By The Valuentum Team
Merck (NYSE:MRK) continues to turn heads.
As with rival Eli Lilly's (NYSE:LLY), the company's dividend has returned to growth following a period of stagnation. The company continues to deliver on major product approvals, and we think it will surprise to the upside in hepatitis C against juggernaut Gilead (NASDAQ:GILD). Advancing the pipeline will be critical to the pace of future dividend expansion, and as of early 2016, the company had ~20 programs advanced into Phase II or Phase III testing. Cost cutting will be par for the course, and we applaud management's newfound shareholder-friendliness (it returned ~$10 billion of cash in the form of dividends and share buybacks in the past 12 months ending September 2015).
Though we're enamored by Merck, we have to mention a few of the risks. For starters, drug research is a risky, expensive proposition and expectations can always come up short. Second, as it relates to income investors seeking consecutive dividend increases over a long stretch of time in the past, it's worth mentioning that Merck does not fit that profile. However, the company's dividend has come certainly back to life, and its Dividend Cushion ratio speaks to sustainability of the payout. The Dividend Cushion ratio considers a company's future expected free cash flow generation and balance sheet health in assessing whether it can cover future cash dividend obligations. At Merck, this ratio is a very solid 1.9.
Going forward, there are few things investors should pay close attention to as well. For one, a laser-focus on newsflow associated with Merck's pipeline and its ability to drive commercial success of key launches is par for the course. Bolt-on acquisitions cannot be ruled out to enhance its pipeline, but we're not expecting a deal of that magnitude to derail the dividend payment anytime soon. Business development, however, is a top priority. We think the future is exciting at the drug giant. Just take a look at that pipeline (source).
Source of Images: Merck
Merck's Investment Considerations
Merck's Investment Highlights
• Merck is a global health care company that delivers innovative health solutions through its prescription medicines, vaccines, and biologic therapies. Januvia/Janumet for type 2 diabetes and Zetia/Vytorin for cholesterol (cardiovascular) are its two largest revenue drivers within its pharma business. The company was founded in 1891 and is headquartered in New Jersey.
• Merck has the #1 treatment for advanced Melanoma in the US in KEYTRUDA. The drug is launching in more than 40 markets across the world now, and the firm is ready to begin reaping the benefits after a period of suppressed growth due to the loss of exclusivity of multiple drugs.
• Merck's recent results revealed in many ways the company has turned the corner with respect to the "patent cliff" and the expiration of exclusivity on its blockbuster Singulair and Nasonex. Worldwide sales, adjusted for currency and acquisitions and divestitures, grew 4% in the quarter as non-GAAP adjusted earnings per share advanced to $0.96 per share from $0.90 in the year-ago period.
• Merck continues to advance its late-stage pipeline, and we think it has promising potential therapies in cancer, antibiotic resistance, cardiometabolic disease, hepatitis C, and Alzheimer's disease. That worldwide sales are advancing at a mid-single-digit clip is a notable positive, and we continue to expect its recent acquisition of Cubist to pay dividends.
• Though revenue is not expected to make a material recovery in 2016, Merck is expecting material bottomline growth. The company is targeting non-GAAP earnings per share in the range of $3.65-$3.77 in 2016.
Merck's Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Merck's 3-year historical return on invested capital (without goodwill) is 12.7%, which is above the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Merck's Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Merck's free cash flow margin has averaged about 21.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Merck, cash flow from operations increased about 7% from levels registered two years ago, while capital expenditures fell about 17% over the same time period.
Merck's Valuation Analysis
We think Merck is worth $55 per share with a fair value range of $44.00 - $66.00. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -5.8%. Our model reflects a 5-year projected average operating margin of 37.1%, which is above Merck's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For Merck, we use a 10% weighted average cost of capital to discount future free cash flows.
Merck's Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $55 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Merck. We think the firm is attractive below $44 per share (the green line), but quite expensive above $66 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Merck's Future Path of Fair Value
We estimate Merck's fair value at this point in time to be about $55 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Merck's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $68 per share in Year 3 represents our existing fair value per share of $55 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.