The entire pharmaceutical industry has been hit by a wave of patent expirations. The pain has been particularly acute with regard to the largest industry participants, where a handful of blockbuster drugs had historically been the driving force behind financial performance. The idea of having just one or two major “hits” works so long as new “hits” come along to pick up the slack when patent exclusivity expires on older drugs.

Such big winners stopped showing up a few years ago, leaving the large drug companies watching the calendar for the day when earnings would be hurt by the loss of key patent protections. One by one, the patents have gone away and so has the associated revenue streams. Merck (MRKFree Value Line Research Report on Merck) is taking some pretty big hits this year.

As Michael Ratty points out in the Analyst Commentary, the company has already lost patent protection on Cozaar/Hyzaar and is watching the calendar for its August loss of Singulair. To make matters worse, Pfizer’s (PFEFree Value Line Research Report for Pfizer) loss of patent protection for Lipitor is also being felt by Merck’s cholesterol drugs (Vytorin/Zetia), as customers move to the cheapest option in the cholesterol space.

The picture isn’t particularly pretty. In fact, Ratty projects earnings over the three- to five-year period of $3.70 per share. That is below 2011’s results ($3.77 per share), below his share net estimate of $3.80 for 2012, and identical with the 2013 estimate. (These figures can be found in the Statistical Array, with estimates presented in bold type and projections found to the right of the headings and in bold.)

Using the VL Page_Historical ArrayWhy would anyone be interested in this company? First, the company has the financial strength to handle the headwinds. Second, the company has been investing for the future. Third, a recent 4.3% dividend yield pays you to wait.

Merck has been awarded Value Line’s highest score for Financial Strength (A++, found in the Ratings box) by Ratty and Value Line’s senior editors. Although a number of factors led to this decision, a few worth noting are a modest level of debt (22% of the capital structure, as shown in the Capital Structure box), ample cash (nearly $15 billion at yearend 2011, as noted in the Current Position box, which is directly below the Capital Structure box), and a lengthy history of solid earnings (which can be seen in the Statistical Array). From a purely statistical standpoint, the stock price has a Price Stability rating of 85 (out of 100), which Using the VL Page_Ratings Boxis good, though not exceptional.

These two factors get combined to generate the Safety Rank, which can be found in the Ranks box. Here, Merck earns a top-notch score of 1 (Highest). Clearly, Merck isn’t going to go out of business because of patent expirations. This gives it time to find a way to get revenues Using the VL Page_Capital Structureand earnings back on track. This may take a few years, but when an analyst is projecting $3.70 per share in the “bad” years, there’s clearly no major rush.

The major drug companies chose many different paths with regard to patent expirations. Some came up with novel ideas, like offering material price concessions and financial support to customers for drugs losing patent protection in an effort to stave off competition. Some simply cut costs by laying off workers and scaling back operations—both on the sales and development side. Some did both. Merck chose to cut back in some places, Using the VL Page_Timeliness Ranks Boxbut was careful not to hurt its research efforts.

Ratty believes that its continued investment here will pay off longer term, as new drugs come on line. Drug development, however, can be a lengthy, and risky, process. So while Merck has a solid pipeline, including five drugs slated to enter the approval process this year and next, the benefits could be a little way off—clearly a major factor in Ratty’s cautious longer-term projections.

Still, the shares are trading near historically low valuation levels. The relative P/E is just 0.62, found in the Top Label, which is near the low end of the historical range for Merck (the Top Label runs across the top of each report, as the name implies, and the annual relative P/E figures can be Using the VL Page_Quarterly Dividend Boxfound in the Statistical Array). This has left the company with a dividend yield that is also toward the high end of its historical range, at a recent 4.3%. That’s a well above the market yield, allowing those with an optimistic view of the company’s future to get paid to wait.

Note that after seven years of paying a static dividend, the company increased the disbursement from $1.52 per year to $1.68 in the first quarter of 2012 (the first quarter 2012 dividend increase can be seen in the Quarterly Dividend box). This is not the action of a company that is concerned about making enough money to pay a dividend. It is more likely a company looking to increase investors’ interest in its stock.

Merck definitely has longer-term issues with which it must contend. However, it seems well positioned to deal with the problems, and still reward those willing to wait for better days.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.