The Year 2016 In Review: Merck Can Look Back And Smile

Merck (NYSE:MRK) has had a reasonably good year. The company saw a turn-around in its business on the back of its relatively new cancer drug, Keytruda. The anti-infectives division sustained itself, with key metabolism drugs Januvia and Janumet gradually inching up. In fact, the competitive pressure from J&J’s Invokana, which threatened Januvia initially, seems to have abated. The stock gained meaningfully despite broad concerns around the pharmaceutical sector, which is by no means a small feat for a company of this size. Having said that, we think investors should exercise caution as Merck’s stock appears to be highly dependent on Keytruda and the oncology pipeline seems rather thin. While Merck has a clear edge as of now, the competitive threat in this segment is likely to increase going forward.

Our price estimate of $65.50 for Merck is nearly 10% above the market.

Merck Saw a Growth Turnaround In 2016

Like many other big pharmaceutical firms, Merck has not been immune to the patent cliff. The company saw its revenue decline by nearly 18% between 2011 and 2015. In 2015 alone, its sales fell by roughly 6.5%. However, the trend seems to have reversed with Merck reporting 1.4% topline growth in the first 9 months of 2016. A small number, yet quite big when seen in the context of what happened in the past few years.

So what changed this year? First, Keytruda’s sales ramp up was impressive. The drug, which was initially approved for advanced Melanoma, saw its usage expand to multiple other areas, including metastatic or recurrent head and neck squamous cell carcinoma, as well as metastatic non-small cell lung cancer. We expect the drug to add nearly $1.25 billion in revenue for the full year 2016, implying well over 100% year-over-year growth. Second, Gardasil continued on an upward track and helped keep the huge anti-infective drugs and vaccine franchise resilient. Some of this was driven by public sector purchases as well as expanded age indication. Third, some of the decline in off-patent drugs that we saw in previous years, abated to an extent.

With The Turnaround And Opdivo’s Failure, The Market Cap Increased Nearly 20% 

Merck’s market cap increased nearly 20% this year while S&P pharmaceutical index was down more than 20%. The overall sector reflected the ongoing concerns around tax inversions weighing on potential M&A activity, the advent of biosimilars weighing on profits, and presidential candidates voicing their concerns over drug pricing. So did the turnaround in Merck’s business warrant such deviation from the sector performance? Perhaps only partially. The other half of the equation revolves around the failure of Bristol-Myers Squibb’s drug Opdivo. Here is what we note.

1. Merck’s stock fell in January, when the overall market suffered due to concerns over China’s economic growth. However, since then, it has been on a recovery path with the biggest single day jump coming on August 5th, 2016.
2. The gradual recovery can be traced to the turn around in Merck’s topline growth, and much of that has to do with the ramp up of Keytruda aided by additional approvals. Although, some of the key drugs including Remicade and Singulair continued their decline, we think that their trajectory was priced in by the market long ago and there were no surprises there. What helped, additionally, was that Merck’s biggest business — anti-infective drugs and vaccines — remained resilient. This segment accounts for nearly  25% of the company’s revenue. Despite Cubicin’s patent loss, higher sales for Gardasil and Proquad have helped investors remain confident about this business. At least, the potential losses aren’t anywhere near in sight with only a few small drugs expected to go off patent in the next few years.
3. The biggest jump, that was observed on August 5, can be attributed to a Phase 3 trial failure of rival cancer drug Opdivo. Investor reacted positively due to a couple of reasons. One, Keytruda appears to be the primary growth engine from Merck and failure of Opdivo implied lower competitive risk. Second, Opdivo’s failure was specifically associated with lung cancer, which can be a significant market for Keytruda.

Pipeline Milestones Were All About Keytruda

Merck’s key pipeline milestone revolved around its cancer drug Keytruda. The drug got FDA approval for recurrent or metastatic head and neck squamous cell cancer and metastatic non-small cell lung cancer for first line treatment for patients exhibiting high levels of PD-L1 (PD-L1 stands for programmed death-ligand 1, which is a type of protein that is known to suppress the immune system and can be used by immuno-oncology drugs to inhibit cancer growth). Additionally, Keytruda received breakthrough designation for classical Hodgkin’s lymphoma, as well as priority review for 2 additional conditions. That’s not all, the company also received FDA approval for Zepatier, which is a Hepatitis C drug targeting genotypes 1 and 4 of the virus. We expect peak sales for Opdivo to be around $6-$8 billion and that for Zepatier to be around $2 billion.

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