The share price of Merck (MRK) has moved up 19% over the past 12 months. At $48.19, the stock is trading near its 52-week high and offers a 3.6% dividend yield. Although I believe Merck represents a solid long-term dividend stock, the price run-up has eroded the investment's margin of safety, and thus I would suggest potential buyers to wait for a pullback based on the following reasons:
1. Merck's valuation appears to be somewhat rich relative to that of Pfizer (PFE). According to the table shown below, Merck's consensus revenue, EBITDA, and EPS growth estimates are generally below Pfizer's. The company's various profitability margins and capital return metrics are also below Pfizer's benchmarks. In terms of leverage and liquidity, Merck carries a slightly lower debt load. The company's free cash flow margin is below that of Pfizer. Both its current and quick ratios are lower, reflecting a mediocre balance sheet condition.
Merck's current forward EBITDA multiple is 10% below Pfizer's. The discount is completely warranted given Merck's weaker near-term growth potential and lower margin performance. However, Merck's forward P/E multiple is 8% higher. After accounting for the long-term EPS growth estimate, the stock's 5-year PEG ratio is even at a 19% premium, suggesting a rich valuation on a relative basis (see chart above).
2. Over the past 6 months, Merck's forward P/E multiple has expanded by 9% (see chart below).
Nevertheless, the company's consensus revenue, EBITDA, and EPS estimates for the current and next fiscal years have experienced multiple downward revisions over the period, implying that the stock valuation has become increasingly frothy (see charts below).
3. From a historical standpoint, Merck's valuation also seems to be expensive. The stock's trailing P/E multiple (9.0x) is approaching its 3-year high and is 23% above the 3-year historical average (7.3x) (see chart below).
However, Merck has only been able to maintain a steady capital return and margin performance over the period (see charts below). In addition, the firm's consensus revenue, EBITDA, and EPS growth estimates for the next few quarters are only showing a somewhat flat trend (see charts below), which is insufficient to support the current P/E multiple.
Despite the above, I would recommend existing shareholders to continue holding the stock provided that:
1. Although Merck's forward P/E ratio (13.6x) is trading at a premium to Pfizer's (12.6x), the multiple remains below the P/E of S&P 500 Index, which stands at 15.2x now (see chart below);
2. Despite the fact that Merck's dividend yield has fallen from 4.5% to 3.6% over the past 3 years, its current level remains above the yield of US 30-Year Treasury Bond, indicating that the stock would continue to draw interest from income investors amid the current low-interest market environment (see chart below); and
3. Sell side continues to favor the stock. Of the total 20 analyst ratings compiled by Thomson One, there are 13 strong buy/buy ratings. In a Morningstar research note dated May 20, Damien Conover commented on the following positives for Merck (sourced from Thomson One, Equity Research):
"Despite the Singulair patent loss in mid-2012, Merck MRK is relatively well positioned for steady growth during the next five years. Partly based on the Schering acquisition, Merck is backing away from its patent cliff with a strong lineup of new products including Bridion (anesthesia), Saphris (schizophrenia), Simponi (immunology diseases), and Dulera (asthma). Also, recently launched drugs Januvia (diabetes) and Isentress (HIV) have already developed into blockbusters and should continue to post steady gains. Additionally, the Schering acquisition opened the door for Merck to implement a major cost-cutting plan, which should eliminate more than $4 billion in annual costs by 2015."
For margin of safety reason, I would suggest potential buyers to wait for a pullback or sell some out-of-money put options. I personally will consider adding more shares at around $45, assuming everything else being equal.
All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.