(Published Jan. 24 by Bob Ciura)
The health care sector is a great place to look for high-quality dividend stocks. Big Pharma companies enjoy high profit margins since consumers often can’t go without their medications.
When it comes to investing in health care stocks, not many investors think of Roche Holdings (RHHBY, Financial). Roche tends to operate in the shadow of the U.S. health care giants like Johnson & Johnson (JNJ, Financial) or Pfizer (PFE, Financial).
But Roche stock should be on the map for income investors. It has an attractive 3.5% dividend yield, which exceeds the dividend yield for many of the company’s U.S. competitors.
It has a long history of steady dividend increases. In fact, Roche would qualify as a Dividend Aristocrat if its payout were measured in its home currency and it was a member of the Standard & Poor's 500.
The Dividend Aristocrats are a select group of companies in the S&P 500 Index with at least 25-plus years of consecutive dividend increases each year.
You can see the list of all 50 Dividend Aristocrats here.
Business overview
Roche was founded in 1896. It is headquartered in Switzerland. The company has more than 90,000 employees and sells its products in more than 100 countries around the world.
The company operates in two core segments:
- Pharmaceuticals (77% of sales).
- Diagnostics (23% of sales).
The pharmaceutical business is Roche’s largest. It has a large drug portfolio with many products that lead their respective categories.
Source: 2016 Fact Sheet, page 2
Its pharmaceutical business is based on oncology and immunology. Roche’s strong pharmaceutical brands have helped it generate revenue growth consistently each quarter over the past several years.
Source: Third Quarter Earnings Presentation, page 7
Roche’s oncology portfolio grew revenue by 4% through the first three quarters of 2016. Meanwhile, the immunology business is growing at a double-digit rate.
Source: Third Quarter Earnings Presentation, page 21
Roche’s impressive pharmaceutical growth over the past several years is due to organic investment as well as its huge $47 billion acquisition of Genentech in 2009. This was a transformational deal for Roche, which instantly added to its portfolio and global scale by acquiring its close competitor.
The benefits of the acquisition are clear. Three of Roche’s current top-selling drugs –oncology therapies Avastin, Herceptin and Rituxan –Â came from Genentech.
Separately, Roche has a highly successful diagnostics business with several strong brands.
Source: 2015 Annual Report, page 18
Its diagnostics portfolio has several industry-leading brands in a wide range of therapeutic areas like blood screening, virology and diabetes care.
Geographically, Roche has a diversified business model, split between the U.S., Europe and the emerging markets.
Source: Third Quarter Earnings Presentation, page 8
The company reported positive across all four geographic markets over the first three quarters of 2016, in both the pharmaceutical and diagnostics businesses.
Growth prospects
In order to generate sustainable growth over the long term, competitive advantages are critically important. Roche enjoys global scale and pricing power, thanks to its strong product portfolio.
Roche has a market capitalization of nearly $200 billion. As such, it has deep pockets –Â and invests heavily to generate growth.
The company’s research and development expense over the past few years is below:
- $9.4 billion in R&D expense in 2013.
- $9.8 billion in R&D expense in 2014.
- $9.7 billion in R&D expense in 2015.
Sufficient spending on R&D is critical for health care companies to combat the effects of patent expirations. Pharmaceutical companies can face a swift and severe drop in revenue once key products go off patent due to competition from lower-priced generics.
The good news for investors is that Roche’s investments in R&D have paid off. The company has a robust pipeline that should fuel continued growth going forward.
For example, Roche ended 2015 with 70 new potential medicines and an additional 63 indications for existing products. Within its pipeline, Roche holds 39 projects in Phase III development.
This has worked well for the company.
Source: Third Quarter Earnings Presentation, page 17
The emerging markets, including China, Latin America and the Middle East, will be an increasingly important driver of Roche’s growth. Roche predicts 50% of its future earnings growth will come from emerging markets.
For 2016, Roche expects sales to increase at a low to mid-single-digit rate on a percentage basis. Earnings per share are expected to rise slightly above its revenue growth rate, thanks to cost cuts.
This growth will be more than enough for the company to continue raising its dividend each year moving forward.
Valuation and expected total returns
The current valuation of Roche is appealing. The stock trades for a price-earnings (P/E) ratio of 22. By comparison, the S&P 500 Index has an average P/E ratio of 25.
If the valuation multiple were to expand to reach the average index multiple, it would generate approximately 13.6% return.
Aside from an expanding P/E ratio, the company will generate shareholder returns through earnings growth and dividends. A breakdown of future returns could be as follows:
- 3% to 5% organic revenue growth.
- 1% earnings growth from cost cuts.
- 1% earnings growth from share repurchases.
- 3.5% dividend yield.
As a result, total annual returns could reach 8.5% to 10.5% including dividends. Expansion of the P/E multiple would be an added kicker to total returns.
Importantly, the dividend is well covered by underlying earnings. Over the past year, Roche generated earnings per share of $1.30. Its dividend per share is currently $1.02 per share.
Roche’s current annualized dividend represents 78% of its trailing 12-month earnings per share. Its payout ratio is a bit on the high side, but the company should continue to generate enough earnings growth to sustain growth of the dividend each year.
Final thoughts
Roche’s share price has declined 11% over the past year. The stock's poor performance was driven by a heightened level of uncertainty regarding drug pricing and economic conditions in Europe and the emerging markets.
But investors should focus on the company's fundamentals, which remain strong. Despite the Brexit vote and unfavorable currency markets, Roche continues to generate solid growth and offers a secure 3.5% dividend yield.
Disclosure: I am not long any of the stock mentioned in this article.
Start a free seven-day trial of Premium Membership to GuruFocus.
Also check out: (Free Trial)
