This is the third in a series of articles highlighting dividend companies that have large and durable economic advantages, or “moats”, that protect their business operations and allow years or decades of strong profitability. When looking for long-term investments, one typically wants to find a business that is performing well not simply because management is on top of their game right now, but rather because the business itself has fundamental and difficult-to-replicate advantages over its competitors. In the last two articles, examples of unrivaled economies of scale and particularly powerful brands were provided.
Some companies keep competitors away by patenting their products. This gives them a number of years where they can get all of their research and development to pay off with nice profit margins. If a company is big enough, they can successfully layer or ladder dozens, hundreds, or thousands of patents so that at any given time, only a subset of their patents are expiring, and new ones are replacing them. That way, most of the product portfolio is continually refreshed with a strong set of patent shields. When a company organizes hundreds or thousands of engineers and scientists, and then layers their products with patent shields, this creates a pretty formidable defense against competitors. Some of the largest patent-holding companies often buy companies just for their patents.
The following is a list of dividend-paying companies with good patent shields. I’ll break this article up into two parts: the diversified health care section, and the industrial/tech section. Rather than making this list unwieldy by providing every company with a good patent collection, I’ve highlighted twelve of them.
It’s not just the number of patents that matter, it’s how effectively a company uses those patents. Tech companies generally have the largest numbers of patents. Health care companies generally have fewer patents, but they can protect multi-billion-dollar drugs. A focus on free cash flow (FCF) is emphasized in the company descriptions.
Johnson and Johnson
Several of Johnson and Johnson (JNJ)’s seven billion-dollar drugs have lost or are preparing to lose patent protection. Fortunately, JNJ buffers its pharmaceutical segment (constituting only one third of total company sales) with a huge medical device segment and a consumer products segment, as well as billions of dollars spent on R&D and acquisitions. The company has a had a rough ride over the last few years with recalls and patent expirations, in addition to the general economic downturn. The balance sheet remains AAA, the free cash flow remains particularly strong, patent losses going forward are mild, and I expect the next five years to be better, financially, than the last five years.
Dividend Yield: 3.49%
FCF Dividend Payout Ratio: 51%
Most Recent Dividend Increase: 5.5%
Total Debt/Equity: 0.30
Price to FCF Ratio: 14.8
Abbott (ABT) has a large set of patent-protected drugs and devices, with the blockbuster drug Humira leading the way. Humira has been immensely profitable, but does face some competition going forward. Abbott has plans to split into two companies, so investors that are currently satisfied with the diversified health care business with a long string of consecutive dividend increases may not be as inclined to own a pure pharmaceutical company, but on the other side of the coin, the two companies could rise in market cap to be worth more than the company is currently valued by the market.
Dividend Yield: 3.45%
FCF Dividend Payout Ratio: 35%
Most Recent Dividend Increase: 9.1%
Total Debt/Equity: 0.67
Price to FCF Ratio: 10.3
Novartis (NVS), the large Swiss diversified health company, has a large pharmaceutical segment as well as a variety of smaller businesses that have helped the business as a whole to produce 14 consecutive years of dividend growth. Unfortunately, the top drug of Novartis, Diovan, will be going off patent this year, and it accounts for more than 10% of sales. This has been known, however, and I feel that the current valuation fully takes this into account. Novartis is also interesting on this list for having a large generics segment. They have the capacity to capture other top drugs that are going off patent for a fraction of their profits. Plus, they have their own pipeline of drugs to replace or grow from their current sales.
Dividend Yield: 4.27%
FCF Dividend Payout Ratio: 46%
Most Recent Dividend Increase: 4.8% (CHD)
Total Debt/Equity: 0.31
Price to FCF Ratio: 11.4
Full Novartis Analysis
For those less interested in the drama of multi-billion dollar patented drugs and drug pipelines, diversified medical device manufacturers with solid engineering and capital allocation may be a reasonable alternative, although they are of course not without risk themselves. Becton Dickinson (BDX), with its robust size and global manufacturing plants, produces medical and surgical supplies, as well as drug delivery systems, diagnostic tools, and bioscience products.
Dividend Yield: 2.32%
FCF Dividend Payout Ratio: 32%
Most Recent Dividend Increase: 9.7%
Total Debt/Equity: 0.56
Price to FCF Ratio: 14.9
Medtronic (MDT) is a medical device producer that’s more than twice as large as Becton Dickinson and offers a similarly modest dividend yield. Unlike Becton Dickinson, Medtronic’s focus is on complex products to treat chronic diseases, including cardiovascular devices such as pacemakers, spinal devices, and various other areas. Health care budgets around the world are being more critically viewed, but Medtronic has strong and diversified positions in both developed and emerging areas.
Dividend Yield: 2.39%
FCF Dividend Payout Ratio: 27%
Most Recent Dividend Increase: 7.8%
Total Debt/Equity: 0.61
Price to FCF Ratio: 11.6
3M Company (MMM) is a broad engineering conglomerate that produces useful products for industry and transportation, health care, consumers, displays and graphics, safety and security, and communications. The company is particularly focused on meeting needs for growing areas, such as water filtration, renewable energy, personal safety, trends toward worker protection in developing countries, and health care in both developed and developing countries. I think 3M stock is a bit expensive right now, but with a moderate pullback, a reasonable entry price could occur.
Dividend Yield: 2.50%
FCF Dividend Payout Ratio: 41%
Most Recent Dividend Increase: 4.8%
Total Debt/Equity: 0.36
Price to FCF Ratio: 16.5
Full 3M Company Analysis
Emerson Electric (EMR) is another broad engineering conglomerate that provides process management and industrial automation technologies, as well as network power products for data centers and telecommunications companies. They also produce climate technologies and appliances and tools. As computing becomes more and more ubiquitous across the world, and as server-based computing becomes more in focus, Emerson’s business with regard to data centers stands to benefit. Plus, I believe that industrial automation and process management have a strong future ahead.
Dividend Yield: 3.08%
FCF Dividend Payout Ratio: 40%
Most Recent Dividend Increase: 14.5%
Total Debt/Equity: 0.50
Price to FCF Ratio: 14.7
Illinois Tool Works
Illinois Tool Works (ITW) is an extremely diversified and decentralized collection of engineering businesses. The company has a strong history of strategic acquisitions, and brings in revenue from numerous areas including transportation ($2.53 billion in sales), industrial packaging ($2.28 billion), power systems ($1.94 billion), food equipment ($1.87 billion), construction products ($1.76 billion), polymers and fluids ($1.36 billion), decorative surfaces ($1.01 billion), and other areas (another $3+ billion). Slightly more than half of revenue comes from outside of North America. ITW is one of the top 100 patent filers in any given year, and currently holds close to 20,000 patents.
Dividend Yield: 2.58%
FCF Dividend Payout Ratio: 51%
Most Recent Dividend Increase: 5.9%
Total Debt/Equity: 0.46
Price to FCF Ratio: 20.4
Full Illinois Tool Works Analysis
It’s worth noting that Dover (DOV), Emerson, and 3M are the three companies on this list that have each increased their respective annual dividends for over 50 consecutive years. There are only a handful of companies in existence that have accomplished that. Dover unfortunately does have a pretty low dividend yield, but they compensate it with solid EPS and dividend growth. Dover is similar to Illinois Tool Works in that they consist of a decentralized collection of engineering businesses with a number of patents.
Dividend Yield: 1.94%
FCF Dividend Payout Ratio: 24%
Most Recent Dividend Increase: 14.5%
Total Debt/Equity: 0.45
Price to FCF Ratio: 13.2
Full Dover Analysis
Microsoft (MSFT) may have recently broken its “magical” $30 barrier that technical analysts might be wary of, but Microsoft’s low valuation (P/E of less than 11 and P/FCF of less than 10) and potentially good growth prospects mean it’s still undervalued in my view. The company, which was in the top 10 companies for U.S. patent winners in 2011, faces the challenges and opportunities of a changing business model mildly away from market-saturated personal computers and towards both servers and mobile devices. Microsoft holds dominant positions in PC operating systems and office software, is preparing the Windows 8 launch, and is growing its server and tools segment considerably. Less enthusiastically, they have produced a well-reviewed mobile operating system but hasn’t yet developed any meaningful market share with it.
Dividend Yield: 2.64%
FCF Dividend Payout Ratio: 22%
Most Recent Dividend Increase: 25.0%
Total Debt/Equity: 0.19
Price to FCF Ratio: 9.5
Article: The Maturation of Large Cap Tech Stocks
Intel (INTC) also faces the challenges of the shift away from market-saturated personal computers and towards servers and mobile devices. Intel has an extremely dominant position in the PC processor market, and also has a strong showing with regards to servers, but has given up the dominant market share in mobile computing to ARM Holdings. At the same time ARM tries to move vertically upward into netbooks and other moderate power/mobility devices, Intel hopes to move vertically downward into the mobile markets. Nonetheless, Intel has huge R&D expenditure, uses a systematic tick tock approach to continued product improvement, has a superb balance sheet and a sizable dividend yield, and the stock is currently priced for no growth.
Dividend Yield: 3.15%
FCF Dividend Payout Ratio: 39%
Most Recent Dividend Increase: 15.9%
Total Debt/Equity: 0.15
Price to FCF Ratio: 13.6
International Business Machines
IBM (IBM) unfortunately has the lowest dividend yield on this list, despite years of consecutive dividend growth. Considering, however, that IBM continually receives more patents than any other corporation on the planet (over 6,000 new patents in 2011 alone, and the holder of the #1 patent recipient spot every consecutive year for almost two decades), the company must be included in a conversation regarding patents. Instead of spending their tremendous free cash flows mostly on dividends, IBM spends the cash mostly on share buybacks. The $200+ billion company has a strong economic advantage in enterprise computing, and over the last decade has transformed itself into more of a software and service business and away from a hardware business. The company, however, does still provide a full array of software and hardware, as well as services, and with so many products and patents, IBM has a sold worldwide market position.
Dividend Yield: 1.55%
FCF Dividend Payout Ratio: 22%
Most Recent Dividend Increase: 15.4%
Total Debt/Equity: 1.34
Price to FCF Ratio: 14.9
Full IBM Analysis
Full Disclosure: At the time of this writing, I am long JNJ, NVS, MDT, BDX, EMR, and MSFT.
You can see my dividend portfolio here.
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