Product Pipeline Successes. Merck has enjoyed a couple of notable successes in its product pipeline over the past year. The first and most important is Keytruda (pembrolizumab), the company’s anti-PD-1 (programmed death receptor-1) immunotherapy treatment for cancer. Keytruda has already been approved to treat melanoma and NSCLC (non-small cell lung cancer). It was awarded Breakthrough Therapy status by the FDA in the treatment of colorectal cancer in November 2015 and classical Hodgkin Lymphoma in April 2016. It is currently being tested in a wide range of solid and blood cancers, with 250 clinical trials covering 30 tumor types, including bladder, breast, esophageal, head & neck and gastric cancers. Merck is also testing the effect of Keytruda in combination with a variety of other cancer medicines. IMS Health predicts that the global market for oncology drugs will expand at a 13.7% annual clip to $147 billion in the three years ending 2018. GlobalData has forecasted that Keytruda will reach $7 billion in annual sales by 2024.
Keytruda’s primary competitor is Opdivo, which is produced by a partnership of Bristol-Myers Squibb and Ono Pharmaceuticals of Japan. Other anti PD-1 therapies are on the horizon. At this point, it is difficult to gauge the potential profitability of Keytruda. The Ono/BMS partnership has challenged Merck’s patents on Keytruda and won a lawsuit in the U.K. finding that its own patent was valid and infringed. Merck has appealed. The partnership is also seeking to file similar claims in other jurisdictions, including the U.S. Although it is difficult to predict the ultimate outcome, Merck believes that the patent dispute will not interfere with its ability to market Keytruda.
In March, Merck won a patent challenge over Gilead Sciences for infringing upon two of its patents related to the compounds used in Sovaldi and Harvoni, Gilead’s blockbuster hepatitis C (HCV) drugs. Its own medicine, Zepatier (elbasvir and grazoprevir), was approved by the FDA in January. In April, a jury awarded Merck $200 million in damages, less than the $2 billion that it was seeking. Merck is also seeking a royalty equal to 10% of Sovaldi’s and Harvoni’s sales. Gilead has petitioned the judge in the case to void the jury’s verdict. If the judge declines to do so, Gilead intends to appeal.
Merck is well behind competitors in launching Zepatier. Gilead, the current industry leader in HCV, recorded $19 billion of sales from Sovaldi and Harvoni last year; while Abbvie generated $1.6 billion from sales of Viekira Pak, its HCV medicine.
Merck has decided to elbow its way into the HCV market by setting its list price for Zepatier at a 40% discount to its competitors. By lowering the price, the company hopes to make the drug available as a treatment option to many more patients. So far, Zepatier is approved in a narrower range of indications. Its side effects are also thought to be more consequential. Still, the discounts should allow Merck to carve out a meaningful share of this market segment and perhaps earn some positive publicity at a time when politicians and other health care market watchers have complained about the high cost of proprietary medicines.
With two potential blockbuster drugs currently in launch, Merck expects that sales from new product introductions will almost completely offset losses from patent expirations in 2016 (and perhaps beyond). It is not clear at this time, however, whether there will be a commensurate increase in profits, given the low price strategy set for Zepatier and the possibility of royalty payments on Keytruda.
GAAP vs. Non-GAAP. Non-GAAP earnings are supposed to exclude unusual or extraordinary items that are unlikely to be repeated in future periods. They are often seen by management as a better indicator of future sustainable performance. However, there has been considerable criticism in the financial community of the proliferation of non-GAAP measures. Critics, including the SEC, have charged that they are used more frequently now to jazz up earnings.
All large pharmaceutical companies report non-GAAP earnings. Merck has supplemented its disclosures with non-GAAP earnings measures for many years. Both Merck and its peers adjust their earnings to exclude certain expenses that they believe are unusual or one time in nature and thus do not reflect the underlying performance of their business. These expense line items are typically associated with programs that are underway to transform their business models.
Even so, I believe that GAAP earnings are a better measure of Merck’s performance. Merck has been transforming its business model for more than a decade now; so transformation is an integral part of its business model. The company initiated global restructuring programs in 2005, 2008 and 2013 and a. Merger Restructuring Program, following its acquisition of Schering-Plough, in 2010. By my estimates, restructuring costs for Merck have averaged $0.30 per share annually since 2005.
Amortization of intangible assets is another expense that is typically excluded to arrive at non-GAAP earnings. These expenses are almost always associated with acquisitions. Merck (and its peers) acquire other pharmaceutical and biotechnology companies as a means of gaining the commercial rights to promising drug candidates and technologies. Consequently, these acquisitions are a substitute for internal research and development costs.
Even though the amortization of intangible assets is a non-cash expense, Merck has paid to acquire them. Such assets are determined to have a limited life; but the company will most likely incur additional ongoing R&D costs or invest in follow-on acquisitions when those intangible assets are fully amortized.
Other miscellaneous income and expense items that are typically added back in the determination of non-GAAP earnings are usually less consequential, but in most cases, even those items are part of the company’s ongoing business activities. In circumstances where those other revenue and expense items are lumpy, it may be appropriate for analytical purposes to average them over multi-year periods. It would usually be a mistake to ignore them.
Merck’s annual non-GAAP earnings have averaged $3.63 per share over the past five years. The high was $3.82 in 2012 and the low was $3.49 in both 2013 and 2014. Last year’s non-GAAP EPS was $3.59.
Its GAAP earnings have been lower and more volatile, averaging $2.22 per share over the same period. The bulk of the average $1.41 per share difference between the Non-GAAP and GAAP earnings represents mostly the costs of restructuring and drug acquisition/development.
For Merck and most other large pharmaceutical companies, amortization of intangibles and restructuring costs form the bulk of the adjustments made in the calculation of non-GAAP earnings. Analysts should adjust GAAP earnings for these expense items only when they are confident that the business transformation process is at or near an end (i.e. when the acquisition of additional intangible assets and incurrence of additional restructuring charges is also at or near an end).
Revenue Performance and Outlook. From 2011 to 2015, Merck’s revenues averaged $44.2 billion, declining steadily from the peak of $48.0 billion in 2011 to $39.5 billion in 2015. Over this five year period, Merck has had to replace lost sales of Singulair, due to its patent expiration. Singulair’s sales fell from $5.5 billion in 2011 to just $0.9 billion in 2015. The 2015 revenue decline was driven mostly by the October 2014 sale of Merck’s Consumer Care business, which had annual sales of about $1.9 billion. In addition, foreign currency headwinds reduced 2015 revenues by an estimated 6%, according to the company’s estimates.
Merck faces patent expirations for three drugs – Invanz, Cubicin and Zostavax – in 2016. The three drugs combined had revenues of $2.4 billion, but it is not clear how quickly revenues for these drugs will decline. My projections assume that the three will produce revenues of $1.7 billion in 2015.
In addition, the company has lost certain marketing exclusivity rights for Remicade, an anti-inflammatory medication produced by Johnson & Johnson. Remicade generated revenues of $1.7 billion for Merck in 2015, down from $2.4 billion in 2014 and I assume that revenues for this drug will fall further to $1.2 billion in 2016.
Merck’s $6 billion Januvia/Janumet franchise has also experienced slowing growth of late. A four-year decline in sales of Januvia has been more than offset by growth in Janumet. Management expects to grow the franchise in 2016, but more competition is on the horizon, so it would not be surprising to see sales slip. My projections assume that sales will remain flat at about $6 billion for 2015 and beyond, which may be optimistic.
These revenue pressures will be offset by growth in other areas, especially from the launch of Zepatier and further rollout of Keytruda. Together, I project that these two will increase Merck’s revenues by $1.8 billion in 2016 and $3.5 billion in 2017.
Accordingly, my revenue projection of $39.8 billion in 2016 represents an increase of only about 1% from 2015, but it is within management’s guidance of between $38.7 billion and $40.2 billion. At $39.45 billion, which is the midpoint of management’s guidance, Merck’s 2016 revenues would essentially be flat. Merck assumes a 3% unfavorable impact from foreign currency in 2016, less than 2015’s 6% negative impact.
Profit Guidance. Management anticipates GAAP EPS of $1.96 to $2.23, up from actual EPS of $1.56 in 2015. Non-GAAP earnings guidance of $3.60-$3.70 compares with actual non-GAAP earnings of $3.59 in 2015. The difference between GAAP and non-GAAP reflects mostly an expected decline in non-GAAP adjustments, including acquisition and divestiture-related costs and restructuring costs. Management’s guidance does not provide for any other miscellaneous non-GAAP adjustments, such as single-country currency devaluations or litigation settlements, which were also a drag on GAAP earnings in 2015.
On balance, therefore, management has issued 2016 guidance that anticipates little change in either the top line or the bottom line when compared with 2015. Consensus estimates are at the high end of the earnings guidance ranges for 2016 and also anticipate only modest non-GAAP earnings growth of less than 2% in 2017.
Valuation. Using management’s GAAP earnings guidance of $1.96-$2.23 per share, Merck is currently valued at 25-29 times anticipated 2016 earnings. That is modestly above the estimated peer group average of about 23 times earnings, according to my estimates.
On a non-GAAP basis, Merck’s stock is valued at roughly 15 times projected earnings for 2016 and 2017, which is slightly below the peer group average of 16.5 for 2016, but in line with the 2017 average of 15.3 times.
Investors are attracted to big pharma stocks in large part because of their relatively attractive dividend yields. Merck’s dividend yield is 3.2%, slightly below the peer group average of 3.4%.
The high GAAP earnings multiples may also be justified by the potential for profit growth. Merck has two promising medicines, Keytruda and Zepatier, which are likely blockbusters. More may be on the way from the company’s pipeline or perhaps from future acquisitions. Merck’s late stage (Phase 3 and under review) pipeline includes candidates that can broaden its portfolio of treatments for cancer, hepatitis C, diabetes, infections, allergies and atherosclerosis, among others. In a recent interview on CNBC, CEO Kenneth Frazier said that the company is also looking aggressively for acquisition opportunities with a focus on expanding its Phase 1 and Phase 2 drug candidates.
According to a report from IMS Health, global spending on pharmaceuticals is expected to grow 4%-7% annually from just under $1.1 trillion in 2015 to $1.4 trillion in 2020. This is slower than the average 6.2% annual growth achieved from 2010 to 2015. Average doses are expected to increase about 4.4% annually over the 2015-2020 period, which implies that pricing will be flat to up slightly. Greater demand from aging populations and growing use in emerging markets accounts for most of the increase in demand. Branded medicines will be the key growth driver in developed markets. IMS expects that the management of drug spending worldwide will be integrated much more closely with overall health care spending. Although IMS acknowledges ongoing pricing pressures and economic risks, its analysis does not anticipate a global economic downturn during the forecast period. As long as the global economy avoids a major downturn, there is room for individual pharmaceutical companies to achieve superior growth rates, which could justify the current (GAAP-based) premium valuations.
Although I believe that GAAP earnings are a better indicator of Merck’s performance, exclusive reliance on GAAP measures is probably too conservative a view, because it implicitly assumes that Merck will remain perpetually in a transformational state. On the other hand, it is more difficult to justify an exclusive reliance on non-GAAP earnings because doing so would ignore completely the cost of acquisitions and restructurings. It is better, therefore, to use something in between the two; but gauging the valuation accurately in this way would require anticipating when this ongoing transformation process will end and what the industry environment will be when it does. For example, a longer anticipated transformation period would argue for a valuation closer to GAAP earnings, while a quicker end to the transformation period would support a non-GAAP earnings-based valuation. Getting those important variables right may be the key to investing successfully in Merck’s stock.
Aside from that, an implied hybrid (GAAP/Non-GAAP) valuation of say 20 times forward earnings is still high, but it is nevertheless roughly consistent or not very much out of line with current valuations on other dividend paying stocks in sectors such as food processing, household products and water utilities, to name a few.
April 22, 2016
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036
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