Financial Market Commentary

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.