Description

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Merck & Co. (“MRK”)[1]

Investment Overview:

I estimate that MRK trades at ~12x forward earnings (with a very clean balance sheet <1x net debt/EBITDA), near the bottom of the multiple range of big pharma peers, despite the fact that i) it has two high-quality, franchise compounders in its Animal Health and Vaccines businesses that I estimate generate ~30% of EBIT and could reasonably support 60%+ of MRK’s enterprise value, which ii) implies that for the core remaining Pharma business, I believe investors are paying less than 60% of the intrinsic value of MRK’s currently producing drugs, which doesn’t include any value for the current pipeline/in-progress R&D which carries significant upside optionality given, iii) MRK has a track record of being a best-in-class R&D organization, and has been a clear leader in revolutionizing oncology treatment with its drug Keytruda in the PD-1 checkpoint inhibitor category – given Keytruda’s dominance, MRK currently has 1K+ ongoing clinical trials looking to combine Keytruda with next generation drugs from other pharma/biotech companies, creating tremendous potential upside optionality for MRK to generate next generation oncology blockbusters. Consequently, I believe MRK has a very attractive asymmetric risk-reward profile and I’ll discuss each of the three businesses in more detail below.

Vaccines:

MRK is one of the leading global vaccine players and I strongly believe the quality of this business and its moat is underappreciated. Vaccines is an oligopoly market with four main players (MRK, PFE, Sanofi, GSK) with high barriers to entry that unlike traditional pharma, does not face drug pricing reform risks or patent cliffs – new products typically become additive to the current base of profits rather than needing to constantly innovate new drugs to keep the treadmill going. Consequently, the vaccines business is a franchise compounder that warrants a multiple much closer to Medtech players rather than Pharma peers.

Success in the vaccines business requires not only being an R&D leader in innovation, but scale to achieve a good cost position in this capital intensive business. Additionally, manufacturing is more complicated than for traditional biologic drugs. There are manufacturing and inventory management standards that are difficult to achieve and for example, new plants are often required to operate for two years prior to commercializing products in order to demonstrate compliance with regulations.  The typical timeline from pre-clinical formulation through commercialization historically has been 10-15 years with payback periods north of 20 years. In the US market, which typically drives 50%+ of vaccine revenues, entry barriers are particularly high as it’s very difficult for new entrants to get approved once an established vaccine is already on the market: i) the FDA requires that a new vaccine must demonstrate that it is at least as good as what’s already on the market, even if that level of protection is excessively higher than the current standard, and ii) it can often be very difficult to even conduct studies that satisfy standards; e.g. MRK’s measles mumps rubella (MMR) vaccine was launched in 1971 and it’s still the only one on the US market - a new entrant would need to conduct a study with ~200k enrollees, which is difficult when the established vaccine is almost ubiquitous and does its job. And in the US, once the Advisory Committee on Immunization Practices recommends a vaccine, insurers and the public sector have to cover it; consequently, vaccines are quite price insensitive with the ability to command stable increases.

MRK’s vaccines business can be broken down into three main groups: 1) Gardasil 9 is the dominant vaccine for HPV (~$4B and 50% of Vaccines revenues) – I believe this business should comfortably grow HSDs+ for a number of years as cervical cancer prevention is an increasing priority for health systems around the world and there’s strong growth in developing countries in particular, as well as potentially expanding vaccination to include males in addition to females; the business has been supply constrained but I believe this should alleviate over the next few years as MRK has invested significantly in new capacity; 2) as noted, MRK has a monopoly positon with its MMR vaccine (~25% of revenues) – this is a LSD grower as it has good pricing power; 3) MRK is the #2 player in pneumococcal with ~15% share, but is launching a next generation vaccine which has real opportunity to take meaningful share from Pfizer’s ~$7B leading position, particularly in the pediatric market where MRK has a very strong and broad pediatric vaccines portfolio that it can leverage to bundle if its new vaccine is comparable in efficacy to Pfizer’s. Putting this all together, I believe vaccines will be a steady mid-single digit (“MSD”) grower. And assuming what I believe to be a very reasonable 20x NOPAT multiple (for a business of this quality that combines steady growth, high margins and returns, and protected by a wide moat), MRK’s Vaccines business should be worth ~$65B, or ~32% of MRK’s current EV.    

Animal Health:

In my opinion, this is a best in-class asset, similar to Zoetis (ZTS). MRK’s business generates ~$5B of revenues, ~2/3 the size of ZTS, with similar 40% operating margins. Some 101s: revenues are split ~2/3 livestock and 1/3 companion animals; 70% Int’l and across 150 markets; products include pharmaceuticals, vaccines (where MRK is #1), and digital technology; well diversified as the top 10 products account for 38% of revenues in this business; and MRK is top of the industry in innovation with 66 new product approvals in the last 5 years. MRK claims its business has consistently outgrown the industry’s ~MSD historical growth, highlighting a high-single digit CAGR since ~2016 in its most recent 10-K. MRK believes this business has competitive advantages/synergies from being able to collaborate with MRK’s human pharma business, (e.g., leveraging diabetes, dermatology and vaccines expertise) – which might be the one downfall as MRK claims synergies are so strong that it doesn’t want to divest this business, even though the question is often asked by analysts why they don’t sell/spin this asset when it could reasonably command a ZTS-type earnings multiple of ~35x, which would represent ~$63B of value, or ~31% of MRK’s current EV.

Pharma:

After recently spinning out MRK’s primarily off-patent established brands business, Organon (6/3/2021), MRK is now a more focused specialty/innovative pharma business (and additionally, this simplifies the business and is expected to drive ~$1.5B of synergies and > 300+bps of margin improvement as Organon only represented 15% of pharma revenues but accounted for 25% of manufacturing sites and 50-60% of SKUs). MRK’s pharma business can be thought of in two buckets: 1) Oncology, at ~$19B of revenues expected in 2021 (of which Keytruda represents ~90%) is ~60% of pharma revenues, and 2) everything else, consisting of ~$13B of expected 2021 revenues, and for the most part is going to be a melting ice cube as most of these drugs are already off-patent and will gradually decline or have loss of exclusivity approaching and will face steeper declines.

It’s important to spend some time discussing Keytruda which has been revolutionary to oncology, as it pioneered and is the dominant leader in the PD-1 checkpoint inhibitor category.  PD-1s essentially work by increasing the patient’s own immune response; Keytruda works by binding to PD-1 and therefore blocking the cancer cells from using their own protein to slot into the same spot and switch off the immune cells, so the T-cells do their job and effectively attack the cancer. Keytruda is most often used in combination with/after initial traditional treatments of chemotherapy, radiation, and surgery – these aim to kill the cancer tumor, but do not prevent the tumor from growing back; Keytruda also helps kill the tumor but importantly helps train the body/immune system from re-growing that tumor.

Keytruda has been called a revolutionary miracle drug – not only has it worked incredibly well to help patients survive cancers previously deemed terminal, but because it trains the immune system response it has proven to work across an incredibly wide range of cancer types, unlike any other drug that’s ever been discovered. Keytruda was first approved in 2014 for melanoma, and then found tremendous success for non-small cell lung cancer (which is ~50% of current revenues), but MRK now has 28 indications across 17 cancer types and this continues to grow as MRK essentially is building out Keytruda organ by organ. Over the last few years, Keytruda has consistently beat and raised long-term revenue estimates as it’s proven success in such a wide range of cancers, and expanded into earlier stages of treatment (e.g., there are some tumors that don’t respond to chemo and Keytruda is used as a first-line of defense, and there are many areas being tested where Keytruda will be used earlier in treatment in combination with other therapies and drugs – often called “adjuvant” therapy).

I believe Keytruda revenues will grow to $25-30B revenues within the next five years, before it loses exclusivity in 2028. This is largely what’s expected by consensus, but the real upside to MRK is the potential to leverage its dominant position at the heart of oncology treatment to launch other drugs. Keytruda is currently being used in ~1400 clinical trials (this is a massive number), 950+ of those are trials in combination with other drugs/therapies – many oncology players want to partner with Keytruda given it has become foundational to so many cancer treatments, so MRK has been able to selectively partner with drugs/companies it believes is interesting. MRK will give them access to Keytruda and in return receives the clinical trial data and experience. This gives MRK multiple upside levers as it can partner with other players (as it’s done with AstraZeneca with the drug Lynparza and with Eisai for Lenvima – combined which are expanding into dozens of other cancer modalities and expected to be multi-billion dollar drugs on their own).

I’ll highlight one of the biggest opportunities in an emerging category of checkpoint inhibitors called TIGIT (also called T cell immunoreceptor with Ig and ITIM domains). While PD1s were revolutionary and highly successfully for the right patients, the issue has been that only ~20-25% of patients respond to them. That is where TIGIT, which aims to work with PD1s to get a second signal response, comes into play – Roche is currently in the lead in TIGIT and has shown studies where response rates are ~doubled with the combination of PD1s with TIGIT vs PD1s alone. But MRK is not far behind Roche in development, and again its dominance with Keytruda gives it great leverage to potentially combo its TIGIT with Keytruda (which in addition to being a potential blockbuster on its own, can potentially help extend the patent life of Keytruda as well as new formulations to create new IP/patents). At this stage, there is growing confidence that TIGIT will work, we just don’t know the scope for how many cancers, at what stages, etc. – but it’s not inconceivable that TIGIT could be as big as the PD1 class of drugs which is expected to reach $50B+ of sales over the coming years.

In valuing the pharma business, I essentially model a DCF of the base business/currently producing drugs, and assuming a reasonable percentage of R&D is invested in this base business primarily to continue expanding Keytruda into future indications to support its expected growth (i.e., I assumed ~$4B, or 55% of 2021 Pharma R&D is invested in this base business, with the remaining 45% being invested into new pipeline/drugs), and an 8% discount rate. Based on such, I believe MRK’s current producing drugs are worth ~$130B, or 65% of MRK’s current enterprise value. After this, I’m essentially assuming that future R&D dollars will earn a cost of capital return, but again I believe there is substantial upside optionality to this if MRK is able to execute on leveraging Keytruda to deliver oncology blockbusters, such as TIGIT. To frame this, I estimate a $10B drug launch has ~$43B of NPV ($17/share). And I’m assuming MRK is investing ~$38B of R&D (NPV) in new pipeline (excluding the base business/currently producing drugs) over the next decade – so essentially MRK needs to come up with ~$9B of new peak drug sales over the next decade to recoup its R&D investment and everything above that is value creation. To re-emphasize, Keytruda will likely be $25-30B of peak sales, and still represents relatively early innings of oncology treatment – if MRK is able to successfully leverage Keytruda and participate in the next generations of oncology treatments then I do not believe it’s crazy that this could deliver significant upside value creation. And I’ll emphasize, I have just been focusing on oncology, and MRK has a robust pipeline outside of oncology (notably in HIV). And the last point I’ll make is that I am thinking about returns on future R&D investment – given the very long development cycles in pharma, from early research to actually commercializing a drug, there is what I’ll call significant current pipeline, or in-progress R&D value to the business that I’m not really ascribing value to (e.g., in the last 5 years, MRK has spent ~$50B on R&D and $25B on M&A – much of this has not yet earned a return, but may help drive future pipeline successes).

One last positive I’ll highlight with MRK is a management team that I believe truly is science focused and capital disciplined. One of the concerns with pharma companies is are they going to destroy value on M&A, particularly those who have large upcoming patent cliffs and need to do large transactions to purchase commercial assets to compensate. What I appreciate about MRK is that management has been very disciplined and very opposed to doing large deals; they strongly prefer focusing business development investments in early stage licensing partnerships as an extension of internal R&D given they are true “science” focused R&D organization. This is a similar approach as Roche, who is often regarded as the top-tier R&D engine in the industry, and this is very different than other pharma companies buying later stage assets at lofty valuations because they have to and because they have weaker internal R&D capabilities.

Valuation:

To summarize what I’ve discussed above, I believe MRK is currently too cheap and pricing in: fair valuations for the Vaccines & Animal Health businesses (~$128B, or 63% of the current EV) and you’re getting the estimated $130B of value of current producing drugs for ~57 cents on the dollar + all current pipeline and future upside optionality for free. While I believe that downside in MRK is limited, supported by two franchise compounders and a mountain of cash that will be generated from currently producing drugs, I will highlight what I believe to be the biggest risks to the business: 1) if Keytruda’s expected expansion into new indications fails; 2) if management is highly unproductive with future investments and essentially burns R&D and M&A dollars on efforts that never come to fruition – pharma is an industry where success in new drugs is often binary and so this is not out of the realm of possibility; and 3) if messenger RNA (mRNA) vaccines are able to successfully enter and take share in some of MRK’s large vaccines businesses such as GARDASIL 9 (though I do not believe mRNA will be a viable candidate for ~50% of MRK’s vaccines revenues).

[1]Throughout this report, historical financial data for Merck & Co was sourced from the firm’s most recent 10-K filing, which was published February 25, 2021 for the year ending December 31, 2020. www.sec.gov/edgar/searchedgar/companysearch.html.  

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herein.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL. 

The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

The author does not hold a position with the issuer of the Security such as employment, directorship, or consultancy.

Catalyst

• Pipeline successes over coming years, particularly in oncology.