1. Merck & Co.
NYSE Ticker: MRK
New Stock Report
Group 3
Recommendation: Buy Market Cap: $149.2B
Industry: Pharmaceuticals Yield: 3.37%
Price: $53.22 Fair Value Estimate: $66.98
2. TABLE OF CONTENTS
Executive Summary
Company and Industry Analysis
Introduction
What the Company Does and How They Make Money
Industry and Competitors
Research and Development
Mergers and Acquisitions
General Analysis and Industry
Major Events
Ratio Analysis
Liquidity Ratios
Asset Management Ratios
Debt Management Ratios
Profitability Ratios
Expectations
Forward Expectations
Pace of growth
Future
Undervaluation Interpretation
Valuation
General Assumptions
Free Cash Flow to Firm Valuation
Free Cash Flow to Equity Valuation
Dividend Valuation
Forecasted Financials
Relative Valuation
Price Target and Recommendation
3. EXECUTIVE SUMMARY
Merck & Company is a well-established drug manufacturer located in the pharmaceutical
sector. At one of the largest domestic drug manufacturer in the United States, they
produce medications for almost every field of medicine. Not only does Merck have a
healthy diverse portfolio of patents, but also an extremely large drug pipeline with over
two dozen medications in phase III trials. In 2014 they allocated over seven billion
dollars into R&D, which in the pharmaceutical industry could be considered the life force
of a pharmaceutical manufacturer. With their massive pipeline and patent banks we can
expect significant growth in the near future.
In doing a ratio analysis, we see that MRK is not as good as the industry but when
looking at growth rates Merck is beating the industry, hands down. We see that Merck is
a very liquid company, which is important to for debt payment. In terms of asset
management, Merck has struggled in the past. Analyzing debt management ratios, we
see that Merck taken on more debt which we see as an effective way at creating value
because they do not have any major patents expiring in the next several years. Finally,
when analyzing their return ratios, we see that compared to the industry Merck does
really well which is shown through their high return on capital and equity ratios.
The actions under the 2013 restructuring program are expected to result in annual net cost
savings of approximately $2.5 billion by the end of 2015. Although they did have a
decline in earnings, it could reflect that lower revenue results from the ongoing impacts
of product divestitures and the loss of market exclusivity for several products, as well as
the termination of their relationship with AstraZeneca LP and the divestiture of MCC.
MRK anticipates that the actions under the 2013 Restructuring Program, combined with
remaining actions under the Merger Restructuring Program, will result in annual net cost
savings of $2.5 billion by the end of 2015, which in turn has increased return on capital.
Merck has continued to execute its multi-year initiative to sharpen its commercial and
R&D focus, redesign its operating model, and reduce its cost base focusing on
innovation.
In the valuation segment of this report, we will explain in great depth five different
valuation models. In each of these models, we will describe the general assumptions that
we made in creating the model, explain all of the factors that make up each model, and
explain the results of our model. We will also perform a sensitivity analysis for each of
the models for both good and bad scenarios. We want to only recommend an investment
that is in our margin of safety or margin of error. Next, we will combine the results from
our model, weight their relevance, and ultimately come up with a final price target and
recommendation for the class.
4. Company and Industry Analysis
Introduction
Our group chose Merck & Company to research and analyze within the pharmaceutical
industry. After thorough research among possible candidates we find that Merck is
undervalued compared to its peers and a company that is a wise long-term investment.
What the Company Does and How They Make Money
Merck & Company is a researcher, developer, producer, and seller of medications. Based
out of Kenilworth, New Jersey, this is an American company founded in 1891. Similar to
other companies that have existed for over one hundred years, multiple mergers and
acquisitions have occurred within the life of Merck. Merck operates within the
pharmaceutical industry and make their money through the development, manufacturing,
and sales of helpful drugs.
Competitors
Companies in the pharmaceutical industry tend to be very differentiated in size. This
industry has extremely high barriers of entry because of the demand for large amounts of
capital to move an experimental medication through development, trials, and marketing
stages. Companies that are just starting out have a very rough few years ahead of them,
and similar to other industries when it comes to startups are most likely to fail. However
in the cases where a company successfully creates a popular and sellable drug, the
company will often have the opportunity to be bought out buy a more developed
company that desires to be put simply, buy out the rights to this new medication. Merck
& Company is one of the largest pharmaceutical companies in the world. It competes
with Pfizer and Johnson & Johnson, which is the only domestic companies relatively
close in size. Both Johnson & Johnson and Pfizer have slightly outperformed Merck in
the last five years. However later on we will explain why we believe Merck to be a better
investment.
Research and Development
Before digging into a specific analysis of Merck & Company it is important that a greater
understanding of the pharmaceutical company is had. First and foremost it is important to
note that the pharmaceutical industry operates differently than most other industries. One
of the biggest differences is the massive cost of research and development that is required
for a producer of medications to be able to survive in the long-term environment. The
5. cash designated to research and development can be used in multiple ways, however the
most dominant factor is researching new drugs to create a healthy drug pipeline. This is a
term used in the industry to describe a pharmaceutical company’s reserve of both
patented medications, and drugs that have a good chance of being approved for
manufacturing and distribution to the public (Stage III). The majority of drugs never pass
early trials, which in reality means that any cash invested into that drug is in laments
terms “burned”. From a statistical point of view, the idea of investing in a high risk
pharmaceutical company is that eventually one drug will be approved and earn more
revenue than the cost of all the other rejected drugs. Drugs that make it through the
harrowing of FDA tests and trials are marketed and sold to many different consumers,
wholesalers, and retailers. When taking a step back, one can realize that at this point
pharmaceutical industry is a risky one. If a company does not properly allocate its
research and development budget, or fails to develop a marketable drug will before too
long run out of money to fuel the required research and development engine.
Mergers and Acquisitions
Another common option that can take a significant amount of pressure off the research
and development success is mergers and acquisitions. The most common scenario of this
happening in the pharmaceutical industry is a smaller, less developed, company develops
a medication that is a great success and is bought out for its patent by a manufacturer that
has the purchasing flexibility and manufacturing ability to buy out the company. The
purchaser of a company in one hand believes that you are purchasing a sure fire source of
income. The medication has already been approved and the acquiring company is sure to
make a significant amount of money from the drug. Along with purchasing another
source of income, the buying out of a smaller company also means reduced competition.
Even if the drug in question is not going to be a cash cow, if the smaller company’s price
tag is less than what sales revenue will be lost upon not executing the acquisition a
company could discontinue the drug channeling the consumer’s demand back onto their
own medications. On the other hand, a company must assess whether the cost of
acquiring the medication is less than the income that will be provided by the new
medicine. Most of all it is important to remember that all of these decisions are taking on
different amounts of risk. Many pharmaceutical companies have both greatly benefited
and suffered from making these choices.
Merck General Analysis and Industry
The pharmaceutical industry analysis of performance is difficult. The pharmaceutical
industry is heavily regulated and is susceptible to changes in the governmental policy.
Large pharmaceutical companies have armies of lawyers to create and protect their
6. patents along with shielding them from impending lawsuits. The only real way to tell
how effectively a pharmaceutical industry allocates their resources, is by looking into the
how effective their research and development budgets are used. Above everything else, a
healthy drug pipeline is needed to survive and thrive. In 2010, Merck allocated just over
$11 billion to research and development (10k). The reason that past research and
development costs are important is because of the delay in amount of time for these
investments to pay off. In 2009, just under $6 billion of R&D was spent. For an analyst,
what this expresses is that Merck buckled down in 2010 deciding that they would
dedicate nearly double their budget.
According to Merck’s website, their current drug pipeline consists of 24 medications in
phase III trials, 11 in stage II, and 3 currently under review. Within the pharmaceutical
industry it is common for a company to patent medications in phase III because it is
presumed that they will be approved. What can be inferred from this statement is this: at
no point in the foreseeable future will Merck’s revenue stream be threateningly
interrupted. Merck’s dedication to further research new medicines foretells that it will
continue to develop sellable medications. While Merck has a number of medications
whose patents will expire in the next few years, this does not mean that their sales will
plummet because these drugs do not make up a significant portion of their sales.
Currently grossing sales of just over $42 billion, their highest selling product makes up
only around $4 billion, or 9% (10k). This product, Januvia, is a drug used for those
diagnosed with type-2 diabetes. With a patent expiring in 2022, Januvia will most likely
remain a healthy source of revenue for close to the next decade.
More importantly than talking about any one medication is the diversity of Merck’s
“portfolio” of already approved drugs. Besides Januvia, there is no one medication that is
an outlier taking up a drastic amount of their segment of sales. Drugs like Zetia and
Remicade, used to treat high cholesterol, crohns, and arthritis are also very high in
demand. The risky scenario that this diverse portfolio of drugs negates is that one of their
higher grossing medications is made obsolete. If a pharmaceutical company were to
invest too much of its faith into one of these medicines and the above scenario happens,
the results would be catastrophic. Just another reason that we believe Merck is a viable
asset to invest in for the long-term.
Major Events
The largest event in recent years was the merger of between Merck & Company with
Schering-Plough in 2009 worth $42 billion. “Merck devised an unusual strategy called a
reverse-merger agreement. Under it, Schering’s ownership will not change, at least on
paper. Instead, even though Merck is putting up the money to buy Schering, and Mr.
7. Clark of Merck would run the combined companies, Merck would technically become a
subsidiary of Schering” (Singer). While they have their independent companies, Merck is
now a parent company to Schering-Plough. The reason for this is because of certain
restrictions on Schering’s-Ploughs ability to sell their number one medication to US
consumers, Remicade, which is exclusively in Europe. Representing just over $2 billion
in 2008 (Singer), Johnson & Johnson had exclusive rights to sell Remicade in the United
States. The agreement stated that the rights would be lost for Schering if ownership
changed. The way that this merger was brokered snuck by this clause by merging the way
that they did. In a Forbes article, a Merck spokesperson released “Since the merger,
Merck has driven the growth of key products, expanded our global reach, launched new
products, and advanced a robust late-stage R&D pipeline”(Herper). In summation, the
benefits of this merger have outweighed the costs by far. Not only did Merck acquire a
number of patents that generate a healthy amount of revenue, but also bought a cutting
edge company that’s real intangible assets lie in its developing drugs.
Other Information About Company and Industry
Currently there have been political debates regarding the deregulation of the
pharmaceutical market. Sparked by the Turing CEO Martin Shkreli’s obscene pricing on
a HIV drug called daraprim, almost all political forerunners have made different plans to
stop the over pricing of drugs. Clinton’s plan states that if elected she would place a cap
on pricing of medications, limit the amount of out of pocket expenses, and increase the
bargaining power of Medicare (Hillary). She would also plan on forcing pharmaceutical
industries that benefit from taxpayers to instead of investing in advertising and
marketing, to focus on further research. Another change that almost all of the political
figures in the presidential race have affirmed is that they would reduce regulations on the
patents, and importation of foreign drugs. The increase in competition would only further
decrease drug prices. The whole situation negatively affected the pharmaceutical industry
briefly. We do believe however that if these changes were made, whether it be from
Hillary or other political figures that the profitability of the pharmaceutical industry
would decay. Although the thoughts of one individual running for office are not to be
cause for concern, this is one risk that we need to keep in mind going forward.
RATIO ANALYSIS
Liquidity Ratios
Liquidity is the first area to analyze when conducting a ratio analysis. Liquidity is
important because of the going concern; it is the assumption that a company will be in
business for the foreseeable future. The reason companies go out of business is because
8. of bankruptcy and liquidity is a measure of if they are able to pay off debt. When looking
at liquidity we measure assets to liabilities as well as see the makeup of current assets.
Current Ratio
The first measure of liquidity is the current ratio which measures all current assets over
current liabilities. Merck has a current ratio of 1.768. This isn’t terrible because
pharmaceutical companies generally have to take on debt to fund R&D and advertising,
so a positive number means they have enough current assets to pay off current liabilities.
It needs to be noted however that Merck’s ratio has declined 2.06% since 2009. When
comparing Merck to the industry current ratio of 1.828, we see Merck lags the industry,
but they are in 3rd
place among comparable companies.
Quick Ratio
The problem with the current ratio is that we don’t know the makeup of working capital.
Knowing the makeup of working capital is important because not all current assets are
liquid enough to pay off debt immediately. One metric of knowing working capital make
up is the quick ratio which his defined by assets-inventory/current liabilities. The reason
for subtracting inventory is because inventory is for selling and not paying off debt.
MRK’s quick ratio is 1.191 and has increased by 34.18% since 2009. This means Merck
is still fairly liquid. Since the quick ratio is increasing and the current ratio is decreasing
we can infer that liabilities are increasing (not good) and inventory is decreasing (good).
When compared to the industry, MRK has a higher quick ratio than the industry average
ratio of 1.304, indicating better asset performance and a substantially higher growth rate
compared to the industry growth rate of 1.79%
Cash Ratio
Due to the fact that liabilities are increasing, we want to know if MRK is in a position to
continue being liquid. Here we can use the cash ratio and cash and equivalents/assets
ratio. The cash ratio tells us cash/current liabilities and this is useful because cash is the
best way to payoff liabilities. MRK has a cash ratio of .838. This is fine because not all
current liabilities are due now. MRK has increased cash by 60.48%, which is good
because they have increased liabilities, so they should be increasing liquidity. Compared
to the industry, MRK is below average in terms of cash holdings but this doesn’t matter
because they are increasing cash faster than the industry growth in cash of 6.94%.
9. Cash and Equivalents/Total Assets
The last ratio is cash and equivalents/total assets. This just says what percent of assets is
cash. MRK has a ratio of 47.385% and this number has increased 45.05% since 2009; this
comes to the same conclusion as the cash ratio and compared to the industry, Merck’s
ratio here is as we did with the cash ratio. I will say though that if cash is increasing and
inventory is decreasing, A/R is decreasing and the balance sheet also reflects this.
Conclusion: Liquidity is great.
Asset Management Ratios
Asset management is important because we want to know if our company is selling
inventory, collecting receivables, and how quickly they generate cash flow.
Asset Turnover Ratio
The first ratio we use is asset turnover, which indicates how much revenue is generated
when selling inventory. This can indicate pricing power, which should be high for MRK
since it relies on patents. MRK has inventory turnover of 2.843 this is great compared to
the industry average of 2.511. Merck has also grown inventory turnover by 45.04% since
2009 compared to the industry, which has declined by 3.59%. We can conclude from this
that MRK has pricing power because they can generate more revenue per $1 of assets
sold compared to the other guys. Also with advertising being a huge part of Merck’s
expenditures, this may be an indicator of effective marketing.
Accounts Receivable Days
The next ratio is accounts receivable days, which indicates the ability to collect accounts
receivables. MRK does a good job with this. The industry takes on average of 65.413
days to collect A/R and MRK takes 59.61 days. This is really good because MRK is able
to collect cash from customers quicker than other companies. Not only can they do this
but also they have decreased the number of days by 10.86% since 2009 where as the
industry has increased days by .95%.
Cash Conversion Cycle
Another asset management metric is the cash conversion cycle. This tells us how many
days it takes for an asset to generate cash flow. MRK takes 132.58 days, this is a below
the industry average of 109.438 days but this is ok. MRK has decreased its amount of
10. days by 36.32% since 2009 where as the industry decreased days by only 25.29%, so
MRK has been improving.
Total Asset Turnover Ratio
The last ratio is total asset turnover. This is like inventory turnover, however this ratio
looks at all assets. MRK has a ratio of .414, which is not great when comparing to an
industry ratio of .532. Right now MRK is not doing well in this metric and it is ratios like
this that we think explain its price decrease, however we also believe the market is
undervaluing MRK because MRK is increasing total asset turnover more than the
industry and comparable firms. MRK has increased TAT by 20.73% while the industry
has decreased TAT by 13.48%.
Conclusion: MRK is coming back and has great asset management.
Debt Management Ratios
Debt management is important for the same reasons as liquidity; we don’t want MRK to
go bankrupt. Bankruptcy is a VERY real threat in pharmaceuticals; MRK has to spend a
lot of cash on advertising and R&D so these ratios need to be stellar.
Interest Coverage Ratio
The first ratio is the interest coverage ratio and it determines if EBIT is sufficient to pay
off interest expense. MRK has a ratio of 7.746 so they can pay off interest expense, but
MRK is nowhere near as good as the industry ratio of 14.69. We do want to point out
thought that MRK has increased this ratio by 51.06% while increasing debt; this is all
while the industries average has decreased by 4.25%. This indicates superb
improvements in debt management and says that they have used debt effectively.
Total Debt to Total Assets Ratio
The second ratio is total debt to total assets. This ratio is important because it shows if a
company is too leveraged or not. MRK has a ratio of 21.765 which is low for a
pharmaceutical company and when compared to the industry average of 28.452. This
means there increase in debt isn’t going to cause problems. We see third party evidence
of this in Merck’s AA bond rating. MRK has been taking advantage of this and has
increased debt to assets by 50.55% since 2009. If you can increase debt without causing
liquidity problems at low interest rates, it makes since to and Merck has certainly done
this. This ratio doesn’t explain Merck’s debt structure, however, there is long and short-
term debt.
11. Long Term Debt to Total Assets Ratio
If we use LT debt to total assets, MRK has a ratio of 19.016, this makes up a majority of
the 21.765% total debt in the previous paragraph. This means that most of their debt is
long term and is due well into the future. Merck generates great cash flow so we don’t see
this as an issue.
Assets to Equity Ratio
The last metric of debt management is the equity multiplier. This ratio indicates what
methods are used to finance new assets. MRK has an equity multiplier ratio of 2.015,
which describes that around half of Merck’s assets are financed with equity. We believe
that this is good because compared to the industry they don’t use as much debt financing.
The industry multiplier is 4.65 and has increased 30.22% since 2009 where as MRK has
only increased 10.75%.
Conclusion: Merck has superb debt management.
Profitability Ratios
Profitability is important because it measures whether everything we have just discussed
matters. Ultimately, the company that wins is the company that can operate profitably.
Gross Margin
The first metric is gross margin, which is defined as Revenue-COGS/Revenue. Gross
margin indicates how much money it can keeps from sales. MRK isn’t the best at this
they have a gross margin of 60.3 compared to the industry margin of 71.157. MRKs
margin has also decreased by 8.38% compared to an industry decrease .66%. We don’t
think this is systematic but rather a bump in the road, because MRK had restructuring
costs associated with the sale of part of its business as well as it has spent a lot of money
to solve problems it faced back in 2010.
Operating Margin
The next margin is operating margin, which is defined as operating income/sales. This is
where we prove that MRK has a great business and pipeline. MRK has an operating
margin of 13.424%, which is below the industry average of 19.685%. However if we dig
deeper, we see that in 2010 they had a large issue. Margins fell from 8.7% to 5.15%;
MRK was in dire straits. Since these troubles in 2010, MRK has increased operating
margins by 60.45%. This absolutely crushes the industry improvement in operating
12. margin of -6.62%. Since then, we believe MRK has created pricing power in their
products, which equals a moat.
Profit Margin
The next ratio is profit margin, which is defined as net income/sales; this margin is all
about growth. MRK has the best profit margin within the comparable companies at
28.22%. The industry average profit margin is 14.841%. Also, in 2010 Merck’s profit
margin went from 47.037% to 1.872%. Taking this 2010 number to its 2014 number of
28.22% that is 1507.33% increase, whereas the industry profit margin has fallen by
18.77% in the same 4-year period. This proves their pricing power, it proves their
pipeline is phenomenal, and it shows that they get their money’s worth from R&D.
Conclusion: It makes killer profits.
Return Ratios
A company’s return ratios are important because ultimately, the success of the company
long term is defined by their ability to earn a return on the money that they place in the
business. In addition, a company who is earning a return on capital that is less than their
weighted average cost of capital is destroying shareholder value.
Return on Assets
Return on assets is the amount of money you generate from assets you have. It is found
through the equation net income/total assets. Merck has a ROA of 11.687 compared to an
industry average of 7.645. Since the troubles in 2010, MRKs ROA has grown 1479.37%
where as the industry ROA declined by 27.89%. This indicates Merck’s improvements
in margins are vastly outperforming the industry as a whole.
Return on Equity
We use return on equity to show how much return is gained on the equity that
shareholders have in the business. We define return on equity as net income/equity, but it
can also be found as (ROE=profit margin*total asset turnover*equity multiplier). This
number needs to be good because it is often one of the most highly recognized indicators
of a good investment and for MRK it is. Merck’s return on equity is 24.224 just right
under the industry average of 24.992. From 2010 to 2014 Merck’s ROE improved by
1595%, where as the industry only improved 1.02%. Merck has had made huge
improvements in generating a return on shareholders money since 2010. Your money is
safe with Merck.
13. Return on Capital
The last and most important ratio we analyze is return on capital, which is defined as net
operating profit after tax/invested capital. This measures profit from investment and is a
key metric when analyzing a moat. For a company with no moat but a great product, the
company will earn fantastic returns on capital for a short period of time until competition
comes in and the excess return is diminished and competed away (ie. Crocs, Razor Cell
phones, Yankee Candle).
For a company that truly has a moat, they are able to earn a high return on capital for a
much longer period of time because their economic moat is able to shield their high
returns from being competed away by competition. This is why the ratio for return on
capital is so important and one that we analyze closely. Merck’s return on capital was
16.858% in 2014, which is the second highest among comparable companies and is
higher than the industry average of 12.448%. From 2010 to 2014, Merck has improved
their return on capital by 922% where as the industry return on capital has weakened by
32.83%. We can attribute this industry wide weakening in return on capital to the
increase in competition amongst the firms and across the entire pharmaceutical industry. I
will say that Merck’s 2014 ROC number is slightly inflated by the sale of the consumer
care segment of its business, but we see this as a positive sign that the company is
focusing on returning cash to shareholders and their drug business, which is their bread
and butter. This portion of their business was low ROC and the sale should increase ROC
even more in the future. We see this divestiture as a way for Merck to increase focus on
their drug business and to continue to build an economic moat in this area where there
was none in consumer care. The company supports our assumption in this passage taken
from their 2014 10k. “As part of Merck’s prioritization efforts, the Company continued to
review its assets to determine whether they could provide the best short- and longer-term
value with Merck or elsewhere. As a result, the Company divested its Consumer Care
(“MCC”) business to Bayer, which provided capital to the Company to better resource its
core areas of focus and return cash to shareholders.”
Conclusion: Merck is a good and improving company. Invest in Merck.
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14. EXPECTATIONS
Although the past year has resulted in lower earnings than previous years, Merck
definitely has a few tricks up their sleeve. Their clinical pipeline includes candidates in
multiple disease areas, including cancer, cardiovascular diseases, diabetes, infectious
diseases, inflammatory/autoimmune diseases, neurodegenerative diseases, osteoporosis,
respiratory diseases and women’s health. The Company also reviews its pipeline to
examine candidates that may provide more value through out-licensing. MRK is
evaluating certain late-stage clinical development and platform technology assets to
determine their out-licensing or sale potential. They continuously maintain a number of
long-term exploratory and fundamental research programs in biology and chemistry as
well as research programs directed toward product development. MRK’s research and
development model is designed to increase productivity and improve the probability of
success by prioritizing R&D on candidates they believe are capable of providing
unambiguous, promotable advantages to patients and payers and delivering the maximum
value of its approved medicines and vaccines through new indications and new
formulations.
In 2013, the company announced a global restructuring program as part of its global
initiative to sharpen its commercial and R&D focus. As part of the program, MRK
expects to reduce its total workforce by approximately 8,500 positions. These workforce
reductions will primarily come from the elimination of positions in sales, administrative
and headquarters organizations, as well as R&D. MRK will also reduce its global real
estate footprint and continue to improve the efficiency of its manufacturing and supply
network.
Since inception of the Restructuring Program, Merck has eliminated approximately 6,095
positions comprised of employee separations, as well as the elimination of contractors
and vacant positions. The remaining actions under the 2013 Restructuring Program are
expected to complete by the end of 2015. “We are focusing our business on our core
areas, which we believe will help drive future growth. We are also making steady
progress to change the business model and achieve our cost production goals (Ken
Frazier-CEO-MRK Q4 CC).” MRK made strong progress in 2014 redesigning its
operating model and reducing its cost base. As a result of disciplined cost management,
Merck remains on track to achieve its overall savings goal by the end of 2015. MRK
recorded total pretax costs of $1.2 billion in both 2014 and 2013 related to this
restructuring program. The actions under the 2013 Restructuring Program are expected to
complete by the end of 2015 with the cumulative pretax costs estimated to be
approximately $3.0 billion. They also expect the actions under the 2013 Restructuring
Program to result in annual net cost savings of approximately $2.0 billion by the end of
15. 2015. The Company anticipates that the actions under the 2013 Restructuring Program,
combined with remaining actions under the Merger Restructuring Program, will result in
annual net cost savings of $2.5 billion by the end of 2015.
As a result of prioritizing its research efforts, Merck is focused on the therapeutic areas
that it believes can make the most impact on addressing critical areas of unmet medical
need, such as cancer, hepatitis C, and Alzheimer’s disease. In 2014, Merck accelerated
several of its key clinical programs, positioning the Company for long-term growth.
According to their website, MRK now has 24 candidates in Phase III clinical trials and 3
candidates which have past Phase III and are under review.
During 2014, Merck continued to execute its multi-year initiative to sharpen its
commercial and research and development focus, redesign its operating model and reduce
its cost base while remaining focused on drug pipeline innovations. The company
received approval for six products in the United States in 2014, including U.S. Food and
Drug Administration approval for Keytruda (for the treatment of advanced melanoma in
patients whose disease has progressed after other therapies), Belsomra (for the treatment
of insomnia), and Gardasil 9 (a 9-valent human papillomavirus (“HPV”) vaccine.) Merck
also enhanced its pipeline with external innovation, including the 2014 acquisitions of
Idenix Pharmaceuticals, Inc. (a company engaged in the discovery and development of
next-generation treatments for hepatitis C virus known as HCV), and OncoEthix (a
privately held biotechnology company specializing in oncology drug development.) In
September of 2014, Merck announced that the FDA granted accelerated approval of
Keytruda, which is an anti-PD-1 (programmed death receptor-1) therapy under review by
the EMA for the treatment of advanced melanoma. The Keytruda clinical development
program also includes studies in more than 30 cancers including: bladder, colorectal,
gastric, head and neck, melanoma, non-small-cell lung, renal, triple negative breast and
hematological malignancies. In addition, Merck has announced a number of
collaborations with other pharmaceutical companies to evaluate novel combination
regimens with Keytruda.
Worldwide sales were $42.2 billion in 2014, a decline of 4% compared with 2013,
including a 1% adverse after of foreign sales due to the current exchange rate. The
decline reflects lower revenue resulting from the ongoing impacts of product divestitures
and the loss of market exclusivity for several products, as well as the termination of their
relationship with AstraZeneca LP (“AZLP”) and the divestiture of MCC, which caused
net income to look really high, although it hadn’t actually changed that much. With the
divestiture, we should have a higher return on capital and more cash behind their words
when they say they are going to commit to innovating their pipeline of drugs.
16. Declines in sales and gross margin were partially offset by growth in immunology, acute
care, diabetes, and vaccine products, as well as higher sales from their Animal Health
business. Merck is determined to use its Animal Health business as a key growth driver
and is committed to looking for ways to augment this business.
As part of its intensified portfolio assessment process, Merck sold the U.S. marketing
rights for Saphris, an antipsychotic indicated for the treatment of schizophrenia and
bipolar I disorder in adults, and divested certain ophthalmic products in Japan and
markets in Europe and Asia Pacific.
Costs for 2014 include an $85 million charge related to the sale of their consumer care
business segment to Bayer. The decline in research and development expenses was
driven by restructuring costs changes (see above), targeted reductions, and lower clinical
development expense stemming from portfolio prioritization. The decline in these
research and development expenses in 2013 as compared with 2012 also reflects lower
payments for licensing activity.
The increases in net income and EPS in 2014 as compared with 2013 were due primarily
to the gain on the divestiture of Merck’s consumer care business, a gain recognized on
AstraZeneca’s option exercise, gains on other divestitures, lower operating expenses,
revenue recognized from the sale of the U.S. marketing rights to Saphris (partially offset
by lower sales), and an additional year of expense for the health care reform fee.
“We will balance investing in our business with funding compelling business
development opportunities. And we remain firmly committed to returning cash to our
shareholders (Ken Frazier-CEO-CC). Still, MRK's capital structure leaves room for more
aggressive growth through acquisitions and more debt-financed share buybacks, should
the company want to grow EPS from the inside out.
With Merck’s pipeline and their redefined capital structure, we believe that MRK has
established a strong and well-diversified portfolio on which to streamline growth. We
also like the fact they continuously give back to their shareholders and which the
company says isn’t going away any time soon.
(Below show Merck’s drugs in clinical trials and their current patent expiration dates.)
Phase 2 Phase 3 (Phase 3 entry date)
Alzheimer’s Disease
MK-7622
Asthma
MK-1029
Bacterial Infection
MK-7655 (relebactam)
Cancer
Allergy
MK-8237, House Dust Mite (March 2014) (1,2)
Alzheimer’s Disease
MK-8931 (December 2013)
Atherosclerosis
MK-0859 (anacetrapib) (May 2008)
Bladder Cancer
17. MK-2206
MK-8628
Contraception, Medicated IUS
MK-8342
Contraception, Next Generation Ring
MK-8342B
Ebola Vaccine
V920
Gastric Cancer
MK-3475 Keytruda
Heart Failure
MK-1242 (vericiguat) (1)
Hepatitis C
MK-3682/MK-8742 (elbasvir)/
MK-5172 (grazoprevir)
MK-3682/MK-8408/MK-5172
(grazoprevir)
Pneumoconjugate Vaccine
V114
MK-3475 Keytruda (October 2014)
Clostridium difficile Infection
MK-3415A (actoxumab/bezlotoxumab)
(November 2011)
MK-4261 (surotomycin) (July 2012)
CMV Prophylaxis in Transplant Patients
MK-8228 (letermovir) (June 2014)
Diabetes Mellitus
MK-3102 (omarigliptin) (September 2012)
MK-8835 (ertugliflozin) (November 2013) (1)
MK-1293 (February 2014) (1)
Head and Neck Cancer
MK-3475 Keytruda (November 2014)
Hepatitis C
MK-5172A (grazoprevir/elbasvir) (June 2014)
Herpes Zoster
V212 (inactivated VZV vaccine) (December 2010)
HIV
MK-1439 (doravirine) (December 2014)
Non-Small-Cell Lung Cancer
MK-3475 Keytruda (September 2014)
Opioid-Induced Constipation
MK-2402 (bevenopran) (October 2012)
Osteoporosis
MK-0822 (odanacatib) (September 2007)
Source: 10k
Product Year of Expiration (in the U.S.)
Integrilin (2) 2015 (use/formulation)
Emend 2015
Follistim AQ 2015
Invanz 2016 (compound)/2017 (composition)
Cubicin (3) 2016 (composition)
Zostavax 2016 (use)
Dulera 2017 (formulation)/2020 (combination)
Zetia (4) /Vytorin 2017
Asmanex 2018 (formulation)
Nasonex (5) 2018(formulation)
NuvaRing 2018 (delivery system)
Emend for Injection 2019
Noxafil 2019
RotaTeq 2019
Intron A 2020
Recombivax 2020 (method of making/vectors)
Januvia/Janumet/Janumet XR 2022 (compound)/2026 (salt)
Isentress 2023
Nexplanon 2026 (device)/2027 (device with applicator)
Grastek 2026 (use)
Ragwitek 2026 (use)
Zontivity 2027 (with pending Patent Term Restoration)
Gardasil/Gardasil 9 2028
Keytruda 2028
Zerbaxa 2028 (with pending Patent Term Restoration)
Sivextro 2028 (with Patent Term Restoration)
Belsomra 2029
Source: 10-K
18. VALUATION
General Assumptions
In order for a valuation model to act as an helpful guide for our class’s investment
decision, it is important to have some key assumptions present to help the model run
effectively. The paragraphs below describe these assumptions and state the reasons for
making them.
Growth Assumptions
First, we are assuming that earnings growth in year one will be 5.9% because this is the
analyst’s estimate of earnings growth next year. By taking their estimate, we are
assuming that the analysts know more about what is going to happen with Merck’s short
term earnings than we do.
Second, we are assuming that earnings growth in the next 5 years will be 6.0%. While
the analyst consensus estimate for the next 5-year growth is 5%, we are assuming that
Merck’s restructuring program that is projected to cut $2.5B annually in costs will work
out as projected. These cost savings, while they cost money in the short run, will payoff
in a huge way when they are to be completed in 2016, according to the company’s 2014
10k. In year 8 and 9, after the company has experienced excellent growth, we are
expecting our Merck’s growth rate to decline by .5% as the firm becomes larger and less
likely to extend the same type of rapid growth. In year 10, we are assuming that earnings
growth will be stabilize at 5% as their current pipeline will still be under patent
protection. In year 11-15, we are assuming that Merck’s earnings growth will begin to
drop off slightly, year by year, as they become a larger and more mature company until
reaching a terminal growth rate of 4.50%.
Because of MRK’s size and importance in their industry, we think that Merck is a
company that is not going to go away any time soon, if ever. Because of this, we think
that Merck will continue to grow as a company until hitting a terminal growth rate, 15
years down the line. At this point, we think that Merck will reach a terminal growth rate
of 4.5% indefinitely. Much of their growth at this point may need to come from
acquisitions of companies with patents. If history is an indicator, we are expecting
greater and greater competition going forward as new technologies and drugs are
introduced.
19. Return on Capital Assumptions
Next, we are assuming a return on capital of 20% for Merck’s next year. This is based
largely on Merck’s commitment to grow what they call their bread and butter, their
pharmaceutical drugs business. This can be seen in the sale of Merck’s consumer care
business segment in late 2014 mentioned in this segment of their 10k “The Company
expects the actions under the 2013 Restructuring Program to result in annual net cost
savings of approximately $2.0 billion by the end of 2015. The Company anticipates that
the actions under the 2013 Restructuring Program, combined with remaining actions
under the Merger Restructuring Program (discussed below), will result in annual net cost
savings of $2.5 billion by the end of 2015 compared with full-year 2012 expense levels.”
Merck currently has a very strong pipeline of drugs to come out within the next few years
and does not have any major patents expiring during that time period. Because of this,
we do not see Merck’s return on capital taking a dip anytime soon, but rather increasing
over the next several years because of these cost savings and the potential success of their
drug pipeline. For these reasons, we are assuming that Merck will earn a 22% return on
capital for the next 5 years. With a $2.5 billion savings from restructuring and labor
reductions compared to a net income of $11.92 billion in 2014, this 22% is not an
unreasonable assumption.
Next we are assuming that after year 6, the company’s return on capital will begin to
decline by 1% per year until reaching a terminal rate of 13%. As the company matures,
return on capital will inevitably decline but at a 13% terminal rate, it is not like we are
assuming the company will go out of business, but rather thrive in its new identity. We
do not see a 13% terminal rate as being unreasonable as a primarily research based drug
manufacturer, which the direction that management is taking the company in.
Free Cash Flow to Firm Valuation Model
A company’s free cash flow to the firm is a measure of their yearly financial performance
that shows the cash available that is left to pay back to shareholders after paying back
their cost of doing business. The FCFF calculation reads = (Operating Earnings - Taxes -
Change in Net Working Capital - Changes in Investments). This valuation technique is
highly useful because it attempts to place a value on a security based off of the present
value of future projected operating cash flow.
20. EBIT-Taxes
Our first year operating earnings are based off of the analyst’s consensus for earnings
growth for 2015 of 5.9%. We expect this increase in earnings growth to stem primarily
from the success Merck’s restructuring program and pipeline of drugs, which is talked
about in more detail in the general assumptions section above.
Return on Capital
Our first year return on capital is 20%. While this may seem high, we are expecting an
increase in return on capital stemming from managements shift towards being a more
research based drug company and the realization of the cost saving associated with their
restructuring program and labor reduction costs. This can be seen by the sale of their
consumer business to focus on core strategy and fund research for new products and is
already evident when looking at their income statement. We kept return on capital
constant at 22% for 5 years as these savings and R&D efforts come to fruition. We next
incrementally increased Merck’s return on capital by 1% per year until hitting a terminal
rate of 13%.
Reinvestment Rate
Our company reinvestment rate is calculated by dividing our earnings growth rate by our
return on capital. The value that remains is reflective of the percentage of earnings that
will be reinvested in the business to fund future growth.
Free Cash Flow to the Firm
Our annual free cash flow to the firm is calculated by taking the company’s after tax
EBIT and multiplying it by what the percentage of earnings that will not be used for
reinvestment in the business.
Weighted Average Cost of Capital
Our weighted average cost of capital is calculated by averaging the company’s cost of
debt and cost of equity. This value describes the cost of the capital that it uses to fund its
business operations. A company’s cost of debt is calculated by taking the combination of
their debt issues and weighting them on a scale based on their interest rate and loan
amount. A company who is earning a return on capital lower than their weighted average
cost of capital is destroying value.
21. Present Value of Free Cash Flow to Firm
The present value of free cash flow to the firm is calculated by taking the company's free
cash flow to the firm and discounting it back to the present time, using their weighted
average cost of capital as the discount rate.
Results
As a result of our projected earnings growth rate and return on capital, our fair value
estimate for Merck’s stock using the free cash flow to the firm model was $63.11 per
share. Our estimates in our FCFF model show that Merck is currently trading at a
15.67% discount to fair value. We believe that this is a fair estimate given the changes
that are occurring in the company. In the combination of all of our valuation models, we
gave this a weight of 25%.
Sensitivity Analysis
Our most important factor in our model for determining the valuation of Merck is
earnings growth rate because this is a factor that is compounded year after year. For
Merck, their growth rate will be dependent on the success of their drug pipeline,
continued focus on R&D, and the firm’s commitment to focus on these areas and avoid
investing lower ROC business segments. What makes valuation tricky is that all of our
assumptions are based off of unknowable factors in the future. In the paragraphs below,
we will tweak our model for two different scenarios to determine a possible price range
for the company.
Sensitivity for Good Scenario
In a good scenario, we see Merck as a company that continues to grow its margins
through the success of its strong pipeline of drugs that they currently have in the works.
In the 2014 10k, management notes that “Merck is continuing to execute its multi-year
initiative to sharpen its commercial and research and development focus, redesign its
operating model and reduce its cost base while remaining focused on innovation.” In a
good scenario, this strategy will be successful in increasing margins and stemming
growth through innovation. With this, they will also earn a higher return on capital.
Because the nature of the pharmaceutical business is based off of patent protection, great
successes in R&D can yield a high growth rate and return on capital for a much longer
period of time than many other industries. In a good scenario for Merck as a company,
their pipeline of drugs to come out over the next 1-3 years will be overwhelmingly
accepted amongst prescribing doctors and will increase earnings and return on capital
22. significantly over then next 10+ years, while the products are shielded from competition
under patent protection laws. With this extra cash flow from these successful drug
innovations, they will continue to add value to shareholders through stock buybacks,
increases in dividend payouts, and reinvesting in their business.
Sensitivity for Bad Scenario
In a bad scenario, we see Merck as a company whose margins become depressed and
whose drug pipeline does not yield the success that they are hoping for. With this, their
return on capital will begin to fall to levels where they have been over the past 5 years
where they have had some trouble. To accompany this, their growth rate will begin to
slow. Because of the nature of the pharmaceutical business is based off of patents and
R&D, even a flop in their current pipeline will have very little effect on Merck’s growth
rate and return on capital for several years because they do not have any major patents
expiring for the next several years. With this, we will not see a stall in growth or return
on capital until about year 5 at which we could see a rapid deceleration in these areas.
The table below shows estimates in both good and bad scenarios.
Good Scenario Bad Scenario Group Estimate
Year Growth ROC Growth ROC Growth ROC
1 0.069 0.21 0.049 0.19 0.059 0.2
2 0.07 0.23 0.05 0.21 0.06 0.22
3 0.07 0.23 0.05 0.21 0.06 0.22
4 0.07 0.23 0.05 0.21 0.06 0.22
5 0.07 0.23 0.05 0.21 0.06 0.22
6 0.07 0.23 0.05 0.21 0.06 0.22
7 0.07 0.23 0.05 0.21 0.06 0.22
8 0.065 0.22 0.045 0.2 0.055 0.21
9 0.06 0.21 0.04 0.19 0.05 0.2
10 0.06 0.2 0.04 0.18 0.05 0.19
11 0.059 0.19 0.039 0.17 0.049 0.18
12 0.058 0.18 0.038 0.16 0.048 0.17
13 0.057 0.17 0.037 0.15 0.047 0.16
14 0.056 0.16 0.036 0.14 0.046 0.15
15 0.05 0.15 0.035 0.13 0.045 0.14
Fair Value $82.68 $50.98 $66.11
Free Cash Flow to Equity Valuation Model
A company’s free cash flow to equity is a measure of their yearly financial performance
that shows the cash available that is left to pay back to shareholders after paying back
their cost of doing business, reinvestment, and debt repayment. The FCFE calculation
reads = (Net Income - Capital Expenditures - Change in Net Working Capital + New
23. Debt - Debt Payments). This valuation technique is highly useful because it attempts to
place a value on a security based off of the present value of future projected net income.
Net Income
Our first year operating earnings are based off of the analyst’s consensus for earnings
growth for 2015 of 5.9%. We expect this increase in earnings growth to stem primarily
from the success Merck’s restructuring program and pipeline of drugs, which is talked
about in more detail in the general assumptions section above.
Return on Equity
Our return on equity is a function of our projected return on capital, which we start at
20%. Our discussion about our estimates for return on capital are talked about in more
detail in the general assumptions section above.
Reinvestment Rate
Our company reinvestment rate is calculated by dividing our earnings growth rate by our
return on equity. The value that remains is reflective of the percentage of earnings that
will be reinvested in the business to fund future growth.
Free Cash Flow to Equity
Our annual free cash flow to equity is calculated by taking the company’s net income and
multiplying it by what the percentage of earnings that will not be used for reinvestment in
the business.
Cost of Equity
Our cost of equity is calculated by taking the average of a company’s levered market
value cost of equity, levered book value cost of equity, and its yield plus growth rate. We
define cost of equity as the annual return that shareholders require for taking that risk of
holding the asset.
Present Value of Free Cash Flow to Equity
The present value of free cash flow to equity is calculated by taking the company's free
cash flow to the equity and discounting it back to now. We use Merck’s cost of equity as
the discount rate.
24. Results
As a result of our projected earnings growth rate and ROC which yields us our ROE used
in this model, our fair value estimate for Merck’s stock using the free cash flow to the
firm model was $70.04 per share. Our estimations in our FCFE model show that Merck
is currently trading at a 24.01% discount to fair value. We believe that this is a fair
estimate given the changes that are occurring in the company. In the combination of all
of our valuation models, we also gave this a weight of 25%.
Sensitivity Analysis
*Note to reader: (The paragraph below is identical to the sensitivity analysis paragraph
describing our FCFF valuation model. It is inserted because the same rational is applied.)
Our most important factor in our model for determining the valuation of Merck is
earnings growth rate because this is a factor that is compounded year after year. For
Merck, their growth rate will be dependent on the success of their drug pipeline,
continued focus on R&D, and the firm’s commitment to focus on these areas and avoid
investing lower ROC business segments. What makes valuation tricky is that all of our
assumptions are based off of unknowable factors in the future. In the paragraphs below,
we will tweak our model for two different scenarios to determine a possible price range
for the company.
Sensitivity for Good Scenario
*Note to reader: (The paragraph below is identical to the good scenario paragraph used in
the FCFF valuation model. It is inserted because the same rational is applied.)
In a good scenario, we see Merck as a company that continues to grow its margins
through the success of its strong pipeline of drugs that they currently have in the works.
In the 2014 10k, management notes that “Merck is continuing to execute its multi-year
initiative to sharpen its commercial and research and development focus, redesign its
operating model and reduce its cost base while remaining focused on innovation.” In a
good scenario, this strategy will be successful in increasing margins and stemming
growth through innovation. With this, they will also earn a higher return on capital.
Because the nature of the pharmaceutical business is based off of patent protection, great
successes in R&D can yield a high growth rate and return on capital for a much longer
period of time than many other industries. In a good scenario for Merck as a company,
their pipeline of drugs to come out over the next 1-3 years will be overwhelmingly
accepted amongst prescribing doctors and will increase earnings and return on capital
25. significantly over then next 10+ years, while the products are shielded from competition
under patent protection laws. With this extra cash flow from these successful drug
innovations, they will continue to add value to shareholders through stock buybacks,
increases in dividend payouts, and reinvesting in their business.
Sensitivity for Bad Scenario
*Note to reader: (The paragraph below is identical to the bad scenario paragraph used in
the FCFF valuation model. It is inserted because the same rational is applied.)
In a bad scenario, we see Merck as a company whose margins become depressed and
whose drug pipeline does not yield the success that they are hoping for. With this, their
return on capital will begin to fall to levels where they have been over the past 5 years
where they have had some trouble. To accompany this, their growth rate will begin to
slow. Because of the nature of the pharmaceutical business is based off of patents and
R&D, even a flop in their current pipeline will have very little effect on Merck’s growth
rate and return on capital for several years because they do not have any major patents
expiring for the next several years. With this, we will not see a stall in growth or return
on capital until about year 5 at which we could see a rapid deceleration in these areas.
The table below shows estimates in both good and bad scenarios.
Good Scenario Bad Scenario Group Estimate
Year Growth ROE Growth ROE Growth ROE
1 0.069 0.286248116 0.049 0.258583178 0.059 0.272415647
2 0.07 0.313913054 0.05 0.286248116 0.06 0.300080585
3 0.07 0.313913054 0.05 0.286248116 0.06 0.300080585
4 0.07 0.313913054 0.05 0.286248116 0.06 0.300080585
5 0.07 0.313913054 0.05 0.286248116 0.06 0.300080585
6 0.07 0.313913054 0.05 0.286248116 0.06 0.300080585
7 0.07 0.313913054 0.05 0.286248116 0.06 0.300080585
8 0.065 0.300080585 0.045 0.272415647 0.055 0.286248116
9 0.06 0.286248116 0.04 0.258583178 0.05 0.272415647
10 0.06 0.272415647 0.04 0.244750709 0.05 0.258583178
11 0.059 0.258583178 0.039 0.23091824 0.049 0.244750709
12 0.058 0.244750709 0.038 0.21708577 0.048 0.23091824
13 0.057 0.23091824 0.037 0.203253301 0.047 0.21708577
14 0.056 0.21708577 0.036 0.189420832 0.046 0.203253301
15 0.05 0.203253301 0.035 0.175588363 0.045 0.189420832
Fair Value $81.12 $58.92 $70.04
26. Dividend Valuation Model
The dividend valuation model is designed to value a security based off the value of all
future dividends discounted by the company’s cost of equity. The dividend valuation
model is best used for larger companies with a consistent track record of dividend
payments.
Earnings per Share
The earnings per share ratio is calculated by dividing net income by shares
outstanding. Our earnings per share is increasing by our projected growth rates.
Payout
The payout ratio is defined as dividing net dividends by net earnings. This ratio shows
analysts the percentage of company earnings that are paid out as a dividend and is widely
analyzed as a measure of dividend sustainability. Generally, we do not want to see a
company’s dividend payout ratio increasing because that means that earnings are not
increasing at the same rate as dividend growth. We would rather see dividend growth
increase in tandem with earnings.
We started our payout ratio at the current payout ratio of 52.29% for the first two years
because this is where the company is at now and has been in the past. We then
incrementally increased the payout ratio to 1% per year as the company begins to mature
and is able to streamline their restructuring into cost savings and boost profitability. We
continued to increase our payout ratio by 1% per year until reaching a terminal payout
ratio of 60%. Our reason for this is because as our firm grows and becomes a more
mature company, we see their economies of scale and efficiency increasing. As a more
efficient organization with less growth potential, the firm will begin to distribute more
and more cash to shareholders through dividend increases and possibly even buyback
programs, hopefully only at times when they believe their stock is undervalued. We did
not think that it would be reasonable to expect the firm to pay out more than 60% of their
net income because we expect Merck to continue to innovate through R&D and grow
through acquisitions.
Dividends per Share
Dividends per share is defined by taking the payout ratio and multiplying it by Merck’s
earnings per share. We are expecting that dividends per share will increase on a yearly
basis with growth in earnings per share. Merck strong and long dividend payment history
27. to shareholders while at history shows, they increase their dividend by about 2%
annually. With this being the case, we would expect their increases to have been minimal
over the past several years because of their lackluster financial performance. As the cash
begins to come in from the successful execution of their current pipeline, we expect
dividends per share to increase as well if they do not decide to use this extra income to
fund R&D and acquisitions.
Present Value of Dividends
To get the present value of our dividends per share, we discount our dividends per share
back to the present value, using our cost of equity as the discount rate.
Results
Using the numbers that we have stated above with a terminal payout ratio of 60%, our
model yields a fair value estimate $63.79. Our dividend valuation model shows that
Merck is currently trading at a 16.57% discount to fair value. We believe that this is a
fair estimate given the changes that are occurring in the company. In the combination of
all of our valuation models, we also gave this a weight of 25%.
Sensitivity Analysis
*Note to reader: (The paragraph below is identical to the sensitivity analysis paragraph
describing our FCFF valuation model. It is inserted because the same rational is applied.)
Our most important factor in our model for determining the valuation of Merck is
earnings growth rate because this is a factor that is compounded year after year. For
Merck, their growth rate will be dependent on the success of their drug pipeline,
continued focus on R&D, and the firm’s commitment to focus on these areas and avoid
investing lower ROC business segments. What makes valuation tricky is that all of our
assumptions are based off of unknowable factors in the future. In the paragraphs below,
we will tweak our model for two different scenarios to determine a possible price range
for the company.
Sensitivity for Good Scenario
*Note to reader: (The paragraph below is identical to the good scenario paragraph used in
the FCFF valuation model. It is inserted because the same rational is applied.)
In a good scenario, we see Merck as a company that continues to grow its margins
through the success of its strong pipeline of drugs that they currently have in the works.
28. In the 2014 10k, management notes that “Merck is continuing to execute its multi-year
initiative to sharpen its commercial and research and development focus, redesign its
operating model and reduce its cost base while remaining focused on innovation.” In a
good scenario, this strategy will be successful in increasing margins and stemming
growth through innovation. With this, they will also earn a higher return on capital.
Because the nature of the pharmaceutical business is based off of patent protection, great
successes in R&D can yield a high growth rate and return on capital for a much longer
period of time than many other industries. In a good scenario for Merck as a company,
their pipeline of drugs to come out over the next 1-3 years will be overwhelmingly
accepted amongst prescribing doctors and will increase earnings and return on capital
significantly over then next 10+ years, while the products are shielded from competition
under patent protection laws. With this extra cash flow from these successful drug
innovations, they will continue to add value to shareholders through stock buybacks,
increases in dividend payouts, and reinvesting in their business.
Sensitivity for Bad Scenario
*Note to reader: (The paragraph below is identical to the bad scenario paragraph used in
the FCFF valuation model. It is inserted because the same rational is applied.)
In a bad scenario, we see Merck as a company whose margins become depressed and
whose drug pipeline does not yield the success that they are hoping for. With this, their
return on capital will begin to fall to levels where they have been over the past 5 years
where they have had some trouble. To accompany this, their growth rate will begin to
slow. Because of the nature of the pharmaceutical business is based off of patents and
R&D, even a flop in their current pipeline will have very little effect on Merck’s growth
rate and return on capital for several years because they do not have any major patents
expiring for the next several years. With this, we will not see a stall in growth or return
on capital until about year 5 at which we could see a rapid deceleration in these areas.
We left our payout ratios the same for all scenarios because we think that this is one
factor that we cannot responsibly estimate effectively because management has many
different directions they can go with excess cash. With this, we are assuming a modest
1% dividend payout increase per year until a terminal rate of 60%.
A table that shows estimates in both good and bad scenarios is pasted below.
29. Good Scenario Bad Scenario Group Estimate
Year Growth Payout Growth Payout Growth Payout
1 0.069 0.5229 0.049 0.5229 0.059 0.5229
2 0.07 0.5229 0.05 0.5229 0.06 0.5229
3 0.07 0.53 0.05 0.53 0.06 0.53
4 0.07 0.54 0.05 0.54 0.06 0.54
5 0.07 0.55 0.05 0.55 0.06 0.55
6 0.07 0.56 0.05 0.56 0.06 0.56
7 0.07 0.57 0.05 0.57 0.06 0.57
8 0.065 0.58 0.045 0.58 0.055 0.58
9 0.06 0.59 0.04 0.59 0.05 0.59
10 0.06 0.6 0.04 0.6 0.05 0.6
11 0.059 0.6 0.039 0.6 0.049 0.6
12 0.058 0.6 0.038 0.6 0.048 0.6
13 0.057 0.6 0.037 0.6 0.047 0.6
14 0.056 0.6 0.036 0.6 0.046 0.6
15 0.05 0.6 0.035 0.6 0.045 0.6
Fair Value $75.45 $51.02 $63.79
Forecasted Financials Valuation
The forecasted financials valuation model attempts to place a value on a security based
off of forecasted financial statements, as a percent of sales. It uses the previous years
financial statements and after applying your forecasted growth rate, calculates a projected
future income statement for the firm and discounts the cash flows back to a present time
period. This valuation technique is highly useful because it attempts to place a value on a
security based off of the present value of future projected operating cash flow.
Sales Growth
We began our sales growth with the analysts’ consensus estimate of 2.60% for the next
full year because we are assuming that they are more knowledgeable about what Merck’s
sales might look like in the short run than we are. We then ramped up sales growth to 5%
for the next 6 year to reflect the payoff that is to come in their R&D pipeline. While the
patents for these drugs may not expire until 10 years down the road, we see sales growth
beginning to fall in year 8 and 9 by .5% annually, as the firm begins to tap the market or
other biosimilar competition begins to compete with Merck’s sales. After year 9, we see
Merck’s revenue growth hitting a terminal growth rate of 4%.
In our model, we are assuming that earnings to grow faster than sales. Our reason behind
this is because of the firm’s commitment to improving margins through their company
restructuring program and their commitment to focusing on their drug business.
30. Cost of Goods Sold / Sales
The cost of goods sold/sales section in this valuation model represents the percentage of
MRK revenue that is taken fund the production and manufacturing of Merck’s drugs. We
used 38% for each year of our model because our 5-year and 20-year averages were 37%
and 39% respectively. We believe that this is a reasonable estimate.
Selling, General, Administrative Expenses / Sales
The sales, general, and administrative section in this valuation model represents the
percentage of MRK revenue that is taken to fund these company expenses which are non-
operating expenses. We used 46% in our model because this is about where the 5-year
average is at and is in between our 5-year and 20-year averages.
Depreciation / Sales
The depreciation as a percent of sales section in this valuation model represents the
percentage of MRK revenue that is used to write off depreciation expenses. We used
4.9% in our model because this is about where the 5-year and 20-year averages are and
this number tends to be recurring and very stable.
Net Working Capital / Change in Sales and Net Capital Expenditures / Change in Sales
For the net working capital / change in sales and the net capital expenditures / change in
sales, we used our 20-year historical averages. This prevents us from including any
bumps in the road that may not be an accurate representation of the company going
forward.
Market Value of Debt
Our market value of debt is taken from our debt sheet. While our total long term debt
from Bloomberg and our total long term debt from the company’s 10k, we used the
Bloomberg data because that value is larger and we do not know what exactly Merck’s
management is describing as long term. All of these debt issues are combined and
weighted based off of their coupon rate and time until maturity back to the present value,
giving us our market value of debt.
Results
As a result of our projected revenue growth rate and our stated values for COGS, SG&A,
depreciation, NWC, and NCE, our forecasted financials valuation model yields a fair
value estimate for Merck’s stock of $67.94 per share. Our estimations in our forecasted
financials valuation model show that Merck is currently trading at a 21.67% discount to
31. fair value. We believe that this is a fair estimate given the changes that are occurring in
the company. In the combination of all of our valuation models, we also gave this a
weight of 25%.
Sensitivity Analysis
*Note to reader: (The paragraph below is identical to the sensitivity analysis paragraph
describing our FCFF valuation model. It is inserted because the same rational is applied.)
Our most important factor in our model for determining the valuation of Merck is
earnings growth rate because this is a factor that is compounded year after year. For
Merck, their growth rate will be dependent on the success of their drug pipeline,
continued focus on R&D, and the firm’s commitment to focus on these areas and avoid
investing lower ROC business segments. What makes valuation tricky is that all of our
assumptions are based off of unknowable factors in the future. In the paragraphs below,
we will tweak our model for two different scenarios to determine a possible price range
for the company.
Sensitivity for Good Scenario
*Note to reader: (The paragraph below is identical to the good scenario paragraph used in
the FCFF valuation model. It is inserted because the same rational is applied.)
In a good scenario, we see Merck as a company that continues to grow its margins
through the success of its strong pipeline of drugs that they currently have in the works.
In the 2014 10k, management notes that “Merck is continuing to execute its multi-year
initiative to sharpen its commercial and research and development focus, redesign its
operating model and reduce its cost base while remaining focused on innovation.” In a
good scenario, this strategy will be successful in increasing margins and stemming
growth through innovation. With this, they will also earn a higher return on capital.
Because the nature of the pharmaceutical business is based off of patent protection, great
successes in R&D can yield a high growth rate and return on capital for a much longer
period of time than many other industries. In a good scenario for Merck as a company,
their pipeline of drugs to come out over the next 1-3 years will be overwhelmingly
accepted amongst prescribing doctors and will increase earnings and return on capital
significantly over then next 10+ years, while the products are shielded from competition
under patent protection laws. With this extra cash flow from these successful drug
innovations, they will continue to add value to shareholders through stock buybacks,
increases in dividend payouts, and reinvesting in their business.
32. Sensitivity for Bad Scenario
*Note to reader: (The paragraph below is identical to the bad scenario paragraph used in
the FCFF valuation model. It is inserted because the same rational is applied.)
In a bad scenario, we see Merck as a company whose margins become depressed and
whose drug pipeline does not yield the success that they are hoping for. With this, their
return on capital will begin to fall to levels where they have been over the past 5 years
where they have had some trouble. To accompany this, their growth rate will begin to
slow. Because of the nature of the pharmaceutical business is based off of patents and
R&D, even a flop in their current pipeline will have very little effect on Merck’s growth
rate and return on capital for several years because they do not have any major patents
expiring for the next several years. With this, we will not see a stall in growth or return
on capital until about year 5 at which we could see a rapid deceleration in these areas.
We are assigning our good scenario a 1% increase in our group estimates and our bad
scenarios a 1% decrease in our group estimates. The table below shows our model’s
sensitivity to both good and bad operating scenarios.
Good
Scenario
Bad
Scenario
Group
Estimate
Year Growth Growth Growth
1 0.036 0.016 0.026
2 0.06 0.04 0.05
3 0.06 0.04 0.05
4 0.06 0.04 0.05
5 0.06 0.04 0.05
6 0.06 0.04 0.05
7 0.06 0.04 0.05
8 0.055 0.035 0.045
9 0.05 0.03 0.04
10 0.05 0.03 0.04
11 0.05 0.03 0.04
12 0.05 0.03 0.04
13 0.05 0.03 0.04
14 0.05 0.03 0.04
15 0.05 0.03 0.04
Fair Value $80.87 $56.77 $67.94
Relative Valuation
Our relative valuation model is fairly simple. We essentially picked out the other 6
largest US based companies whose businesses were similar to Merck. These companies
were PFE, JNJ, ABBV, LLY, BMY, and BAX. We decided against using non-US based
33. companies because these firms are affected by different regulations than our company,
with the drug industry being highly regulated in the United States.
After the companies were selected, we plugged in their respective financial data into a
spreadsheet and calculated their respective weighted average costs of capital. Then
through comparison, we were able to see which of the companies we thought was the best
and were going to continue to perform at a high level in the future.
Results
As a result of our relative valuation model, it is obvious to the analyst that Merck is
undervalued when comparing its ratios to its peers. Our model shows that Merck is
undervalued on a P/E ($120 price target), P/S ($58.7 price target), P/B ($118 price
target), Value/Revenue ($64.6 price target), and Value/EBITDA ($75.2 price target)
basis. Our model shows that Merck is fairly valued on a PEG ($57.3 price target) basis
when comparing it to its peers.
In our valuation combination using all of our models, we are weighting the relative
valuation model 0%. Our reasons for this are:
1. The relative valuation model measures value in relation to those firms in which
we have subjectively chosen.
2. The relative valuation model does not show us if the entire industry is
undervalued.
3. The relative valuation model is not forward looking.
4. The relative valuation model does not capture improvements or trends, but rather
takes a snapshot of all of the firms at one point in time.
5. The relative valuation model is a rough guide. Lazy investors use it for valuation.
We do not think that this valuation model is an accurate representation of Merck’s true
value. We think that this model is a great way to get similar companies side by side and
analyze their financial data but we think that more work needs to be done to warrant an
investment decision.
TARGET PRICE AND RECOMMENDATION
Upon the completion of these five valuation models, our group has come to a conclusion.
We are recommending Merck (MRK) to the class and are placing a MODERATE BUY
at current prices. The math and weightings behind our target prices for each model is
calculated below giving us a target price that encompasses a combination of the FCFF
Valuation Model, the FCFE Valuation Model, the Dividend Valuation Model, and the
Forecasted Financials Valuation Model.
34. FCFF Valuation Model Target Price = $66.11 * .25 = $16.53
FCFE Valuation Model Target Price = $70.04 * .25 = $17.51
Dividend Valuation Model Target Price = $63.79 * .25 = $15.95
Forecasted Financials Model Target Price = $67.94 * .25 = $16.99
FINAL TARGET PRICE = $66.98
We have come up with our fair value estimate and target price of $66.98. This represents
a 20.54% upside to current prices is within our margin of safety to recommend a
moderate buy rating.
42. SOURCES
1. Singer, Natasha. "Merck to Buy Schering-Plough for $41.1 Billion." The New York
Times. The New York Times, 09 Mar. 2009. Web. 16 Nov. 2015.
2. Herper, Mathew. "Should Merck Have Have Bought Schering-Plough." Forbes.
Forbes Magazine, 13 Jan. 2011. Web. 16 Nov. 2015.
3. Analysis of Manufacturing Costs in Pharmaceutical Companies
http://moodle.univlille2.fr/pluginfile.php/28162/mod_resource/content/0/Analysis
%20of%20Ma nufacturing%20Costs%20in%20pharma%202008.pdf
4. Merck 10k Reports
http://www.merck.com/investors/home.html
5. Yahoo Finance: MRK
https://finance.yahoo.com/q/ae?s=MRK+Analyst+Estimates
6. Morningstar: MRK
http://www.morningstar.com/stocks/xnys/mrk/quote.html
7. "Hillary Clinton's Plan for Lowering Prescription Drug Costs." Hillary Clinton's Plan
for Lowering Prescription Drug Costs. N.p., n.d. Web. 16 Nov. 2015.
