Introduction – how a growing mega-cap becomes a relative value play
Merck (MRK) reported Q4 and full-year earnings recently, and guided for 2020. Q4 sales were marginally below consensus, and guidance was probably cautious. The stock has gotten hammered since then. My guess is that there are a few reasons for this, including:
- relative undervaluation of large stable drug names
- increased worries about MRK’s pipeline
- the spinoff.
I will discuss these points in order, with the third point the crux of the article. After these sections, I will comment on Q4 and the year ahead.
Large pharma/biotechs may simply be out of favor and thus undervalued
Rather than regurgitate P/Es, profit margins, political threats to drug prices, etc., I’d like to bring in an independent analytic house, Morningstar, and provide some info from a Feb. 12 commentary, 5 Cheap Stocks With Growing Dividends. The company discussed its criteria for dividend growth stocks and out of the 50 most heavily weighted stocks, only 5 were judged to be undervalued. The 5 were, with the ratio of the stock price to fair value shown:
- Chevron (CVX): 0.80
- Gilead Sciences (GILD): 0.82
- Merck (MRK): 0.83
- Pfizer (PFE): 0.83
- Wells Fargo (WFC): 0.85.
What is striking is that 3/5 of these names are large drug stocks. I wonder how many times that has happened before. Of these three names, both GILD and PFE are in some degree of turnarounds, with recent changes at the CEO level and with each new CEO pledging to improve performance. In contrast, MRK is sailing along with growing sales, cash flows, and EPS. Its growth has actually been mildly constrained by the need to construct additional manufacturing facilities for its blockbuster Gardasil vaccine.
It is a surprise to see three major drug companies in this grouping along with troubled WFC and an inherently-troubled oil major. It is especially strange to me to see a healthy MRK on this list.
Moving to the second bullet point:
MRK’s pipeline is “good enough”
Going back a few years, I considered MRK a neutral investment because Opdivo and other drugs such as Tecentriq were serious threats to Keytruda, and because the pipeline was weak. Now I think there is so much going on with new oncology indications with Keytruda as well as Lynparza and Lenvima that MRK’s Phase 3 program is solid. This is so even if vericiguat’s Phase 3 CHF data turns out to be insufficient to justify marketing the drug.
A look at the pipeline shows some interesting products in Phase 2. It’s still smallish, and the pipeline is an issue. However, MRK is spending appropriately on R&D, which in today’s world includes acquisitions such as last month’s deal for ArQule and its oncology portfolio.
When a company has a super-strong product line, as MRK does, with numerous other strengths ranging from diabetes to hospital products to vaccines, those strengths can more than make up for a sluggish stretch in the new chemical entity part of an integrated pharma company. In fact, Forest Labs became very successful with a game plan of purchasing Phase 2-type products, completing development, and marketing them superbly, with no or virtually no drug invention capabilities.
A current example of how a global major such as MRK can do well without inventing a product comes from Novo Nordisk (NVO) making a deal for MRK to market NVO’s diabetes products such as Rybelsus to primary care doctors in Japan. This was important enough for NVO to mention it in its recent conference call, but it’s too minor for MRK to have given it a shout-out.
Putting all the above points together, indeed MRK’s basic science capabilities may or may not be back on track, but its pipeline is active and promising, and it has numerous other strengths.
Now that gets us to the main event of this article, the spinoff plan.
MRK messes up its messaging, but the idea is good
I think it was a mistake to mix in a novel plan to spin off about 12% of sales next year with a Q4 and year-end conference call, especially when the quarter was just okay, but I like the plan. As MRK describes in accompanying the call, next year it will spin off a motley group of off-patent drugs, biosimilars and some women’s health products led by the implantable drug-device Nexplanon.
This will relieve MRK of perhaps half its products and, the company assures investors, lead to synergies in both companies. The spun-off company will have a certain amount of R&D capability and a sales run rate of $6 B plus next year. MRK will suffer a certain amount of EPS loss, the amount of which was discussed in some detail in response to a question from Umer Raffat.
Various objections to this plan have been raised, such as the fact that it makes Keytruda that much more central to MRK.
But aside from modest costs of the actual spin and of running two public companies rather than one, the upside is significant and the downside is almost non-existent.
Think of this Newco within MRK. Think of an executive committee meeting regularly. It gets reports on Keytruda, which is already a good-sized company (equivalent) in and of itself. Now think of the alliances that encompass the growing Lynparza/Lenvima franchises. That’s oncology, but the EC has to think of Arqule, which could have an oncology NDA filing sooner rather than later.
Then the committee has to deal with:
- Jardiance and other diabetes products
- Bridion and other hospital products, notably novel antibiotic launches
- HIV products
- animal health products
- general pipeline issues
- business development.
I’m tired just thinking of all these things. At some point, the old stuff, the me-too stuff such as biosimilars, and so on have no seat at the table, no champion. But management actually has to deal with them, like it or not.
But: spin them off to shareholders with a stock price, dividend-paying ability and an incentivized management, and good things are (much) more likely to happen. Products can be carefully shopped for sale, or conversely, the difficult job of finding complementary products to acquire or co-market can be done with some zest. Greater effort can be put into life-cycle management for Nexplanon; what about a smaller device that does the same job, or an improved product?
So, to me, these and other reasons mean that the first benefit to MRK shareholders is that about 1/8 of the company’s sales base can be optimized.
The second benefit is probably more speculative. If MRK insists that the “RemainCo” will function more smoothly, I see no reason to argue.
All in all, I like the strategy of the spin, and only quibble about mixing the message in with the earnings release.
Now for a few comments on the quarter and guidance for 2020.
Q4 was okay, guidance probably designed to allow beats
Sales in Q4 were up 7.9% versus Q4 2018, and were depressed by about 1 point due to a strong dollar. However, a special order for Gardasil in Q4 2018 meant that underlying sales growth was more like 10%. Keytruda sales were up from $2.15 B to $3.1 B and were $11.1 B for the year.
MRK’s total sales in 2019 were $46.8 B. Given the yoy rate of increase of Keytruda sales, I think that it alone may take MRK sales to the $50+ B sales mark this year if the rest of the company’s business were unchanged. Yet depending on how much extra production MRK can get out of its Gardasil franchise – and I expect some – it would appear to have enough growth drivers to make its guidance of $48.8-50.3 B quite conservative. If so, then its guidance for non-GAAP EPS of above $5.70 would similarly be conservative.
The most important takeaway for me is that again, MRK management insists that the Street is not optimistic enough about its ability to grow strongly for years to come. The CFO said in his prepared remarks:
And looking out to 2024, we believe our revenue growth potential is underappreciated, even more so as we begin to realize the benefits of this transaction.
Using MRK’s approximate $4.65 GAAP EPS projection for this year, at Thursday’s closing price of $81.97, it is trading below an 18X P/E. In contrast, the S&P 500 (SPY) is trading about 20X S&P’s presentation of consensus GAAP EPS for the index. So MRK is at greater than a 10% discount to the market despite its many strengths and growth drivers, and about a 3% highly secure dividend yield.
I am looking for upside to MRK’s guidance as the year progresses, and for angst about the spinoff to fade and possibly vanish.
MRK is not a 1-product company by any means, but with all the attention Keytruda generates, any shortfalls in its sales or prospects may have outsized effects on the stock. Many other risks exist, though none other stands out in my thinking as especially worth noting here. As always, please familiarize yourself with MRK’s recitation of risk factors to owning the stock in its regulatory filings, especially the 10-K which I expect to be released imminently.
As implied above, MRK has done an amazing job first with Keytruda, then with the deals that brought it half-shares (or so) of Lenvima and Lynparza. The company has several durable strengths, such as in vaccines, antibiotics, hospital products, HIV and other anti-viral therapies, and animal health. Its globe-girdling operations give it further resilience.
I think almost no stocks are outright cheap in today’s market, and the ones that are tend to be little players with limited liquidity that may languish unnoticed indefinitely.
Perhaps pharma is indeed cheap to the market, however.
I tend to agree with Morningstar that the best values for dividend growth are to be found in Big Pharma/Big Biotech. I consider fair value for MRK to be even higher than Morningstar, well above $100 in my view.
In May 2017, I wrote an article on Roche (OTCQX:RHHBY) (OTCQX:RHHBF), titled Morningstar: This Large Biotech Could Be The World’s Best Stock. Morningstar judged RHHBY’s ADRs, then around $34, to be about the most undervalued of any large cap it covered. The stock went nowhere but down for the next 13 months, but here it is at $43.68 and still only at a market multiple. Meanwhile, the annual and healthy, rising dividends have kept accruing, making the wait tolerable for the most part. Now it simply may be MRK’s turn in the undervalued category.
Pharmaceuticals have well-publicized price-affordability issues, just as in 2017, RHHBY was held back by its upcoming patent cliff. Yet as so often happens, that cliff was surmountable, and the stock is in all-time high territory and resisting market selloffs. Whatever is ailing MRK shares may similarly work itself out in the fullness of time. When this happens – and it is unpredictable – I mentally convert MRK into a bond equivalent from an asset inflation play and sleep well at night with my overweight position. Warren Buffett’s favorite holding period is forever, and that may be the right approach to MRK right now.
Thanks for reading and sharing any comments you wish to contribute.
Submitted Thursday after hours.
Disclosure: I am/we are long MRK, GILD, NVO, SPY. 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: Not investment advice. I am not an investment adviser.