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Coverage initiated August 26, 2020, at $85 in the Healthcare portfolio.
by Lawrence Rothman

Company Overview

Merck is a 130-year old company that produces prescription medications, vaccines, biologic therapies, and animal health products around the world. Earlier this year, the company announced that it plans to spin off a business that covers women’s health, certain legacy brands in the dermatology, pain, respiratory categories, and some cardiovascular products including Zetia and Vytorin. The new group’s business has annual sales of $6.5 billion and consists of older and slower-growth products. For instance, Zetia and Vytorin had combined sales of $875 million last year, down from $2.1 billion and $1.4 billion in 2017 and 2018, respectively. Management expects to separate the business, called Organon, in the first half of 2021.

Pharmaceuticals account for about 90% of its $47 billion of annual sales. The key driver of sales growth over the last few years has been Keytruda. Sales for the oncology drug, which is used to treat all kinds of cancers, have been growing by leaps and bounds. It was $3.8 billion in 2017 and it zoomed up to over $11 billion last year. Keytruda is under patent protection until 2028 in the U.S. and EU, and expires around the same time in Japan. Not confined to treating just one type of cancer, we aren’t too concerned that this is a big chunk of the company’s sales. Even better, the company is testing the drug to treat even more types of cancers. It currently has around 10 trials going on. While the outcome and subsequent governmental approval are never sure things, based on its track record so far, we are betting on the company moving forward and marketing the drug for different indications.

If you are troubled about Merck’s reliance on Keytruda, the company is also beefing up its oncology pipeline. In December, the company acquired ArQule for $2.7 billion. This company has a drug candidate in a Phase 2 trial that is designed to treat cancer. There were also other recent deals to acquire molecule inhibitors that have shown more success than traditional chemotherapy.

Aside from the recent acquisition, it is important to know that Keytruda isn’t the only treatment experiencing growth. We’re sure you’ve heard of Gardisil from advertisements. This treats human papillomavirus, commonly called HPV, an STD. Sales grew 19% last year, to $3.7 billion. Bridion, used during surgery, is another strong performer. The drug’s sales hit over $1 billion last year, achieving blockbuster status.

Merck has also put its hat in the COVID-19 ring. With a strong presence in vaccines, this is a natural challenge for the company to take on. There are three treatments it is working on. Two are vaccines in the pre-clinical stage. This puts the company behind others in the race, but to us, winning means having the most effective vaccine, not getting the first one to market.  That will play out over time. It is also working on an oral antiviral drug, which is currently in a Phase 2 trial.

Competitive Analysis

Merck’s competitors include a familiar cast of large pharmaceutical companies. Bristol Myers Squibb offers a competing product to Keytruda. Pfizer and Roche are a couple of other companies that compete with Merck.

With a long period of exclusivity for Keytruda and other key drugs like Gardasil, Merck is in a strong position while it continues to develop more drugs. The key to maintaining their competitive advantage is to use the company’s strong cash flow from existing treatments and either invest in new drugs or acquire them to replace those with expiring patents. It is not an immediate threat since its core Keytruda doesn’t come off patent for several more years.

Fortunately, Merck has built up a large operation, a big competitive advantage in the Pharmaceutical industry. It conveys all kinds of benefits like achieving economies of scale and allowing the company to invest in R&D on multiple projects.

Financial Analysis

Recent results were hurt by the pandemic due to social distancing causing fewer doctor visits. In turn, there were fewer well visits, vaccinations, and other physician administered products. 2Q20 sales fell 8% versus a year ago to $10.9 billion. Management did a good job on costs, and earnings rose from $2.6 billion to $3 billion.

Meanwhile, Keytruda sales kept on growing, increasing 29% year-over-year to $3.4 billion in the quarter. Its other products were weaker. As restrictions are lifted and people start returning to the doctor and having elective surgeries, no doubt this will bounce back, and we expect to start seeing this reflected in 3Q20 revenue.

Management expects COVID-19 to dent this year’s revenue by $2 billion. Despite this, their guidance calls for revenue of $48.0 billion compared to 2019’s $46.8 billion. The pandemic has resulted in cost savings, and they expect that to total $400 million. Even with some revenue pressure, management’s earnings guidance calls for $4.65 a share, markedly higher than $3.81 in the year-ago period.

Turning to the balance sheet, with a strong investment-grade rating, we have no concern. There is $11 billion of cash, sustaining debt of $31 billion.

Traditionally, Merck has raised its dividend annually. It currently offers shareholders a decent 2.9% yield.

Stock Performance

The stock is down 8% this year, falling to $85 from $92. With its strong oncology and vaccines franchised, it won’t stay down for long. Even without producing a COVID-9 treatment, the company’s results will rebound after a rough 2Q. With Keytruda and people visiting doctors again, this is a good opportunity to own a blue chip company when the price is down.


Merck is a solid investment. There are several companies pursuing a COVID-19 vaccination - there is competition in this huge area; we know this. However, there may very well be more than one winner. Merck is likely to be among them giving the stock strong upside potential.

Even if others get there ahead of Merck, the Keytruda franchise will lead the way for several more years. In that scenario, we expect steady revenue and income growth.

We are initiating coverage with a $93 Target Price and a $71 Sell Price.