Why Merck Shares Are Cheap And Could Rise To $60

May.23.13 | About: Merck & (MRK)

While many stocks are trading near 52-week highs or at stretched valuations, investors who selectively seek opportunities can find value in this market. For example, Merck (NYSE:MRK) shares were trading at nearly $49, but a recent pullback to about $46, makes the stock worth buying for the generous dividend and the longer-term upside potential.

Merck is a leading manufacturer of vaccines, pharmaceuticals and other health products. It has some well-known products such as Gardasil for human pampilloma virus, Zostavax for zoster (shingles), Afluriafor for influenza virus. It also owns a number of popular consumer healthcare products, which include Coppertone and Bain de Soleil (sunscreen), Dr. Scholl's (foot care), Claritin (for allergies), Afrin (nasal sprays) and many more.

Merck recently reported first-quarter earnings for 2013, which disappointed some investors. Results were impacted by generic drugs, which compete with Merck's Singulair asthma drug and other products. It earned $1.59 billion, or 52 cents per share, which was a bit below the results in the same quarter last year of $1.74 billion or 56 cents per share. However, when one-time charges are excluded, the company earned 85 cents per share for Q1 of 2013. Merck offered full-year earnings guidance of $3.45 to $3.55 for 2013, which was down from a previous forecast of $3.60 to $3.70. Still, the stock looks cheap at current levels because it is only trading at about 13 times earnings. The S&P 500 Index (NYSEARCA:SPY) is currently trading for around 16 times earnings, which means Merck is trading at a discount of about 30% to the market.

Merck did announce some good news recently that could help boost earnings in the future. The company is able to borrow money cheaply and it plans to sell $6.5 billion worth of bonds, which will be used to fund share repurchases. It is offering 30-year notes and 10-year bonds that are just a bit above the current yield for U.S. Treasuries. This is a good idea because the dividend yield it pays is more than the borrowing costs for these bonds. Buying back shares will reduce Merck's dividend payout and it will also reduce the number of shares, which could help to boost earnings in the future.

Under this new plan, Merck could buy back about $15 billion worth of stock over the next few years. Since the company has a current market capitalization of around $140 billion, this implies that it could buy over 10% of the outstanding shares and that should help increase earnings.

Merck pays a quarterly dividend of 43 cents per share and this provides a yield of nearly 3.7%. The dividend has been increased in recent years and the stock buyback could help enable additional increases in the payout in the coming years.

Overall, Merck appears to be a solid value in an overbought market. Investors are well-rewarded with a dividend of nearly 4% while waiting for a higher share price. The downside risks of patent expirations seem to be limited at this point, especially since the company has been dealing with this challenge for a number of years while still providing investors the dividend and a stock that has been trending higher for the past few years.

Analysts at Barclays (NYSE:BCS) recently reiterated an "overweight" rating on Merck and set a $60 price target for the stock. With Merck trading at just around $45 now, that could offer investors gains of roughly 30% in capital appreciation on top of the generous dividend yield it offers. The $60 price target seems reasonable if you apply an average market multiple of about 16 times earnings to earnings that are just shy of $4 per share. With current earnings just below $4 now, the implementation of the stock buyback plan over the next year or two could be enough to boost EPS to just about $4. That's why the $60 level seems achievable in the next year or two, and that is why buying Merck now (and especially on dips), makes sense.

Data is sourced from Yahoo Finance. No guarantees or representations are made. Please consult a financial advisor before making investments.

Disclosure: I am long MRK. 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.