GE v Merck – Which Stock is The Better Investment For 2018?

Last Updated: May 31, 2019
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Both General Electric Company (NYSE:GE) and Merck (NYSE:MRK) are part of the Dow best performing stocks during the years. But what can we tell about them in 2018? Are they still a good investment as they were in the past? Steve Green has analyzed them and here's the results:

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Dogs of the Dow, have you ever heard about it?

This strategy is to pick the ten highest yielding stocks from the Dow Jones Index at the end of the year.

It often produces out of favor companies where share price weakness has resulted in a higher dividend yield. A good example is GE, which despite cutting its dividend still qualifies.

What does it mean?

GE and Merck are two of the dogs that happen to be among the poorer past performers over many time periods. I shall examine their prospects of whether these two dogs can bounce back.

General Electric Company (NYSE:GE)

Buying GE now looks to me like the “hero” trade to be wary of attempting. Investors could potentially go on to say that it was a blue-chip name that was always going to bounce back. That it ticked the box with obvious catalysts in sight. Fresh management, cost-cutting, and spinning off assets are among the actions you are looking for in a turnaround situation.

The problem is such of rationale has been used for bottom pickers about a year ago when the price was nearer $30!

I agree the typical catalysts are there but..

I would prefer some obvious indications of value to enter such an uncertain situation. During a recent conference call, CEO John Flannery reiterated that “all options are on the table” when it comes to carving up the company. Previously he has flagged selling at least $20 billion of assets over the next two years.

This is whilst they look to focus on their three main business in aviation, power and healthcare. What remains as businesses under the GE stable in a couple of years’ time though appears to be anyone’s guess. In such a situation, I would expect the company to appear obviously cheap versus its earnings outlook.

Despite the share price falls, is GE cheap?

I expect GE shares to continue to remain volatile, and likewise analyst’s earnings estimates. This is particularly the case given only recently they unveiled a $6.2 billion hit from their insurance division. The shares this year have tended to imply a forward P/E of about 18 times for 2018 expected earnings.

This kind of multiple might be cheap in this market for companies with a sound and predictable future, but not so GE. Reliance on such multiples must be done so with caution, as GE’s financial reporting can be complex. A prospective GE investor should at least familiarize themselves with the debate over GAAP & Non-GAAP reported earnings.

GE in the last year

The three core business areas they wish to focus on do have some attractive characteristics. I wouldn’t say though they are particularly exciting in terms of growth prospects, and the power division has its challenges.

One wonders when GE will get into a position to fully focus on an ideally smaller company in the future. Apart from the latest distraction from their insurance business, shareholders have varying views on the best path forward. Then there is still the huge pension liabilities problem overhanging the stock.

Pension Problems

Their pension liabilities are by far and away are the largest of any US company. A good explanation of how they got where they are can be found here.

These are big numbers in the context of the market cap of GE, which has been around $150 billion for much of this year. I have read many well-respected investors arguing that we should dramatically lower our expected investment returns over the next decade.

Why?

A key to this is very high starting points for US equity valuations now. Some even estimate comfortably negative real returns for US equities over the next decade. In assessing their pension liabilities, GE is basing this on annual returns of 7.5%. I don’t think this is a realistic estimate from GE.

In trying to ensure these liabilities don’t get too large, in the short term they shall pre-fund $6 billion worth this year. This “one off” move allows them to exclude it from their free cash flow summary in their investment presentation last November as per below.

GE cash flow summary

 

I often see that companies buying back shares and paying out sizeable dividends is good for the share price (See my top dividend stocks for 2018). I worry though that such moves by GE in recent years gone by were detrimental to its future. The ramifications may still to be felt in the GE stock price over the course of 2018.

Merck & Co., Inc. (NYSE:MRK)

Merck was also a poor performer of the Dow in 2017, but not nearly as bad as GE. The share price suffered from their large suite of products facing lackluster growth. The positive was the impressive growth seen in their drug Keytruda. This drug has had success in treating various types of cancer and has plenty of potential.

Controversial Results

In Q3 the sales number achieved for Keytruda was year on year growth of 194% from Q3, 2016.  It is now approaching 10% of overall revenues. On the other hand, another main drug of theirs is Januvia that treats type 2 diabetes. Its year on year sales declined by 2%. This means we now see the market eagerly anticipating any news surrounding Keytruda. Yet this is not always a good thing, as we witnessed in October last year.

Bad Performance

This was a major factor that led to Merck is one of the Dow Jones Index worst performers last year. Outside of this, the stock traded in a relatively narrow band for the year. Whilst disappointing, this kind of setback can be part and parcel with investing in a leading pharmaceutical company.

Merck in the last year

One could argue that the setback in the share price can present an opportunity. Already in January we have seen some positive test results. This may assist in addressing the issues surrounding the Keytruda lung cancer EU filing.

Merck P/E, Mind the Gap

Merck trades at a lower forward P/E than the overall market. It is weighed down also by the lackluster growth in sales in products outside of Keytruda.

Total sales fell by a couple of percents in Q3 2017, compared with the prior year. Merck shares so far in 2018 have generally implied a forward P/E of around the 15 mark. Like GE, caution should be adopted when considering GAAP and non-GAAP numbers. Merck tends to have significant differences between the two.

Defensive Qualities

Looking at the Q3 results stating the first 9 months of 2017, it appears about half of the difference sits with acquisition costs. I can understand this being excluded from the non-GAAP numbers they report. I am however a little skeptical about R&D which is the other major factor explaining the difference.

Without going into specifics, I prefer to be conservative and consider the forward P/E more like 20 rather than 15 times. This doesn’t look that exciting given the mixed sales growth prospects I touched on earlier, but remember the stock has defensive qualities (If you would like to hear more about defensive investments, read our top defensive ETFs for 2018).

Defensive Characteristics

Demand for drugs is less likely to be affected by economic downturns and this is appreciated by many investors. Merck is also carrying a modest level of debt which enhances this defensive nature. It can at least retain its ability to attract investors searching for a reliable dividend stream in the future.

Merck Q3 2017 Results

Despite overall sales looking flat, earnings can get a boost thanks to the high margins on Keytruda and its growth projections.

Conclusion

In spite of both included in the “dogs of the dow” list – I at least find Merck with a more certain and lower risk future ahead.

They both began 2018 with similar market caps, with Merck trading more positively over the first few weeks. I expect that trend to continue, and for Merck to finish as a stronger performer when we look back at 2018. Also, still see risks for another negative year for GE and I remain uncertain whether the break-up value provides much downside support.

Steve Green

Investor based in Australia focused on global asset allocation, special situation and activist investing strategies. Keen interest in Listed Investment Companies (LICs) and Closed End Funds (CEFs). You can follow some of his ideas at his investment blog here at http://valueinvestingforaliving.com Not licensed to give financial advice or aware of your personal circumstances so please do your own research.