Is This Giant Drug Stock a Buy, Hold or Sell Today?

Merck & Co. (NYSE:MRK) is one of the top pharma companies, and historically the Pharma sector has qualified as a place to go when economic conditions call for defensive plays. With a 5 Year dividend history of 4.04% average yield and a share price up almost 27% year to date and 54% year over year, is Merck a BUY, a WAIT and SEE, or a STAY AWAY?

Let’s analyze the stock with the relevant sections of our CHEAT SHEET investing framework:

C = Catalyst for the Stock’s Movement

FDA approval of a drug with broad market potential can produce dramatic upward movement in the manufacturer’s stock price. Merck has a fracture reduction drug in Phase III trials but industry experts do not see it having “blockbuster” potential, although some see a modest bump in the share price of 6% to 8%.

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H = High Quality Pipeline

Drug pipelines are what big pharma is all about and Merck shares got a bit of a bump last week when the company announced some good results from its Phase II study of a drug treatment for Type 2 diabetes. With companies like Merck, it is usually a race between patent expiration of big winners like Singulair and the introduction of new revenue producing drugs. Right now, the company has 20 drugs in its Phase III pipeline. Industry analysts see five drugs as having the potential to fill the gaping hole left by the loss of Singulair revenues.  The drugs are insomnia treatment drug Suvorexant; Bridon, which is a neuromuscular reversal agent; an HPV cancer prevention drug V503; a cholesterol treatment drug Tredaptive; and Endocyte, for late stage oncology treatments.

E = Equity to Debt Ratio is Close to Zero

Merck has one of the lowest Debt to Equity Ratios of any of the big pharma players globally at a respectable 0.34.  The company’s total debt is $18.9 billion with $17.56 billion cash on hand, giving Merck one of the strongest balance sheets in the industry.  In contrast, international competitor Glaxo SmithKline (NYSE:GSK) has a bloated debt to equity ratio of 2.44 with $27.8 billion in debt and $12.3 billion cash on hand.  Pfizer (NYSE:PFE) has a debt to equity ratio of 0.48 with $38.5 billion in total debt and $24.3 billion total cash on hand.

T = Technicals on the Stock Chart are Strong

As of October 8, the stock price is 3.5% above its 20 Day Simple Moving Average; 5.45% above the 50 Day SMA; and 17.23% above the 200 Day SMA.  The share price crossed above all three averages in June of this year and with the exception of a brief drop below the 20 day SMA in August, the share price has remained above these three averages.  If you are a believer in the Relative Strength Indicator as a buy/sell signal, it is over 90.  As you may know, values above 70 or 80 signal overbought conditions and the possibility of a pullback in share price.

S = Support is Provided by Institutional Investors & Company Insiders

Merck is 75.18% institutionally owned.  The top five holders are Capital World Investors, Wellington Management, Vanguard Group, Franklin Resources, and BlackRock Institutional Trust.  Institutional interest is broad based, with 1438 institutions with a position in Merck.

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E = Earnings Are Increasing Quarter over Quarter

Merck’s Earnings per Share dropped 10.19% quarter over quarter.  In contrast, Glaxo SmithKline’s EPS increased 16.55% quarter over quarter and Pfizer’s EPS were up 33.52%.

E = Excellent Relative Performance to Peers

In general, Merck slightly outperforms rival Pfizer but lags behind Glaxo.  Merck has a Return on Equity of 12.15% with operating margins of 18.86% compared to Pfizer’s 10.49% ROE and 20.16% operating margin.  Glaxo SmithKline has a stunning ROE of 66.22% with operating margins of 28.86%.

T = Trends Support the Industry in which the Company Operates

Big pharma may well be a sector facing countervailing winds with as yet uncertain outcomes.  On the positive side, you have hefty tailwinds stemming from increased life expectancies and the global reach of the baby boomer retirement phenomenon. This means a dramatic increase in market potential for drug providers.

However, there are at least three strong headwinds the sector faces which in theory could radically alter the picture.

First, the trend of legal challenges to existing drug patents is growing.  Merck is not the only big pharma company facing staggering revenue losses from loss of patent protection.  Industry analysts estimate Merck could lose over $100 billion in revenue over the next few years but conventional wisdom says Merck and others will be able to bring new drugs online to offset revenue loss.

But the second trend sounds a warning bell.  Have you heard of “Pharmerging?”  It is the technical capability of manufactures in emerging markets to make generic versions of major blockbuster drugs.  These generic drugs appeal to an increasingly financially strapped public unable or unwilling to pay the staggering costs of some of big pharma’s big winners. Generic drug manufacturers are growing globally and pose a severe threat to the profitability of the biggest players in the sector.

Third, governments everywhere are struggling to keep up with the rising costs of health care on all fronts.  In a world plagued by debt investors need to note the fact healthcare costs are one of the biggest drains on any national budget.  Look for legislation and reforms everywhere, all aimed at driving down costs which will not be good for big pharma as it now exists.

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Conclusion

Merck and its big pharma cousins get lots of BUY recommendations based on size, stability, and dividend income.  But one could make a pretty strong case based on healthcare trends that big pharma “ain’t what it used to be.”

Government interventions across the globe and increasing generic competition may prove to be lasting game changers in the industry.  Certainly the world’s population will demand drugs in increasing numbers, but the price they are willing to pay and their wavering belief the best treatment comes from a prescription brand name drug could lead to dramatic changes in the sector.  If you believe big pharma can respond to the headwinds, you could adopt a WAIT and SEE posture.  However, it seems the contrarian point of view here is to STAY AWAY and look for better opportunities.

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