Shares of Merck & Co (MRK) have dropped by 10.9% from their 52-week high of $48.00 achieved in October 2012. At $42.75, the stock is standing at around the mid-point of its 52-week trading band between $36.91 and $48.00, and offers a fairly high dividend yield at 4.0%. Does the recent pullback suggest a buying opportunity? My valuation analysis discussed in this article may assist you in formulating an investment decision.
Sell-side analysts on average project Merck's revenue, EBITDA, and EPS to grow at 2-year CAGRs of -0.5%, -2.7%, and 10.1%, respectively, over the next 2 fiscal years (see comparable analysis chart below). Those consensus growth estimates are all below the averages of 0.1%, -1.0%, and 14.1, respectively, for a peer group consisting of Merck's primary competitors. Similarly, Merck's EBITDA margin is predicted to compress by 1.9% over the same period, compared to the peer-average estimated decline of just 0.9%. On the profit side, however, Merck's performance is fairly comparable to the group. The company's EBITDA, EBIT, and net profit margins are somewhat on par, but its capital return metrics, including ROE and ROIC, underperform the peer averages. Merck's debt level is fairly in line with the peer group as reflected by its slightly lower debt to capitalization ratio, but higher debt to EBITDA rate. In terms of liquidity, Merck's free cash flow margin and interest coverage ratio are both on par, and both its current and quick ratios are slightly above the peer averages, reflecting a healthy liquidity position.
To summarize the financial comparisons, given Merck's in-line profitability and cash flow performance, the company's relatively weaker growth potential appears to be the primary drag on the stock's valuation. The current stock valuations at 7.1x forward EV/EBITDA and 12.0x forward P/E represent an average discount of 16.1% to the peer-average trading multiples (see chart above), suggesting that Merck's current valuation is reasonable.
Moreover, Merck's forward P/E multiple of 12.0x is now trading at a 14.3% discount to the same multiple of the S&P 500 Index (see chart below). Despite the fact that Merck's long-term estimated earnings growth rate at 3.9% is markedly below the average estimate of 8.0% for the S&P 500 companies, I believe the stock's trading multiple discount implies an attractive valuation level provided that 1) Merck has been able to maintain a robust free cash flow margin (above 20%) in recent years; 2) The stock offers a 4.0% dividend yield, which is considerably above the averages of the overall market and the pharmaceutical sector; and 3) Merck has diversified product lines and a solid market share.
I also performed a DCF analysis to support my view (see DCF chart below). The model incorporates the market's consensus revenue and EBITDA estimates. Other free cash flow related items including depreciation, tax expense, capital expenditure, and net working capital investment are projected based on their historical ratios to the revenue. The terminal revenue growth rate is set to be 0.0% for conservatism, as the market is currently projecting an average revenue growth rate of 0.1% from fiscal 2012 to fiscal 2017. The EBITDA margin from fiscal 2015 to the terminal year is assumed to be constant at 40.0%, which is slightly below the average margin of 41.1% between fiscal 2012 and fiscal 2014 predicted by the market.
A company-specific risk premium of 4.0% is applied in the cost of equity calculation to account for the financial projection risk. As such, based on a reasonable WACC of 9.0%, a terminal growth rate of 0.0%, and an implied terminal EBITDA multiple of 6.9x (currently at 7.1x as mentioned earlier), the DCF model yields a stock value of $44.51, which is 4.1% above the current share price at $42.75. Since the model assumptions are fairly conservative, the analysis indicates that Merck is slightly undervalued. Additionally, the DCF sensitivity tables suggest that a somewhat extreme combination of -1.0% terminal growth rate and 10.5% WACC would drag down the stock value to $35.92. On the other hand, a mix of -1.0% terminal growth rate and 36.0% terminal EBITDA margin would suggest a stock value of $38.01. Both scenarios represent an average loss of 13.5% from the current share price, but once the 4.0% dividend yield is accounted for, the downside does not appear to be significant.
The chart shown below suggests that Merck's free cash flow has recovered from its trough in fiscal 2009. Since then, the company's dividend payout represented only approximately a half of the annual free cash generated, meaning that Merck has sufficient capacity to at least sustain the current dividend level. To test the downside, assuming a 1-year target dividend yield at 4.5% (the yield's upside is likely weighed by the strong investor demand for income assets under the low-interest market environment) and that the annualized dividend per share stays constant at $1.72, this very conservative scenario would result in a stock value at $38.22, representing only a downside of 10.6% before adding the 4.0% dividend yield.
Sell-side analysts are generally bullish on Merck. According to Thomson One, of the total 21 stock ratings, there are 5 strong buys and 8 buys. Chris Schott, the research analyst at JPMorgan, elaborated on his long-term investment thesis in a recent research note (sourced from Thomson One, Equity Research):
"We continue believe Merck's late-stage pipeline updates in 2013 represent key drivers for the stock and see MRK shares as well positioned for multiple expansion with the company offering healthy earnings growth (7% CAGR through 2020), one of the lowest valuations (12x our 2013E EPS) and with several approaching phase III data releases over the next 12-18 months."
In conclusion, the recent pullback has pressed the stock valuation to an attractive level. Given the stock's 4.0% dividend yield, which appears to be sustainable, and the company's solid prospects, I recommend buying the shares at the current price level. To limit the investment risk, selling out-of-the-money put options would be a viable and conservative trading strategy.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and charts is sourced from Capital IQ.