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By Guan Wang

Drug manufacturing companies spend years and tons of money developing drugs that are superior to anything on the market. Once a drug is approved, that manufacturer can charge (within reason) just about whatever it wants. Obviously, there are some restrictions. The biggest of these is that the company has exclusive rights to the new drug only for a limited period of time. Once that patent expires, other companies can manufacture generic versions of the drug, potentially (read: likely) taking away from the revenue of the company that developed the drug in the first place.

In order to offset the negative impact of the expiring patents, drug manufacturers usually devote significant resources in developing new product lines. For example, Novartis AG (NVS) spent $9.6 billion in research and development last year, about 16.4% its sales. It seems to have paid off. In April 2011, the company announced plans to make regulatory filings for more than 60 new products through 2015. We think the gains from the new products will more than offset the losses from patent expirations and the decreasing sales of certain old products. The major new products launched by Novartis over the past few years include: Galvus, a treatment for diabetes; Gilenya, an oral treatment for multiple sclerosis; Tasigna, a treatment for leukemia; Afinitor, a drug for kidney cancer; and Menveo, a vaccine for meningitis. There are also many other treatments under different stages of development.

In addition to developing new product lines, Novartis has also been strengthening its position through acquisitions. In April last year, the company completed its acquisition of Alcon, a leading manufacturer of consumer eye care products. The total acquisition cost was about $50 billion. Novartis bought a 25% stake in Alcon from Nestle in 2008 and another 52% in 2010. It purchased the remaining shares last year for about $9.6 billion. We think the acquisition of Alcon will enable Novartis to achieve a much stronger position in the eye care market. The acquisition is also expected to create about $300 million of annual cost synergies. According to Novartis, head office and general & administration costs are expected to be reduced by up to 40%. Though the deal diluted shareholders' interest, Novartis planned to mitigate the dilution through share repurchases. In December 2010, the company announced to reactivate its $10.3 billion share buyback program, which was suspended in 2008.

Novartis also has an attractive dividend yield of 4.49%, more than double the 2% yield of 10-year Treasury bond. The company's earnings yield is around 7%, which means it pays out about 64% of its earnings as dividends. Analysts expect Novartis' earnings to grow at around 5% per year over the next couple of years. The relatively low payout ratio and the stable earnings growth of Novartis indicate that the company will be able to raise its dividends in the next few years. As a matter of fact, Novartis has been increasing dividend payments for 11 consecutive years. In February this year, Novartis raised its dividends from $2.3527 per share to $2.4601 per share. We expect the company will continue to do so in the future.

Major players in the drug manufacturing industry include Merck & Co Inc (MRK), Pfizer Inc (PFE), and Sanofi (SNY). Like Novartis, these stocks also pay attractive dividends - their dividend yields range from 3.94% to 4.73%. They are also trading at low multiples. Novartis is expected to make $5.49 per share in 2012 and $5.65 per share in 2013. Its forward P/E ratio is about 9.98, versus 10.23 for Merck, 9.89 for Pfizer, and 9.5 for Sanofi. Novartis' growth expectation is slightly higher. It is expected to grow at 4.78% annually, versus 3.4% for Merck, 4.76% for Pfizer, and 1.9% for Sanofi.

All in all, we like Novartis and hedge funds seem to agree. At the end of last year, of the nearly 400 hedge funds we track, there were 20 hedge funds with Novartis positions in their 13F portfolios. In total, they invested nearly $180 million in this stock. Money manager Ken Fisher had about $44 million invested in Novartis as of December 31, 2011. Jean-Marie Eveillard, Louis Navellier and Murray Stahl were also bullish about Novartis (see Louis Navellier's top stock picks).

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

Source: Dividend Focus: Novartis