Merck: Strong Profits And Income Dampens Risks

| About: Merck & (MRK)

The healthcare sector has been one of the best performing sectors of the stock market thus far this year, offering very attractive returns to investors who have been able to ride the trend. Using the Healthcare Select SPDR (XLV) exchange-traded fund ETF as a proxy, healthcare is up over 12.5% thus far this year. The questions for investors at this point is whether the trends continue, reverse, or whether the sector is just too hot overall. In looking at the overall dynamics of the major pharmaceutical companies, Merck (MRK) stands out as an interesting buy at current levels. To arrive at this conclusion, there are some important fundamental metrics that should be considered, but in a trend this strong, checking the technical picture is prudent as well.

How Merck Stacks Up

In a recent study, Matt Schilling ran a basic screen to help find attractive drug companies with high profit margins. The criteria used required that any stocks to be considered had the following characteristics:

  1. Minimum Return On Equity of 9.50%
  2. Minimum Return On Assets of 6.25%
  3. Minimum Profit Margin of 13%
  4. Minimum Dividend Yield of 3%

The four companies that made the cut were Merck, Pfizer (PFE), GlaxoSmithKline (GSK) and Abbott Labs (ABT). While the statistics for each metrics are available at the above link, there are two that stand out in particular: the profit margin and the dividend yield carried by Merck. The company has a profit margin of 14.46% relative to 14.45% for Pfizer, 18.44% for GlaxoSmithKline and 13.01% for Abbott. With the second highest in the group, this combines with the dividend yield to make this an interesting stock to consider.

Merck recently announced that it would end trials ahead of schedule for its osteoporosis drug, Odanacatib, after it was found to be very effective. While it will be several months before Merck can close out the trials fully, the company does plan to submit applications for approval by mid 2013. This development is certainly a big positive for the company.

At the same time, Merck's dividend growth is somewhat troubling. Looking at the past ten years, for example, Merck's dividend has never grown more than 3%. During five of those years, Merck reported 0% dividend growth.

Merck currently has a dividend yield of 3.9%, compared to 3.8% for Pfizer, 4.8% for GlaxoSmithKline and 3.1% for Abbott. This yield places Merck as the second highest yielding stock in the Dow 30.

Merck currently has total cash of $15.57 billion and total debt of $18.16 billion. The company has operating cash flow of $12.82 billion and levered free cash flow of $11.07 billion.

How To Trade Merck

Given the recent 52-week high, some investors may be hesitant to enter the stock at such high levels. In order to develop a plan for the stock, it is important to consider the various factors. First, the strong uptrend has been seen in the overall sector, not just in this given stock. This should not come as a great surprise as healthcare stocks have fared well during recent presidential elections; healthcare is a focus of politics and the exposure and government support tends to be good for the stocks of these companies. While this trend may slow, it seems unlikely that it will be allowed to reverse prior to the conclusion of the election.

While the stock is not the strongest on every metric, its overall position, particularly as a Dow Jones Industrial Average (Dow 30) stock, makes it a good candidate to be a core holding for most investors. When the strength of the technical indicators is included, the stock becomes even more attractive. To put these into context, while some of the fundamental metrics for GlaxoSmithKline were stronger, that stock has been trading in a range between $43.50 and $47 without breaking out. In June and July, Merck broke well above the previous $39.50 top of its range and this is considered a bullish sign for the stock.

There is some risk associated with buying a stock this close to its own recent highs. In the case of Merck, the fact that the company has a significant profit margin and a very strong income stream should dampen the risk to an extent. Taking such a risk is not always a bad idea, as long as one is aware of the risk being taken. Both the stock and the sector continue to look very strong and attractive at current levels - any pullback should be viewed as a buying opportunity. Once in the stock, watch for any moves below $41. If the stock closes below these levels, it will be necessary to reevaluate one's position.

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

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