Houston, we may have a problem.
Pharmaceutical juggernaut Merck (NYSE:MRK) reported its fourth-quarter earnings results before the opening bell on Wednesday, and while its Q4 profits did indeed surpass what Wall Street had been forecasting, two data points from its report, in particular, have investors concerned about its near-term growth prospects.
Merck's Q4, by the numbers
For the fourth quarter, Merck reported $10.22 billion in sales, a 3% decline from the prior-year quarter. Included in this decline was a 7% negative effect from currency translation, as well as a 3% benefit from acquisitions and divestments (i.e., its acquisition of Cubist Pharmaceuticals). Running the math, we're looking at operational growth of about 1%, which is more or less consistent with what we've seen throughout 2015 for Merck. For context, Wall Street was expecting $10.36 billion in total sales.
On a profitability basis, the company delivered $104 million more in adjusted net income than during Q4 2014 despite the drop in revenue, resulting in $0.93 in adjusted EPS, a 7% improvement over the $0.87 reported in the prior-year quarter. Wall Street had been looking for just $0.91 in EPS.
There were quite a few strong points in Merck's Q4 report. The profit beat implies that Merck's cost-cutting efforts are working, and its operational growth demonstrates to some extent that the sum of the parts is working, even if currency moves are beyond its control. Strength was seen in human papillomavirus prevention vaccine Gardasil, whose sales rose 42% on a constant currency basis from Q4 2014, and in animal health where operating sales improved 8%.
Not surprisingly, though, the biggest boost came from cancer immunotherapy Keytruda, which in early October saw its label expanded by the Food and Drug Administration for use in patients with second-line, metastatic non-small cell lung cancer with high PD-L1 expression. Sales for Keytruda rose to $214 million from $50 million on a year-over-year basis, and 35% from the sequential third quarter. It looks to be on pace to hit $1 billion in full-year sales in 2016.
But, this strength, and the earnings beat, took a back seat to two worrisome figures in Merck's Q4 report.
Worry No. 1: Januvia/Janumet sales
The big "proceed with caution" flag in Merck's quarterly results has to do with the weakness seen in Januvia (known as Janumet in overseas markets).
Januvia is a DPP-4 inhibitor designed to treat type 2 diabetes, and it also happens to be Merck's top-selling drug. Among DPP-4's, Januvia holds the vast majority of market share. During Q4, Januvia/Janumet sales dropped to $1.45 billion, a 12% year-over-year decline. When factoring in the effects of currency translation, the operating decline was a subtler 6%. Nonetheless, investors were probably shocked to see any decline considering how much Merck has invested in recent quarters in terms of marketing Januvia and shoring up the brand's appeal with physicians.
The worry is that Januvia's sales decline may not be a one-quarter event, and it could be tied to the emergence of SGLT-2 inhibitors. SGLT-2 inhibitors block glucose absorption in the kidneys, allowing the patient to excrete excess glucose through their urine and providing the desired glycemic balance. In addition, positive side effects have been observed with SGLT-2 inhibitors, such as weight loss and lowered systolic blood pressure (which are both good news since type 2 diabetics are often overweight or obese and have high blood pressure, more often than not). The main SGLT-2 players are Eli Lilly (NYSE:LLY) and Boehringer Ingelheim with Jardiance, Johnson & Johnson (NYSE:JNJ) with Invokana, and AstraZeneca with Farxiga.
In September, Eli Lilly and Boehringer released detailed study data from its long-term cardiovascular outcomes trial known as EMPA-REG OUTCOMES involving Jardiance. The results showed a statistically superior 32% reduction in all-cause mortality for the Jardiance cohort compared to the current standard of care, leaving some investors to wonder if Januvia could slowly be phased out in favor of SGLT-2 inhibitors like Jardiance. By the second-half of 2016 we'll also be receiving top-line data from Johnson & Johnson's long-term CV trial for Invokana. If Invokana demonstrates a superior CV effect as well compared to the placebo, Januvia could be in trouble.
We've been wondering whether these two classes would be complementary or competitive; and the data since Lilly's and Boehringer's CV trial release suggests it may be more of the latter than the former.
Worry No. 2: Full-year guidance below expectations
The second issue with Merck's quarterly results was its full-year guidance for 2016. The company anticipates its full-year sales will total $38.7 billion to $40.2 billion, which is inclusive of a 3% negative effect of foreign currency translation. It's also forecasting $3.60 to $3.75 in adjusted EPS, with earnings negatively affected to the tune of 4% by currency moves. On a comparative basis, the midpoint of sales guidance implies a slight sales decline in 2016, while adjusted EPS is forecast to rise by a low single-digit percentage at the midpoint.
However, Wall Street wasn't thrilled. The consensus had called for nearly $40.2 billion in full-year sales, and $3.72 in full-year EPS. Even though these are within the ranges provided by Merck, the midpoint is below the current consensus.
The reason this is so worrisome for investors is that there are so many reasons beyond just currency moves why Merck's top- and bottom-line results could underperform in 2016.
For starters, Merck could be factoring in additional pressure on its Januvia/Janumet franchise from SGLT-2 inhibitors. We're talking about a drug responsible for around 15% of Merck's total sales, so upsetting that revenue stream could indeed be a big deal.
There's also concern that Merck's "diversified brands" could continue to weigh down its top-line. Merck, like other drug developers, is a victim of the patent cliff and increasing levels of competition. Unfortunately for investors, it's still feeling the effects, whereas some of its peers have moved over that temporary hump. Singulair sales dropped another 15% in 2015, while Nasonex sales plunged 22%. It's possible we could continue to see this sales weakness from mature products carry through and beyond 2016.
Perhaps the biggest concern is over the launch of Zepatier, Merck's hepatitis C doublet that was approved by the Food and Drug Administration last week. This once-daily doublet offers HCV genotype 1 and 4 patients a new treatment path, but it also was priced very aggressively for a 12-week treatment course ($54,600) relative to competitors' Harvoni ($94,500) and Viekira Pak ($83,319). Although the pricing move might just remove some of the negotiating between insurers and Merck, it could also wind up adversely impacting Merck's margins. Thus, Merck's conservative 2016 guidance might really be a reflection of uncertainties regarding Zepatier.
The truth is we really can't grasp all of the facets of why Merck's guidance failed to meet the mark, but it'll bear close monitoring in 2016.
For now Merck remains a drug developer capable of substantial cash flow generation and it bears an above-average dividend yield of 3.6%. That, along with Keytruda's combination potential, should help provide some support to its valuation. Still, weakness in Merck's leading drug, and conservative growth guidance, may also cap any near- and intermediate-term upside in its valuation.