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The pharmaceutical sector can be a scary place for investors. Legal challenges, patent cliffs, competition from generics, and new regulations are just as a few of the hurdles these companies face. But few companies in the pharmaceutical sector have met legal challenges head on while also maintaining strong growth as well as Merck (MRK). In this article, I will highlight several reasons why Merck is a strong investment candidate at current price levels. I will focus on the recent Vioxx settlement, new products Isentress and Januvia, valuation, the overall market picture, and the competitive landscape.

Beyond Vioxx

Investors liked news coming out of Missouri, where Merck agreed to a settlement of a class-action suit related to its discontinued arthritis drug, Vioxx. Shares of Merck peaked at a split-adjusted high of nearly $100 in the early 2000's. Following 2004's Vioxx scandal, which caused Merck to pull the drug from the market, shares lost a tremendous amount of value, but the stock has been looking up in recent years. Friday's settlement was one more step towards putting the ugly Vioxx incident behind Merck.

A company agreeing to settle a class-action suit normally results in a pull-back in the stock's share price, but in this case, investors liked the news. Merck disclosed the issue and booked the charge in Q3, and now that a settlement has been reached, there is greater certainty for Merck's shareholders. The court still has to approve the deal, but no one seems to think that outcome is in doubt.

Merck announced its Q3 earnings on October 26th. Earnings per share were up, beating expectations, but estimates for the current quarter were revised lower. Still, the settlement reduces future risk, and that's bullish for Merck. The company should have no problem meeting its -14% earnings-per-share growth projection, and an upside "surprise" would hardly be surprising at all. This, in essence, is what traders were collectively saying by giving Merck's shares a boost on an otherwise bearish day on Friday, when the settlement was announced. Merck has moved beyond Vioxx and can now focus on its new products.

New Products and Acquisitions

Isentress and Januvia are two of Merck's newest products, and they have both outperformed analysts' sales projections, thus far. Both enjoy virtual monopoly positions within their fields, and they enjoy patent protection against would-be competitors bringing similar drugs to the market. Isentress treats HIV; Januvia treats diabetes; and there's also the more controversial Gardasil, which is a vaccine for the human pappilomavirus (HPV). Merck has also developed a follow-up to Gardasil, V503, which holds even stronger pricing power than its predecessor.

Merck's acquisition of Schering-Plough in late 2009 is projected to provide as much as $4 billion in annual cost savings by 2015. Synergies achieved through economies of scale, as well as the elimination of redundancies will more than pay for the acquisition. Potential blockbuster drugs like Victrelis, for the treatment of hepatitis C; and the anesthesia-treatment Bridion are also catalysts for Merck's growth. Managers Merck can focus on these and other growth drivers now that they no longer have to worry about Vioxx.

Valuation and Fundamentals

Merck is currently trading at 21 times trailing earnings. This is a bit higher than the average firm in Merck's industry, but well under Merck's own five-year average of 40.1 times earnings. On a forward basis, Merck's 12.2 earnings multiple looks even more attractive. In terms of price-to-book, price-to-sales, and price-to-cash flow, Merck is currently trading at a discount to its historic valuation. Merck also pays a 3.7% dividend.

Merck's gross margins have been improving since 2010, when they hit a decade low of 60%. In 2012, gross profit jumped to 65%, and it's expected to gain another half-percentage point in 2012. The settlement of the Missouri suit, which was by no means a given when Merck issued these projections, will have no effect on gross margins, but should boost Merck's operating income, which was 16% in 2011 and was last projected to be 18.5% in 2012.

Market Analysis

In reality, Merck's toughest competitors are the producers of low-cost, generic drugs based on Merck's own research and development. The patent system offers relief from these copy-cats, but only temporary relief. Singulair, Merck's biggest drug by sales volume, lost its patent protection in 2012. This is obviously not a good thing for Merck, but it was anticipated and thus accounted for.

In theory, Merck's chief competitors are other Big Pharma firms like Pfizer (PFE), Eli Lilly (LLY), GlaxoSmithKline (GSK), and Novartis (NVS), but as Merck's settlement was a company-specific event, it had minimum impact on its competitors. If anything, the settlement is slightly bearish for these firms, as it will mean a tougher competitor in Merck. Nevertheless, it is worthwhile to take a closer look at the other Big Pharma stocks before determining whether to buy, sell, or hold Merck.

Competitors

Pfizer is a stock with a history similar to Merck's: a once great drug company that got hammered and devalued by lawsuits. Merck has dealt with its troubles head-on, at least in recent years, and looks poised for growth. Pfizer, by contrast, is in retreat mode, scaling back R&D in the name of present-cost savings. Pfizer also has substantial exposure to Europe, and austerity measures across the continent will likely be bad for Pfizer's bottom line.

Eli Lilly is another drug company headed in the wrong direction. Its margins have been cramped to the point that there's uncertainty as to whether there will be sufficient cash flow to cover its dividend payments beyond 2015, and most of the drugs in its pipeline aren't scheduled to come to market until 2014 or '15 -- that's cutting things close. Lilly has also suffered steady loss of market share in the insulin market, thanks to rapid-acting insulin analogs produced by competitors.

GlaxoSmithKline is another overly comfortable drug maker. It has purposely sacrificed growth for reliability, as its diverse operating platforms protect it from problems associated with one product, but reduced the probability of the kind of breakout blockbuster that can excite investors. Its patent protections are weak and fading, too.

Finally, Novartis: It, along with Pfizer, is one of the few drug makers with bigger market caps than Merck, and, like Pfizer and the other drug makers profiled here, it has its share of operational problems, going forward. Novartis's leading drug Diovan lost patent protection this year, and it accounted for 10% of the firm's 2011 sales. Manufacturing problems in Novartis's consumer products division are lasting longer than expected, and there's brewing discontent between Novartis's branded and generic divisions.

Outlook

Merck will outperform within its industry. It is a mega-cap drug maker that is still growth-oriented, and it has met its legal challenges head on. Merck had a tough go of things for a half-decade or more coming out of its Vioxx scandal, but those days are largely behind it now. If you hold Merck, you should continue to do so. If you have not yet established a position in Merck, you should buy at its current price of around $46.

Source: This Big Pharma Should Outperform Its Sector This Quarter