Merck & Co., Inc, started 2010 with its stock hovering around $35. Two years later, it began 2012 with its share price near the same level, as the pharmaceutical giant continues to battle a chronic malaise that has gripped the large-cap pharma universe and left shareholders in need of a prescription for anti-depressants.
The reasons for this lackluster performance are readily visible: the market is concerned that pharmaceutical companies like Merck won’t be able to offset the impact of expiring patents on some of their most lucrative drugs, given what is widely seen as an underwhelming pipeline of potential blockbusters to replace them. But looking more deeply at Merck’s fundamentals, there are some signs that all the pessimism may be overdone.
Clues to Merck’s ability to shake off the negative sentiment that has dogged it for years will be found most readily in the company’s financial fundamentals. In search of some indication that the future may be an improvement on Merck’s recent past, we deployed the StarMine Earnings Quality (EQ) Model to gauge the caliber of the pharmaceutical company’s earnings. Corporate profits come from sources that vary in their degree of sustainability and this model ranks companies on a 1-100 scale: the higher the score, the better the quality of those earnings. Given all the gloom surrounding it, Merck’s score of 91 may seem high, putting it among the top 10% of all companies in North America with respect to the caliber of its earnings. A closer look at Merck’s free cash flow helps explain why. The chart below compares that free cash flow to the company’s reported net income. Whenever cash flow exceeds net income, the surplus is shown in green; when it lags, it is indicated in red. In the third quarter (the most recent period for which data is available) the company generated more than $4 billion in free cash flow and just less than $1.7 billion in net income . Free cash flow now stands at the highest level recorded in any one of the last 20 quarters. Huge free cash flows of that kind are exactly what are needed to finance Merck’s dividend payments to shareholders, as well as enable the company to keep funding research and keep scouring the landscape in search of attractive acquisition opportunities. This chart paints the picture of a company that has plenty of financial flexibility.
Source: Thomson ONE / StarMine
Moreover, while analysts may worry about competition from generic pharmaceuticals eroding profit margins on brand-name drugs produced by Merck and its rivals, the following chart shows that those have generally been on the rebound. This chart shows three forms of margins most often scrutinized by analysts and investors: gross margins, operating margins and net margins. Yes, across the board, margins took a big hit between late 2009 and late 2010, but since then, gross margins have largely recovered and the other two metrics also are bouncing back.
Source: Thomson ONE / StarMine
Merck has another advantage: by historical standards, the stock seems downright cheap, trading well below its 15-year median level on the basis of price-to-earnings (P/E), price-to-book, price-to-cash flow, and other common ratios. Its 12-month forward P/E ratio of 10 is well below its 15-year median P/E of 16.
The StarMine dividend discount model-based Intrinsic Valuation methodology tells us what growth expectations are already priced into the stock. In Merck’s case, the answer to that question is that the market isn’t expecting much from the company: its Implied growth rate is a mere 0.2% compounded each year for the next 10 years, or well below the rate of inflation. If you believe that the company is able to post higher growth rates than that, the stock would seem significantly undervalued.
The pharmaceutical industry’s woes aren’t illusory; Merck and other companies will remain under siege from generic drug manufacturers and the pressure on them to develop – or acquire – generation after generation of breakthrough blockbuster drugs will never ease up. But while some degree of investor pessimism may be warranted, much of that is reflected in the low-growth expectations already priced into the stock. And Merck’s current long-suffering shareholders are able to alleviate their suffering by contemplating Merck’s relatively hefty dividend yield of 4.5% (based on the company’s current stock price of $38 a share.) That kind of cash return, when measured against the razor-thin returns banks grudgingly offer on their CDs and that Treasury securities yield today, may be just what the doctor ordered.
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