Diving for Dividend Growth in Big Pharma

By Justin Carley - May 3, 2012 | Tickers: ABT, AZN, GSK, NVS, SNY | 0 Comments

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Large-cap pharmaceutical stocks aren’t the gunslinger type, but they can have a valuable position in an investor’s portfolio.  Their strong economic moats and high dividend payments make them viable long-term options.  Not only that, but in today’s miniscule interest rate environment, they serve as substitutes to many fixed-income alternatives.  GlaxoSmithKline (NYSE: GSK) just tapped the debt market this week and issued $5 billion in debt.  Would you rather own their 10-year bonds and clip a 2.85% coupon or their stock and a 4.8% dividend coupon?  The difficult part with large-cap pharmaceuticals is deciding which stock to own.  Nearly all of them have cheap fundamental ratios and pay a dividend yield in the 3-5% range.  Most of them have well known patent issues, little catalysts, and drug pipelines that are next to impossible for the Average Joe to understand.  Using a key criteria, dividend GROWTH, helps create notable differentiation between the stocks.  Hint- look to European-based pharmaceutical companies.

The coveted dividend growth, as measured by 5-year CAGR, is vital to providing continuously growing dividends.  This component is much more important than a stagnant, high-yield investment that doesn’t provide the opportunity for increasing payouts.  The chart below highlights the 5-year compound annual growth rate in dividends for large-cap pharmaceutical stocks.

Six companies have a 5-year CAGR in dividends at or above 10%.  This is a good starting point for an investor looking to this sector in order to reap the rewards of high AND growing dividends.  To narrow the list, we can eliminate Bayer AG.  They delisted from U.S. exchanges in 2007.  It does trade on the pink sheets under the symbol BAYRY, but with tiny daily volume that is a detriment to investors.  Roche Holdings also should be eliminated because of its pink sheet positioning.  Volume here is more than Bayer, but still rather thin.    Abbott Laboratories (NYSE: ABT), the sole U.S. representative, is a great company and investors should do their due diligence on the name.  I am eliminating it from this discussion because of the planned split into two separate entities later in 2012.  The company will spin-off into a new entity the diagnostic, nutritional, and medical device units and leave the more mature pure pharmaceutical business under the existing name.  This leaves three viable options, AstraZeneca, Sanofi, and Novarits as the leading candidates for new investment dollars in the space.

AstraZeneca Plc

AstraZeneca ADR (NYSE: AZN) is based in London, England and is a globally diversified pharmaceutical manufacturer with annual sales in excess of $30 billion.  It is smaller than some of the super heavyweights, but is a pure pharmaceutical based company.  Simply put, it is the cheapest pharmaceutical stock by a long shot, but also faces the most onerous patent cliff.

The company’s existing drug pipeline is top-heavy with it three leading drugs, Crestor, Seroquel, and Nexium comprising approximately HALF of total sales.  These drugs start losing patent protections in various jurisdictions between 2014 and 2016.  This is a headwind that will persistently overhang the shares for the next couple of years.  This is a tremendous challenge that the company faces and they will likely turn to acquisitions to fill in the sizeable gap.  If they had a strong M&A track record, investors might feel better.  Unfortunately, they really don’t have a great record and their $15 billion purchase of MedImmune in 2007 is still seen by analysts as being too rich of a price.

For all these issues, investors can nab shares at just 7x earnings and receive a robust 8.7% dividend yield.  This yield is nearly twice the industry average and higher than most junk-bond indices.  The company needs to crank down operating expenses in the coming years, similar to what Pfizer has been able to achieve ahead of their Lipitor patent expiration.  The headlines have not been all that great either.  The stock fell 5% last week when the company reported sub-par 1Q results, lowered their full-year guidance, and had their CEO abruptly retire. UGH!  Is this stock a value or a value trap?  Investors need to decipher this, but I lean to the latter.

Sanofi

Sanofi ADR (NYSE: SNY) is headquartered in Paris, France.  They are bigger than AstraZeneca with annual sales of $47 billion and a market capitalization above $100 billion.  Sanofi is facing the cliff as of this writing.  They are forecasting earnings-per-share to decline between 10%-15% in 2012 and growth will likely be flat for a couple of years thereafter.  Here, investors can face the pain and then start looking forward as patent expirations slow notably after 2013. 

The company is well positioned from a diversity standpoint.  Pharmaceuticals account for 70% of sales, but only one product, Lantus, accounts for more than 10% of total sales.  While clearly a pharmaceutical company, Sanofi also has a notable presence in Vaccines, which carry nice margins, as well as Animal Health and Consumer Health segments.   Geographic diversity is more pronounced than peers.  Emerging markets contributed 30% of fiscal 2011 sales, the highest ratio among the major pharma companies.  This is a key differentiator with emerging markets contributing more than Western Europe, as the region remains a risk to the industry under the umbrella of austerity. 

Sanofi offers a much better outlook than AstraZeneca and its valuation is still pretty attractive.  The price-to-earnings ratio is 10x and the dividend yield is 4.5%.  Investors can have much more faith in the 10% growth rate in dividends persisting over the coming years.  The free cash flow yield (free cash flow dividend by enterprise value) is clearly in value territory at close to 9%.  The only real knock on the stock is the muted return on invested capital numbers generated in recent years.  These have hovered around 10% whereas many peers are in the 20%-30% range.  If investors can put this issues aside, then Sanofi looks like a high-quality investment opportunity.

Novartis AG

Novartis AG ADR (NYSE: NVS) is headquartered in Basel, Switzerland and is the largest of the three highlighted companies.  They produce annual sales north of $50 billion and yield a market capitalization of $168 billion.   Novartis has less reliance on patent pharmaceuticals at just 55% of total sales.  They own the second-largest generic drug company in the world- Sandoz, and this brings total drug reliance up to 70% of sales.  These two franchises work together to help buffer the top line.  The generic unit can keep branded products falling off patent from becoming irrelevant too soon.  Also, Sandoz results are inflated when a lot of drugs are facing expiration as is the environment this decade.  Adding to the diversity is the fact that Novartis owns Alcon, a leading eye care company, which offers consistent growth opportunities.  Simply put, the company has a higher valuation and a much better and visible growth profile.

Earnings will likely fall in 2012 as Novartis losses patent on it biggest drug seller, Diovan, but at just under 10% of sales, it isn’t crippling.  Earnings are forecasted to be flat in 2013 as it will be a transition year, but thereafter the market is anticipating 8%-10% EPS growth.  For this industry leading outlook, investors still don’t need to reach on valuation.  The price-to-earnings ratio is 15x against a 4.5% dividend yield.  The free cash flow at 7.5% is still attractive despite being the lowest among European peers.  And similar to Sanofi, investors will need to overlook subdued ROIC numbers.  Still, for paying up slightly, investors can patiently clip their 4.5% dividend coupon for two years as they wait for earnings to start growing again, maintain strong conviction in continually growing dividends, and then be part of steady earnings growth in the back half of the decade. 

Bottom line

Pharmaceutical stocks aren’t dead.  In fact, the S&P 500 Pharmaceutical Index has produced a total annual return more than 2% higher than the S&P 500 over the last five years.  To decipher between the pack, investors should focus on companies that have consistently grown their dividends.  This leaves three viable options, all European-based, and two that stand ahead of the pack.  Sanofi and Novartis are solid picks for investors adding new money to the attractively valued large-cap pharmaceutical space.

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