Slowing earnings growth a concern for Merck

The company faces a revenue loss as one of its blockbuster drugs, Singulair, loses patent protection this year.

By Jim J. Jubak Feb 27, 2012 4:27PM
Image: Prescription medicine expenses © Don Farrall/Photodisc/Getty ImagesEarlier this month, I dropped three stocks from my dividend income portfolio and added three more.

I'm going to give you more detail on one of those I let go: Merck (MRK). (I'll also actually make the change on the dividend portfolio page. The remaining two changes will follow in what I will try to make short order.)

Merck just raised its quarterly dividend to 42 cents a share from 38 cents. The resulting annual dividend of $1.68 works out to a yield of 4.4%. So what's my problem with Merck as a dividend stock?

Earnings growth. Or, actually, the lack of it.

Companies that don't grow earnings don't have a lot of ability to raise dividend payouts significantly. That's especially true in an industry, like the drug industry, that has to spend big on research and development.

So how bad is the Merck earnings growth picture?

The Wall Street consensus is looking for earnings growth of 1.3% in 2012 and a decline in earnings per share of 1.6% in 2013.

The main problem is Singulair. That blockbuster allergy and asthma drug -- $5.5 billion, or 11%, of 2011 sales -- will lose patent protection in 2012 and face increasing competition from generics.

Merck also faces declining sales from immunology drug Remicade as some marketing rights go to Johnson & Johnson (JNJ) as a result of a 2011 arbitration decision and a drop in payments from AstraZeneca (AZN) as a marketing alliance with that drug company comes to an end.

Balancing those negatives are continued cost savings from the company’s 2009 merger with Schering-Plough.

It's hard to judge the dividend friendliness of any management these days, and certainly a company that just raised its annual dividend 10.5% can’t be called dividend-unfriendly, but Merck's recent record seems to emphasize big share buybacks as a way to return cash to shareholders. The company spent $1.4 billion over the last 12 months on buying back shares as part of an ongoing $5 billion buyback program.

Putting the slow or negative earnings growth together with the emphasis on buybacks, I have to conclude that Merck isn't great candidate for dividend increases big enough to push up the yield (or even just keep it steady) if shares move significantly higher. 

To see what I mean, take a look back at September, when the annual trailing 12-month payout was $1.52 (instead of the current payout of $1.68). The share price then was just $31.36, however, so the yield came to 4.8% instead of the current projected yield of 4.4%. I'd prefer not to place my dividend bets hoping that the share price won’t rise and cut into my yield.

On background

Let me back up a moment and explain the latest moves.

In my Feb. 3 post, I added three stocks to my dividend income portfolio and dropped three.

The reason, I argued then, was that the growing popularity of dividend-paying stocks at a time when income vehicles such as Treasuries and CDs pay almost nothing had created a glorious but still real problem for income investors. 

As investors flocked into dividend-paying shares, they drove up share prices. That was great for investors already fully invested, but for investors looking to get into new positions or for investors looking to put more cash into existing positions, it meant that yields were in constant danger of erosion. 

In this situation, income investors needed to look for stocks that paid higher yields now and that were also positioned -- by their growing cash flows and by management disposition -- to keep raising dividends. Look for those stocks, I advised, and beware dividend payers that didn't seem to be in a position to keep raising dividends.

And with that as background, I tweaked this portfolio by adding General Electric (GE -0.70%), Westpac
Banking (WBK +0.40%) and Kinder Morgan Energy Partners (KMP -0.76%) while dropping Potlatch (PCH +0.45%), Merck and Abbott Laboratories (ABT -0.17%).

At the time of this writing, Jim Jubak didn't own shares of any companies mentioned in this post in personal portfolios. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned. The fund did not own shares of Merck, Johnson & Johnson, or AstraZeneca as of the end of December. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here. 
4Comments
Feb 27, 2012 6:04PM
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I think Mr. Jubak fails to look at the pipeline. Right now Merck has the most drugs in Phase 3 trials than anyone else. At least 3 of those drugs are billion dollar drugs and 2 should be approved before the end of the year. There are 3 others that could be billion dollar drugs. They have another 7 that are in phase 2 trials. This was the first negative article I have seen on Merck in mote than 3 months. Full disclosure, I am long on Merck. 
Feb 28, 2012 9:41AM
Feb 28, 2012 10:17AM
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Seems to me that all of the people making excuses for Merck are employees trying to keep their jobs.  I tend to think of them like they think of the average person taking their drugs.  Its all about the money.  Who cares about the pipeline?  Those items may or may not be instrumental in helping patients and making money for the company.

 

What makes Merck viable today?  I don't see much.

Feb 28, 2012 9:43AM
avatar
I think Mr. Jubak fails to look at the pipeline. Right now Merck has the most drugs in Phase 3 trials than anyone else. At least 3 of those drugs are billion dollar drugs and 2 should be approved before the end of the year. There are 3 others that could be billion dollar drugs. They have another 7 that are in phase 2 trials. This was the first negative article I have seen on Merck in mote than 3 months. Full disclosure, I am long on Merck. 

Just like a lot of large drug companies, they have major patent expirations in the coming years and or currently. The pipeline *might* be good, but in the near term I'd expect price pressure. Plus, there's not many signs they will ever be able to grow beyond single digits in profits annually in the long term.

 

Wait a minute, what?  Price appreciation doesn't affect your dividend yield.

Yes it does.

 

Yield is calculated by current share price.

 

If you mean you're going to get the same payout because the nominal payout amount is already set, then yeah. But that's not the yield. Yield (at least the common one everyone uses) is latest full year dividend amount divided by the current share price.

 

His analysis is more about whether or not Merk will keep increasing it's dividend in the event of capital appreciation. Something you look for if you are targeting dividend payers.

 

MCD for instance, has had great capital appreciation, but all the more delight, they have also increased their dividend over these years, keeping the yield stable.

 

In addition to worrying about keeping an attractive yield, if the yield falls, that can have a negative impact on companies like this that attract investors because of the yield. No one is piling into Merck on the basis of capital appreciation (at least, they shouldn't be).

 

Long term, dividends are what produce gains. Over 100+ years, dividends are responsible for more than 2X gains as compared to price appreciation.

 

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