MKKGY - Merck KGaA: A German Free Cash Flow Machine

2023-04-18 11:30:00 ET

Summary

• Merck KGaA (not to be confused with the US-based Merck) is a German company in the life sciences and healthcare sector.
• The balance sheet is looking very healthy again focusing on the reduction of the net debt.
• This means Merck is in a position again to pursue a relatively sizeable M&A transaction.
• The stock is not cheap, but likely never will be cheap again. Temporary weakness could be an opportunity.

Introduction

I have been following Merck KGaA (MKGAF) (MKKGY) since 2016 as I liked the company's approach to pursue large M&A transactions and subsequently use the incoming free cash flow to rapidly deleverage its balance sheet again. That was a great move in an era of cheap debt, but it obviously is so much harder to replicate in today's interest rate environment.

Merck KGaA, not to be confused with the US company Merck ( MRK ) is a large German life science and technology company. The ticker symbol on the Deutsche Boerse exchange is MRK (which doesn't exactly help with the confusion as that's the same ticker symbol as Merck & Co uses in the USA) and the average daily volume is just over 300,000 shares. And just to be clear, every time I refer to Merck or MRK from here on, I'm referring to the German Merck as this article does not involve the US-based Merck at all. I will use the Euro as base currency throughout the article. The current share count is approximately 435M shares as investors need to use the theoretical number of shares to correctly reflect the general partner's interest. Based on the current share price of 164 EUR, the pro forma market capitalization is approximately 71.3B EUR.

Looking back at Merck's performance in 2022

The company's performance is pretty resilient. It recorded a total revenue of 22.2B EUR in 2022 which is an increase of approximately 13% compared to the preceding year. The gross margins remained pretty stable and there was an 11% increase in gross profit to 13.7B EUR coming from 12.34B EUR in FY 2021.

And while the EBIT increase may be a bit disappointing (mainly due to a lower 'other' operating income - primarily related to upfront payments and milestone payments and a higher 'other' operating expense, mainly related to profit-sharing agreements and impairment losses), the EBIT result of almost 4.5B EUR is very reasonable given the elements that impacted the results in 2022. And with a pre-tax income of 4.3B EUR and a net income of 3.34B EUR of which 3.33B EUR was attributable to the shareholders of Merck KGaA. The EPS was 7.65 EUR which means that based on the current share price of approximately 164 EUR, Merck is trading at just over 21 times its 2022 attributable net income.

That being said, Merck also releases a so-called 'pre' result. An adjusted result which mitigates the impact of non-recurring items. As you can see below, the EBITDA result was impacted by about 198M EUR in restructuring expenses and 88M EUR in integration expenses. The EBITDA before these elements was 6.85B EUR.

This also had an impact on the cash flow results as reported by the company. As you can see below, there were about 345M EUR in cash adjustments to the financial performance and that, in combination with the much higher net working capital investment, goes a long way in explaining why the operating cash flow on a reported basis decreased by almost 8% to 4.26B EUR.

On an adjusted basis (excluding the impact of the working capital investments, the underlying operating cash flow was approximately 5.18B EUR and approximately 5.17B EUR after taking the distributions to non-controlling interests into account.

The total capex during the year was approximately 1.8B EUR (excluding investments, disposals and M&A transactions) which means the underlying free cash flow result was approximately 3.36B EUR or 7.73 EUR per share. And keep in mind this includes the cash spent on non-recurring items which means the free cash flow result on an underlying and normalized basis likely exceeds 8.5 EUR per share.

As of the end of 2022, Merck had 1.85B EUR in cash, 9.2B EUR in long-term debt and 1.2B EUR in current financial debt for a net debt of approximately 8.65B EUR or between 1.2 and 1.3 times the adjusted EBITDA. This calculation excludes the financial assets and the liabilities to related parties. And thanks to the higher interest rates on the financial markets, the pension fund can use a higher discount rate to calculate the current fair value of its future obligations. Thanks to a higher discount rate, the net pension deficit decreased from 3.63B EUR as of the end of 2021 to 2.27B EUR as of the end of 2022.

This clearly indicates Merck has its balance sheet perfectly under control given the conservative debt ratio and the rapid decline of the net pension deficit.

The growth will pause in 2023 but resume in 2024

While Merck warns 2023 will be a challenging year due to a slowing semiconductor market and a further decrease in demand from COVID-19 related products, it expects a small organic revenue growth while the EBITDA will remain unchanged (indicating slightly lower EBITDA margins).

This means 2023 will likely be a transition year whereby Merck tries to protect its margins while setting up the company for better growth results in 2024 and 2025. The company has reiterated its target to generate a revenue of 25B EUR in 2025 which would be an increase of more than 10% compared to 2022. If Merck would aim to keep its margins roughly stable in 2025 as well, we can expect an underlying EBITDA result of approximately 7.5B EUR and an EPS of close to 10 EUR per share using an average tax rate of 22% (similar to what Merck is expecting for 2023).

And of course the company will continue to invest in its products and this will obviously have its ups and downs, as recently shown in the Phase 3 trial of a MS drug .

Investment thesis

Merck invests the majority of its cash flows in itself, either through organic R&D and capital expenditures, or by pursuing M&A. The company does pay a dividend ( 2.20 EUR over FY 2022 ) but this represents a dividend yield of just 1.35% (subject to the standard dividend withholding tax of 26.375% in Germany), which means investors should solely focus on the potential for long-term capital appreciation.

It definitely feels like Merck has its ducks in a row and now the debt ratio has dropped to less than 1.5 times the adjusted EBITDA I wouldn't be surprised if Merck would pursue another M&A transaction this year. While it's too bad the era of cheap debt appears to be over, the valuation of life sciences companies has come down as well I trust Merck KGaA to be smart enough to find accretive transactions.

I currently have no position in Merck but I would be interested in picking up stock in the 150 EUR range. I'm in no rush and perhaps there will be good buying opportunities later this year, but Merck doesn't appear to be expensive at this time.

For further details see: