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Stock Strategist

Is Amgen Ready for a Dividend?

The big biotechs are growing up, but they're not large pharma--yet.

As a quick  screen for dividend-paying drug stocks reveals, biotechs and dividend yields don't often mix. There are several well-known reasons for this divide--biotech's rampant net losses and large growth prospects are chief among them. Some investors, however, might be wondering when the largest biotechs will make the shift. After all, leading biotechs  Amgen (AMGN) and  Genentech  have market capitalizations north of some of their large pharma peers. Amgen's net income surpassed the billion-dollar mark way back in 1999, and we're predicting that revenue growth rates could soon dip into the single digits.

However, Amgen and Genentech have no intention of paying a dividend anytime soon; according to their most recent annual filings with the SEC, both companies intend to feed any profits into operations or share repurchase programs (i.e., "buybacks"). In fact, Amgen just approved another $5 billion share repurchase program last month, which shouldn't come as a surprise to longtime investors in this cash-generating firm.

To get a better perspective on the issue of dividends with respect to these aging biotechs, we compared their financial performance and history of dividends/buybacks to those of two classic large pharmaceutical firms,  Eli Lilly (LLY) and  Pfizer (PFE). Based on our analysis, we don't think that investors would be well served by dividends from big biotechs just yet, and we have expanded on the two key reasons below.

Volatile Revenues and Spending Needs
A recent study by the Tufts Center for the Study of Drug Development pegged the cost of developing a biologic drug at $1.2 billion, a pricey endeavor to say the least. While the study noted that the current cost of traditional pharmaceutical drug development is likely similar to or even higher than this number, pharmaceutical firms are well-positioned to handle this sort of investment. For example, Pfizer's 10 blockbuster drugs and close to $50 billion in annual revenue helps to shield it from the effects of any one program, even disappointments as large as the recently discontinued cholesterol-lowering drug torcetrapib. As shown in the table below, growth in research and development expenses for Pfizer and Lilly tend to mirror sales growth, which allows these firms to stay on budget and consistently pay (and raise) dividends to their shareholders.

 Sales and R&D Spending
  Biotechs Pharmaceuticals
Amgen Genentech Eli Lilly

Pfizer

2006 estimate    
Sales $14.1 billion $9 billion $15.5 billion $48.4 billion
Sales growth 14% 36% 6% 2%
R&D expense $3.1 billion $1.76 billion $3.1 billion $7.4 billion
R&D growth 35% 40% 3% 2%
2005    
Sales $12.4 billion $6.6 billion $14.7 billion $47.4 billion
Sales growth 18% 44% 6% -10%
R&D expense $2.3 billion $1.3 billion $3 billion $7.3 billion
R&D growth 15% 33% 11% -6%
2004    
Sales $10.6 billion $4.6 billion $13.9 billion $52.5 billion
Sales growth 26% 40% 10% 17%
R&D expense $2 billion $0.9 billion $2.7 billion $7.7 billion
R&D growth 21% 31% 15% 3%

 

Amgen's story is quite different. Despite the company's five blockbuster drugs, 46% of this revenue is related to its anemia franchise, and total sales are set to just surpass $14 billion for 2006. With a relatively small portfolio and highly concentrated revenue, Amgen needs to retain the flexibility to invest heavily in its research and development programs--in fact, these expenses are set to vastly outweigh sales growth for 2006. Therefore, not only are growth rates large for biotech, they also appear to be less consistent and less conducive to dividends.

The Value of Amgen's Buybacks
Firms that utilize buybacks instead of dividends to reward shareholders are often criticized for the decision. We agree that buybacks are less straightforward; if the stock is overvalued by the market, buybacks could represent a poor method of returning value to shareholders. However, when it comes to biotechs, buybacks enable the kinds of variable levels of research and development spending I discussed in the previous section. As shown in the table below, Amgen is actually spending more money per share in its efforts to reward investors than Pfizer, taking Pfizer's $6 billion-plus annual dividend into account. It's also important to note that buybacks more than counter the effect of stock option dilution for each of these firms, as evidenced by the declining share counts.

 Returns to Shareholders
  Biotechs Pharmaceuticals
Amgen Genentech Eli Lilly

Pfizer

2006    
Share count* 1.194 billion 1.072 billion 1.088 billion 7.251 billion
Cost of share repurchases* $4.8 billion $0.758 billion $0.122 billion $4.5 billion
Average repurchase share price** $71.64 $84.22 $58.10 $26.16
Dividends paid*** -- -- $1.7 billion $7 billion
Per-share dividend/buyback spending $4.02 $0.71 $1.71 $1.58
2005    
Share count 1.258 billion 1.081 billion 1.092 billion 7.411 billion
Cost of share repurchase $4.4 billion $2.015 billion $0.378 billion $3,797 billion
Average repurchase share price $69.62 $83.61 $56.42 $26.37
Dividends paid -- -- $1.7 billion $6 billion
Per-share dividend/buyback spending $3.50 $1.86 $1.86 $1.32

* as of the third quarter of 2006
** for the first three quarters of 2006
*** full-year estimate

Amgen's 2005 10-K filing states that the company's stock repurchase program reflects "confidence in the long-term value of Amgen common stock" and that buybacks are "an effective way of returning cash to our stockholders." Given our 5-star Morningstar Rating for the stock, we're inclined to agree; in this case, buybacks appear to be a smart way for management to invest the roughly 30% of sales that flow through to cash. It's important to note that Genentech's share repurchase program remains smaller compared with Amgen's; this makes sense on two levels. Genentech, with a smaller revenue base (and less of this revenue translating into cash), remains in a higher growth phase than Amgen. In addition, share repurchases to date in 2006 have trailed off significantly when compared with the program over the previous two years; since we believe this 3-star stock is fairly valued, lower buyback levels could reflect a less promising return for Genentech's investment in its own stock when compared with the potential return of its drug pipeline.

Future Biotech Dividends?
Despite the current environment, we have no doubt that the situation will change with time. As large pharmaceutical firms develop expertise in biologics and tiny "biotechs" launch traditional, chemistry-based drugs, the line between the two sectors will continue to blur. If Amgen and Genentech work hard to diversify and expand their product portfolios, the sheer size of their revenue bases will limit sales growth, which could not only make managing research and development expenses more critical for earnings growth, but also put pressure on management to consider a dividend. For now, we think Amgen investors should be content with buybacks, given current share prices and the freedom they afford management to invest in the next potential blockbuster.

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