Dividend of the Week

The global pharmaceuticals sector is, in the main part, characterised by excellent cash flows and high profitability which both give the potential for good dividends. But over the past couple of decades the sector has lost a great deal of the investment glamour that was its hallmark since the 1980s.

The sector has been slowly losing its lustre over the past 30 years, with investors turning to biotechnology for stellar returns; indeed, the area is akin to oil exploration stocks, where gains and losses can be extraordinary. But no realistic, long-term investor would invest in these areas without a huge amount of knowledge to justify their investment. So we will focus on the large pharmaceutical stocks and we will start with a global perspective.

The initial criterion is to select the pharmaceutical sector globally and this gives us a list of 21 stocks that are covered by DividendMax.

Our next selection criterion is to screen out those stocks that don't offer a yield of more than 3 per cent, based upon looking out over 18 months rather than our usual perspective of the next three dividends. This is because most of the companies in this sector follow American convention and tend to pay their dividends quarterly. This brings the list down to 11 companies, with the vast majority being from the US. They are listed below.

AstraZeneca (AZN), GlaxoSmithKline (GSK), Eli Lilly (NYSE: LLY), Pfizer (NYSE: PFE), Merck & Co (NYSE: MRK), Teva (NYSE: TVA), Johnson & Johnson (NYSE: JNJ), Dechra Pharmaceuticals (DPH), Bristol-Myers (NYSE: BMY), Bayer (DE: BAYN) and UCB (BR: UCB).

To further reduce the list, we will look at their dividend history and consider only those companies that have delivered more than five consecutive annual dividend increases. This brings us to our short list of five companies which is now dominated by the UK with three London-listed stocks, AstraZeneca, GlaxoSmithKline and Dechra Pharmaceuticals, joined by Teva and Johnson & Johnson.

At this point we can look at the fundamentals.

The long list features companies with some notable contrasts. AstraZeneca is currently in the midst of a great deal of change as it tries to revamp its business amid concerns about the paucity of new products coming through its pipeline. This has prompted the company to launch a number of acquisitions in a bid to refresh its pipeline. Teva Pharmaceuticals is an Israeli generic drug manufacturer which has grown consistently over many years, allowing it to advance its dividend strongly in recent years. GlaxoSmithKline looks to be on track to deliver its strategy of de-risking its business by altering its balance between pure pharmaceuticals and softer healthcare products. Johnson and Johnson is a massive and established company with a market capitalisation of more than $200bn (£125bn). Despite being a FTSE 250 company, international veterinary pharmaceuticals business Dechra Pharmaceuticals is relatively small compared with its peers on the list with a market capitalisation of £600m.

For my money, given its size, Johnson & Johnson's shares look too expensive on a price-earnings (PE) ratio of over 16. Teva is undergoing a huge firing programme that will see 5,000 employees lose their jobs. It has come under pressure due to the impending loss of patent protection for it's highly profitable multiple sclerosis treatment, Copaxone, due in 2014. For these reasons, we will also eliminate Teva from this analysis and concentrate on the three remaining UK stocks.

Let's have a look at the dividends paid by the remaining groups over the past six/seven years:

AstraZeneca (3,209p)

AstraZeneca paid a slightly increased 2013 half-year dividend of 59.2p (flat in dollar terms)

GlaxoSmithKline (1,578p)

GlaxoSmithKline has paid the 2013 Q1 & Q2 dividends, and Q3 results are on 23 October

Dechra Pharmaceuticals (684p)

*2013 final dividend declared at 9.66p, going ex-dividend on 6 November.

And what do the brokers say about the three survivors? The table below represents the number of brokers in each of the recommendations categories of buy, hold or sell.

Dechra Pharmaceuticals is a good business, but its high PE ratio and relatively low yield count against it and, frankly, in 2012-13 the dividend increase offered did not justify this premium rating. So we are going to focus on the big two in the UK.

The battle of the big two has been an intriguing one for investors over recent years, and at the moment GlaxoSmithKline looks to be in the ascendant. But, as often happens, the market has priced this in and it leaves investors with a difficult decision. There is no doubt in my mind, given the international scope of their businesses that the big two British pharmaceutical companies look very good value compared with their international competitors. Their PE ratios are low and their yields are way above the global pharmaceutical sector average.

But, as described above, AstraZeneca is in a period of transition, with some of its most profitable drugs losing patent protection and the pipeline not yet producing replacement products. AstraZeneca faces a particularly tough test after in 2016 when its blockbuster cholesterol drug Crestor loses patent protection. After hiring former-Roche lifer Pascal Soriot, who used to head that company's successful Genentech biotech unit, the company has approached the problem by making simple bolt-on acquisitions of drugs that might one day yield promising, but not spectacular product sales. The acquisition of heart drug firm Omthera for $2bn late last year, for instance, is evidence of a step-by-step strategy that will ultimately secures the dividend by not wasting too much capital on big one-off purchases - a particular sin of AstraZeneca's as its underperforming $15.2bn puchase of Medimmune illustrates. Omthera's price tag contrasts with the $20bn that analysts estimates Soriot can afford to spend to bring Astra's pipeline up to scratch.

GlaxoSmithKline, although in a better position in terms of its product pipeline, is also transitioning its business away from pure pharmaceuticals into a more broad-based healthcare company principally to lessen dependence on its own pipeline. This was always the narrative management wanted to tell over the past few years, but chief executive Andrew Witty's time in office has been characterised by some big product sales. For example, the company recently disposed of its Lucozade and Ribena brands for £1.35bn to Japanese company Suntory. This probably an increase in confidence in the the underlying product pipeline and GSK seems content to offload lower margin consumer brands if it raises a decent amount of cash. Consultants and analysts can argue over whether this conflicts with its stated strategy, but ultimately the cash in-flow secures the dividend.

AstraZeneca versus GlaxoSmithKline has been one of the great investment conundrums for income investors over recent years and it remains very difficult to call. For safety first investors, seeing what is on the table, in my view you have to go for GlaxoSmithKline, but the contrarian in me is leaning towards AstraZeneca. It is too soon to successfully assess the acquisitions that the company has been making recently and you have to wonder if the corporate governance in the target companies will match that of AstraZeneca. The case for AstraZeneca would be stronger if it was growing organically, but that appears to be off the agenda until it improves its organic pipeline of products, which could take years to happen. But AstraZeneca does have the stronger balance sheet of the two and has the flexibility to gear up over the coming years, both for internal research and development expenditure and for further acquisitions.

Looking at the broker views above suggests that there is a collective lack of faith in AstraZeneca at the moment within the City. But I am confident that the company will maintain its dividend (at least in US dollar terms, so UK investors could be looking at a slight decrease in real terms), but I like the look of its potential for an improvement in newsflow and, with it, sentiment. GlaxoSmithKline will continue to be a Steady Eddy and looks perfectly capable of producing solid if unspectacular earnings and dividend growth over the next five years. But, for me, AstraZeneca is the more exciting prospect and I like the fact that it is remaining a pure pharmaceutical company. There is no doubt that this carries a higher risk than GlaxoSmithKline, but for me the current lowly rating has more than priced that in. Both stocks are currently sat in the middle of their 52-week trading ranges, so there is no particular pointer there.

Because of the lowly rating, potential for improving newsflow, strong balance sheet and relatively new management (a new finance director will be appointed shortly as Simon Lowth moves to BG Group early in November), coupled with the likelihood of continued dividend payments, our dividend of the week is AstraZeneca.