When it comes to investing, the general rule is follow the money - follow the money to better understand a company, follow the money to see where most inflows are trending, follow the money to see how a macro-event could change everything.
When we saw that 46 hedge funds out of the 350-plus funds we track had a total of almost $1.3 billion invested in Merck (NYSE:MRK) at the end of the fourth quarter 2011, including Jacob Gottlieb's Visium Asset Management and Jean-Marie Eveillard's First Eagle Investment Management, we had to take another look at this company to see whether it is really worth investing in.
Merck is expected to make $3.80 per share this year and is currently trading at $37.72 per share. This means that its forward P/E ratio is below 10, compared to an average of 16.90 for its peers, which is a considerable discount compared with other pharmaceutical stocks, but there are some reasons to be skeptical.
Merck will face some loss in revenue over the distribution rights of other drugs. In April 2011, the company agreed to divide foreign distribution rights on Remicade and Simponi with Johnson & Johnson (NYSE:JNJ). We think that this transition of rights may also negatively affect Merck's sales.
There is also some concern over Merck's foreign operations. In 2011, foreign operations accounted for about 57 percent of Merck's total sales. On the one hand, operating internationally provides Merck exposure to the fast-growing emerging markets, but, on the other hand, that means it is also exposed to foreign exchange rate risks and, at least lately, foreign exchange rates are affecting Merck unfavorably. In early February, Merck forecasted its 2012 revenues to be at or near its 2011 levels on a constant currency basis, but that number should be about 2-3% lower based on the exchange rates as of early February.
The biggest reason we can think of for the disparity is that Merck's patent protections on certain drugs, like Singulair, are about to expire. Singulair is one of the largest selling products in Merck's brand portfolio. Its sales totaled $5.5 billion over the past year, but the expiration of the patent protection will definitely have a negative influence on those revenues. Patent expiration is an issue equally facing Merck's primary competitors - GlaxoSmithKline (NYSE:GSK) and Pfizer (NYSE:PFE).
Despite the expiration of patents and the unfavorable exchange rates, there is still a variety of reasons to be bullish about Merck. In early February, Merck announced that it planned to file five major products in United States in the following two years: Bridion, a neuromuscular reversal agent; V503, a vaccine for cancers associated with HPV; odanacatib, a drug for osteoporosis patients take just once a week; tredaptive, a niacin-based cholesterol reducing drug; and, suvorexant, an insomnia therapy drug that could become first-in-class.
We believe these new products will enable the company to have stable growth over the long term. We are also positive about some of Merck's existing products, such as Januvia/Janumet and Isentress. In 2011, sales of these two products were $4.7 billion and $1.4 billion, respectively, and we expect strong growth in revenues over the next couple of years.
In addition, we also expect Merck to realize cost synergies from its merger with Schering-Plough. Merck purchased Schering-Plough, its rival drug maker, in November 2009 for about $41 billion. Merck has already realized about $2.9 billion cost synergies by the end of last year. It expects the merger to yield annual synergies of about $3.5 billion by the end of 2012.
To its credit, Merck also has a higher dividend yield of 4.46%. Its payout ratio is a little high at 77%, but its dividend payouts have been quite stable over the past decade, and trending upward. It increased its quarterly dividend from $0.35 per share to $0.36 per share in late 2002, and increased it again to $0.37 per share in mid-2003. The company had been paying $0.38 per share of quarterly dividend from late 2004 to 2011. It recently raised its quarterly dividend to $0.42 per share. In addition to paying out dividends, Merck is also using some of its earnings to buy back shares. In April 2011, Merck announced that its Director has authorized a $5 billion share repurchase program.
Looking at Merck's competitors GlaxoSmithKline and Pfizer, both stocks are trading at relatively low forward P/E ratios of around 10. In 2013, GlaxoSmithKline is expected to make $4.38 per share and Pfizer is expected to make $2.36. As such, their P/E ratios for 2013 are 10.3 and 9.2, respectively, versus 10.1 for Merck. They also both have appealing dividend yields of above 4%. Where these companies really differ is in their outlooks and we see lots of opportunities in place for Merck. That combined with the company's low pricing makes Merck a buy in our books.
Note: This article is written by Renee O'Farrell and edited by Meena Krishnamsetty.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.