This article was first published by Glenn Freeman in Livewire Markets on 31 October, 2022.
The likelihood of share buybacks and the prospect of inking its biggest deal in a decade next year are just some of the reasons Antipodes Partners’ Nick Cameron is so upbeat about this big pharma stock.
The Q3 earnings results for Merck & Co (NYSE: MRK), one of the world’s largest drugmakers, beat expectations across most measures. And yet the investor reaction to the result has been slightly underwhelming, says Cameron.
Merck’s shares closed up 1.35% on the day, beating its pharmaceutical company peers by one to two percentage points. But Cameron expected a sharper lift, referring to the small scale of the rise as one of the most surprising aspects of the latest earnings announcement.
“The market may be overlooking the strength of the operating income growth and margins, which are accelerating. That’s the emerging story that we think is being missed in the Merck shares now,” says Cameron, portfolio manager and healthcare sector lead.
Describing Merck as a “coiled spring…set to unleash after years of being a bit unloved” Cameron is upbeat in his expectations. Why? A potential acquisition in the offing, for one thing. Having had a sniff at buying cancer drug maker Seagen in August, negotiations were ultimately abandoned when the two sides couldn’t agree on a price.
“We wouldn’t rule out Merck having another look at acquiring Seagen. It would be a transformative story for Merck. If not Seagen, we think another deal is probably more imminent than people think,” says Cameron.
Headquartered in New Jersey, US since 1891 but founded in Germany by the eponymous Merck family in the 1600s, Merck & Co developed the world’s first smallpox vaccine in the late 18th century. More recently, the firm is known for its prescription medicines, vaccines, and animal health products. Its flagship product, Keytruda, is the world’s top-selling cancer drug. But as Cameron explains in the following Q&A, this same treatment also underpins one of the biggest threats on Merck’s horizon.
Merck (NYSE: MRK) Q3 Key Results
Note: The consensus figures mentioned below are Zacks Consensus Estimates.
- EPS of $1.85 a share versus a consensus estimate of $1.67
- Revenues of US$14.96 billion, up 14% year on year
- KEYTRUDA sales grew 20% to US$5.4 billion
- GARDASIL/GARDASIL 9 sales grew 15% to US$2.3 billion
- Management guided to raised full-year 2022 worldwide sales of US$58.5 billion-US$59 billion.
EDITED TRANSCRIPT
In one sentence, what was your key takeaway from the Merck result?
The very strong sales performance and perhaps a bit of market underappreciation for the underlying operating margin improvement and growth that’s going on at Merck.
What was the market’s reaction to the result? Was it an overreaction, an underreaction, or appropriate?
The market reaction was positive, with shares closing up 1.35%, which outperformed its pharmaceutical company peers by one to two percentage points on the day.
But we’d probably lean toward calling the reaction maybe a bit of an underreaction. And that’s because the market may be overlooking the strength and the underlying earnings or operating income growth and margins, which are accelerating.
That’s the emerging story that we think is being missed in the Merck shares now.
Looking deeper into the Q3 numbers, we note the company incurred a US$690 million additional R&D expense for collaboration and licensing activities. These are usually considered one-offs but weren’t treated as such in the accounts. This really overshadowed what we would call the true underlying operating margin expansion that’s accelerating at Merck.
The impact on earnings per share was also material, with about a 12-percentage point impact, which would’ve taken the EPS growth year on year into the teens. So, with the solid sales results from Keytruda, Bridion, and Gardasil all set to continue on their strong trajectory, absent these one-off costs, the true underlying margin expansion, and earnings growth story will become more apparent going forward.
Were there any major surprises in this result that you think investors should be aware of?
The key surprise was in the underlying operating margin and operating earnings growth improvement at Merck. Management has executed what they’ve said they’ll do in terms of simplifying the business. For example, they’ve spun off Organon, which was the women’s health business (in June 2021), which simplified the operations at Merck. And that’s starting to be reflected in the numbers. More important, though, is the solid sales trajectory of the key drugs.
After years of heavy investing and building the oncology business from scratch around Keytruda, a lot of that heavy lifting on SG&A (sales, growth, and administrative expenses – the costs of doing business) has matured. As has a lot of that work Merck has done to establish itself as a leader with Keytruda.
Outside of this, we also saw more consistency in management’s messaging around the urgency of business development and M&A to help offset the longer-term picture the market has been worried about – the fact that its key drug, Keytruda, will comprise around 40% of the company’s total sales by 2028. There’s real urgency there from management. For example, its recent activity with Acceleron Pharma (acquired in November 2021) has been very successful.
But in the same vein, I was surprised to see more emphatic messaging around the use of buybacks if the deals don’t materialise quickly. That shift in tone around the selective, opportunistic buying back of stock was much more noticeable this time around, which I think is very supportive of the share price.
Would you buy, hold, or sell Merck on the back of these results?
Given what we’ve said about the result being a bit underappreciated in the market, and the strong margin story and sales trajectories, we would be buyers off the back of these results.
We think they’re executing very well, particularly in this market, where defensive businesses with highly visible earnings growth should outperform.
We see Merck as a coiled spring now, given where margins are going, after years of underperformance and being a bit of an unloved story. The company’s ready to unleash and the broad market conditions are favourable to this kind of stock with these qualities.
What’s your outlook on Merck and its sector over FY23? Are there any risks to this company and its sector that investors should be aware of?
It’s very positive. Management has upgraded guidance all the way through this year, despite the continued worsening of foreign exchange headwinds. We don’t try to predict currency movements, but it does look like the US dollar is topping out and perhaps some of those headwinds are abating.
I think the operating performance we’ve spoken about above will continue in 2023. We see the sales trajectory continuing as it is and for earnings and margins to continue improving.
And I think the real story that everyone’s waiting for from Merck – more products in the pipeline from Acceleron and some of the other business development activity – will materialise further in 2023.
In terms of risks, the elephant in the room for some time has been Keytruda and what management is going to do in 2027 and 2028, when potentially 40% of their sales are at risk. But we think we’re going to see more drug pipeline-positive stories emerging.
And this might be a bit controversial, but we wouldn’t rule out Merck having another look at acquiring Seagen. This would be another deal along the lines of Acceleron, but bigger, which can offer a platform to delivery drugs for the next decade. It would be a transformative story for Merck, and we think this is probably more imminent than people think.
As for any biopharmaceutical company, there’s also always the risk of clinical trial failure. And litigation risk is another one that’s particularly fresh in investors’ minds given what’s happened to shares at GSK (NYSE: GSK), Sanofi (NYSE: SNY), and Pfizer (NASDAQ: PFE). (These companies and others were rocked by a class action lawsuit in August).
The other thing that could emerge is more regulatory guidance around how the US drug pricing reforms will be implemented. There are some ambiguities and potential loopholes, but I think Merck is probably one of the least affected by drug pricing legislation as it stands.
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