Many risk-averse investors, like retirees, buy dividend-paying stocks for their regular distribution of cash to shareholders. Dividends are not guaranteed, and management can cut them at any time, so it's important to understand how safe the dividend is when analyzing a company. Many times, the higher the yield, the riskier the stock. That's why investors should look at the payout ratio, the ratio of dividends paid to net income, in order to determine if the payout is sustainable.
Unfortunately, nothing is that easy in investing. Earnings can be massaged through accounting tricks or understated due to non-cash charges that have no bearing on the ability to pay the dividend. That's why I like to look at the ratio of the dividends paid to free cash flow. This measurement tells me how much the company paid shareholders compared to what management had available to spend. Often, this view can help avoid high-yield traps that are too good to be true.
1. Abbott Labs
Abbott Labs is a diversified healthcare company comprised of four business units: medical devices, diagnostics, established pharmaceuticals, and nutrition. Abbott Labs spun off its branded pharmaceutical business as AbbVie (ABBV -1.04%) in 2013. With it went the best-selling drug on the planet, Humira.
Although sales stagnated between $20 billion and $21 billion for three years, sales grew due to the acquisition of St. Jude Medical in 2016. Revenues have continued to grow post-acquisition, reaching nearly $32 billion in 2019. Gross margin and operating margin have remained largely unchanged in the time since the AbbVie spinoff.
The dividend, which stands at 1.3%, has gone from consuming almost 80% of free cash flow in 2016 to about 50% today. While that yield isn't the wallet-fattening return many retirees look for, having more than enough free cash flow to cover the payout makes it considerably safer than many higher-yielding stocks.
Having a diverse product offering in a demographically advantaged industry -- 10,000 baby boomers turn 65 every day -- puts Abbott Labs in an enviable position. The company's diagnostics business is proving it is up for the challenging times, growing 39% in the most recent quarter reported on Oct. 21.
Most recently, the business has led the charge in the effort to bring rapid testing to the U.S. The company received U.S. Food and Drug Administration (FDA) approval for its rapid COVID-19 test in August. The test delivers results in just 15 minutes with no instrumentation required. Sales grew 10.6% in the most recent quarter and management raised earnings guidance for the full year, expecting to deliver more than 100 million COVID-19 tests in 2020. With strong prospects and a dividend that management can easily pay from cash flow, Abbott Labs deserves a place in the portfolio of healthcare investors looking for yield.
2. Becton, Dickinson & Co
Becton, Dickinson (BDX -1.39%) supplies a broad range of devices and systems for the healthcare industry. The company's products and services span instruments for various surgeries, medication delivery and management systems, and diagnostics solutions.
The company has made two large acquisitions to bolster its offerings in the past five years. In 2015, it purchased CareFusion for $12.5 billion, bringing medication management and patient safety solutions into the fold. CareFusion makes devices that that improve safety from the pharmacy to the hospital floor, such as smart pumps. These devices are integrated with computerized order systems and electronic health records (EHRs). In 2017, the company purchased C.R. Bard for $24 billion. This acquisition brought in various products like catheters, patient monitoring systems, wound management tools, vascular and urological devices, and surgical grafts. These devices are essential to procedures, so while they were affected when elective procedure volumes went down in 2020, they are not subject to expense management in the same way a discretionary expense would be.
Management has been slow to digest the new businesses, and integrating them hasn't produced the synergy one would have hoped. Operating margins have steadily declined in the past five years, from over 17% in 2016 to less than 13% in 2019. However, free cash flow generation has been solid, growing from $1.85 billion to $2.47 billion over the same span. This cash flow generation easily covers the 1.3% dividend -- which consumes about 41% of free cash flow.
The company has recently named a new Chief Technology Officer and a new President for the life sciences business. These changes, along with the tailwinds from producing 12 million rapid antigen tests for COVID-19 per month by February 2021, provide near-term catalysts for the stock.