Merck Stock Remains Significantly Undervalued At $77

Merck (NYSE: MRK) looks very attractive at current levels of $77, as it is up only 17% from the levels it was at on March 23, 2020, when broader markets made a bottom due to the spread of Covid-19. This marks a significant underperformance compared to the S&P which has moved 75% since its March 2020 lows, with the resumption of economic activities as lockdowns are gradually lifted and vaccination programs have been initiated in multiple countries. This underperformance doesn’t make sense in our view. While there are investor concerns over the company’s diabetes portfolio of Januvia and Janumet (accounts for 12% of Merck’s
MRK
total sales), which will likely see a slowdown in sales going forward, as it nears the end of the exclusivity period, it does not explain the large underperformance. In fact, we believe that Merck is currently one of the best picks in pharmaceuticals sector. Even if we were to look at a longer time period, MRK stock is up a mere 1% from levels seen toward the end of 2018.

This is surprising given the robust fundamentals of the company. Merck’s total revenue grew 13% to $48.0 billion in 2020, as compared to $42.3 billion in 2018. Also, the company saw an expansion of 390 bps for its adjusted net margins from 27.5% in 2018 to 31.4% in 2020, resulting in a 30% growth in net income from $11.6 billion to $15.1 billion over the same period. The company’s total shares also saw a decline of 5% over this period, and on a per share basis, adjusted earnings grew a solid 37% to $5.94 in 2020, as compared to $4.34 in 2018. Despite the robust performance over the recent years, Merck’s P/E multiple has contracted, and we believe it will likely expand going forward. Our dashboard, ‘What Factors Drove 1% Change In Merck Stock between 2018 and now?‘, has the underlying numbers.

Merck’s P/E multiple contracted from 18x in 2018 to 14x in 2020 based on trailing adjusted EPS. While the company’s P/E is at 13x now, it can see an expansion in the near term, led by steady earnings growth. We discuss more in the section below.

So what’s the likely trigger and timing for upside?

For Merck much of the revenue growth over the recent years has been led by its oncology drug – Keytruda – which saw its sales double from $7.1 billion in 2017 to $14.4 billion in 2020. Though the Covid-19 pandemic surely impacted the sales growth for some of its drugs due to fewer hospital visits, and a lower vaccination rate for Gardasil and Proquad, this will likely reverse as the Covid-19 crisis winds down. Keytruda continues to gain market share in several markets given its approval in multiple indications, including, lung, head & neck, bladder, renal, and skin cancer among others. Now, Keytruda’s patents are protected till 2028, which is at a distance, and it will likely garner over $25 billion in annual sales by 2026. Other than Keytruda, Merck is seeing steady growth in its Animal Health business, while Lynparaza and Lenvima look promising, aiding the company’s overall revenue growth. Furthermore, Merck, over the next few months, will complete the spin-off of its women’s health, legacy brands, and biosimilars businesses, forming a new company – Organon & Co. This will allow Merck to focus on more profitable drugs, implying better margins going forward.

Looking ahead, Merck will likely see an increase in sales, as the Covid-19 crisis winds down. That said, any further recovery in the economy and its timing hinge on the broader containment of the coronavirus spread. Our dashboard Trends In U.S. Covid-19 Cases provides an overview of how the pandemic has been spreading in the U.S. and contrasts with trends in Brazil and Russia. Looking at valuation, at the current price of $77, Merck is trading at 12x its estimated adjusted EPS of around $6.56 in 2021, compared to levels of over 17x seen in 2018 and 2019, implying there is more room for growth for MRK stock. Also, with the steady earnings growth going forward, led by improved margins and market share gains for Keytruda, the P/E multiple will likely expand further. As such, we believe Merck is significantly undervalued at the current levels of $77.

While MRK stock may see higher levels, 2020 has created many pricing discontinuities which can offer attractive trading opportunities. For example, you’ll be surprised how counter-intuitive the stock valuation is for UnitedHealth vs Ingevity.

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