By Mark Bern, CPA CFA
Most of my analysis is based upon history and trends, but I also look into the qualitative aspect as well as I can to determine if there are advantages that could translate into higher growth rates for one company over another. I think it is worth pointing out that these two companies, while having similarities, also have some stark differences. The greatest difference, in my opinion, is how the two companies are approaching the blockbuster drug patent cliff that looms just ahead.
Merck’s acquisition of Schering-Plough (11/09) is resulting in a healthier pipeline and cost savings that will dampen the impact of declining future revenues. Merck seems to have chosen to slow its growth while Pfizer seems to be willing to accept a faster decline while cutting costs to remain profitable. This should translate into more stable earnings for Merck versus a potential dip in earnings for Pfizer when cuts in R&D portend future gaps in new revenue necessary to compensate for materially lower sales after blockbuster drugs lose patent protection.
Near term concerns for both companies include loss of patent protection on drugs that represent major sources of sales and increased generic competition that will tend to hurt margins, especially over the next two years. Specifically, Pfizer’s best-selling product, Lipitor, loses patent protection this month and the company will see its $2.6 billion of revenue from the latest quarter begin to deteriorate under pressure from generic competition. Merck faces similar problems as it prepares for the loss of patent protection in 2012 on Singulair, its top-selling product. Pfizer, having reduced its investment in R&D may have future holes in its pipeline. Only time will tell.
On the brighter side Pfizer will continue to reduce its cost structure to better match revenue streams and I expect additional share repurchases to help support per share earnings. Recent quarterly earnings for both companies were positive surprises, beating consensus earnings expectations. Merck saw strong growth of 20% in sales at its Animal Health operations and sales of its diabetes medication Januvia rose 41%.
Now let’s look at the numbers. Return on Equity has risen at both companies since 2009. However, the rise has been more pronounced at Merck which sported a 21.5% ROE in 2010 compared to 12.5% in 2009. Pfizer, on the other hand, has seen its ROE improve to only 10.5% in 2010 from 9.6% in 2009. The industry average is 16%, placing Merck above the average and Pfizer below. Pfizer’s debt to equity level as of the end of 2010 is 44.1% while Merck is 28.7%. The industry average is 27%, putting Merck in line and Pfizer a little high. Merck has the higher profit margin at 24.3% while the industry average is 19%. Pfizer’s profit margin for 2010 is 13.5%. Cash flows and earnings per share both suffered setbacks for the two companies during the great recession but are rebounding for both. The edge so far appears to go to Merck.
Now we are about to delve into the meat of the analysis for me, looking at sales and dividend growth. I like dividends, while increasing sales combined with stable or improving profit margins generally lead to rising dividends, the cornerstone of long-term investing.
Merck currently offers the better yield of 4.3% compared to Pfizer’s 4.1%. Merck also has the lower payout ratio at 41% compared to 70% for Pfizer (both are based upon estimated full year 2011 EPS and current dividend information). That would tend to indicate that Merck has a little more flexibility in increasing (or at least maintaining) dividends going forward and is likely to be able to maintain the higher dividend yield unless their stock price rises more rapidly. Sales for Merck have increased at a slightly higher rate in 2011 compared to 2010, rising an estimated 3.3%, while rising by 67.7% in the previous year. Pfizer’s sales are expected to remain relatively flat in 2011 over 2010, having grown by 35.6% in the previous year. Going forward, I believe that revenue growth will prove hard to come by for either company, it will most likely remain flat for Merck and fall by about 2% for Pfizer.
So, which one would I chose to own and why? I believe that Merck deserves a P/E ratio premium to Pfizer based on my analysis. At current valuations, Merck is cheaper with a P/E ratio of 9.3 (based upon full year 2011 estimated earnings of $3.75 per share) compared to its historic average P/E of 13. Pfizer’s average historic P/E is also 13 and its current P/E is 15 (also based upon full year 2011 estimated earnings of $1.30 per share. In five years I expect Merck to sport a share price of about $50 while Pfizer should reach about $27.50. Including dividends, I get total return expectations of 16 percent for Merck and 15 percent for Pfizer. So, my nod goes to Merck, but only by a whisker. Merck, in my opinion, will offer a little more price and dividend stability over the next five years while Pfizer has more potential for growth in the latter half of that period. Add Merck now and pick up some Pfizer after about two years would be my sentiment.
I don’t think a long-term investor could go wrong with either stock and the dividends above 4% will provide a steady income stream during the wait for the eventual appreciation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
