by Lawrence Meyers | September 5, 2013 12:13 pm
When I analyze a company to determine its overall situation, the cash flow statement tells me more than anything else.
If a business is generating tons of cash flow and growing quickly, then it’s probably plowing that cash back into growth. If growth has slowed, then hopefully that cash is being put to good use in the form of a dividend or buyback. Generally, I prefer dividends, because buybacks don’t offer a tangible reward. If the dividend isn’t great but the stock is undervalued, then I’m fine with that, as I’ll hopefully enjoy capital gains.
Some people hold stocks because they pay a dividend, and that’s great. However, if the dividend isn’t all that high and the company isn’t growing, the company might just be using cash to run in place and hold its position. With pharmaceutical companies, that’s often the case.
Bristol-Meyers Squibb (BMY[1]) is a great example. From a cash flow standpoint, it seems exciting at first glance. FY12 free cash was $6.4 billion, which is up from FY11’s $4.5 billion and $4 billion in FY10. In each year, the company paid out about $2.2 billion in dividends. As you can see, that leaves a lot of cash that must be plowed back into R&D … yet I’m not seeing huge results in that regard.
As a pharma company, BMY must constantly be pursuing new drugs as others go off patent or competitors enter the market. In its last quarter, net sales were down 23% as the company’s exclusive market for Plavix and Avapro vanished.
With a long-term growth rate of 8.25%, the company trades at 25x earnings. Now, I understand that the 3.4% dividend is attractive, but that does not justify paying two to three times fair value for it. You can find that kind of payout in many other places, including well-diversified ETFs that don’t carry the risk that BMY does if its drug pipeline fizzles.
I feel the same way about AstraZeneca (AZN[2]), a world-class pharma company. Its FCF has gone from $9.88 billion in FY10 to $7 billion in FY11 and $6.3 billion last year. First, let’s start with the fact that this number has been declining each year. On top of that, the company announced that operating costs will increase. Meanwhile, patents are expiring, and loss of exclusivity has already hit revenue to the tune of $500 million.
Earnings are expected to decline from $6.41 per share last year to $5.19 this year and $4.88 next year … yet investors are still paying 10x earnings for declining EPS without clarity as to when it will grow again. I don’t care if the yield is 3.7% — I can get that yield, and better, with much less risk. Don’t believe me? iShares S&P US Preferred Stock Index (PFF[3]), a basket of preferred stocks, yields 5.36%.
And then there’s Merck (MRK[4]), which was a core holding for me in the 1990s. I sold it in October of 1998 and never looked back. The stock has lost a third of its value since then, even while cash flow has been churning to the tune of billions every year — $8.1 billion in FY12 alone.
Merck struggles with the same issues the other pharma stocks mentioned do, and earnings are expected to fall to $3.48 this year, from $3.82 last year and then rebound to only $3.68 next year. The stock, meanwhile, trades at almost 14 times earnings. That’s too risky for a 3.6% yield.
So remember, while free cash flow can be a good indicator of health, it’s meaningless if the stock isn’t actually moving forward.
As of this writing, Lawrence Meyers was long PFF. He is president of PDL Broker, Inc.[5], which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books[6] and blogs about public policy, journalistic integrity, popular culture, and world affairs[7]. Contact him at pdlcapital66@gmail.com[8] and follow his tweets @ichabodscranium.
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