Dividend growth investing is lots of fun, especially if you have a systematic methodology to determining which companies' dividends are safe and which ones' aren't. That is why we created a forward-looking assessment of dividend safety in our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion™. In this article, let's evaluate the investment merits of Eli Lilly (LLY), as well as its dividend under this unique but yet very straightforward framework.
But first, let's get this out of the way. We think Eli Lilly's dividend yield is excellent, offering roughly a 3.5% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Eli Lilly fits the bill thus far.
Eli Lilly earns a ValueCreation rating of EXCELLENT, the highest possible mark on our scale. Our ValueCreation rating compares a company's return on invested capital with its cost of capital. If the firm's return on invested capital is greater than its cost of capital by a large margin, it receives an excellent rating. Lilly has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged an impressive 45.1% during the past three years.
Eli Lilly has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 17.2% in coming years. Total debt-to-EBITDA was 0.9 last year, while debt-to-book capitalization stood at 34%.
Eli Lilly continues to face substantial revenue and earnings pressure as a result of the Zeprexa patent expiration. Cost control and the advancement of its solid Phase III pipeline will be critical to long-term success. We think the firm's strong pipeline could serve as a catalyst to jumpstart its dividend growth in coming years, as we outline in our dividend report below.
Our Dividend Report on Eli Lilly
Let's now dig into its dividend. The safety of Eli Lilly's dividend is good, in our view. We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.
That has led us to develop the forward-looking Valuentum Dividend Cushion. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Eli Lilly, this score is 1.8, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow roughly 2 times.
Now on to the potential growth of Eli Lilly's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is not the case for Eli Lilly. We have the firm rated as having good growth potential (not excellent), but only due to the fact that Lilly hasn't raised its dividend in a number of years. Still, we think the future is much brighter.
And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Eli Lilly's case, we currently think the shares are fairly valued, so the risk of capital loss medium. If we thought the shares were undervalued, the risk of capital loss would be low. All things considered, we like the potential growth and safety of Eli Lilly's dividend. We're expecting the company to jumpstart dividend growth in the coming years.