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or SELL Recommendation on Merck |
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Merck & Co (NYSE: MRK) Nov 5 close: $26.21
RECOMMENDATION: ACCUMULATE
Strategy: Write MRK=PX April 2005 Puts Strike@22.50
Price at the market close Nov 5: $1.05
OneChicago Single Stock Futures (MRK1C): MRK1C Z4 (Dec 04) $25.84
Among general reading, here is material I used to make this decision: EasyStock Interactive charts: Monthly, Weekly, Daily, Hourly, 30-Minute and the Reuters data at Yahoo Finance as well as the Value Line report.
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| The case for accumulating (the stock): |
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1. MRK is value-priced today, following the pullout of one of their top selling drugs, Vioxx, and the spectre of class-action lawsuits and a corporate debt rating downgrade to junk status.
2. Merck & Co, however, remains one of the premier drug manufacturers in the world. Revenues will still average about $22.5 billion for each of 2004 and 2005. Earnings after tax will still average $5.75 billion.
3. Excluding Vioxx, PE is 10.0 for this year and next based on the week’s closing price of $26.21. Dividend yield is now 5.65 percent. Buying for the high dividend yield is a good reason, but long-term investors should not expect the dividend to increase in the next few years.
4. With my accumulation target of $25 on MRK (which is enhanced by writing puts), my price targets are $32.00 (+28%) by year-end 2005; $43 (+72%) by year-end 2006; and $50 (+100%) by year-end 2007. These estimates are based on the reasonable prospects for a share price recovery to the mean averages of the drug industry, even if MRK trades at values that are below average because of the Vioxx situation.
5. Regardless of the credit watch put out on the Merck debt, the company is still a cash cow. The net profit margin is still 30 points. President Bush’s policies help these domestic drug manufacturers, too.
6. Merck is still financially strong; Value Line rates its financial strength A++. But there are some questions now from S&P and Moody’s about that strength. Still, the Net Working Capital ratio is almost 5; it’s Current Ratio (1.2), Quick Ratio i.e., acid test (0.9) Liquidity Ratio i.e., cash (0.44) are quite ok.
7. The Debt Ratio at 61.6 is lower than it has been in the past five years. Interest coverage is 26.8, which is solid. Altman’s Z-score Ratio, which is another solvency test, is at 3.17 versus 2.62 for IBM and 2.34 for HPQ (comfortably over the 1.80 test). Compare this to GE at 0.74 and BA at 1.65 and you begin to see which companies are going to suffer relatively more if, as and when interest rates increase.
8. With the credit watch and subsequent market sell-off, the short-term technical indicators (MACD, STO and DMI) have turned south, which will take the long-term (monthly data) indicators downward pointing as well, but this is what you look for with a stock that is getting beaten up in the market.
9. At $26, every share bought in MRK will be at a lower cost than EVERY share bought after September 1995. That gives me comfort when I look at the earnings power of this huge company.
10. It is laughable to compare this company to GOOG with a market cap of about $54.5 billion last Wednesday, compared to Merck’s $58.15 billion. Merck will earn net, net this year and next a total of about $5.75 billion, while Google earned just $106 million (2003), and may earn (consensus estimates) $690 million (2004) and $920 million (2005).
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The case against accumulating (the stock):
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1. Investors ought to give the independent rating agencies, S&P and Moody’s, the greatest respect. Unlike the sell-side of Wall Street, these people are objective. If they downgrade Merck debt to junk status, then that could be a good reason for avoiding the stock. In this case, I decided to look the other way (for now).
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Trader Wizard's expectation for this trade: |
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1. Writing the MRK=PX Merck Apr5 22.5 puts give me a premium income of $1.05. If the stock continues to drop between now and April 15 expiry (158 days), then my cost will be $21.45, which would be a decline of 18.16 percent from here. That is unlikely, as the stock would have to drop through support in the mid-twenties going back to 1992. The fundamentals are too strong for that to occur, in my opinion.
2. I am not yet ready to aggressively buy the stock (or buy the calls) because MRK is in a sharp downtrend as a reaction to the credit watch. I don’t know how that situation is going to work out. So, I expect to earn the $1.05 premium, which is the sole expectation for this trade, or to close the naked short in the interim, at a profit.
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Trader Wizard Profit & Loss: |
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The ‘Trader Wizard buy or sell’ Ezine intends to present a P&L for individual trades. In the Daily Blog, I have been showing readers just how profitable these trades have been.
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