In the ten years since hitting its all-time high in November, 2000, the NYSE Arca Pharmaceutical stock index has fallen 29%. Even if we go back to November, 2007, in order to eliminate the distorting effect of the financial crisis, the picture looks little better. At that time, the index was down 20% from its November, 2000 high. This poor ten-year performance looks even worse compared to the five-year period between November, 1995 and November, 2000, when the same index experienced a 217% gain.

Using the VL Page_Historical ArrayTwo of the largest companies in this industry are Merck (MRK – Free Value Line Research Report) and Pfizer (PFE – Free Value Line Research Report). A brief look at the Price Chart of each company shows that both have shared in the dismal performance of the broader sector over the last ten years, with Merck experiencing a few more ups and downs in recent years, and Pfizer a more consistent downward trajectory. Unsurprisingly, the P/E multiples of both stocks also fell in this period, as can be seen by examining the Average Annual P/E Ratio in the historical portion of the Statistical Array. Both reached a peak in 1998, 51.2 times earnings for Pfizer and 30 times earnings for Merck. Since then the multiples for both companies have contracted, rapidly during the 2000-2001 stock market correction and associated recession, and more slowly in the ten years thereafter.  Using the VL Page_Business Disc

Despite this ugly recent track record, value-oriented investors are still attracted to the pharmaceutical sector, possibly because the depressed prices of its marquee names imply valuation multiples that may well be irrationally low. But in trying to decide which of the Dow 30 pharmaceutical names to invest in, Merck or Pfizer, investors initially may have a difficult time finding ways to differentiate between the two. 

Looking at the Business Description reveals that both are industry-leading drug manufacturers with a stable of blockbuster products, such as Lipitor, Viagra, and Zoloft for Pfizer, and Prilosec, Singulair, and Vytorin for Merck. As the Ranks box at the top left of the page shows, Merck outranks Pfizer for Timeliness, but Pfizer outranks Merck for Safety. Both Using the VL Page_Timeliness Ranks Boxare relatively stable, as reflected by their Beta scores (found in the Ranks box), or their similar Price Stability ratings (found in the Ratings box). Also, both have high Financial Strength ratings (A or A+), which can also be found at the bottom right of the page. Perusing the Top Label (so-called because it lives on the strip at the top of the page) reveals that Merck is trading at a lower forward P/E currently (10.8) than Pfizer (14), but that Pfizer’s projected dividend yield (4.5%) is higher than Merck’s (4.1%).

From this jumble of information, it seems there is no one metric that clearly makes one stock more desirable than the other. Adding together several pieces of information from the Value Line page, however, reveals that the stocks differ in small but important ways. The biggest discrepancy immediately evident is that the two stocks have different Timeliness ranks (Merck: 3, Pfizer: 4) and are trading at different forward P/E multiples (Merck: 10.8, Pfizer: 14.8). Using the VL Page_GraphLooking at the “Cash Flow” Line (the line found on the Price Chart, which is solid for historical results and dashed for year-ahead projections) shows that, while both companies’ current prices are below the projected “Cash Flow” value line, Merck’s is much further below the line. This, combined with Merck’s lower forward multiple and less unfavorable Timeliness ranking, suggests that Merck is cheaper than Pfizer, and likely to have better relative price performance in the coming six to 12 months.

Using the VL Page_Current Position BoxSo Merck is more undervalued than Pfizer. The other obvious difference between the two stocks, however, is that Pfizer has a better Safety rank than Merck (Pfizer: 1, Merck: 2), which would make Pfizer more attractive. Pfizer’s less risky profile can be explained in part by its larger size, significant cash hoard (which can be seen in the Cash Assets line in the Current Position box), and its resulting superior Financial Strength rating (found in the Ratings box).

Why is it that Pfizer, while safer than Merck, has worse prospects for relative price performance? Many reasons are possible, but one plausible explanation is that there is a relationship between stock price and acquisition activity. Pfizer stock’s long downward trajectory in the 2000s coincided with three major acquisitions. These major changes to the company’s structure are indicated on the Price Using the VL Page_Ratings BoxChart by bold vertical bars that are footnoted. The footnotes explain that Pfizer acquired Warner-Lambert, Pharmacia, and Wyeth in 2000, 2003, and 2009, respectively. Merck, on the other hand, refrained from major acquisitions until 2009, when it bought industry giant Schering-Plough, roughly doubling the size of its business. The low valuation assigned to Merck may reflect investor anxiety regarding the prospects for this merger’s success. Although Pfizer is also in the midst of integrating a significant acquisition (Wyeth), it is a larger company, has a stronger financial cushion, and has a ten-year track record of integrating mergers, all of which could explain why investors are more confident of its ability to successfully execute the merger of two large organizations. These could explain Pfizer’s higher multiple and better Safety rank.

As perusal of the Analyst Comment makes clear, another key factor in Pfizer’s below-average growth pUsing the VL Page_Analyst Commentrospects is patent expirations. As Frederick L. Harris III points out, Pfizer’s blockbuster Lipitor loses patent protection in early 2011. It is uncertain whether the company can either stave off generic competition or replace Lipitor revenue from other sources.

Thus, while Pfizer is trying to preserve revenue, Merck, by means of its acquisition of Schering, is seeking the growth that eluded it through much of the 2000s. Though the Schering integration creates risk and uncertainty, and is thus depressing the stock’s price somewhat, a successful conclusion to the merger would likely lead to better price performance and capital appreciation for shareholders. This explains Merck’s lower multiple but better Timeliness rank. As the Analyst Comment indicates, the Schering acquisition, combined with further bolt-on purchases, should help the company move into emerging markets, leading to better growth prospects.

Using the VL Page_Quarterly Dividend BoxThe analysis above is complicated somewhat by the dividend history of the two stocks. Looking once more at the historical portion of the Statistical Array, we see that through 2005, both companies had a more-than ten-year record of annual dividend increases. Starting in 2006, however, Merck, wary perhaps of coming problems (the company’s top and bottom lines were flat or down from 2003 to 2006, which can be seen in the Array), kept its dividend steady, while Pfizer kept on increasing its payout. Thus, Merck’s dividend yield stagnated at between 3%-4% in the middle years of the decade, while Pfizer’s kept rising (albeit from a lower baseline). In response to the financial crisis, on the other hand, Pfizer slashed its distribution, while Merck kept its steady. A look at the Quarterly Dividend box shows that Pfizer is raising its payout once again.

This dividend history suggests that Merck is a bit more conservative with its dividend policy than Pfizer; indeed, Pfizer’s credibility took a hit when it was forced to cut its quarterly payout in half in the June period of 2009. On the other hand, Pfizer’s return to increasing payouts suggests that the company is committing to maximizing shareholder’s total return, whereas Merck shareholders may have to sacrifice dividend yield to growth, at least for the time being.

All told, the Value Line page tells us that Pfizer is a larger, more stable company. Its stock has solid total return potential, factoring in dividends, but has subpar price appreciation potential, both in the near and longer term. Merck, on the other hand, is a company looking to grow substantially. Though its stock is still quite safe (Safety: 2), it is suited for investors willing to take on a bit more risk (and forgo dividend growth) to get above average potential price appreciation.

For investors bullish about the pharmaceutical industry’s prospects, Pfizer provides a conservative, capital-preserving type of investment, while Merck offers an opportunity for above average 3- to 5-year growth.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.