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Equity Focus: Merck

Updated: Jun 21, 2020

After recently starting an internship as an Equity Research analyst, I have decided to share some of my thoughts and opinions on certain stocks, in a series titled Equity Focus. The information provided in these articles will offer a very brief overview of a company's case for investment, as well as its potential shortcomings. Please note that this is not intended to be investment advice, but rather, purely educational material. For this very reason, I have decided not to include my overall verdict or buy/sell recommendation. Due to formatting issues, any financial data such as balance sheet, and income and cash flow statement figures and ratios, have also been excluded. I do not hold a position in any of the stocks that will be included in the series.


Essentially, these articles will provide an insight into my thinking - why I like/dislike a company, and where its strengths/weaknesses lie. I hope you enjoy reading, and please don't forget to subscribe to The Student Investor to receive posts straight to your email inbox!



About:

Merck and Co., Inc, is a global pharmaceutical company, headquartered in New Jersey. It is listed on the NYSE under the ticker MRK, yet outside of the U.S., the company is also known as MSD. Merck has a successful history that spans more than 125 years, and, with over 70,000 employees worldwide, it is truly a global company.

The Case for Investment:

Merck is a diversified pharmaceutical business. Its main product is Keytruda, a “ground-breaking treatment that fights cancer with patients’ own immune systems.” However, unlike many other pharmaceutical companies, Merck does not solely rely on this drug for sales and revenue. With a recent management decision to trim some of its businesses and spin-off its women’s health, legacy brands and biosimilars segments into a stand-alone NewCo business, Merck has ensured that the wider business will benefit, as it will allow for greater focus on its oncology, vaccines, animal health, and hospital businesses. Increased prioritization will bring with it higher growth, greater efficiency, and increased value creation.

Not a one-trick pony

Although this streamline decision initially raised concern among investors that Merck would now rely almost solely upon the performance of its key drug and success story, Keytruda, fears have since been allayed. After all, Keytruda represented just 24% of 2019 total revenue for the company. As already mentioned, Merck has a diversified line-up, but this has been further developed by entering into a “strategic oncology collaboration” with Taiho Pharmaceuticals and Astex Pharmaceuticals. As part of this collaboration, Merck will pay $50m upfront and further performance-based incentives for the rights to some of Taiho and Astex’s pipeline candidates.


Moreover, in a climate of cost-reduction measures and cash preservation, Merck continues to flex the strength of its balance sheet with the $2.7bn acquisition of the ArQule biopharma company that offers cancer and rare disease treatments. Likewise, while writing this report, Merck announced this morning that it is developing two vaccines for Covid-19 and licensing an oral drug that will help to treat it. As a result, it is buying the Vienna-based company, Themis, while partnering with the non-profit IAVI to bring about a successful vaccine within the next few months.

Performance

Merck ticks many boxes for long-term investors who want both capital gains and a decent income from dividend pay-outs. On a forward P/E ratio of 15 and a dividend yield of 3.2%, the shares are undoubtedly attractive, given the prospect of double-digit growth over the next five years, as well as the much higher valuation of certain industry rivals, such as AstraZeneca, Bristol Myers Squibb, and Roche. The current share price is about 18% below its late-2019 peak. Merck also has a relatively strong balance sheet and healthy returns on capital. Interest on debt is covered over twenty times by earnings, and free cash flow per share is sufficient for maintaining dividend pay-outs. Thus, the prospect of Merck defaulting on debt repayments is very low.



Due to Covid-19, Merck has trimmed expectations, but still expects growth this year. The impact of the pandemic on its Q1 performance was “immaterial,” with earnings up 23% YOY, sales up 11%, and both beating expectations. Strong sales growth was in line with its major competitor, Novartis (also 11% growth), and it outperformed Pfizer (8% growth). Inevitably, Covid-19 will have an impact in Q2 and the second half of the year, because treatments are being delayed and hospitals are being reprioritised in the near-term. Nevertheless, with countries moving past their infection and death rate peaks, it is hoped that this won’t continue for too long. After all, “It is not a problem of underlying demand, but rather one of health accessibility, and the treatments will go ahead at some point.” The current price of around $76.40 suggests a potential one-year upside based on prevailing forecasts of around 20-25% to $95. Analysts also believe that a price of $120 would not be an excessive prediction on a three-to-five-year view. Major new cancer treatments are in the pipeline, and there are very high hopes for its Ebola treatment, which has already been used in Africa with 97% efficacy and success. Its $10bn of cash and healthy cash flow point to even further acquisitions.

A high-profile success story – and Keytruda

Former U.S. President Jimmy Carter believed he had just weeks to live when, in 2015, he announced that his metastatic melanoma (skin cancer) had spread to his liver and brain. Then, the 90-year-old began to undergo immunotherapy using Keytruda, a drug produced by Merck. Just three months later, Carter was found to be completely clear of cancer and is now leading a healthy, active life at age 95.

In 2015, Keytruda was new and sanctioned only for skin melanoma, an increasingly common yet hard-to-treat condition. Since then it has been approved to treat certain cancers in the lungs, head, neck, bladder, stomach, throat, kidney, and cervix, as well as Hodgkin Lymphoma. Already a blockbuster drug, with Q1 2020 revenue for Keytruda alone up 45% YOY to $3.3bn, some analysts think it could become the most-prescribed medication on record. History of Recovery Looking at statistics and data from the 2007/08 financial crisis, Merck’s stock fell by 52%, while the S+P 500 fell by 51%. By January 2010, Merck had already rebounded 59%, while the S+P 500’s recovery lagged behind, at 48%. What does this tell us? Well, it could certainly be a sign of underlying strength – that in recovery, Merck tends to outperform the wider market. Of course, the current pandemic is completely different and poses new market risks and conditions, but historical signs of good and quick recovery is definitely a positive. Risks While threats of revisions to the U.S. healthcare system have been cause for concern, the withdrawal of devoted reformer Bernie Sanders as the Democrat candidate for the next Presidential election has settled most of these nerves. Likewise, Covid-19 will have an impact on sales and supply in the short-term, with people keen to avoid hospitals and clinics. There have been short-term supply chain disruptions in China, but these are unlikely to be prolonged – especially as China has been quick to open up its economy once again. Social distancing laws have led to a subsequent fall in revenue from physician-administered Merck products. However, there remains a high underlying demand for these products, which will presumably be realised and converted into increased revenue and sales growth once the brunt of the pandemic subsides. With Merck’s manufacturing and supply sites fully operational worldwide during the current crisis, again they are well-positioned to emerge from this pandemic in a strong position. In terms of competition, with a market cap of $193bn and a global reach, Merck seems to be fairly well-positioned. Keytruda continues to outperform and outgrow rival treatments, such as Bristol Myers Squibbs’ Opdivo. Now more than ever, pharmaceutical companies are crucial, and, with such a diverse offering and continued growth in recent years, Merck shouldn’t be too worried. It is considered a specialist and industry leader in a wide range of cancer drug treatments, trials, as well as other diseases.


Revision to Guidance and Expectations Due to the coronavirus outbreak, Merck has been forced into lowering its guidance for FY2020 performance estimates. As part of this revision, full-year revenue guidance is down by $2.1bn to $46-48bn. Most of this is attributable to a fall in pharmaceutical revenue expectations, while animal health accounts for about $400m of this. Similarly, EPS is forecast to fall by $0.43 per share to $4.12-4.32 (GAAP) or $5.17-5.37 (non-GAAP (excluding acquisition, divestiture, and restructuring costs)). Operating expenses, which already fell by $100m in Q1 due to lower promotional and selling costs, are expected to fall by $400m across the whole year to a level lower than 2019 by a low single-digit rate. Many believe that “Merck’s shareholders are getting double-digit earnings growth for at least five years,” and with Keytruda expected to be hitting sales of $22bn within three years’ time – double last year’s $11bn and nearly six times 2017’s level - there is certainly a lot to like. Human trialling is already underway for treating prostate and breast cancers next, and its potential role in the race for a vaccine to prevent Covid-19 means that it has an exciting future ahead. In the words of Investment Columnist, Stephen Connolly, “consistent returns are always hard to find, but Merck is a quality company that is attractively valued with a healthy balance sheet, a high dividend, strong development pipeline, respected management and a blockbuster, best-selling product." Nevertheless, it is still important to conduct your own research on the company before making an investment decision.



Disclaimer:


The Student Investor is not a registered investment, legal or tax advisor or broker/dealer. All opinions expressed by The Student Investor are from the personal research of the author, and are written for educational purposes only. Although best efforts are made to ensure that all information is accurate and up-to-date, occasionally unintended errors and misprints may occur. Please note that the value of your investment can go up or down, and The Student Investor takes no responsibility for any decisions made by readers.