Merck Offers Value and Steady Dividend Growth
Brian Bollinger | Aug 24, 2016 10:53AM ET
Merck (NYSE:MRK) is a recession-resistant business model , attractive operating margins, and reliable free cash flow generation.
This is the type of consistency I like to see for investments I consider for our Conservative Retirees dividend portfolio.
Currently, the business looks attractive with a nearly 3% dividend yield and optionality for additional dividend increases; however, with many large pharmaceutical companies struggling with billion-dollar revenue drugs’ patent protection expiring, should investors continue to count on Merck’s dividend stability?
Business Overview
Merck has an extremely long company history which dates back to a German apothecary shop in the 17th century. However, they trace their roots in the United States only back to the late 1800s where they were established to be a chemical supplier for their German parent. Today, they operate the business primarily through two main categories: Pharmaceuticals (88% of sales) and Animal Health (8.4% of sales).
The Pharmaceuticals business discovers, develops, and produces therapeutic and preventive agents for the treatment of human disorders. Merck’s target markets include cardiovascular, diabetes, general medicine and women’s health, hepatitis, HIV, acute care, immunology, oncology, respiratory, and vaccines.
In 2015, their top 10 therapeutics accounted for around 47% of total sales and included 9 different billion-dollar drugs. The largest therapeutics include Januvia (treatment of type 2 diabetes), Zetia (cholesterol), Janumet (type 2 diabetes), Gardasil/Gardasil 9 (HPV), and Remicade (inflammatory diseases).
The Animal Health business discovers, develops, and produces products for livestock, poultry, companion animals, and aquaculture. Their products range from antibiotics for use in cattle and swine to a chewable tablet that kills fleas and ticks in dogs to vaccines against bacterial diseases in fish.
Overall, Merck is one of the largest pharmaceutical companies in the world by market capitalization, only behind Johnson & Johnson (NYSE:JNJ), Novartis AG (NYSE:NVS), and Pfizer (NYSE:PFE). Compared to these competitors, Merck had sales of over $39 billion in 2015 versus $70.1 billion at Johnson & Johnson, $49.4B at Novartis, and $48.9B at Pfizer.
Business Analysis
The business model for a multinational pharmaceutical company comes down to investing in R&D, patenting new therapeutics, and then using manufacturing and distribution scale to get the products to market.
The cost to bring a drug to market after years of research, development, and clinical trials is astronomical. Some estimates now put the total cost at over $2 billion dollars. However, once a company gets a new product to market, they enjoy years of monopoly status with a recession resistant product.
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This leads to a relatively stable margin and revenue structure over time, which is exactly what individuals living off dividends in retirement like to see in their investments.
Source: Simply Safe Dividends
These industry characteristics illustrate that Merck isn’t going anywhere anytime soon. However, conditions aren’t always stable for drug producers.
Key Risks
Merck has gone through a very difficult period of time as they have faced patent expirations in many of their blockbuster drugs and settled a multibillion-dollar lawsuit over the painkiller Vioxx.
Merck’s sales peaked in 2011 at over $48 billion and have declined to $39.5 billion in 2015. The company has executed a couple of divestitures over this time that have contributed to the sales decline.
However, even if these transactions are adjusted out, organic growth has still been negative. This is further illustrated by total employee count decreasing over this period from 86,000 to 68,000.
The declining sales are a result of the well-publicized “patent cliff” that many of the major pharmaceutical giants recently faced.
Also, Merck has had some major setbacks in their pipeline over the last few years. They dropped plans for approval of cardiovascular drug Tredaptive in the U.S. and pulled out of markets where it had already been approved.
Another example is Odanacatib, which was an osteoporosis drug that underwent many delays over safety questions. Neither of these once-promising drugs is meaningful to Merck today.
Furthermore, a number of their current billion-dollar revenue drugs, including Januvia, Isentress, Gardasil, Remicade, Zetia, Vytorin, and Nasonex, have either recently come off patent or have patents expiring over the next few years.
Clearly, the pipeline setbacks and outlook for many of their key drugs should be a cause of concern for investors.
However, even with all of its challenges, not everything is going wrong at Merck. They appear to be through the worst of their patent cliff and still are able to spend nearly $7 billion per year on research and development, which has led to some promising new products.
Also, the company has improved the effectiveness of their R&D spend by targeting unmet areas of specialty care such as diabetes and cancer, rather than primary care.
In addition, Merck has a few levers to pull that can extend the patent window of some of their key drugs. They can work to hold later-granted patents on processes and intermediates related to the most efficient manufacturing method of the active ingredient. Additionally, they can generate unique compositions and formulations that could push out expiration dates for some treatment options.
With all that said, the most promising new therapeutic is Keytruda. According to Merck, Keytruda can treat different cancers including melanoma or lung cancer or head and neck cancer by working with the immune system.
The share of these markets Keytruda can capture got a boost when Bristol-Myers Squibb’s Opdivo failed in a lung cancer trial earlier this month, which sent Bristol-Myers Squibb’s stock price down 18%.
Kaytruda is addressing huge markets, and it is widely expected for the drug to increase sales from the current annualized rate of roughly $1 billion to be a multibillion-dollar therapeutic.
Dividend Analysis: Merck
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Merck’s dividend is very safe with a Dividend Safety Score of 69. The company’s strong score is driven by Merck’s stable business model and relatively modest free cash flow payout ratio of 46%.
Analysts are projecting future diluted earnings per share of $3.75, $4.05, and $4.43 in 2017, 2018, and 2019, respectively. This forecast implies low- to mid-single digit earnings growth and a safe payout ratio below 50%.
Merck’s dividend safety is also helped by the company’s consistent free cash flow generation, which is needed to sustainably pay and grow dividends.
As seen below, Merck has generated positive free cash flow for more than a decade:
Source: Simply Safe Dividends
Most of Merck’s products are non-discretionary purchases as well. Pharmaceuticals are needed regardless of how the economy is doing, which helped Merck report a sales decline of just 1% in 2008.
The company’s balance sheet is also very supportive of the dividend. Merck maintains investment-grade credit ratings from the major agencies, reflecting the company’s strong market position, diverse revenue mix, healthy profit margins, and consistent cash flow generation.
Merck has $11.8 billion in cash compared to $23.6 billion in debt. The company could retire all of its debt using cash on hand and just 1.5 years of earnings before interest and taxes (EBIT).
Overall, Merck’s dividend payment is very safe. The company’s payout ratio is healthy, cash flow generation is excellent, the balance sheet is reasonably flexible, and earnings are expected to continue growing at a moderate pace.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Merck’s Dividend Growth Score is only 35. This low score shouldn’t be a surprise considering the patent cliff the company faced and hiccups with the product pipeline.
Merck has paid a consistent dividend since initiating it in 1970. Nonetheless, the company is not adividend aristocrat because they have not been a consistent dividend grower.
In fact, Merck held its quarterly dividend constant at 38 cents per share from September 2004 through September 2011. Furthermore, they do not have as good of a dividend growth track record as some of the other global pharmaceutical giants.
Merck has grown their dividend at a 10-year CAGR of only 1.8%, 5-year CAGR of 3.6%, and 3-year CAGR of 2.3%.
This is well below Johnson & Johnson, which has grown their dividend at an 8.7% 10-year CAGR, 5-year CAGR of 6.9%, and 3-year CAGR of 7.1%. During the same time periods Pfizer has grown their dividend at 4%, 9.2%, and 8.4% per year, respectively.
During the first quarter of 2016, the board of directors at Merck elected to maintain the same quarterly dividend of 46 cents per share that they paid in the fourth quarter of 2015.
Historically, the fourth quarter is when the company decides whether or not to increase the dividend. In the fourth quarter of 2015, they elected to increase the dividend by roughly 2%.
Overall, we would expect Merck to continue to increase the dividend at a low-single digit rate, which should keep up with inflation. I don’t expect any significant increases in the free cash flow payout ratio, which has consistently been around 50% for the last decade.
Source: Simply Safe Dividends
Thus, future increases in the dividend will have to come from earnings and cash flow growth, which is a function of introducing new therapeutics and managing the decline of off patent drugs.
As of now, major risks to the dividend are more likely to come from lawsuits, recalls, and lack of successful new product introductions than anything to do with the economy or business model.
Valuation
Merck’s stock currently trades at 17x forward earnings estimates and offers a dividend yield of 3%, which is somewhat below the stock’s five-year average dividend yield of 3.65%.
Assuming the company the company continues growing earnings at a low- to mid-single digit rate, the stock appears to offer total annual return potential of 7-10% and looks reasonably priced today.
Conclusion
Merck is a large cap dividend stock that appears to be a good investment to consider for investors looking to add more yield to their portfolio.
The company has a solid balance sheet, a recession-resistant business model, generates consistent free cash flow, a reasonable forward P/E ratio of 17x, and has paid a consistent dividend since 1970.
However, outside of introducing a number of major blockbuster drugs to the market, Merck is unlikely to grow it dividend much in excess of inflation over the next few years.
Investors looking for a true dividend growth name that could grow to have a high yield on cost someday should pass on the company.
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