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Summary

  • We pitch two companies from the pharmaceutical sector, Merck and AbbVie, against one another in the latest installment of our Head-To-Head series.
  • The article focuses on the relative strengths and weaknesses of Merck and AbbVie based on business performance and sustainability/dividends/forecasts.
  • It ends with discussion of the current valuations of the two companies, and details whether Merck represents good relative value at current price levels.

Merck Background

Merck (NYSE:MRK) provides various health solutions through its prescription medicines, vaccines, biologic therapies, animal health, and consumer care products worldwide. The company's Pharmaceutical segment offers human health pharmaceutical products, such as therapeutic and preventive agents for the treatment of human disorders in the areas of cardiovascular, diabetes and obesity, respiratory, women's health and endocrine. Its Animal Health segment discovers, develops, manufactures, and markets animal health products comprising vaccines, antibiotics, and anti-inflammatory drugs for respiratory diseases, as well as products for the treatment of fertility disorders. The company's Consumer Care segment develops, manufactures, and sells over-the-counter products consisting of non-drowsy antihistamines; decongestant-free cold/flu medicine for people with high blood pressure; nasal decongestant sprays; and products for occasional constipation.

Team Money Research Rating

Our investment philosophy is to focus on company fundamentals and identify stocks that are displaying strong business performance, that operate sustainably and that pay a decent, well-covered dividend.

We analyze each company relative to the other on the following criteria within each of our two main buckets:

Business Performance

  1. Return on equity
  2. Return on assets
  3. Operating margins
  4. Quarterly revenue growth
  5. Quarterly earnings growth

Sustainability/Dividends/Forecasts

  1. Debt to equity ratio
  2. Dividend payout ratio
  3. Forward yield
  4. Annual EPS growth forecast

Once we have analyzed the two companies based on the first two buckets, we can then assess whether they represent good value based on the current prices of the two stocks. We use the following criteria to assess valuations on a relative basis.

Valuation

  1. Forward price to earnings ratio
  2. Price to book value ratio
  3. Enterprise value to EBITDA
  4. Price to 3-year average free cash flow ratio
  5. 5-year price to earnings growth ratio

So, for example, a company that performs well compared to its rival on the first two buckets (business performance and sustainability/dividends/forecasts) and that is undervalued relative to its peer (based on the third bucket: valuation) could outperform its competitor going forward.

The table below provides the data that we will use to analyze Merck and AbbVie (NYSE:ABBV) for the first two buckets.

Stock

Merck

AbbVie

Business Performance

Return on equity

8.56%

108.18%

Return on assets

5.58%

14.15%

Operating margins

21.95%

33.23%

Quarterly rev. growth

-3.80%

5.40%

Quarterly EPS growth

7.00%

1.20%

Sustainability/Dividends/Forecast

Debt to equity ratio

53.59%

314.07%

Dividend payout ratio

114.00%

17.00%

Forward dividend yield

3.00%

3.20%

Annual EPS growth forecast

4.61%

22.29%

The way in which the two companies are financed has a major impact upon scores for the first bucket. Merck is conservatively financed, with a debt to equity ratio of just 53.59%, while AbbVie has a much larger ratio at 314.07%. This means that AbbVie's thin amount of equity generates an exceptionally high return on equity figure of 108.18%, which is significantly higher than Merck's return on equity of 8.56%. However, AbbVie also scores better than Merck in terms of return on assets and operating margins. This is disappointing for investors in Merck and, although the company is profitable, it appears as though it is not profitable enough.

Of further concern is Merck's dividend payout ratio, which currently stands at 114%. Although shares yield 3% right now, we are concerned that Merck is over-exerting itself in terms of payments to shareholders and we wonder whether the company might be best to reinvest a proportion of profits in the business going forward.

Meanwhile, Merck's EPS growth forecast is roughly in-line with the wider market, although it is well behind AbbVie's score in this criteria. Although Merck is improving profitability through various efficiencies, its top-line remains under pressure - as shown in the quarterly revenue numbers in the first bucket, which declined by 3.80% last quarter.

Overall, a slightly disappointing performance from Merck and a fairly comfortable victory for AbbVie in the first two buckets.

Valuation

Due to its underperformance of AbbVie in the first two buckets, we would expect Merck to trade at a discount to its sector peer. Let's see if it does.

Stock

Merck

AbbVie

Valuation

Forward price to earnings ratio

16.11

14.19

Price to book ratio

3.41

18.44

EV/EBITDA

11.16

12.83

PEG

4.21

1.83

Price to free cash flow ratio

17.67

14.64

We're surprised to see that Merck trades at a premium to AbbVie on two of the valuation criteria. For example, Merck's forward P/E is 16.11 versus 14.19 for AbbVie, while its price to free cash flow ratio is 17.67 versus 14.64 for AbbVie. Sure, its EV/EBITDA ratio is marginally more attractive, while its price to book ratio is much better than that of AbbVie, although AbbVie's is skewed as a result of its reliance on debt financing and small amount of equity. Overall, we expected Merck to trade on bigger discounts (and no premiums) in terms of its valuation after its performance relative to AbbVie in the first two buckets. As a result, we feel that Merck could underperform AbbVie going forward.

Conclusion

Merck is a high quality company that posted reasonable scores on The Team Money Research Rating System. Its scores, though, were no match for those of pharmaceutical peer, AbbVie, which delivered strong numbers. Furthermore, we remain concerned regarding Merck's profitability as well as its dividend payout ratio being above 100%. As a result, we believe that Merck could underperform AbbVie going forward.

Here's another Head-To-Head article that appeared on Seeking Alpha and that you may find useful. Click here to take a look.

Source: Merck Looks Overpriced Compared To This Sector Peer