Dueling Fools: Merck Bull

Drugmaker Merck (NYSE:MRK) has been a stalwart of the pharmaceutical industry since it began in the late 19th century. It has survived for so long, and through so many technological iterations, because it has always remained on the cutting edge of drug development innovation and technology. Let's delve into some of the reasons to be bullish on shares of this well-run organization.

Innovation
Even today, Merck is pumping out new blockbuster drugs at an amazing rate. Just this year, it has brought to market five new drugs, several with the potential for billion-dollar sales. At least another six new products have the potential to be on the market by 2008, and this doesn't include the 35 research partnerships that Merck started this year or the 20-plus drug candidates it has in phase 2 clinical trials.

With spending of nearly $4 billion on research and development annually, Merck is always on the forefront of drug development and can afford the most talented scientists and clinical researchers in the business. For example, In 2006 Merck's top-notch scientists have brought to market the novel diabetes treatment Januvia and the first vaccine to rid the world of several strains of the sexually transmitted human papillomavirus, a cause of cervical cancer.

The financials
Now let's get to why so many investors love holding shares of pharmaceutical companies: those lovely profits! With 74% gross margins so far in 2006, 24% net margins, and a steady recession-proof source of income (since people get sick and need medicine in all stages of the business cycle), Merck shares have treated their investors to 500% returns since 1990 and a bewildering 5,000% return on their investment since only 1980. Even more incredibly, those returns do not include dividend reinvestment. Merck's current dividend is yielding an impressive 3.5% right now.

Speaking of the dividend, there's still plenty of room for Merck to increase this impressive payout, considering that the dividend accounted for only $3 billion of its $6 billion in free cash flow last year.

Earnings for 2006 are expected to come in at $2.50 per share at the midpoint. That means shares today are trading at an attractive 17 times multiple of earnings, not including restructuring costs. Earnings could be much higher going forward, though, when Vioxx-related expenses start to abate as Merck continues to win most of the lawsuits related to the drug. Defending against the Vioxx cases has cost Merck $325 million in litigation costs thus far this year, and once some of the cases start to be dropped, expenses related to them will result in much lower sales, general, and administrative spending.

Investors need not fear the potential damages paid out in Vioxx cases, since Merck has lost only four out of 18 Vioxx-related court cases, and I wouldn't be surprised to see the few that they've lost thrown out on appeals.

The future for Merck
Merck expects earnings to be roughly flat next year, while its newly marketed drugs pick up the revenue slack for some of the blockbusters losing their patent protection. So short-term investors need not invest in Merck. More patient investors will be rewarded as Merck returns to double-digit compounded annual earnings growth by 2010.

These earnings projections could also prove to be conservative if Merck dips into some of the $6 billion and growing cash on its balance sheet to acquire companies with late-stage drug candidates -- which it has stated it will do -- or partner with companies with promising technologies, such as what it has done with FoxHollow (NASDAQ:FOXH) this year.

With one of the most productive research teams in the world and the best manufacturing facilities in the industry, Merck will undoubtedly be around for another hundred years. Investors who buy shares of Merck today and hold for the long term may be just as happy with their investment in this best-in-class pharma as are those who bought in during the '80s and early '90s.

So, essentially, what you are getting with Merck is one of the best-managed pharmas out there that will be experiencing solid double-digit earnings growth in the not-too-distant future with a smart dividend payout. It even trades at a fairly cheap 17 times earnings this year. What more could anyone ask for?

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Fool contributor Brian Lawler can't wait to see his favorite aunt and uncle from New Jersey for the holidays and does not own shares of any company mentioned in this article. The Fool has adisclosure policy.