March 28, 2009 by Jamie Coonce, Amanda Repp, Rob Weigand and Cheng Xi.
The 2008-09 bear market has created some apparent dividend plays in certain industries, big pharma among them. Widows and orphans, tax-free endowments and pension funds should naturally be interested in these opportunities. We took a look at 4 compelling dividend yields and analyzed which stock was best in class in terms of financial stability and the ability to maintain the high dividend payout throughout the downturn and over the long run (10 years or longer). The analysis below suggests that at Friday’s closing price of $32.38, Astrazeneca’s dividend is best in class and the one most worth chasing. Note that this forecast focuses only on sustainable dividend yields, and does not include a prediction regarding future price appreciation.
We compared Merck (MRK), Pfizer (PFE), Astrazeneca (AZN) and Eli Lilly (LLY). The chart below shows that MRK, PFE and AZN currently have the best yields, although PFE’s expected future yield falls due to their announcement that they intend to cut their dividend in half to help finance the merger with Wyeth.
High, sustainable return on invested capital (ROIC) is a key variable in our stock selection process. The chart below shows that both historically and in our forecasts, AZN and PFE are the clear winners in this category.
We believe the market also prices in more conventional earnings and margin metrics; we therefore compared the 4 firms based on net profit margin. LLY’s margins fell through the floor after their poor earnings performance in 2008, and MRK’s margins have been declining for several years. AZN’s margins are the most stable, while our forecasts indicate that PFE’s margins could be best in class if all the proposed synergies and cost savings with Wyeth materialize (although these big mergers rarely work out as well as management expects, we’ll give them the benefit of the doubt for now).
With their lower dividend yields, lower ROIC and lower margins, MRK and LLY are starting to fall behind in our little horse race experiment. We next calculated two financial fitness “scorecards”: the 11-point Piotroski score and Ed Altman’s probability of bankruptcy Z-score. Once again, PFE and AZN move to the top of the group. AZN scores a solid 10 out of 11 on the Piotroski score, with PFE and MRK scoring a respectable 7. LLY lags with a score of 6. AZN and PFE are solidly healthy according to the Altman test, with scores of 3.98 and 4.22, respectively. MRK lags a bit with a score of 3.01, and LLY falls into Altman’s “grey area” of concern, with a low score of 1.86. Based on our preference for holding financially stable stocks, we eliminated LLY at this point.
We next examined each company’s Economic Value Added (EVA), which measures the extent to which firms are earning an economic profit, i.e., have the greatest amount of total capital deployed that is earning the largest spread of return on capital above their cost of capital. Historically PFE’s EVA is largest, while AZN shows steady EVA momentum. MRK clearly lags, with their EVA contribution turning negative in 2007, and tailing off in our 10-year forecasts.
We looked at each firm’s Enterprise Value/EBITDA ratio to determine if there were any compelling bargains in terms of relative valuation. MRK would appear to be the big bargain, but as if often the case, we believe their low relative valuation reflects their poor prospects going forward. AZN still appears to be reasonably priced (their 1-year trailing P/E ratio is 7.7 compared to PFE’s 11.8). Our analysis indicates PFE has the best potential for future margin expansion, but that’s contingent on perfect execution with the Wyeth merger.
Conclusion: If you’re looking for a high dividend yield stock with reasonable upside potential, AZN is the stock for you. AZN beats PFE, LLY and MRK in terms of current yield, ROIC and profit margin, and is slightly more financially stable than PFE, whose management has a lot on their plate in managing the merger with Wyeth. If that merger works out as forecasted — a rarity in markets — PFE probably has the most upside price potential. But in terms of a pure dividend play, AZN’s decision to raise dividends in 2009 by a full 10% confirms our analysis that their current large dividend yield is the safest and most sustainable in the sector.
Proponents. It is probably no surprise that President Obama’s economic stimulus package is attracting at least as much criticism as support. One of the package’s few outright advocates, Robert Aliber, Professor Emeritus of International Economics & Finance at the University of Chicago School of Business, considers the plan a good deal overall. Professor Aliber calls it “80% ideal and 20% baggage.” He is particularly keen on the large tax cuts that should lead to an increase in both household spending and an improved sense of optimism, which he predicts will result in noticeable improvements in the economy in the near term.  CNN’s Ted Barrett and David Goldman echo the more widespread sentiment that there is no true optimism for the bill. They report that few proponents of the stimulus package are in love with every provision in the bill, but support it more because they feel it is necessary. 
Skepticism. Expert opinion is mainly confined to varying degrees of skepticism. CNBC Mad Money’s Jim Cramer asserts that the stimulus bill is essentially useless in confronting any real economic problems. Cramer referred to the package as an “utter joke,” because it comes up short on job creation, falling home prices, and the banking crisis.  Michala Marcussen from Societe Generale Asset Management shares Cramer’s sentiments – she claims that a lack of transparency about the details of many of the bill’s provisions are fueling pessimism and the negative market reaction. The bill is essentially long on ideas and short on concrete details. Pierre Gave from Gavekal Holdings agrees that the lack of information is causing many to express reservations.  James Falkiner, director & CEO of Falkiner Global Investors is not optimistic about the short term effects of the stimulus package. Most experts are in agreement that consumers will continue to save money to shore up their personal balance sheets. 
Market Reaction. US and global markets have not responded well to the stimulus bill. Laura Mandaro of Dow Jones MarketWatch observed a few weeks of mixed sentiment surrounding a second economic stimulus package manipulate the benchmark indexes. She asserts that optimism fueled a rally in stocks during the first week of February, but the S&P 500 Index and Dow Jones Industrial Average gave back most of those gains in the past two weeks with some spectacular intraday dives on February 10th and 12th, due to anxiety that the stimulus would fall short.  Bill Rhodes, chief investment strategist at Rhodes Analytics, maintains that people are concerned about the provisions of the stimulus package and about how they are going to play out. This investor pessimism about the US economy pushed the S&P 500 down 5 percent during the second week of February, and left the Dow at its lowest close since November 20.  Mark Luschini, Chief Investment Strategist at Janney Montgomery Scott, asserts that at some point the stimulus will instill some confidence in the economy that the markets can grasp onto. However, the investment community is waiting for positive prospects of the effectiveness of the government interventions. Investors are showing skepticism about whether these government injections are worth their face value. Luschini holds that the market is currently retracing its steps. It is returning the gains made in January when after benefitting from expectations that the market would recover.  In the 10 trading days following February 13, the Dow lost over 600 points (7.6%), and the S&P has followed giving up 8%, or nearly 70 points.
Breakdown. The stimulus bill allocates spending to three roughly equal sectors of the economy. The Congressional Budget Office reports that $308.3 billion, roughly 39%, is allocated to appropriations spending. That includes $120 billion on infrastructure and science and more than $30 billion on energy-related infrastructure projects. It devotes another $267 billion, or 34%, on direct spending, which includes things like unemployment benefits and food stamps. The bill also apportions $212 billion, or 27%, to tax breaks for individuals and businesses, with most of these enjoyed by individuals. 2
Stimulus Multiplier. The most hotly debated issue concerns the likely effectiveness of each spending category. Most experts rely on the concept of the stimulus multiplier, which is the expected amount of increase in GDP per unit of stimulus. The Global Insight group calculated the fiscal multipliers used by the Obama economics team. They found that the most effective component of the fiscal stimulus is infrastructure spending, which provides a multiplier of 1.7. This type of spending fuels GDP directly by putting idle resources to work, and indirectly by giving businesses and individuals extra income, which allows them to spend more. Transfers to state and local governments also give a highly effective multiplier of 1.4. The direct economic boosts will be as diverse as these different government units, but the key idea behind this spending is to prevent the economic downturn from becoming more severe. With many state and municipal budgets nearing default, there is little argument against this type of spending. The personal tax cuts/transfer payments have the smallest bang-for-the-buck, with a multiplier 0.6. They have no clear direct effect on GDP because they boost activity only when spent. It is widely agreed that a large proportion of the tax cuts will be saved as households try to rebuild their financial assets. 
Christina Romer, head of the Council of Economic Advisers, claims that tax cuts and fiscal relief to the states are likely to create fewer jobs than direct increases in government purchases. However, because there is a limit on how much government investment can be carried out efficiently in a short time frame, and because tax cuts and state relief can be implemented quickly, they remain crucial elements of any package aimed at easing economic distress quickly. 
Arpitha Bykere of RGE ‘s U.S. EconoMonitor holds that with the limited multiplier effects of tax cuts for households and firms, and a delay in the multiplier effects of federal and state government spending, much of the impact on growth in 2009-10 will come from automatic stabilizers such as unemployment benefits, food stamps, Medicaid and transfers to states. She therefore asserts that the stimulus should have allocated higher spending on automatic stabilizers, transfers to states and payroll tax cuts, and reduced spending on government projects that have high short-run fiscal costs but will impact growth only in the long run. 
Winners/Losers. Partisanship aside, passage of the economic stimulus bill has created winners and losers. The following list describes who came out on top and whose expectations were spoiled.
Education. The package includes a $25 billion down payment on K-12 school reforms and $47 billion to prevent cuts in state aid to school districts. Schools got roughly $100 billion in stimulus funding to be used for school construction bonds, programs for disabled students, low-income school districts and Pell grants.
The jobless and the poor. Unemployment benefits will be temporarily extended and increased while food stamp programs also receive a boost. Billions of dollars will flow into job training and temporary welfare payments.
The alternative energy industry. The package allocates $50 billion for energy efficiency and renewable energy programs.
General Motors Corp. Automakers got a tax break worth $3.2 billion that preserves its ability to claim refunds against taxes paid when times were good.
Large hospices. They won a reprieve, worth about $134 million, from cuts in the amount Medicare pays them to care for dying patients.
Technology companies benefit on two fronts: $7 billion to expand broadband Internet services, particularly in rural areas, as well as potential new business from $19 billion to help doctors and hospitals convert paper medical records to electronic files.
Homebuilders suffered a scale back of a $39 billion tax break that would have provided a $15,000 tax credit for homebuyers. The housing market will have to wait for another day for government help.
The nuclear energy industry lobbied relentlessly for $50 billion in federal loan guarantees for technologies that use little to no carbon, but saw it cut from the package.
The defense industry. There is no significant money for weapons systems; however, lawmakers approved several billion for military facility construction.
Large and medium-sized businesses. They lost $18 billion in tax breaks that would have allowed them to get refunds from applying current losses against taxes paid in years when they were profitable.