Which Dividends Would Be Safest If Drug Prices Were Slashed Tomorrow?

By George BudwellFool.com

The debate over new drug prices has taken center stage in the political arena, with Democratic candidates Hillary Clinton and Bernie Sanders making this issue a cornerstone of their respective campaigns. As such, the market seems to think that profit margins in the pharmaceutical industry could be in deep trouble going forward. If true, dividend payouts across the industry could also be dramatically reduced or cut altogether.

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So with the political rhetoric over this issue rising to fever pitch, I think now is a good time for investors to consider which major drugmakers might be most susceptible to a dividend reduction if drug prices do indeed tumble in the near future.

With this mind, let's take a deeper dive into five of the most popular dividend-paying drugmakers -- AbbVie , Gilead Sciences , Johnson & Johnson , Merck & Co. , and Pfizer -- to see which companies might offer investors a safe haven in a worst-case scenario.

If drug prices crater, payout ratios won't provide much insight into a dividend's sustainabilityThat's why I think investors need to look beyond payout ratios and consider other issues such as the company's current profitability, as well as the strength of its balance sheet. In short, we need to understand how much of a haircut a company could withstand in terms of its profitability and cash flows before it runs into trouble meeting its long-term financial obligations.

To this end, let's start by looking at some data compiled from S&P Capital IQ:

The first thing you might want to take notice of is that the gross margins among these top pharma and biotech companies are astronomically higher than the average for most other industries, which tend to hover around 40%. And that's the crux of the entire drug pricing debate.

Pharma companies have traditionally countered this complaint by stating that their expenses, mostly from R&D, are much higher than other industries, leading to comparatively normal profit margins. With the clear exception of Gilead, the data reveals that the profit margins among these top drugmakers probably aren't unreasonable, although they do fall on the high side when pitted against most other major industries.

With the broad strokes out of the way, let's now get down to the business of which stocks have the safest dividends (if any). Based on the data, AbbVie has to be considered the drugmaker with the most dangerous dividend if drug prices head south. The company's balance sheet appears to be highly levered, given its total debt-to-equity ratio, and its profit margin falls well below its immediate peer group. Topping it off, AbbVie has the highest yield among these companies, suggesting that any further declines in profitably may necessitate a cut to shareholder rewards such as dividend payouts.

In terms of a winner, J&J probably takes the cake here. Unlike Merck, Pfizer, and Gilead, J&J's balance sheet is comparatively leverage free. That said, J&J's dividend would still probably have to be reduced if its profit margin fell dramatically from current levels. After all, its profit margin isn't abnormally high, either within the pharma industry or compared with large-cap companies in many other major industries.

Having said that, Gilead is probably one of the few large-cap drugmakers that could reasonably navigate a hefty decline in drug prices based on its remarkable profit margin. Even so, the biotech's balance sheet still carries enough leverage to make its current dividend payout highly suspect if its sky-high margins were hemmed in moving forward.

Source: Pixabay.

Key takeawaysComparing some of the industry's top names helps to put the drug-pricing debate into proper context. Basically, politicians and payers are grumbling about the industry's eye-popping gross margins, while pharma companies themselves are busy pointing to their fairly standard net margins as evidence that new drug prices aren't unreasonable.

So who's right? There probably isn't a right or wrong answer to this question -- only probable ramifications if drug prices are slashed. No dividends, which are pivotal shareholder rewards that attract long-term investors, would be 100% safe if there is a major downturn in the prices of new drugs -- that is, unless cuts are made to other important aspects of these businesses.

After all, drugmakers, at their core, are businesses run for a profit, meaning that management teams would most likely be forced to find ways to buoy profit margins. And the most obvious choice would be to cut back on the money spent on the riskiest types of experimental drugs -- some of which may ultimately lead to ground-breaking changes in the standard of care for many life-threatening ailments. Put simply, lower drug prices will probably lead to a much slower rate of medical innovation, as a direct consequence of managerial teams attempting to appease long-term shareholders.

The article Which Dividends Would Be Safest If Drug Prices Were Slashed Tomorrow? originally appeared on Fool.com.

George Budwell owns shares of AbbVie, Gilead Sciences, and Johnson & Johnson. The Motley Fool owns shares of and recommends Gilead Sciences. The Motley Fool recommends Johnson & Johnson. 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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