vzphotos/iStock Editorial via Getty Images In the past, I have not considered Merck ( MRK ) a valuable addition to my portfolio due to the company’s comparatively weak free cash flow and its over-reliance on Keytruda, especially in light of the drug price negotiation initiative (briefly covered in my overview from last year ). However, after reviewing the company’s 2021 financial statements, I finally got my head around the company and consequently opened a starting position. In this article, I want to briefly share why I have changed my opinion on Merck and why I consider the stock a compelling value pick at the current share price. The stock went nowhere since early 2019 and remains trapped in a trading window between the low $70s and the high $80s. Investors who are looking for rapid capital appreciation might consider the stock “dead money”. However, I’d argue that it is precisely these situations that prove rewarding over the long term, especially from a dividend growth investment perspective. Why I Finally Got My Head Around Merck
In the world of large pharmaceutical companies, Merck certainly qualifies as a major blue chip, with a current market capitalization of around $200 billion and an enterprise value of $227 billion. One of the main reasons that kept me from investing in Merck is the reliance on the checkpoint inhibitor Keytruda (pembrolizumab), which contributed 35% to total 2021 sales, with a strong emphasis on the U.S., where Merck earned $9.8 billion in sales with the cancer drug (i.e., 20% of total 2021 sales). However, when reviewing the performance of Merck’s current main contributors to sales, it can be learned that the company is actually fairly well diversified and continues to report stable sales from somewhat older drugs/vaccines and operates a well-performing animal health business (Figure 1). The shrinking but still very meaningful contribution from its Diabetes franchise (Januvia & Janumet) and the robust performance of its animal health segment and various vaccines (e.g., Gardasil and ProQuad/M-M-R II/Varivax) are certainly worth mentioning. Keytruda’s performance was very strong in 2021 with sales growth of 20% while Gardasil – Merck’s human papillomavirus vaccine – performed even better with sales growth of 44% YoY. Gardasil’s 2020 sales growth (5% YoY) suggests that 2021 sales certainly benefitted from pent-up demand due to the COVID-19 pandemic. Likely due to the pandemic-driven increase in pet ownership, Merck’s animal health segment performed exceptionally well with sales growth of 18% in 2021. At 11% of total 2021 sales, the segment has certainly become a significant contributor to Merck’s top-line. Figure 1: Sales contributions from selected drugs and vaccines; note that the sales denominator for 2021 does take into account the divestiture of Organon (own work, based on the company’s 2016 to 2021 10-Ks) Merck is certainly among the most profitable pharma companies with a current gross margin of almost 73% and an operating margin of 33%. Its return on invested capital is among the highest in the pharma space at currently 17%, on par with Amgen ( AMGN , 18%) and Eli Lilly ( LLY , 19%). From a historical perspective, Merck’s operating performance has certainly improved on most metrics (Figure 2). Nevertheless, the company’s capex-to-sales ratio of currently over 9% is certainly high for a pharma company and the comparatively weak free cash flow was another reason that made me favor companies such as AbbVie ( ABBV ) and Bristol Myers Squibb ( BMY ) in the past. However, I was probably too conservative in my estimate of free cash flow and was irritated by several multi-billion impairment charges related to intangible assets (e.g., $1.7 billion in 2020 and $3.9 billion in 2016). I realized that Merck was able to increase its dividend at a five-year CAGR of 7.4% and repurchase $23.4 billion worth of company stock since 2016, both without materially increasing its leverage ratio. Figure 2: Selected profitability-related metrics for Merck, as published on Seeking Alpha The bottom line is that Merck is certainly strongly reliant on Keytruda but this is understandably owed to the striking success of the drug, which is expected to receive authorizations for several further cancer-related indications in the near future. Also, the drug’s immunology-related properties should not be underestimated. In terms of the over-reliance on a single drug, I see Merck somewhat similar to AbbVie. The latter was overly reliant on its cash cow Humira (adalimumab) and as a consequence sought diversification through the acquisition of Allergan besides organic growth efforts (e.g., Skyrizi and Rinvoq). AbbVie […]
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