Blue chip drug makers such as Merck (MRK) have historically been very popular with income investors because of their defensive nature, meaning that drug demand isn’t really affected by economic downturns.
However, what many investors fail to realize is that, while the pharmaceutical industry as a whole may be recession resistant, successful long-term dividend growth investing is far harder to achieve at the company level.
This is why just two drug makers are part of the venerable dividend aristocrats list, meaning they are S&P 500 companies that have managed to raise their payouts for at least 25 consecutive years.
Let’s take a look at Merck to see if this high-yield favorite is a reasonable choice for a diversified dividend portfolio, especially in light of recent challenges that have sent MRK’s stock on its largest two-day decline in more than eight years, according to Reuters.
Business Overview
Merck has deep roots, going back to 17th century Germany, but in the U.S. it was founded in 1891 in Kenilworth, New Jersey. Today Merck is one of the largest pharmaceutical giants in the world, with 69,000 global employees selling drugs in over 140 countries through two main divisions.
Pharmaceutical (88.7% of Q3 2017 revenue) makes patented drugs to treat all manner of diseases and conditions, such as cardiovascular disease, type 2 diabetes, asthma, chronic hepatitis C virus, HIV-1 infection, fungal infections, hypertension, arthritis, osteoporosis, and fertility diseases.
It also offers anti-bacterial products, cholesterol modifying medicines, and vaginal contraceptive products, as well as vaccines for measles, mumps, rubella, varicella, chickenpox, shingles, rotavirus gastroenteritis, and pneumococcal diseases.
The company’s bread and butter sales, earnings, and free cash flow stem from just nine main large drugs, including blockbusters Januvia (type 2 diabetes) and Keytruda (antibody based cancer drug).
Source: Merck Earnings Release
Animal Health (9.7% of Q3 2017 sales) sells antibiotic and anti-inflammatory drugs to treat infectious and respiratory diseases, fertility disorders, and pneumonia in cattle, horses, and swine; vaccines for poultry, parasiticide for sea lice in salmon, and antibiotics and vaccines for fish
Merck’s remaining sales come from two smaller divisions (1.6% of Q3 2017 revenue), Healthcare Services (serves drug wholesalers and retailers, hospitals, government agencies and entities, physicians, physician distributors, veterinarians, distributors, animal producers, and managed health care providers) and Alliances segments (collaborations with Aduro Biotech, Inc, Premier Inc, Cancer Research Technology, Corning, Pfizer Inc, AstraZeneca PLC,and SELLAS Life Sciences Group Ltd).
Merck’s 2016 sales were geographically diversified, with the U.S. responsible for 46.5% of revenue, with international markets representing 53.5%.
Business Analysis
Like most major drug makers, Merck struggles to maintain consistent top and bottom line growth.
Source: Simply Safe Dividends
This is inherent in the business model, which relies on patented medications, whose patents eventually roll off, resulting in strong generic competition. In addition, rival medications, even for patented drugs, are constantly hitting the market, meaning that its top products face a boom and bust cycle.
Combined with high fixed costs, primarily in R&D spending on developing its large drug pipeline ($9.9 billion or 24.8% of last 12 month’s revenue), Merck’s margins and returns on capital can be volatile, as are its overall earnings and free cash flow.
Another problem Merck faces is that because of the drug development hamster wheel (even new blockbusters merely replace revenue lost to patent expirations and rival products), its growth is largely dependent on large-scale acquisitions, such as its $41 billion purchase of Schering-Ploughin 2009 to help diversify the busienss.
Such large purchases are incredibly tough to pull off successfully because they require careful integration of differing corporate cultures, R&D pipelines, and administrative organization to deliver on expected synergistic cost savings (i.e. elimination of overlapping business costs).
Another challenge for Merck is that in this industry there are three primary factors that determine success: drug pipeline, manufacturing efficiency, and distribution. In other words, economies of scale.
However, while Merck is a large player, it’s management is not nearly as high-quality as those of larger and better run rivals such as Pfizer (PFE), and Johnson & Johnson (JNJ), which is arguably the gold standard of drug makers.
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