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Investing in companies that pay above average dividends has historically been a good investment strategy. Of course investors, specifically those looking for income, want more than just a current high dividend yield; they also want the company to continue to pay out that high dividend and hopefully increase it as well. A recent study by Tweedy Browne (the dividend studies begin on page 30) sheds some light on what investors might want to look for in addition to just a high yield.

The historical study shows that investors can increase their returns by narrowing the list of stocks with high dividend yields to those that also have low dividend payout ratios. This makes sense, as a low payout ratio implies a few key things. First, most importantly, and obviously, it means the company is actually making enough money to support its dividend. A low payout ratio can also imply that the company is finding productive uses for the portion of earnings that it is not paying out and using those earnings to grow the business and increase the dividend in the future. If they have a high payout ratio it could mean the company can’t find profitable ways to reinvest its own earnings. A low payout ratio also means the dividend payment is isolated to some degree from falling earnings. If the payout ratio is only 40% and net income drops 25%, there is still enough cushion to maintain the dividend payment. A low payout ratio also means there is room for the company to increase the payout ratio and grow the dividend.

One such company that fits the criteria of both a high dividend yield and low payout ratio is Britain’s GlaxoSmithKline (NYSE:GSK). GlaxoSmithKline is one of the largest global pharmaceutical companies. GSK has large portfolio of patent-protected drugs, vaccines and biopharmaceuticals covering multiple major therapeutic areas that it sells worldwide. Pharmaceutical sales make up approximately 80% of revenues, while the smaller consumer healthcare division accounts for 20% of revenues.

GSK currently has a dividend yield of approximately 5% and a modest payout ratio of 54.5%. While GSK might seem a bit expensive with a P/E of over 16, it is trading cheaper by other more robust measures. GSK has an EBIT yield of 13% and a price to free cash flow ratio of 10.4.

Patent Expirations

As with many pharmaceutical companies, the biggest threat to earnings is the patent expiration of a blockbuster drug. GlaxoSmithKline is no exception. It has endured a major patent cliff from 2007 to 2009. It is now seeing the light at the end of the tunnel with the last two major drugs coming off patent this year: Advair (in the US) and Valtrex. It also faces the loss of revenue from one time sales of pandemic vaccines. In 2009, Advair and Valtrex accounted for £2592 and £1605 of sales, respectively. The company has gross margins of 73.7%, so we can infer that those two drugs contributed approximately £3093 to GSK’s bottomline.

The good news is that GSK has largely replaced that revenue. For the third quarter of 2010, revenue dipped 2%. But year-to-date revenue has increased by 4%. Over this time, both Advair and Valtrex have gone generic, leading to third quarter drop of 75% in revenues from Valtrex and 65% from Advair. Trailing twelve months free cash flow of £6422 is about the same as 2009’s free cash flow number and more than enough to cover trailing twelve month dividends of £3248. GSK’s success in replacing the revenue from Valtrex, Advair, and the pandemic vaccines is due both to its successful research and development efforts and its focus on diversifying revenue by therapeutic and geographic areas.

Deep Pipeline

GSK’s research and development spans more than eight therapeutic areas. They have a strong pipeline with 35 compounds in Phase I trials, 65 in Phase II trials, and 31 in Phase III trials as of 2010Q1. The company also has 15 compounds that have received regulatory approval and 10 compounds that have passed Phase III trials and have been submitted for regulatory approval.

The company has also worked to make R&D more efficient by laying off more than 25% of the R&D staff since 2006. The company also reduced lab space by more than 15%. Ordinarily, reduction in R&D expenditures might be a red flag, as R&D and new product creation is the heart of what drives the value of pharmaceutical companies.

But GSK seems to have been successful in its quest for efficiency. Its pipeline has remained strong, and it survived patent expirations of some of its major drugs, such as Wellbutrin and Paxil, among others, that accounted for more than 18% of sales in 2006. GSK also continues to remain successful at introducing new products. So far in 2010, GSK has introduced seven new products, which year to date have contributed an additional £1.25B of revenue. The drive towards efficiency has also been beneficial to shareholders, since the company has posted a five year average Return on Invested Capital (ROIC) of 28.7%.

Broad Scope in Geography and Therapeutic Area

The other advantage GSK has is its focus on diverse markets. GSK is a global company with only 32.4% of revenue coming from the United States. Europe accounts for 27.1% of sales; Asia and Japan; 10.5%; Emerging Markets; 9.5%; and Consumer Healthcare, 16.4%. Unclassified pharmaceutical sales make up the remaining 4.2% of revenue. This broad geographic exposure should help insulate GSK against healthcare changes in any one country.

Revenue is similarly diversified by therapeutic area with Respiratory accounting for the most sales at 29%; Antivirals at 18%; Vaccines at 16%; Cardiovascular and urogenital at 10%; CNS at 8%; Antibacterials, 7%; Metabolic, 5%; Oncology and emesis, 3%; and unclassified at 4%. The company has also been expanding its research in biopharmaceuticals and has quintupled its biopharma R&D expenditures since 2006.

With the goods news out of the way, there are two risk factors that investors should consider before adding GSK to their portfolio.

Not Your Typical Dividend Aristocrat

GlaxoSmithKline doesn’t fit the profile of your typical dividend aristocrat. While the company generates large amounts of free cash flow and pays out generous dividends, it doesn’t exhibit the decades-long streak of continually increasing dividend payments that enchant many dividend investors.

Over the past six years, the company has cut the dividend once, but only by 1p, in 2004.

But how important are those streaks in making your investment decisions? Just ask investors of the bluest of the blue chips, GE, or many of the large financial stocks how their dividends faired. What is important are the prospects for the company going forward. The history of the company only benefits the past investors.

With GSK diversifying its revenue sources, surviving the worst of its patent cliff problems, and making a public commitment to returning cash to shareholders, the dividend should be safe in the future.

Exchange Rate Risk

The biggest risk for investors outside of Britain who are looking for income from GSK is the exchange rate risk. GSK is a British company and pays its dividend in pounds (GBP). While we saw above that GSK has been largely successful in paying out a substantial growing dividend when the exchange rate was factored in, U.S. investors saw a dividend that has fluctuated. It has increased from 2004 to 2007 before dropping from 2007 to 2009. Assuming stable exchange rates and GSK pays out the same amount in 2010Q4 as in Q3, then U.S. investors will receive of a dividend of about $2.03, which is an increase over the 2008 and 2009 amounts.

Because of the fluctuating nature of exchange rates, the income from GSK will be lumpy. The ride for investors might be bumpy but should ultimately prove to be profitable.

In summary, while GSK may not fit the profile of a traditional dividend aristocrat, it does meet the criteria in the Tweedy Browne study of a high dividend yield and low payout ratio implying good odds of investing success in the future.

Source: GlaxoSmithKline: An Atypical Dividend Investment