Right now, Merck (NYSE: MRK), this nation’s second biggest pharmaceutical maker, is a curious animal: a value stock that’s priced like a growth stock. It’s almost enough to for me to put a “Sell” recommendation on the stock, but not quite. An explanation is in order.
At $56.80, Merck shares were trading at 37.4 times trailing 12-month earnings, compared to an average of 16.1 for the other 29 Dow stocks. The closest is Nike (NYSE: NKE) at 26.2, and analysts project its earnings to grow by 13.35% per year for the next five years. The Merck’s PE says that investors are expecting an upside earnings explosion in the foreseeable future. Yet, Wall Street isn’t confirming that view: analysts’ consensus estimate is that Merck earnings will grow at an uninspiring rate of 4.03% a year. And still, eight of the 19 analysts who cover Merck call the stock a “Buy” or “Outperform” and all the rest say “Hold.”
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MRK pays a respectable dividend of $1.76 a share, for yield of 3.1% right now. A key ratio I use to assess whether the market is asking an unreasonable price for a stock is one takes its dividend yield and estimated 5-year earnings growth rate into account. It’s called the dividend-adjusted PEG (Price to Earnings Growth Rate), and Merck’s is 2.21, also the highest on the Dow and one that almost screams “sell me!”
Now add to that signal the facts that Merck’s current dividend payout ratio is 114%, and its average over the past five years is 125%, not including two quarters when the ratio was infinite, because Merck lost money. A red flag goes up when the ratio exceeds 75%. Often, it signals that dividends might soon be cut. In Merck’s case, it recently meant seven years (June 2009 to September 2011) without an increase in the $1.52 annual dividend. Since 2011, Merck has increased its dividend by 8 cents a year. Over the last 10 years, the dividend has grown at a disappointing rate of 1.3% a year.
What makes Wall Street so optimistic – at least so NOT pessimistic – about MRK? First, it’s rung up four straight quarters of earnings growth, the last, reported this past week, surprising analysts by four cents at 85 cents a share. Second, that 12-month improvement supports Wall Street’s consensus that for all of 2014, Merck’s earnings will be $3.49 per share, more than double 2013’s $1.47. The latest earnings were driven by a 19 percent quarter-over-quarter increase in sales of its consumer products and healthy gains in several of its key patented drugs, including its anti-arthritis drug Remicaid (up 15%) Isentress (up 10%), used to treat HIV infections, and its human papillomaovirus vaccine, Gardasil (up 7%).
But what’s really making investors drool are Merck’s prospects for some nine potential blockbuster drugs now in various stages of development. These include Pembrolizumab, an investigational drug to treat advanced melanoma, which is Phase III trials and which has FDA granted “breakthrough status.” Merck CEO Ken Frazier says Merck is studying the possible application of the drug to treat 30 different kinds of cancer. It’s expected to reach the market later this year. Other patentable drugs in the pipeline in advanced trials include more effective drugs to treat hepatitis-C, insomnia, Alzheimer’s, osteoporosis, diabetes and a new “first-class” anesthesia drug, Sugammadex.
These are the kinds of drugs Merck needs to make up for the revenue losses it suffered from mature blockbusters that have since lost patent protection and given birth to less expensive generics. But the problem is that the impact of these drugs on Merck’s income statement are unknown, which is why analysts still project mediocre earnings growth head. It’s all a wee bit speculative.
It’s the speculative nature of MRK’s future that makes me shy away from it. When an investor buys a Dow stock, he or she is expecting predictability – not the moon, but steady earnings and attractive, growing dividends. Right now, MRK offers neither, so I can’t recommend it as a “Buy.”
As for my “Hold” recommendation, what I’m counting at is the upcoming sale of Merck’s consumer product line to Bayer for $14 billion to provide a healthy injection of cash to keep Merck’s dividends and R&D projects intact. That should tide investors over for another year or so, by which time some of Merck’s new drugs will have had the opportunity to prove themselves.
By the way, my projection is that investors could expect an average total return of about 7.7% over the next gives. That’s based on the current analyst consensus for earnings growth, and no growth in dividends. That’s considerably better than a poke in the eye with a sharp stick, but in the same industry you can find stronger and steadier opportunities.
For example, take a look at fellow Dow member Johnson & Johnson (NYZE: JNJ) and AbbVie (NYSE: ABBV), not on the Dow but a “dividend aristocrat.”. At $99.90, JNJ’s PE is 19.1, it carries a dividend yield of 2.80% and its earnings are expected to grow by 7.10% a year over the next five years. AbbVie, spun off from venerable Abbot Laboratories last year, closed at $52.48 today, at 20.4 times trailing earnings and yielding 3.20%. Analysts expect its earnings to grow by 9.23% a year, more than double MRK’s estimated rate.
About Lawrence Meyers Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at firstname.lastname@example.org.