Pharma: Dividend Payouts Shrink

With important patents set to expire and existing drug development pipelines proving disappointing, large cap U.S. pharmaceutical companies are likely to make more acquisitions down the road to shore up their vulnerable product stables.

But unlike in the past, these companies will be forced to use more debt to make their purchases, which likely means falling dividend payout ratios across the sector, says Barbara Ryan, Deutsche Bank analyst.

"Historically, pharma companies have had high dividend payout ratios owing to strong cash flows, long product life cycles, and underleveraged balance sheets," Ms. Ryan said in a note to clients, adding their relatively high P/E's allowed them to use stock to fund large acquisitions.

"Today, things are far different; profit life cycles are shorter, new product development has been disappointing, and P/E's have fallen dramatically. Much‐needed acquisitions must now be funded with relatively low‐cost debt. With increased leverage, we expect payout ratios to fall into the 30's versus their historical mid‐40's."

To demonstrate her point, Ms. Ryan noted that Pfizer Inc. (PFE) recently cut its dividend by 50% to help fund its purchase of rival drug maker Wyeth.

Faced with the loss of its patent protection for Lipitor, the company's biggest drug, in 2012, Pfizer needed to make an acquisition or else suffer a severe hit to its bottom line. But since the company's price/earnings ratio is so low, the bid for Wyeth could not be funded using stock. Instead, a combination of cash and debt was utilized. And in order to pay the debt back down more quickly, Phizer decided to cut its dividend.

"In 2010, Pfizer’s debt/equity should be about 50%, versus 20% in 2007 [and] the company’s payout ratio has fallen from 48% in 2008 to 35% currently," the analyst wrote.

"We expect therefore that Pfizer could increase its dividend by 15‐25% to as much as $0.80 in December of this year (a quarterly rate of $0.20) to reflect the possibility for 20% EPS growth in 2010, but will remain well below its more recent payout levels."

Like Pfizer, Ms. Ryan said other pharma companies will also see increases to their debt levels, which will ultimately be accompanied by changes in dividend policy. In other words lower overall payout ratios.

"The return of cash to shareholders through dividends will continue to be important, and probably generous, but it is unlikely to be sustained at the historic ratios of the past, and is already moving down," she said.