Dividend Investor's Archnemesis

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Dividend investors in the health-care space should be shouting from the rooftops, "Give us OUR cash."

Pharmaceutical companies aren't cutting dividends, but they aren't exactly handing over the cash to dividend investors, either. Instead, they're using their cash hoards to repurchase shares.

Merck recently announced that it was repurchasing $15 billion worth of Merck stock, including $5 billion in a large accelerated repurchase. Last November, Pfizer announced a $10 billion repurchase, and that was on top of a $10 billion repurchase program the year before.


Eli Lilly , which is smaller than the other two, is playing it a little more subdued, pledging just $1.5 billion after completing a $3 billion program started in 2000. Still, $1.5 billion is 2.5% of its outstanding shares.

Even big biotech Amgen is playing the game. At the end of first quarter, the company had 751 million shares outstanding, down from more than 1 billion shares four years earlier.

Fake growth
The reason why health-care companies like share repurchases so much is because they boost the companies' EPS without having to earn any additional profit. Take 10% of the shares out of circulation and you get a nice 11% boost to EPS.

That's all well and good, but it's not growth you can build on. If a drug produces 10% more revenue, margins can expand to produce an even greater increase in earnings, and there's the possibility of seeing that 10% growth year after year. You can't repurchase forever.

A wash... except
Companies will tell dividend investors that the net effect of a share repurchase and reinvesting the dividend is the same. And mathematically they're right.

The difference, of course, is that a dividend investor has the choice of where to put the dividend to work. Perhaps there are better deals than purchasing additional shares of the company? Maybe you want to spend it on a vacation? With share repurchases, dividend investors are forced into buying shares.

The other problem is timing. CFOs aren't necessarily the best judge of the valuation of the shares of their company. When Pfizer was near $40 per share in early 2004, the company had 7.6 billion shares outstanding. When it bottomed out around $12 per share five years later, there were 11% fewer shares. Buying all the way down wasn't exactly the best financial investment the company could have made.

A third possibility
While most dividend investors would probably like companies to just issue larger dividends or perhaps a special dividend like Merck could have done with the $5 billion it used on its accelerated repurchase, dividend investors and companies should consider a third possibility: use the cash to buy biotechs that could boost earnings through revenue growth.

It's certainly more risky buying pipeline drugs, but the payouts could be substantially higher. Alternatively, I guess, dividend investors could do it themselves, using their dividends from pharma companies to buy biotech companies for the growth part of their portfolio.

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The article Dividend Investor's Archnemesis originally appeared on Fool.com.

Fool contributor Brian Orelli and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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