These firms long ago realized that that free cash flow handily exceeded their capital spending needs (mainly research and development), and to attract investor interest, a dividend made sense. (A caveat: These companies are growth constrained and often can’t afford dividend hikes. Merck & Co., Inc. (NYSE:MRK)’s dividend, for example, has barely budged since 2004).
Yet you’ll notice a pair of large biotechs on the table above, Gilead Sciences, Inc. (NASDAQ:GILD) and Celgene Corporation (NASDAQ:CELG). With each passing year, these companies are starting to resemble the Big Pharma stocks with their rising free cash flow that now exceeds capital spending. Why don’t they pay dividends? Short answer: They will.
In fact, biotech pioneer Amgen, Inc. (NASDAQ:AMGN) has already kicked off the trend, with its first-ever dividend in 2011 (for 56 cents a share) and a payout that now approaches $2 a share.
Not paying a dividend made sense for Celgene Corporation (NASDAQ:CELG) in 2004 through 2008, when the company generated an average annual free cash flow of $125 million. That figure hit $800 million in 2009 and $1.6 billion by 2011, and is on track to exceed $2 billion this year. Gross cash now exceeds $4 billion, even after Celgene Corporation (NASDAQ:CELG) has acquired a variety of smaller biotechs over the past five years.
The fact that Gilead Sciences, Inc. (NASDAQ:GILD) has never had a dividend is even more perplexing. Free cash flow has averaged $2.5 billion a year over the past five years, and as I noted this week, a soon-to-be-approved new drug may take that cash flow even higher.
In the past few years, Gilead Sciences, Inc. (NASDAQ:GILD) has taken advantage of a weak stock price to buy back more than 300 million shares. Yet with shares now breaking out to new heights, buybacks make less sense. Of these two, Gilead Sciences, Inc. (NASDAQ:GILD) looks to be a first mover in terms of a dividend initiation, though Celgene Corporation (NASDAQ:CELG) and Biogen Idec Inc. (NASDAQ:BIIB) may not be far behind.
The No-Brainer Pick
Yet there is one company on the table above for which a dividend — and a good one at that — appears to be in the offing. It’s a company that once paid out annual dividends in excess of $10 a share, was decimated by the 2008 financial crisis, and is now a lot healthier than many realize.
I’m talking about American International Group, Inc. (NYSE:AIG), the once-reviled insurer that needed a massive government bailout but has since exited many risky lines of business. American International Group, Inc. (NYSE:AIG) now focuses on a pair of insurance lines (life and property/casualty) that generate steady predictable cash flow. In 2012, free cash flow exceeded $3.5 billion, and analysts see that figure hitting $5 billion by next year. With 1.7 billion shares outstanding, a $2-a-share dividend would be quite feasible, and as interest rates rise (boosting American International Group, Inc. (NYSE:AIG)’s returns on its gross cash holdings), this dividend could climb higher from there.
Frankly, with shares trading well below tangible book value of $65 a share, a stock buyback makes even more sense. CEO Robert Benmosche discussed both of these options in a recent interview with CNBC.
Risks to Consider: Dividend growth has been a key investment theme in recent years — yet as we saw in 2008, a weak economy can lead to dividend cuts, so don’t be alarmed if your dividend-paying stock does so. History says that dividends will be back at full strength after the economic weakness passes.
Action to Take –> Don’t just focus on companies that don’t yet have dividends. Some companies that have only recently begun to offer a payout also have the potential for robust dividend growth. My favorite example is Ford Motor Company (NYSE:F), which in my view could triple its current 40-cent-a-share dividend over the next few years without making a dent in the balance sheet.
This article was originally written by David Sterman and posted on StreetAuthority.
