Merck: The Most Undervalued Company In Pharma

Feb.21.13 | About: Merck & (MRK)

I recently wrote a positive article on the merits of Roche (OTCQX:RHHBY) due to its dominant position in cancer care and diagnostics. Roche continues to be my favorite European pharmaceutical company. In the U.S., several drug stocks have done very well in the past twelve months, including Pfizer (NYSE:PFE), Eli Lilly (NYSE:LLY), and Bristol-Myers (NYSE:BMY). Merck (NYSE:MRK), however, has struggled. Since topping out at $48 a share in October, Merck's share price has declined by 14%. At the current discounted price level, Merck now offers the highest appreciation potential of any of the U.S. drug companies. To build a strong case for Merck, I examine nine key selection criteria, which include;

Key Selection Criteria

  1. A market capitalization over $10 billion.
  2. A leadership position within a growing industry.
  3. A dominant, or large, market share within its product mix.
  4. A strong position internationally.
  5. A strong balance sheet and high credit rating.
  6. A high free cash flow number.
  7. A low historical relative valuation as measured by price/sales and/or price/earnings ratios.
  8. A strong dividend growth rate.
  9. A catalyst of new revenue opportunities (pipeline).


Merck is a large-cap healthcare firm, with a current capitalization of $125 billion.


Merck maintains a leadership position in many facets of the pharmaceutical arena. Merck currently maintains a 17% market share in vaccines, an area that is growing at a double digit rate. It has three vaccines in the top ten including #3 Gardisil, #7 Varifax, and #9 RotaTec. These three vaccines brought in nearly $1.3 billion in revenue for Merck. Other popular vaccines that combined bring in more than $600 million in revenue include Zostavax, Pneumovax, and MMR. Merck is also strong in the animal health business. The business unit achieved sales in 2011 of over $3 billion and is the world's second-largest animal health company. Merck has a leadership position in several pharmaceutical categories, including cardiovascular (Zocor) and diabetes (Januvia).


Merck International Sales

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Total Revenue Intl.%Total
2009 45,964M 54%
2010 45,987M 56%
2011 48,047M 58%
2012 47,267M 59%
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Source: Merck Annual Report

International revenue has remained a large portion of Merck's revenue and has continued to accelerate. It has risen from 54% of total sales to nearly 60% today. Merck has focused energies on the international markets. For example, Merck has increased its sales force in China to nearly 4000 sales representatives. The Asia Pacific market now accounts for less than 10% of total pharmaceutical sales, with China less than 3%. However, the Asia Pacific market will account for a larger share of Merck's revenue over the next decade. Merck's Asia Pacific business is growing at double digit rates, including an annual growth rate of 25% in China alone for 2012. Total emerging market growth year-over-year for 2012 was at a 13% rate, the highest rate of any of the other major pharmaceutical firms.

Balance Sheet/FCF

The balance sheet of Merck is in excellent condition. Merck maintains a credit rating of AA from Standard & Poor's Ratings Services. This rating was affirmed this past September. S&P commented "The strong investment-grade rating on Merck & Co. Inc. reflects its diverse portfolio of high-margin products that address a wide range of medical conditions and a near-term pipeline that promises a steady stream of new product launches, key elements supporting its "excellent" business risk profile, according to our criteria. A long history of conservative financial policies and solid cash flows that we expect to exceed capital spending and dividends by over $7 billion in 2012 underpin our "minimal" financial risk assessment for the company".

2011 10660M
2010 9144M
2009 1931M
2008 5273M
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Source: Merck Annual Report

Free cash flow generation by Merck has been very strong. In fact, in 2011, Merck had the highest free cash flow generation in the firm's history. Free cash flow has been exceptional, growing from $5.2 billion in 2008 to over $10 billion in 2011. Merck expects to generate over $13 billion in free cash flow this year. Cash and investments increased substantially in the past three years, rising from $9.3 billion in December 2009 to $17.3 billion in September 2012.

Relative Valuation

As for relative valuation, I have a preference for price/sales ratio when examining the merits of a pharmaceutical company. Merck is trading toward the lower end of its range in history in terms of price to sales. Merck has traded at a price/sales ratio range of 1.7 to 5.5 in the past decade. The average price/sales ratio since 2004 has been 4.1. Sales per share has risen by 50% in the past ten years from 10.3 to 15.5. This was aided in large part by the acquisition of Schering Plough. During the same time period, the share price of Merck has dropped from $49 in January 2004 to $42 today. Not only have sales risen, but earnings as well. Earnings per share in 2004 were $2.61 while expectations for earnings per share in 2013 are $3.70. Cash flow growth has been more remarkable, nearly doubling from $3.29 to over $6.00 a share. At the current moderate pace in sales per share growth, Merck could present investors with attractive capital gains. Sales per share growth is both driven by increased revenue and/or reduction in shares outstanding. Shares outstanding in Merck have increased by one third since 2004, with the majority of the share increase due to the acquisition of Schering Plough. However, share count has been on a declining trajectory since the buyout. Its new share repurchase program of $5 billion was initiated in 2011, which raised the total amount of stock that could be bought back by Merck to $6.4 billion. In calendar year 2012, Merck repurchased $2.6 billion of stock.

Date Price/Sales Ratio Avg. Sales Per Share
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2012 3.1 15.1
2011 2.4 15.8
2010 2.7 14.9
2009 2.5 9.8
2008 4.1 11.3
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With its continued stock buybacks, new pharmaceutical products in cardiology and diabetes, and its continued growth in animal health and vaccines, I expect Merck sales per share to advance from just over 15 today to 17 by 2016. Based upon an average conservative 3.5x price/sales ratio (below historical average), my expected price for Merck would be $59 a share within a three-year time frame. This would result in a $17 capital gain profit based on today's price of $42 a share. Importantly, this does not include dividends, which will be an additional component in total return for Merck investors.

2016 SPS Projected 17
Price/Sales 2016 3.5
Target Price $59.50
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Since implementing their dividend program in 1935, Merck has consistently raised dividend payouts. Dividends have nearly tripled in the past fifteen years. Although Merck stopped raising its dividend from 2004 until 2010, it began dividend increases once again and has committed to further hikes in the future.

20-Year Dividend Payout History

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1990 1995 2000 2005 2010 2013
Dividends Per Share .20 .65 1.21 1.52 1.52 1.72
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Source: Merck Annual Report

Merck only pays out 46% of its net income in dividends, thus offering room for further expansion of its annual payouts. If Merck demonstrates only modest dividend increases of 5% in the next three years, dividend payments would be $1.80 in 2014, $1.90 in 2015, and $2.00 in 2016. This would result in an additional collection of $5.70 in dividends over the three-year period. Added to my target price based upon price/sales analysis ($59.50), appreciation from both capital gains and dividends could result in a total return of 55%. This also does not include reinvested dividends. Building wealth through dividend growth and reinvestment of dividends is a strong methodology for outperforming the markets over time.


In order for Merck to advance its sales per share to 17 in three years, the firm must continue to maintain its leadership position in vaccines and animal health. Several of their new pipeline drugs must also hit the market, offsetting the dilution in sales from the expiration of Singulair. Merck is one of the largest spenders on R&D within the industry, partitioning 18% of total revenue ($8.4 billion) towards research. Although the rewards from this high level of spending have been mixed, Merck has the opportunity over the next five years to produce several blockbuster drugs.

I believe vaccines are a key area for Merck in meeting its growth targets. Vaccines are one of the most powerful and cost-effective solutions for healthcare providers today. During the next decade, vaccines are projected to achieve a growth rate of nearly 15% per year, which should be above traditional pharmaceutical drug growth. The expansion of vaccines is due to several factors, most notably increased global demand, solid patent protection, and excellent pricing power. The worldwide vaccine market has been growing rapidly over the last five years as it has doubled its market share in 2011 compared to 2005. The worldwide pediatrics vaccine market is expected to be more than $23 billion by 2015. As the second leading player in the vaccine market, Merck will benefit from this strong growth. Merck has three new vaccines in the pipeline including V212 for shingles, V503 for HPV-related cancers, and V419 for Pediatric hexavalent combination. V212 is in Phase III with the study to be completed in 2016. V503 is a follow on to Gardisil. It is recognized as a strong candidate within the pipeline with potential sales of over $1 billion. The vaccine has the potential to protect girls and young women from cervical cancer caused by a wider range of types of HPV than from Gardasil. V503 protects against five more cancer-causing HPV genotypes than the two in Gardasil. Results were delayed earlier, but the 15,000-patient trial of V503 compared to Gardasil should be completed by the end of the year.

Within pharmaceuticals, Merck needs to improve the outlook with the recent demise of cardiology drug Tradaptive and the setback from Odanacatib. These drugs were counted on to replace the revenue lost from Singulair and accelerate top line growth. Singulair was the blockbuster asthma and allergy treatment. Revenue from Singulair contributed $5.5 billion of Merck's $48 billion in total revenue. Merck needs a replacement and top drug prospect Odanacatib needs to be successful. Odanacatib ,codenamed MK-0822, is an investigational treatment for osteoporosis and bone metastasis. It is an inhibitor of cathepsin K, an enzyme involved in bone resorption. Odanacatib should be the heir to the company's previous bone drug, Fosamax, which generated $3 billion in annual sales before its patent expired in 2008. In February, Merck disappointed the investment community by delaying the approval process for Odanacatib until 2014. The primary factor in the postponement was safety. Merck indicated the osteoporosis drug met efficacy goals, but there were other undescribed "safety" issues. Merck wants to wait for additional data regarding these safety issues, thus the delay. Merck's management indicated they continue to believe in the potential of Odanacatib. With management's positive outlook, indications are it might be a risk affecting an enzyme. In this case, Merck could have some flexibility in altering the compound to mitigate the side effects. A portion of the disappointment is that Merck's competitors in the space are losing patent protection. Evista loses patent protection in 2014 and it would be good to have Odanacatib on the market before Evista's expiration. If Odanacatib survives the safety issues, which look likely, it should be a blockbuster drug ($1 billion revenue +) for Merck starting in 2015.

Suvorexant from Merck is a new sleep aid product. This new insomnia product targets the brain's arousal system and thus can enable a shorter sleep onset. It opens a new category of sleep drugs by blocking orexin, the brain's chemical emissaries that promote alertness. It is currently in late-stage trials, where it has demonstrated the ability to improve a person's ability to fall asleep and stay asleep. Suvorexant was filed with the Food and Drug Administration for review in November. As the insomnia market is a $2 billion industry, Suvorexant could easily be another blockbuster drug for Merck.

Vintafolide is another strong pipeline drug for Merck. Merck placed a big bet in April 2012 on the cancer drug. The company paid Endocyte $120 million up front with the potential for $880 million to enter into an agreement to develop and commercialize Endocyte's novel investigational therapeutic candidate Vintafolide (EC145). The companies said the deal encompasses Vintafolide's use in six cancer indications. Vintafolide is currently being evaluated in a Phase III clinical trial for platinum-resistant ovarian cancer, (PROCEED trial) and a Phase II trial for non-small cell lung cancer (NSCLC). Both cancer markets are extremely large and the potential total sales with Vintafolide is over $1 billion.

Merck's Anacetrapib (MK-0859) is a controversial cardiology drug due to the fact that it is a CETP (cholesterol ester transfer protein) inhibitor . The drug boosts HDL by blocking something called the cholesterol ester transfer protein (CETP). But the record of HDL-boosters has not been very well received. In 2007 Pfizer bet more than $1 billion on a CETP drug which boosted HDL. Unfortunately for Pfizer, the drug known as Torcetrapib actually caused heart attacks and deaths. Last year also showed the demise of another CETP inhibitor, Roche's dalcetrapib. The two large clinical trial failures certainly raises doubts about the benefits of inhibiting CETP to raise HDL. Many analysts have postulated that the form of HDL made by this class of CETP drugs might not be as good as the real chemical. Merck's other HDL raising drug Tredaptive, which has a different mechanism for boosting good cholesterol, flamed out in a Phase III in January and was pulled from the market in Europe. Despite the lack of proof that any line of CETP inhibitors actually work, Merck has steadfastly marched on with Anacetrapib. It is progressing through because the upside is so dramatic. A proven drug that raises HDL without side effects and that maintains heart attack prevention capability could easily be worth $5 to $10 billion in annualized revenue. I believe Merck is committed to the product. Commentary from Merck's team has been positive. Late last year Merck's Yale Mitchel was quoted "Based on what we now know with dalcetrapib and how far along we are with Anacetrapib, the idea of having a deleterious effect is very unlikely,"

Overall, Merck provides an investor with strong upside price potential with a lower than average risk profile. The lower risk profile is based upon a trough price/sales ratio and a series of setbacks that are already well discounted. Merck has a strong stable of growing products that are offsetting the patent loss of Singulair. The company's key franchises are continuing to grow at sizeable double digits (YOY) including Januvia (+25%), Janumet (+24%), and Isentress (+17%). If one or more of the above pipeline products makes it to market, Merck's sales growth could accelerate into the mid-single digits. Merck has generated sizeable free cash flow growth and maintains a stellar credit rating. Along with a sizeable stock buyback program and a high dividend yield, Merck presents investors with an opportunity for double digit annualized profit potential through 2016. It remains my preferred selection in the U.S. pharmaceutical market.

Disclosure: I am long MRK, OTCQX:RHHBY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.