does that mean Bristol is a sure thing? Of course not. The risk profile of the drug industry is complex and include

  • drug trial failures (during a process that takes 10 to 15 years and costs between $600 million and $2.7 billion to bring a drug to market)
  • peak sales estimates that are modeled on uncertain market share gains
  • constant patent expiration cliffs that create a hamster wheel like need to constantly launch new drugs/expand indications to keep sales steady, much less grow them
  • litigation risk (should approved drugs cause harm later)
  • political/regulatory risk (including headline risk from grandstanding politicians)

However, as I'll now explain, Bristol's margin of safety is so high that I consider all of these risks to be priced in and then some.

Valuation/Total Return Potential: Fantastic Total Return Potentials In Low-Risk Blue Chip Packages For Patient Investors

With deep value dividend blue-chips income investors have the opportunity to potentially enjoy growth stock like returns, but with lower risk and while enjoying generous, safe and rising income.

Company Yield 5-Year Expected Earnings Growth Total Return Expected (No Valuation Change) Valuation-Adjusted Total Return Potential (5-10 Years CAGR)
British American Tobacco 7.2% 5.9% 13.1% 17.9% to 25.2%
CVS Health 3.8% 6.5% 10.3% 16% to 22.5%
Bristol-Myers 3.6% 6.3% 9.9% 13% to 17.2%
S&P 500 1.9% 6.5% 8.4% 1% to 7%

(Source: Simply Safe Dividends, F.A.S.T Graphs, Morningstar, management guidance, Yardeni Research, Yahoo Finance, Multipl.com, Gordon Dividend Growth Model, Dividend Yield Theory, Moneychimp, analyst estimates)

All three of these companies are offering nearly two to 3.5 times the yield of the S&P 500 and expected to grow earnings (and over the long-term dividends) at about the same rate. That means, ignoring valuation entirely, all three are likely to prove market beaters over the next 5+ years.

But since valuations always matter in the long-term, when you factor in the likely multiples expansion each company will enjoy if management delivers on their growth strategies, then the return potential rises to truly impressive amounts.

Company Forward PE 5-Year Average Forward PE Growth Baked Into Current Price Analyst 5-Year Forward Growth Consensus
British American Tobacco 9.0 16.8 0.7% 5.9%
CVS Health 7.7 14.0 0% 6.5%
Bristol-Myers 11.0 (6.6 post-merger) 21.1 1.8% 6.3%

(Sources: Simply Safe Dividends, Benjamin Graham)

One popular valuation method investors use is the forward PE ratio. From that perspective, you can see all three blue-chips are trading at about half their five-year averages (and baking in almost no long-term growth). Bristol, when you adjust for the Celgene merger, is trading at a truly absurd forward pro-forma PE of 6.6. This is literally a depression era valuation only appropriate for poorly run companies that are dying, not thriving (it's latest results clearly prove it is).

What kind of valuation boosts can investors expect if these companies deliver on their growth plans (and thus the market is forced to price them on fundamentals as opposed to knee-jerk risk fears?)

To adjust for historical valuations, I turn to my favorite blue-chip valuation method, dividend yield theory or DYT. This has been the only approach used by asset manager/newsletter publisher Investment Quality Trends since 1966. DYT, which compares a stock's yield to its historical norm, has been the only approach IQT has used for 53 years, and only on blue-chips, to deliver market-beating returns with 10% lower volatility to boot.

(Source: Investment Quality Trends)

According to Hulbert Financial Digest, IQT's 30-year risk-adjusted total returns are the best of any US investing newsletter. Basically, DYT is the most effective long-term valuation approach I've yet found, which is why it's at the heart of my retirement portfolio's strategy and drives many of my article recommendations.

DYT merely compares a company's yield to its historical norm because, assuming the business model remains relatively stable over time, yields, like most valuation metrics, tend to revert to historical levels that approximate fair value.

I like to use DYT as one end of my valuation range with the other end provided by the conservative analysts at Morningstar.

Company Yield 5-Year Average Yield Estimated Discount To Fair Value Upside To Fair Value 5-10 Year Valuation Boost (CAGR)
British American Tobacco 7.2% 4.0% 44% 77% 5.9% to 12.1%
CVS Health 3.8% 2.1% 44% 78% 5.9% to 12.2%
Bristol-Myers 3.6% 2.6% 27% 36% 3.1% to 6.3%

(Sources: Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model, F.A.S.T Graphs, management guidance, Moneychimp)

Note that Morningstar also expects BTI's yield to return to 4%.

DYT estimates that these companies are trading at fire-sale prices, up to 44% below their historical fair value. That implies that over the next five to 10 years (if that's how long it takes for the market to stop hating them) shares could outpace earnings and cash flow growth by 3% to 12% annually (good enough to likely beat the market on multiple expansion alone).

Adding those valuation boosts to the Gordon Dividend Growth Model (total return = yield + long-term earnings/dividend growth, assuming fair value and no valuation changes) is how I build my valuation-adjusted total return model (historically accurate with 20% margin of error).

But in case you think that Dividend Yield Theory, one of the most accurate valuation methods for dividend stocks, is being overly bullish on these three companies, let's consider one final valuation approach, Morningstar's long-term, three-stage discounted cash flow estimates.

Morningstar's analysts are famous for some of the most conservative growth assumptions on Wall Street. I consider them the Warren Buffett of valuation estimates, meaning almost always erring on the side of caution. If Morningstar says a blue-chip is fairly valued, it's likely a good buy. If they say it's undervalued then it's likely a strong buy.

Company Current Price Estimated Fair Value Moat Management Quality Discount To Fair Value Long-Term Valuation Boost
British American Tobacco $37.22 $59 (low uncertainty) Wide (negative trend) Standard (good to average) 37% (5-star stock, very strong buy) 4.8% to 9.7%
CVS Health $52.97 $92 (medium uncertainty) Narrow (positive trend) Standard (good to average) 42% (5-star stock, very strong buy) 5.7% to 11.7%
Bristol-Myers $45.91 $65 (medium uncertainty) Wide (stable) Standard (good to average) 29% (4-star stock, strong buy) 3.6% to 7.3%

(Source: Morningstar)

BTI, CVS, and BMY are some of the most undervalued blue-chips Morningstar tracks, with its valuation estimates closely matching DYT in this case. CVS and BTI are 5-star stocks (very strong buys) while BMY is a 4-star stock (strong buy).

For my official recommendations, I average DYT and Morningstar's conservative fair value estimates to conclude

  • British American Tobacco: 41% undervalued
  • CVS Health: 43% undervalued
  • Bristol-Myers: 28% undervalued

Under my blue-chip valuation scale that makes all of these company very strong buys at least, with CVS and BTI being ultra strong buys (aka table pounding, back up the truck buys).

Of course, that's only if you're comfortable with their risk profiles and remember to use proper risk management.

Risks To Consider

It's always important to keep in mind Peter Lynch's reminder that even good analysts are right just 60% of the time.

(Source: Tipranks)

My mostly contrarian value-focused blue-chip approach has helped me to make it into the upper ranks of analysts and investment bloggers, but invariably some investment thesis will fail.

This is why I'm constantly reminding readers to never forget about proper risk management and asset allocation.

Here are my risk management rules of thumb, which are designed with input from several market studies as well as a trusted colleague with decades of experience as a mutual fund manager.

It's also important to remember that all my dividend stock recommendations are only meant for the equity portion of your portfolio, and never as a bond alternative. Similarly, my "blue-chip" and "SWAN" quality classifications are NOT meant to imply a stock can't fall severely (even an already deeply undervalued one) in the short-term.

Company Beta (Volatility Relative To S&P 500) Peak Decline (Late 2018 Correction) Peak Decline (Great Recession)
British American Tobacco 0.87 32.2% 31%
CVS Health 0.92 20.2% 38%
Bristol-Myers 0.67 20.5% 32%
S&P 500 1.0 19.8% 57%

(Sources: Simply Safe Dividends, Ycharts)

All three of these companies typically have below average volatility. But as you can see, each also crashed as much or more than the market during the late 2018 correction (the worst since 2009). And while all three outperformed the S&P 500 during the Great Recession, anyone having to sell them to meet expenses (such as retirees using the 4% rule) would have deeply regretted not having the proper asset allocation.

Asset allocation just means the mix of stocks/bonds/cash (like T-bills) you own. Stocks, even blue-chips and SWANs (such as dividend aristocrats and kings) are still a "risk asset" that can be highly volatile. This is precisely why they deliver superior returns to bonds over time.

You should always own the right mix of bonds to smooth out your portfolio's volatility. Remember that historically superior total returns from stocks mean nothing if you can't stomach the inevitable sharp declines that cause so many investors to panic sell at a loss.

Bonds also provide stable or appreciating assets to sell during corrections and bear markets, allowing you to fund living expenses (expected and unexpected) without becoming a forced seller of blue-chip dividend stocks at fire-sale prices.

Diversification is often called "the only free lunch on Wall Street" because it can actually help not just smooth out performance, but also enhance your realized returns.

For example, anyone who was 100% invested in the S&P 500 over the past 20 years would have enjoyed 5.6% CAGR total returns (historically low due to two 50+% market crashes during that time). That's superior to bonds, which delivered 1.1% smaller returns.

But note that the average retail investor suffered 1.9% CAGR total returns, worse than inflation and every other asset class. In contrast, a 60/40 stock/bond portfolio enjoyed 93% of a pure stock portfolio's returns, but with far less volatility (making those returns far more achievable for most people).

Even an ultra-conservative 40/60 stock/bond portfolio (such as what many advisors recommend for 80-year-old retirees) delivered 5% CAGR total returns, which was 163% better than the average investor's horrible market timing was able to generate.

The point is that while buying undervalued dividend blue-chips is a time tested long-term strategy, you always need to remember that no single investment is guaranteed to succeed. And even when they do it might require the patience of a monk (some of Peter Lynch's best ideas took up to four years just to break even).

This is why a well-diversified portfolio, both by companies and sectors, is so crucial to long-term success for most people. Being 30% in a high-quality company that languishes for many years, can lead to overall poor long term portfolio returns.

To paraphrase Yoda

Desire for quick profits leads to disappointment, disappointment leads to frustration, frustration leads to impatience, and impatience leads to costly mistakes."

By following sound risk management and portfolio construction methodology you can minimize dangerous emotions like market envy and panic during inevitable but temporary declines. That's ultimately what will help you achieve your financial goals because as Buffett points out

The stock market is designed to transfer money from the active to the patient."

Bottom Line: These Three Deep Value Dividend Blue-Chips Are Very Strong Buys If You're Patient Enough To Wait For Market Fears To Abate

Let me reiterate two key points. First, I'm not a market timer and am NOT claiming that any of these deep value blue-chips are necessarily at their final bottoms, or are guaranteed to pop soon (the market can be infinitely stupid in the short-term).

Nor am I saying that all three are "must own" stocks that everyone should buy. It's important to stay in your circle of competence and comfort zone, so as to avoid making costly mistakes (like panic selling during periods of high market fear).

Some people simply don't like owning tobacco companies or anything connected to the complex world of healthcare. If that describes you then, by all means, do what's right for you and avoid BTI, CVS, and BMY.

However, if you are comfortable with each company's risk profile and business model, then buying a properly sized position in a well-diversified and properly constructed income portfolio at these valuations is a high probability/low-risk investment that could pay off handsomely over the next five to 10 years.

Not just do British American, CVS, and Bristol-Myers offer dividend lovers attractive and safe current yields, but, over the long-term, each is likely to grow its payout, while possibly delivering sensational double-digit total returns that will leave the market in the dust.

My confidence in these companies is great enough that I own all of them in my retirement portfolio and have four limits set for British American should it fall to a yield of 7.6% ($35.27). That would fill out my position in the company, and at even more attractive valuations (and result in a YOC of 7.4%).

Disclosure: I am/we are long BTI, CVS, BMY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.