Merck: Dividend Growth Investors Beware

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 |  About: Merck & Co Inc. (MRK)
by: Mike Young

Merck & Co., Inc. (NYSE:MRK) is a global healthcare company that provides prescription medicines, vaccines, biologic therapies, consumer care products and animal health products to its customers. It has four operating segments, which are the Pharmaceutical, Animal Health, Consumer Care and Alliances segments, and operates in over 140 countries.

Historical Dividends & Free Cash Flow

Merck has been a rock-solid dividend paying company, and has issued a dividend every quarter for the past 10 years without fail. In addition, the dividend amount issued has never declined from the previous quarter, providing investors with a steady income stream and a level of predictability.

However, the company has also provided investors with very little along the lines of dividend growth. Although it did announce a dividend increase of 11% at the end of 2011, Merck has held the dividend at the same level for the previous 7 years. Furthermore, dividend increases before that time were a paltry 2%-3% annually.

Below are Merck's historical dividends and growth rates for the past 10 years:

Year Dividend Growth Rate
2002 $1.41 --
2003 $1.45 3%
2004 $1.49 3%
2005 $1.52 2%
2006 $1.52 0%
2007 $1.52 0%
2008 $1.52 0%
2009 $1.52 0%
2010 $1.52 0%
2011 $1.52 0%
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A closer look at Merck's free cash flow (FCF) per share over the same time period provides some insight as to why the company has been unable to grow its dividend at a rate adequate to keep up with inflation. Although FCF/share has grown over 63% ($6.29 vs. $3.85), it has been extremely volatile, fluctuating between positive and negative growth during different years.

This led to a wide range in the payout ratio, which has been between the mid-20s to the mid-60s, in terms of percentages.

Year FCF/Share Growth Rate

Payout Ratio (Div vs. FCF/Share)

2002 3.85 -- 37%
2003 3.56 (-8%) 41%
2004 3.29 (-8%) 45%
2005 3.34 2% 46%
2006 3.59 7% 42%
2007 2.42 (-33%) 63%
2008 4.48 85% 34%
2009 3.21 (-28%) 47%
2010 5.87 83% 26%
2011 6.29 7% 24%
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Dividend Discount Model

Using the dividend discount model, I determined the value of the company based on its future dividend payments. In performing this valuation, I made several assumptions. First, I used 9% as my discount rate, based on the long-term average return of the stock market. Next, I used Merck's 11% dividend increase to estimate the full-year dividend amount for 2012 ($1.68). Finally, I applied a constant dividend growth rate of 3% to the estimated 2012 dividend amount.

While 3% may seem like a low growth rate, I feel it is appropriate given the lackluster dividend growth the stock has experienced for an extended period of time, combined with the recent double-digit increase in the dividend. In addition, Merck will be losing its patent on Singulair, which makes up over 10% of total sales, later this year.

Based on these assumptions, I calculated that Merck's intrinsic value is $28 per share. At its current price of $37.18, the stock is priced 33% above its intrinsic value and appears to be overvalued.

Conclusion

While the dividend, currently yielding 4.5%, is not likely in any danger of being reduced, the stock price provides no margin of safety. In addition, it prices in a dividend growth rate that Merck is unlikely to achieve, given the company's performance over the past decade. Therefore, long-term income-oriented investors may want to look elsewhere for a more favorable risk-reward opportunity to put their money to work.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.