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When investing in pharma companies, you want the best of the breed. The companies with the most safety, the biggest moats, and the ones that have been around and mastered most crises. At least if you’re a conservative dividend investor, which if you read my articles, you have some interest in being or reading about.
Because of this, the number of pharma and healthcare investments I have is fairly limited – not necessarily in overall portfolio size, but in number and type of companies. I like the sort of companies that can survive almost anything, such as pharma companies, large healthcare megacaps, pharma companies with dozens of billions in revenues.
This is where the subject company of today’s article comes in – It’s Merck (MRK).
Merck – What does the company do?
Merck is a multinational company in the field of pharmacology. It is, in fact, one of the largest pharma companies in the entire world, founded all the way back in 1887 by a German-born long-term employee of the German founding company. I say German because Merck can in fact trace its roots back to the original founding in 1668, making the company older than the US itself. Back then, it wasn’t any more than a drug store in the German city of Darmstadt, but during the 19th century, the company evolved into what would become the major pharmaceutical player when they began commercially manufacturing morphine.
Between 1891 and 1917, the US subsidiary operated under the Merck Group, but the company was later nationalized in 1917, and from that point, the company would be a different legal entity from its German roots. Merck & Co. holds the right to the company name in the US and Canada, while it can’t use it outside of these geographies, with the former company having the rights anywhere else.
The company partnered with the Philadelphia company Sharp & Dohme Inc. to become the largest drugmaker in the US back in 1953. In 2009, the company then announced a merger with its competitor Schering-Plough in 2009, which was an attempt to retain Remicade for Schering-Plough.
That, and many smaller acquisitions later, is where we find Merck & Co. today.
The company, as of today, is split into the following segments.
- The Pharmaceutical segment, including human health pharma and vaccine products, which are sold to wholesalers, retailers, government agencies, and organizations such as benefits managers.
- The Animal Health segment, focusing on veterinary pharma and vaccine products as well as related products in disease control amongst livestock and animal companion species. These are sold to veterinarians, distributors, and animal producers.
- The Healthcare Services segment, focusing on analytics, engagement, and clinical services, which recently sold certain businesses. The segment is in the process of being divested, but it still exists as a segment as of the publication date of this article.
- The Alliances segment, including activities from AstraZeneca (AZN) with sales of Nexium and Prilosec, which were finished in 2018. Nonetheless, it exists as a segment.
Merck’s success can be shown through its historical approval rate of new drugs – since the early 19th century and up to 2013, Merck has received approval from the FDA for 63 new molecular entities. As it stands today, its major products include:
- Keytruda, an immuno-oncology therapy drug.
- Lynparza, an inhibitor of Poly ADP-ribose polymerase, or PARP
- Lenvima, a multi-kinase inhibitor
- Bridion, a medication for neuromuscular blocking during surgery.
- Januvia, an inhibitor for type 2 diabetes
- Zetia, a medicine used to lower cholesterol levels
- Remicade, a monoclonal antibody used in arthritis, Crohn’s disease, and other diseases.
- Belsomra, a medication for the treatment of insomnia.
- Gardasil, a cervical cancer vaccine.
- Isentress, an HIV treatment drug.
…And many more.
These drugs continue performing well, delivering sales to the tune of over $45B annually for the company. It’s important to note that the company you’re investing in has announced plans to spin off its Women’s Health and Biosimilar division, which includes things like Zetia in the NewCo. This is expected to occur in 1H21, and Merck shareholders would receive the new company as stock.
(Source: Merck FY19 Presentation)
In terms of product sales, the company’s sales are fairly straightforwardly structured, with the company’s main drug being Keytruda.
(Source: Merck 10-K Report)
It hardly needs mentioning that the company is one in a highly competitive market with a strong set of competitors both outside and inside of its home geography. In addition, like all pharma companies, the company faces risks from legislation, healthcare costs, mediation costs, and other factors. It’s not an easy environment to exist in, nor to compete in, regardless of how good a company is in terms of historical results and trends.
A large part of the trends for any pharma company is the expiration of its patents. For the company’s most significant product, Keytruda, the patent expiration is no sooner than 2028 in the US, EU, and 2032-2033 in Japan. The first drug to suffer from expiration is Emend, which as of FY19 had already expired in the US, and expires 2020 in the EU and Japan. Januvia is next, expiring in 2022, which will bring some significant potential competition for the company’s next-largest product. After that, it’s 2 years to the next one, with other patents stretching from 2026-2033 (Source: Merck 10-K).
The company’s research pipeline is extremely well-filled and with candidates across the spectrum. Take a look.
(Source: Merck 10-K)
Merck has over 71,000 employees across the world, with 26,000 in the US and Puerto Rico. Around 30% of the company’s workforce is covered by collective bargaining agreements.
The company’s fundamentals are what I would consider ‘beyond solid, making Merck a class-1 company. A 42% LTM payout ratio for a 30+ year streak of dividends without any sort of reduction, and a 6% 5-year average DGR makes the dividend safe and appealing. The company has a 1.06X net debt to EBITDA ratio, making debt and capital likely a non-issue, especially with the company’s double-A rating (AA-) from the Standard & Poor’s. Merck recently achieved a $200B+ market capitalization, currently standing at $203B, making it one of the largest pharma companies in the entire world.
Let’s look at how this company has performed during COVID-19.
Merck – How has the company been doing?
To put it succinctly, investors need not worry about Merck even during the midst of one of the most significant pandemics in decades. 1Q20 came in at 13% YoY sales growth (before FX), and 12% pre-FX pharma sales growth, outshone only by 21% pre-FX Animal Health sales growth.
Despite 2Q20 not being as good, the company still managed a 9% non-GAAP EPS growth due to extensive financial discipline and savings. Highlights during the recent quarter/half-year included:
- 7 FDA approvals in the company’s oncology portfolio, 4 for Keytruda, 2 for Lynparza, and 1 for Koselugo.
- Approvals outside oncology continue as well, with Gardasil granted accelerated approval by the FDA for HPV-related cancers. In short, the company’s excellent tradition of approvals continues.
- 4% half-year YoY revenue growth, with 12% half-year YoY growth in Animal Health.
- Excellent growth for Oncology, with 31% year-over-year Keytruda sales, despite slight COVID-19 decline.
- Growth from Lynparza and Lenvima, 62%, and 57% YoY respectively.
Some areas were of course somewhat impacted. Vaccines are one of them.
(Source: Merck 2Q20 Presentation)
The same was, unfortunately, true for the company’s hospital segment, with 18% YoY Bridion sales due to delayed procedures. Natural, as things can be considered due to COVID-19. However, these headwinds should be considered only temporary given the relative strength of the company’s approvals, with RECARBRIO, HABP, and VAPB approvals, and as soon as COVID-19 fades, we should see an uptick in this segment again.
Animal Health delivered solid numbers despite COVID-19, with even a 3% YoY sales increase during 2Q20, which more than absorbed the $100M COVID-19 headwind for the segment. Merck continues acquiring things here, with a recent M&A in Animal Health Intelligence.
As things stand, we can continue seeing a large-scale global decline in pharma sales…
(Source: Merck 2Q20 Presentation)
…but strong companies such as Merck will continue to grow due to sheer strength of their existing products, and continued solid pipeline as well as their historical track records. Far from being a one-trick pony, Merck has the fundamentals and potential to grow despite these headwinds.
(Source: Merck 2Q20 Presentation)
The company sees recovery trends during the end of 2Q20 and expects things continuing to normalize following the pandemic impact height in April of 2020. Hospital access is being improved, and the healthcare system is better positioned to provide care through the end of the year. The forecast for 3Q20 is a gradual recovery with a recovery to normal operating levels during 4Q20, setting us up for a quite positive FY21 if this should materialize.
Capital allocation continues to be one of the company’s main strengths, with almost $20B invested over 5 years, including extending its manufacturing capacity for its main areas – more than $10B of this has been invested in the US. The company’s main news is of course the spin-off, which by the way will take the name “Organon Co”, and this remains on track despite COVID-19 with plans for a 1H21 spinoff.
In short, the company has seen some moderate COVID-19 impact in some areas, but overall fundamentals and company plans remain very much intact going into 2021. In the end, I expect COVID-19 to be no more than a momentary blip on Merck’s radar when we look back on it in 10-20 years, and recent results confirm this.
This makes it relevant to look at current valuations for the company.
Merck – What is the valuation?
(Source: F.A.S.T Graphs)
There is, in fact, a lot of things to like about companies like Merck. The company provides predictable, slowly growing earnings, and has for over a decade and more. With an average EPS growth rate of 6%, expected to continue into 2021 and beyond, the company is currently trading at an average weighted earnings multiple of 14.3X. This is, of course, as things would state for a company like this, at least slightly undervalued, and the recent history confirms this if we put any credence in such numbers.
I’m torn between allowing for the company’s slight premium and not – but being conservative, I would prefer not to consider the premium valid, as this might color forecasts inaccurately. I would rather low-ball an estimate than excessively forecast it. The fact is, however, analysts simply do not fail to estimate company earnings with a 10% margin of error. Earnings don’t come in higher, and they don’t come in lower. FactSet analysts have a 100% hit rate, both on a 1-year and 2-year basis, making this company quite unique in this respect. I, therefore, consider the estimates to be extremely likely.
Even trading only at a 15X earnings multiple and considering current forecasts valid, an investment into the company here would bring nearly 12% annual returns, which is not only better than the overall market is expected to return over the next few years, it’s also within what I look for when I invest in dividend-paying companies.
Assuming that the company may trade higher brings this potential rate of return up to nearly 15% based on the company’s historical premium. The downside is very small. The company would have to trade near unheard-of low multiples for you to lose money in the long term. I don’t consider this a possibility with the company’s current trends – if you do, then this is probably not a suitable investment for you in the first place.
I’m willing to pay a 14-15X 3-year forward average EPS multiple for the company, based on current estimates and including 2020. This means that based on the average earnings of $6.31/share, I’d be willing to pay between $88-$94/share for the company, which would make it at least 9.51% undervalued, but with a potential for an undervaluation up to 17% based on the upper range of that estimate.
Street targets for the company from S&P Global are even higher. Based on 19 analyst estimates, the company has a price target range of $84-$107/share, with a current mean of $95.63/share, higher even than my most optimistic current price target estimate. This means that in my estimates, I’m even more conservative, and that’s a good place to be.
The one drawback to the company is the relatively limited 3% yield. It may be enough to scare some dividend-hungry investors off – but I say to you, consider the company’s overall safeties prior to a high dividend here. What you get is one of the most conservative, AA-rated pharma companies – in fact, one of the oldest if not the oldest pharma company in the entire world.
When considering this, then the price becomes a good one, as I see it.
Merck – Bulls & Bears
The bullish case for Merck is one that I view as fairly straightforward, as it’s based on a continued overall outperformance to the norm from a company that, on a historical basis, has done just that.
Merck has a solid history of meeting its forecasts and estimates, and over the past 100 years, has a tendency to outperform even peers. It has a history of responsible and effective allocation of capital, seeing the company’s AA-rating from S&P.
The company’s planned spin-off comes with a couple of notes – in that the company will lose around 10-15% of its annual EPS, which would mean that the company’s EPS payout ratio risks rising above its stated target of 50%. Even in the bearish case that the company’s payout does rise to near its limit, all that would happen is likely a somewhat slower rate of dividend growth. On the other hand, investors in Merck can of course expect incremental new income from the spin-off in the shape of a potential dividend.
So, the bullish case, in my view, stands even in the face of the spin-off, making Merck one of the most desirable, if not most undervalued investments in the healthcare/pharma sector today.
Bears would take a slightly different tact here. First, the spin-off doesn’t exactly contain the diamonds in the tiara. More accurately, bears would consider the assets that are being spun off as even “undesirable” in some respects, with expectations for the new company’s revenue being either flat or negative due to instant loss of exclusivities for Zetia and a Women’s health product, which actually are substantial parts of the Newco’s revenue.
Bears would point that this sets the stage for investors actually being somewhat disappointed by the Newco spinoff, at least initially. They would also argue that it’s impossible to forecast whether later trends would improve given that most of the new company’s revenue comes from legacy brands. Add to this the fact that the new company’s lauded women’s health actually only account for 30% of revenues, which is a problem given that’s what’s being pushed to the foreground.
If you read deeper, you’ll also find that Merck will want an $8-$9B tax-free dividend from NewCo, meaning that NewCo will go into existence with, if not instant massive debt, quickly growing debt while at the same time not exactly having blockbuster drugs. Expectations are for the new company to have debt 3-4 times as large as Merck from the get-go, which instantly weakens its supposed dividend safety and payout ability.
Bears have a point here. With all said and done, Merck relies heavily on Keytruda as an earnings and growth driver, and Merck isn’t – according to bears – that far from being as reliant on Keytruda as AbbVie (ABBV) is on Humira. This gives the company a ticking clock until 2028, at which point Merck needs to have a new blockbuster drug ready to continue growth.
Bears would, as a result of all of this, be somewhat more cautious than bulls are being.
I lean more towards the bullish thesis, giving capable management the possibility to showcase their skills and acumen going forward. Even in the negative case, Merck has excellent safeties and fundamentals, and these will only shift somewhat as a result of this spin-off. In its current position, the pharma company is undervalued somewhat and even the most conservative estimates show potential for a market-beating rate of return.
The pharma/healthcare segment is rife with investment opportunities. Pharmacies trade very undervalued – the same is true for many healthcare companies of quality. Merck has the distinction of being fundamentally better than either pharmacies, having a diversified list of assets and a good pipeline, while also offering more yield than companies like Bristol Myers Squibb (BMY) (although not by much).
I own only a few healthcare/pharma holdings, but Merck is one of them for the reasons made in this article. I expect to grow my current holding to a solid stake of 1-1.25% of my portfolio, at which point I will enjoy considerable, growing annual dividends from what I view to be one of the best pharma companies on the market.
That, and its undervaluation, makes the company a “BUY” here.
Thank you for reading.
Due to an undervaluation of 9-17%, I view Merck as an excellent “BUY” at a price of below $94/share.
Disclosure: I am/we are long ABBV, MRK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.
I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.