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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.

Dividend Profile

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

2012

2011

2010

Net Income

$6,661

$6,272

$861

Depreciation and other noncash charges

$7,178

$7,427

$7,381

Funds from Operations [FFO]

$13,839

$13,699

$8,242

change in noncash current assets

$1,256

$896

$1,358

change in noncash current liabilities

$1,137

$420

$1,222

Operating Cash flows

$11,446

$12,383

$10,822

Capital Expenditures

$1,779

$1,723

$1,678

Free Operating Cash Flow

$9,667

$10,660

$9,144

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.

Essential Metrics

Essential Ratios

2012

2011

2010

Funds from Operations [FFO]/Total Debt

0.89

0.88

0.53

FFO/Capital spending requirements

7.78

7.95

4.91

Free Operating Cash Flow + interest expense/ Interest expense

13.87

15.23

13.79

Debt Service coverage

4.44

4.79

3.70

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.

Summary

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.

Source: Merck: Enjoy This Generous Yield