Thesis: MRK GY is a turnaround story with limited downside and potential for 100%+ upside over the next 2-3yrs. The business has been mis-managed for over a decade: capital allocation is horrible, the cost structure is super bloated, communication with investors/street is poor and management accountability/incentives are not properly structured. The Merck family (owns 70% of the business) brought in a new all-star CFO, Matthias Zachert, to help turn around the business earlier this year. Our research indicates that Zachert is the right person to execute on the turnaround and we are in the early innings of this transition. Over the next 2-3yrs, MRK GY EBIT margins/ROICs will go from worst in class to best in class. MRK GY trades at ~5-6x our 2013E EPS which is ~50% ahead of consensus expectations.
How This Plays Out: Improvements in capital allocation, cost structure, investor communication and management incentives will drive an increase in profitability and multiple expansion. MRK GY will generate low single digit annual top line growth over the next few years. Significant cost cuts in SG&A/R&D in the pharma biz will allow them to generate a ~1,000bps increase in overall EBITA margins by 2013. Matthias will use FCF generation to reduce debt and do tuck in acquisitions focusing on the Millipore business. MRK GY will generate ~10-11 EUR/share in 2013E EPS vs consensus expectations of ~7 EUR/share.
What the Bears are Focused On:
1) Structural Headwinds: Rebif, Erbitux and LCD business make up ~30% of revenues and are all facing increasing competition over the next few years.
2) Change Will be Slow to Occur: New management has indicated that the changes will be evolutionary and not revolutionary. This business has been a chronic underperformer and will be hard to turnaround
3) Cost Cutting Will Be Limited: They need to invest in their R&D pipeline to sustain growth which will limit cost cutting abilities. Cost reductions will also be offset by revenue pressures.
4) Non-Compelling Valuation: Trades at ~8x 2013E consensus EPS which is roughly in line with other pharma peers facing secular headwinds, limited growth potential and poor capital allocation.
Our Key Points:
1) Top Line is Stable/Structural Concerns Overblown: Our research indicates that concerns over structural headwinds to Rebif/Erbitux are overblown in the near/mid-term. Even under conservative assumptions, MRK GY should grow top line by low single digits over the next few years. This should give Matthias plenty of time to deal with potential revenue headwinds that could develop in 2-3yrs+ from now.
- Rebif and Erbitux are ~45% of Serono revenues (~20% of total revenues) and should be relatively stable/slightly declining in the next few years. Rebif volumes are likely to decline by mid-single digits annually and Erbitux volumes should be stable. The rest of the Serono business should grow by approximately 5%+ annually. This should drive annual low single digit revenue growth for the Serono division overall.
- The risks to Rebif are 2-3yrs+ from now when new oral MS drugs are likely to come to market (ie BG 12). We expect that Rebif could decline by 40-50% over the next 4yrs but that will be very back-end loaded (ie yrs 3 and 4). A potential offset could be if MRK GY gets approval on their own oral MS product which is currently in development. The risks to Erbitux would similarly be if Vectibix was approved for 1st line colorectal cancer in conjunction with chemotherapy. This is also a risk that could materialize in 2-3yrs+ from now and needs to be monitored. The potential offset here is that Erbitux could get approved for non-metastatic colorectal cancer which would expand the TAM.
- The LCD business is ~10% of revenues and is a cyclical business that will face some near term headwinds but secular concerns over OLED displacement are overblown. Meaningful OLED penetration likely won’t begin until 2-3yrs from now and it will be 5yrs+ before OLED penetration has a meaningful impact on LCD volumes (if ever). In addition, MRK GY is currently disputing a patent position that would allow them to transition their LCD chemicals business to selling into the OLED market.
2) Massive Opportunity for Margin Expansion/Better Capital Allocation: MRK GYs pharma business currently has margins and ROICs that are < 50% of pharma peers that are inefficiently run themselves. Massive opportunity to improve margins, capital efficiency and FCF generation and reinvest cash flows into paying down debt and growing their higher quality Millipore business.
- Serono has ~20% EBITA margins vs 30-35% for pharma peers (several of which have lower gross margins). R&D as % of sales for Serono is ~20% vs 10-20% for pharma peers and SG&A as % of sales is ~40% vs 25-30% for pharma peers. ROICs for Serono are <15% vs ~30% for pharma peers. Serono has a massive opportunity to increase margins by 1,500bps+, improve capital efficiency and increase ROICs by 2x+ and the right management team to execute on this opportunity.
- A super lean and well run pharma company like VRX has ~50% EBITA margins with R&D as % of sales of ~5% and SG&A as % of sales of ~20%.
- Millipore is ~15% of EBIT and is a high quality consumables business with solid secular growth potential selling products into the biotech/pharma lab/manufacturing market. Matthias is likely to use FCF to pay down debt as well as look for tuck-in product acquisitions where he can leverage Millipore’s sales team to sell into a large installed base of customers.
3) New CFO With Excellent Turnaround Track Record: Our research indicates that the new CFO is the right person to implement this turnaround.
- Matthias has a history of turning around under-performing businesses by dramatically improving capital allocation, the cost structure and communication with investors/street. He has a unique ability to make tough decisions and execute on them quickly. Most recently as the CFO of LXS GY, he was able to improve margins/ROICs from worst in the industry to being in line with the rest of the industry and was able to do this within 2-3yrs. He consistently met or exceeded his goals while at LXS GY and the stock tripled over his tenure vs his peer group which appreciated by 0-100% over the same time period.
4) Limited Downside and Potential for 100%+ Upside: Negative sentiment has created a very skewed risk/reward.
- Limited Downside: Due to concerns over structural headwinds to their key products and poor operational performance, MRK GY trades at a depressed multiple on depressed margins. Investors/sell-side give no credit for margin expansion or improved capital allocation. There is so much room for cost cutting/improved capital allocation that even if we are wrong on the top line, there is a very low probability that earnings power is permanently impaired.
- Potential for 100%+ Upside: MRK GY trades at ~5-6x our 2013E EPS which is ~50% ahead of consensus expectations. Our #s are based on low single digit top line growth and 1,000bps of margins expansion driven almost entirely by improvements in the Serono business. This business will deserve a higher multiple under this scenario (10-12x seems reasonable) as capital allocation, investor communication, R&D pipeline opportunities, growth prospects, incentives, etc will all be dramatically improved.
What are we Observing today: Early Signs that Significant Change is on the Come
1) New senior management brought in across the organization including new all-star CFO (Matthias Zachert) with excellent turnaround track record
- Senior management starting to bring in fresh blood below them across the organization
2) Insider buying
- Matthias has purchased a few hundred thousand $s worth of stock recently at ~70 euros/share which we estimate at 10%+ of his net worth
- Chairman of the board who is one of two Merck family members on the board started to buy stock for the first time ever in November of 2010 and recently bought more for a total of 1m Euros worth of stock at around 60-65 euros/share
- CEO and other insiders have purchased stock recently as well
3) Matthias took significant write-downs and reduced guidance in 2Q 11 right after he took over as CFO
4) Management recently laid out broad brushstrokes of their strategy which included the following
- Change management and foster awareness for need of cultural change throughout the organization
- Improve profitability by optimizing cost structure and streamlining internal processes
- Strengthen R&D efficiency/processes in pharam business
- Deliver growth by leveraging sales potential for Millipore business in regional/local markets and deliver on growth strategy in emerging markets
1) Merck family/CEO hold Matthias back from making big change (ie they don’t want him to execute on massive layoffs)
2) Headwinds to Rebif/Erbitux/LCD business are significantly worse than we expect and put additional pressure on top line at the same time that Matthias faces pushback on cost cuts
3) MRK GY is too big and bureaucratic for a successful turnaround to be implemented
4) Over-levered sovereigns are forced to cut back dramatically on healthcare spending (ie significant reimbursement rate cuts globally)
1) further announcements of coming change in early 2012
2) cost cuts starting to flow through in 2012
3) rebif/erbitux/lcd holding up better than expected in near/mid term
4) positive commentary on potential for stimuvax approval