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Merck & Co. Inc. (NYSE:MRK) has recently announced a dividend increase of $0.01 per share a few days back. Merck is one of the companies that consistently pays dividends and shares its success with investors by offering a high dividend yield. Merck is paying a dividend yield of 3.60 percent which is well above the industry average of 1.89 percent. However, two key products, Januvia and Singulair, witnessed a significant decline in their sales. During such difficult times, when the company's two key products are losing their ground will it be possible for the company to sustain its dividends in the future? To determine the answer to this question let us analyze the company's future prospects and historical performance.

Products in Pipeline

Dividends are dependent upon the earnings which are further dependent upon the growth in revenues. Therefore, I believe that in order to analyze the company's ability to pay dividends I have analyzed its top-line growth.

The company's two popular products, Januvia and Singulair, are losing their foothold in the market because of increasing competition and this has recently resulted in a significant decline in revenues. During the first nine months of the current fiscal year, Singulair's revenues declined to $898 million from $3,373 million in 2012. The huge decline of 73.38 percent in the sales of Singuliar was one of the main reasons behind the 8 percent decline in total sales during the first nine months of fiscal year 2013 compared to 2012's results. The main reason behind the decline in the sales was the expiration of patents in the US and European markets.

Here the question arises: will the company be able to offset this decline in revenues in the future? To determine the answer let us analyze the company's products in the pipeline. As of 31 December 2012, the company had 22 products in phase II, 16 products in phase III and 4 products under review.

Such a large number of products in phase III indicates that they are close to being filed at the Food and Drug Administration (FDA). Furthermore, Merck recently announced its collaboration with GlaxoSmithKline (NYSE:GSK) in order to discover a treatment for renal cell cancer. The start of clinical trials combining the Glaxo's Pazopanib and Merck's MK-3475 might encourage natural immune responses to fight against cancer and other diseases. I believe the success of this sort of drug may prove to be a breakthrough for the company.

Moreover, MK-3475 is not the only drug that can boost revenues. The following graph shows the number of those suffering from Alzheimer's. The total number of patients suffering from Alzheimer's was 4.7 million in fiscal year 2010. This number is expected to rise to 13.8 million by 2050. Merck's MK-8931 can be another breakthrough for the company's revenues as the number of Alzheimer sufferers are increasing at a rapid pace. The cost of caring for people suffering from Alzheimer's will increase from $203 billion this year to $1.2 trillion per annum by the end of 2050. Therefore, I believe that the MK-8931 can also help the company to sustain its dividends as the drug can offset the decrease in revenues due to the decline in popularity of Singuliar and Januvia.

(click to enlarge)SOURCE: Report 2013

Key Metrics to Measure the Dividends' Sustainability

There are certain key metrics that help investors measure the sustainability of dividends. I give more weightage to the dividend payment ratio and dividend payout ratio over any other sustainability measures. The dividend payout ratio is defined as (Dividends/ (Cash Flow from Operations - Capital Expenditures)). The dividend payout ratio is less than 30 percent which indicates that not only will the company be able to sustain dividends in the future but the company will also be able to increase its dividends. Now, let us analyze the company's dividend payment ratio.

Note: Peers include GlaxoSmithKline, Pfizer Inc. (NYSE:PFE) and AstraZeneca (NYSE:AZN)

The table above shows that the dividend payment ratio improved in fiscal year 2011 to 2.57 times from 2.28 times in fiscal year 2010. In fiscal year 2012, this ratio significantly declined in the fiscal year 2012 because Singulair it lost market shares of in the United States. Moreover, over the past two years the company's dividend payment ratio was higher than its peers.

I prefer using the free cash flows rather than the net income of the company to compute the dividend payout ratio because net income includes certain non-cash items like depreciation. In addition, cash flows are difficult to manipulate compared to net profit because in the calculations of net income, discretion of management is involved. That is why I prefer free cash flows over net income in the calculations of the payout ratio.

Merck's payout ratio was lower than its peers in fiscal years 2011 and 2012. Therefore, I can conclude that Merck's dividends will be more sustainable than its peers in the industry.

Final Thoughts

The company's better dividend payment ratio and payout ratios than its peers can help the company to sustain its dividends in the future. Despite the fact that the company has recently witnessed a decline in the sales of its core products, I believe that there are still a couple of potentially profitable drugs in the pipeline that can bolster the revenues of the company in the future. These drugs will not only help the company to increase its revenues but will also help the company to sustain its dividends. Therefore, I do not believe that investors should worry because the company's prospects are bright. That is why I would recommend buying the stock.

Source: Will Merck Be Able To Sustain Its Dividends?