Why We Prefer Novartis To Gilead

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About: Novartis AG (NVS), Includes: GILD
by: Individual Trader
Summary

We've done a comparison of Novartis vs. Gilead.

We still prefer our pick despite its higher valuation.

Gilead, despite all the soundbites about its cash flows, has a much weaker balance sheet than Novartis.

Irrespective of the probable short-term duration of the impending bubble in U.S. equities, many long-term investors will undoubtedly ignore short-term noise by keeping their focus on the big picture. That's why for any newsletter that is selecting stocks at present, the companies in question need to be able to stand up to long-term scrutiny. Why? Because many investors will not sell especially if the company in question is a dividend growth stock.

In this article, I'm going to compare one of our holdings, Novartis (NYSE:NVS), with Gilead Sciences (NASDAQ:GILD) as both are at present dividend growth stocks. I wrote an article recently about Gilead in which I went through a short-term trading strategy. I like trading Gilead over a shorter-term horizon where stop-losses are clearly defined. However, as an intermediate to longer-term hold, I prefer Novartis for a number of reasons. Let's go through them one by one.

Many Gilead bulls immediately point to the huge dividend growth rate since the dividend was initiated in 2015. The annual payout has gone from $1.29 in 2015 to now $1.98 annualized when calculated over a 12-month trailing average. Furthermore, even with this now 53% growth already in the dividend, Gilead's payout ratio stands at 21%. That means it has ample cash flow to keep raising the payout.

When the aforementioned numbers are compared to Novartis' numbers, it appears as if Gilead is the clear winner from an income standpoint. Novartis' payout ratio is currently reported at 99%, and its dividend per share has only risen only 7.6% when averaged out over an annualized three-year period. However, income investors in this sector forget that Novartis' dividend yield remains a strong 3.19%. This yield is both above the industry's average yield (3.1%) and the S&P's 2% number.

However, the payout ratio reported for Novartis is not accurate, in my opinion. Earnings do not pay dividends, but cash does. Therefore, if we calculate Novartis' payout ratio on its 2016 numbers, we can see that it actually came in at 67%. $6.38 billion was paid out in dividends and $9.47 billion of free cash flow was generated. We need to calculate Novartis' dividend like this as the dividend is only paid out once a year. Therefore, Novartis' dividend growth prospects are not as poor as many believe.

Many of the above numbers deal with what has already happened. Yes, the payout ratio can give us some hint as to future dividend increases, but I prefer to look at the debt/equity ratio, projected earnings growth and interest coverage. These metrics illustrate potential future cash flow levels and liquidity. Let's see how both companies shape up at present.

Debt To Equity Interest Coverage Projected Earnings/Next 5 Years
Gilead 1.16 16.39 - 7.0%
Novartis 0.33 11.66 +7.25%

What is interesting here is that before Gilead made its latest acquisition, every analyst was going on about the company's huge cash pile. Nevertheless, Novartis has 3x more equity on its balance sheet when compared to its debt. Both companies have similar levels of debt, but what makes Novartis stand out with respect to having a superior balance sheet is its intangible assets, which came in at over $60 billion last quarter. This line item in this sector is normally made of patents and the like. One day many of Novartis' patents will expire, but the steady growth curve of this line item over the past decade is why I remain interested in this stock.

Furthermore, the new CEO Vas Narasimhan, who has extensive experience in drug development, seems to me to be the right person to keep the company's intangible assets growing over time through solid acquisitions. Gilead's intangible assets incidentally come in at around the $10 billion mark. Gilead has made a sizable acquisition (Kite Pharma) in the cell therapy area, but it needs far more diversification to compete with the likes of Novartis, in my opinion.

Both companies have healthy interest coverage, which basically means dividends are not at risk anytime soon. When the figure is over 10, it basically means any interest payments are being easily covered by pretax profits. However, this is today. Look at what consensus is expecting from both companies growth-wise over the next five years. If these growth projections come to pass, one is actually looking at an annualized 14% average earnings difference over the next five years.

Gilead has the liquidity at present, but the lack of equity on its balance sheet is a worry -- especially if negative earnings growth over a sustained period of tie really does occur. Novartis is an investment for the long haul because of its pipeline, balance sheet and stronger dividend. Irrespective of Gilead's much cheaper valuation, I still see more upside in Novartis.

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Disclosure: I am/we are long NVS. 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.