Merck Insiders Are Selling, Should You?

| About: Merck & (MRK)

Summary

Merck insiders have been selling.

It doesn't mean that you should.

Merck is not necessarily a buy, but long-term upside outweighs the downside.

Insiders are selling shares of Merck (NYSE:MRK). During the last few days, CEO Kenneth Frazier sold 60,000 shares at a price of $58 and officer Graddick Weir Mirian liquidated 45,000 shares. During the last six months insiders have a net short position worth 26% of the float. Insiders sell for a number of reasons, and it doesn't always mean that they think the price will go down. But it is worrying that these sales have occurred at prices either at or below the current market price. The consensus among analysts is that Merck is more or less fairly valued. Yahoo Finance reports an average price target of $61.45. While the recent selling could easily be interpreted as an ominous sign, we don't think current shareholders should cash out.

Merck, like all of its peers in the pharma sector faces a number of headwinds. The most obvious one is pricing pressures from governments and third-party payers around the world. In recent years legislators have cracked down on the price-gauging practices of patented drug manufacturers. But now they are looking to cut costs further due to budget pressures and the challenge of funding the health care costs of an ageing population with a diminishing tax base. In addition to the US, governments in Japan and the Eurozone are lowering reimbursements. Due to Japan's unsustainable fiscal balance (government debt is 230% of GDP), operators in Japan are subject to biennial price reductions. IMS Health, a healthcare services companies, estimates that drug spending by European governments declined at a 1-2% CAGR between 2012 and 2016. Budget balanced have worsened, and these pricing pressures will continue to be a headwind over the long-term.

Merck also still faces some legal risk related to Vioxx, an anti-inflammatory drug that the company discontinued in 2004. More than 60,000 claims have been filed, as scientists discovered that it caused heart attacks, stroke, and death. Vioxx is an extreme example but it serves as a reminder that lawsuits are a major risk when it comes to drug makers. And the damage extends beyond reputation. Due to the high R&D costs that are required to bring new drugs to market, product recalls and settlement payouts can lower margins significantly through negative operating leverage. Merck also still faces litigation risk for Fosomax, an osteoporosis drug that has been linked to a number of side effects. The ongoing threat of lawsuits means that these instances should not necessarily be dismissed as one-time items when they occur.

But these risks are nothing new, and investors have been aware of them for a long time. They don't offer a compelling enough reason to sell and we think the long-term upside for Merck outweighs the downside. MRK's "patent-cliff" is mostly in the rear view, so competition from cheaper generics should not be as intense during the next few years as it has been. A number of MRK's drugs lost patent protection in recent years, causing sales to decline for six consecutive years. But Bloomberg thinks that 2015 marked a low point, and that sales are on a path to recovery. One of MRK's key advantages it its expertise in drug development and strong financial resources for R&D, which allows it to maintain a strong pipeline and offset the negative impacts of patent expirations. As of January 2015, MRK had 6 compounds under regulatory review, 14 products in late stage Phase III trails, and 11 drugs in Phase II. We expect MRK to average sales growth of approximately 2% annually over the next ten years.

There are a number of reasons to be optimistic about MRK's future. The company has revamped its R&D strategy in two ways: first, it is spending more than it did in the past, and second, management is shifting the focus away from primary care toward specialty care, which should lead to productivity enhancements. Recent launches of Januvia, Insentress, and Gardasil have been blockbusters, and while competition has increased, their successes show the strong market potential in the segment. The immune-oncology market is a particularly exiting market. Merck has 20% share in this space, and its products have demonstrated strong efficacy. According to Morningstar, data from the American Society of Clinical Oncology "represents a paradigm shift in treatment options that significantly prolong patient lives in several cancers". A problem with MRK in the past is that it had trouble securing approval for many of its drugs in the primary care unit. Its cardiovascular drugs, in particular, struggled due to a combination of side effects or a lack of compelling efficacy. MRK is now deploying its resources more efficiently in specialty care, and we expect non-approval risk to be lower going forward than it has been in recent years.

Like all drug makers, MRK faces headwinds. However, investors should not interpret the insider selling as a sign that it's time to cash out. MRK offers an attractive dividend yield of 3%, and relative safety during uncertain times for investors. MRK has a wide moat thanks to patents, financial resources, technological expertise, and scale, which allows it generate sustainable economic profits and return cash to shareholders. We don't have any reason to change our outlook on MRK, and while it is not necessarily a "Buy" at these levels, we don't think owners should sell either.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.