Company Overview

Merck & Co. operates as a global healthcare company. It operates through two segments, Pharmaceutical and Animal Health. The company was officially founded in 1891 and is headquartered in Kenilworth, New Jersey, though Merck has a long and interesting history, dating back to Friedrich Jacob Merck's 1668 purchase of an apothecary in Darmstadt, Germany. Fast forwarding to more modern times in 1984, Merck had become the largest U.S.-based manufacturer of drugs in the three largest markets—the United States, Japan, and Europe. Success came from three factors: a productive research organization; manufacturing capability that allowed for cost-efficient, high-quality production; and an excellent marketing organization. During the late 1980s, double-digit annual sales increases led to Merck’s undisputed leadership of the pharmaceutical industry. The company’s research efforts in the 1960s and 1970s laid the foundation for Merck's drug 'bonanza' of the 1980s. Vasotec, a treatment for congestive heart failure, was introduced in 1985 and became Merck's first billion-dollar-a-year drug by 1988. Mevacor, a cholesterol-lowering drug introduced in 1987, and ivermectin, the world's top-selling animal health product, also contributed to the company's impressive growth. In the late 1980s, Merck was investing hundreds of millions of dollars in research and development, or 10% of the entire industry's total R&D budget. Over the course of the decade, Merck's sales more than doubled, its profits tripled, and the company became the world's top-ranked drug company as well as one of Business Week's ten most valuable companies. Merck is a blue chip invesment.

Investment Thesis

After some history of mixed results, Merck's research and development productivity is improving as the company shifts more toward areas of unmet medical need. Due to side effects or lack of compelling efficacy, Merck experienced major setbacks with several cardiovascular disease drugs along with a treatment for migraines. Additionally, safety questions ended the development of an osteoporosis drug. Despite these setbacks, Merck’s intellectual patents and economies of scale sustain a powerful competitive advantage over its competitors. The company's enormous cash flows support a powerful salesforce that not only sells currently marketed drugs, but also serves as a deterrent for developing drug companies seeking to launch competing products. As a result, Merck offers an attractive partnership opportunity for externally developed drugs. The cash flows also put the company in the strong position of supporting the approximately $800 million in research and development needed on average to bring each new drug to the market.

Merck is one of the largest global pharmaceutical companies, with specialty drugs that treat cancer, cardiometabolic disease, and infections. The company also has a substantial vaccine business that treats Hepatitis B, Shingles, HPV, and pediatric diseases. Merck has existed for over 130 years, generating about half of its revenues in the United States with the balance internationally sourced. Merck has seen solid revenue growth, driven by non-Organon related drugs, as Organon saw a revenue decline before being spun off to shareholders in June 2021.

Merck's research laboratories hold a vast database of knowledge that should help the company maintain its leadership positions in drug discovery and development. The company's dominant position in the emerging immuno-oncology area should strengthen Merck's competitive advantage with drugs that carry very strong pricing power. Additionally, Merck's vaccine franchise provides an additional layer of protection from intellectual property and cost competition, as the company's large-scale production enables a lower cost base, which can be critically important in the vaccine market. We estimate that Merck’s operations will produce well over $100 billion in free cash flow over the next five years, or approx 35% of the company's current enterprise value.

With returns on invested capital well in excess of the company’s cost of capital, we believe this is a solid high single digit compounder at current prices (ex-dividend), with further upside to this if the Keytruda patent estate does not sunset in 2028.

Business

Merck & Co. is a leading global health care company that offers innovative health solutions through prescription medicines, vaccines, biologic therapies, and animal health products. Since the Organon spin off at the end of 2Q 2020, the company is organized into two operating segments: Pharmaceutical and Animal Health.

The company has three key growth drivers: oncology, vaccines, and hospital acute care medications and treatments. Merck’s top-selling drug, Keytruda, was first approved by the FDA in 2014 as a second-line treatment for melanoma. Since then, the drug has become a driving force in Merck’s operating results with increasing numbers of approvals for its use in different cancers, whether as a first-line or a second-line treatment. Keytruda is currently approved for treating, among other things, melanoma, non-small cell lung cancer, small cell lung cancer, head and neck squamous cell cancer, Hodgkin lymphoma, cervical cancer, and esophageal cancer.

Most analysts peg Keytruda’s patent expiration at 2028, though a recent February 2023 note from Evercore suggests the potential for more sunlight beyond 2028; perhaps to 2035. This observation was in reference to a N.Y.T. article highlighting Merck’s Keytruda patent estate (encompassing 180 patents), and whether these could extend past 2035. "Merck didn’t specify actual dates", but it reads that Merck did not push back on the assertion.

Vaccine segement sales have been led by Gardasil/Gardasil 9 vaccines, which prevent certain kinds of cancers caused by the human papillomavirus (HPV). In the Hospital Acute Care segment, Bridion broke the $1 billion revenue level in 2019. Bridion is used to reverse two types of neuromuscular blocking agents used during surgery. Bridion’s patent expiration in the U.S. is 2026. Over recent years, these drugs have contributed over $5 billion in revenue each year and have represented Merck’s second-best-selling drug complex.

Such is the nature of the pharmaceutical industry, the continuous need to develop new drugs that will replace those coming off patent. We believe that the company’s current lineup of drugs, taken together with its pipeline, will be sufficient to replace the lost revenue from 2022 and 2023. In June 2021, the Company spun off products from its women’s health, legacy brands, and biosimilar businesses into a separate publicly traded company, Organon & Co. The transaction resulted in an $9 billion tax-free dividend to Merck from Organon.

Valuation

Following the divestment of Organon, Merck remains well positioned with immuno-oncology drug Keytruda and cancer drug Lynparza as well as HPV vaccine Gardasil. Management expects Keytruda to dominate the late stage non-small cell lung cancer market. We model steady long-term growth for the entire company, partly driven by the solid outlook for cancer drug Keytruda and to a lesser extent the strong outlook for HPV vaccine Gardasil, which should do particularly well in the international marketplace according to company management. Keytruda is obviously critical to Merck's valuation, and recent forecasts expect the drug to reach peak sales of nearly $30 billion, largely based on strong efficacy in several cancer types including lung, head and neck, melanoma, and several other cancer indications. In looking at the entire company, over the next five years, we expect that Merck will conservatively post just over 6% annual top-line growth with new drugs offsetting drugs lost to generic competition.With returns on invested capital far exceeding the company’s cost of capital, Merck will generate substantial amounts of free cash flow over the next five years.

While Merck has been a consistent dividend payer for over fifty years, its record of dividend increases, and the growth rate of such increases was somewhat less than desirable until recently. As discussed during Merck’s June 2019 Investor Day, the company has committed to a roughly 50% dividend payout ratio, which we believe will result in steadier increases based on the expected growth in Merck’s earnings. Despite Merck’s current and relatively paltry dividend yield (compared to the one way direction in treasury yields over the last year), we believe that with continued growth in Keytruda revenues, Merck is well-positioned in the life cycle of its drugs and pipeline to power future dividend increases.

Merck has a solid balance sheet, and in reference to the mention of the dividend yield / treasuries, it is interesting to look back at Merck's placement of $4.5 billion in debt in June 2020. 2026 notes sold at 0.75%, 2030 notes at 1.45%, 2040 notes at 2.35%, and 2050 notes at 2.45%.

From an earnings perspective, the company has committed to a long-term goal of growing revenues faster than expenses to materially increase operating margins over time, and have been achieving that.

Fiscal year guidance of $6.80-6.95 appears to be lower than $7.45 consensus, but is basically a wash, since Merck includes ~$0.46 charge for business development deals, not captured in consensus. 

Risk to Investment

Merck's near-term risk largely centers on market acceptance of new drugs. Like all pharmaceutical companies, Merck faces regulatory risk from the FDA. Product delays or non-approvals could hurt the stock. Also, the growing power of managed care and a more price-sensitive U.S. government may reduce Merck's pricing power.

Additionally, the success of Keytruda has increased the company's dependence on the drug for growth, which could become very problematic if any side effects show up or new therapies emerge quickly in treating cancer. However, given the wide diversity of largely inelastic drugs in the company's portfolio, we remain confident that the company’s traditional strength in research and development alleviates Keytruda’s long term risks.

Merck generates close to half of total sales from U.S. prescription drug sales, which is largely in line with its peers; therefore, major pricing reforms could weigh on sales and margins. Policy changes around reforms to Medicare would certainly weigh on our fair value estimate. Merck’s Januvia (diabetes) and Keytruda (oncology) generate close to 40% of the company’s total sales and these drugs have significant exposure to Medicare.