Better Margins Can't Hide Merck's Growth Challenges

By Stephen D. Simpson, CFA | July 30, 2013 AAA

In spite of pretty weak top-line results, pharma companies like Merck (NYSE:MRK), Pfizer (NYSE:PFE), and Bristol-Myers (NYSE:BMY) have benefited from a relatively bullish sentiment on healthcare stocks. That sentiment may be petering out, though, and that could make it harder for Merck's stock to outperform. I believe that this company's pipeline strategy (significant quantity, but not necessarily many stars) leads to investors underestimating its potential, but I wouldn't go so far as to think it's a tremendously cheap stock today.

Another Pharma Quarter Built On Margins
Not unlike Pfizer, which also reported on Tuesday morning, Merck's quarter saw weak top-line performance compensated by relatively stronger margin results.

SEE: Pfizer Looking A Little Tired

Revenue fell 11% as reported, or 8% on an operational basis, leading to a minor (2%) miss. Pharmaceutical revenue declined 12% as reported, with slight weakness in Januvia/Janumet (up 5%) and Remicade (up 2%). Although the Januvia franchise is a significant component of revenue (more than 15%), as is the combined Vytorin/Zetia businesses (more than 11%), Merck has relatively fewer big contributors than many of its peers. Outside of drugs, animal health was down 2% and consumer health was down 11%, though the underlying performance there was actually stronger than it appears.

Although Merck recaptured some lost financial momentum with better than expected margins, the absolute performance wasn't great. Gross margin declined 150 basis points, with operating income declining 22% from the year-ago period. Operating margin did beat expectations by about a point, but that would seem to be due in part to lower R&D spending – not exactly a high-qualty beat for a drug company.

Important Data Read-Outs On The Way
Merck gets a lot of flack for its pipeline, but a couple of high-profile data releases could bring a bit more positive attention. Phase 1 data on lambro (the anti-PD1 drug lambrolizumab) in lung cancer should come out in the fall, and positive data here is expected to further clarify the multi-billion dollar potential of this drug outside of melanoma. As a reminder, Bristol-Myers and Merck are early leaders in the PD-1 space, with Roche (Nasdaq:RHHBY) a little further behind but still very much in the race.

Merck is also expected to report interim data on its BACE inhibitor MK-8931 in Alzheimers late this year, and almost any Big Pharma Alzheimers drug garnering a lot of attention.

Are Valuations Keeping Merck On The Sidelines?
Earlier this year, Merck management had talked in such a way that it seemed further licensing deals or acquisitions were very much on the radar as a way of supplementing the near-term business and the long-term pipeline. Not all that much has actually happened in the interim.

Given the bull market in biotech, this isn't entirely surprising. There are certainly companies out there that could make sense – Onyx (Nasdaq:ONXX), Allergan (NYSE:AGN), and Celldex (Nasdaq:CLDX) come to mind – but valuations have gotten pretty step and it's likely a great deal more difficult to find and structure deals today that generate worthwhile long-term returns.

The Bottom Line
I don't think Merck management needs to be in any particular hurry. When the inevitable tumble in biotech valuations arrives, there will be plenty of worthwhile candidates for Merck to pick through, though I do expect some competition from other pharma rivals looking to improve their long-term growth prospects.

SEE: Evaluating Pharmaceutical Companies

In the meantime, Merck is like most pharma companies – relatively weak top-line growth prospects, but still with some potential incremental margin improvement. I do believe the Street is likely too skeptical about the company's pipeline potential, but then I also believe the Street is too bullish about Januvia. All told, I'm looking for very low revenue growth over the long term (but with the potential for upside), as well as very modest free cash flow growth. With the shares worth about $50 today, I wouldn't be in a rush to buy, but there could still be some upside for patient holders.

Disclosure – As of this writing, the author owns shares of Roche.

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