Should You Forget Pfizer and Buy This Magnificent Drug Stock Instead?

Merck (NYSE: MRK) has a $210 billion market cap. Pfizer (NYSE: PFE) has a market cap of $135 billion. They are both pharmaceutical industry giants with long and successful histories behind them. But there's one huge difference today for dividend investors. Pfizer is offering a 7% dividend yield while Merck's yield is roughly half that at 3.7%. Here's why the lower yield could be the better choice.

Merck and Pfizer have similar businesses

As noted, Merck and Pfizer are both large pharmaceutical companies. Making and selling drugs is complex, expensive, and competitive. There are massive research and development costs involved in identifying potential drug candidates. When a candidate is discovered, it has to be tested for efficacy and safety. That drug also has to gain the approval of regulators before it can be sold to the public. Mass-producing the drug and selling it might actually be the easiest part of the process.

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The cost to find new drugs is so expensive that companies are granted a period during which they have the exclusive right to sell a drug. Those patent protections can lead to huge profits for a period of time. However, when the patents expire, revenue can fall dramatically as generic competition comes into the market. That's known as a patent cliff. This is a normal part of the business, but the loss of important patents can be a huge drag on near-term financial performance.

Both Merck and Pfizer have upcoming patent cliffs. And both are working to deal with the issue. However, from a dividend perspective, they are in vastly different positions. Merck's dividend payout ratio is roughly 40% right now, while Pfizer's payout ratio is over 100%. From this perspective alone, more conservative income investors should probably favor Merck over Pfizer despite Pfizer's higher dividend yield.

Pfizer's moves are more aggressive

For those thinking that Pfizer's lofty yield is worth the risk, it is notable to look at the company's acquisition efforts around Metsera (NASDAQ: MTSR). The two companies agreed to a deal in which Pfizer would pay $47.50 per share in cash for Metsera, with potential earn-outs worth another $22.50 per share. The goal was to get a hold of Metsera's weight-loss drug candidates because Pfizer's own weight-loss drugs flamed out.

However, a competitor came in and outbid Pfizer, upending this plan. Pfizer was forced to come in with a higher bid, securing the deal at an upfront price of $65.60 per share in cash, with earn-outs worth as much as $20.65 per share. If all of the earn-outs are earned, that amounts to an over 25% increase in the price. That's how important this deal is to Pfizer, showing that it is, perhaps, a bit desperate to enhance its drug pipeline.

There are two problems. First, the drug pipeline Pfizer is buying is still just that, a pipeline. There is more work to be done before these drugs come to market, if they come to market. So this isn't a certain fix; it is just a potential fix. And, second, the last time Pfizer made a big acquisition (Wyeth), the board of directors cut the dividend. Wyeth was a much larger deal, but with the payout ratio hovering around 100%, investors shouldn't rule out the risk of a dividend cut.

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Merck doesn't come with the same dividend worries thanks to a lower payout ratio. But there's more than just that. Merck's debt-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio is lower than Pfizer's, and it has higher coverage of its trailing interest expenses. In other words, Merck has much more wiggle room financially than Pfizer. Merck could end up inking its own acquisition, but it would be doing it from a stronger foundation, and the dividend wouldn't likely be in question. In fact, Merck's dividend has largely trended higher (though not every year) for decades.

Both will survive, but caution could be warranted

Pfizer isn't going anywhere as a company, so investors could easily justify buying it and holding for the long term. But if you are buying for the dividend, there is a chance that you could end up with a nasty surprise. And given the lofty payout ratio at the same time that Pfizer is spending billions to buy a company to fortify its drug pipeline, the risk of a dividend cut isn't immaterial. Merck's lower yield looks much more likely to survive the patent cliff headwinds these two industry giants face today, and that will probably make it a better option for more conservative income investors.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Merck and Pfizer. The Motley Fool has a disclosure policy.