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.
Glaser: So, even if you have a great amount of cash generation, if the stocks are too expensive, you're still not going to get a great yield. Where the valuation stands right now?
Conover: That's interesting. So, if you look at the historical context of the pharmaceutical firms, usually pharmaceutical firms trade at multiples in the mid- to high teens. All the valuation work we do here is based on discounted cash flow models, and our fair value estimates imply that the multiples should be more in the low-teen range. Right now, the pharmaceutical industry is trading at about 11 to 12 times earnings, so there is a lot of opportunity here for capital appreciation, but when looking at just the dividend yield and its historical context, these stocks are trading much lower than what they have historically, which opens themselves up for very high dividend yields.
Glaser: So, let's take a look at some individual names. What do you think are some of the best picks for investors who are seeking yields right now?
Conover: I think there are couple, and the first one I would point to is Pfizer. Pfizer has probably one of the best pipelines that it's had in the last half decade. Also, it's largely getting through its patent cliff in 2012 and has made a commitment to increasing its dividend payout ratio to about 40% over the next couple of years. So, while the bottom line may not be growing as robustly as some of the other pharmaceutical firms, you are going to get that continued increase in the dividend because more is going toward the dividend from the earnings.
Glaser: How about another name?
Conover: One other name that we think is poised for upside is Johnson & Johnson. This is a company that we think will have one of the fastest earnings growths within the space. So, the dividend yield will likely keep up with that earnings growth. So, it's going to be a nice story. Not only you'll see likely earnings growth, but you'll also see the dividend probably keep pace with that earnings growth.
Glaser: And do any of the European companies look attractive?
Conover: Yes. So, if we look kind of across the Atlantic, the name that we think is most undervalued is Novartis. Novartis, we believe has one of the best pipelines and is a little bit more diversified. And when we look at Johnson & Johnson, obviously, that's a very diversified company, but one of the things that Novartis gives you that most of the other pharmaceutical firms don't give you is exposure to generic sales. So, Sandoz is one of the divisions within Novartis; it’s the second-biggest generics firm after Teva and very well-positioned for growth. And this, like Johnson & Johnson, has a decent earnings growth on the bottom line, which we expect the dividends to keep pace with that.
Glaser: Damien, thanks for your thoughts today.
Conover: Thanks for having me Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.