Look beyond Merck’s miracle cancer drug for profits

When former US president Jimmy Carter announced in 2015 that he had skin cancer that had spread to his liver and brain, he thought he had just weeks to live. But the 90-year-old undertook immunotherapy, a ground-breaking treatment that fights cancer with patients’ own immune systems, using Keytruda, a drug from Merck (NYSE: MRK), the global pharmaceutical giant. Now, five years later, Jimmy Carter is clear of cancer and leading a healthy, active life.

In 2015 Keytruda was new and sanctioned only for skin melanoma, an increasingly common condition. Since then it has been approved to treat certain cancers in the lungs, head, neck, bladder, stomach, throat, kidney and cervix, as well as Hodgkin Lymphoma. It is, in short, a blockbuster. Some analysts think it could become the most-prescribed medication on record.

Keytruda is transforming lives as it eliminates sickness and helps people live longer. Data for lung cancer, for example, shows that 25% of patients are still alive after five years, a huge improvement over the historical 5% rate.

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For Merck, the widening application and growing sales of Keytruda have been one factor helping the stock outperform rivals. This year, though, investors have become more cautious and the stock has underperformed its peers and the market.

Changes to the US healthcare system have been a worry, but nerves have settled since committed reformer Bernie Sanders withdrew as a Democrat candidate for president. Covid-19 will have an effect, with people avoiding hospitals and clinics, and delays to elective treatments all leading to a postponement of pharmaceutical use, although this should resume quickly once the crisis ebbs.

For investors who can look beyond this, the current share-price weakness is an opportunity. At a 40% discount to the S&P 500, the benchmark US index, Merck’s shareholders are getting double-digit earnings growth for at least five years. Keytruda is a standout product expected to be hitting sales of $22bn in three years’ time – double last year’s $11bn and nearly six times 2017’s level. Trialling is under way for treating prostate and breast cancers next.

Further potential winners

But it’s not all about Keytruda. Merck is in fact a diverse business with overall sales last year of $46.8bn, of which Keytruda comprised 24%. It has fast-selling and growing medications in diabetes and various vaccinations, along with an animal health business.

The product portfolio is expanding via research and acquisition. Major new cancer treatments are in the wings and there are hopes for its Ebola treatment, which has already been used in Africa with 97% efficacy. Its $10bn of cash and healthy cash flow point to further acquisitions. Meanwhile, Merck is spinning off some legacy and mature brands into a new company. These are cash-generative and investors will be given shares. Shedding the non-growers will boost the growth rate of Merck’s remaining portfolio.

The move has left some investors worried that reducing the size of the healthcare portfolio means an unhealthy focus on Keytruda. However, beyond the short term, management should be proved right as Merck concentrates on its best commercial opportunities and research projects. And more immediately, relying on Keytruda is reasonable: it is, after all, a proven winner.

A giant set to sprint ahead

Merck ticks many boxes for long-term investors who want both capital gains and a decent income. On a forward price/earnings ratio of 15 and a dividend yield of more than 3%, the shares are attractive given the prospect of double-digit profit growth over the next five years. The price is about 20% below the late-2019 peak.

Shareholders can also take comfort from the relatively strong balance sheet and healthy returns on capital of this $193bn giant. Interest on debt is covered over 20 times by earnings and free cash flow per share is adequate for maintaining the payment of dividends to shareholders. The prospect of Merck defaulting on debt repayments is very low.

Covid-19 has clearly unsettled many forecasts of future earnings. Many companies are loath to say how performance might turn out given the uncertainty.

Merck has trimmed expectations, but does see growth this year. Covid-19 will have an impact because treatments are being delayed and hospitals are being re-prioritised near-term, but this is already changing as countries and regions pass their infection peaks. It is not a problem of underlying demand, but rather one of health accessibility, and the treatments will go ahead at some point.

The current price of around $76.50 suggests potential one-year upside based on prevailing forecasts of around 20%-25% to $95. A price of $120 would not be an unreasonable projection on a three- to five-year view.

Consistent returns are always hard to find, but Merck is a quality company that is attractively valued with a healthy balance sheet, a high dividend, strong development pipeline, respected management and a blockbuster, best-selling product. Investment opportunities hardly get much better than this.

Stephen Connolly writes on finance and business, and has worked in investment banking and asset management for over 25 years (SC@plainmoney.co.uk)