Merck: Analyzing 2016 Performance and Outlook for 2017
GuruFocus.com
- By Ben Reynolds
Written by Bob Ciura
On Feb. 2, Merck (MRK) reported fourth-quarter results that met analyst forecasts on earnings, but missed on revenue. However, the miss was only by a slight amount.
All things considered, the company performed well. Over the past year, Merck has dealt with the strong U.S. dollar, a number of difficult patent expirations and regulatory scrutiny over drug pricing.
The health care sector is filled with strong dividend stocks. Many of Merck's peers, including Johnson & Johnson (JNJ) and Abbott Laboratories (ABT), are Dividend Achievers, a group of companies with 10-plus consecutive years of dividend increases.
Merck is not yet a Dividend Achiever, as it held its dividend steady from 2004 to 2011. But the good news is the company resumed dividend growth in 2011.
It increased its dividend again in 2016, and with a few more years of dividend increases, Merck will join the Dividend Achievers list.
Financial results overview
Merck is a global pharmaceutical company. It operates in the following segments:
Pharmaceuticals (88% of sales).
Animal Health (9% of sales).
Other Revenue (3% of sales).
The pharmaceutical business is by far Merck's most important segment. Within pharmaceuticals, the company's products treat a number of therapeutic areas, including cardiovascular, diabetes, women's health, oncology, vaccines and more.
The pharmaceutical business generated 1% revenue growth in 2016, led by oncology drug Keytruda. Revenue from Keytruda soared 148% in 2016.
Revenue from the drug soared last year, and Keytruda is now a $1.4 billion drug by annual revenue. Keytruda is the foundation of Merck's oncology strategy.
MRK Oncology
Source: Investor Update Presentation, page 4
Overall, fourth-quarter revenue declined 0.9% to $10.12 billion. This slightly missed analyst expectations, but only by about $100 million.
Meanwhile, adjusted EPS fell 4.3% to 89 cents per share, which was in-line with analyst estimates.
Other revenue drivers for Merck in the fourth quarter were Januvia, which grew 1.2% for the period. In addition, revenue from Janumet and Gardasil increased 9.7% and 9.1%. Lastly, the animal health business grew revenue by 6%.
Growth from these areas offset declines in other areas. For example, revenue from Zetia and Isentress declined 11.4% and 9.9%.
Plus, Merck incurred about $887 million in revenue decline due to the loss of patent exclusivity on Nasonex and Cubicin in the U.S.
For the year, worldwide sales increased 1% to $39.8 billion. Excluding foreign exchange, organic sales increased 3% in 2016.
Full-year adjusted EPS, including one-time costs such as acquisition and restructuring expenses, rose 5.3% to $3.78.
Growth prospects
Going forward, the biggest concern for Merck is continued patent losses. In April 2017, Merck will lose U.S. patent exclusivity for Vytorin, which generated $473 million in sales last year.
As a result, Merck's pipeline is instrumental for the company to continue growing.
Keytruda is arguably Merck's most important near-term growth catalyst. In addition to currently treating non-small cell lung cancer, Merck hopes to get Keytruda approved for usage in multiple types of cancer.
MRK Keytruda
Source: Investor Update Presentation, page 7
Merck reached some important milestones for Keytruda in the fourth quarter. The FDA approved priority review for three supplemental license applications for Keytruda, which could help Merck monetize the product more effectively.
Merck's long-term growth will be the result of its pharmaceutical pipeline. Fortunately, the condition of the pipeline is strong.
Merck has 15 programs in Phase II and another 19 programs in Phase III. These products cover a wide range of applications.
MRK Pipeline
Source: Investor Relations
Aside from oncology, Alzheimer's is a separate therapeutic area that Merck is targeting with a long-term focus. The company is in the beginning stages of developing Alzheimer's drugs, but has made meaningful progress so far.
Merck is working on a BACE inhibitor, called Verubecestat (MK-8931), which works to block the rapid progress of the disease.
Merck has a three-pronged strategy for developing Alzheimer's drugs. The company is specifically hoping its medications will control neuropsychiatric signs and symptoms, slowing or halting progress of the disease, and finally improving function among patients.
Alzheimer's could be a compelling growth catalyst for Merck over the long term.
For 2017, Merck expects adjusted EPS to be in a range of $3.72 to $3.87. At the midpoint, guidance calls for 2% earnings growth.
Competitive advantages and recession performance
Merck's robust pipeline is the result of significant research and development investment over the past several years.
A successful R&D program is what separates major pharmaceutical companies from competitive threats. As Big Pharma faces patent expirations and generic competition, it is critical to continue innovating new therapies, which is done through R&D.
A breakdown of Merck's R&D investment over the past few years is as follows:
2014 R&D expense of $7.2 billion.
2015 R&D expense of $6.7 billion.
2016 R&D expense of $7.2 billion.
The benefit of all this spending is that successful product launches provide major pharmaceutical companies like Merck with a steady stream of profits.
This is true even when the economy takes a downturn. Consumers often cannot do without their medications.
Merck's stability allowed the company to remain solidly profitable, even when the Great Recession hit:
2007 EPS of $1.49.
2008 EPS of $3.64.
2009 EPS of $3.25.
Consistent profits helped Merck keep its dividend stable, even during the depths of the financial crisis. And, it allowed the company to resume dividend growth shortly after the recession ended.
Valuation and expected returns
Merck stock trades for a PE ratio of 17, based on 2016 adjusted EPS. This is a fairly modest valuation. The S&P 500 Index trades for a PE ratio of 26.
As a result, Merck stock appears to be undervalued, compared with the broader stock market index.
In addition to expansion of the price-to-earnings ratio, investor returns will be comprised of earnings growth and dividends. A summary of future returns could be as follows:
3% to 5% organic revenue growth.
1% margin expansion.
1% share repurchases.
3% dividend yield.
Under this scenario, future returns would reach 8% to 10% per year, not including expansion of the valuation multiple. Therefore, it is not unreasonable to predict double-digit annual returns for Merck going forward.
Final thoughts
Overall, Merck performed well in 2016. The company is growing sales and earnings, even in a difficult environment. And, Merck's investments in R&D are clearing the way for future growth.
The stock valuation is modest. Merck's growth allowed the company to return to dividend growth. The company recently raised its dividend by 2.2%.
Merck is an attractive stock because it offers a combination of value, growth and income.
Disclosure: I am long ABT.
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