Aside from the high-dividend yields and low betas, BioPharma is particularly attractive (see here) due to the potential for medical breakthroughs. On the flip side, patent cliffs often cause the market to price in irrationally-low growth expectations. In this article, I will run you through my DCF model on Merck & Co. (NYSE:MRK) and then triangulate the result by reviewing the fundamentals against those of Bristol-Myers (NYSE:BMY) and Mylan (NASDAQ:MYL).
First, let's begin with an assumption about the top-line. Merck finished FY2011 with $48B in revenue, which represented a 4.5% gain off of the preceding year. Analysts model a 3.9% per annum growth rate over the next half decade or so, which I think is much too conservative. But, for the sake of proving my point, I accept the projection.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures and taxes. I model cost of goods sold as 36% of revenue versus 27.5% for SG&A, 17% for R&D, and 3.7% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around -1% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8.5% yields a fair value figure of $43.88 for 14.1% upside. If we assume just moderately higher per annum growth over the explicitly projected time period at 5% (instead of 3.9%), the fair value jumps to $46.51. The point is that the bottom is well secured, especially in light of the 4.4% dividend yield.
All of this falls within the context of strong momentum:
Our performance in the first quarter underscores key things that we've emphasized since early 2011: growth and execution. We remain committed to building shareholder value through continued execution while focusing on both performance and innovation. All in all, this quarter shows a strong start in a year when we intend to overcome a significant patent expiry. We are building momentum, particularly with our key growth drivers and plan to achieve numerous major milestones in our late stage pipeline, including a series of important filings with significant commercial potential. Our focus on aligned execution across geographies and divisions allowed us to deliver worldwide sales of $11.7 billion in the quarter, with solid growth in each of our 3 major businesses, 6% in the global pharmaceutical and vaccines business when one excludes the impact of the J&J arbitration, 7% in Consumer Care and 8% in Animal Health.
From a multiples perspective, Merck is also attractive. It trades at 19x past earnings but only 10.4x forward earnings. This compares with corresponding figures of 15.4x and 17.2x for Bristol and 18x and 8.3x for Mylan. Assuming a multiple of 12x and a conservative 2013 EPS of $3.63, Merck's stock would hit $43.56 - virtually in-line with my DCF result.
Consensus estimates for Mylan's EPS forecast that it will grow by 18.6% to $2.42 in 2012 and then by 10.7% and 6% in the following two years. Assuming a multiple of 12x and a conservative 2013 EPS of $2.63, the stock would hit $31.56 for 42.9% upside. While the company may not offer a dividend yield like Merck, the discount to intrinsic value is still substantial and definitely merits opening a long position.
Consensus estimates for Bristol's EPS forecast that it will decline by 13.6% to $1.97 in 2012, decline by 2% in 2013, and then grow by 18.1% in the following year. Assuming a multiple of 15x and a conservative 2013 EPS $1.90, the stock would still fall. The company may offer a dividend yield of 4.2%, but the discount to intrinsic value is exceeded by both Mylan and Merck for now.
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