The booming biotechnology sector has stolen the thunder from the big pharmaceutical companies in the last year. That’s worked out well for us income investors though, because it left the steady dividend payers among the Big Pharma group reasonably priced.

Merck & Co is particularly attractive now, because while most of the other majors have posted decent recoveries from the recent market swoon, Merck at $50 is well off its 52-week high of $63. A big reason for that is Merck hadn’t had any drug breakthroughs in several years, but had focused on selling just a few major drugs rather than casting a wide drug development net. But a recent management shakeup has increased the company’s commitment to new drug discovery, particularly for diseases with few, or even any, effective treatments.

Another major plus is Merck is past the worst of its patent expirations. While Merck has dealt with some major losses over the past several years, it only faces a handful of patent losses over the next few years. The only potentially significant expirations are on Cubicin, used to treat major infections mainly from multiple drug-resistant bacteria, which was picked up when Merck acquired Cubist Pharmaceuticals. Immunology drug Remicade could also potentially face competition soon.

Blockbuster Potential

However, most of the company’s losses on expirations are being offset by its other major sellers and its strong pipeline of new drugs. Showing blockbuster potential for Merck are its recently launched Januvia for treating diabetes, Keytruda for melanoma, Isentress for HIV and its Gardasil vaccine used to prevent human papillomavirus. Its Ebola vaccine, which was developed with NewLink Genetics and still needs to be approved, has been shown to be 100% effective in preventing Ebola infections, an impressive feat.

Its work on the Ebola virus is also representative of Merck’s renewed focus on unmet medical needs. That’s not a novel approach, but the early 2000s were marked by major pharmaceutical companies competing head-to-head to treat the same basic diseases. There’s now more differentiation between the major pharmaceuticals, as Merck focuses on Ebola and the others work on other, less common, diseases. That parting of the ways actually makes it easier to pick out the best pharmaceutical companies, since they’re now working on vastly different projects instead of them all just racing to make a better drug to lower cholesterol.

Merck financials are strong. It had just over $40 billion in revenue last year, and free cash flow over the trailing twelve months amounted to an impressive 14% of total sales. That helps to support more than $6 billion in annual research and development spending, a driving force behind Merck’s success in launching new drugs. The company also carries very little debt, with a debt-to-equity ratio of just 0.38, meaning debt stands at only about a third of equity. It also has a current ratio of 1.62 in its latest quarter, meaning it could pay off its debts in the next twelve months if need be.

That also means that its current quarterly dividend of $0.45, for a yield of 3.6%, is well-covered by cash flow and quite secure.

Despite its strong financial position and its pipeline of 38 drugs in late-stage development, Merck is undervalued relative to its peers. It trades at just 14.5 times trailing twelve months earnings, versus the industry average of 17.6 and its own five-year average of 30.3. And while earnings are expected to be relatively flat this year versus last year ($3.50 this year versus $3.49 in 2014), it is expected that they will hit $3.79 next year and $4.41 by 2018.

Part of the reason why Merck is undervalued relative to its peers is its earnings are expected to take a few years to ramp up after its recent new launches,. But that also means this is a good time to pick up shares on the cheap, especially since that earnings ramp up means dividend growth down the line is a strong possibility.

That’s particularly true since Merck pays out more of its earnings in the form of dividends then its major competitors, even while keeping debt low and funding a large R&D program.

Gaining Notice

Large investors seem to be recognizing Merck’s long-term potential though, with data from Morningstar showing that buying activity from institutional investors and mutual funds is picking up. In the past quarter, institutional investors added 17 million Merck shares to their holdings, and while funds as a whole were net sellers, almost all sales were from mid-cap growth funds.

With Merck’s current market cap of $140 billion – well above what anyone would consider a mid-cap stock – that’s probably mostly long-term holders trimming winners and stocks which no longer meet their investment mandates.

With dividend that has room for growth, a full pipeline and potential blockbuster drugs in the works, Merck is being added to our Conservative Portfolio as a buy up to $65.