Merck’s Spinoff Promises Higher Dividends and Big Upside

Merck (NYSE:) reported stellar fourth-quarter and full-year 2019 earnings on Feb. 5. Net income on a non-GAAP basis was up 15% and its earnings per share were up 20% year-over-year. But there was a surprise for shareholders. The company is going to spinoff several non-core divisions as a separate publicly traded company.

Merck spent a good deal of time on its conference call discussing the benefits of the spinoff. Two of the largest benefits are a special dividend and margin benefits to MRK stock.

In effect, shareholders will now own two simpler, more agile companies. For example, NewCo — the current name for the new company — will include about 15% of Merck’s from 2020.

In addition, it will reduce that division’s manufacturing footprint. The spinoff will cut the number of products by 50% and its stock-keeping units by 60%.

that NewCo will have about $6.5 billion in assets. This will include women’s health products and cholesterol treatments that have lost patent protection — equal to 15% of its prescription drug sales.

The cost-shedding move will allow MRK to focus on faster-growing cancer drugs, vaccines and animal-health items. The deal will lead to more than $1.5 billion in savings by 2024 for Merck. In addition, its manufacturing costs will fall by 25%.

Merck made $13.4 billion in adjusted net income in 2019. So the saving will increase its existing earnings by 11.2% before taxes.

The Wall Street Journal’s Jared S. Hopkins said that other drug companies like Pfizer (NYSE:) and GlaxoSmithKline (NYSE:) have dropped similar legacy and slower-growing divisions. The idea is that the remaining company will have faster growth with higher margins.

Spinoff Will Benefit MRK Stock

Another huge benefit from the spinoff will be a huge between $8 billion and $9 billion paid from NewCo to Merck. This will allow Merck to buy back even more shares than it already does.

Merck will be able to keep its existing $2.44 dividend per share for shareholders. It said that “future increases” in the dividend will be possible.

In addition, NewCo will likely also pay a dividend. According to management, the spinoff will create a company that remains competitive with its peers.

So, shareholders will end up with a double whammy in terms of dividends, plus more share buybacks. These buybacks tend to increase earnings and dividends on a per-share basis over time.

In effect, shareholders will benefit from having two highly focused companies, extra dividends and share buybacks. In addition, the remaining Merck divisions will benefit from faster growth and higher margins.

Analyst Reactions to the Spinoff

Some analysts were truly “blindsided” . Evercore’s Umer Raffat said he had no explanation as to why this transaction came out of left field.

RBC’s analyst, Randall Stanicky, said that it would increase Merck’s dependence on one cancer drug, Keytruda. This one drug accounts for $11.1 billion of its $46.8 billion in annual sales, over 20%. The spinoff would increase this share.

In addition, Merck has been other cancer drug makers with promising therapies. JPMorgan Chase says that by 2040 cancer drugs could become 40% of its total sales.

On the other hand CEO Ken Frazier said this was the right thing to do. He said Merck no longer needs the cash the legacy products were throwing off to support the company’s oncology business. He was referring specifically to the growing success of Keytruda.

What Should Investors in MRK Stock Do?

The spinoff is not likely to occur until sometime next year. The company has not announced the terms of the spinoff. For example, we don’t know yet how many shares will be received in NewCo for every share owned in MRK stock.

Moreover, Merck’s exact financial operating estimates for NewCo are not yet clear. So there will be plenty of time to study this when Merck reveals the details.

Meanwhile, MRK stock is very cheap at just 13 times forward earnings and a 2.9% dividend yield. MRK stock is also down about 12% off of its 52-week high of $92.64.

With the prospective spinoff’s benefits, including the extra dividend, Merck stock represents a cheap and good buy.

As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the  which you can review here. The Guide focuses on high total yield value stocks. Subscribers receive a two-week free trial.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.