Despite the coronavirus crisis, S&P rallied 16% in 2020, to a new all-time high. As a result, it has become particularly challenging to identify attractively valued stocks. Merck (MRK) is an exception, as it is reasonably valued and has promising growth prospects ahead. Notably, Merck accounts for 3% of the investment portfolio of OrbiMed Advisors, an investment firm that is well known for its expertise in the healthcare sector thanks to the life-long experience of its team in this industry.

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Business overview

Merck is one of the largest pharmaceutical companies in the world, with annual revenues of $47 billion and a market capitalization of $208 billion. Merck has two COVID-19 vaccine trials underway but it has lagged its competitors, Pfizer (PFE), Moderna (MRNA), and AstraZeneca (AZN), which have already begun to distribute their vaccines in some countries.

However, Merck has one of the most promising drugs in the world, Keytruda. This drug treats some types of tumors, such as melanoma, lung cancer, and colorectal cancer. Oncology is an immense business in the pharmaceutical industry, as it is expected to grow to $180 billion in annual revenues by 2025.

In the third quarter, Merck incurred a $475 million hit in its revenues due to the pandemic but it still grew its revenue 2% thanks to the performance of Keytruda, which grew its sales 21%, to $3.7 billion. In the absence of the pandemic, the company would have grown its revenue 6%. In the U.S., Keytruda continued to grow its sales across all key tumor types. Thanks to its strong business momentum, Merck grew its adjusted earnings per share 18% over the prior year’s quarter and raised its guidance for its earnings per share in 2020 from $5.63-$5.78 to $5.91-$6.01.

Growth prospects

Investors should be particularly careful when they try to evaluate the growth potential of pharmaceutical companies. When a patent of a major drug expires, the company runs the risk of incurring a plunge in its revenues. Therefore, investors should be aware of the expiration dates of the patents of the most popular drugs of a company in order to avoid getting hurt by patent cliffs.

Merck was unable to grow its earnings per share between 2011 and 2016, partly due to the expiration of some patents. However, the company has returned to growth mode in the last four years, in which it has grown its earnings per share at a 12.1% average annual rate.

Moreover, Keytruda has exciting growth potential ahead. This drug has multiple growth drivers, as it will be used in an increasing number of countries and its price is likely to rise in the upcoming years. In addition, Keytruda is likely to be applied in more cancer types in the future. It is also important to note that the patent protection of Keytruda is set to expire in 2028, 2030, and 2032 in the U.S., the European Union, and Japan, respectively. It is thus evident that Keytruda will be a major growth driver for Merck in the upcoming years.

On the other hand, as Merck achieved record earnings per share in 2020, it is prudent to be somewhat conservative in future growth estimates. Overall, it is reasonable to expect Merck to grow its earnings per share by approximately 5% per year over the next five years.

Dividend

Merck spends a significant portion of its revenues on R&D expenses. In the last four years, the company has spent $8.0-$10.0 billion per year on R&D expenses or 21% of its revenues on average. This fact and the lackluster earnings growth in some periods due to patent cliffs and competition help explain the unimpressive dividend growth record of Merck. The company froze its dividend between 2005 and 2011 and grew its dividend by only 2% per year between 2012 and 2017. Nevertheless, Merck has raised its dividend at a decent 4.8% average annual rate over the last decade.

The stock is currently offering a dividend yield of 3.1%. While this yield is not impressive, it is essentially double the yield of the S&P 500 (1.5%). In addition, thanks to the healthy payout ratio of 41% and the strong balance sheet of the company, investors can rest assured that the dividend is safe. Overall, the dividend yield of Merck is not exciting but it is safe and much better than the average yield of the broad market.

Valuation – Expected Return

Merck has traded at an average price-to-earnings ratio of 12.6 over the last decade. However, this period includes many years of stagnation and hence we believe that the stock deserves a higher earnings multiple. Given the exciting growth potential of Keytruda, we assume a fair price-to-earnings ratio of 15.0 for the stock. Merck is currently trading at a price-to-earnings ratio of 14.1. If the stock trades at our assumed fair valuation level in five years from now, it will enjoy a 1.2% annualized boost in its returns thanks to the expansion of its price-to-earnings ratio.

Given also its 3.1% dividend yield and its 5.0% average annual earnings-per-share growth, Merck can offer a 9.0% average annual return over the next five years. This an attractive expected return, particularly given the fact that the broad market is trading at an all-time high, with most stocks appearing fully valued right now.

Final thoughts

Merck has returned to growth mode in the last four years. It also has exciting growth prospects ahead, primarily thanks to the expanding use of Keytruda. Given also the reasonable valuation of Merck and its 3% dividend yield, the stock could offer a 9.0% average annual total return over the next five years. This is an attractive expected return, particularly given the fully valued status of the broad market.