Does The Valuation Gap Between Merck Stock And Zoetis Make Sense?

Zoetis stock (NYSE:ZTS) has risen 2x from levels of $92 that it was at on March 23, 2020, when broader markets made a bottom, to levels of $184 now, while Merck’s stock (NYSE:MRK)  has underperformed and gained only 26% of its value. Looking at valuation, Merck stock trades at about 4x trailing revenues, compared to around 13x for Zoetis. This underperformance doesn’t make sense in our view. While there are investor concerns over Merck’s diabetes portfolio of Januvia and Janumet (accounts for 12% of Merck’s 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, both as compared to broader markets (S&P 500 up 89%) as well as to Zoetis.

However, as we look forward, we believe Merck stock will likely fare better than Zoetis because of its valuation, restructuring initiatives, and expansion of Keytruda. Specifically, Merck has spun-off its low-growth women’s health and older drugs portfolio and it is now focused on high-growth products. Keytruda, in particular, remains the biggest asset for Merck with sales of over $14 billion (roughly 30% of total revenues) in 2020, and it will likely continue to gain market share. These initiatives will likely aid Merck’s revenues as well as margins over the coming years.

Let’s step back to look at the fuller picture of the relative valuation of the two companies by looking at historical revenue growth as well as operating income and operating margin growth. Our dashboard Merck vs. Zoetis: MRK stock looks undervalued compared to ZTS stock has more details on this. Parts of the analysis are summarized below.

1. Revenue Growth

Between 2018 and 2020, Merck’s revenues grew by about 13%, from around $42.3 billion to $48.0 billion, primarily led by its oncology drug, Keytruda, which saw its sales double from $7.1 billion to $14.4 billion over the same period. Looking at Zoetis, total revenue grew 16% from $5.8 billion in 2018 to $6.7 billion in 2020. Zoetis has seen steady top-line growth, even in 2020, due to higher demand for parasiticide products for companion animals, while the sales for the livestock segment has seen a slight decline over the recent years. Looking forward, Merck’s revenues are expected to rise in low single-digits, while Zoetis may see a top-line growth in low-teens in 2021. Note that Merck’s sales will be impacted by its recent spin-off of its women’s health and older drugs business.

2. Operating Income

Merck’s operating income grew from $8.3 billion in 2018 to $11.6 billion in 2019, before falling to $8.0 billion in 2020. The decline in 2020 can largely be attributed to a contraction in margins from 19.6% in 2018 to 16.5% in 2020. Merck increased its investments into R&D in 2020, impacting its overall margins. R&D expenses as a percentage of revenue grew over 500 bps from 23.1% in 2018 to 28.2% in 2020. Looking at Zoetis, the operating income has seen a gradual rise from $1.9 billion in 2018 to $2.2 billion in 2020. Zoetis’ operating margins have seen a modest rise from 32.5% to 33.4% between 2018 and 2020.

The Net of It All

It is evident that Zoetis’ historical revenue growth, operating margins, as well as operating income growth, all compare favorably with Merck. However, as we look forward, Merck will likely see steady revenue growth led by market share gains for Keytruda, and it will also benefit from its robust pipeline, which includes expansion of existing drugs, such as Keytruda, Lynparaza, and Lenvima for other treatments.

Barring the increased R&D investments in 2020, Merck’s operating margins have actually been on an upward trajectory, and it will likely trend higher going forward. Now that Merck has completed its restructuring with the divestiture of women’s health and the older drugs business, the company can look forward to much better margins over the coming years, implying stronger earnings growth. As such, we think the difference in valuation for Merck versus Zoetis will likely narrow going forward in favor of more attractively priced candidate, implying better returns for Merck.