For a dividend stock to be great, it needs to offer investors strong, sustainable, and growing payouts. Today, we'll look at whether Gilead Sciences (NASDAQ:GILD) falls into the category of being a great dividend stock or not. While a lot of the hype surrounding the California-based biopharmaceutical company in recent weeks has been around remdesivir and the drug's potential to fight COVID-19, investors shouldn't neglect the dividend that the company pays.

With a yield of 3.5%, Gilead offers a better payout than the 2% that investors would typically expect from an average S&P 500 stock. But let's take a closer look to see how impressive Gilead's dividend really is, and whether the stock is a great option for income investors.

Dividend hikes continue, but at a slower rate than in previous years

Gilead has been a solid dividend stock to own as the company has increased its payouts over the years. However, the rate of those increases is starting to slow down. Its current dividend payment of $0.68 every quarter is up 58% from five years ago when Gilead was paying $0.43. That averages out to a compounded annual growth rate of 9.6%. In 2019, the company raised its payout by 10.5%. But when Gilead announced its most recent rate hike in February, the dividend was increased by just 8%. What that tells us is that while Gilead's been increasing its dividend at a high rate, it's started to slow down.

Man standing in money falling from the sky.

Image source: Getty Images.

However, part of the reason for the high rate of increase is also likely due to Gilead not having a long history of paying and increasing dividends. Gilead has been paying a dividend for five years while some companies have been paying dividends for more than a century, and some have been hiking their payouts for more than 50 years in a row. And raising dividend payments by close to 10% every year would be difficult to keep up over such a long period, which is why it's rare to see such a high level of growth.

As earnings start to slow down or even decline over the years as a company reaches its peak, the harder it is to continue increasing dividend payments. That's why the longer that Gilead increases its dividend payments, the lower the rate of increase will likely be in the future. While that wouldn't make the stock a worse buy, it's important for investors to ensure their expectations are realistic. 

Is the dividend sustainable?

The most important question these days when it comes to a dividend stock is how safe it is. And to help answer that question, investors should look at the company's profits and its cash flow. Over the trailing twelve months, Gilead's generated diluted earnings per share (EPS) of $3.90. Its dividend payments total $2.72 per share on an annual basis, which is 70% of the company's diluted EPS. That's a decent payout ratio that's nowhere near even 90%, which suggests that it's manageable and that there could be room for more increases in the future.

But it's important to confirm that the dividend is sustainable by looking at Gilead's cash flow as well. Accounting income can be misleading since it includes non-cash items. Gilead's generated positive free cash flow in each of the last 10 periods, and the lowest that it's been during that time has been $1.2 billion. In its most recent quarter, Gilead paid out $874 million in dividends. At the low end of its free cash flow of $1.2 billion, that would put its payout ratio at 73%, which also suggests the dividend is sustainable.

Another important factor for investors to consider is the company's outlook. HIV sales made up 74% of the company's total product sales in 2019. That's up from 67% in 2018 and just 51% the year before that.

Gilead's growing more dependent on the strength of its HIV drugs, and that could pose a risk to investors, especially as HIV rates are decreasing in the U.S. New drugs are needed for the company to help drive growth as well as sustainability in the dividend. HIV sales were up 12% in 2019 and 2018, but if that starts to slow down, it could lead to problems down the road for Gilead's bottom line, and in turn, its dividend.

One drug that could help alleviate some of Gilead's dependency on HIV drugs is filgotinib. In December, Gilead submitted a new drug application for filgotinib in treating rheumatoid arthritis, which the Food and Drug Administration (FDA) is currently reviewing.  Another potential drug that could help Gilead's growth is remdesivir. On May 1, the FDA issued emergency use authorization for the drug to be used to treat patients with severe COVID-19. If it proves to be effective in treating patients with the coronavirus, it could be a tremendous opportunity for the company.    .

Gilead isn't a great dividend stock just yet

Investors can earn a solid payout from holding shares of Gilead today. However, there are two glaring reasons why I wouldn't classify it as great.

The first is that dividend investors value a company that has a strong track record, and Gilead just doesn't have one yet. It's done well over the past five years in paying and increasing its dividend, but that's a very small sample size.

If the company continues paying dividends during a prolonged downturn, that would certainly help add credibility to the strength of the company and its dividend. But at the very least, it would probably take at least another five years of dividend growth to make the case that it's a great dividend stock and that it's among the best.

Another reason it isn't great is that its future is questionable. The lack of diversification in its revenue is likely concerning for investors. And while Gilead has many other non-HIV drugs in its portfolio and in its pipeline, HIV drugs still drive much of the company's results and growth. That has to change for investors to have confidence that the dividend will remain intact for many years into the future.

If the FDA approves filgotinib or if remdesivir proves effective in treating COVID-19, that could make Gilead a much stronger buy. However, it's still too early to tell at this point if either one of the drugs will be successful in generating significant growth for the company.

Gilead offers investors a good dividend, and I think the healthcare stock is still a solid buy. But it has a long way to go before becoming a great dividend stock.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.