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The healthcare sector remained quite volatile over the past few weeks due to uncertainty regarding the US government shutdown and now the US government shutdown is quite prominent. The initial launch of the Obama healthcare program proved to be great news for healthcare companies and all the healthcare components of S&P 500 were on a hike. The top performing sub sector within the healthcare sector was pharmaceuticals with a 1.49% gain for its 13 companies. Among those, the frontrunner of the whole sector was Merck & Co, Inc. (NYSE:MRK) as its share has increased by 2.4%.

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Source: Y-charts

Merck's Restructuring Efforts

The jump in share price of the company is associated with the company's plans to restructure its research unit and cut roughly 8,500 jobs in addition to a previously announced plan to slash 7,500 jobs. This will result in a reduction of nearly 20% in the total work force of the company, in order to focus more heavily on its commercial, research and development operations.

The recent cut in jobs would help the company save $2.5 billion in operating expenses by the end of 2015. It also expect to start seeing $1 billion of the savings by the end of 2014. In terms of its research divisions, the company stated that it would focus on its drug development efforts in a few key areas including diabetes, acute hospital care, vaccines and oncology. The company is also planning to bring in new drugs from outside companies through licensing agreements and acquisitions. Moody's investor services has commented on Merck's current restructuring effort as credit positive for the company. I think such efforts would help the company in moving out of the industry as well as tackle the company's specific challenges.

Recent performance

The company's performance in the first half of 2013 was not up to expectations. Global sales for the company were down by 10% in comparison to the first half results of prior years. Global efforts toward healthcare cost containment continue to exert pressure on the product prices and market access worldwide. These are the industrywide challenges that are impacting the performance of the company.

The specific problems that Merck is facing is the expiration of some of its patents. The patents that provide US-market exclusivity and European-market exclusivity for Singular expired in August 2012 and February 2013, respectively. The company experienced a rapid decline in sales in the first half of 2013 in these regions because of the patent expiration. The company has several other patents with Janumet and Zostavax that partially offset the decline in revenue. Several other drugs are in development and are expected to fill the gap created by the expiration of some patents.

Let us explore the financial conditions of the company. Merck is operating at a current debt to equity ratio of 0.59 that is lower than the industry average. This means that the company is successful in the management of its debt. Along with a favorable debt to equity ratio, the company maintains an adequate quick ratio of 1.41 that shows the company's ability to avoid short-term income problems.

Growth opportunities

One of Merck's phase 2 immunotherapy cancer drugs known as MK-3475 has triggered a response in 24% of lung cancer patients in its initial experimental trial. Merck reported that the cancer of 38 patients had stopped responding to earlier rounds of treatment and amongst them 24% had an immune system response to that drug. The trial also showed that 21% of patients experienced tumor shrinkage. The result of the initial trial was good and the drug is expected to clear its phase 3 trial sooner than expected and go into the production phase in the coming future. Lung cancer represents the largest potential market for the PD-1 therapy and the success of this drug would have a positive impact on the company.

Unfortunately a single American is diagnosed with diabetes every 17 seconds and nearly 19 million people in the country have been diagnosed with either type 1 or type 2 diabetes. There are 7 million people in the US that have undiagnosed diabetes and 79 million people are pre-diabetic. The US has the largest market for diabetes in the world totaling around $22 billion. In order to capture a slice of this market Merck has several successful drugs named Janumet and januvia and has two more drugs in development named domarigliptin and ertugliflozin.

Omarigliptin is in the latest stage of its study and is expected to enter the market in the near future. Ertugliflozin is in its phase 2 trial but could emerge as a front runner for Merck in the diabetes market. These products would help the company increase future revenue growth.

Dividends and Buyback

Merck has a long history of returning value to shareholders in the form of both dividends and share buybacks. It has a positive dividend yield of 3.53% in comparison to the industry average of 0.38%. The company also returns excess cash to its shareholders in the form of buybacks. Recently the company announced authorization for the repurchase of $15 billion of its common stock and is expected to repurchase $7.5 billion within the next 12 months. This announcement has resulted in the company's price to earnings ratio moving to 13.4 from the current level of 29. This makes the company's future very optimistic.

Valuation

As discussed earlier, Merck has a rich history of dividends. Due to its positive dividend history, the Dividend Discount Model is the best model to calculate its fair value. I have taken certain assumptions to calculate the fair value using the DDM. I have calculated the 15.09% growth rate by giving different weights to the analyst consensus growth estimate, historical growth, internal growth and sustainable growth. After five years growth will gradually decrease at the level of 2.05% over five years from fiscal year 2018 to fiscal year 2022.

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Source: Morningstar

Cost of equity is 9.39% which was calculated by using an adjusted beta of 0.70, a risk free rate from a 10-year treasury bond of 2.65% and a market return of 12.28%. As shown in the following table, fair value of the stock is $54.02 which gives a 10.83% upside potential.

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Sensitivity analysis

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The sensitivity analysis shows the company's valuation price with respect to the expected growth rate and required rate of return. The table shows that in the best case scenario with an expected growth rate of 16.39 percent and 9.04 percent, the required rate of return will create an upside potential of 24.76% percent and with a price of $60.81 a share. On the other hand, in the case of an 11.09 percent growth rate and 10.09 percent required rate of return, a downside of 17.92 percent is incurred with a stock price of $40 a share. The sensitivity analysis shows that the stock provides a stronger advantage in the case of volatility with respect to growth and cost of equity.

Conclusion

Merck struggled in the first half of fiscal year 2013 due to the challenges faced by the overall industry and expiration of some of the company's patents. The company is recently undergoing a restructuring program which would enable the company to save $2.5 billion by the end of 2015. The company has also changed its focus toward improving research in a few key segments that have a high potential for growth. These changes would bode well for the future of the company.

Merck has some excellent products that are expected to hit the market soon and serve as a catalyst for the future growth of the company.

In terms of its valuation the results are quite obvious. Merck is currently trading at $48.74, while its intrinsic value, calculated from the dividend discount model, is $54.02. With an upside potential of about 10.83% and trading at a price to earnings ratio of 13.4 Merck is a sound investment. Therefore, I will recommend buying the stock.

Source: Is Merck Still A Good Buy?