MRK Preview: Solid Cash Flow

Merck (MRK - commentary - Cramer's Take) is scheduled to report third-quarter earnings before the bell on Wednesday morning, and analysts are looking for the company to earn 75 cents per share, for year-over-year growth of 5%, on $5.977 billion in revenue, for a year-over-year decline of 1.5%.

When we covered the Merck call last quarter, the poor results led us to believe that earnings expectations would continue to decline, and that has been the case, although the rate of decline is moderating as Merck and a number of other large-cap pharmas (see Tom Au's preview for Pfizer (PFE - commentary - Cramer's Take)) are looking at trough valuations.

Exiting the July conference call, analysts were at $3.29 in EPS on $24.183 billion in revenue for 2008 and $3.59 in EPS on $25.253 billion in revenue for 2009, for expected year-over-year growth of 9% and 4%, respectively. Today, analysts expect the company to post EPS of $3.28 on $24.007 billion in revenue for 2008 and $3.54 in EPS on $24.950 billion in revenue for 2009, for expected year-over-year growth of 8% and 4%, respectively.

Revenue growth is flat for the foreseeable future (the next three to five years), as the company struggles with patent expirations, a dearth of pipeline drugs and challenges with Vytorin, Zetia and Gardasil. BMO Capital Markets recently cut revenue estimates for Singulair and Gardasil, while Natixis Bleichroeder lowered EPS estimates on Vytorin and taranabant.

The cash flow is rock solid. With a $65 billion market cap, one analyst model expects Merck to generate $9 billion to $10 billion in cash from operations for the next several years, leaving the stock trading at 6 times to 7 times cash flow. Of that $9 billion to $10 billion in cash flow from operations generated annually, about half goes to capital expenditures and the dividend, thus there is further room for dividend increases, even though the stock at $30 per share is yielding over 5% currently.

To conclude, Merck stock ran from below $30 in late 2004 to $60 in early 2008 on the success of Gardasil and Zetia, and then collapsed after the ENHANCE data (Zetia) and safety and efficacy data around Gardasil badly hurt revenue. The stock is cheap once again, and the price discounts a lot of bad news, but you need to be the most patient of investors.

---

At the time of publication, Gilmartin had no positions in the stocks mentioned, although positions may change at any time.

Brian Gilmartin, CFA, founded Trinity Asset Management (TAM) in 1995, where he is currently a portfolio manager. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gilmartin appreciates your feedback; click here to send him an email.