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By Jeremy Glaser and Damien Conover, CFA | 09-18-2012 01:00 PM

Big Pharma Dividends Alive and Well

Pharmaceutical firms' lower-than-historical valuations and high-margin, patent-protected products are positive signs for investors seeking more yield.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. As investors continue to scramble for yield, one area that many have been looking at is the pharmaceutical industry. I am here with Damien Conover, our director of pharmaceutical research, to take a closer look.

Damien, thanks for joining me today.

Damien Conover: Thanks for having me, Jeremy.

Glaser: So, let's talk a little bit about some of the structural aspects of the pharmaceutical industry that maybe mean that companies can throw off some more cash to investors. Why are these companies able to produce this cash? Do they just not have the ability to reinvest it in their own businesses?

Conover: I think that's a good question. When we take a look at the fundamental nature of big pharmaceutical firms, they can price their products at very high levels. So, we're talking about gross margins in the 80% range. Keep in mind, obviously, they do need to put some cash to work to market these products, as well as a lot of capital to work for reinvesting in the next generation of products, but really at the end of the day, you're left with a very healthy margin, usually in the 20% range with a lot of cash coming back into the business.

So, that really leaves them with a few different options. They can repurchase shares, increase dividends, or make acquisitions. While, most of the pharmaceutical firms are doing all of the above, the dividend yields are really a primary focus for pharmaceutical firms for getting cash back to shareholders.

Glaser: But certainly when you see those huge excess returns, what's stopping that from being competed away? How has the industry kind of built that competitive advantage around themselves?

Conover: One of the core things we look at here at Morningstar is the economic moats of these pharmaceutical firms, and really the cores of these moats lie in the patents that they have for these products. So, these products that generate enormous amounts of cash flow are patent-protected. Granted, other firms can develop similar types of products and avoid the patent, but for the most part these are well-protected products, very high-margin products that bring in a lot of cash flow, protected by the patents. Therefore, they've got a lot of cash coming in, and while they can repurchase shares and make acquisitions, dividends is usually where a good bulk of the cash goes for these pharmaceutical firms.

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