SGEN - Merck & Co.: Running A Bit Hot

Summary

• Merck has seen a significant valuation re-rating take place over the past years.
• This comes amidst the success of Keytruda, which creates some dependency risks as well.
• With no growth seen in 2023, amidst tough comparables from a pandemic-related contribution in 2022, I am a bit cautious here, as shares keep riding higher.

Late in October, I concluded that Merck (MRK) was a great medicine for the portfolio, as it has seen strong growth, even after stripping out the "contribution" from the pandemic.

Growth has resulted in an uptick in the valuation multiple, while market multiples have come under pressure amidst rising interest rates. Still liking the long-term set-up, I saw no reason to alter a long-term core long position.

Keytruda Driving The Show

Merck was a business which generated $47 billion in sales in 2019, a year in which it posted earnings of $5.19 per share. An $80 stock commanded a 15-16 times earnings multiple at the time, as the company guided for 2020 sales to rise in a modest fashion.

Revenues rose a mere 2% to $48 billion in 2020, with growth held back by the pandemic, as sales of key drug Keytruda rose 30% to $14.4 billion, with non-Keytruda sales coming down a bit, and reliance on the top-selling drug only increasing, as a result of its success.

With the company guiding for 2021 sales to rise to $53 billion and earnings seen in excess of $6.50 per share, a $70 price looked rather compelling. That was a bit too simplistic as the company spun-off Organon (OGN) during the year, which made that pro forma sales fell to $47 billion and earnings would come down to $5.50 per share. Moreover, the move only increased the reliance on Keytruda, albeit that net debt would fall to $18 billion.

The market has grown more appreciative of the business as 2021 sales rose to $48.7 billion, on which earnings were posted $6.02 per share, despite the Organon spin-off. Keytruda sales rose 20%, outpacing organic sales growth of 17% by a few points, thereby increasing the revenue share of Keytruda to 35% of total sales. With the company guiding for 2022 sales at nearly $57 billion and earnings north of $7 per share, this created a nice roadmap for shares to rise to $100 by October.

With the company having posted third quarter results at the time, the company hiked the full year guidance to $58.5-$59.0 billion, including a $5 billion revenue contribution of Covid-19 drug LAGEVRIO in the first three quarters of the year, with full year earnings seen around $7.35 per share. Net debt stood at $21 billion, based on the second quarter reports as the third quarter 10-Q report was not yet filed at the time.

The resulting 14 times multiple looked reasonable given the growth, although Keytruda's reliance is a small concern. The company was simply executing and at the time was announcing bolt-on dealmaking, although it was rumored to be making an $40 billion offer for Seattle Genetics ( SGEN ) last summer, a potential huge deal in relation to a $270 billion valuation at the time. All of this left me to sit on very nice gains, as I saw no reason to alter my long position.

Doing Well

Since October, shares of Merck have risen another 10%, now trading hands at $110 per share which is remarkable as many big pharma names have recently seen a bit of a pullback here.

Soon after the release of the third quarter results in October, Merck announced a $1.35 billion deal to acquire Imago BioSciences ( IMGO ) at $36 per share in cash. The company aims to strengthen its presence in hematology with the purchase of this clinical stage biopharmaceutical company. The company was comfortable in its long-term trajectory, announcing a quarterly dividend of $0.73 per share, for a solid near $3 per share payout.

Early in February, Merck posted its full year results. Fourth quarter sales rose just 2% to $1.38 billion, with a strong dollar hurting sales growth by six points. Non-GAAP earnings fell 10% to $1.62 per share, yet full year earnings rose to $7.48 per share. Fourth quarter LAGEVRIO sales came in at $852 million, an uptick from the third quarter. Keytruda sales rose 19% to $5.5 billion for the quarterly period, increasing its reliance to 39%, that is despite the incidental impact of LAGEVRIO. The more rapid increase in the reliance is in part the result of Merck facing competition for JANUMET, its diabetes drug which saw fourth quarter sales down a third to less than a billion now.

Amidst the stronger contribution of LAGEVRIO, which thrived on the pandemic, full year sales came in at $59.3 billion, as the company expects some kind of normalization with sales seen at a midpoint of essentially $58 billion in 2023. Adjusted earnings are set to fall a bit as well to $6.80-$6.95 per share. With LAGEVRIO sales only seen at a billion, compared to $5.7 billion in 2022, it is clear that outside this boom, modest revenue growth is seen. Net debt was reported at a very modest $18 billion by the end of the third quarter.

What Now?

Truth be told is that 2023 is somewhat of a bridge year as reported numbers will likely be negative given the decline in LAGEVRIO sales. This will make it hard to see growth, as it is troublesome that Keytruda's reliance keeps increasing, and hence bolt-on deals like Imago are key to reducing this reliance over time.

With shares having risen to $110 per share, the earnings multiple has risen 16 times based on the adjusted earnings multiple seen this year. This makes that earnings multiple have risen, amidst a market valuation multiples which are still pressured by higher interest rates, as the set-up is less convincing than it was in the past.

Given all of this, I am trimming part of my position here, moving it into other big pharmaceutical names which have seen some setbacks in recent times.

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