Despite Outperforming The Broader Markets, Merck Appears To Be Oversold At $80

Merck (NYSE:MRK) stock declined 10% from $90 levels in the beginning of this year to $80 levels as of April 22, compared to a 13% decline for the broader S&P 500. While Merck’s stock has marginally outperformed the broader markets, we believe there is over 20% upside potential from the current levels. Why is that? Merck’s stock has been on a strong run, with 55% jump since the start of 2018, a little over two years ago, as compared to 6% growth for the S&P 500. Our dashboard, ‘What Factors Drove 55% Change In Merck’s Stock Between 2017 And Now?‘ provides the key numbers behind our thinking, and we explain more below.

The stock price gain over the past two years can primarily be attributed to strong revenue and earnings growth for the company. Merck’s revenues were up 17% from 2017 to 2019. This combined with a 250% jump in net income margin from (a depressed) 6.0% in 2017 to 21.0% in 2019, helped earnings per share swell 336% (from low levels). Note that these numbers are based on Merck’s GAAP results. The reason for the low margin in 2017 was tax provisions of $4.1 billion, as compared to $718 million in the prior year. This can be attributed to the impact of changes in the U.S. tax laws. This led to lower GAAP EPS in 2017, thus swelling the EPS growth over the following years. For comparison, on an adjusted basis, Merck’s EPS grew 30% between 2017 and 2019. We explain the drivers for Merck’s expenses and net income margin in ‘Merck Expenses‘ interactive dashboard analysis.

A sizable drop in Merck’s P/E multiple (back to more normalized levels) has largely mitigated the rise in the company’s earnings. Merck’s P/E multiple dropped from 60x (again due to the changes in tax law, GAAP EPS figure was low, thus swelling the P/E ratio) at the end of 2017 to 23.5x by the end of 2019. Moreover, Merck’s P/E is down to about 21.2x now, given the volatility of the current situation. This reflects a 64% decrease in P/E multiple since December 2017. We believe there is a potential upside for Merck’s multiple when compared to levels seen over the recent period – P/E of 23.5x at the end of 2019, and 21.2x currently. Note that Merck’s P/E multiple has expanded over the recent years, compared to some of its peers, including Pfizer.

The reason for Merck stock’s outperformance over the recent years can be attributed to the massive success of its cancer drug, Keytruda. The drug garnered sales of $3.8 billion in 2017, and it jumped 3x to $11.0 billion in 2019. And the party isn’t over, as its peak sales are estimated to be north of $22 billion in 2025. The reason for this massive success of Keytruda is its expansion to several cancer types. Initially, the drug was approved for skin cancer in 2014, and since then it has been on a roll with several regulatory approvals for different types of cancer, including lung, head & neck, gastric, cervical, renal, and bladder, among others. The approval for first line treatment of lung cancer was the game changer for Keytruda, and lung as an area now accounts for close to 70% of the drug’s total sales. Our analysis on ‘Merck’s Revenues‘, provides more details on the company’s business model, segments, historical revenues and our forecasts.

Looking forward, Keytruda is under phase 3 trials for new areas, including breast cancer, which is a large addressable market. As such, Merck’s stock could potentially continue to outperform over the next few years, and any decline in stock price could be seen as a buying opportunity. We also looked at an ‘outlier’ case, where Keytruda could add over $22 billion in incremental revenues over the next few years, led by establishing a leadership position in existing therapeutic areas, and expanding into new ones. This outlier scenario would result in over $200 billion valuation for Keytruda alone. For comparison, overall Merck’s current valuation is around $200 billion.

How Is Coronavirus Impacting Merck’s Stock?

The global spread of coronavirus has led to lockdown in various cities across the globe, which has affected industrial and economic activity. This is likely to adversely impact Merck’s revenues, as it faces supply chain disruptions, and potential impact on direct sales, due to postponement of minor health related issues and surgeries. Between January 31st and April 22nd, Merck’s stock has lost 6% of its value (vs. about a 13% decline in the S&P 500). A bulk of the decline in the stock markets came after March 6th, when an increasing number of Coronavirus cases outside China fueled concerns of a global economic slowdown. Matters were only made worse by fears of a price war in the oil industry triggered by an increase in oil production by Saudi Arabia. Notably, Merck derives 40% of its revenues from the U.S., which has become the new epicenter of the outbreak, with the country recording the largest number of COVID-19 cases across the globe. As such, revenues are likely to be impacted by the ongoing crisis in the near term. We believe Merck’s Q1 results next week will confirm the trend in revenues. Going by historical trends, and potential of Keytruda, we believe that the company’s stock could potentially offer upside returns. In fact, based on our ‘Merck Valuation‘ dashboard, the upside for Merck could be over 20% from the current levels. Even during the 2007-08 crisis period, Merck outperformed the broader markets, something we explain in our 2007-08-2020 crisis comparison dashboard for Merck.

In addition, our dashboard forecasting US COVID-19 cases with cross-country comparisons analyzes expected recovery time-frames and possible spread of the virus.

Further, our dashboard -28% Coronavirus crash vs. 4 Historic crashes builds a complete macro picture. Additionally, the complete set of coronavirus impact and timing analyses is available here.

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