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Shares of Merck (MRK) missed out on the general market rally on Friday as the global healthcare company received little love from analysts at Jefferies, which downgraded the stock to a hold.

I must agree with Jefferies. Merck trades at quite high earnings multiples, especially on a GAAP-basis, while offering few prospects for immediate revenue growth. While the recently announced cost saving program looks appealing, it hardly offsets lost revenues from SINGULAIR.

While the dividend looks appealing, the payout ratio is quite high, leaving little room to raise the dividend. This makes me cautious to invest at these levels.

Jefferies Is Cautious

Analyst Jeffrey Holford downgraded Merck from "buy" to "hold" while lowering the price target by three dollars to $50 per share.

While Merck has executed on cost savings and share repurchases, two out of the three value drivers as identified by Jefferies, the magnitude of this was less then hoped for.

Holford still believes it is likely that the Consumer and/or Animal Health business will be diversified or placed in a joint venture. Yet this is not enough to still warrant the buy recommendation given pressure on the core business, notably in terms of poor R&D productivity.

Holford does appreciate the potential of Merck's PD-1 asset, yet it will operate in a competitive area. Jefferies is modeling risk-adjusted peak sales of $4 billion for the product, reflecting the potential adequately according to analysts.

Valuation

Merck ended its second quarter of this year with $18.1 billion in cash, equivalents and short-term investments. Total debt stood at $28.1 billion, for a net-debt position of $10 billion.

Revenues for the first six months of the year fell by 10% to $21.7 billion. Net earnings fell by 29% to $2.5 billion, while diluted earnings per share came in at $0.82 per share.

At this pace, annual revenues are seen around $43 billion, while Merck guides for GAAP earnings of $1.84-$2.05 per share for the full year of 2013. Non-GAAP earnings are seen between $3.45 and $3.55 per share.

Trading at $47 per share, the market values Merck at some $138 billion. This values the operating assets of the firm at around 3.2 times annual revenues, 24 times GAAP earnings and 13-14 times non-GAAP earnings.

Merck pays a quarterly dividend of $0.43 per share, for an annual dividend yield of 3.6%.

Some Historical Perspective

Shareholders had little pleasure from their investment in Merck over the past decade. Shares halved from $50 in 2004, to lows of $25 a year later, after which shares rallied to highs of $60 at the start of 2008.

After shares fell back to $25 again in 2009, they managed to recover, currently trading around $47 per share. Between 2009 and 2012, Merck has grown its annual revenues by a cumulative 73% to $47.3 billion. Growth was mainly driven by the $41 billion acquisition of Schering-Plough. Net earnings have come in around $6 billion in recent years.

Investment Thesis

While Merck stresses the usage of non-GAAP earnings in its earnings reports, I would urge investors to keep a close eye on GAAP earnings.

For starters, the gap between both metrics is quite large. Furthermore the components between the discrepancy, mainly restructuring costs and write-down on acquisitions, appear to be quite structural, making me hesitant to use the non-GAAP numbers.

While a spin-off of the animal health business or the consumer business could attract some short-term buyers, I am a bit cautious. Earlier this year Pfizer (PFE) divested its animal business Zoetis (ZTS), which failed to boost the share price of either firm in a significant way.

While Merck is upbeat about PD-1, which disables a brake preventing the immune system from attacking cancer cells, Merck simply needs successes to even maintain revenues. Even so, it will take more time before contributions will come in.

To attack the urgent profitability issues, Merck did announce a large cost savings program two weeks ago, although not large enough for Jefferies' taste. The program will reduce the workforce by 7,500 jobs, resulting in expected savings of $2.5 billion per annum in 2015, of which $1 billion should be achieved by the end of 2014.

The plan comes at a steep cost. Merck expects to take a $2.5-$3.0 billion charge related to the cost savings, of which the majority are cash outlays.

While the planned cuts look sizable, and it certainly is in dollar terms, the impact on the bottom line is not that great. Note that a 80% drop in SINGULAIR sales, generating just $281 million in revenues over the past quarter, implies that Merck is already losing out on $1 billion in quarterly sales compared to a year earlier. These dramatic sales results undo all the positive effects of the cost-saving program.

I agree with analysts at Jefferies and wouldn't touch upon shares at the moment. While the current dividend yield of 3.6% is attractive, it results in a $5 billion cash outflow for the firm, quite steep compared to annual GAAP earnings of $6 billion in recent years. This obviously leaves little room for future hikes. At the same time, Merck will incur quite some more costs in the short term to execute on its cost reduction plan while revenues still haven't stabilized yet.

Enough reasons for me to remain quite cautious at the moment. I don't find the shares attractive at all at these levels, and remain on the sidelines.

Source: Merck - Little Appeal Despite Recently Announced Cost Cuts