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3 Stocks Could Double Their Dividends -- But Shouldn't

By Michael Douglass - Apr 25, 2017 at 8:43AM

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A big dividend raise isn't always the right move for a business.

Everybody loves dividends. I mean, seriously, who doesn't love a stock that pays you cash as a thank-you for investing? Additionally, dividends are usually a solid indicator that a company is actually making money -- after all the financial finagling, it still has the cash to schedule payments to investors. Escalating dividends are often taken as a sign that management is particularly bullish on the company's future -- so much so that they're willing to hike how much they pay investors each quarter.

It's understandable, then, that the idea of a company doubling its dividend is exciting. To get paid literally double what you were previously being paid is great on its own, but it also means the company has the wherewithal to sustain all that extra cash going out the door -- a sure sign of its strength as a business.

But there's a big difference between "can" and "should" -- and while these three companies can give income investors a doubled dividend, here's why they shouldn't.

Child measuring height of self

Good growth comes with time. Image source: Getty Images.

Incoming mergers and acquisitions

Gilead Sciences (GILD 0.19%) is generating a big ol' pile of cash.

To be more precise, in 2016 Gilead produced $15.9 billion in free cash flow (FCF) -- that's operating cashflow minus capital expenditures -- and only paid out about $2.5 billion in dividends (data courtesy of S&P Market Intelligence). During the first quarter of 2017, management hiked the dividend 11%, which translates to a 2017 dividend payout ratio of under 20% assuming FCF remains flat.

Clearly, Gilead has plenty of room to bump up its dividend, as a doubling would still leave it spending under 40% of FCF on dividends.

But management is resisting something so aggressive, and with good reason: Gilead's Hepatitis C franchise is rapidly losing steam, and even its strength in HIV isn't enough to make up the revenue declines. Gilead is stockpiling cash and rapidly buying back stock, which makes sense given the company's rock-bottom valuation of under seven times 2016 earnings.

Gilead's best opportunity from here is undoubtedly to buy other companies to restock its drained pipeline, and I expect we'll be seeing management do exactly that with its cash hoard.

Until then, the dividend can wait.

It's all in the pipeline

Amgen (AMGN 0.15%) is another stock with plenty of room to increase its dividend. Last year management paid out about $3 billion in dividends out of $9.6 billion in FCF, for a cash dividend payout ratio of 31% -- and unlike Gilead, management is guiding for Amgen's earnings per share to grow modestly in 2017. Amgen has a longer history of dividend hikes, too, having increased its dividend over 300% since 2011.

Yet Amgen's best opportunities lie in its late-stage pipeline and in ensuring that those drugs are properly resourced in their final clinical trials, through (hopeful) approval by the U.S. Food and Drug Administration, and then during their market launches.

Amgen has three major drugs approaching the market -- Evenity for bone health, migraine drug erenumab, and kidney-disease treatment Parsabiv. All three have blockbuster potential, with analysts particularly bullish on erenumab's potential peak sales of over $2 billion annually. (As of this writing, Parsabiv has been approved, Evenity faces FDA action later this year, and Amgen is intending to file submissions for erenumab in 2017.)

Despite the impressiveness of those drugs, Amgen's largest opportunity may lie in biosimilars, which are essentially generics for complex biologic drugs. Keep a special eye on its Avastin and Herceptin biosimilars, as both are late-stage and will be up for approval in the near future.

While predicting the precise market opportunity for the biosimilars is difficult given that they are such a new development in drug research, Avastin and Herceptin combined to bring in over $13 billion for Roche last year -- and cost-conscious payers will likely push to use the cheaper biosimilars if they're approved. Even if Amgen's biosimilars gained most of the market share at half the price, they'd be massive blockbusters for the company.

Amgen investors are best served by the company flawlessly executing on these business opportunities before they clamor for a major dividend increase.

Getting out of debt

At first blush, CVS Health (CVS 0.27%) might also seem like an obvious candidate for a dividend double. After all, in 2016 the company only paid out 23% of FCF in dividends. And as the largest pharmacy benefit manager (PBM) and second-largest retail pharmacy in the United States, it has broad exposure to the major demographic shifts that should drive healthcare spending (and investor profits) in the coming decades.

And yet, it has better things to spend the money on -- things that can help investors in its stock far more than a measly dividend double.

Fact is, CVS is sitting on a sizable debt load -- $25.6 billion, as compared to a total market cap of roughly $84 billion. That's more than doubled from 2014 levels, as CVS needed financing to purchase Target's in-store pharmacies as well as provider of long-term-facility services Omnicare.

Reducing that debt load will give CVS more balance-sheet flexibility to continue acquiring competitors, and investing in its retail stores and brand-building efforts. To be honest, those moves will be a much bigger win for investors over the long term than a dividend increase.

Love your dividends. Cheer when companies increase them. Look forward to that quarterly check. But don't focus on dividends at the expense of the business -- and don't expect management to, either. To maximize long-term shareholder value, the most important thing most companies can do is to grow and stabilize their businesses. That provides a platform from which they can hopefully grow their dividends for a long time to come.

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Stocks Mentioned

CVS Health Corporation Stock Quote
CVS Health Corporation
$92.78 (0.27%) $0.24
Gilead Sciences, Inc. Stock Quote
Gilead Sciences, Inc.
$62.46 (0.19%) $0.12
Amgen Inc. Stock Quote
Amgen Inc.
$247.11 (0.15%) $0.38
Target Corporation Stock Quote
Target Corporation
$144.16 (-1.06%) $-1.55
Roche Holding AG Stock Quote
Roche Holding AG
$41.60 (0.08%) $0.04

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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