Biotech Deserves A Piece Of Every Dividend Growth Portfolio

| About: Amgen Inc. (AMGN)


Amgen has become one of the best dividend growth stories of the past 5 years, that story will continue.

Gilead Sciences is following in Amgen's footsteps and already offers a solid yield at current prices.

In addition to their attractive dividend prospects, both Amgen and Gilead Sciences reward shareholders with share buybacks.

These activities are supported by their excellent balance sheets, superb cash flow generation, and attractive growth prospects.

Taking into account their projected EPS growth rates and potential for dividend growth, both companies, but in particular Gilead Sciences, are attractively valued relative to the market.

Amgen (NASDAQ:AMGN): A Dividend Growth Success Story

Amgen became a pioneer in the biotech world when it became the first large biotech stock to begin paying a regular dividend in 2011. In the years since, it has become one of the best dividend growth stories of the market, increasing its dividend by an average of 29% annually over the last five years, including a 26.6% dividend increase announced already for this year. Following that recent increase, Amgen now yields 2.6%, making it attractive as an equity income stock not only because of its rapid dividend growth rate, but also due to its attractive yield relative to the overall market.

It's also important to note that Amgen's yield has been substantially muted by the rapid growth in its stock price. For long-term investors in the stock, their current yield to cost basis is fantastic. For example, if you had bought Amgen's stock at the end of 2011, when it closed out the year trading at $64.21, the current $4/share annual dividend gives you a yield to cost of 6.2%. The stock's 5 year trailing return of 23.8% (through Friday's close) has not quite kept up with the pace of dividend increases, but it's been kept close enough to prevent Amgen from becoming a high yield stock. As an investor, that kind of performance is certainly nothing to be displeased about. However, when evaluating a stock from a dividend growth perspective, I believe it is important to look at the yield on cost, essentially removing the impact of capital appreciation. From that perspective, Amgen has few peers. As mentioned above, Amgen's current dividend payout yields 6.2% relative to its 2011 year end price. Relative to its 2012 year end price, it's a 4.6% yield, and relative to year end 2013, its 3.5%. Relative to the end of 2014, the current dividend represents a 2.5% yield as the stock price has marginally declined since that time.

Looking at its financial situation, Amgen has no red flags on its balance sheet. While it carries some debt, it also has a hefty cash pile and essentially operates from a net cash position. Furthermore, Amgen generates excellent free cash flow, ~$8.8 billion over the trailing 12 months, easily covering dividend payments and its buyback activities with plenty of cushion left over. After accounting for the hike going into effect later this quarter, the dividend is expected to represent 37.5% of consensus expectations for 2016 earnings. That is a more than reasonable payout ratio, particularly in light of consensus expectations for the company to grow earnings long-term at a rate of 9.5%, suggesting that Amgen is quite capable of continuing its above average dividend growth in future years.

Gilead Sciences (NASDAQ:GILD): Following in Amgen's Footsteps

Gilead Sciences only became a dividend stock recently, making its first dividend payment in June 2015. However, despite its relatively brief dividend payment history, Gilead is more than deserving to be considered for any dividend growth portfolio. First of all, despite only initiating its dividend earlier this year, the current payout is competitive with the overall market, with the recent decline in Gilead's stock price pushing its yield up to 1.9%. While not particularly attractive on an absolute basis relative to the overall market, that's an impressive starting point for a new dividend payer. The important question with Gilead is whether or not it will choose to follow in the footsteps of Amgen and reward shareholders with years of above average dividend growth. This coming May will provide very important clues for investors as Gilead will make an announcement regarding its June dividend at that time, the likely point at which the company would announce a hike as it will mark the anniversary of its first payout.

In my opinion, Gilead will announce a substantial dividend hike at this time, similar in size to those announced by Amgen over the past several years. This will mark an important moment for the stock for multiple reasons. First, and most obviously, a sizable increase could make Gilead's yield attractive on a current income basis relative to the overall market. An increase of 30% to the dividend, consistent with the type of increases we have seen from Amgen, would give Gilead an above average yield of nearly 2.5%. More importantly, a sizeable increase acts as an important signal to the market that dividend growth is something they intend to pursue as part of the company's strategy moving into the future. This has the subsequent impact of opening the door to the massive world of dividend growth investors, many of whom are currently on the sidelines on the stock waiting for the company to declare its dividend growth intentions. In fact, Gilead is not eligible as an investment for many dividend strategies until it shows evidence of dividend growth, a requirement fulfilled for many if it hikes later this year.

The important question is whether Gilead's current financial situation supports my contention that the company will announce a sizeable increase to the dividend in early May, and, on a longer term basis, above average dividend growth well into the future. From a balance sheet perspective, Gilead does not have any issues to speak of. Despite a $10 billion debt issuance in 2015, debt levels are easily manageable and the company has a heft cash hoard topping $15 billion. On top of that, Gilead is a free cash flow machine, generating nearly $18 billion over the trailing 4 quarters. In addition, the current dividend payout represents under 15% of expected 2016 earnings and current consensus forecasts project a long term earnings growth rate of 14.1%, adding to the case that it is primed and capable of delivering on a significant dividend hike later this year and multiple years of above average dividend growth in the future.

Share Buybacks Offer Further Proof of Friendly Intentions to Shareholders

While the focus of this article is more towards Amgen's impressive dividend growth track record and the potential for a similar future from Gilead Sciences, it should also be noted that both companies have substantially rewarded shareholders in recent years via significant repurchases of their own stock.

In Gilead's case, in 2014 the company put its free cash flow to work, reducing shares outstanding by just over $5 billion. Through the first 3 quarters of 2015, they have reduced net shares by ~$6.6 billion. While it's important to evaluate this relative to the company's market cap of just over $132 billion, the company's efforts remain significant. Investors should expect this treatment to continue as Gilead announced a new $15 billion/3 year buyback extension in early 2015.

Amgen's history of buybacks has been choppy, but they appear to have developed a more consistent approach in recent quarters. The company bought back a net of $15 billion in stock from 2010 - 2012, which, it should be noted was at much lower prices than the stock currently trades at. However, Amgen bought back just a little over $800 million in 2013 and actually had a small net issuance in 2014 due to a suspension in buybacks while it absorbed the $10 billion acquisition of Onyx Pharmaceuticals. The company said it planned to buy back $2 billion worth of stock in 2015, and it appears well on track to do so, having repurchased $1.7 billion through the first 3 quarters of the year. Given the company's past history, I feel it's reasonable to expect elevated buyback activity to continue in the absence of the company making another major acquisition.

Compelling Valuation Makes Now the Time to Buy Gilead

While I believe the case for the dividend growth potential for both Amgen and Gilead Sciences has been made, as well as further evidence of the shareholder friendly nature of the companies as evidenced by their respective buyback activity, the question is whether or not now is the time to be a buyer of the stocks? Thanks to the recent pullback in the market, both companies are trading at attractive valuations, in particular Gilead Sciences, suggesting that each offers significant capital appreciation potential along with the dividend growth potential highlighted above.

Following the recent pullback in its shares, Gilead trades at an extremely attractive valuation of just 7.6x consensus earnings estimates for 2016, a significant discount to the overall market and its peers. That seems amazing considering that current consensus expectations are for a long term earnings growth rate of 14.1%. In addition, this is not a situation where earnings expectations for the company are declining, with consensus earnings expectations for 2016 up 11.1% from the level where they were a year ago. Lastly, it should be noted that consensus has consistently underestimated Gilead, with the company topping consensus expectations in each of the last 4 quarters, including an earnings beat of 26.6% when it reported in Q1, a beat of 16.2% in Q2, and a beat of 12.3% in Q3. The ultra-low valuation the stock currently trades at, its impressive growth expectations, a positive trend of increasing earnings expectations, and a track record of topping expectations all suggest this is an excellent entry point to be buying shares in the stock. This is further backed up by the company's excellent balance sheet, superb free cash flow generation, and its anticipated emergence as a dividend growth story. Given its compelling valuation and potential catalyst as an emerging dividend growth story, I view this as an excellent entry point to buy the stock for long term investors interested in dividend growth and capital appreciation. In addition, it is my belief that given the current extreme nature of the stock's undervaluation relative to the overall market and peers, along with the potential catalyst of a dividend hike in early May, Gilead offers the opportunity for significant capital appreciation in the near term as well.

Amgen Looks Attractive at Current Levels

Amgen doesn't command as jaw-dropping of a valuation as Gilead, but it is certainly not expensive either at 14.6x consensus earnings estimates for 2016. In addition, this valuation is supported by consensus expectations for a long-term growth rate of 9.5% for the company, as well as its impressive history of dividend growth. As with Gilead, expectations for Amgen's earnings have been rising, with consensus estimates for 2016 up 1.9% from their level this time a year ago. Not a major increase, but a positive sign when expectations for many companies have been falling over the past year. Also like Gilead, Amgen has shown a regular ability to top expectations, beating consensus expectations in each of the last 5 quarters, including an earnings beat of 17.5% over expectations in Q1, 5.9% above expectations in Q2, and 14.4% above expectations in Q3 so far in 2015. The slight discount relative to the market at which the stock currently trades, the positive trend of increasing earnings expectations, and its track record of beating earnings expectations suggest this is a stock investors should keep a watchful eye on. This is further supported by its strong balance sheet, excellent free cash flow generation, above average dividend yield, and a 5 year+ history of impressive dividend growth. Long-term, I don't think you are going to go wrong picking up Amgen at its current valuation, particularly as its proven track record of dividend increases makes it a compelling stock for dividend growth investors. That being said, in the near term, I believe Gilead's more compelling valuation offers superior return potential. However, I would become an aggressive buyer if Amgen stock fell back to the $140 range, at which point it would trade at just over 13x consensus earnings estimates for 2016 and offer a nearly 3% dividend yield.

Disclosure: I am/we are long GILD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I initiated a small position in Gilead Sciences (GILD) following the recent pullback and will continue to build that position while the stock remains undervalued relative to the market. As discussed in the article, I would look to initiate a position in Amgen (AMGN) if the stock fell back to the $140 area.