Although it is important to avoid focusing solely on the yields themselves, the market is still largely devoid of income-producing alternatives and will remain that way until yields in Treasury bonds see sustainable gains.
To capture the attractive dividends that can be found in the sector, investors need to avoid companies with shaky fundamentals and uncertain futures. It is all too easy to find examples of companies that have offered unsustainable dividend yields, and were forced to make sizable reductions later.
Dividend reductions can have drastic effects on stock values, so companies will generally wait to commit to increases in quarterly yield payouts until there is a good level of certainty that those payouts can continue to be made on a consistent basis. That is why younger companies with limited dividend histories are in a weaker position to make those commitments.
This is also why bigger (a higher dividend yield) is not always better. Ideally, we only want to invest in companies that exhibit stable cash flows and sustainable payout ratios, while offering attractive dividend yields for income investors at the same time. Here, we will test this idea by looking at two of the better-established companies in the pharmaceutical sector, and compare their dividend payouts with their fundamental outlooks.
Lower Yields, Stronger Outlook
GlaxoSmithKline (GSK) offers one of the biggest dividend yields in the pharmaceutical sector, at 4.3%. Its payout history is also impressive -- the company has shown a clear commitment to raising its dividend over the last four years. These increases have even come during times of severe earnings pressure, as significant legal costs in 2010 led to declines in earnings per share of more than 50%.
Glaxo's plans to keep dividends rolling, even when experiencing declines in earnings, have held coverage below two times prospective earnings, which is the security benchmark typically used to determine sustainable dividend levels. This year, Glaxo's earnings are expected to show gains of 2%, followed by an 8% increase in 2014. EPS improvements should help push dividends above the 5% mark, while at the same time keeping coverage below the safety reading.
While Glaxo will see a few of its patents expire in the next few years, the outlook for this stock remains supported by one of the most impressive product pipelines in the industry.
Glaxo has 14 drugs that are expected to enter the late-stage clinical data phase, and this provides a solid layer of protection against any revenue challenges that might be seen after the company's next patent losses.
Overall, Glaxo's drug portfolio will continue to generate continued upside in the stock's value, creating a stable picture for investors looking to capitalize on big pharma's high dividend yields.
Higher Yields, Cloudier Outlook
AstraZeneca (AZN) offers an even more impressive dividend yield, showing the highest levels in the pharmaceutical industry at 7.4%. But when we look at the company's fundamentals, we can see that the added yield does not come without its risks.
To be sure, AstraZeneca's 62% payout ratio is lower than what is seen at GlaxoSmithKline. But the company's cloudy outlook and shaky financials call into question the sustainability of these higher yield offerings.
Patent expirations are a common problem in the industry. But this is a difficulty that has posed even larger obstacles for AstraZeneca. After the company's patent for schizophrenia drug Seroquel expired, its year-over-year revenue for 2012 dropped by 17%.
The next critical patent expirations will be seen with Cresta and Nexium -- two of the company's bestselling products. With little else to be excited about in the drug pipeline, the outlook for AstraZeneca remains cloudy at best.
To help improve these prospects, AstraZeneca has shown interest in acquiring smaller companies to build on its stream of developmental drugs. At this stage, however, it is difficult to forecast where this company will be by the end of next year. This lack of potential stability removes many of the benefits created by higher dividend yields, and also makes it less likely AstraZeneca will be able to offer these yields longer term.
Look for Sustainable Yields From Strong Businesses
Big Pharma offers some of the market's highest-paying dividends. But as we can see when comparing GlaxoSmithKlein and AstraZeneca, bigger is not always better.
Sustainable yields are often preferable to higher yields, especially for investors with lower tolerance for risk. As a general rule, a solid business must be attached to those higher dividend yields before they should be considered as acceptable candidates for long-term investment.
At the time of publication, the author had no positions in stocks mentioned.
Richard Cox
06/11/13 - 01:13 PM EDT
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