Big Things Are Happening at This Pharmaceutical Company

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Pharmaceutical company Pfizer (NYSE: PFE) has been doing some interesting things lately. The company has been shedding its non-pharmaceutical assets in order to focus on its core business which carries high profit margins. In April 2012, Pfizer sold its infant nutrition business to Nestle, and this February, the company spun off its animal health business Zoetis.

Pfizer's stock has fallen more than 10% from its high in April, pushing the dividend yield up to 3.45%. This increased yield, along with faster dividend growth than peers, makes Pfizer one of the best big-pharma dividend stocks out there.

A troubled past

Big pharmaceutical companies typically grow their dividends slowly, and Pfizer is no exception. From 2003 to 2012, Pfizer's dividend grew at an annualized rate of just 4.3%, and in 2009, the company was forced to cut its dividend dramatically. The good news is that Pfizer has a far lower payout ratio with respect to the free cash flow than competitors like Merck (NYSE: MRK) and Eli Lilly (NYSE: LLY).

<table> <thead> <tr><th><strong>Company</strong></th><th><strong>Payout ratio</strong></th></tr> </thead> <tbody> <tr> <td>Pfizer</td> <td>42%</td> </tr> <tr> <td>Merck</td> <td>64%</td> </tr> <tr> <td>Eli Lilly</td> <td>51%</td> </tr> </tbody> </table>

This allows Pfizer some room to grow the dividend, and at the end of last year, the company raised the dividend by 9%. But the big story here is the massive share repurchases which Pfizer has been doing.

Being aggressive

Pfizer has been using the cash generated from selling off its non-core assets to aggressively repurchase its shares. From 2011 through the first quarter of 2013, the company spent a total of $21.8 billion on share repurchases, reducing the share count by just about 10%. What's more, the company still owns 80% of Zoetis, a position which it plans to unwind in short order. That's nearly an additional $10 billion which can be used for share buybacks.

On top of that, the company generated over $15 billion in free cash flow in 2012, and after the dividend payment, that leaves about $9 billion which could be used for buybacks. Reducing the share count lowers the total dividend payment that the company has to make, thus lowering the payout ratio and creating more room for future dividend growth. And given that the stock trades at less than 13 times the free cash flow, the company is paying a reasonable price for its own shares.

Because the cash flow is so robust, Pfizer hasn't needed to increase its debt in order to fund the buybacks. The company has a total of $40 billion in debt and an additional $11 billion in pension obligations, but cash and investments cover nearly all of that at $50.7 billion. Some companies take on huge amounts of debt to fund buybacks, which in general I don't like, but Pfizer doesn't have to.

Without the effect of these buybacks, Pfizer wouldn't look all that attractive as a dividend stock, mainly because earnings growth will likely be slow. But, the buybacks will allow the company to raise the dividend faster than earnings growth without increasing the payout ratio. And with a fairly low payout ratio, there's room for dividend growth on that front as well.

Better than its peers

Merck, with its high payout ratio and much less aggressive buyback program, would be unable to grow its dividend at a very fast rate. The most recent increase last year was just 2.4%, and I think that's about what the typical dividend increase will look like in the future. The yield is a bit higher than Pfizer at 3.53%, but the minuscule growth kills it as a dividend growth stock.

Eli Lilly looks a bit better at first, with a 3.77% dividend yield and a lower payout ratio than Merck. But, Eli Lily hasn't raised its dividend since 2009 and has no share buyback program to speak of. What's worse, Eli Lilly faces a steep patent cliff as its most important drugs will soon be open to generic competition. It's unlikely that we'll see a dividend increase anytime soon, and there may even be a dividend cut. Best to avoid this one.

The bottom line

What makes Pfizer the best choice is its aggressive buyback program funded by a strong cash flow and selling off non-core assets. I expect these massive buybacks to continue and the dividend to continue to grow at a reasonable rate given the yield. There's also been talk of Pfizer spinning off its generic drug business and becoming a pure-play drug maker. This would raise Pfizer's margins and likely lead to a higher valuation. Pfizer is an interesting stock and a solid dividend play. It's definitely on my radar.

Can Merck beat the patent cliff?
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