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Merck (NYSE:MRK) is one of the world's largest healthcare companies. A member of the S&P 500, it occupies 11% of the index's total market capitalization. The company has consistently maintained a hold on key vaccine, drug, and other healthcare products that are now part of everyday practice.

Given the present valuation and overall promise of the company, I recommend a long-term buy for Merck both for the 12/18-month investor and the 3-year investor. Slightly undervalued, Merck's long-term growth potential is unique among pharmaceutical companies. It has a large set of potential blockbuster drugs presently in development and maintains a fertile research highway. For Merck, competitive valuation plus concrete prospects for growth means a buy.

Valuation

At around $38, Merck shares are favorably priced. The forward P/E for Merck shares is 10.2, which is lower than many of its competitors. For instance, Johnson & Johnson (NYSE:JNJ) has a forward P/E of 12.12, and Eli Lilly (NYSE:LLY) has a forward P/E of 12.72. The average forward P/E for the healthcare industry is at around 13, making Merck significantly cheaper than its peers. While these companies maintain a slightly more competitive cost structure than Merck, I will mention below how Merck is trying to curb this.

On a price/sales basis, Merck's multiple of 2.5 is within the inner three quartiles for the industry. That said, some of the larger cap competitors of Merck, including GlaxoSmithKline (NYSE:GSK) and Johnson and Johnson have higher ratios between 2.6 and 2.7. Though Merck's price/cash flow ratio of 8.2 is within the inner three quartiles for the healthcare sector, nevertheless it has a lower ratio than Eli Lilly, GlaxoSmithKline, and Johnson and Johnson and is lower than the sector average of 11.8. Thus, given its quality of business and its projected earnings, Merck has a competitive valuation within its sector. As indicated below, the stock stands to settle around $42 to $44 if drug trials yield positive results.

Developments on the Horizon

Though Merck has a variety of flagship drugs that have bolstered past performance, what new developments on the horizon would justify a buy for Merck? After all, Merck shares are trading near their 12-month highs, so what is the story for growth?

Some of Merck's major drugs, like Singulair, are coming off patent in 2012. At the moment, there are three major phase III hopefuls for the company. The major risk, of course, is whether or not Merck will actually be able to push these through. However, recent news indicates that one of these three drugs, suvorexant, is nearly ready for final stage development. Announced on June 13 as the result of a phase III efficacy tests, the drug was shown to help insomnia patients fall asleep faster by deactivating their wakefulness centers (usually, insomnia pills simply induce sleepiness). These are great results for the drug, and it now awaits FDA application and approval.

Other drug prospects are also promising. The Januvia/Janumet drugs for type 2 diabetes, the Isentress HIV therapy, and the Victrelis hepatitis C therapy are all promising revenue drivers. Additionally, Activyl was recently released for the large pet medicine market. This topical medicine protects various household pets from ectoparasites like fleas, and this could be a significant driver of profit for Merck. There is a fair amount of competition on all of these fronts: Vertex Pharamaceuticals (NASDAQ:VRTX), for instance, has experienced great success with its phase II drugs for hepatitis C. However, the large number of independent projects for Merck helps to dilute the risk of any single drug failure, and consistent research and development at Merck further lessen investment risk.

About 15% of Merck's total sales go to research development, and it maintains this allotment while using only about 25% of sales for management, advertising, and other overhead, which is below average for the sector. Merck maintains a debt/capital ratio of 24%, and its debt is rated a competitive AA by S&P. In all, I would like to see Merck continue to increase its net margin, which is about 2% below the peer average. To that end, it is engaging it a rather extensive workforce cut of about 12% by 2015, though it intends to maintain overall R&D figures. This will help improve its return on investment, which is presently at a humble 8% (most of its peers have figures in the teens).

Risks with Pharma and Merck

The precarious position of the U.S. health system leaves the sales structure in the United States relatively uncertain as its Supreme Court will be deciding on the constitutionality of its health laws. Additionally, as with the rest of the market, European austerity pricing might be an issue for sales. Drug development is often a hit-or-miss, and many drugs fail in phase I or II before even being tested for efficacy. Merck's drug testing history is not completely in the clear either as its Vytorin/Zetia line of drugs has had sub-par clinical trials. That said, this setback is an expectation in this sector.

Conclusion

Merck is pushing to file a docket of "major five" drugs by the end of 2013. This includes Bridion (a neuromuscular drug), V503 (an HPV vaccine), odanacatib (an osteoporosis drug), tredaptive (a cholesterol reduction medication), and Surovexant (the insomnia drug described above). These will lead the company to an excellent year, and the consensus earnings per share estimate for Merck is $3.85 for 2012, up from $2.02 in 2011. Though earnings might slump as economic factors tighten, Merck is a long-term value stock that is trading at very competitive multiples. The positive momentum of upcoming drug releases might push share prices well above the $43 12-month target for the long-term, assuming management executes its cost-cutting program.

Source: Merck: Buy Now And Ride $4 Higher In 2013