Blue chip drug makers such as Merck (MRK) have historically been very popular with income investors because of their defensive nature, meaning that drug demand isn’t really affected by economic downturns.
However, what many investors fail to realize is that, while the pharmaceutical industry as a whole may be recession resistant, successful long-term dividend growth investing is far harder to achieve at the company level.
This is why just two drug makers are part of the venerable dividend aristocrats list, meaning they are S&P 500 companies that have managed to raise their payouts for at least 25 consecutive years.
Let’s take a look at Merck to see if this high-yield favorite is a reasonable choice for a diversified dividend portfolio, especially in light of recent challenges that have sent MRK’s stock on its largest two-day decline in more than eight years, according to Reuters.
Merck has deep roots, going back to 17th century Germany, but in the U.S. it was founded in 1891 in Kenilworth, New Jersey. Today Merck is one of the largest pharmaceutical giants in the world, with 69,000 global employees selling drugs in over 140 countries through two main divisions.
Pharmaceutical (88.7% of Q3 2017 revenue) makes patented drugs to treat all manner of diseases and conditions, such as cardiovascular disease, type 2 diabetes, asthma, chronic hepatitis C virus, HIV-1 infection, fungal infections, hypertension, arthritis, osteoporosis, and fertility diseases.
It also offers anti-bacterial products, cholesterol modifying medicines, and vaginal contraceptive products, as well as vaccines for measles, mumps, rubella, varicella, chickenpox, shingles, rotavirus gastroenteritis, and pneumococcal diseases.
The company’s bread and butter sales, earnings, and free cash flow stem from just nine main large drugs, including blockbusters Januvia (type 2 diabetes) and Keytruda (antibody based cancer drug).
Animal Health (9.7% of Q3 2017 sales) sells antibiotic and anti-inflammatory drugs to treat infectious and respiratory diseases, fertility disorders, and pneumonia in cattle, horses, and swine; vaccines for poultry, parasiticide for sea lice in salmon, and antibiotics and vaccines for fish
Merck’s remaining sales come from two smaller divisions (1.6% of Q3 2017 revenue), Healthcare Services (serves drug wholesalers and retailers, hospitals, government agencies and entities, physicians, physician distributors, veterinarians, distributors, animal producers, and managed health care providers) and Alliances segments (collaborations with Aduro Biotech, Inc, Premier Inc, Cancer Research Technology, Corning, Pfizer Inc, AstraZeneca PLC, and SELLAS Life Sciences Group Ltd).
Merck’s 2016 sales were geographically diversified, with the U.S. responsible for 46.5% of revenue, with international markets representing 53.5%.
Like most major drug makers, Merck struggles to maintain consistent top and bottom line growth.
This is inherent in the business model, which relies on patented medications, whose patents eventually roll off, resulting in strong generic competition. In addition, rival medications, even for patented drugs, are constantly hitting the market, meaning that its top products face a boom and bust cycle.
Combined with high fixed costs, primarily in R&D spending on developing its large drug pipeline ($9.9 billion or 24.8% of last 12 month’s revenue), Merck’s margins and returns on capital can be volatile, as are its overall earnings and free cash flow.
Another problem Merck faces is that because of the drug development hamster wheel (even new blockbusters merely replace revenue lost to patent expirations and rival products), its growth is largely dependent on large-scale acquisitions, such as its $41 billion purchase of Schering-Plough in 2009 to help diversify the busienss.
Such large purchases are incredibly tough to pull off successfully because they require careful integration of differing corporate cultures, R&D pipelines, and administrative organization to deliver on expected synergistic cost savings (i.e. elimination of overlapping business costs).
Another challenge for Merck is that in this industry there are three primary factors that determine success: drug pipeline, manufacturing efficiency, and distribution. In other words, economies of scale.
However, while Merck is a large player, it’s management is not nearly as high-quality as those of larger and better run rivals such as Pfizer (PFE), and Johnson & Johnson (JNJ), which is arguably the gold standard of drug makers.
This can be seen in Merck’s inferior profitability, including lower returns on invested capital and a lower free cash flow margin.
Trailing 12-Month Profitability
Now that’s not to say that Merck is a terrible company. After all, it does have a solid track record of bringing numerous successful drugs to market, including its current rock star, cancer drug Keytruda.
Thanks to receiving numerous approvals for a growing number of cancer indications, plus greater rollout to over 50 countries in the past year, Keytruda sales increased to $1.05 billion last quarter, up from $356 million a year ago.
Better yet? Analysts expect this drug to eventually generate peak sales of $10 billion per year, according to Morningstar.
Unfortunately, global sales may not be as robust as analysts currently hope. Merck provided an update last Friday that it was withdrawing an application to sell Keytruda as a first-line treatment for lung cancer in combination with chemotherapy in European markets.
The company also said it experienced a delay in another Keytruda study. A decision to make overall survival a main goal for a pivotal lunch cancer trial of Keytruda plus chemotherapy will push back those results until February 2019, according to Reuters.
With lung cancer representing the most lucrative oncology market and first-line approval giving access to most patients, this news was unsurprisingly received poorly by investors.
While this news is certainly not lethal for the company or its dividend, it potentially disrupts a very important growth driver that investors had been banking on.
Outside of Keytruda, Merck has a large pipeline of 36 drugs in development, including several potential blockbuster drugs including biosimilar (i.e. biological generics) versions of other companies’ blockbuster medications, such as Humira, Remicade, Enbrel, Lantus, and Herceptin, which combined sold $40 billion last year.
This strong pipeline should at least keep its sales, earnings, and free cash flow relatively stable in the coming years. For example, Merck currently expects 2017 sales to be essentially flat compared to 2016 ($39.6 billion vs $39.8 billion, respectively).
Despite stagnant revenue, due to the high margins on Keytruda, which still has patent protection, and cost cutting actions over the past year, EPS is expected to rise about 18% in 2017.
This impressive operational leverage (earnings growing faster than sales) is a hallmark of the drug industry; while a drug has patent protection and is growing quickly, profits can surge.
However, this patented drug hamster wheel is also a double-edged sword because unlike Johnson & Johnson, which also markets stable over-the-counter consumer products, as well as medical devices, Merk is essentially a pure play biotech company, whose earnings and free cash flow can be highly volatile.
So while short-term focused Wall Street might cheer at brief periods of explosive earnings growth, ultimately long-term dividend growth investors have a lot less to like about the highly complex, and cyclical nature of big drugmakers such as Merck.
That’s because the company faces numerous challenging headwinds that could make it a rather underwhelming long-term dividend growth investment.
While the worst of its patent cliff is behind it, Merck will lose patent protection on several key drugs in the coming years, including cholesterol drugs Zetia and Vytorin (generic competition likely in 2017 and 2018), as well as its steroid and decongestant Nasonex. These drugs combine for around 5% of company-wide revenue.
In fact, Merck’s selloff this past Friday was driven in part by disappointing sales of off-patent pharma products. Here’s what the company stated in its press release:
“The pharmaceutical sales decline was largely driven by the loss of U.S. market exclusivity for ZETIA (ezetimibe) in late 2016 and VYTORIN (ezetimibe/simvastatin) in April 2017, medicines for lowering LDL cholesterol, and the ongoing impacts of generic competition for CUBICIN (daptomycin for injection), an I.V. antibiotic, and biosimilar competition for REMICADE (infliximab), a treatment for inflammatory diseases, in the company’s marketing territories in Europe. In the aggregate, sales of these products declined approximately $800 million during the third quarter of 2017 compared to the third quarter of 2016.”
Management is wisely focusing on oncology, where it has a first mover advantage in revolutionary new therapies based on antibody treatments (very high margin), specifically in treating non-small-cell lung cancer, but this space is going to be increasingly competitive, with major drug trial results for rival products expected in 2017 and 2018.
In addition, Merck is forced to spend a fortune on R&D to bring its drug pipeline to market, up to $2.7 billion per drug (and climbing over time), and there is no guarantee that potential blockbusters will actually receive approval.
For example, in the past Merck has faced numerous failures in drug development, including:
- Cardiovascular disease drugs Tredaptive, Rolofylline, and TRA
- Telcagepant for migraines
- Osteoporosis drug odanacatib
In addition, late-stage drug anacetrapib (for heart disease), is chemically similar to rival drugs (torcetrapib and dalcetrapib) which failed to receive approval.
In other words, there is a lot of uncertainty around just how valuable Merck’s drug development pipeline will truly be to the bottom line, especially in light of its recent update on Keytruda, the company’s biggest earnings driver over the short-term.
Next, it’s worth mentioning that all drug makers (as well as all companies in the medical space) face constant uncertainty regarding healthcare regulations.
For example, Merck does most of its overseas business with national health systems that sometimes have strict regulations limiting drug prices, which forces Merck to turn to U.S. sales to cover its expensive and time consuming (up to 12 to 13 years to bring a drug market) development process.
However, U.S. healthcare policy is also in flux, not only because an eventual repeal of the Affordable Care Act could remove over 20 million Americans from the healthcare system (lowering access to and demand for drugs), but also because current regulations forbid Medicare and Medicaid from negotiating bulk drug purchases with pharmaceutical companies.
If this changes in the future, then all drug makers could see significant margin compression. Merck, already recording from below average profitability, could suffer more than most, especially when it comes to its future dividend growth.
Finally, be aware that all drug makers face significant legal risk, specifically from lawsuits of approved drugs that end up harming consumers.
For example, in 2004 Merck pulled its pain killer Vioxx from the market after subsequent studies showed it increased the risk of heart attack and stroke.
Over the next 12 years the company faced numerous class action lawsuits from consumers, the Department of Justice, and various states Attorney’s General. All told, the long legal battles resulted in almost $6 billion in fines and settlements.
The bottom is that Merk isn’t as low risk of a stock as many investors may believe, and its overall payout profile is a bit lacking, both when it comes to safety and long-term growth potential.
Merck’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Merck has a Dividend Safety Score of 58, indicating about average dividend safety, and far lower than Johnson & Johnson’s 96. That’s not surprising given that Merck’s dividend growth record leaves a lot to be desired, especially compared to dividend king JNJ.
As you can see, while Merck’s dividend has generally moved in the right direction (with no cuts in the past three decades), the company’s volatile sales, earnings, and cash flows can also mean long stretches with no growth at all.
This is because Merck’s EPS and FCF payout ratios have historically been much higher than rivals such as Pfizer and Johnson & Johnson, resulting in less secure payouts and forcing management to be far less consistent with its dividend increases.
The good news is that, despite high EPS volatility, Merck’s free cash flow usually covers the dividend, which combined with a strong balance sheet allows it to deliver safe (though slow growing) income to investors.
At first glance you might think that Merck’s large net debt position makes for a rather precarious dividend. However, we need to keep in mind that, due the need for massive R&D spending and the occasional large acquisition (to fuel growth), most drug makers have similarly high debt levels.
For example, when we compare Merck’s debt levels to those of its peers, we find a slightly below average leverage ratio (debt/EBITDA), and average (but conservative) debt to capital and current ratios (short-term assets/short-term liabilities).
And thanks to its strong cash flows, Merck’s above average interest coverage ratio gives it one of the best investment grade credit ratings in the industry.
That allows the company to borrow very cheaply (about 3.7% average interest rate), which is far below its return on invested capital. In other words, Merck has plenty of access to cheap growth capital to continue investing in its business, while also paying out a generous dividend.
Overall, Merck’s dividend payment appears to be quite 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. With uninterrupted dividend payments since 1970, the company is very committed to its payout.
Merck’s Dividend Growth
Merck’s dividend has historically grown at a relatively slow pace, recording 4% compound annual growth over the past five years. This isn’t surprising given the cyclical nature of the drug business, which led Merck to hold its quarterly dividend constant at 38 cents per share from September 2004 through September 2011.
However, thanks to a strong pipeline, especially of breakthrough treatments for cancer (and cancer drug combinations), analysts expect Merck’s earnings and cash flow to grow at about 5% to 7% over the next ten years. This is far stronger than in the past five years, when a steep patent cliff resulted in negative organic growth.
That being said, because of Merck’s relatively high payout ratios, the dividend will likely need to grow slower than the bottom line in order to ensure a strong safety buffer against future profit declines.
This means that investors can potentially expect 3% to 5% annual dividend growth over the long-term, which is about in line with the company’s long-term payout growth rate.
Over the past year, Merck has underperformed the S&P 500 by about 25%. As a result, the company’s forward P/E ratio has dropped to 13.2, a meaningful discount to the S&P 500’s 17.9 ratio and the stock’s historical norm of 22.7.
From an income perspective, Merck’s 3.4% dividend yield is somewhat higher than the stock’s five-year average yield of 3.1%.
At current prices, Merck has potential to generate long-term annual total returns of 8.4% to 10.4% (3.4% yield + 5% to 7% annual earnings growth). While that’s nothing to scoff at, there is elevated uncertainty today given recent developments with Keytruda.
Overall, Merck’s current valuation doesn’t seem unreasonable given the company’s long-term outlook.
Merck is one of those boring but beautiful blue chips that you’re unlikely to lose money on, as long as you hold long enough.
After all, management, though periodically struggling to deliver consistent sales, earnings, and free cash flow growth, has proven itself incredibly dedicated to maintaining the dividend over time.
With a solid balance sheet, a recession-resistant product portfolio, consistent free cash flow generation, and a discounted P/E ratio, Merck could be interesting for investors who are willing to look past disappointing news on the company’s most important drug over the short-term.
However, Merck is unlikely to grow its dividend much in excess of the rate of inflation over time. Investors looking for a better combination of income and growth, without the uncertainty that comes with drug pipelines, can review some of the best high dividend stocks here.