Share tips: Innovative drugs maker with great upside

If there is a double dip, then it's likely the quantitative easing (QE) taps will be turned on again. That will cause fixed-income investors to lose even more money after inflation. Personally, even after last week's 10% market fall, I'd prefer to chance my arm with equities that pay solid dividends and offer greater upside.

Merck, the world's second-largest drug maker behind Pfizer/Wyeth is a firm jam-packed with best-in-class science, and which spends more than $8bn on research and development alone (or 17% of turnover). It possesses leading franchises tackling Alzheimer's, cardiovascular diseases, diabetes, vaccines, obesity, oncology, pain relief and sleep disorders. Each of its top-ten blockbuster drugs generate sales of more than $1bn per annum.

By acquiring Schering-Plough for $41.1bn two years ago it added products in biologics, consumer and animal health. The combined pipeline is now one of the strongest in the sector, despite some recent setbacks in cardiovascular (Vorapaxar) and respiratory (Dulera) products. It has 18 compounds in late-stage trials and another six being reviewed by health regulators prior to final approval. All of these innovative treatments offer excellent prospects. But its strongest point lies in its focus on vaccines designed to prevent cervical cancer (Gardasil), hepatitis B, shingles and pediatric diseases.

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Merck (NYSE: MRK), rated OVERWEIGHT by JP Morgan

Over the past 20 years, this area has consolidated into a few major players, creating a semi-oligopoly with resilient pricing power. Also, the science behind these treatments is advancing rapidly, creating new opportunities. Historically, vaccines were derived from micro-organisms. But with the deciphering of the human genome, researchers can now map specific viruses and target their DNA structures more precisely. These organic substances generally have fewer side-effects, yet produce equally lucrative profit margins as lower marketing expenses generally offset higher production costs.

Wall Street is forecasting 2011 revenues and underlying earnings per share (EPS) of $47.5bn and $3.73 respectively. That puts the shares on an attractive price/earnings (p/e) ratio of around nine and a 4.6% dividend yield. What's more, the company sports a cast-iron balance sheet with net debt of $5bn representing less than a quarter of its projected 2011 earnings before interest, tax, depreciation and amortisation (EBITDA) of $21bn.

Further out, I believe earnings can grow from new therapies and cost savings from the merger. Indeed, the group is on track to hit its targeted $3.5bn per year of synergies by the end of 2012. That involves a 17% reduction in staff together with the rationalisation of manufacturing and research and development facilities. On this basis I would value the group on a 6.5 times EBITDA multiple. After adjusting for debt and $2.2bn in retirement obligations, that throws up an intrinsic worth of $41 per share.

Like its peers, Merck is exposed to the usual issues of patent expiries (eg, Singulair for asthma in 2012 with sales of $5bn), increasing regulatory scrutiny and tighter government spending. Nonetheless, with a host of innovative new compounds in the pipeline it is well placed to benefit from the trends of ageing populations and growth in emerging markets. JPMorgan has a $44 price target.

Rating: LONG-TERM BUY AT $32