Dividend Growth Stock of the Month for December 2017

This month we’re going to take a look at Merck & Company (MRK), one of the world’s pharmaceutical giants.

Merck’s Dividend Record

Merck’s dividend record is that of a mature, slow-growth company. Its yield is good at 3.4%, but its dividend growth rate over the past few years has been in the 2%-3% range per year.

Merck has paid uninterrupted dividends for more than 25 years. The company did not increase its dividend between 2005 and 2011, at which time it started a dividend increase streak that has now reached 7 years. After a 10% increase to begin the streak, Merck has been increasing its annual dividend by $0.04 per year since then. That translates to annual increase rates of a little over 2% per year.

I use two services to rate dividend safety. The first, Simply Safe Dividends, uses the following scale:

Simply Safe Dividends’ score of 98 for Merck is almost as high as you can get, suggesting that its dividend is very unlikely to be cut.

The second service, SafetyNet Pro, grades dividend safety as follows:

Their “C” grade for Merck indicates that they see the dividend as moderately safe. (For more insight on dividend safety, see Dividend Growth Investing Lesson 17.)

Merck’s Business Model and Company Quality
Headquartered in New Jersey, Merck is a 125-year-old leading global drugmaker. Its business lines are pharmaceuticals, vaccines, and animal health.

Merck has been responsible for many medical advances over its history, from the discovery of vitamin B1, to the first measles vaccine, to cold remedies and antacids, to the first statins to treat high cholesterol.

Today, the company is a premier research-intensive biopharmaceutical company. Its current developmental focuses include hepatitis C, HIV, diabetes, and immuno-oncology.

Merck operates through four segments:

• Pharmaceutical: Human pharmaceutical and vaccine products marketed either directly by the company or through joint ventures.
• Human health pharmaceutical products consist of therapeutic and preventive agents, generally sold by prescription. Merck sells its human health pharmaceutical products primarily to drug wholesalers and retailers, hospitals, government agencies, and managed healthcare providers (such as health maintenance organizations, pharmacy benefit managers, and other institutions).
• Vaccine products consist of preventive pediatric, adolescent, and adult vaccines, primarily administered at physician offices.
• Animal health.

Merck is a worlwide operation. Foreign operations account for a little over 50% of sales and a faster rate of growth than the domestic market. The global market’s main source of expected growth over the next few years is projected to be emerging markets, spurred by rising standards of living and growing government spending on health care.

Merck has several “blockbuster” products with more than $1 billion in annual sales. They include Januvia/Janumet (for type 2 diabetes); Remicade (rheumatoid arthritis); Isentress (HIV/AIDS); Vytorin (cholesterol); and Zetia (cholesterol).

However, Merck has faced many patent expirations recently. Expirations have affected Fosamax, Propecia, Zocor, Singulair, Vytorin, Nasonex, and Zetia.

Newly introduced Keytruda (cancer) has been an immediate success, launching in the USA for 6 indications, for 4 in Europe, and 3 in Japan. It took in almost $1 billion in quarterly worldwide sales in Q3 2017. Merck says that Keytruda is the most prescribed drug for first line cancer treatments.

Merck is also a leading maker of vaccines, including ProQuad (measles, mumps, rubella, and chicken pox); Gardasil (human papilloma virus): and RotaTeq (rotavirus).

Merck’s R&D expenses over the past few years have been 15%-17% of sales, or about $6-$7 billion per year. On average, it takes about $800 million to bring a new drug to market.

S&P gives Merck a below-average quality grade, although their report does not explain why. On the other hand, Morningstar awards Merck a wide moat rating based on the company’s patents, economies of scale, “powerful intellectual base,” and powerful salesforce.

Merck’s Financials
The financial report card for Merck is decent, but it displays year-to-year inconsistencies.

Looking back 10 years, the company has generated positive earnings and cash flow each year, but its growth rate has been inconsistent, sometimes positive and sometimes negative compared to the preceding year.

Merck’s return on equity (ROE) has settled into the 10% range over the past few years, but that is a low range. I consider 12%-19% to be OK and require 20%+ to be considered good.

[Source of all yellow-bar graphs: Simply Safe Dividends]

Merck’s free cash flow has been positive every year for the past 10 years, but we see inconsistent growth, including some annual declines.

Merck operates with less debt than most companies, which is good, and it has a good credit rating as seen in the prior section, but as shown here, the company’s debt level has been slowly rising for the past several years.

Merck’s Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation. Let’s go through the steps.

Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value. The basic valuation estimate uses a standard reference price-to-earnings (P/E) ratio of 15, which is shown by the orange line on the following chart. The black line shows Merck’s actual price.

The price is just below the fair-value line. Merck’s P/E of 14.3 is 0.95, or 95%, times the reference fair-value P/E of 15, suggesting that its stock price is 5% under fair value.

I call anything within 10% of fair value “fair,” because stock valuation is an inherently imprecise process. Dividing the current price by 0.95 gives us an estimated fair price of about $59 compared to Merck’s actual price of about $56 per share.

Step 2: FASTGraphs Normalized. The second valuation step is to compare Merck’s price to its own long-term average P/E ratio. This gives us a picture based on the stock’s own long-term valuation instead of the market’s long-term valuation.

Here, the fair value reference line is in dark blue. It is drawn at a value of P/E = 13.8, because that is Merck’s 5-year average historical valuation.

Viewed from this perspective, Merck is a tiny bit overvalued, but still in the “fair” range. The degree of overvaluation is 14.3 / 13.8 = 1.04, or 4% overvalued. This suggests a fair price of $54.

Step 3: Morningstar Star Rating. Morningstar uses a discounted cash flow (DCF) process for valuation. Their approach is comprehensive and detailed. Many investors consider DCF to be the best method of assessing stock valuations.

In their approach, Morningstar makes a detailed projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.

Morningstar considers Merck to be undervalued, giving it 4 stars on their 5-star scale. Their estimated fair price is $65.

Step 4: Current Yield vs. Historical Yield. Last, we compare the stock’s current yield to its historical yield. This is an indirect way of calculating fair value, based on the idea that if a stock’s yield is higher than normal, it may indicate that its price is undervalued (and vice-versa).

According to Morningstar, Merck’s 5-year average yield has been 3.5%. The current yield of 3.4% is nearly identical. That suggests that Merck is fairly valued at its current price.

Valuation Summary:
Miscellaneous Factors
Beta
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility, because they present fewer occasions to react emotionally to rapid price changes, especially sudden price drops that can induce a sense of fear. There is also academic research that suggests that low-volatility stocks outperform the market over long time periods.

Merck has been a low-volatility stock, with 5-year beta of 0.8 compared to the market as a whole at 1.0. That means that its price moves about 80% as much as the market on average. This is a positive factor.

Analyst’s Recommendations

In their report on Merck, CFRA averages the recommendations of 23 analysts who cover Merck. Their average recommendation is 3.9 on a scale of 5. This translates to “buy.” This is a positive factor.

Share Count Trend

Merck issued shares in 2010 in connection with a major acquisition. Then, as shown in the following chart, they began a share buyback program that has been steadily reducing the share count annually.

I like declining share counts, because the annual dividend pool is spread across fewer shares. That makes it easier for a company to maintain and increase its dividend.

Bottom Line

Here are Merck’s positives:

• Good yield at 3.4%.
• Good dividend safety.
• Blue chip global pharmaceutical company. New blockbuster cancer treatment – Keytruda – has started fast out of the gate around the world.
• Decent financials, marked by erratic growth. Low debt ratio, although it has been growing over the past few years.
• Declining share count.
• Low volatility compared to the market.
• Stock is slightly undervalued.

And here are its negatives:

• Slow dividend growth rate at about 2% per year.
• Revenue and earnings have been impacted by patent expirations and (therefore) generic competition.
• Inconsistent earnings and cashflow growth, although both have been positive the past 10 years.
• Growing debt ratio.

As always, this is not a recommendation to buy, hold, or sell Merck. Perform your own due diligence. And always be sure to match your stock picks to your financial goals.

— Dave Van Knapp

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