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Among the top dividend stocks that I post every month, many of the top payers are pharmaceutical companies that are in the business of doing research, inventing and then marketing drugs that will solve all types of problems. These companies typically have strong balance sheets and certainly look like very attractive dividend stocks. We decided to take a deeper look into these stocks to see if they were worth holding in a diversified dividend portfolio.

On the surface

Strong dividend yield

No doubt, these companies offer very attractive dividend yields. The 5 companies that I will discuss here pay between 3.75% and 5.78% of dividend yield, strong numbers no matter what industry you are looking into. The fact is that these companies are healthy, profitable and paying great dividends.

Three of these companies have also increased their payout over the last 5 years and could increase it much more in the coming years.

Strong balance sheet

Often, strong dividend payers have fragile balance sheets which makes them vulnerable to rises of interest rates or any slight downturn in their business. That is not the case for these 5 companies which have very little debt. They can sustain pretty much anything that will come at them in the coming years and still be in business.

Solid profits

Not only are these companies paying high dividends and they have a strong balance sheet but also these companies are very profitable. Despite paying a lot of money out to shareholders, these companies still have low payout ratios as they continue to make much more than what they are paying out.

Let’s take a look at the top big 5 of Big Pharma that pay dividends:

Ticker Name Price Dividend Yield Payout Ratio Ex-Date Debt to Market Cap 5 year div growth
ABT Abbott Laboratories 46.88 3.75 43.09 1/12/2011 0.2 9.65
BMY Bristol-Myers Squibb Co 25.86 4.97 77.84 12/29/2010 0.15 2.71
LLY Eli Lilly & Co 33.85 5.78 49.73 2/9/2011 0.16 5.22
MRK Merck & Co Inc 35.46 4.29 27.89 3/9/2011 0.16 0
PFE Pfizer Inc 16.77 4.29 57.06 2/2/2011 0.33 -1.08

Beneath the surface

Expiring patents

Many of the big pharmaceuticals make all of their sales and profits from just a few products. Those products are sold exclusively for a few years while the drug companies hold the patents but those patents do come to expiry at some point and the sales & profits take a major drop when the patent comes to expiry. For example, next year, Pfizer’s patent on Lipitor, a cholestorol drug, comes up. The drug brings in sales of over $12 billion which will take a major drop. The other big pharma companies also have similar patents coming to maturity which will mean a big hit for the revenues and profits.

Lack of new products

That would not be a problem if the big companies were coming up with enough new products to replace the expiring patents. But that is not the case. Despite huge R&D budgets, they have been unable to come up with cures to problems like AIDS or cancer which means that the sales of drugs for the upcoming decade will likely be much lower. It is a huge problem and all the big companies seem to be stuck with this issue. Of course, if there was an easy solution, these companies would implement it. But visibly, there isn’t. That has left these companies with few options; all of them will have major impacts on the future of the pharma business.

Acquisition costs going through the roof

One of the ways that these companies have tried get around expiring patents and declining sales is buying smaller companies that either have valid patents or are in advanced stages of promising products. One such example would be French company Sanofi-Aventis (NYSE:SNY) which has been going after Genzyme (GENZ). The problem is that these small companies are not easy to find and they are very expensive to buy. When a company looks like a promising target, all of the big ones jump on board trying to find ways to get access to the products either through alliances or even better, by acquiring the firms. It is far from clear that these companies will be able to replace their existing lines of products and if they are, it will probably come at a very steep price. How will it affect future dividends? Difficult to say. But it’s not all green, I can tell you that.

Uncertainty of US legislation

The ongoing changes in the US health system are bound to have consequences on the drug companies.The US pays more to these companies than anyone else, on an absolute basis but also on a relative basis. Will the changes affect the pharmaceutical companies? No doubt. But it’s difficult to say how it will affect them. I don’t know that the changes will be bad because everyone has an incentive in getting these companies to invent new cures. But the US is currently paying a very large share of that cost and that might change in the near future.

Good but only to an extent

In my opinion, the conclusion is not to avoid pharma companies but rather to avoid a high concentration of pharma stocks in a dividend portfolio. Those stocks, like financials, carry their load of risk right now. They are good dividend payers and might remain so in the future. But be careful and do not include most of your stocks in this portfolio.

Click to enlarge charts

Abbott Laboratories

Bristol-Myers Squibb Co

Eli Lilly & Co

Merck & Co Inc

Pfizer Inc

Disclosure: We do not hold positions in any of these names

Source: A Look Beneath the Surface of Big Pharma Dividend Stocks