Merck - Current Valuation Is Based On Future Pipeline, Amidst Poor Current Earnings Quality

Aug. 5.14 | About: Merck & (MRK)

Summary

Merck reported earnings last week which were largely in line with expectations.

This is as the company is in transformation: boosting its pipeline and cut costs to prepare for meaningful and continued growth.

Given the poor quality of current GAAP earnings, a lot of the valuation is tied to the potential of the pipeline.

Investors in Merck (MRK) hardly reacted to the company's second quarter results which were released last week and did not contain any big surprises. As typically is the case, Merck has many items impacting the GAAP and non-GAAP earnings picture.

I outline below why I think the current earnings are of low quality, being aided by incidentals, with true GAAP earnings profitability being limited at the moment. Therefore the current valuation relies heavily on the pipeline of the company which does indeed contain a few potential blockbusters.

That being said, I am not sure about the potential sales of these drugs candidates, making me reluctant to buy or initiate a position just on the promise of a good pipeline.

Second Quarter Highlights

Like many big pharmaceutical businesses, Merck is struggling to report revenue growth. The company posted second quarter sales of $10.93 billion, a fall of 0.7% compared to the year before. Analysts believed that sales could fall to levels as low as $10.6 billion.

Reported non-GAAP earnings fell by 1.5% to $2.49 billion as share repurchases allowed the company to report a penny increase in earnings to $0.85 per share. This was better than anticipated, with analysts looking for a decline in earnings to $0.81 per share.

GAAP earnings more than doubled to $2.00 billion as last year's results were very much impacted by one-time items. On a GAAP basis, earnings came in at $0.68 per share.

Looking Into The Performance

Merck still largely relies on its pharmaceutical business which makes up 83% of total revenues for the quarter. Given the announced sale of its consumer business this percentage is set to increase even further.

Overall pharmaceutical sales were down by 2% to $9.09 billion despite growth at its two largest drugs. Sales of the combination of JANUVIA and JANUMET, designed to lower blood sugar levels, have been up by 2% to $1.58 billion. At the same time combined sales of ZETIA and VYTORIN, used to lower LDL cholesterol, rose by 6% to $1.13 billion.

Despite the modest growth at its top selling drugs, and the modest increase in the sales of several other multi-billion dollar per year drugs, overall pharmaceutical sales were down. This was due to the decline of the ¨all other¨ sales, which fell by 15% to $1.21 billion. Other prominent declines were seen in the sales of NASONEX which fell by 20% to $258 million due to loss of market exclusivity. Sales of TEMODAR fell by 59% for the same reason.

The animal health business managed to post a 2% increase in sales to $872 million, despite currency headwinds shaving off a percent in reported revenues. Adjusting for the voluntarily stop of the sale of ZILMAX, which is a feed supplement for beef cattle, and sales would have been up by 9% on an annual basis.

Consumer Care sales rose by 19% to $583 million. This was due to the termination of certain Chinese distribution agreements which hurt sales last year. Adjusted for that the unit reported a 4% increase in sales. This is the unit which Merck has agreed to sell to its German counterpart Bayer in a $14 billion deal.

The quarter was again full of ¨one-time¨ charges creating the discrepancy between GAAP and non-GAAP earnings. Non-GAAP earnings excluded $1.76 billion in acquisition and divestiture related costs, as well as $421 million in restructuring costs. This was partially made up for by a $741 million gain related to the AstraZeneca (AZN) option exercise as well as certain tax benefits.

This makes the income statement quite messy. One thing I would like to highlight was the further reduction in research & development efforts, with non-GAAP expenses falling from $1.85 billion towards $1.62 billion.

Full Year Outlook

For the current year, Merck anticipates non-GAAP earnings to come in between $3.43 and $3.53 per share. Included in this guidance is the dilutive effect of $0.06-$0.09 per share related to the sale of the consumer care business to Bayer. Furthermore included is the dilution anticipated from the acquisition of Idenix.

Excluded are capital gains related to the sale of the consumer care business, which are estimated at $11 to $11.3 billion, as well as gains on the option exercise of AstraZeneca.

As such GAAP earnings are actually seen higher than adjusted non-GAAP earnings this year. Full year GAAP earnings are seen between $4.44 and $4.77 per share. This is as total revenues are anticipated to come in between $42.4 and $43.2 billion for the year.

Valuation

I did not see a consolidated balance sheet in Merck's press release or attached financial details report. The company did end the first quarter with $20.5 billion in cash and equivalents while operating with about $28.1 billion in total debt. This results in a net debt position of about $7.6 billion.

Trading at $57 per share, given that there are some 2.95 billion shares outstanding, the market values equity in the business at roughly $168 billion. Based on the guidance as discussed above, this values equity at 3.9 times annual sales and 16-17 times anticipated non-GAAP earnings.

The non-GAAP earnings guidance suggests that non-GAAP earnings are seen at little over $10 billion in actual dollar terms. While it excludes one-time items like gains on the option exercise and the sale of the consumer care unit, it also excludes recurring and very sizable restructuring as well as acquisition related costs. Combined these two items are seen at $6.2 to $6.8 billion for the year. This implies that the real current operational profitability is limited to just about $3-$4 billion.

History Of Acquired Growth, What About The Future?

Between 2004 and this year, Merck has roughly doubled its annual revenues. This is of course largely the result of the in 2009 announced $41 billion acquisition of Schering-Plough. Excluding this deal revenues would have hardly grown at all. As a matter of fact, total sales are still down by about 10% from their peak at $48 billion in 2011.

Notably net earnings have been volatile in recent years amidst ¨one-time¨ issues. Operating earnings have come in anywhere between $2 and $10 billion per annum over this time period. Worse, the outstanding share base has increased by about 30% since 2004, of course resulting from the large share component in the deal with Schering-Plough.

Final Takeaway

Merck likes to focus on the future and it has made a few big moves already this year. For starters is of course the $14.2 billion deal to sell the consumer care business, thereby shedding little over $2 billion in annual sales.

Yet it should be noted that Merck will pay its German counterpart Bayer (OTCPK:BAYRY), which is the buyer of the unit, a billion in clinical development collaboration payments. This effectively results in a reduction of the purchase price.

This sale could allow the company to completely reduce its net debt position, but a sizable part of these anticipated proceeds have already been used to acquire Idenix Pharmaceuticals (IDIX) in a $3.85 billion deal. This acquisition allows Merck to expand its portfolio of investigation therapies for hepatitis C.

The deal raised some eyebrows at the time as the deal involved a huge premium with shares of Idenix trading just around $7 in the days before the news of the acquisition was released. In the end Merck paid about $24.50 for the shares in the company which is simply a huge premium. This deal should provide some imagination about Merck's pipeline at a time when Gilead's Sciences (NASDAQ:GILD) Sovaldi is a big hit in the market for hepatitis C.

The company also announced that the US FDA and the European Medicine Agency have accepted the application for pembrolizumab (MK-3475), for the treatment of patients suffering from advanced melanoma. This drug is the major focus areas for the company, as it hopes to launch the drug in October. Besides treating melanoma, it hopes that the drug is also effective for cancer treatment in the lung and neck, among others.

As such CEO Frazier is happy with the progress being made in the transformation, focusing on the best opportunities available. He furthermore ruled out mega-deals and instead wants to focus on more nimble deals like the acquisition of Idenix. He also hopes to launch Suvorexant later this year or next year, a drug aimed at the treatment of insomnia.

Yet at the moment, Merck has a lot to prove in my eyes. As discussed before, I believe the current real GAAP earnings rate is just about $3-$4 billion per annum after subtracting very real and continued restructuring and deal-related costs. This ¨real¨ profitability is simply not a lot given the huge valuation being attached to the firm. As such higher hopes are placed on the pipeline of the firm which needs some real success to justify the valuation going forwards. The announced job restructuring plan last year, which involves 8,500 job cuts in anticipation to save a billion per annum, is not enough to move the needle significantly in my eyes.

While the 3% dividend yield is appealing, the current business can by far not support the current valuation and real future growth is required to support the share price going forwards. Not having great visibility on the anticipated peak sales of its leading drugs candidates I remain cautious and stay on the sidelines.

Disclosure: The author is long GILD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.