I'll say this right up front: Merck
Because the bull argument really boils down to this: Merck is cheap. And there's no denying that.
How cheap is Merck? Well, using the plain vanilla price-to-earnings ratio as your valuation tool, Merck has a P/E of 13. Consider that, over the past 10 years, Merck has ranged in valuation from a P/E as low as 10 to as high as 38 and averaged out at about 20, and there's only one conclusion to draw: Bad as the Vioxx mess might have been for Merck's business, for Merck investors it proved an incredible boon -- offering them the chance to buy stock in a great company at a 35% discount to its usual sales price. Any investor who believes that Vioxx doesn't constitute a fatal coronary event for Merck, anyone who believes that over time, Merck will again prove its greatness, should be buying Merck stock hand over fist.
Follow the money
On a trailing-12-months basis, Merck currently trades at just 10.5 times its own free cash flow. It has a rock-solid balance sheet, with $9.4 billion in cash and short-term investments, $4.8 billion more in long-term investments, and just $5.7 billion in long-term debt. Net result: about $8.5 billion in net "cash."
As if that were not enough, Merck constitutes a veritable cash-producing machine. Last year, the company generated $7.1 billion, an increase over the past three years' average of $6.7 billion.
Now keep that number in mind, because it doesn't just demonstrate Merck's cash-producing prowess. $6.7 billion is also more than twice the amount of cash that Merck pays out to its shareholders every year in the form of dividends. The company currently sports a 4.6% dividend yield. To put that into cash-in-your-bank-account terms, the company pays out $1.52 per share every year, for a total dividend payout of $3.3 billion.
How does Merck do it? Where does all the money come from, to create that enormous river of cash that gushes into the company's coffers before overflowing into the pockets of shareholders? Profits, baby. At nearly 25%, Merck's business boasts the highest net profit margin of any of its competitors. It's more profitable than Pfizer
FDA could save the day
I can hear the bear growling already: "But Merck's 25% profit margin owed a lot to Vioxx, and Vioxx could be out of the picture now." Don't worry, Bear. You're having a bad dream. Go back to bed.
You see, Vioxx is most definitely not out of the picture -- not now that a Food and Drug Administration panel has recommended that it be returned to market. What's more, even if Vioxx were forbidden for future sale, Merck's numbers over the past six months (when it was not selling Vioxx) show that the company remains immensely profitable. Again, on a free cash flow basis, in Q4 2004 and Q1 2005 combined, Merck generated $2.8 billion. Annualize that number, and we could easily see Merck produce $5.6 billion in cash this year, for a price-to-free cash flow ratio of less than 11.
For one of the best brand names in Big Pharma, that's not just cheap. It's a steal.
Want to read the opposing viewpoint? Check out Stephen Simpson's argument. Also read Rich's rebuttal and Stephen's rebuttal. Merck is an active stock recommendation in our Income Investor newsletter service. Check outthe latest dealfor new subscribers.
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Fool contributor Rich Smith owns no shares in any company mentioned in this article, but two of these companies have received the Fool seal of approval: Motley Fool Income Investor has recommended Merck, and Motley Fool Inside Value has recommended Pfizer.
