Diversification has fallen somewhat out of favor in Big Pharma, as many companies are looking to a smaller number of larger therapeutic areas to generate better growth and cash flow. Merck (NYSE:MRK) is among them, as the company has made it clear that immuno-oncology is a top priority, along with hepatitis C (HCV) and vaccines to lesser extents.
It is certainly true that focusing intensely on oncology has done Roche (NASDAQOTH:RHHBY) no harm, and it is a path that Bristol-Myers Squibb (NYSE:BMY) is also choosing to follow. Merck also has some opportunities and options for restructuring its animal health and consumer businesses in a way that could add value. Although investor enthusiasm for immuno-onocology has driven these shares to a strong performance over the past year, they are not unreasonably priced for long-term investors.
It would seem that earnings barely matter
As I have commented in the past with companies like Bristol-Myers, the Street is giving only perfunctory attention to earnings releases these days unless there's a sizable miss. Merck's results were no exception.
Revenue was down 4% as reported, and down 1% in constant currency, and that was just a bit below the average Street guess. Pharmaceutical sales were down 3% (flat ex-foreign exchange), with Januvia/Janumet sales up 2% (making up more than 15% of pharma sales), Zetia up 6% and Remicade up 13%. Animal health sales were down 3% in reported terms, with consumer care down 1%.
Continuing the theme this quarter, Merck's margins were mixed. Gross margin was weaker than expected, falling two points, but the company made it up with lower SG&A and R&D spending. As a result, operating margins were slightly above expectations and Merck remains one of the stronger margin stories in the big pharma industry.
Time to shuffle the deck?
Concentration and focus is now in vogue in Big Pharma, and Merck looks to be following in the footsteps of Pfizer (NYSE:PFE) and others when it comes to restructuring its business. In particular, management has openly acknowledged that it is considering strategic options for its animal health and consumer/OTC businesses.
One of the more popular rumors is that Merck will trade with Novartis (NYSE:NVS) – swapping Merck's consumer business for the animal health and vaccine businesses of Novartis. While there would need to be some cash involved to make the deal balance, there's some appeal – Merck has a sub-scale consumer business and Novartis has a sub-scale vaccine business and both could likely benefit from the swap. The animal health part might be more problematic, as Merck's animal health business is large (second to Pfizer's former business Zoetis) and there may be antitrust issues that would interfere with this swap.
Even without Novartis's animal health business, it would be a deal worth considering. Vaccines are less than 5% revenue and contribute almost no profits to Novartis, while Merck's consumer health is tiny by Merck standards but would expand the Novartis consumer health business by roughly one-third and bring in brands like Claritin, Dr. Scholls, and Coppertone.
Full speed ahead in immuno-oncology
Merck has not been shy in professing its enthusiasm for immuno-oncology, with the CEO calling it a once-in-a-career opportunity and a top priority for R&D dollars. As I have written before, that enthusiasm is not at all misplaced, as this therapeutic class could ultimately be measured in the tens of billions of dollars of annual revenue opportunity. What's more, Merck's PD-1 compound MK-3475 (lambrolizumab) makes it a very serious contender against Bristol-Myers and Roche.
Comparing across early stage clinical trial results is problematic and often misleading, but the results seen to date from MK-3475 suggest that it is a legitimate candidate in melanoma and perhaps even better than Bristol-Myers' nivolumab in non-small-cell lung cancer (NSCLC). Merck has also managed to move much faster than expected, with a rolling submission for MK-3475 in melanoma already under way. Bristol-Myers' nivo will probably get to market first in NSCLC, but it now looks as though Merck will be first in melanoma. Although I believe the market is getting a little too hung up on time to market (and I believe Roche is may be slipping to "underrated" in immuno-oncology), it's still a strong step for Merck.
Merck is also moving aggressively to establish MK-3475 as a potential platform therapy. The company announced collaborations with Pfizer, Amgen, and Incyte to evaluate MK-3475 with other oncology therapies, including Pfizer's Inlyta and PF-2566. As Pfizer's oncology pipeline is arguably not up to scratch today (at least not in immuno-oncology), this could be a useful ride-along opportunity. It's also worth noting that the potential to combine immuno-oncology drugs with other oncology therapies is a major plus in Roche's column (due to its deep and broad oncology platform), so this is a logical competitive move for Merck.
The bottom line
Sell-side analysts have added more than $3 billion on average to their 2020 revenue estimates for Merck's pipeline, with a lot of that coming from immuno-oncology. That in turn has helped drive a 30% move in the shares over the past year, and it's hard to argue that Merck's shares have been overlooked. Only modest free cash flow growth (around 2%) is needed to support a fair value in line with today's price, though, and while I think it will be challenging for Merck to exceed that growth rate, I see the move in the shares as only taking Merck from under-valued to fairly valued, leaving the shares as a credible option for long-term investors.