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Summary

  • Shares of Merck have risen some 17% already this year.
  • Cost-cutting is providing a boost to earnings, yet pipeline success is required to justify the current valuation.
  • Merck aims to steer away from mega-deals within the industry as it focuses on becoming a pure-play pharmaceutical business.

Investors in Merck (NYSE:MRK) are enthusiastic about the first-quarter results released by the pharmaceutical giant. While topline revenues fell, earnings were up, sparking enthusiasm among the investment community.

Despite this enthusiasm driven by cost-cutting efforts, Merck has to show real success in its pipeline to justify the recent run-up in its shares.

First-Quarter Headlines

Merck generated revenues of $10.26 billion in the first quarter, down by 3.2% on the year before. Merck stressed that revenue declines are to a large extent the result of unfavorable currency movements, which shaved off two percent of total revenues.

The company reported non-GAAP earnings of $2.60 billion, which was up by 0.6% compared to last year. Important to notice is the large discrepancy between GAAP and non-GAAP earnings, which is structurally large at Merck. The company took $1.13 billion in acquisition-related costs and another $326 million in restructuring costs.

As a result, GAAP earnings came in at $1.70 billion, up by 7.7% compared to last year. Share repurchases fueled earnings per share growth, with earnings increasing by five cents to $0.57 per share.

Mixed Picture In Pharma Sales

Total pharmaceutical sales fell by 5% to $8.45 billion. Note that Merck has a relative small animal health and consumer care business in comparison to some of its competitors. As a result, both of these businesses are essentially for sale at the moment, as the company lacks scale in these areas to succeed in the future.

Top-selling drug JANUVIA/JANUMET, which is used to lower blood sugar levels, reported 3% revenue growth to $1.33 billion, despite adverse currency moves. Further growth was seen at REMICADE, which treats inflammatory diseases, as revenues were up by 10% to $604 million on the back of a strong performance in Europe. Revenues from ISENTRESS were up by 8% to $390 million, as Europe and emerging markets saw increased demand for this HIV-1 infection treatment.

This growth was offset by a 5% decline in ZETIA/VYTORIN sales, which resulted in revenues coming in below the billion mark at $972 million. Notably weaker demand triggered the decline in revenues for Merck's #2 drug. Steeper revenue declines were recorded at NASONEX and SINGULAIR. Sales for these two smaller drugs sales fell by a fifth after these drugs lost market exclusivity.

Focus On Costs

Merck saw a bit of pressure on its gross margins, which contracted by 90 basis points to 62.0% of total revenues. This was more than offset by a strong cost focus. Non-GAAP marketing and administrative costs were down by 8.7% to $2.69 billion, while the research and development budget was lowered by 18.2% to $1.53 billion.

Pipeline Developments

To show topline growth, Merck desperately needs new products. One of Merck's most promising clinical product candidates is the MK-5172/MK-8742, which is an oral combination to treat hepatitis C. Drugs in this area are the hottest thing in town after the hugely successful introduction of Sovaldi by Gilead Sciences (NASDAQ:GILD).

MK-1439 is in Phase II development, being an investigative treatment for HIV. The Phase III clinical program regarding this treatment is targeted to begin in the latter half of this year.

MK-3475 is possibly the pipeline drug with the most potential, targeting cancer by using the body's immune system to attack the cancer in the skin and lung. Several clinical collaboration agreements to evaluate the potential have already been signed earlier this year.

The FDA has been busy approving several products of Merck during the quarter. GRASTEK and RAGWITEK have been approved as allergen extract immunotherapy tablets. The FDA furthermore accepted the resubmission of the new drug application of suvorexant.

Looking Ahead

For the year of 2014, Merck anticipates non-GAAP earnings between $3.35 and $3.53 per share. Given the significant discrepancy between GAAP and non-GAAP earnings, I tend to give more weight to the former metric. GAAP earnings are seen between $2.15 and $2.47 per share.

In comparison, Merck reported GAAP earnings of $4.4 billion, or $1.47 per share, for the year of 2013. Earnings growth is the result of cost-cutting after the company last year said it would cut 8,500 jobs in order to save $1 billion in costs. Some of these effects have already been seen in the first-quarter results.

Revenues are seen between $42.4 and $43.2 billion, which is down from the reported $44.0 billion for 2013. The fall in revenues comes on the back of patents expiration and divestitures.

Valuation

Unfortunately, Merck did not provide a balance sheet with its first-quarter results yet. The company ended its fourth quarter of last year with $17.5 billion in cash and equivalents, while holding $25.1 billion in debt. Note that cash holdings exclude $9.8 billion in long-term investments.

Trading around $58 per share, Merck is valued around $172 billion. This values Merck's equity at 4.0 times this year's expected revenues and roughly 25 times GAAP earnings. To lessen the pain for shareholders amidst lower revenues, Merck is currently paying a quarterly dividend of $0.44 per share for a 3.0% dividend yield.

On top of this, Merck repurchased $7.5 billion worth of stock over the past twelve months, returning even more cash to its investors.

Takeaway For Investors

In today's merger-mania environment in the wider pharmaceutical and biotechnological sector, Merck will probably participate in the consolidation of the industry in one way or another.

CEO Frazier commented by saying that Merck is not interested in mega-deals like Pfizer's (NYSE:PFE) attempt to buy AstraZeneca (NYSE:AZN) with a size of over a $100 billion, but rather wishes to focus on smaller deals.

With revenues eroding quicker than anticipated, Merck might have to step up, even as short-term profits are better than expected. Earlier, news reports surfaced that Merck is close to selling its consumer healthcare business for $14 billion to possibly German Bayer AG (OTCPK:BAYZF, OTCPK:BAYRY) or to Reckitt Benckiser (OTCPK:RBGPF).

Such a transformation into a focused pharmaceutical business will undoubtedly be applauded by shareholders. However, to continue to justify today's valuation and fund the dividends and share repurchases, earnings will have to increase substantially towards the $10 billion mark.

This requires major success in the upcoming pipeline on top of the cost-cutting efforts. As the stock has already jumped some 17% year-to-date, it might be better to stay a bit more cautious.

Source: Merck - Pipeline Success Is Required To Justify The Recent Momentum