By: Ahmed Ishtiaq
Merck (NYSE:MRK) makes medicines for a number of conditions, from stuffy noses and asthma to hypertension and arthritis. The pharmaceutical giant's top prescription drugs include asthma medication Singulair, diabetes drug Januvia, anti-inflammatory Remicade, cholesterol combatants Vytorin and Zetia, and hypertension fighters Cozaar and Hyzaar. In addition, Merck makes childhood and adult vaccines for such diseases as measles, mumps, hepatitis, and shingles, as well as veterinary pharmaceuticals through Merck Animal Health.
Merck is one of the best dividend payers in the market, and offer a sumptuous dividend yield of 4.15%. At the moment, the company pays an annual dividend of $1.72 per share. However, high-yield sometimes can be deceptive and investors can lose money by falling into yield trap. I always look at the payout ratio based on free cash flows while evaluating the stability of dividends for a company. Current payout ratio for Merck stands at around 53%, which is easily manageable. The company paid $5.1 billion in dividends and generated $9.6 billion in free cash flows over the past twelve months. I decided to use my free cash flows model in order to check the strength of the free cash flows and some debt metrics of the company.
Free Cash Flows
Free Cash Flows
Depreciation and other noncash charges
Funds from Operations [FFO]
change in noncash current assets
change in noncash current liabilities
Operating Cash flows
Free Operating Cash Flow
Source: SEC Filings
Over the past three years, net income of the company has improved dramatically. At the end of 2010, net income stood at $861 million, which went up to $6.66 billion by the end of 2012. Merck's funds from operations have followed the trend in net income over the past three years while depreciation expense has remained fairly stable.
Furthermore, operating cash flows have also shown improvement over the last three years. At the end of 2010, cash flows from operations stood at just under $11 billion, which went up to $11.4 billion by the end of 2012. Capital expenditures are a significant element on the books of the company, and in each of the previous three years, the company has spent over $1.5 billion in capital expenditures. Over the past twelve months, Merck spent $1.7 billion in capital expenditures, highest in the previous three years. As a result of solid cash flows from operations, the company has impressive free cash flows. Free cash flows of the company have shown a varied trend over the past three years. Free cash flows in the last twelve months have gone down by almost $1 billion.
Funds from Operations [FFO]/Total Debt
FFO/Capital spending requirements
Free Operating Cash Flow + interest expense/ Interest expense
Debt Service coverage
First ratio shows that coverage provided to debt by FFO has improved over the past three years. FFO to total debt ratio indicates that the firm generates enough funds from operations to cover its total debt. I believe the ratio may get better as the trend in FFO is extremely encouraging for the company. The second metric in the table (FFO to capital spending requirements) shows that the capital spending requirements of the company has been appropriately covered through internally generated funds. Merck's capital expenditures have been increasing over the past three years while operating cash flows have shown a varied trend.
Merck's free operating cash flows have shown a mixed trend during the last three years, and interest expense has been increasing. However, overall interest coverage ratio has shown a slight improvement over the period of evaluation. Nonetheless, interest coverage ratio is incredibly strong for the company, and it should not face any trouble meeting its interest obligations. Finally, the debt service coverage ratio for the company is solid, although mixed trend is apparent in this metric as well. Merck should not face any trouble meeting its debt servicing needs. Overall, the metrics indicate the firm is in excellent financial position.
Merck is one of the biggest companies in the sector with market cap of over $125 billion. Furthermore, its dividend yield backed by healthy free cash flows puts it among the best dividend payers in the market. After my analysis, I can say that Merck can easily maintain its current dividend levels, and even increase dividends in the future. It is an excellent investment for income hunters and should be added to income portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Efsinvestments is a team of analysts. This article was written by Ahmed Ishtiaq, one of our equity analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.