Merck & Co., Inc. (MRK): Slow And Steady Dividend Growth by Simply Safe Dividends
Merck is a blue-chip dividend stock that has paid a consistent dividend since 1970 and has grown its dividend at a 1.8% annual rate over the last 10 years.
They have been able to continually pay a dividend during difficult times thanks to a recession-resistant business model, attractive operating margins, and reliable free cash flow generation.
This is the type of consistency I like to see for investments I consider for our Conservative Retirees dividend portfolio.
Currently, the business looks attractive with a nearly 3% dividend yield and optionality for additional dividend increases; however, with many large pharmaceutical companies struggling with billion-dollar revenue drugs’ patent protection expiring, should investors continue to count on Merck’s dividend stability?
Merck has an extremely long company history which dates back to a German apothecary shop in the 17th century. However, they trace their roots in the United States only back to the late 1800s where they were established to be a chemical supplier for their German parent. Today, they operate the business primarily through two main categories: Pharmaceuticals (88% of sales) and Animal Health (8.4% of sales).
The Pharmaceuticals business discovers, develops, and produces therapeutic and preventive agents for the treatment of human disorders. Merck’s target markets include cardiovascular, diabetes, general medicine and women’s health, hepatitis, HIV, acute care, immunology, oncology, respiratory, and vaccines.
In 2015, their top 10 therapeutics accounted for around 47% of total sales and included 9 different billion-dollar drugs. The largest therapeutics include Januvia (treatment of type 2 diabetes), Zetia (cholesterol), Janumet (type 2 diabetes), Gardasil/Gardasil 9 (HPV), and Remicade (inflammatory diseases).
The Animal Health business discovers, develops, and produces products for livestock, poultry, companion animals, and aquaculture. Their products range from antibiotics for use in cattle and swine to a chewable tablet that kills fleas and ticks in dogs to vaccines against bacterial diseases in fish.
Overall, Merck is one of the largest pharmaceutical companies in the world by market capitalization, only behind Johnson & Johnson, Novartis, and Pfizer. Compared to these competitors, Merck had sales of over $39 billion in 2015 versus $70.1 billion at Johnson & Johnson, $49.4B at Novartis, and $48.9B at Pfizer.
The business model for a multinational pharmaceutical company comes down to investing in R&D, patenting new therapeutics, and then using manufacturing and distribution scale to get the products to market.
The cost to bring a drug to market after years of research, development, and clinical trials is astronomical. Some estimates now put the total cost at over $2 billion dollars. However, once a company gets a new product to market, they enjoy years of monopoly status with a recession resistant product.
This leads to a relatively stable margin and revenue structure over time, which is exactly what individuals living off dividends in retirement like to see in their investments.
Source: Simply Safe Dividends
These industry characteristics illustrate that Merck isn’t going anywhere anytime soon. However, conditions aren’t always stable for drug producers.
Merck has gone through a very difficult period of time as they have faced patent expirations in many of their blockbuster drugs and settled a multibillion-dollar lawsuit over the painkiller Vioxx.
Merck’s sales peaked in 2011 at over $48 billion and have declined to $39.5 billion in 2015. The company has executed a couple of divestitures over this time that have contributed to the sales decline.
However, even if these transactions are adjusted out, organic growth has still been negative. This is further illustrated by total employee count decreasing over this period from 86,000 to 68,000.
The declining sales are a result of the well-publicized “patent cliff” that many of the major pharmaceutical giants recently faced.
Also, Merck has had some major setbacks in their pipeline over the last few years. They dropped plans for approval of cardiovascular drug Tredaptive in the U.S. and pulled out of markets where it had already been approved.
Another example is Odanacatib, which was an osteoporosis drug that underwent many delays over safety questions. Neither of these once-promising drugs is meaningful to Merck today.
Furthermore, a number of their current billion-dollar revenue drugs, including Januvia, Isentress, Gardasil, Remicade, Zetia, Vytorin, and Nasonex, have either recently come off patent or have patents expiring over the next few years.
Clearly, the pipeline setbacks and outlook for many of their key drugs should be a cause of concern for investors.
However, even with all of its challenges, not everything is going wrong at Merck. They appear to be through the worst of their patent cliff and still are able to spend nearly $7 billion per year on research and development, which has led to some promising new products.
Also, the company has improved the effectiveness of their R&D spend by targeting unmet areas of specialty care such as diabetes and cancer, rather than primary care.
In addition, Merck has a few levers to pull that can extend the patent window of some of their key drugs. They can work to hold later-granted patents on processes and intermediates related to the most efficient manufacturing method of the active ingredient. Additionally, they can generate unique compositions and formulations that could push out expiration dates for some treatment options.
With all that said, the most promising new therapeutic is Keytruda. According to Merck, Keytruda can treat different cancers including melanoma or lung cancer or head and neck cancer by working with the immune system.
The share of these markets Keytruda can capture got a boost when Bristol-Myers Squibb’s Opdivo failed in a lung cancer trial earlier this month, which sent Bristol-Myers Squibb’s stock price down 18%.
Kaytruda is addressing huge markets, and it is widely expected for the drug to increase sales from the current annualized rate of roughly $1 billion to be a multibillion-dollar therapeutic.
Dividend Analysis: Merck
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Merck’s dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Merck’s dividend is very safe with a Dividend Safety Score of 69. The company’s strong score is driven by Merck’s stable business model and relatively modest free cash flow payout ratio of 46%.
Analysts are projecting future diluted earnings per share of $3.75, $4.05, and $4.43 in 2017, 2018, and 2019, respectively. This forecast implies low- to mid-single digit earnings growth and a safe payout ratio below 50%.
Merck’s dividend safety is also helped by the company’s consistent free cash flow generation, which is needed to sustainably pay and grow dividends.
As seen below, Merck has generated positive free cash flow for more than a decade:
Source: Simply Safe Dividends
Most of Merck’s products are non-discretionary purchases