Merck (MRK): Selloff = violent over-reaction ~ market folly

Friday, April 25, 2008

Merck (MRK): Selloff = violent over-reaction

MRK: Sold off due to over-reaction
Posted 0 days ago on 4/24/08
Buy: MRK, Target Price: $75, Time Frame: 1 year

Yet again, Merck (MRK) has seen its shares sold off irrationally and hastily. In recent months, MRK's value has plummeted due to investor/trader overreaction. Sure, the negative news that came out each time warranted a slashing of MRK shares. But, what we saw instead in this uncertain market environment was a complete and utter beatdown. 4 months ago, MRK was trading at $60. Now, it trades at around $38. Investors sold off this name on the panic (just like many other names) but then the shorts leaned in on this name and really drove it down. Look at it this way, nothing has materially changed at MRK's business. Their earnings are still strong and the worries surrounding their drug Vytorin are overdone. If you've followed the street for any amount of time you know that when a company misses estimates or comes out with negative news, the shares drop. Pile that in with a bear market and you've got a recipe for disaster. So, all this overreaction has simply presented an opportunity for longer term MRK investors. Remember the Vioxx scare? MRK certainly rebounded from that back up to $60. Vytorin worries now? No problem. Just pick up some shares of MRK on the drop and hold it for the year and you should see a solid recovery story just like before. Normally, when a stock announces it's going to be losing $4.85 billion, that would be seen as a very bad thing. But, in Merck's case, it is not. Merck (MRK) has settled its Vioxx lawsuits to the tune of $4.85 billion. This is actually a very good thing for the company because if they had fought each case individually, chances are, they would have had to pay a lot more. And, more importantly, it gets rid of the Vioxx noose that has been around its neck for so long. And now, with Vytorin questions looming, investors "sell now, ask questions later."

MRK has lost a third of its value this year mainly over Vytorin concerns. Yet, they have even said Vytorin is not meaningfully going to impact earnings in a negative manner. In fact, MRK just reported earnings and beat estimates by 3 cents. Even in this recession. Sure, they lowered the estimates for Vytorin and Zetia which obviously should not send the stock higher. But, it should not take off a third of the stocks value when you have not seen it affecting earnings. And, management has even said it should not change anything too much in their quarters. Roughly, this drug can represent 8% of MRK's sales and they just lowered the guidance. They didn't say this drug won't sell, they didn't say they're going to take a loss either. They're simply going to not make as much money as they once thought. MRK is trading at about 12 times earnings for this year. You be the judge.

Fundamentals: Merck has a trailing PE of 25 and a forward PE of 10.5, reflecting even more growth going forwards. Its PEG ratio of 1.27 is slightly high, but still manageable when you see that its price to sales ratio is just 3.55, indicating ndervaluation. So, Merck is actually fairly valued here. In addition to that, they have operating margins of 25.8% and a return on equity of 18%, very solid numbers in both categories. This is the main reason to buy MRK for the long term. Sure, eventually growth will slow. But, until then, you have to be in this name. Not to mention, MRK also has only $5.7 billion in debt, as compared to its $8.2 billion in cash. So, their debt to equity ratio is quite low and they can service this debt without any problems. Lastly, they are a dividend darling in the sense that they have a strong dividend of 4% and this dividend has been raised over numerous years. Since it's a long term play, treat it as your high yield savings account as this stock by itself yields more than typical online high yield savings accounts and most bonds or CD's. In addition, you get whatever share appreciation there should be over the year. And, if you want to make the deal even sweeter, write some covered calls on this name 10% or so out of the money each month. This will generate some premium that you can pocket each month in addition to the dividend.

Institutional Ownership: Some of the great hedge funds out there own this name. MRK can be found in numerous hedge funds' portfolios including: Maverick Capital, Caxton Associates, Ken Fisher, and Bridgewater Associates. Maverick is a $10 billion fund with consistent guidance from Lee Ainslie. Caxton Associates is a $20 billion fund with a global macro trading platform. Ken Fisher runs a $30 billion asset management firm and is a well respected big time investor. Bridgewater is a powerhouse in the hedge fund industry, managing over $160 billion. So, as you can see, there are some big guns in MRK and the most interesting bit is that all these funds implore different strategies, yet they are all in MRK. That says a lot about MRK as a company. No matter what strategy they are using, they all want to be in MRK for different reasons. MRK is clearly a solid play. And, you can bet that some of these firms have been adding on the severe "fire sale" of MRK shares.

MRK has been beaten down solely because of the market environment we are in. Should this have been a typical bull market, MRK shares would only be off 10% at most. Yet, since we are in a bear market with uncertain conditions, MRK has seen investors panic and short sellers lean in on this name. This 30% haircut MRK has seen is simply a casualty of the market environment. Be smart and think for the long term to add on the dips for this name if you're a long term player. If you're not a long term player, then move along this name's not for you. 1) They finally got the massive Vioxx lawsuit off their hands. Yes, they had to pay a lot to do so, but it saved them a ton of money by settling rather than fighting each individual case. 2) Their fundamentals are very very strong and that's the main reason they are so dominant in their industry. Their quarterly earnings growth is huge, and this is the main driver for any company. That is one of the main numbers you look at in terms of a company's ability to perform. 3) Numerous big investors and hedge funds have large stakes in MRK. Whether it be for valuation reasons, macro reasons, or growth reasons, all the big names mentioned earlier have large positions in MRK. They fully expect MRK to continue to grow and dominate within the pharmaceutical industry. 4) Vytorin worries are overstated. Yes, they will not see as many sales as anticipated. But, right now the street has effectively priced in as if they will practically no Vytorin. Not to mention, this drug only makes up around 8% of their total sales for the year. Violent reactions create excellent opportunities. Buy MRK for the long term (at least a year) to capitalize on a severe market overreaction.

Buy: MRK, Target Price: $75, Time Frame: 1 year


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