I'm Buying Merck At 52-Week Lows

Summary

• It's rare to find high quality names like Merck trading at 52-week lows. Down double digits last week alone, I added to my position.
• I think the market has overreacted with regard to MRK's recent earnings and negative Keytruda news.
• I did quite well buying Bristol-Myers last year when Opdivo posted negative results and now I hope to do the same with Keytruda.

It’s funny how the stock market seems to move in cycles. This time last year I was adding heavily to my Bristol-Myers Squibb (BMY) on its Opdivo related weakness. Much of this weakness appeared to be related to fears that competitor Merck’s (NYSE:MRK) immuno-oncology drug, Keytruda, was winning important areas of the market, and therefore, the overall expectations for Opdivo across the broad spectrum of the oncology space were lowered. Well, Ironically, a year later, I find myself buying shares of Merck on weakness regarding its flagship drug, Keytruda, as the market now fears that it won’t quite live up to massive expectations.

I wasn’t very impressed with MRK’s recent earnings report; however, with the stock down 12.7% during the last four trading days, I couldn’t help but feel like I was witnessing an overreaction by the market. I typically like buying into these sorts of opportunities. In the past, I’ve done well buying high quality names into weakness like this. With that said, I have no way of knowing where MRK’s near-term bottom will lie. My recent purchase was at $55.41 and my next target to the downside is in the $50 area. I hope that I don’t end up making 5 purchases of MRK as I average down like I did last year with BMY; however, those BMY trades have paid off nicely now and I’m going to stick with my guns with regard to buying high quality names when I believe they’ve been irrationally discounted by the market.

One thing I like about Merck is that the company has proven itself to be a strong value creator for shareholders over the long term. I understand that looking through the rearview when you’re driving forward isn’t exactly the safest way to do things, but I think the assets and talent that Merck has collected over the years should certainly play a role in an investor’s due diligence when looking at the company.

With that said, MRK has struggled in recent years to grow its sales. Sales growth seems to be the name of the game in the big pharma/bio-pharma space. Gilead (GILD) is a great example of this. GILD has made it a habit to post impressive profitability results, but the share price rarely seems to react positive as the market focuses on lagging sales. Without sales growth, fear bubbles up in the market with regard to the long-term viability of these profits. MRK’s sales aren’t falling off the same cliff as GILD’s, but the company has posted annual revenue losses on four out of the last five years (and 2016, which was the one position year, only amounted to top-line growth of 0.8%). This is a concern, but as I said, when investing in the space, the market tends to focus much more on forward estimates, highly discounting sales/earnings from legacy products.

	2012	2013	2014	2015	2016
Revenue	$47,267	$44,033	$42,237	$39,498	$39,807
Growth %	-1.60%	-6.80%	-4.10%	-6.50%	0.80%

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Patent cliffs play a large roll in this mindset and it appears to me that MRK is sitting in a relatively strong position with regard to patent protection. Zetia/Vytorin goes off patent in the U.S. in 2017 and 2018 and 2019 in the EU, respectively. However, other than this, MRK has years of protection left of many of its top producers. Namely, top selling diabetes treatments, Januvia/Janumet, which goes off patent in the U.S. in 2022, multi-billion-dollar franchise Gardasil/Gardasil 9, which are both protected in the U.S. until 2028, and the much ballyhooed Keytruda, which also has protection in the U.S. until 2028.

In 2016, MRK had eight drugs that produced at least $1B in sales (and a ninth that nearly hit that mark with $915M) as well as its Animal Health segment that produced sales of nearly $3.5B. In the company’s most recent quarter, the company saw y/y sales fall on four of these $1B producers, including the company’s largest drug in terms of sales, Januvia/Janumet. I suspect that it won’t be long before the aforementioned powerhouse, Keytruda, takes over this top selling throne for MRK, though for the time being, it’s never a good thing to see falling sales from these older drugs that are likely producing nice margins for the company at this point in time.

Falling sales from certain drugs aside, I feel comfortable owning MRK because of its highly diversified portfolio of assets/upcoming pipeline. What’s more, MRK maintains a relatively strong balance sheet, giving company flexibility in terms of future R&D and M&A. M&A seems to be the name of the game these days in the big pharma/biopharma space. Merck isn’t considered to be a “one trick pony” that absolutely needs to protect its future revenue stream with purchased assets and/or pipelines; however, I like the fact that MRK could capitalize on attractive opportunity in the market should they have the desire to do so.

At the end of 2016, MRK had ~$26B in “total worldwide investments” including $14.3B in cash, cash equivalents, and short-term investments. This was compared to ~$24B in long-term debts. This debt level isn’t a great cause of concern for me because MRK has made a habit out of posting strong operational cash flows which have exceeded $10B annually four out of the last five years.

	2012	2013	2014	2015	2016
Operational Cash Flow	$10,022	$11,654	$7,860	$12,421	$10,376

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One thing that does concern me about MRK’s stock at the moment is the large discrepancy between GAAP and non-GAAP numbers when the company reports earnings. I’m not an accountant and I’m not going to sit here and attempt to justify the wide gap one way or the other. All I can say is that it bothers me personally, but it appears to be the trend in the industry, with other big pharma names, including PFE that announced earnings this morning, primarily using non-GAAP figures as well. I imagine creative accounting makes sense for these very large companies with so many moving parts involved; however, I still tend to worry when I see such large gaps between the GAAP/non-GAAP numbers when valuations seem to be based on the latter.

Typically, I like to rely on GAAP figures when doing my due diligence, though in MRK’s case, the company is only attractively valued in the present if an investor relies on management’s non-GAAP figures and guidance. Right now, the company’s 2017 GAAP EPS guidance is $1.78-$1.84 while the non-GAAP guidance comes in at $3.91-$3.97. Using the non-GAAP figure, we see that the stock is trading for ~14x this year’s earnings. That’s pretty good. However, using the GAAP figure, the company’s 2017 P/E multiple is more than 30x, which isn’t go good, especially considering the fact that MRK is guiding for low single-digit sales growth.

I like buying shares at established support levels, and as you can see on this F.A.S.T. Graph below, this 14x level has served as strong support for MRK stock during dips in both 2015 and 2016. I’m not really a chartist, but it’s pretty clear to me that since late 2013, MRK has traded in a pretty tight range between this 14x trough and a ~17x peak.

When buying shares here at the bottom on this range, assuming the support level holds and the average EPS growth estimates that the analysts on the Street have for the company hold true, I’m looking at a pretty solid annual rate of return. As you can see on this F.A.S.T. Graph, because of the stock’s hefty dividend, I’m looking at a ~9% annual ROR a few years down the road if the stock trades for 14x its projected 2020 earnings. This 2020 annual ROR rises to nearly 11% if the stock were to trade back up to the 15x P/E level, which is still below the midpoint of its recent trading range.

The final F.A.S.T. Graph I’ll show you here highlights my least favorite part about MRK as an investment: the dividend. Yes, shares are currently yielding 3.4%. This is a nice, high yield which helped to slightly increase the average yield of my portfolio. However, as you can see below, MRK doesn’t have a very consistent history with regard to dividend growth. Over the last 6 years, the company has given shareholders an annual dividend increase, but from 2005-2011, the company simply maintained its payment. Over the long term, MRK’s dividend has surely trended in the right direction. I hope to hold these shares for the long term, and I suspect that the dividend will be much higher in 10-20 years than it is today; however, I don’t think investors should expect the typical staircase pattern of annual increases that many DGI portfolio managers typically seek.

Now, these forward analyst EPS estimates that I’m basing my potential returns on are based, in large part, on Keytruda, and its ability to live up to expectations. Before I mentioned that several of MRK’s top sales producers posted y/y losses in Q3, but much of the stock’s recent sell-off appears to be based upon the fact that the company ended phase 3 trials for Keytruda as an initial, first line treatment in the lucrative lung cancer space in European markets.

Lung cancer is a ~$15B market and is expected to be the biggest driver of sales for Keytruda moving forward. Any negative news in this space will hurt the stock, just as similar negative news hurt BMY when Opdivo didn’t fare well in first-line NSCLC trials. Although Merck withdrew from the phase 3 trials, it’s worth noting that company isn’t admitting defeat in the lung cancer space. Keytruda is still currently involved in another trial involving a combination with chemotherapy. These results are expected in the coming years. It also appears that the company could resubmit an amended phase 3 study for Keytruda as a first-line treatment, though the current delay gives competitors, namely Bristol-Myers Squibb and Roche (OTCQX:RHHBY), the opportunity to swoop in and take market share that Merck seemed to be in the lead for.

At the end of the day, I’m happy with my purchase. It’s rare to find high quality names like this trading at 52-week lows. Like I said before, I think this sell-off is overdone and I plan on capitalizing on this irrationality. In general, I think several sell-offs in the healthcare space have gone too far. I already bought Celgene (CELG) on earnings related weakness and I think there is an argument to be made for buying GILD on recent weakness as well. Throughout the year in 2016, I ended up going overweight on healthcare as a sector as political tweets drove down prices within the sector. Throughout 2017, I’ve trimmed those positions, locking in profits/protecting gains as the sentiment turned. Well, it looks like the tide may be turning again here in healthcare, so I will keep followers up to date on any purchase I make in the space. I get nervous being overweight healthcare; I know some view it as a more defensive sector, but I don’t agree. Either way, I go where the opportunity lies and it’s starting to look like that might be large-cap bio-tech/bio-pharma.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long MRK, GILD, CELG, BMY. 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.