Today’s post is about another undervalued dividend growth pharmaceutical company, which is Merck & Co (MRK). Also, it is a company that Warren Buffet just recently opened a new position in. He owns approximately $1.8 billion of $1.9 billion of the company. This is not surprising as pharma is undervalued relative to other industries, many companies have a yield of 3% or more, and the companies are cash cows with high free cash flow. Merck is no exception and it is a large-cap pharma stock with solid dividend growth. Furthermore, Merck is a Dividend Contender.

Overview of Merck

Merck & Co. Inc. (MRK) is an American pharmaceutical company. MRK was founded in 1891 by a German-born Merck employee, Theodore Weicker. Mr. Weicker received a capital of $200,000 from E. Merck to start the subsidiary of the German Company Merck, which was founded in 1668 by the Merck family. Merck & Co. was expropriated by the US government during World War I and subsequently established as an independent American company in 1917. While it operates as Merck & Co. in the United States and Canada, the original Merck based in Darmstadt holds the Merck name’s rights everywhere else. Merck is known as MSD outside of the U.S. and Canada.

Today, Merck & Co. is the world’s seventh-largest pharmaceutical Company by market capitalization and revenue. The Company develops and produces different products like medicines, vaccines, and animal healthcare products. Merck has a strong effort in development of oncology products. Merck operates in two segments: Pharmaceutical (~90% of total revenue) and Animal Health (~10% of total revenue). Major products are KETRUDA (cancer immunotherapy), JANUVIA (diabetes), GARDASIL (HPV), PROQUAD (MMR vaccine), VARIVAX (varicella vaccine), BRIDION (muscle relaxant), and PNEUMOVAX 23 (pneumococcal vaccine). Both Lynparza and Lenvima for Animal Health are also growing rapidly. Total revenue was $47,994 million in 2020.

Source: Merck Q4 2020 Earnings Presentation

Merck Dividend History, Growth, and Yield

Merck has been growing its dividends for 11 straight years with a 5-year dividend growth rate of 6.7%. The dividend growth rate is more than double the rate of inflation. This type of growth rate will help you beat off inflation while in retirement. If you are not in retirement, this will greatly help compound and reinvest the dividends every year. The most recent dividend increase was 6.6% in November 17th of last year. This increase shows me the strength of this Company. Not only was it able to continue to pay out the dividend through the COVID-19 pandemic, while so many companies were either cutting or suspending its dividend. Merck increased it right in line with its own 5-year average growth rate. I expect the Company to continue to grow its dividend at this rate or slightly higher at 7% to 8% for the foreseeable future. 

The current dividend yield is desirable for both income investors and investors who don’t need the income right now but want to take full advantage of the compounding. Merck pays out a 3.4% dividend yield, which is 44 basis points higher than its own 4-year dividend yield average of 2.96%. Also, the dividend yield is much better than the current S&P 500 yield of 1.47%.

Source: Portfolio Insight

 Is the dividend safe? We should always ask this question if we are looking for an undervalued dividend growth stock to invest in. This is why it is essential to look at the dividend payout based on earnings and free cash flow (FCF).

Earnings are expected to be $6.56 per share for the 2021 fiscal year. Currently, Merck pays out a $2.60 dividend per share. Based on earnings, this gives a dividend payout ratio of 39%. This tells me that the dividend is very safe, and the Company has much more flexibility to continue to raise the dividend for years to come at the 6% to 7% rate.

Next, let’s look at the dividend coverage based on FCF. Analysts forecast that Merck will make $5.84 per share for the year 2021 in free cash flow. Using the same dividend payment gives us a payout ratio of 44% based on FCF. FCF is an excellent indicator that the dividend is safe and very well covered. 

The Company has been increasing its capital expenditures (CapEx) every year. MRK spent only $1.6 billion in CapEx in 2016. Now the Company spent over $4 billion in 2020. This is a little concerning considering that Merck’s net cash from operating income has been flat over the past five years.

Merck Revenue and Earnings Growth / Balance Sheet Strength

So, the dividend history and the dividend payout ratio all look great. But this is all in the past. Can Merck continue the dividend growth while keeping it safe for years to come?

 We will now look into revenue growth and earnings growth for the past and expect for the foreseeable future. These are the significant metrics I like to evaluate when I am looking for a new investment. Without revenue growth, a company can’t have sustainable earnings growth and cannot continue paying out a rising dividend. 

 For the past ten years, Merck has grown revenue at a Compound Annual Growth Rate (CAGR) of (0.1) %, which is flat. This is not very exciting growth. As a matter a fact, I won’t be interested in a Company that can grow revenue in 10 years. However, analysts expect Merck will increase sales by 9.5% for this year and 6% for FY2022. 

Most of the growth will come the blockbuster KEYTRUDA drug. KEYTRUDA is a drug used for several kinds of cancer treatment. By 2026, KEYTRUDA is expected to be the best-selling drug in history, with $27.75 billion in annual sales. The patent for KEYTRUDA will expire in 2028 so there are many more years of growth ahead before loss of exclusivity. This is very promising considering that the Company is undervalued based on earnings which we will discuss later in this article. Merck also conducts M&A and with periodic bolt-on acquisitions. The company also has strategic collaborations & licensing.

Source: Merck Q4 2020 Earnings Presentation

Now let us look at earnings. Earnings have been growing 5.2% annually for the past ten years, which like revenue, is not very exciting. However, last year’s earnings grew a whopping 14%, from $45.19 per share in 2019 to $5.94 per share. And in 2019, earnings rose 20% when compared to FY2018. This is something that I am very much interested in. 

 Also, The Company has a solid balance sheet. Currently, Merck has an S&P credit rating of AA-, which is an investment grade—at the same time, sporting a low debt-to-equity ratio of 1.3, which meets my criteria of 1.5 or lower. Overall, this shows me that Merck is a high-quality company with excellent growth prospects and a solid balance sheet. However, on the downside, the Company does have a high financial leverage ratio of 3.62X compared to the past 5-year average leverage ratio of 2.7X. But on a brighter note, Merck is able to meet its debt obligation with an interest coverage of 11.6X, which is very secure.

Merck Valuation

One of the valuation metrics that I like to look for is the dividend yield compared to the past few years’ histories. I also want to look for a lower P/E based on the past 5-year or 10-year average. Furthermore, I like to use the Dividend Discount Model (DDM). I use a DDM analysis because a business is ultimately equal to the sum of all the future cash flow that that business can provide.

Let’s first look at the P/E ratio. Currently, Merck has a P/E ratio of 11.7X based on Fiscal Year (FY)2021 earnings of $6.56 per share. The P/E is very low compared to the past 5-year P/E average of 14.1. If Merck were to vert back to a P/E of 14.1, we would obtain a price of $92.50 per share.

 Now let’s look at the dividend yield. Like I mentioned, the dividend yield currently is 3.4%. Merck has a 5-year dividend yield average of 2.94%. So, if Merck were to return to its dividend yield 5-year average, the Company would have to trade hands at $88.44 per share.

 The last item I like to look at to determine a fair price is the DDM analysis. I factored in a 10% discount rate and a long-term dividend growth rate of 7%. That projected dividend growth rate is right in line with the most recent dividend increase. This gives us a fair price target of $92.73 per share.

 If we average the three fair price targets of $92.50, $88.44, and $92.73, we obtain a reasonable price of $91.22 per share. This gives Merck a possible upside of 19.4% from the current price of $76.40. The chart below is from StockRover*.

Source: StockRover*

Conclusion on Merck – Pharma Dividend Growth

Merck is a high-quality pharma company that is undervalued and perfect for a dividend growth investor. The fundamentals are great, and they’re only getting better. With a market-beating yield, strong dividend growth, a low payout ratio, 11 consecutive years of dividend raises, and the potential that shares are 19.4% undervalued, this might be one of the very best deals in today’s overvalued market.