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Merck's Dividend Remains Secure Following Completion of Spinoff

Last week Merck completed the spinoff of its women's health, biosimilars, and off-patent drugs businesses into the newly formed Organon & Co (OGN).

Investors of Merck received one-tenth of a share of Organon common stock for every Merck common share owned, with cash paid in place of any remaining fractional shares.

Organon has not declared an official dividend yet, but the company has communicated its long-term plans to pay a dividend with a payout ratio in the low 20% range.

Based on guidance from management, we estimate that Organon has the potential to pay a dividend of around $1 per share annually, which implies a dividend yield just shy of 3% at today's stock price.

However, Organon also needs to address one-time spinoff costs of around $600 million (nearly half of its annual net income), invest in working capital to support the business, and reduce debt (the firm has a BB junk credit rating from S&P).

These uses of cash could cause management to initiate a dividend below $1 per share, with plans to work towards a higher payout as progress is made across these objectives.

Merck's goal with the spinoff is to improve operating efficiencies and focus marketing efforts on higher-demand drugs with more growth potential. 

The departing pharmaceuticals accounted for only 15% of sales but nearly a quarter of Merck's manufacturing sites and half of all products. No longer protected by patents, these drugs were seeing a steady erosion in sales too.

Besides shedding these products, Merck also received a $9 billion tax-free dividend from Organon that it plans to use towards adding new drugs to its portfolio. This amount isn't a game-changing sum as it represents only about 5% of Merck's market cap, but it does provide additional flexibility for acquisitive growth. 

You can read more about the spinoff and our thoughts here.

Despite becoming a faster-growth and higher-margin business following the spinoff, Merck's shares trade at a 3.5% dividend yield – which is nearly 20% higher than their 5-year average.

This diminished valuation may, in part, be due to growing concerns around political pressures leading to a cap in drug prices.  Ultimately, price caps would compress margins and restrict growth in future cash flows.

Currently, public sentiment overwhelmingly believes drug prices are too high. Even so, any policy changes in Washington will require bipartisan support, which has been hard to find lately.
 
Although investors shouldn't ignore the risk of price caps, any potential changes will likely take years to play out.

Looking within Merck, there is also some concern about the company's dependence on the cancer treatment drug Keytruda, which will provide roughly 35% of revenue following the spinoff.

The concentration in revenue tied to Keytruda will become a greater risk in a few years when the blockbuster drug gets closer to its 2028 patent expiration date.

Until then, Merck has time to diversify by pushing new products to market from its pipeline.  The pharma giant has 23 drugs in phase three trials, which typically take 1-4 years to test, and six drugs that have completed testing trials and are under review by regulatory authorities. 

It's hard to evaluate the commercial potential of these drugs and how much Keytruda revenue they can help replace in 2028 and beyond. But Merck has other levers it can pull to protect its future cash flow stream. 
 
The company's strong balance sheet capacity, which includes the $9 billion in spinoff proceeds and an A+ credit rating from S&P, provides additional flexibility to acquire new products and bolster Merck's drug portfolio over the next few years.

Overall, neither drug price controls nor revenue diversification is a near-term concern for the company.  

Although these concerns could intensify over time, especially as Keytruda's 2028 patent expiration gets closer, Merck is well-positioned to mitigate future disruptions with its strong balance sheet, including plenty of liquidity and low debt.

As such, we are reaffirming our Very Safe Dividend Safety Score for Merck. In addition, we believe the company's favorable payout ratio, which is projected to sit below 40% in the year ahead despite losing Organon's earnings, offers a solid platform for the dividend to grow as Merck transitions into a more focused and operationally efficient business.

We would consider revisiting our Dividend Safety Score in the next few years if efforts in Washington to cap drug prices intensify or if Merck fails to make progress diversifying its revenue stream.

Either way, Merck has time and financial flexibility on its side.

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