Merck Bull's Pen
by Paul Larson ([email protected])
Merck is a company that has a glorious history and an even brighter future. In fact, the company manufactured the first dose of penicillin in the United States and developed techniques that made mass production of the first antibiotics possible. Dr. Selman Waksman, who won the Nobel Prize for discovering streptomycin, once said that, "Without Merck, most, if not all, antibiotics that we isolated would have remained bibliographic curiosities." There is no doubt that Merck is a company that is making the world a better place.
Nevertheless, we aren't here to tug on the heartstrings, we're here to discuss the investment worthiness of the company. Without a doubt Merck is one of the bluest of blue chips there is, both in the drug industry itself as well as the market as a whole. The company is the largest domestic drug company in existence and is second in the world to only Glaxo Wellcome <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GLX)") else Response.Write("(NYSE: GLX)") end if %> in size.
First, let's look at some of the macro trends affecting the industry as a whole. There are numerous reasons to like the pharmaceutical industry in general and Merck in particular. The first major factor helping the industry is the aging of America. As the population starts to get a little grayer on average each year, the use of pharmaceutical products will rise since older folks, obviously, use more drugs than the young. Furthermore, as standards are raised in the world's healthcare in emerging markets, there will be an increase in demand across the board. After all, Americans are not the only ones with heartburn that can benefit from taking Merck's Prilosec or Pepcid. Put it all together and worldwide drug sales are expected to grow at close to a 10% annual rate for the foreseeable future. As the cliche goes, a rising tide raises all the ships.
The drug industry also tends to fare relatively well in times of economic uncertainty. Folks might cut out their planned Caribbean cruise and put off buying a new car for a year or two when recessions hit, but those taking some of Merck's products such as Crixivan (for HIV treatment) or Maxalt (for migrane headaches) sure won't miss a dose. In other words, it's a defensive industry and earnings are not nearly as dependent on a vibrant economy. There is a reason the market has awarded the industry rich valuations, and safety (as well as growth) of earnings is a huge factor.
Domestically, the group is seeing a friendlier regulatory environment since the FDA has streamlined its drug approval process. In 1996, the average drug spent 35 months in the approval process, while in 1997 the average was nearly halved to 19 months, and continued shortening is planned. This not only means a shorter amount of time from the lab to the prescription counter (shorter time to recoup investment), but it also gives the drug makers a longer period with which their products will be protected from competition by patent.
Like many other companies in the industry, Merck is quite exciting because it has an established base of profitable products (aka, cash cows) that can be used to finance research and development to find new drugs. To be concise, it's a compound growth story at its brightest. Merck's commitment to research is unwavering as the company's R&D budget is fast approaching $2 billion annually. Of course, the discovery process is largely hit-and-miss, but with a shotgun of the gauge reading into the billions of dollars it's a pretty safe bet that the company will score at least a few hits.
Let's now look at Merck's financials. You could almost set your watch to the company's earnings and dividend growth. Merck has been able to grow its dividend every year for the past decade, including 13% annual growth in the last five years. Except for a minor pause in 1993, the company's earnings have also advanced every year for the past ten years. Additionally, the company has an ongoing, modest share repurchase program in place, indicating company's confidence in the stock.
Shareholders have been rewarded handsomely as the stock is worth approximately 10x more than it was eleven years ago, and that does not include dividend payments. Reinvest the dividends and the returns become much more impressive. There's no better way than to look at a picture of the earnings, dividend, and stock growth than to look at a chart of the historical results by clicking here. Of course, past performance is no guarantee of future results, but I'm a Fool and believe it's a pretty darn good indicator.
The company's performance measures are also top notch. Gross and net margin as well as return on assets, equity, and invested capital all smoke the general market. Take a look at the following measures, courtesy of Media General:
Merck Market Average
Gross Margin 53.6% 44.9%
Net Margin 19.9% 7.5%
Return on Assets 18.5% 2.9%
Return on Equity 37.3% 15.3%
Return on Invested Capital 33.9% 7.9%
Rather impressive, eh? Even though the sustainable growth should be clearly evident from looking at the historical picture, it can also be seen mathematically since the company's return on invested capital is far above its cost of capital. Even so, the company needs little financing at all since it generates a great deal of cash internally.
Of course, no analysis is complete without looking at the going price tag for what we are discussing. At the time this was written, Merck was trading at 32x trailing profits and 27x forward estimates. Of course, this is above the rest of the market on average, but I think I've shown why the company as well as the industry deserves more than a small premium. Look at the following table and it is clearly evident that compared to its peers the stock is relatively inexpensive:
Ticker Trailing P/E*
Pharmacia & Upjohn PNU 66x
Pfizer PFE 66x
Warner Lambert WLA 58x
Schering-Plough SGP 48x
Glaxo Wellcome GLX 38x
Merck MRK 32x
*(as of 11/1/98)
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