5 Dogs Of Dow That Are Dividend Traps

by: MarketWizard

A sustainable competitive advantage, strong free cash flows, high dividend yield and a robust operating performance are conditions for divided investing. In my last article "5 Dogs of Dow to Buy", I analyzed 5 Dogs that have fundamentals strong enough to be in an investor's portfolio for 2012. In this article I will discuss the other 5 Dogs of Dow that have high dividend yields but suffer from operational issues, are more likely to cut dividends in future and are not worthy investments. These stocks are overvalued at their current levels on relative multiples and technical indicators. Investors looking for exposure in the respective industries are better off investing in other stocks.

Merck & Company, Incorporated (NYSE:MRK) is the world's second largest pharmaceutical company. It provides global healthcare in the form of prescription medicines, vaccines, biological therapy, animal health and consumer care products. Despite delivering nearly $46 billion in revenue in 2010 (with earnings per share of $3.42) and $10.7 billion as net income, the company is overvalued at its current price. Merck is trading at a Price to Earnings multiple of 28 times as compared with the industry average of 14. Changes in industry and company dynamics are going to depress the stock price. Though the company has new drug launches in the pipeline for 2012, 10 of its hit drugs will lose patent exclusivity by the end of 2013. This loss of patents will bring down total revenue by as much as $100 billion. In order to remain competitive, Merck will have to incur more R&D to offset losses with new drugs. In my view, this will bring down the high dividend payout of 110%. These factors may create pressure on the stock price and erode unrealized gains. The stock may be available at more attractive levels going forward. The price chart of Merck shows that the stock, currently near $37, is trading above its 90 Day Exponential Moving Average of $34.

E.I. du Pont de Nemours and Company (NYSE:DD) has a diversified product portfolio. It operates as a science and technology company worldwide in several segments: Agriculture & Nutrition, Electronics & Communications, Performance Chemicals, Performance Coatings, Performance Materials, Safety & Protection, and Pharmaceuticals. The demand for major DuPont products is primarily dependent on the macro-economic conditions. With the recent global recession, DuPont has witnessed a decline in revenue. Many of DuPont's divisions rely on raw materials, which are primarily hydrocarbon-based. Hydrocarbon prices' dependence on various macroeconomic and political factors makes them highly volatile. A spike in prices can put a downward pressure on DuPont's gross margins for some of its divisions. Additionally, rising environmental concerns, primarily relating to the paints & coating division, may have an impact of $1 billion of sales if restrictions over the usage of certain organic compounds are implemented. The company has maintained a dividend payout ratio of 45%, and carries a dividend yield of 3.2%.
DuPont's Relative Strength Index reveals an overbought level of 93.48. The fact is further fortified by the relative price multiples. The Price-to-Earnings multiple of DuPont is 13.85 times compared with the industry average of 10.9, and the Price-to-Sales multiple is 1.22 times compared with the industry's 0.54. The company's beta value of 1.62 shows the volatility of the stock price. Overvaluation, high volatility and uncertainty over the macroeconomic environment warrant a cautious stance on DuPont.

Johnson & Johnson (NYSE:JNJ) is engaged in research and development, manufacturing, and selling of various products in healthcare worldwide. The company recently announced its fourth-quarter earnings for 2011, reporting sales of $16.3 billion. This is 3.9% higher as compared with the fourth quarter of 2010. Net earnings and diluted earnings per share for the full-year 2011 were $9.7 billion and $3.49 respectively. J&J has been under pressure from the broader economic slowdown and has also faced internal problems, such as quality-related product recalls over the past two years. Though sales have been stable, pre-tax charges of litigation settlements and product liability expenses have hurt the bottom line. J&J is trading at a Price-to-Earnings multiple of 18.8 times against the industry average of 14. Additionally, its Price-to-Sales multiple of 2.76 times is higher than the industry average of 1.8. Both these multiples depict an overvaluation at the current price of around $66. The PEG ratio of 2.08 compared with the industry's 0.97 also shows that, when buying J&J, investors will be paying more for the potential growth prospects. J&J gained 6.5% during the trailing six months (August '11-January '12) compared with DJIA's return of 17% for the same period. Although J&J maintains a dividend payout ratio of 64%, with upward potential and stable profit margins, I still believe that investors are better off investing in other industry players that are cheap at their current valuation.

General Electric Company (NYSE:GE) has a product portfolio that includes products and services related to aircraft engines, power generation, water processing, household appliances, medical imaging, business and consumer financing and industrial products. The company's diverse product offering shields the company's stock from sensitivity to any particular market. GE's industrial businesses are struggling due to pressure on prices from competition and weak demand, impacting margins and profitability. The company's fourth-quarter (pdf) revenue, for 2011, fell 7.9% to $38 billion from $41.23 billion a year earlier. Profit also fell to $3.7 billion from $4.5 billion in same period last year. General Electric is trading at a Price-to-Earnings multiple 15.3 times compared with the industry average of 11.8. Its Price-to-Sales multiple of 1.36 is higher than the industry average of 0.66. Both these multiples illustrate an overvaluation at the current price of around $19. The company is trading above its 90-day Exponential Moving Average of $17 and is a highly volatile stock as evident from its beta of 1.95. Other players in the industry, such as Siemens AG (SI), provide better investment opportunities. Siemens is trading at better relative multiples than General Electric.

Pfizer, Incorporated (NYSE:PFE) is the world's largest pharmaceutical company. The company offers prescription medicines for humans and animals worldwide. Pfizer's 2011 fourth-quarter profit declined 50% as sales of its widely used cholesterol drug Lipitor fell. This sales decline was as a result of losing patent protection on Lipitor. Pfizer, in the face of generic competition stemming from the lost patent protection, has aggressively marketed Lipitor by offering price discounts. Despite these efforts, further loss in sales is expected as health payers encourage greater use of generic medicines. The company's implied Sustainable Growth, from a dividend payout of 63% and ROE of 11.45%, is 5% compared with the industry growth rate of 14%. In order to compete with the industry, Pfizer would need to cut back on its dividends to retain earnings for expansion. Now with the patent protection is gone, the company will have to invest more in R&D to develop new drugs. In my view, cuts in the payout ratio may disinterest investors and create selling pressure on the stock. The stock is slightly overpriced on its Price-to-Earnings multiple of 14.9 times against the industry average of 14. But it is expensive on its Price-to-Sales multiple of 2.41 times against the industry average of 1.8. Though Pfizer is taking drastic steps to tackle its issue, I believe that once the full impact of the patent loss sets in, the company will lose more in terms of revenue. This drop in revenue, thus earnings, and the factors outlined above make Pfizer an unattractive investment.

Investors should have a look at following 5 Dogs, which offer high dividend yields, have market leadership and are expected to maintain their payout ratios: Intel Corporation (NASDAQ:INTC), Verizon Communication (NYSE:VZ), Chevron Corporation (NYSE:CVX), Procter & Gamble (NYSE:PG) and AT&T (NYSE:T).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.