In These Turbulent Times, Reach for Merck
I've been a fan of Pfizer ever since the 2009 acquisition of Wyeth (I discussed my view most recently in May.) Although I still think Pfizer should be a core holding, here's another to consider: Merck.
Admittedly, I'm late to the party. Merck shares are up 42% over the past year. Even so, I think there's upside from here. Let's review the key issues.
Earlier this month, Merck's multi-blockbuster asthma drug Singulair lost U.S. patent exclusivity. As the market is flooded with inexpensive generics, U.S. sales of the branded version will rapidly disappear. European patents for Singulair expire early next year, although ex-U.S. generic erosion curves tend to be somewhat more gradual.
The Singulair patent "cliff" is not a surprise to Wall Street, but that doesn't mean it won't have an impact on the company's income statement. Despite retaining "rest of world" -- non-U.S. and non-European -- exclusivity, I expect nearly 75% of the drug's $5.5 billion in worldwide sales to disappear over the next six months.
Importantly, Singulair's operating profit margin likely far exceeds the company's other major franchises, since it doesn't require as much marketing as less well-entrenched products. As a result, the loss of exclusivity hurts both sales and profit margins. That's the downside to a dominant pharmaceutical franchise, and explains why investors often underestimate the impact of a generic "cliff." In Merck's case, Wall Street analysts and investors seem to have modeled Singulair's erosion well enough that the impact has been correctly built into consensus earnings.
I like Merck for two reasons. First, the company pays a 3.8% dividend, slightly higher than those of Pfizer or Johnson & Johnson. Even with repeated R&D screw-ups, like those at competitor Eli Lilly, investors seem unwilling to let the dividend yield creep much above 4.5%. That provides a valuation floor for Merck around $37 per share.