As a rule of thumb the City doesn’t like uncertainty. Offending stocks tend to be savagely marked down, remaining undervalued until investors can see light at the end of the tunnel. This creates a fertile environment for bargain-hunting.
Tip of the week: Merck (NYSE:MRK), rated OVERWEIGHT by JP Morgan
Take Merck, one of the world’s biggest pharmaceutical groups. The stock was hammered in 2004, when its Vioxx painkiller was withdrawn after it was found to cause cardiovascular risks. At the time, some analysts predicted Merck’s liability could spiral as high as $30bn, threatening the entire business. In the end, the firm settled the bulk of its lawsuits for around $5bn in late 2007. Yet the stock still trades at downtrodden levels, which makes it good value.
Merck is a healthcare behemoth which has numerous patents and a vast knowledge of drug discovery. It spends about 20% of its revenues on research and development alone and has leading franchises in Alzheimer’s, cardiovascular treatments, diabetes, vaccines, obesity, oncology, pain relief and sleep disorders. All these have great growth prospects.
The stand-out to me is Merck’s strength in vaccines, including products that protect against cervical cancer, hepatitis B, shingles and pediatric diseases. Over the last 20 years, the sector has consolidated down to three major players, creating an oligopoly with strong pricing power. The science behind vaccines is also advancing rapidly, creating new opportunities. Historically, these treatments were broadly derived from micro-organisms. But with the advancement of research on the human genome, researchers can now map specific viruses and target their DNA characteristics more precisely. Profit margins on vaccines are also as lucrative as those on pharmaceuticals because the lower marketing expenses generally offset the higher manufacturing costs.
Wall Street expects 2008 revenues and underlying earnings per share of $24.3bn and $3.33 respectively, rising to $25.4bn and $3.63 in 2009, which puts the shares on attractive p/e ratios of 11.1 and 10.2. Costs are being cut and the company sports a robust balance sheet with $1.9bn of net funds as at the end of March. Due to its healthy profits, the group should stay cash-positive, even after the settlement of all its Vioxx claims.
What are the potential pitfalls? The Vioxx agreement is largely done-and-dusted, but it still needs to be ratified by the courts. And as with most big pharmas, Merck is threatened with patent challenges and expiries over the next five years, although it already has a number of new blockbuster drugs in late-stage clinical trials. Merck is also having to face up to increasing regulatory scrutiny, more frugal government reimbursements and setbacks in its pipeline.
In May, the group was hit by the US Food & Drug Administration’s rejection of one of its most promising drugs, a cholesterol medicine to be called Cordaptive, that analysts had predicted would generate $2bn of annual sales. Second-quarter results are scheduled for 21 July.
Recommendation: LONG-TERM BUY at $38.65
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments