For those who scoff at the idea that stock markets are efficient, skepticism can be an investor's best friend. Recognizing good news (or potential) when you see it and buying in before it's commonly accepted can be a ticket to above-average performance, and that has been true for Merck (MRK) and its shareholders recently. While I've been positive on this giant Big Pharma for some time now, it seems like others on the Street have woken up to the value and potential here over the past couple of months.
Good Earnings Support One Leg Of The Thesis
Part of my optimism on Merck has been grounded in the belief that this company will outperform others like Pfizer (PFE), Novartis (NVS), and Bristol-Myers Squibb (BMY) over the next few years in earnings and cash flow growth. To that end, an above-expectation second quarter certainly doesn't hurt!
Revenue rose just 1% this quarter versus last year, but also 5% over the first quarter and a little more than analysts had expected. Growth was quite solid in the U.S. (up 11%), and pharmaceutical sales rose 2% on the strength of blockbuster diabetes drug Januvia (up 33%) and ongoing strength in late-cycle drugs Singulair (up 6%) and Zetia (up 7%).
Margins were more of a standout, as the company continues to reap some of the promised synergies from the Schering Plough deal. Gross margin improved about a half-point, while operating income rose 9% on good SG&A leverage. Please note that the operating income number is an adjusted figure.
Suddenly The Pipeline Is Looking More Promising
The second part of my bullishness on Merck was predicated on the idea that the company's pipeline was better than commonly thought. Here too it seems like the Street is making up for lost time and revaluing the company's potential revenue streams.
Perhaps the biggest positive incremental data point was the news that the odanacatib study was halted ahead of schedule because of strong efficacy. This is a controversial drug for two primary reasons. First, there are still questions about the drug's safety (always an issue in osteoporosis). Second, the drug will have to compete against generic Fosamax - an effective drug that will be significantly cheaper. Bears say that this drug might be relegated to 2nd3rd-line status, but I think the strong efficacy argues differently. If the company can capture 10% of the market, that could mean nearly $3 billion in revenue for a drug that many believe is more likely a $1 billion to $1.5 billion opportunity.
Investors also had to digest the disappointing clinical trial data for Roche's (RHHBY.PK) dalcetrapib - a drug that was among the most promising in Roche's pipeline. While this may call the efficacy of the whole CETP inhibitor class into question, the fact is that rival compounds from Merck and Lilly (LLY) were more effective than Roche's in early studies. If Merck succeeds where Roche failed (admittedly a riskier proposition now than before), this could be a multi-billion dollar blockbuster.
Last and not least are drugs like suvorexant, ridaforolimus, and tredaptive that all target large markets (insomnia, oncology, and heart disease, respectively), but come with caveats. Can suvorexant earn a differentiated label and stake out ground in a space dominated by cheap generics? Can ridaforolimus stand out in an increasingly crowded oncology market? Can tredapative show enough incremental efficacy to stand out from generic Niaspan?
The Bottom Line
At a minimum, Merck has less risk to its near-term earnings outlook than most companies. With just one upcoming patent expiration of note (Singulair), Merck's generic risk exposure is about half that of the average Big Pharma and substantially below that of Lilly and Bristol-Myers. On the flip side, there's plenty of risk to the long-term outlook, as Merck has a number of potential blockbusters in the making, but many of which have drawbacks or serious questions left to answer.
All of that said, I'm not pounding the table on these shares anymore. Merck has done nothing wrong, but the Street is catching up (the average sell side price target has moved up more than 10% over the last quarter). A stock that was almost 30% undervalued relative to my target of nearly $50 is only about 10% undervalued today. That's good enough to hold, but not a compelling enough discount to buy.
Disclosure: I am long RHHBY.PK.