Merck Is Deleveraging Faster Than I Expected After An Excellent First Quarter

| About: Merck KGaA (MKGAY)

Summary

Merck performed really well in the first quarter, as it saw its revenue increase by approximately 20%.

A large part of this increase was caused by the consolidation of Sigma-Aldrich's financial results, but the organic growth rate was also almost 5%.

Merck generated strong free cash flows and has started to reduce its net debt position.

I think my previous estimate of a net debt/EBITDA ratio of 2.75 by the end of this year was too conservative.

Introduction

Earlier this year, I made a case for Merck (OTCPK:MKGAF) (OTCPK:MKGAY) after its acquisition of Sigma-Aldrich (NASDAQ:SIAL), as I expected the company's net debt to evaporate pretty quickly. I applauded the company's move to use debt to expand its business rather than paying special dividends or spending it on outsized share buybacks. It looks like my expectations were quite right, as Merck continued to generate a massive amount of free cash flow.

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The Merck I'm talking about is the German Merck and should not be confused with its American sister company Merck (NYSE:MRK). As it's a German company, you'll also be better off by trading in the company's shares through the facilities of the Xetra or the Frankfurt Stock Exchange where the combined daily volume is approximately 500,000 shares. The ticker symbol is MRK.

So, how was the first quarter?

For those who have read my initial article, I was quite positive on Merck after its acquisition of Sigma-Aldrich. Even though the net debt/EBITDA ratio reached an exorbitantly high level, I was very confident this ratio would be reduced pretty fast due to a lower net debt (as the cash flow would be used to reduce the net debt) and a higher EBITDA ratio, as 2016 would be the first year wherein the Sigma-Aldrich EBITDA would be consolidated with the Merck EBITDA.

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Source: company presentation

After the first quarter of this year, Merck has now confirmed the integration of SIAL is 'progressing quickly', and Sigma contributed in excess of half a billion Euro ($560M) to the total revenue of the company which increased to 3.7B EUR ($4.15B). Even though the majority of this revenue increase can be attributed to the SIAL acquisition, I think it's important to emphasize Merck's organic revenue growth was almost 5%, so even without Sigma, Merck would be much better off.

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Source: quarterly report

The Q1 revenue increased by 20% but the COGS increased at a faster rate. So even though the gross profit did increase by almost 15%, the gross margin fell slightly from 68% to 64.3%. That being said, the EBIT almost doubled resulting in a huge increase in the company's net profit to 591M EUR ($662M), or 1.36 EUR ($1.52) per share. That's great, but was Merck also able to convert this accounting profit into a positive free cash flow? There's only one way to find out, and fortunately, Merck has provided us with a detailed cash flow statement as well!

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Source: quarterly report

The operating cash flow was relatively low at 352M EUR, but you should keep in mind this also contained the changes in Merck's working capital position. If you'd correct the OpCF for these changes, the adjusted operating cash flow would be 597M EUR ($670M) which is pretty good. Also keep in mind the company has divested some assets, and this resulted in an additional cash inflow of almost $400M. Merck has correctly reported these cash flows as an investing cash flow instead of an operating cash flow (as some companies try to boost the OpCF result by including these one-timers).

After deducting the $193M in capital expenditures, the adjusted free cash flow in the first quarter was approximately $476M (or $1.9B on an annualized basis).

Does this mean the company remains on track to reduce its debt pile and debt ratio?

Yes. Merck has always had a conservative capital allocation strategy, and this allowed the company to be almost debt-free when it decided to pull the trigger on the SIAL acquisition. Merck is continuously doing this, and it repaid $560M of debt in the first quarter of this year. That's indeed a higher amount than the adjusted free cash flow (after paying the dividend to the private Merck company), but this shortfall was covered by the proceeds of Merck's decision to sell some of its investments (and the proceeds of the sale of some of its assets). The net debt fell by a total of approximately $650M (helped by a $125M currency exchange gain) to 12.1B EUR ($13.55B).

And what about the net debt/EBITDA ratio? I expected the net debt to decrease (check!), and the EBITDA to increase due to the fact Merck was now able to include an entire quarter of SIAL-EBITDA in its consolidated results. The EBITDA (before exceptional items) increased to 1.1B EUR ($1.27B), resulting in a pro-forma annualized EBITDA of approximately 4.4-4.5B EUR (and I would expect Merck to achieve the higher end of this range as it still needs to capture the benefits of implementing SIAL in its existing corporate structure.

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Source: company presentation

As the net debt fell to 12.1B EUR, the current pro-forma net debt/EBITDA ratio has fallen to 2.75. Will Merck meet my year-end target of less than 2.75? Yes, I do believe so. I would expect Merck to reduce its net debt by at least an additional 1.1B EUR this year, which would result in a year-end net debt of 11B EUR ($12.4B), reducing the ratio to at or slightly below 2.5. That's still relatively high (for a conservative investor like me), but it's definitely more acceptable, and it's pretty obvious the net debt position is decreasing extremely fast (as expected).

Investment thesis

Merck is definitely on the right track, and as expected, it has made a reduction of its net debt its number one priority (which I can only applaud, as Merck really needed to get that net debt/EBITDA ratio down). I'm still expecting Merck to generate a positive free cash flow of 2B EUR ($2.24B) further down the road, and this means the company should still be on track to reduce its net debt/EBITDA ratio to less than 2 by the end of next year, or Q2 2018 the latest.

Merck is one of those companies you should buy and forget about looking at it for a while. A smart management team which knows the best way to spend it is worth a lot in this environment, and I wouldn't want them to spend the cash on anything else but reducing the net debt.

Disclosure: I am/we are long MKGAF.

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.

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