MRK - Organon: A Bitter Pill

2023-03-24 14:03:55 ET

Summary

• Organon & Co. has seen mostly margin disappointments since the spinoff from Merck & Co., Inc.
• While the performance is not comforting, valuations are non-demanding.
• Leverage is high, but stabilization in the business, longer-term maturities, and fixed rates alleviate many leverage concerns.
• Organon & Co. shares look compelling here, for those with a long-term horizon.

In August, I wondered what the recipe was for shares of Organon & Co. ( OGN ), as the business had seen real struggles in its first year as a publicly listed business. While investors were not looking for growth, the margin pressure seen came unexpectedly, as this meant that leverage ratios increased, creating few triggers for the near-term investment horizon.

The Spinoff

Organon was spun-off from Merck & Co., Inc. ( MRK ) in the early summer of 2021, starting its life as a publicly traded business in the thirties, albeit seen with some volatility.

Ahead of the spinoff, Organon was a $6.6 billion business which focused on women's health, including unintended pregnancies, treatment of peri- and postmenopausal symptoms and uterine fibroid, among others. The company posted sales across two segments: a $4.5 billion "established brands" business; and a $1.6 billion women's health business, including biosimilar products.

The company is a global business and posted adjusted EBITDA of $2.8 billion, which translates into very fat margins. While there were concerns relating to loss of exclusivity, the business was quite diversified in terms of the product lineup and geographical exposure. That said, a $6.1-$6.4 billion guidance for 2021 sales indicated that stabilization was not achieved, but that sales would come down.

Based on the $2.8 billion in EBITDA number, I pegged earnings power around $1.6 billion if we factor in $200-$300 million in capital spending, $400 million interest costs and tax rates. This could translate into earnings of $6.50 per share, as that looked compelling given the valuation of the shares at the time.

The 5 times earnings multiple looked very low, but there were some concerns which included pressure on sales and margins and a debt load, with net debt of $8.6 billion being largely equal to the equity valuation at the time, with leverage coming in at 3.1 times EBITDA.

After trading in the $30s, Organon & Co. shares fell to $28 in August as I picked up coverage again. In the first half of 2022, the company posted its 2021 sales at $6.3 billion, but the issue is that EBITDA fell to $2.4 billion, down 10 points to 38% of sales.

The company guided for flattish sales between $6.1-$6.4 billion in 2022 with EBITDA margins of 35% revealing potential EBITDA around $2.2 billion, reducing earnings power probably to the tune of around $6 per share, or less. This was the original guidance, as the midpoint of the sales guidance was cut to $6.2 billion following the second quarter results, with EBITDA margins now seen at 33%, making that EBITDA was seen down as much as levels to the $2 billion mark.

This meant that leverage ratios increased to about 4 times EBITDA, meaning that real execution was needed to avoid leverage concerns and drive appeal in the shares.

Coming Down

Shares have fallen from the $28 mark in August to $22 at this point in time, as the 2022 results were pretty reasonable on the topline. Reported sales fell 2 points to $6.17 billion as revenues otherwise would have grown 4%. Reported EBITDA was down 8% to $2.08 billion which made that adjusted earnings fell from $6.20 per share to $5.03 per share, with GAAP earnings coming in around $3.50 per share. A bit of a concern is that net debt is only coming down painfully slow, although an $8.2 billion net debt number might benefit from better working capital conversion this year.

The 2023 guidance calls for more stagnation with sales seen between $6.15 and $6.45 billion which at the midpoint of the guidance calls for 2% growth. This might be driven by the dynamics of the 2022 results as well. The largest established brands business posted a 5% fall in sales to $3.87 billion, in part offset by a 4% increase in women's health to $1.67 billion in sales and a 13% increase in biosimilar revenues to $481 million.

The small anticipated increase in sales came after a recent pullback in the dollar and a general inflationary environment of course, making that real growth is still not seen. EBITDA margins are seen between 31 and 33%, down from 33.7% in 2022, which suggests a bit more pressure on this front as well, albeit minimal.

This suggests another year of stagnating performance and higher leverage, but investors can look forward to a solid earnings yield and a dividend yield in excess of 5%. With regard to debt, about $3.5 billion in debt appears to be floating if we look at the 10-K filing, or about 40% of total debt, which is comforting as Organon has many maturities until 2028 and beyond.

Still Holding

While cheapness in itself is never an argument, Organon & Co. appears to be doing quite alright, in the sense that sales have stabilized. Since the spinoff, margins have fallen a great deal, but hopefully we should see stabilization later in 2023, as biosimilars might play a role in the growth revamp of the business.

At such a point in time, certainly as leverage ratios come down, there is significant potential value in the case of a valuation re-rating. The Organon & Co. business appears to be quite stable, and although leverage remains a continued point of attention, over time appeal should be found here.

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