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Is Merck & Co. a Buy?

By George Budwell - Aug 21, 2018 at 9:27AM

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Merck's massive surge higher might be coming to an end. Here's why.

Merck & Co. (MRK 0.08%) has the distinguished honor of being the second best-performing big pharma stock so far this year. The drugmaker's shares have been powered higher by the outstanding performance of cancer immunotherapy Keytruda, along with the U.S. tax reform legislation that has greatly expanded the company's financial capacity for further business development. 

In the wake of Merck's massive 24.8% gain this year, however, its shares might be ready to cool off. The drugmaker's stock is currently trading at 52-week highs and its price-to-sales ratio of 4.52 is now among the highest within its immediate peer group. Are Merck's shares ready to revert to the mean or can they push even higher? Let's take a look to find out. 

Man in a business suit holding a bear figurine in one hand a bull figurine in the other.

Image source: Getty Images.

The bull case

Merck's main growth driver, Keytruda, saw its sales grow by an astounding 89% in the second quarter compared to the same period a year ago. This jaw-dropping growth has been fueled by Keytruda's ability to break into the frontline setting for locally advanced or metastatic non-small cell lung cancer (NSCLC) -- an indication Bristol-Myers Squibb's competing therapy, Opdivo, presently lacks.

While Keytruda is set to face other competitive threats in the all-important NSCLC market going forward, Wall Street still believes that this drug can achieve global sales in excess of $12 billion by 2024. Heading up the rear, Merck is also expected to benefit from strong growth in its Gardasil franchise, muscle relaxant reversal compound Bridion, and PARP inhibitor Lynparza, which is being co-commercialized with AstraZeneca

The good news is that this trio of growth drivers is already generating impressive levels of free cash flow. In the second quarter, for instance, the drugmaker's free cash flow came in at a stately $2.8 billion for the three-month period. As a result, Merck's financial capacity to execute on any number of business development opportunities has been steadily rising this year, and that increased capacity could be key to future growth.

The bear case

Merck's story isn't all sunshine and roses, however. The company is quickly becoming too dependent on Keytruda for growth, and that could present serious problems as the cancer immunotherapy market matures. Cocktail therapies consisting of two or more drugs might end up proving superior to Keytruda in some key indications down the road.

Merck therefore needs to diversify its revenue stream by bringing new growth products online soon. Unfortunately, the drugmaker's pipeline isn't all that well-stocked at the moment. Outside of the experimental pneumococcal conjugate vaccine V114, Merck presently lacks another clear-cut star in its mid- to late-stage clinical pipeline.

In fact, Merck's clinical pipeline was ranked a lowly eighth among major drug manufacturers in terms of net present value, according to a recent report by EvaluatePharma. This bottom-tier ranking is certainly concerning from an investing standpoint. Merck, after all, has among the highest research and development expenses as a percentage of total sales in the industry.  

This dearth of star drug candidates in the pipeline and the increasingly competitive nature of the immunotherapy market are expected to eventually put a chill on Merck's growth. As things stand now, Wall Street has the drugmaker's top line rising by an anemic 1% on average over the next six years. That projected growth rate is good for last place among big pharma and blue chip biotechs. 

Time to buy?

Merck has had a stellar run this year, but it's starting to look like this red-hot stock may be nearing a top. Merck shares are arguably fairly valued based on their elevated price-to-sales ratio, which seems to bake in a good bit of Keytruda's future growth. As such, it might not be a smart idea to chase this stock right now. Other big pharmas -- like Astra and Bristol -- offer far more attractive long-term growth prospects than Merck, after all.

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