With interest rates still sitting near record lows, investors looking for current income have been forced to move from fixed-income positions and into stocks to find yield. To help offset those risks, one of the first things dividend investors do is look for companies operating in stable, growing industries like Eli Lilly (LLY 2.41%). But before doing the foolish thing and taking this dividend for granted, let's take a closer look at whether it's truly worthy of a spot in your portfolio.
Health is priceless; health care isn't.
As a pharmaceutical company, Eli Lilly benefits from many of the unique elements of the industry that make it attractive for dividend investors. We all know it's impossible to put a price on one's health and well-being. Because of that, and due to the unbearable cost of emergency health problems, insurance companies and government entitlement programs have taken over as the gatekeepers of health care spending around the world.
But the industry's high costs didn't just appear out of thin air. Partly to blame is the fact that our insurance systems have effectively masked the direct costs of health care by turning the system into a kind of all-you-can-eat buffet, removing most of the consumer-driven pricing mechanisms that exist in practically every other industry. This dynamic, along with the aging and increasingly unhealthy society that we're all well aware of, is a key reason health care spending will continue to grow.
But while these big picture trends might be driving the overall industry, investors looking at specific health care dividend stocks need to dig a layer deeper to understand the company-specific issues at work. After all, dividends aren't a guarantee, and if the going gets tough enough, even a "stable" health care stock could cut -- or eliminate -- its dividend. With that being said, let's check on where Eli Lilly's dividend has been, and try to determine where it's going.
Payout Ratios
A quick-and-dirty technique for checking a dividend's sustainability is taking a look at something called the payout ratio. Typically this is expressed as a percentage, looking at a company's dividend per share relative to its net income per share. That's a decent start, but I prefer to use a slightly different measurement that replaces net income, an accounting measurement, with something more tangible -- cold hard cash. The chart below shows how much of Eli Lilly's free cash flow has been eaten up by its dividend payments over the past two years. The lower the better, suggesting more capacity for future dividend hikes.
Not all dividends are created equal. At first glance, a high dividend yield may look nice, but all too often it means a problem is lurking around the corner for a business. Looking at Eli Lilly's 3.6% dividend yield in isolation only tells half of the story, which is why investors need to have an understanding of how the market perceives a company prior to buying a stock. We can do this by comparing a few financial multiples, like price to earnings, to its peers in the industry.
Up to this point, we've looked at Eli Lilly's dividend in the past, and we've also seen how its stock is being perceived by the market today. However, the most important factor to consider when understanding a dividend's future is where the company's cash flow is heading. It's hard to generate more cash without growing sales, so let's take a look at what industry analysts are expecting for Eli Lilly's revenue growth relative to peers this year.
Like many of its peers, Eli Lilly has faced, and continues to face, significant patent cliff headwinds. Cymbalta and Humalog accounted for one-third of 2012 sales, and both drugs lose patent protection this year. That presents a big challenge to cash flow and payout ratio. The company seems to like its $1.96 annual payout (it's been at that level for four years and counting), and while I don't think it' at risk of dropping, I also think these challenges decrease the chances that it will grow in the near term.
