Published on July 9th, 2019 by Nate Parsh
With a market cap of more than $200 billion, Merck & Co. (MRK) is one of the largest companies in the world. Merck is also a member of the Dow Jones Industrial Average, a group of 30 large cap U.S. stocks.
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Shares of Merck have performed very well over the past year, gaining more than 37% and easily outpacing the S&P 500’s 6.8% return during this period of time. The stock currently yields 2.6%, well below its decade long average of 3.7%.
The increase in share price has also resulted in the Merck reaching a valuation that makes the stock look very expensive today.
Despite the company’s business performance and catalysts for growth, investors should seek investments elsewhere in the pharmaceutical sector.
Business Overview and Recent Events
Merck is a global leader in the healthcare sector. The company provides innovative solutions through its prescription medicines, biological therapies, vaccines and animal health products. Merck has a market capitalization of $219 billion, with annual revenues in excess of $44 billion.
Merck reported first quarter financial results on 4/30/2019.
Source: Earnings Presentation
Adjusted earnings-per-share increased 17% to $1.22. This was $0.17 above what analysts had expected. Revenue increase 8% to $10.8 billion, topping expectations by $370 million.
Keytruda, Merck’s top selling pharmaceutical, grew 55%. Keytruda treats cancers, like melanoma, that cannot be removed by surgery as well as non-small cell lung cancer.
Sales for the company’s HPV vaccine Gardasil increased more than 30% to $838 million. Gardasil is Merck’s third highest grossing product. Other vaccines showed high rates of growth as well. For example, Varivax, which is the company’s vaccine for chicken pox, had sales growth of 25% in the quarter.
Merck has seen some declines among its top selling pharmaceuticals, particularly when it comes to the company’s Januvia/Janumet franchise. Januvia/Janumet treats diabetes and is the company’s second best-selling product, but has come under pricing pressure in the U.S. This has offset growth in international markets. Sales for this franchise declined 5% to $1.4 billion.
Following first quarter results, Merck now expects revenue in a range of $43.9 to $45.1 billion for the year, up from the company’s previous guidance of $43.2 to $44.7 billion. The company also expects to earn between $4.67 to $4.79 per share in 2019, up from $4.57 to $4.72 earlier.
If Merck were to achieve the midpoints of its updated guidance, then revenue would grow 4.2% and earnings-per-share would increase 9% from 2018’s totals.
As stated previously, Keytruda showed strong growth rates in the most recent quarter.
This type of growth is likely to continue as the product has been approved by the U.S. Food and Drug Administration in a variety of additional areas. For example, Keytruda can now be used as a first line treatment for patients with advanced renal cell carcinoma.
Source: Earnings Presentation
Keytruda was also approved for treatment in combination with chemotherapy for certain types of lung cancer in the European Union. And China recently gave the drug approval for use in lung cancer in the region as well.
Keytruda grossed more than $7 billion in 2018 and could reach peak sales of $15 to $17 billion. Between 2019 and 2020, Merck will conduct nine clinical trials for different uses of the drug. With more markets approving the drug for more uses, Keytruda will be a primary driver of growth for Merck in the years to come.
Merck also has an additional 12 clinical trials schedule between now and next year for other drugs in its oncology and vaccine lineups.
The company’s business has done very well in overseas markets.
Source: Earnings Presentation
Though the company saw growth in all of its major markets, it is China that is quickly becoming one of the more important markets for Merck.
Including a 9% currency headwind, sales in China grew 58% to $725 million. While sales in this market represented less than 7% of total sales in the first quarter, Merck’s products are in strong demand there.
Recent approval for Keytruda should only increase the company’s business in the country. In addition, much of Gardasil’s growth in the most recent quarter came from the ongoing commercial launch of the vaccine in China.
From 2009 through 2019, Merck’s earnings-per-share compounded at 2.9% annually. With the likely growth trajectory of Keytruda, we forecast that earnings-per-share can grow at 5% annually through 2024.
Merck has increased its dividend for the past eight years. The company has increased its dividend:
- By a CAGR of 2.6% over the past three years
- By a CAGR of 2.5% over the past five years
- By a CAGR of 2.7% over the past 10 years
While dividend growth rates over the short, medium and long term have not been very generous, they have at least been consistent.
However, Merck increased its dividend by 14.6% for the payment made to shareholders on January 8th, 2019. A dividend raise of this magnitude can be interrupted by investors that Merck believes its future to be very bullish.
Of course, a dividend increase doesn’t mean much if the company cannot afford to pay it. How safe is Merck’s dividend?
In the first quarter 2019, Merck’s earnings-per-share totaled $1.22. For context, the company paid a quarterly dividend of $0.55 per share, which implies a payout ratio of 45% in the most recent quarter.
Looking out over a longer time horizon, our conclusion is the same. Merck generated $4.34 of earnings-per-share in 2018. The company paid out $1.99 of common share dividends during the same time period for a dividend payout ratio of 46% in the full fiscal year.
Many analysts prefer to use free cash flow as a measure of dividend safety.
Merck generated $1.34 billion of cash flow from operating activities in the first quarter of 2019 and spent $595 million on capital expenditures during the same time period for free cash flow of approximately $750 million. The company paid out $1.4 billion of common share dividends during the same time period for a free cash flow dividend payout ratio of 187%.
Looking out over a longer time horizon, the company’s payout ratio is much lower. Merck produced $10.9 billion of cash flow from operating activities in 2018 and spent $2.6 billion on capital expenditures for free cash flow of approximately $8.3 billion.
The company distributed $5.2 billion of common share dividends during the same time period for a free cash flow dividend payout ratio of 63%.
Using earnings-per-share or the long term picture for free cash flow, Merck’s dividend appears to be well-covered.
Valuation & Expected Returns
Shares of Merck currently trade for $85. Using the midpoint of the company’s updated guidance of $4.73 in earnings-per-share for the year, the stock has a price-to-earnings ratio of 18. This is well above the stock’s 10-year average price-to-earnings multiple of 13.2.
Given the growth of Keytruda and other important products, we have assigned a 2024 target multiple of 14x earnings. If shares were to revert to this price-to-earnings ratio by 2024, then valuation would be a 5% headwind to annual returns.
Total returns would consist of the following:
- 5% earnings growth
- 2.6% dividend yield
- 5% multiple reversion
We anticipate that Merck can offer a total annual return of just 2.6% through 2024. This is a very low expected return, an indication that the stock is significantly overvalued and its growth will not be enough of an offset to this.
Thanks to products like Keytruda and Gardasil, Merck’s future looks bright. Both products have high rates of growth and should continue to produce in the years to come.
Keytruda appears to be on its way to becoming one of the best-selling pharmaceuticals in the world. Improvements in international markets is also a positive sign for the company.
Another positive sign is that Merck has also become much more aggressive in increasing its dividend, at least in the short term.
Unfortunately, the market has caught on to this and has driven shares up accordingly. Any projected uptick in earnings growth will likely be offset by a reversion in valuation. Given that we expect the stock to return just 2.6%, shares of Merck receive a sell recommendation from Sure Dividend at this time.