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Is Merck & Co., Inc. (MRK) Destined for Greatness?

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Merck & Co., Inc. (NYSE:MRK)Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Merck & Co., Inc. (NYSE:MRK) fit the bill? Let’s take a look at what its recent results tell us about its potential for future gains.

What we’re looking for
The graphs you’re about to see tell Merck & Co., Inc. (NYSE:MRK)’s story, and we’ll be grading the quality of that story in several ways:

Growth: are profits, margins, and free cash flow all increasing?

Valuation: is share price growing in line with earnings per share?

Opportunities: is return on equity increasing while debt to equity declines?

Dividends: are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let’s take a look at Merck & Co., Inc. (NYSE:MRK)’s key statistics:

MRK Total Return Price Chart

MRK Total Return Price data by YCharts.

Passing Criteria 3-Year* Change Grade
Revenue growth > 30% 38.1% Pass
Improving profit margin (63%) Fail
Free cash flow growth > Net income growth 232.5% vs. (48.9%) Pass
Improving EPS (61.4%) Fail
Stock growth (+ 15%) < EPS growth 43.8% vs. (61.4%) Fail

Source: YCharts.
*Period begins at end of Q1 2010.

MRK Return on Equity Chart

MRK Return on Equity data by YCharts

Passing Criteria 3-Year* Change Grade
Improving return on equity (66.2%) Fail
Declining debt to equity 19% Fail
Dividend growth > 25% 13.2% Fail
Free cash flow payout ratio < 50% 63.9% Fail

Source: YCharts.
*Period begins at end of Q1 2010.

How we got here and where we’re going
Merck, despite its status as one of the world’s largest pharmaceutical companies, doesn’t look too impressive here, as it earns only two out of nine possible passing grades. Despite this apparent inadequacy, Merck & Co., Inc. (NYSE:MRK)s shares have made an impressive comeback over the past six months, and have finally reclaimed the multiyear highs left behind early in 2008. Merck’s trailing-12-month free cash flow is almost 33% more than its net income, which puts it in a stronger position — however, so much of this cash is being spent on dividend payments that the company may not have much financial wiggle room going forward. Let’s dig a little deeper to see what Merck & Co., Inc. (NYSE:MRK) is doing to maintain or grow its position.

Let’s get the patent cliff out of the way first: the pharmaceutical industry is staring at a revenue loss of around $300 billion due to patent expirations this decade. Like many of its peers, Merck has faced a significant decline in revenues and profitability due to last year’s patent expiration  of Singulair, its best-selling drug (accounting for 11% of 2011 revenues). Sales of anti-hypertensive drugs such as Cozaar and Hyzaar have also declined by 26% since losing market exclusivity in U.S. and European markets in 2010. Moreover, Merck & Co., Inc. (NYSE:MRK)’s brain tumor treatment Temodar, and hit prostate-and-bald-patch pill Propecia, should also see generic competition in the coming year.

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