Today, we'll conclude our evaluation of Merck (NYSE: MRK) by discussing its valuation. Merck closed as of this writing at $69.02 per share, hovering near a 52-week low of $60.35 per share, and it faces significant patent expiration exposure, a seemingly weak pipeline, and declining gross margins, as its less profitable pharmacy benefit management unit, Merck-Medco, becomes a larger part of the top-line.
The weakness in Merck's stock price drove us to start learning more about the pharma giant. The financial and business model advantages -- including excellent margins, low Flow Ratios, and tremendous cash flow -- in the drug industry also makes the world's third largest drug maker an ideal Rule Maker candidate.
We also think Merck will be a bigger and stronger company over the next five years. The company has a solid portfolio of blockbuster drugs. Vioxx (pain), Singulair (asthma), Fosamax (osteoporosis), Zocor (cholesterol), and Cozaar/Hyzaar (hypertension) had combined sales of $11.1 billion last year, an increase of 54% from 1999. Merck-Medco, meanwhile, grew sales 48% to $6.5 billion last year.
Simply picking Rule Makers won't allow us to beat the market, however. We need to determine the appropriate price, so we know we're getting the best return for our investment. With Rule Makers, we want companies to double over the next five years. That said, with a review of Merck's underlying business already finished -- see these three columns -- let's look at what it will take for 2x5y returns.
I like to begin any valuation study looking at historical price-to-free-cash-flow (P/FCF) and price-to-earnings (P/E) ratios. It's a good idea to look how the market has priced a stock in the past, and then compare it to the current price. Merck closed yesterday at $69.02 per share, leaving it with a market cap of $158 billon and trading at 36 and 23 times trailing free cash flow and earnings, respectively.
Here's a look at Merck's historical P/FCF and P/E ratios (calculated at year-end):
Merck TTM* '00 '99 '98 '97 5Y Avg S&P P/FCF 35.6 43.6 43.8 51.9 26.1 37.6 23.2 P/E 22.9 32.4 27.4 34.4 28.5 29.6 24.1
*trailing twelve months
While Merck's valuation is below both five-year averages, it trades at a slight discount to the S&P 500 only on a P/E basis. Merck trades at a 53% premium to the market on a P/FCF basis, a better reflection of its actual value, and an indication it might not be as cheap as we thought. Still, looking how the market has valued a stock is only a starting point. A stock's value could easily change if it increased its returns on invested capital or invested in an unsuccessful business, for example.
Though it has been pointed out before in many other columns, we'd rather determine Merck's value based on cash flows, not earnings. Earnings are reported in accrual accounting -- meaning revenue is recognized when earned -- while expenses are recognized when incurred, instead of when cash is paid. While this disparity can allow accountants to tweak the income statement to make a business look more robust than it actually is, the cash flow statement prevents such airbrushing.
Over the last 12 months, Merck generated $4.4 billion in free cash flow. In order for the stock to double over the next five years, the company needs to justify a $316 billion market capitalization. Assuming a price-to-free cash flow of 25 times, compared to the S&P 500's current P/FCF ratio of 23 times, Merck needs to grow free cash flow 23% annually over the next five years to more than $12.5 billion. Below are estimated P/FCF ratios and the growth rates required for 2x5y:
Projected P/FCF 30 25 20 FCF Growth Rate for 2x/5y 19% 23% 29%
We are not so sure Merck can grow its free cash flow 23% annually over the next five years. Given that between 1997 and 2000 Merck managed to grow free cash flow 15%, (31%), 6%, and 39%, respectively, and that the company will lose anywhere from $4 billion to $6 billion in revenues because of patent expirations, even at a higher multiple of 30 times free cash flow, it's looks as if it will be a challenge for the company to post the returns required for the stock to double.
If Merck's stock price dropped to $55 per share, below it current 52-week low, but above where it traded in March of 2000, Merck would need to grow free cash flow 18% annually to $13.5 billion, assuming again a P/FCF ratio of 25 times. That appears more likely, but it's still hardly a forgone conclusion. Below are estimated P/FCF ratios and the growth rates required for 2x5y at a price of $55 per share.
Projected P/FCF 30 25 20 FCF Growth Rate for 2x/5y 14% 18% 23%
We could be wrong, however. Free cash flow growth has been stymied over the past couple of years because Merck has invested heavily in production and research and development facilities. With a history of creating tremendous value, we'd rather it identify new areas for investment than simply amass a large cash balance and have nowhere to put the money. The investments could ultimately lead to increased returns, allowing Merck to exceed our estimates for free cash flow growth.
At the current price, the Rule Maker Portfolio might find more compelling opportunities elsewhere. I'd argue the recent price drop might have made the stock less risky, rather than created an obvious buying opportunity, as it faces significant patent expiration exposure. Its history of innovation also leads me to believe Wall Street's concerns over its pipeline are overcooked, and at the very least Merck will improve its situation through small acquisitions or partnerships.
That, combined with the revenue growth Merck-Medco provides, means Merck won't be going away and we'll keep the company on our Rule Maker watch list.