May has brought increased volatility in commodities and high beta stocks. Exactly what one would expect from the coming end of QE2, given most of the excess liquidity from that program went into these areas. The market has also seen the beginnings of a rotation into the defensive sectors like Healthcare and Telecom, given their low valuations and good dividend yields. A stock that is perfect to play this trend and has a very reasonable valuation and a solid dividend yield is Merck.
Merck (MRK) - Merck & Co., Inc. provides various health solutions through its prescription medicines, vaccines, biologic therapies, animal health, and consumer care products. The company’s Pharmaceutical segment provides human health pharmaceutical products, such as therapeutic and preventive agents for the treatment of human disorders in the areas of bone, respiratory, immunology, dermatology, cardiovascular, diabetes and obesity, infectious diseases, neurosciences and ophthalmology, oncology, vaccines, and women's health and endocrine. This segment also offers human health vaccines, such as preventive pediatric, adolescent, and adult vaccines. Its Animal Health segment discovers, develops, manufactures, and markets animal health products. This segment offers antibiotics, anti-inflammatory products, vaccines, products for the treatment of fertility disorders, and parasiticides for cattle, swine, horses, poultry, dogs, cats, salmons, and fish. The Consumer Care segment develops, manufactures, and markets over-the-counter, foot care, and sun care products. Its over-the-counter product line includes non-drowsy antihistamines; treatment for occasional constipation; decongestant-free cold/flu medicine for people with high blood pressure; nasal decongestant spray; and treatment for frequent heartburn. This segment’s foot care products comprise topical antifungal, and foot and sneaker odor/wetness products; and sun care products include sun care lotions, sprays and dry oils; and sunburn relief products.
Valuation – Merck sells at 10 times this year’s earnings and just over 9.5 times 2012’s consensus earnings. It sells at the bottom quarter of its five year valuation range based on P/E, P/B, and P/S. It yields a little over 4% in dividends.
10 Positive Trends and Catalysts – There are numerous things to recommend Merck other than its low valuations and high dividend. These include:
- Street consistently underestimates earnings demonstrated by Merck beating earnings estimates handily each of the last four quarters.
- Merck has a 40% payout ratio and can afford to increase dividends in line with earnings going forward.
- There has been little to no insider selling over the last six months.
- Drug stocks are historically good buys during times of increasing inflation.
- Last earnings report delivered a 6 cents/share beat on cost controls and stronger sales in some of its key products.
- Rotation into Healthcare stocks seems to have begun.
- Synergies from Schering – Plough acquisitions seem to be ahead of schedule and have contributed to cost savings in recent earnings report.
- Strong R&D pipeline and growth in consumer and animal health divisions should offset the loss of revenues from drugs going off patent.
- Initiated $5B stock buyback program in April.
- Merck has strong vaccine franchise.
Prognosis – Given valuations, solid pipeline, and a dividend over 4%; Merck deserves a higher valuation. A conservative estimate of 11-12 times this year’s consensus earnings of $3.73 seems more appropriate. This would produce target of $42 to $46, in line with Credit Suisse’s $45 price target. BUY.