By no means is Merck (NYSE:MRK) a perfect company or a perfect stock. Admittedly there are legitimate concerns about the company's pipeline, its ability to ameliorate a big upcoming patent cliff, and the long-term relationship between for-profit health care companies and the federal government. All of that said, this stock has been stagnant long enough and value-oriented investors should consider this name as a long-term revaluation play. (For more on value investing, read The Value Investor's Handbook.)


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Decent Third Quarter Results
To be sure, Merck is not going to blow anyone away with its top-line momentum. Merck posted 8% growth in reported sales growth this quarter, with growth more on the order of 3%, in constant currency terms. While Singulair remains a very significant drug with over 10% of sales, Januvia/Janumet is growing nicely into a number two platform and other newer compounds like Gardasil and Isentress are showing solid growth, as well.

Profitability strikes me as a mix of good and bad news. The half-point improvement in gross margin is certainly positive, as is the good control that the company is showing in marketing expenses. Unfortunately, much of the 17% growth in adjusted operating income can be tied back to lower R&D spending. Given that bench and clinical research are the cornerstones of long-term success, that's not a uniformly positive development.

Playing the Hand it Has
Merck's near-term pipeline is not going to radically change the business. Accordingly, a lot of the company's success is going to come from successfully marketing existing compounds like Januvia and Isentress. Diabetes and HIV are crowded markets, though, and rivals like Johnson & Johnson (NYSE:JNJ), Novo Nordisk (NYSE:NVO), Gilead (Nasdaq:GILD) and Lilly (NYSE:LLY), are not going to give them any extra room to breathe.

On the other hand, that isn't to say that there aren't growth opportunities. Gardasil, for instance, is still arguably under-utilized in its core market. While the self-appointed guardians of public morality are not likely to just give up the fight, there are increasing recommendations from public health organizations to utilize this vaccine more broadly, including administering to teen-age boys. (For an example of drugs which have done will in the past, read Pharmaceutical Phenoms: America's Best-Selling Medicines.)

Recharging the Pipeline
Merck does not have the strongest pipeline among its large-cap peers; it's not in the same boat as Forest Labs (NYSE: FRX), but it is an issue. While companies like Novartis (NYSE:NVS) and Johnson & Johnson may be looking at meaningful contributions from their pipelines in the next few years, Merck will probably be sorely pressed to maintain stable revenue.

It is worth wondering what management intends to do about this. Another deal on the scale of the Schering-Plough acquisition is probably not too likely, but there is no shortage of biotechs or specialty pharmaceutical companies that could add some worthwhile sales to the top line. Cost is an issue, however; a name like Alexion (Nasdaq:ALXN) or Vertex (Nasdaq:VRTX) could goose the revenue line, but it's not likely that Wall Street would value that growth enough to justify the considerable valuation that a deal would have to carry.

More likely, then, are lower-key licensing deals and long-term development agreements, that could pay off well over a longer stretch of time.

The Bottom Line
As big-cap drugs have been laggards for several years, investors have plenty of choice in the space. Much of what can be said about Merck can also apply to Pfizer (NYSE:PFE), just to name one example. Still, Merck offers a solid dividend payout and a relatively stable, even if not exciting, business outlook. While drug companies like Merck have spent many years in the investor penalty box, it may be time for investors to reevaluate them and appreciate them for the cash flow they do still offer. (For more on the importance of cash flow in your stocks, see The Essentials Of Corporate Cash Flow.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Tickers in this Article: MRK, JNJ, LLY, PFE, FRX, ALXN, VRTX, NVO, GILD

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