Why Rising Dividends in Big Pharma May Be Bad News for Investors

According to research firm FactSet, which issues a quarterly report on dividend payouts within the S&P 500 (^GSPC -0.58%), 418 of the S&P's 500 components paid a dividend in the fourth quarter. Not only did this mixture of 500 large- and medium-cap companies pay a dividend, but the average payout rose 11.8% over the fourth quarter of 2012 with $80.6 billion being divvied out to shareholders.

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Why dividends are rising
This robust increase in dividend payouts has been based on two bifurcating factors. First, the U.S. economy is rebounding and a number of sectors are taking part in the recovery. Although Wednesday's slow GDP growth may not tell the full tale as the polar vortex cramped growth in the first quarter, a dramatically improved jobs market and historically low lending rates are doing their job and demonstrate strong underlying growth prospects.

On the other hand, as this recovery matures, select sectors are having trouble finding new avenues of quick growth. Instead, they're turning to cost-cutting and shareholders incentives such as share buybacks (which hit their second-highest level ever in 2013) and dividend increases in order to appease investors.

Under normal circumstances bigger dividends should be applauded by investors -- and rightly so. According to ABC News' Susanna Kim, 90% of all nominal growth in the S&P 500 between 1910 and 2010 was a result of dividend yield and dividend growth. Dividends provide retirees with supplemental income that can be crucial to their well-being while it provides a means to compound big gains for younger generations of investors.

But a rising dividend isn't always great news.

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Why rising dividends can be deceptive
I know this goes against everything we at The Motley Fool would usually instill in investors. In essence, the idea that dividends are a sign of a healthy and stable business, and that rising dividends are a good thing as it means more shared money in shareholders' pockets. But a rising dividend in a big pharmaceutical stock can also mean something entirely different. It could mean the company in question has run out of ideas on how to effectively deploy its capital and is using that dividend to appease investors -- and that can be a long-term problem if a company's product pipeline doesn't come through with new products.

Let's take a look at Pfizer (PFE -1.05%) for example. Since cutting its dividend in half to $0.16 in 2009 when it announced the purchase of Wyeth, Pfizer has boosted its dividend with some regularity. As of the latest quarter, Pfizer was paying out $0.26 per share. Since 2010, however, following Wyeth's inclusion in its full-year results, the company's top-line has deteriorated by 8.7% per year. This is primarily a cause of patent expirations on key drugs such as cholesterol-fighting medication Lipitor, the best-selling drug in the world in terms of all-time sales.

Now keep in mind, this isn't to say that Pfizer isn't making an effort to deploy its capital for the benefit of its shareholders, or that it doesn't have a few tricks up its sleeve. For instance, Pfizer has been trying to court AstraZeneca (AZN 0.39%) in an effort to bring two companies together that have what I believe the other desires. If combined, the cost savings from reducing overlapping businesses could be huge. 

Pfizer also has palbociclib in its pipeline, a breakthrough designated therapy that in phase 2 advanced breast cancer trials improved progression-free survival by 10 months to 20.2 months. In other words, Pfizer isn't exactly sitting on its hands, either.

Yet, with its top-line falling in the wake of patent expirations I'd point out that Pfizer boosting its dividend with consistency might not be the wisest use of its cash and could be luring in unsuspecting high-yield seeking investors who aren't as familiar with the ebb-and-flow nature of the pharmaceutical sector or patent expiration periods. 

We've also seen a similar story play out with Merck (MRK 0.25%). On the surface it might appear that Merck has grown like wildfire over the past decade, but the majority of its growth came from its acquisition of Schering-Plough in 2010. Since 2011, though, its total revenue has fallen each year due to the loss of key patented drugs, all while its dividend has steadily increased. It could wind up being a potentially unwise use of cash flow if a couple of blockbusters don't step forward for Merck.

Of course, like Pfizer it's not as if Merck isn't trying to deliver for shareholders. A cornerstone of Merck's future could be MK-3475, an anti-PD1 therapy that wowed investors in treating advanced melanoma with a progression-free survival rate of 36 weeks and an overall survival of 81% of patients after a year. So again, Merck still has plenty of pipeline promise, but these dividend increases could be covering up Merck's recent lack of top-line growth.

Now, make no mistake; I'm not saying dividends or dividend increases are bad. In fact, in many instances they're great for shareholders. But in those rare instances when a company is struggling to find avenues for growth and is cash flow rich, investors need to be vigilant in questioning the motive behind a growing dividend.