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Is Merck's Decision to Slim Down a Buying Opportunity?

By George Budwell – Updated Feb 6, 2020 at 9:13AM

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It wasn't a big hit with investors on Wednesday.

On Wednesday, the multinational pharmaceutical giant Merck (MRK 1.41%) revealed plans to carve out its women's health, legacy brands, and biosimilars units into a stand-alone business. This strategic spinoff will reportedly transform the biopharma into a growth-oriented business focused on branded cancer medicines, vaccines, hospital products, and animal health. The split is planned to take effect in the first half of 2021. 

Merck's decision to slim down follows similar moves by peers AstraZeneca (AZN 2.96%)Eli Lilly (LLY 8.08%), GlaxoSmithKline, and Pfizer (PFE 1.42%). All of these top pharmas have jettisoned one or more of their business segments in the past year in an effort to spotlight their newer growth products. For Merck in particular, this carve-out will place an even greater focus on its top-selling cancer immunotherapy medicine Keytruda.  

Tiny shopping cart with pills on top of a pile of hundred dollar bills.

Image source: Getty Images.

Although Merck's brain trust reassured conservative-minded income investors that it will continue to pay a respectable dividend (and the resultant spinoff will even pay a modest dividend as well), the drugmaker's shares still fell by almost 3% on the heels of this news. Is Merck's planned de-merger actually a compelling buying opportunity, or was the market's initial pessimism warranted? Let's break down the big pharma's near-term outlook to find out.

Opportunities and risks

The clear-cut benefit from this planned spinoff is that it will spotlight the healthy growth of Keytruda, the neuromuscular blockade reversal drug Bridion, and the company's top-flight vaccine portfolio. Before the split announcement, Wall Street was forecasting Merck's top line to rise by a pedestrian 2.2%, on average, over the next five years. After this split, however, this key growth metric should improve markedly, thanks largely to the excision of several off-patent medicines like the cholesterol drugs Zetia and Vytorin from its portfolio. 

This strategic move does create some real problems, however. By shaving off its women's health, legacy brands, and biosimilars segments, the drugmaker will lose approximately 14% of its annual revenue. That's a big chunk of money that will no longer be available for shareholder rewards and business development activities. This higher top-line growth will thus come at the substantial cost of significantly lower free cash flows -- which obviously isn't sitting well with risk-averse folks. 

Going one step further, this split might ultimately force Merck to become an ultra-aggressive player on the merger and acquisition (M&A) scene. While acquisitions can turn out to be a boon for pharma companies, they can also turn into expensive misadventures. One of the core reasons the market hasn't warmed up to Pfizer's planned split, after all, is that the company arguably overpaid for most (if not all) of its recent acquisitions. Pfizer seemingly had no choice but to open up its pocketbook in order to boost its late-stage pipeline ahead of this de-merger. Merck, in turn, might end up in the same boat. 

Time to buy?

Merck is clearly trying to take a page out of Astra's and Lilly's playbook. By excising noncore assets and pivoting toward oncology as a key growth driver, these two big pharmas have both turned into top-performing growth stocks. Unfortunately, Merck probably won't follow in their footsteps. Astra and Lilly both sport broad portfolios of branded growth products, amassed over fairly lengthy time periods. The same can't exactly be said for Merck as things now stand. 

The company has a lot of work to do to first dilute Keytruda's overall importance and, second, to build a stable of branded products capable of sustained, long-term growth. That simple fact means that Merck will likely have to spin the wheel on the high-risk M&A roulette table soon. So, until the company begins this process in earnest, it might be best to stay on the sidelines.   

  

George Budwell has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Merck & Co., Inc. Stock Quote
Merck & Co., Inc.
MRK
$87.05 (1.41%) $1.21
Pfizer Inc. Stock Quote
Pfizer Inc.
PFE
$44.72 (1.42%) $0.62
AstraZeneca PLC Stock Quote
AstraZeneca PLC
AZN
$54.81 (2.96%) $1.57
Eli Lilly and Company Stock Quote
Eli Lilly and Company
LLY
$336.24 (8.08%) $25.14
GSK Stock Quote
GSK
GSK
$29.57 (3.19%) $0.92

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