Investors shouldn't settle for just an average dividend stock, certainly not during the COVID-19 pandemic when many dividend stocks are proving to be unstable. Instead, investors should look for great dividend stocks -- ones that offer sustainable payouts that are also safe, pay a good yield, and are likely to increase in the future.
Today, I'll look at whether drug manufacturer Merck (MRK 1.64%) falls into the category of a great dividend stock and whether income investors should consider adding it to their portfolios.
Where the dividend is today
Currently, Merck pays its shareholders a quarterly dividend of $0.61. At a price of around $78, that means investors today are earning about 3.1% annually in dividend income. That's higher than the S&P 500 average of 2%, and it means that Merck's dividend passes the first test -- it's above average.
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Equally important, however, is whether the stock is sustainable and whether the payouts are safe over the long term. To do that, it's important to consider the company's profitability and the cash flow that it's generating.
Today, its payout ratio comes in at under 60%, suggesting that Merck's profits are strong enough to support its current dividend payments. And if we look at the company's free cash flow in recent years, that tells investors the same thing -- the dividend is safe. In each of the past 10 years, Merck has generated positive free cash flow and in all but one of those years, it's come in higher than the amount of dividends that the company's paid out.
A look at the dividend's growth
You can't call a dividend great if it isn't growing. Dividend growth is what makes a dividend stock worth holding for the long term. Merck doesn't have a long enough track record of increasing dividends for it to be considered a Dividend Aristocrat, but it has been increasing its payouts regularly since 2012. In its most recent increase, in 2019, Merck hiked its payouts by 10.9%, from quarterly payments of $0.55 to $0.61.
Five years ago, the stock was paying a quarterly dividend of $0.45. During that time, Merck's increased its dividend payments by 36%, which averages out to a compounded annual growth rate (CAGR) of 6.3%. That's above the rate of inflation, and it hasn't had an adverse effect on the company's ability to pay dividends, suggesting that it's a stable rate of dividend growth.
If the stock were to continue to grow at that rate, it would take a little more than 11 years for the dividend payments to double.
Is the business in good shape?
A key consideration dividend investors always need to take into account is a company's underlying business.
And the good news for dividend investors is there's reason to be optimistic about the company's future. On Feb. 5, Merck announced it was spinning off its women's health business, its legacy brands, and biosimilars into a new company. The remaining business would focus on better growth opportunities surrounding its vaccines, oncology, animal health, and hospital segments. Merck said in its release that it "anticipates future increases" to the dividend and that it's targeting a payout ratio between 47% to 50%. The company projects that the transaction will be completed by the first half of 2021.
And there's even more potential revenue growth in the company's future. On May 26, the New Jersey-based company announced it acquired Themis Bioscience, an Austrian vaccine company. Merck is now focusing on developing multiple vaccines for COVID-19, and it says it could begin vaccinating volunteers in the coming weeks. If it can develop an effective vaccine against the coronavirus, it could add even more growth for the company and make it an even better long-term buy.
If the company's sales and profits grow, then that increases the probability that dividend investors will continue to see their payouts rise over the years. And the business is already producing some solid results even before it benefits from the attractive growth opportunities noted above.
When the drug manufacturer released its first quarter results of 2020 on April 28, its sales were up 11% year over year from the prior-year period. Merck said that the impact COVID-19 had on its financials was "immaterial." However, it noted that for the entire fiscal year, it expects the pandemic to bring the company's top line down by $2.1 billion. Last year, the company's sales were up 10.7% and they grew by 5.4% the year before that. Merck has been profitable in each of the past 10 years, and only twice during that time has its profit margin been below 10%.
Is it a great dividend stock?
With the company focusing on growth and working on vaccines for COVID-19, there's reason for investors to be excited about Merck's future. However, there's not as much excitement when looking at it primarily as a dividend stock.
There are many other dividend stocks that investors can choose from that provide comparable yields and growth. There's just too much uncertainty surrounding Merck to make it a good buy for its dividend. If the company starts investing a significant amount of capital into vaccine development or other growth initiatives, it may be inclined to scale back its dividend, or at least its dividend growth rate. And without a long track record for increasing payouts, it's easier to stop pay hikes for a company like Merck than it is for a Dividend Aristocrat that may be less inclined to interrupt its streak of dividend increases.
Merck's a great buy overall, but I wouldn't call it a great dividend stock. I'm not convinced its payouts will continue rising at a high enough rate that it'll make it a better dividend stock to own than other, higher-yielding stocks out there. Year to date, the healthcare stock's down 15% while the S&P 500 has declined by a more modest 1%, so investors may want to consider dividend stocks that are performing better in current market conditions.
