Merck: A Great Dividend Stock for Retirees

Dividends are the lifeblood of Big Pharma stocks. The payouts ensure a steady income stream even when a company’s shares stagnate. But a healthy dividend isn’t the only reason to consider the shares of Merck & Co. (symbol MRK). Not only does the drug maker’s stock deliver a 3.3% yield, it also has potential for gains.

With more than $39 billion in annual sales, Merck makes money from more than 50 prescription medicines. Top sellers include Januvia, a blockbuster diabetes drug, as well as drugs to treat cancer, high cholesterol and other ailments. Vaccines and animal health products round out Merck’s lineup.

Sales have dipped from a peak of $48 billion in 2011, partly because Merck sold its consumer-products business in 2014. Analysts expect profits per share to inch up by just 3.5% over the next 12 months (compared with earnings in the 12-month period that ended June 30). The stock has lagged far behind such rivals as Pfizer (PFE) and Bristol-Myers Squibb (BMY), trailing each by more than 20 percentage points over the past year.

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But Merck could be on the cusp of breaking out of its rut. The Kenilworth, N.J., company recently spent $8.4 billion to acquire Cubist Pharmaceuticals, a leading maker of antibiotics, including drugs to treat “superbugs” that can cause pandemics. Merck says Cubist will add more than $1 billion to revenue in 2015 and bolster earnings per share in 2016. But more compelling from a profit perspective is Merck’s pipeline of new products, including several with potential for more than $1 billion in annual sales.

Merck's Next Blockbusters?

Leading the way is Merck’s cancer drug Keytruda, part of a new class of “immuno-oncology” medicines that harness the body’s defenses to shrink tumors. Already approved to treat melanoma, a form of skin cancer, Keytruda has shown effectiveness in treating some types of advanced lung cancer—a potentially much larger market. The Food and Drug Administration is slated to rule on Merck’s application for Keytruda to treat non-small-cell lung cancer in early October. Assuming Merck gets the green light and receives FDA approvals for other uses—two big ifs—Keytruda sales could reach $9 billion by 2023, estimates Bank of Montreal Capital Markets analyst Alex Arfaei.

Other potential hits include a new drug for hepatitis C; a weekly diabetes drug (potentially expanding Merck’s share of the diabetes-treatment market); and an anesthesia drug that has already been approved in Australia, Europe and Japan, and is under review by the FDA. All told, Merck is “on the verge of five to six years of strong growth,” says Arfaei, who recently upgraded the stock from a rating of “neutral” to “outperform” and raised his 12-month price target to $70 per share, 30% above Merck’s closing price on August 24 of $53.99.

Merck still faces tough competition. Keytruda and other drugs vie for sales against rivals, and pressure from insurance companies could force Merck to lower prices, reducing profitability. Moreover, although future products look exciting, some may never reach the market. And there’s always the chance that doctors will favor treatments made by other companies.

Yet investors aren’t paying a steep price for Merck’s future profit potential. The shares trade at 15 times estimated earnings of $3.60 per share over the next 12 months. That’s roughly in line with the price-earnings ratios of Pfizer and Johnson & Johnson (JNJ). But investors may be underestimating the value of Merck’s pipeline of new products, says Morningstar analyst Damien Connover. Even if the stock doesn’t bounce over the near term, investors can collect that healthy dividend yield as they wait for all those drugs to reach pharmacy shelves.