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Merck: An Undervalued Stock With a Safe Yield

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Merck & Co Inc. (NYSE:MRK) has enjoyed solid returns over the last year as the stock price is up 13.6%, not including dividends.

This shouldnt be the only reason that shareholders rejoice, as Merck pays a high dividend yield that looks to be very safe. Considering the strength of the companys business model, payout ratios and balance sheet, it looks like Merck will be able to continue to grow its dividend for years to come.

Lets look closer at the company to see why I believe Mercks dividend is among the best in the health care sector.

Company background and results history

Merck is a leading health care company valued at more than $210 billion. Following the spinoff of its womens health and biosimilar portfolio into Organon & Co. (NYSE:OGN) in early June of last year, Merck is now almost entirely focused on prescription medicines and vaccines. The company also had an animal health business as well. Revenue was close to $49 billion last year.

Merck ended 2021 on a high note as fourth-quarter revenue grew more than 23% to $13.5 billion while adjusted earnings per share of $1.80 was considerably better than the 98 cents the company produced in the prior year. For the year, revenue grew more than 17% while adjusted earnings per share of $6.02 was a slight increase from results seen in 2020.

Revenue was essentially flat over the last decade, but this isnt exactly an apples-to-apples comparison. The businesses that were spun off with Organon accounted for about 15% of annual revenue, helping to explain the minimal revenue growth since 2012.

Earnings per share have experienced a much better performance. Since 2012, earnings per share have a compound annual growth rate (CAGR) of 5.2%. A 2% annual reduction in the share count has aided results, but net profit has seen a steady increase over this period. Mercks net profit margin has improved from 24.8% in 2012 to 31.4% last year as the company has improved its ability to generate higher profits from revenue.

Looking at just the last five years, annual growth for revenue, net profit and earnings per share have increased 5%, 8.6% and 10.9%, respectively, as Merck has brought key products to market that should have investors excited for the future.

The key product for Merck is Keytruda, a prescription medicine used to treat melanoma and other types of cancer. Keytruda revenue grew 16% in the fourth quarter and 20% for the year. The drug cleared $17 billion in annual revenue in 2021 and continues to be approved for additional uses. Merck holds patent protection on Keytruda until 2028 in the U.S., 2030 in the European Union and 2032 in Japan. These are the three top markets for the drug, which should provide Merck years of revenue growth as Keytruda is likely to maintain and expand its dominance.

Dividend growth history and recession performance

Merck has raised its dividend for 11 consecutive years, most recently increasing its distribution by 6.2% for the Jan. 7 payment date. Prior to this period of raises, Merck had maintained its dividend at the same amount through 2011. Dividend growth following this time was mostly of the 1 cent per share per quarter variety up until recently.

Dividend growth over the last decade was 5% annually, but this accelerates to 8.4% following double-digit growth in 2019 and 2020.

Health care companies are typically much more recession resistant due to their products and services being in demand regardless of economic conditions. Below are the adjusted earnings per share totals for Merck before, during and after the last recession:

  • 2006 adjusted earnings per share: $2.52

  • 2007 adjusted earnings per share: $1.49 (40.9% decrease)

  • 2008 adjusted earnings per share: $3.64 (144% increase)

  • 2009 adjusted earnings per share: $3.25 (10.7% decrease)

  • 2010 adjusted earnings per share: $3.42 (5.2% increase)

  • 2011 adjusted earnings per share: $3.77 (10.2% increase)

  • 2012 adjusted earnings per share: $3.82 (1.3% increase)

Adjusted earnings per share tumbled in 2007, but more than doubled the following year. Declines and gains traded off somewhat regularly in the few years following the Great Recession. Earnings have experienced growth every year since 2014, with the past three years seeing the bulk of the gains.

Mercks performance during the last recession was more varied than most health care companies, but the companys results during the first year of the Covid-19 pandemic were reassuring. Revenue grew 2.5% while earnings per share improved 14.5% in 2020. A lower share count was a tailwind to results, but net profit was up 12.7% for the period.

Merck, aided by strength in Keytruda, would likely see positive results in the event of a recession as the companys products and services would likely see high demand as people prioritize their health and wellbeing.

Shares now have a dividend yield of 3.3%, slightly above than the 10-year average yield of 3.2% and 200 basis points better than the average yield of the S&P 500 Index.

Payout ratios and future dividend growth

Up until recently, Merck had mediocre dividend growth. That has changed in the near term, but is Merck in a position to continue to raise its dividend by larger than usual amounts? The earnings and free cash flow payout ratios should help answer that question.

The company distributed $2.60 of dividends per share last year while earnings per share totaled $6.02, leading to a payout ratio of 43%. This is just below Mercks average payout ratio of 46% since 2012.

Switching to free cash flow, Merck paid out $6.6 billion of dividends last year while generating free cash flow of $9.7 billion. This gives the company a free cash flow payout ratio of 68%. This compares to the average free cash flow payout ratio of 72% that Merck had for the prior three years.

On an earnings basis, Mercks dividend looks very safe. The free cash flow payout ratio, though elevated, is still within a safe range. It is likely that free cash flow growth will determine if Merck is able to grow its dividend at a faster rate, making this metric something investors will need to monitor.

The impact of debt of dividend security

Now, lets consider the companys debt on its balance sheet to see if this could hinder Mercks ability to continue to make its dividend payments.

Merck had interest expense of $806 million in 2021. With total debt of $33.1 billion at years end, the company has a weighted average interest rate of just 2.4%.

Consider the following chart to see what level the weighted average interest rate would need to reach before dividends were no longer covered by free cash flow:

Merck: An Undervalued Stock With a Safe Yield
Merck: An Undervalued Stock With a Safe Yield

Source: Authors calculations

As the image above shows, Merck would need to see its weighted average interest rate rise above 11.6% before dividend payments were not covered by free cash flow. This gives the companys dividend a very wide margin of safety with regards to its debt obligations.

Valuation analysis

Wall Street analysts surveyed by Yahoo Finance predict that Merck will earn $7.27 per share in 2022. Shares are thus trading at a forward price-earnings ratio of 11.5 times at the moment. This is well below the stocks 10-year average price-earnings ratio of 14.4.

The GuruFocus Value chart also shows that Merck is trading at a discount to its intrinsic value.

Merck: An Undervalued Stock With a Safe Yield
Merck: An Undervalued Stock With a Safe Yield

With a share price of $83.49 and a GF Value of $97.76, Merck has a price-to-GF-Value ratio of 0.85. The stock would return 17.1% were it to reach its GF Value before dividends were added to total returns. Merck is rated as fairly valued by GuruFocus.

Final thoughts

Merck has seen decent returns over the last year as the company continues to see very high growth rates in its most important product Keytruda. Dividend growth above the minimum has returned over the past three years and Mercks payout ratios are in healthy ranges. The stock also trades with a very reasonable valuation. This suggests that investors looking for a health care stock offering a safe and generous yield along with the potential for upside share price appreciation may want to consider Merck.

This article first appeared on GuruFocus.