In the world of stocks, big pharmaceutical companies are often viewed as relatively safe. Their business model is reliable, and they make the drugs people need.

If chronic disease and old age were treatable with donuts, then Dunkin’ Brands (Nasdaq: DNKN) would be considered the safest stock in the world. Who wouldn’t follow a doctor’s orders to “take one Boston cream” and call him in the morning?

[ad#Google Adsense 336×280-IA]Unfortunately, we’re not getting any younger, and as we age, we tend to require more medicine.

This keeps the revenue and cash flow going for big pharma companies.

This week, let’s look at one of the largest of the big pharma companies: Merck (NYSE: MRK).

The New Jersey-based drug giant has more than 100 approved products on the market.

Its roster includes Januvia for the treatment of diabetes, Fosamax for osteoporosis, and a new cancer killer, Keytruda.

Merck also has three dozen clinical trial programs in progress, including treatments for Hodgkin lymphoma, colorectal cancer and Alzheimer’s.

But investors need to know whether it has the resources to pay shareholders this year and whether it will be able to raise future distributions.

While earnings tell one story, free cash flow tells another.

Merck currently pays an attractive 3.4% yield. It’s raised its dividend a total of 38 times since it began paying one in 1970. It cut the dividend once, by half a penny, in 1988. But it boosted it again the very next quarter.

Shareholders have seen raises for the past five years in a row. Between 2004 and 2011, Merck held its dividend steady at $0.38.

So the big question is, what’s ahead?

The Earnings Dilemma

If we calculate Merck’s payout ratio based on earnings, the way most people do, it comes out to a sky-high 115%. This is based on net income of $4.4 billion and total dividend payouts of $5.1 billion.

By this measure, you’d look at Merck and say, “it doesn’t make enough money to pay the dividend.”

But earnings don’t tell the whole story.

[If there] was more than $6 billion in depreciation – a noncash expense that lowers net income – the picture changes. When you add the depreciated items back in (you add them because they do not represent an outlay of cash), free cash flow comes out to $11.1 billion… giving us a low 46% payout ratio.

This is an excellent example of why I use cash flow to calculate the payout ratio instead of earnings. In Merck’s case, earnings don’t come close to accurately showing whether or not Merck can pay its dividend.

The only reason Merck doesn’t get the Safety Net’s highest rating is its free cash flow is expected to decline slightly in 2016.

It will still have enough to pay the dividend, but here at Safety Net headquarters, we don’t like to see free cash flow fall.

We want a larger margin of safety, not a smaller one.

Merck investors have nothing to worry about when it comes to their dividends.

Despite the small drop in cash flow expected this year, Merck should generate plenty of cash to pay the dividend – even if the company raises the dividend in the near future.

With the company’s spectacular dividend track record dating back to the Nixon era, Merck shareholders are perfectly safe.

Dividend Safety Rating: B

— Marc Lichtenfeld


Source: Wealthy Retirement