Disappointing Quarter for Undervalued Merck

We plan to maintain our fair value estimate for Merck MRK following slightly disappointing fourth-quarter earnings but solid 2020 guidance along with the surprising spin-off announcement of several legacy drug platforms (including women’s health and biosimilars). We continue to view the company as undervalued, with the market not fully appreciating the firm’s strong position in immuno-oncology, led by Keytruda. Additionally, we don’t expect the spin-off of the older product lines to impact Merck’s wide moat, as Merck's intangible asset moat source remains intact, supported by a strong portfolio of drugs generating cash flows to develop the next generation of drugs.

Merck’s decision to divest older legacy drugs (just over $6 billion of expected 2021 sales or close to 12% of sales) should set up faster sales growth and a more focused company (50% less products), but sales dependence on Keytruda will grow. Merck is planning the spin-off in the first half of 2021, which should enable slightly faster growth for the remaining company. The spin-off should give Merck $8 billion-$9 billion in a special dividend, which we expect Merck will use for share buybacks and small tuck-in acquisitions. However, with the loss of the legacy drugs and the expected growth of Keytruda, we expect Merck’s dependence on Keytruda will grow to almost 40% of total sales by 2022, up from 24% currently. While Keytruda holds an excellent outlook, the increasing dependence on one drug increases Merck’s uncertainty.

Turning to the quarter, overall sales growth of 9% in the quarter was led by cancer drug Keytruda (up 46%). We expect Keytruda to lead overall growth for the next several years, supported by leading efficacy in lung cancer and likely new indications in earlier use settings. Lower sales from human papillomavirus vaccine Gardasil (partly due to shifts in inventory) weighed on the quarter, but we expect the vaccine to return to growth, driven by international markets.

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