Simply put, during the recession, U.S. companies began hoarding cash at an unprecedented pace. Today, these companies are sitting on $1.7 trillion -- more cash than they know what to do with, so they're beginning to raise dividends and buy back stock at an equally unprecedented pace.
The flood of dividend increases is already well under way -- S&P 500 dividends rose by 17% last year to a record $281.5 billion. Another record year of dividend gains is anticipated in 2013.
Pharmaceutical stocks may lead this trend. Big Pharma is immensely profitable and defensive, which has allowed these companies to accumulate massive wealth. At the end of 2012, for instance, the top five drugmakers in the United States held more than $70 billion in cash and short-term investments.
The Big Pharma Stock with a $21 billion "Dividend Vault"
One of my favorite cash-rich drug stocks is Johnson & Johnson (NYSE: JNJ). This iconic 120-year-old company is the world's eighth-largest drugmaker, owning the No. 1 or No. 2 share in 70% of its markets.
Today, Johnson & Johnson holds more than $21 billion in cash and short-term investments -- an impressive amount of cash, especially considering the company's $217 billion market value. This means Johnson & Johnson is valued at just 10 times the company's cash position.
In addition, this reliable performer has generated 29 consecutive years of earnings growth and 50 straight years of dividend payments. Analysts expect the company's earnings growth to nearly double in the next five years to a 6.4% annual rate -- up from an annual rate of 3.5% in the previous five years.
Johnson & Johnson paid out more than $6.6 billion of cash dividends to investors last year, well-supported by free cash flow exceeding $12.5 billion. Dividends have been rising by 8% annually for five years, payout is moderate at 62% of earnings, and the yield roughly 3%.
Johnson & Johnson is best known for its consumer health business -- which owns familiar brands such as Band-Aid, Listerine and Tylenol -- but the company generates more revenue from its medical devices and diagnostics division (41% of sales) and prescription drug business (38% of sales).
Like most of its peers, Johnson & Johnson faces challenges from patent expirations on key drugs such as ADHD medication Concerta and rheumatoid arthritis treatment Remicade, which represented about 5% and 22.5% of total revenue in 2011, respectively. (2012 numbers haven't been released yet.)
However, these losses will likely be offset by new drug launches and continued growth in China and Russia, where Johnson & Johnson already has strong sales and market share. This year, the company plans to launch Canagliflozinits, a new drug for diabetes, and Xarelto, a new treatment for thrombosis and pulmonary embolism. In addition, Johnson & Johnson secured early approval for a tuberculosis drug that is expected to drive strong sales in emerging markets where tuberculosis is still a growing concern.
The company's medical devices and diagnostics division received a huge boost in 2012, when Johnson & Johnson acquired Swiss orthopedic device maker Synthes. That move effectively removed one of Johnson & Johnson's key competitors and solidified its own market share. In addition, the merger allowed Johnson & Johnson to pursue expansion opportunities in an orthopedic market poised for growth linked to aging baby boomers' need for more knee and hip replacements.
A $24 billion "Dividend Vault"
The world's largest pharmaceutical company, Pfizer (NYSE: PFE), is another top pick of mine. It ranks sixth based on the size of its cash holdings, with cash and short-term investments totaling more than $24.3 billion. Pfizer is currently valued at $207 billion, only 8.5 times the company's cash position. Pfizer generates more than $18 billion in annual free cash flow and has a low 45% payout that leaves plenty of room for dividend growth. Pfizer yields roughly 3.5%.
Pfizer cut its dividend in half in 2009 when it decided to purchase fello Wyeth, but it has been growing its payout by 10% a year since then.
Pfizer owns the best-selling prescription medication in the world -- the cholesterol-lowering agent Lipitor. While Pfizer lost market exclusivity on this blockbuster drug last year, the company hopes to make up lost revenue with drugs recently approved by the FDA such as Xeljanz. This rheumatoid arthritis drug could generate $2.5 billion in annual sales. Another promising new FDA-approved drug is Eliquis, a blood thinner co-developed with Bristol Myers Squibb (NYSE: BMY)
Pfizer is freeing up even more cash by divesting some of its noncore businesses. In November 2012, the company sold its infant nutrition unit to Nestle for $11.9 billion and booked a $4.8 billion gain on the sale. In February, Pfizer completed a public offering of its animal health business Zoetis (NYSE: ZTS) that raised $2.24 billion. Pfizer still holds 83% of Zoetis and expects to gradually reduce its stake and use the proceeds for dividends and stock repurchases.
Analysts forecast modest earnings growth averaging a little more than 3% in each of the next five years. However, this is a big improvement from the prior period's earnings decline. Forecasts are also looking too conservative, given the fact that Pfizer has blown past consensus analyst earnings estimates in three of the last four quarters.
Risks to Consider: My biggest concern regarding Johnson & Johnson is product recalls that have harmed the company's reputation. In the past five years, there have been major recalls of key products such as Motrin, Aveeno baby lotion and Tylenol.
Action to Take --> Both of these cash-rich pharma companies offer excellent prospects for dividend hikes. Johnson & Johnson is my top pick of the two because of its greater diversity and more consistent record for dividend growth. Pfizer is more of a pure-play on drug development and is totally reliant on the strength of its drug pipeline for sustainable growth. But considering the size of their respective "Dividend Vaults," either one is a good bet for safe, rising dividends for investors.