Merck: Getting Stronger

Summary

• Merck has returned to growth driven by continued growth of Keytruda and currency tailwinds.
• While accelerating growth is very nice to see, GAAP earnings took another beating following another multi-billion R&D charge.
• A return to growth, very strong balance sheet, and reasonable earnings multiple make me continue to be upbeat on Merck and add to my position.

Merck's (NYSE:MRK) fortunes continue to be dominated by the rise of miracle drug Keytruda. Back in February, I concluded that the drug was doing just fine in this article, Merck: Keytruda Remains Key.

The good news for investors is that Keytruda seems to be outcompeting its competitor drug from Bristol-Myers (BMY), which is reassuring as continued success of Keytruda is needed to offset sales declines at the rest of the business. These declines have weighed a bit on the shares, and I have gradually been scooping up some at average levels just below $55 per share amidst a very reasonable valuation and real prospects for growth in 2018.

Keytruda - A Real Blockbuster To Come

Merck has a great history of developing drugs which have benefited societies over the past decades, in fact over much longer time frames as well. Good things come in waves and that appears to be the case for Merck as well. After a long period of stagnation (in recent decades), Merck appears to have a real blockbuster at hand again.

Shares traded at just $2 in the '80s, a level now equal to the annual dividend payout, as they jumped to $80 during the dotcom crisis, followed by a painful decade for Big Pharma. Shares lost about 75% of their value between 2000 and the financial crisis. The emergence of Keytruda and the deal with Schering-Plough in 2011 have however allowed for a return of fortunes as shares have risen to levels around $55 by now.

Keytruda - Let's Tackle Cancer

Keytruda is one of the most prominent drugs in the treatment of cancer as we of course all know the prevalence and impact of this disease. While there are many indications of cancer, the good news is that Keytruda seems to have a real effect in many forms of cancer such as head and neck, NSCLC, bladder, melanoma, and Hodgkin's lymphoma cancer.

These approvals are just the start as the company has many programs in testing stage, not to mention the hundreds of combos which it is working on together with other pharmaceutical and biotechnology companies.

Approval for Keytruda first rolled in late 2014, and the revenues from the drug quickly rose to $1.4 billion in 2016, before a real acceleration in growth was seen last year. First quarter sales for 2017 already approached $600 million, jumped to nearly $900 million in Q2, and surpassed the billion mark in the third quarter at $1.05 billion. Growth was very solid in the fourth quarter with sales coming in at $1.3 billion, for a 2017 sales number of $3.8 billion and a run rate of $5.2 billion.

Revenues continue to trend up nicely as first-quarter sales of Keytruda hit $1.46 billion and already running at a rate of close to $6 billion a year. A further continuation of growth makes a $8-9 billion run-rate attainable by the end of this year. Furthermore, operating momentum continues to be driven by positive research results on the drug which continue to roll in.

Finally, Growth

While the pick-up in sales of Keytruda was very noteworthy in 2017, the growth contribution was not strong enough to offset declines at other drugs and thereby hardly impacted overall sales results in 2017. That is about to change as Keytruda is growing larger quickly while the strong dollar has been helpful as well.

Total revenues were up by 6% in the first quarter to $10.0 billion, although half that growth is driven by currency moves. The 9% reported growth rate in the key $8.9 billion pharmaceutical business is entirely attributable to Keytruda, which is now the biggest drug, but still "only" makes up 16% of pharmaceutical sales. The drug has now surpassed the combination JANUVIA/JANUMET in terms of top selling drug as the overall combined performance of the other drugs was relatively flattish.

Animal health saw a solid quarter as well with revenues being up 13% to $1.07 billion, while other revenues collapsed from $310 million to $53 million. This number is a bit hard to read into as this classification includes revenue hedging activities as well, as the company obviously sees headwinds given the recent currency moves.

Growth Emerges, What About Earnings?

Following the strong start to the year and favourable currency moves, Merck is now seeing sales at $41.8-43.0 billion this year, up from a previous guidance of $41.2-42.7 billion. Included in this guidance is a 2% tailwind from currencies, a point more than the previous assumption, indicating that underlying sales are seen at roughly the same levels as three months ago.

This will boost earnings as well with non-GAAP earnings now seen at $4.16-4.28 per share, up from a previous guidance of $4.08-4.23 per share. Note that these are adjusted metrics as GAAP earnings are actually negatively revised, now seen at $2.45-2.57 per share, while previously at $2.97-3.12 per share. The roughly half a dollar cut in the guidance stems from the collaboration charge taken with Eisai (OTCPK:ESALY), resulting in a steep $1.4 billion R&D expense.

While it is nice to see modest growth in adjusted earnings, from the $3.98 per share reported last year, the problem is that the gap between GAAP and non-GAAP earnings remains both very large and very persistent. For 2018, GAAP earnings amount to just 60% of adjusted earnings, assuming no more "one-time" charges occurring later this year. This is due to Merck structurally taking large M&A-related charges, and even as recent as last year, it took a huge charge on the fallout from the cyber attack, among others.

Sound Balance Sheet

Merck ended 2017 with $20.6 billion in cash, equivalents, and related investments, as the first-quarter balance sheet has not been provided yet. Total debt stood at $24.4 billion for a very manageable net debt position of $3.8 billion, or a number just shy of $6 billion if pension-related liabilities are included. It goes without saying that this is a very modest amount for a company with the earnings power of Merck.

With adjusted earnings already surpassing $11 billion (as adjusted EBITDA is even larger of course), Merck is in a strong financial position. Keytruda continues to show decent growth, supporting overall growth of the company going forward. The real question is which earnings metric should be relied upon.

At $57, shares trade at just 13-14 times adjusted earnings, indicating that the market is not buying the adjusted earnings number as well, as this multiple is very low. Based on suggested GAAP earnings, the multiple comes in at levels in the low 20s, marking a huge difference of course. One way to tackle the valuation discrepancy is to look at sales.

The 2.7 billion shares of Merck value the company at $154 billion, or $160 billion including debt and pension liabilities, which works out to less than 4 times sales. This is actually a very modest multiple for a large pharmaceutical company, especially if growth prospects continue to improve amidst continuation of growth of Keytruda.

It should be said that much of the charges taken, such as the $1.40 billion charge associated with Eisai, as well as last year's $2.35 billion charge in relation to AstraZeneca (AZN), are really upfront costs to boost Keytruda. As a result neither the GAAP nor non-GAAP earnings number can be taken for granted.

Continue To Add

In all fairness, we are working with a $2.51 per share guidance based on the midpoint of the GAAP outlook for this year. It is fair to say that the Eisai charge is an investment, which is really an upfront payment and could be regarded as a good investment. If we add this charge back, GAAP earnings come in closer to $3 per share.

The remaining difference with non-GAAP earnings of roughly $1.20 per share relates largely to acquisition and amortisation related charges, and restructuring costs to a much smaller degree. If I assume that half these costs are somewhat structural, or value destructive, or involve cash outflows, realistic earnings might really come in at roughly $3.60 per share. Based on such an earnings assumption, shares trade at a multiple of 15-16 times.

This is not too demanding for a business which has returned to growth, has a strong financial footing, and great (Keytruda) pipeline. Hence I am a happy holder at these levels, cashing in decent dividend checks, and continue to look to expand the position.

Analyst’s Disclosure: I am/we are long MRK. 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.