Show Us the Money, Drugmakers

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Drugmakers have cash and they aren't afraid to use it -- on themselves.

In February, Pfizer (NYSE: PFE  ) said it was upping its potential share repurchases to $9 billion, including a plan to buy back $5 billion worth of shares this year. Earlier this year, GlaxoSmithKline and AstraZeneca also announced plans to use some of their cash to buy back shares.

Wednesday, Merck's (NYSE: MRK  ) board authorized the repurchase of $5 billion worth of shares on top of the $1.4 billion that was leftover from the old plan. Having more clarity about the revenue it can bring in from Remicade and Simponi after settling with Johnson & Johnson (NYSE: JNJ  ) probably made the decision easier.

Even smaller companies are getting in on the act. Amgen (Nasdaq: AMGN  ) said it was establishing a dividend last week, but also announced a $5 billion buyback on top of the $2.2 billion it has remaining from a previous authorization. Hospira's (NYSE: HSP  ) board authorized a $1 billion buyback earlier in the week. It may not sound like much, but Hospira is only a $10 billion company.

Is this the best use of cash? There are certainly good arguments for issuing dividends rather than doing share buybacks, not the least of which is that it puts the cash in the hands of the investors to do as they see fit.

Cheap shares
At this point in time though, buybacks make more sense for most drugmakers. Most pharma companies are trading at historically low valuations. Retiring shares helps boost EPS by decreasing the pie than the earnings have to be split between.

The problem with increasing the dividend rather than repurchasing shares is that many pharmaceutical companies are approaching a patent cliff. While they may have the free cash flow to increase their dividend now, that may not be the case in a few years. Pfizer will lose Lipitor to generic competition this year and Bristol-Myers Squibb (NYSE: BMY  ) will face generic competition for the second-best-selling drug Plavix next year.

Share repurchases allow the companies to be flexible. Investors don't tend to go ballistic when companies don't issue a repurchase after finishing the last allotment like they do when a company reduces a dividend.

Cheaper than anything else?
The more important question investors should be asking themselves is whether the pharmas should be returning cash to shareholders at all. I'm not convinced that share buybacks or dividend increases are necessarily the best move.

Blasphemy, you say, it's your money and you want it one way or another?

Hold your horses. I'm not arguing they give it away or spend it on private jets for management "retreats." But there are growth opportunities in the biotech space that the drugmakers could invest in.

Yes, the companies could hand over the cash to investors and let them invest it in the likes of Human Genome Sciences (Nasdaq: HGSI  ) with the potential for monster returns. But I suspect that most investors that are investing in dividend-offering pharma companies aren't all that abreast on the biotech industry. Warren Buffett certainly isn't.

Why not let the scientists at the pharma companies scout out drugs for you? They can license them or make outright acquisitions with the dollars they would have returned to you, and you'll benefit from increased revenue and earnings.

Of course, pharmaceutical companies do this already. Bristol's recently approved Yervoy was acquired through a purchase of Medarex; Johnson & Johnson's Zytiga came from Cougar Biotechnology. I'm just advocating that pharmas and their investors might be better off if they upped the mergers and acquisitions with smaller drug developers.

What say you, drugmaker investors? How do you want your cash returned to you? Take the poll and fill in your thoughts in the comment box below.

Johnson & Johnson and Pfizer are Motley Fool Inside Value picks. GlaxoSmithKline is a Motley Fool Global Gains pick. Johnson & Johnson is a Motley Fool Income Investor selection. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of GlaxoSmithKline and Johnson & Johnson. Alpha Newsletter Account, LLC owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.

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