Merck & Co.: Attractive Valuation With Margin Stability In Focus
Summary
- This article focuses on the margin stability of Merck & Co.
- Its marginal efficiency of capital, a key indicator for its future profitability, has been under some pressure.
- However, its recent OGN spinoff and Acceleron acquisition are expected to improve return on capital.
- Combined with the attractive valuation, I am bullish and expect an annual total return in the double-digit range for the next few years.
Marko Georgiev/Getty Images News
The investment thesis
This article focuses on the margin stability of Merck & Co. (NYSE:MRK). More specifically, you will see that its marginal return on capital employed ("MROCE") has been under pressure in recent years. To me, return on capital employed ("ROCE") and MROCE are the most two important metrics for analyzing a business. They reveal the two most fundamental aspects of the same central issue of profit Sustainability. ROCE tells us how profitable the business has been or is SO FAR, and MROCE sheds insights into which direction the profitability is likely to go.
MRK has been earning a very healthy and consistent ROCE in the past with an average of about 31%. However, its MROCE in recent years has been lower, putting pressure on its profitability. Potential investors should closely monitor the direction of the MROCE. For me, I am optimistic about the strategic moves it undertook recently. Its recent OGN spinoff and Acceleron acquisition are expected to improve return on capital and improve margin. Combined with the attractive valuation, I am bullish and expected an annual total return in the double-digit range for the next a few years.
Pipeline and Acceleron acquisition
A bit of general background for my approach to evaluating pharmaceutical companies. When I evaluate pharmaceutical companies, I do not invest because I have high confidence in certain drugs that they are developing the pipeline. In other words, I do not bet on a few particular ideas. Instead, I feel more comfortable betting on the process. I've studied many high stake R&D cases in detail and have been involved firsthand in quite a few of them myself. There are a few key lessons that I've learned. First, the success or failure of a given project is largely a matter of chance and luck - no matter how much resources we throw at it and how high a priority management has assigned to it. Second, the successful cases are only made to appear as a planned success - AFTER they become successful.
An illustrating example here involves Pfizer's Viagra, a huge blockbuster drug. But did you know that Pfizer's original goal in that project was to develop a drug to treat cardiovascular problems? It certainly was not a successful project as a cardiovascular drug for many reasons. However, a negative and unintended side effect, accidentally discovered by a nurse, made the drug into the success as we know it today.
So instead, I focus more on the process with the understanding that if the process itself is sound and efficient, sooner or later a good idea will be developed into a successful project as long as there are plenty of ideas to be tried.
As seen from the next chart, MRK maintains a large and healthy pipeline and plenty of good ideas. This large pipeline consists of a large number of drugs. These drugs target potential foundational early-stage disease programs across many tumor types. Furthermore, the recent Acceleron acquisition adds strong external science and potential long-term growth driver in sotatercept. In particular, sotatercept is highly complementary to and strengthens MRK's existing cardiovascular portfolio and pipeline, ranging from heart failure, to pulmonary hypertension, to anti-thrombotic, and to atherosclerosis.
Source: MRK earnings release
Return on capital employed ("ROCE")
ROCE stands for the return on capital employed. ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how effectively the business uses its capital to earn a profit. As aforementioned, many of the drug development projects won't be successful. So instead of betting on some particular ideas, the process matters more for me. ROCE provides a good measure of the effectiveness of the process. If the business does not have an effective process, it will be reflected in a high requirement of the working capital to conduct its daily business, a low utilization rate of its properties and equipment, and/or wasted R&D money.
Based on the above considerations, the ROCE of MRK over the past decade is shown below. Details have been provided in my earlier article and the method is summarized here briefly to facilitate the discussion. In these results, I consider the following items capital actually employed 1) Working capital, including payables, receivables, inventory, 2) ross Property, Plant, and Equipment, and 3) either capitalized Research and development expenses OR amortized intangible book value. As seen, both approaches provided similar results, a good sign of the assumptions. MRK was able to maintain a respectably high and very stable ROCE over the long term: on average 31% for the past decade.
Source: author and Seeking Alpha.
Marginal return on capital employed ("MROCE")
In addition to ROCE, an equally important concept is the marginal return on capital employed ("MROCE"). ROCE tells us how profitable the business has been or is SO FAR. And MROCE sheds insights into which direction the profitability is likely to go.
Detailed background information of MROCE can be found in my earlier article here. And a brief summary is provided here to facilitate this discussion. What the concept captures is a basic law in economic activities: the law of diminishing returns. As illustrated in the next chart, a business will first invest its money at projects with the highest possible rate of return. Therefore, the first batch of available resources is invested at a high rate of return - the highest the business can possibly identify. The second batch of money will have to be invested at a somewhat lower rate of return since the best ideas have been taken by the first batch of resources already, and so on. And finally, the end result is a declining MROCE curve as shown.
Source: author
MRK's MROCE pressure
For investors, a dream business to invest in would be a business that enjoys a flat MROCE curve as shown by the solid blue line. However, there has been no business that can keep growing while at the same time maintaining a constant return on capital. At some point, gravity always catches up and the return begins to decline (as shown by the dashed blue line).
So for investors, the next best deal is to invest in a business that A) has a high and stable ROCE (which MRK enjoys), and B) that is still in the scalable stage (the gravity of diminishing return has not caught up yet). And as shown in the next chart, at its current stage, MRK seems to be under the pressure of diminishing returns.
This chart shows the MROCE and ROCE for MRK over recent years. The ROCE data are the same as those shown in the previous section. The MROCE data are estimated by the following steps. First, the capital employed was calculated for each year. Second, the earnings were calculated each year. Third, then the incremental of capital employed year over year was calculated. Similarly, the incremental earnings year over year were also calculated. And finally, the ratio between the incremental earnings and incremental capital employed was calculated to approximate the MROCE. During years when there were large fluctuations in either the incremental earnings or the capital employed, a multi-year running average was taken to smooth the fluctuations.
The results shown in the following chart show that at this stage, MRK has been actually able to maintain an MROCE that is above the average ROCE so far. As seen, the ROCE has been on average 31% in recent years as aforementioned, and the MROCE has been on average 22%. So this result shows that MRK has been under margin pressure in recent years. And if the current MROCE continues, the average ROCE will keep declining and eventually converges to 22%.
Source: author and Seeking Alpha data.
Expected return
The market is obviously concerned about the margin pressure too, as reflected in MRK's currently depressed valuation.
To evaluate the valuation, what I always like to do is a reality check as shown in the chart below. It is essentially a back of envelop calculation to estimate what is the growth rate and valuation required to deliver a target ROI in the next a few years, say 5 years. Dividends are not reinvested. And see if such growth rate and valuation can pass a common-sense test.
As an example to provide a tutorial to read this chart, if we require a 10% annual ROI, represented by the red line (10% annual return translates to 60% total return in 5 years because 1.1^5=160%), the growth rate will have to be only about 6.5% (the dividends make up the remaining ~3.5%) if the PE ratio does not change from its current level - something we all know already. And if the PE contracts, say to 10.8x as shown by the green line, the growth rate would have to be higher (about 11%) to deliver the required 10% ROI.
With the above background, we can see that the current valuation easily passes the reality check. The stock has been valued for an average of 15x PE in the past. The consensus forecast of earnings growth for the 5 years is about 9% CAGR. Even if the growth rate is below the consensus, say only in the range of 5% to 7.5%, a handsome return can still be expected as shown.
In particular, the purple box symbolizes my conservative projections of returns for the next 5 years. For the valuation, I expect the PE to be about 15x (historical average). The expected return would be about 13.5% in the next 5 years as shown.
Even if PE further contracts to 10.8x - the lowest level during the 2020 COVID crash, the expected return would be 4.9% as shown. We still won't lose money.
Source: author
Risks
There are risks involved with the investment in MRK as detailed below.
- The COVID-19 pill molnupiravir. Management expressed optimistic estimates of the pill, expecting between $5 billion to $7 billion in sales through 2022. However, a final analysis of the full data set showed that its efficacy was not as potent as initially expected. This, coupled with the release of Pfizer's seemingly superior rival pill Paxlovid, could dampen molnupiravir's potential contribution.
- FX impact. As a global business, MRK is subject to FX fluctuations. Management's 2022 earnings estimate has been raised to $5.70 a share from $5.57 release earlier (Non-GAAP EPS). These estimates are all based on favorable FX impact (ranging from 1.5% to 2%).
- Macroeconomics. The biggest risk as I can see is the pace and degree of the post-COVID economy recovery. MRK itself assumed ~3% negative impact due to COVID-19, particularly during the first half of 2021. Although the vaccination is progressing extensively and the economy is re-opening at a steady pace. However, the pandemic is far from over yet and uncertainties like the delta and omicron variants still exist and the impact can be larger than MRK expected.
Conclusion and final thought
This article examined MRK's marginal efficiency of capital to gauge the future direction of its profitability. ROCE tells us how profitable the business is/has been SO FAR. And MROCE sheds insights into which direction the profitability is likely to go. In particular,
- MRK has been maintaining a healthy and consistent ROCE, a hallmark of a business with a stable moat. Its ROCE has been on average 31% in recent years. However, its MROCE has been on average 22% only, noticeably lower than the average ROCE. At its current stage, MRK is under the pressure of diminishing returns.
- The market is concerned about the margin pressure too, as reflected in MRK's currently depressed valuation. The stock is currently valued at 13.4x FW PE, compared to an average of 15x PE in the past.
- I expected its recent OGN spinoff and Acceleron acquisition to improve return on capital. Combined with the attractive valuation, I am bullish and expected an annual total return in the double-digit range for the next a few years. Even if the growth rate is below the consensus (say 7.5%) and valuation reverts to a historical of 15x PE with an improving margin, the expected return would be about 13.5% per annum.
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This article was written by
** Disclosure: I am associated with Sensor Unlimited.
** Master of Science, 2004, Stanford University, Stanford, CA
Department of Management Science and Engineering, with concentration in quantitative investment
** PhD, 2006, Stanford University, Stanford, CA
Department of Mechanical Engineering, with concentration in advanced and renewable energy solutions
** 15 years of investment management experiences
Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.
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Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of MRK either through stock ownership, options, or other derivatives. 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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Comments (20)
No. ROCE is the profit earned on the capital ACTUALLY employed, and it is not same as ROC. Because not $ in the asset is actually employed. A good example is a business that sits on a large amount of idle cash. Even more details can be found in my earlier article.seekingalpha.com/...Q2. Is anyone of the following common profit margin metrics equivalent to MROCE? net profit margin, EBIT margin, EBITDA margin, et al. None. If you think of all those common margin metrics as speed, then MROCE would be equivalent to acceleration. MROCE measures the *rates at which profit margin changes*.
This is not a Biosimilar, so the patent cliff will be steep.
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