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Back to Part XXIV - Americans' Addiction to Drug Companies

By Mark Bern, CPA CFA

We are nearing the end of this series, so if you are a regular reader, you can feel gratified that you are nearly through my entire list of preferred, quality companies. While my list does not cover all industries and, thus, does not contain all quality companies available for consideration, I believe you'll agree that it does provide investors with a lot of great companies from which to choose. If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

This is the second installment of my assessment on the pharmaceuticals (drug) industry. In the first installment, I provided some background information about how the industry is changing to give readers a better understanding of my perspective. This article will contain the next five companies and conclude with a brief discussion as to why other companies in the industry did not make the list.

One thing investors should be aware of is that many countries require taxes to be withheld from dividends. If you are investing through a tax-deferred account, getting those taxes returned is, in many cases, impossible. If you are investing through a taxable account, you can at least claim a foreign tax credit on your income tax return. So, be aware of the tax treaties between the U.S. and country in which your target country is domiciled. This article is a good reference for the rates of withholding by country. Here is a link to the IRS page that explains tax treaties.

My next company featured is Novartis (NYSE:NVS). Headquartered in Switzerland, NVS offers a wide range of products including diagnostic and vaccines, pharmaceuticals and health-oriented consumer products. Novartis is not immune to the trend of having blockbuster drugs coming off patent. As a matter of fact, NVS has registered a decline in revenues over the past five years. However, I believe that the company is now better prepared to weather that storm with more a significant number of new products in its drug pipeline that include some promising potential offerings in the areas of vaccines and cancer. The company has a good record of winning approval of new pharmaceutical products, and I expect that trend to continue for the foreseeable future. I believe that the new products will more than offset the revenue losses producing reasonably consistent growth prospects. Let's look at the metrics.

Metric

NVS

Industry Average

Grade

Dividend Yield

4.1%

3.5%

Pass

Debt-to-Capital Ratio

18.0%

18.0%

Pass

Payout Ratio

58.0%

40.0%

Fail

5-Yr Average Annual Dividend Increase

22.4%

N/A

Pass

Free Cash Flow

$1.14

N/A

Pass

Net Profit Margin

15.8%

19.0%

Neutral

5-Yr Average Annual Growth in EPS

4.5%

2.0%

Pass

Return on Total Capital

13.4%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

-3.4%

1.3%

Fail

S&P Credit Rating

AA-

N/A

Pass

Two fails, one neutral ranking and seven passes make Novartis a borderline case. There are things to like about NVS, but the stock has run up recently, and I believe it is somewhat overvalued for the potential return. My five-year price target for NVS is $75 which would result in an average annual total return of about 9 percent.

The next company on the list is Abbott Labs (NYSE:ABT). ABT operates in four segments: Pharmaceutical Products, Diagnostic Products, Nutritional Products and Vascular Products. The company plans to spin off the pharmaceutical segment with the new name of AbbVie which accounted for about 45 percent of sales and 69 percent of operating cash flow in 2011. Stronger margins and cash flow along with a likely lower growth profile probably means that this will be the higher yielding of the two new companies. The remaining company will retain the current name and will likely appeal more to growth investors. I expect that the new spinoff company, AbbVie, will continue to provide good stability and yield. Let's look at the metrics.

Metric

ABT

Industry Average

Grade

Dividend Yield

3.1%

3.5%

Neutral

Debt-to-Capital Ratio

39.0%

18.0%

Fail

Payout Ratio

40.0%

40.0%

Pass

5-Yr Average Annual Dividend Increase

9.8%

N/A

Pass

Free Cash Flow

$2.47

N/A

Pass

Net Profit Margin

18.9%

19.0%

Pass

5-Yr Average Annual Growth in EPS

13.1%

2.0%

Pass

Return on Total Capital

20.5%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

11.1%

1.3%

Pass

S&P Credit Rating

AA

N/A

Pass

One fail, one neutral ranking and eight passes is a great showing. The debt is a little high, but manageable. I would have to say that whether I would recommend hanging onto either of the two companies after the split will depend upon the how the capital structure of the two companies turns out. While it earns a place on my list, I rate the company as a Hold. The share price has run up lately, and I believe it to be a bit overvalued. I do not have a price target because of the impending split, but I suspect that if an investor owns the stock now, I would expect an average annual total return of about seven percent. There are better choices available in this industry, in my opinion.

Sanofi (NYSE:SNY) is the largest drug company in continental Europe and the fifth largest in the world. The company expects to lose more than $2 billion in sales to generic competition to blockbuster drugs that have come off patent. But the company is making strong headway with its recent acquisition of Genzyme and should begin to see profit improvements again in 2013. The company is well-positioned in China, which I expect to become the second largest market for drugs in just a few years. Its "patent cliff" will mostly be behind the company by sometime in 2013. Let's look at the metrics.

Metric

SNY

Industry Average

Grade

Dividend Yield

4.2%

3.5%

Pass

Debt-to-Capital Ratio

18.0%

18.0%

Pass

Payout Ratio

23.0%

40.0%

Pass

5-Yr Average Annual Dividend Increase

11.3%

N/A

Pass

Free Cash Flow

$1.51

N/A

Pass

Net Profit Margin

17.8%

19.0%

Neutral

5-Yr Average Annual Growth in EPS

8.9%

2.0%

Pass

Return on Total Capital

8.9%

12.5%

Neutral

5-Yr Average Annual Growth in Revenue

7.0%

1.3%

Pass

S&P Credit Rating

AA-

N/A

Pass

Two neutrals and eight passes would rank among the best. The two neutral rankings are related, though. The fact that the company has produced a net margin below average is reflected in the underperformance in the return on total capital category. Neither is disturbing, especially when one considers that the debt level is right at the relatively low level of the industry. The best part is that the payout ratio is low while the dividend is already well above the industry average with plenty of room for the outstanding annual increases to continue. But I don't expect much price appreciation for current levels, as the price has gotten ahead of the valuation. My five-year target price for SNY is $48, which would result in an average annual total return of about 7.5 percent.

Bristol-Myers Squibb (NYSE:BMY) has done well for those investors who purchased since the lows of 2009, but then again, so have most stocks. Looking back further to the high of 2001 at $75.30 per share, recent gains provide little solace to long-term investors. The dividend has done more in that department, having averaged above 4 percent in each year during the span since 2003. The better news for investors is that the future looks brighter now that it has for some time. BMY's pipeline looks more promising; some of the more promising pipeline candidates are Sprycel (for leukemia), Abilify (schizophrenia), Sustiva (immunodeficiency virus Type 1), Orencia (rheumatoid arthritis), Reyataz (HIV) and Yervoy (melanoma). Several of these have the potential to hit $1 billion in annual sales or more. BMY's new blood thinning agent, Eliquis, could help fill the gap left by Plavix, which has gone off patent. All in all, the dividend looks secure and likely to climb. However, BMY has had the tendency to increase the dividend slowly, and often in steps that have left the dividend flat for several years at a time. This one is for investors looking for good yield that will rise slowly combined with a little appreciation potential and above average safety to principal. Let's look at the metrics.

Metric

BMY

Industry Average

Grade

Dividend Yield

4.2%

3.5%

Pass

Debt-to-Capital Ratio

24.0%

18.0%

Neutral

Payout Ratio

61.0%

40.0%

Fail

5-Yr Average Annual Dividend Increase

3.5%

N/A

Neutral

Free Cash Flow

$0.92

N/A

Pass

Net Profit Margin

17.5%

19.0%

Neutral

5-Yr Average Annual Growth in EPS

21.7%

2.0%

Pass

Return on Total Capital

18.3%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

6.7%

1.3%

Pass

S&P Credit Rating

A+

N/A

Pass

One fail, three neutral rankings and only six passes is not a great showing. If it were not for the promise of the pipeline, I would not consider BMY for the list. The fail comes from the payout ratio being significantly higher than the industry average. But that ratio has come down by ten percent in just the last year even with the dividend increase. It is likely to continue to fall, however more gradually, over the next few years as EPS prospect improve as the margin continues to rise. My five-year price target for BMY is $42, which would translate into an average annual total return of about ten percent.

My final company to make the list from this industry is Medicis Pharmaceutical (MRX) which offers both prescription and non-prescription products to treat dermatological conditions. The company has an interesting stated growth strategy which encompasses a sort of an "all of the above" approach within a relatively narrow niche: expanding sales of existing brands; launching new products from R&D efforts; acquisitions of complimentary products and businesses; and collaboration. This is a relatively small company compared to the behemoths of the industry at which we have been looking. However, the company grades out well with two concerns: a low dividend and a past habit of not consistently raising its dividend consistently. I expect that the latter problem will remain in the past, but I am not as convinced that the yield will rise as far or as fast as I would prefer; more on that in a minute. Let's see how MRX grades out.

Metric

MRX

Industry Average

Grade

Dividend Yield

1.2%

3.5%

Fail

Debt-to-Capital Ratio

<1.0%

18.0%

Pass

Payout Ratio

11.0%

40.0%

Pass

5-Yr Average Annual Dividend Increase

21.7%

N/A

Pass

Free Cash Flow

$2.32

N/A

Pass

Net Profit Margin

22.2%

19.0%

Pass

5-Yr Average Annual Growth in EPS

24.5%

2.0%

Pass

Return on Total Capital

19.3%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

15.0%

1.3%

Pass

S&P Credit Rating

NR

N/A

Neutral

One Fail and one Neutral against eight pass rankings is one of the best report cards in this industry. The Neutral ranking comes from not having enough debt to be rated by S&P, so I really should not count it. This brings us back to the concern over the low dividend yield. One could argue that there is ample room for future dividend increases because the payout ratio is so low, and they would be right. My concern is that there are many other options in the industry that offer much higher yields, but few offer as much potential growth due to improving revenue and EPS. This one is more suitable for the growth-oriented investor looking for capital gains as it does, even with minimal debt, carry more risk due its size and lack of diversification. Still, I cannot disregard management's consistent growth since 2006 and the potential for more of the same going forward. My five-year target for MRX is $48.50 per share, which equates to an average annual total return of about 11 percent.

First off, I will reiterate for new readers that I do not include companies that do not pay a dividend nor do I include companies that pay either a flat dividend that does not rise consistently or a dividend from which the yield is much below one percent. This is, after all, the "dividend investor guide" by name, and I feel it important to stick with that rule. I also do not allow companies that have recently cut the dividend or that have cut dividends multiple times in the past. That, to me, exhibits less than satisfactory management of the capital structure and resources of the company. Pfizer (NYSE:PFE), the world's largest drug company fails to make the list on that basis. But PFE has another concern for me, with the payout ratio at 72 percent compared to the industry average of 40 percent, a net margin of 12.9 percent (19 percent industry), negative EPS growth over the last five years of (11.6) percent per year, the return of total capital is only 8 percent (12.5 percent industry), and then the dividend is down an average of 3.5 percent a year from 2006 to 2011. This represents far too many failings to make the list.

Merck (NYSE:MRK), Allergan (NYSE:AGN), and Ely Lilly (NYSE:LLY) all fall into the flat dividend category. If course, AGN does not pay much of a dividend, it would be disqualified on that basis also. I also expect MRK to report anemic growth over the next five years and look for total return to come almost solely from the dividend. GlaxoSmithKline (NYSE:GSK) has seen its revenues flatten, experienced zero growth in EPS from 2006 to 2011, has debt equal to 58 percent of capital (compared to an industry average of 18 percent), a relatively high payout ratio of 60 percent (40 percent industry), and the dividends for U.S. investors have been fluctuating due to unfavorable currency exchange movements. It's not a bad company, but I just can't put it on the list unless I see some significant, consistent improvements in these areas.

A bit more on LLY, for those who are interested; the dividend has been flat at $1.96 since 2009, and I doubt seriously that it will be increased over the next five years. LLY will face more patent expirations over the next two years including Cymbalta, Humalog, and Evista which combine for roughly 30 percent of 2011 revenue. I just think investors can do much better elsewhere.

I have not been covering one other company that I need to consider, Novo Nordisk (NYSE:NVO). I will report on this company at some point in the future since my first take on the company is positive. I apologize for not including more about NVO here, but I really need to go back into the financials for the last few years and take some time to look into the pipeline to understand future prospects.

That concludes my assessment of the pharmaceutical industry. I hope you are finding this series interesting and informative. If you would like to read my assessments on other industries, a complete list of all articles in this series is available with the articles listed both chronologically by date of publication and by industry in my blog titled, "The Dividend Investors' Guide to Successful Investing Index Concentrator." As always I welcome comments and will attempt to answer any questions. The exchange of information is always welcome and it is how we all become better informed investors.

Source: The Dividend Investors' Guide: Part XXV - America's (Continued) Addiction To Drug Companies