Merck & Co., Inc.

Moat: 4/5

Understandability: 3/5

Balance Sheet Health: 4/5

Merck & Co., Inc. is a global healthcare company that discovers, develops, manufactures, and markets a range of human health pharmaceutical and vaccine products, as well as animal health products.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

Merck, a global pharmaceutical leader, operates through two main segments:

  • Pharmaceuticals: This segment focuses on human health therapies, including prescription drugs and biologics for a wide range of diseases. It’s primarily composed of Oncology, Hospital Acute Care, Immunization, and Cardiovascular franchises, among others.
  • Animal Health: This segment develops and markets products for livestock and companion animals, including vaccines and medications.

The company is focused on innovative drug discovery, development, manufacturing, and marketing in core areas such as oncology, vaccines, immunology, cardiometabolic disorders, and animal health. It operates across a complex web of global regulations and intellectual property laws.

Revenue Distribution and Trends:

  • Global Reach: Merck operates across the globe, with significant revenue contributions from the United States, Europe, and Asia-Pacific regions.
  • Sales Growth Drivers:
    • Keytruda continues to be a powerful growth driver in human health, fueled by new approvals and expanding indications.
    • Vaccines contribute to growth, with Gardasil and HPV vaccines remaining high revenue generators.
    • Animal health is a growing and less volatile business that shows some steady revenue stream and margin protection.
    • Strong underlying growth in emerging markets has supported overall financial performance.
  • Recent Trends:
    • A trend towards biologics and other complex drugs is clearly visible.
    • There has been increased consolidation in the healthcare industry and increasing price competition from generic manufacturers, which creates price pressures, but also opens the door for new innovations.
    • The changing regulatory landscape and increased scrutiny into drug pricing continues to challenge the profitability of the industry.

Profitability and Margins:

  • Profitability: Merck is generally a highly profitable company, thanks to the high prices for new drugs and its pricing power in areas like oncology and vaccines. However, its profitability can fluctuate significantly depending on new product launches, regulatory pressures, and competition.
  • Margins: The company benefits from its highly profitable pharmaceutical products. There are, however, pressure points caused by higher costs and competition from generic manufacturers.
  • Recent Trends: * There has been increased investment in research and development (R&D) in order to continue to produce new blockbuster drugs and generate higher returns on capital * There was an increase in both gross margin and operating margins this past year.
    • While margins tend to trend upward for the most part for Merck, that may come at the expense of a higher price premium.
  • There can also be significant fluctuations due to large one time gains/losses (e.g. the sale of a business) and a significant change in currency fluctuations.

Competitive Landscape:

  • Highly Competitive Industry: Merck operates within the fiercely competitive pharmaceutical and health care industries. Competitors include global giants like Pfizer, Johnson & Johnson, Abbvie, Roche, and many other drug makers who are trying to achieve blockbuster status as well.
  • Key Areas of Competition: Competition is most acute in key therapeutic areas such as oncology, immunology, and diabetes, which all have potential to be huge growth drivers. A lot of effort is going in trying to find new and innovative drugs and therapies.
  • The Threat of Generics: Patent protection is the foundation of their economic moat, but the eventual expiration of patents gives an opportunity to generics manufacturers to capture the market for lower prices.
    • This is why, the drug pipeline is the ultimate measure of the strength and success of pharmaceutical companies.

What Makes Merck Different:

  • R&D Excellence: Merck has a robust R&D pipeline, especially in areas such as oncology.
  • Global Presence and Scale: This scale enables them to negotiate better prices and enter new markets more easily.
  • Diverse Portfolio: The company has a mix of drugs and vaccines across multiple areas, mitigating risk from any single therapeutic area.
  • Experience and Track Record: The company has a good track record of drug approvals, and strong relationship with the regulators, which helps in its R&D efforts.

Risks that Could Harm the Moat:

  • Patent Expirations: Loss of exclusivity for key products due to patent expirations leads to generic competition, eroding sales and pricing power.
  • Pipeline Failure: Research and development is inherently risky and high rates of failure are common. The inability to produce future blockbuster drugs would be devastating to the financial performance.
  • Regulatory and Legal Challenges: Increased scrutiny on drug prices, slower regulatory approvals, and patent litigation can threaten the company’s profitability and growth prospects.
  • Generic Competition: Entry of generic versions of key drugs can severely reduce sales.
  • This risk was visible in the last couple of years with massive drop in revenues after patent expirations of key products.
  • Competition: Competition in highly profitable areas like oncology, or lack of ability to get into new markets, can hurt the company’s profitability.
  • Recession and Economic Downturn: In times of poor economic situation, people are more likely to postpone or skip healthcare products, and that might hurt profits of a healthcare provider like Merck.

Business Resilience:

  • Diversified Products: Merck is somewhat insulated by the broad and diversified portfolio, covering multiple areas such as oncology, vaccines, and animal health.
  • Geographic Diversity: Geographic diversity insulates from adverse economic and political effects of a single nation.
  • Strong Financial Position: The company has access to cash and ability to fund itself in times of crisis through the capital markets.
  • Brand Loyalty: Merck has built a reputation for quality which keeps its customers from switching to other options, it has built a brand.
  • High Margins: Despite intense pricing pressures, its high margins enable it to face difficulties and still maintain profits.

Financial Deep Dive Income Statement: Merck’s revenue is primarily derived from sales of pharmaceuticals and animal health products. In recent years, Keytruda has been their star product, with increased sales over the years. There has been a lot of fluctuation in other line items based on one time factors and changes in the regulatory environment. However, overall, the top line revenue has been growing steadily. The gross profit margin has been consistently high over the years at around 70-72%. Operating expenses can be a volatile figure depending on the current R&D strategies and other one time changes. For example, there has been a significant fluctuation in R&D expenses over the past few years. The net income attributable to Merck has been positive over the last several years, but has shown big swings each year because of the volatility mentioned previously, and other external and internal factors.

Balance Sheet: The company has a sizable balance sheet, most of which is in the form of intangible assets. It also has a healthy amount of cash and a reasonable long term debt. The current liabilities are well under the current assets suggesting the company is well placed to meet its financial obligations in the short to mid term. The debt to equity ratio suggests a high amount of leverage which has both advantages and disadvantages which we have already discussed.

Cash Flow: The company’s cash flow from operations is consistently healthy and positive, which suggests that the business is efficient in generating cash from operations. It has consistently invested a large portion of the operational cash to investment activities and R&D which helps the long term financial outlook. The cash flow from financing activities has also been positive over the last couple of years primarily as a result of new debt issuance.

Understandability Rating and Justification: Rating: 3 / 5 Merck’s business involves complex operations and processes: R&D, clinical trials, regulatory approvals, marketing, and global distribution. Understanding the intricacies of drug development and its market is a pretty big task. While some aspects, like brand management, are easier to understand, the company’s complex drug discovery and regulatory processes can be difficult to grasp without any expertise in pharmaceutical companies. This is why I have rated the business with a 3 in understandability.

Balance Sheet Health Rating and Justification: Rating: 4 / 5 Merck has a well-structured and diversified asset base, including significant investments in research and development and intangible assets. Its financial health is reasonable as it has good long term debt levels that can be easily paid given the positive free cash flows and cash and short-term investments on hand. The cash and current assets are also adequate for current obligations. But given the reliance on patent protected drug sales for revenue generation, the company’s financial stability can be dependent on the success of their future products. The liabilities are mostly made up of long-term obligations like debt and retirement liabilities. These liabilities may become onerous if the company starts facing troubles in its main business. Overall though, the balance sheet health is fairly good at 4/5.

Recent Concerns/Controversies/Problems:

  • Keytruda Patent Cliff: The company is highly dependent on Keytruda revenue which will be facing patent expiry in the later half of the decade. The management is trying to bring new drugs and expand indications to extend the economic moat of the company.
  • Acquisitions: Management had indicated some interest in acquiring new companies to replace their expiring profits from key drugs and it can be a source of concern to the investors as the financial implications are unclear as of now.
  • Pricing Pressures: There are increasing regulatory actions on the pricing of medicines, which could negatively affect their profit margins.
  • Inflationary Pressures: Higher inflation means higher operating costs and R&D costs. Companies in general have had issues in trying to fully transfer the higher costs to their customers. That is a major challenge for Merck.

Management’s Response to Challenges:

  • R&D Focus: Merck is investing heavily in new therapeutic areas like oncology, vaccines, and immunology to sustain long-term growth.
  • Acquisitions and Partnerships: The company is exploring acquisitions, and partnerships to broaden its pipeline and diversify its revenue sources.
  • Emphasis on Innovation: The management has indicated that it will continue to strive to find new and innovative products which have the potential to become blockbusters and generate large profits.

Final takeaways:

Merck is a leading pharmaceutical company with a fairly durable economic moat built on their research capabilities, patent protection and their brand recognition. It has a stable financial position with good current assets and cash flows. It does, however, face threats from patent expirations, regulation changes, intense competition, and high R&D costs. Even though it faces these problems, it is reasonably well positioned to overcome those challenges in the coming years given its diversified portfolio, global reach and its history of success in the pharmaceutical field. It is a good candidate for the long term investor.