Merck Just Marking Time

02/27/2012 3:17 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

And for dividend investors, the risk of declining yields is too high, writes MoneyShow's Jim Jubak, who also writes for Jubak's Picks.

In my February 3 post, I added three stocks to my Dividend Income portfolio, and dropped three.

The reason, I argued then, was that the growing popularity of dividend-paying stocks at a time when income vehicles such as Treasuries and CDs pay almost nothing had created a glorious but still real problem for income investors.

As investors flocked into dividend-paying shares, they drove up share prices. That was great for investors already fully invested, but for investors looking to get into new positions or for investors looking to put more cash into existing positions, it meant that yields were in constant danger of erosion.

In this situation, income investors needed to look for stocks that paid higher yields now, and that were also positioned—by their growing cash flows and by management disposition—to keep raising dividends. Look for those stocks, I advised, and beware dividend payers that didn’t seem to be in a position to keep raising dividends.

And with that as background I tweaked this portfolio by adding General Electric (GE), Westpac Banking (WBK) and Kinder Morgan Energy Partners (KMP), while dropping Potlatch (PCH), Merck (MRK) and Abbott Laboratories (ABT).

Today, I’m going to give you more detail on one of those drops, Merck (and also actually make the change on the dividend portfolio page. The remaining two changes will follow in what I will try to make short order.)

Merck just raised its quarterly dividend to 42 cents a share, from 38 cents. The resulting annual dividend of $1.68 works out to a yield of 4.4%. So what’s my problem with Merck as a dividend stock?

Earnings growth. Or actually, the lack of it.

Companies that don’t grow earnings don’t have a lot of ability to raise dividend payouts significantly. That’s especially true in an industry like pharmaceuticals that has to spend big on research and development.

So how bad is the Merck earnings growth picture? The Wall Street consensus is looking for earnings growth of 1.3% in 2012 and a decline in earnings per share of 1.6% in 2013.

The main problem is Singulair. That blockbuster allergy and asthma drug—$5.5 billion (or 11%) of 2011 sales—will lose patent protection in 2012 and face increasing competition from generics.

Merck also faces declining sales from immunology drug Remicade, as some marketing rights go to Johnson & Johnson (JNJ) as a result of a 2011 arbitration decision, and a drop in payments from AstraZeneca (AZN) as a marketing alliance with that drug company comes to an end.

Balancing those negatives are continued cost savings from the company’s 2009 merger with Schering-Plough.
 
It’s hard to judge the dividend friendliness of any management these days—and certainly a company that just raised its annual dividend 10.5% can’t be called dividend-unfriendly—but Merck’s recent record seems to emphasize big buybacks of shares as a way to return cash to shareholders. The company spent $1.4 billion over the last 12 months on buying back shares as part of an ongoing $5 billion buyback program.

Putting the slow or negative earnings growth together with the emphasis on buybacks, I have to conclude that Merck isn’t great candidate for dividend increases big enough to push up the yield (or even just keep it steady) if shares move significantly higher.

To see what I mean take a look back at September, when the annual trailing 12-month payout was $1.52 (instead of the current payout of $1.68). The share price then was just $31.36, however, so the yield came to 4.8% instead of the current projected yield of 4.4%.

I’d prefer not to place my dividend bets hoping that the share price won’t rise and cut into my yield.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Merck, Johnson & Johnson, or AstraZeneca as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio here.

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