We're witnessing a changing of the guard in the ownership of Merck (MRK - commentary - Cramer's Take), a leading pharmaceutical company and a component of the Dow Jones Industrial Average. Growth investors who bid up the stock in the late '90s to unrealistic heights, when price-to-earnings ratios soared to the high 30s, have made a mad dash for the exits, leaving the stock for dead.

Value investors have Merck firmly in their sights now. Is the company a compelling value, against a tough market backdrop and questionable fundamentals within the industry?

I say yes, Merck is very undervalued at roughly 14 times earnings and a 3.1% dividend yield. Of course, those are the obvious metrics that everybody looks at. Below, I'll review some less obvious points and why I think Merck is a "new cycle" stock. First, though, a word about the accounting at Merck, the subject of a negative Wall Street Journal article a few weeks ago.

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In my view, the WSJ article concerned a nonissue, namely: the booking of sales for prescription co-payments that were not collected by Merck. Because of an equivalent cost offset, there's no impact on earnings. There's also no effect on cash flow, assets or liabilities. Although revenue is higher with this GAAP treatment, net profit margins are understated.

I like Merck partly because it fits the paradigm of companies that I think will thrive in the new cycle. Here are three characteristics of new cycle companies, and how Merck fits the bill:

Cash to shareholders: If you buy Merck today, you can expect to receive a 15% to 20% return on your capital over the next few years in the form of dividends and stock buybacks. Merck recently announced a $10 billion buyback, which is on top of a previous $10 billion buyback started in February 2000. The earlier buyback is roughly 80% complete, with $2 billion still authorized.

Couple the 3.1% dividend with a buyback of 10% to 11% of the shares outstanding, and you have a company that not only generates a lot of cash from operations, but also returns much of that cash to shareholders.

Organic growth: All growth is not equal. Because of the sheer number and scope of problems suffered by acquisitive companies in the last cycle, the new cycle should favor companies that generate internal, or organic, growth. The accounting is cleaner, there's no risk of overpaying, and there are no integration issues. Despite a tough period in its history with several drugs coming off patent, the pipeline is reasonably rich if you're willing to look past the current year. Also, the potential for new indications is something that the current valuation overlooks.



Stability: Investors have had enough of boom-and-bust cycles. The new cycle should show a preference for stability over hype. Pharmaceutical earnings are more stable than other industries. They're not affected by economic cycles. Look at this sector's earnings over the last couple of decades, and you'll see steady growth despite multiple economic cycles and different political environments.

FaceOff: Aug. 8
Who won this FaceOff?
	Arne Alsin
	Glenn Curtis