Merck – Top 2 Selling Drugs Begin To Lose Patent Protection In 2028

In my February 8, 2021 post, I disclose a new Merck & Co (MRK) position in a 'Core' account within the FFJ Portfolio with the purchase of 300 shares @ ~$75/share. I subsequently disclosed in this May 3, 2021 post the purchase of another 100 shares @ ~$75/share. Through the automatic reinvestment of the dividend income, my MRK exposure is now 414 shares.

In subsequent posts which are accessible through the Archives, I indicate my decision to pass on adding to my MRK exposure.

My most recent MRK post was on October 28, 2022 at which time MRK had just released its Q3 and YTD2022 results. I concluded that I would continue to focus on acquiring shares in other great companies that appeared to have temporarily fallen out of favour.

MRK has now released its Q2 and YTD2023 financial results on August 1, 2023 and thus my decision to revisit this holding.

Business Overview

MRK has transformed over the last couple of years. You may find it beneficial to review the company's website, the FY2021 10-K, and the recently released Q2 2023 Form 8-K (the Q2 Form 10-Q is currently unavailable).

Pipeline

A critical factor in determining whether to invest in a pharmaceutical company is the robustness of a company's pipeline; MRK's pipeline is accessible here.

The drug development process is rigorous and lengthy. In the US, for example, the US Food and Drug Administration has a multi-step process before a drug receives FDA approval; a good explanation of the entire drug approval process is accessible here.

Drug development is a time-consuming and costly undertaking and most programs will likely not make it beyond Phases 2 or 3. MRK's current pipeline includes 80+ programs in Phase 2, 30+ programs in Phase 3, and 10+ programs under review.

YTD2023, Keytruda has generated $12.065B of MRK's total YTD2023 $29.522B revenue (~14%). MRK's blockbuster drug is an immunotherapy cancer medication approved to treat many different types of cancer, including lung cancer, skin cancer, bladder cancer, and more. It is given as an intravenous (IV) injection by itself or in combination with other cancer treatments. This cancer drug begins to lose patent protection in 2028. New cancer drugs, however, are being co-formulated with Keytruda and pivotal data is likely in 2024-26.

Gardasil and Gardasil 9 are HPV vaccines that protect against infection with human papillomaviruses (HPV). HPV is a group of more than 200 related viruses, of which more than 40 are spread through direct sexual contact. Gardasil 9 has, since 2016, been the only HPV vaccine used in the United States.

Gardasil and Gardasil 9 are the 2nd highest revenue-generating drug within MRK's drug portfolio having generated $4.3B in YTD2023 revenue. This drug begins to lose patent protection in 2028.

While 2028 might seem to be well into the future, it takes years from the time a drug enters Phase 1 to the time it receives regulatory approval. Mly does not have that much time and is keenly aware that it needs to build a more robust pipeline.

Acceleron Pharma Acquisition

In November 2021, MRK completed its ~$11.5B acquisition of Acceleron Pharma Inc.; this deal brought a heart drug (Sotatercept) into MRK's pipeline.

On October 10, 2022, MRK announced positive top-line results from a pivotal Phase 3 trial in the evaluation of Sotatercept for the treatment of adults with Pulmonary Arterial Hypertension (PAH); MRK has now completed its FDA submission.

Prometheus Laboratories Acquisition

On June 16, 2023, MRK completed the acquisition of Prometheus Biosciences, Inc.. This acquisition accelerates MRK's growing presence in immunology and augments its diverse pipeline. The following is Prometheus' pipeline for which MRK paid ~$10.8B.

MRK is currently actively integrating the Prometheus team and is moving toward initiating a Phase III clinical trial.

Financials

Q2 and YTD2023 Results

Details of MRK's Q2 and YTD2023 results are reflected in the Form 8-K and Earnings Presentation.

In Q2, MRK incurred a ~$6B GAAP loss resulting in a YTD ~$3.154B GAAP loss. The R&D expense skyrocketed in Q2 to $13.321B versus $2.798B in Q2 2022. This higher R&D expense, however, includes a one-time $10.2B charge related to the Prometheus acquisition. Excluding this charge, operating expenses grew 10%.

On the Q2 earnings call, management stated that this expense growth reflects increased investments in support of near-term opportunities for the existing portfolio and disciplined investments for the future to advance early- and late-phase pipelines.

The Prometheus one-time charge is not tax deductible thereby resulting in an 18.4% negative tax rate.

The $2.35/share GAAP Loss and $2.06/share Non-GAAP Loss include a $4.02/share charge related to the acquisition.

 

We see from the FY2020 - FY2022 and the first half of FY2023 sales results that Keytruda is MRK's blockbuster drug. As noted earlier, Keytruda loses its patent protection in 2028.

Capital Allocation

The following reflects MRK's current balanced capital allocation strategy and the capital allocation over the past 12 months.

FY2023 Guidance

MRK's revised FY2023 guidance does not assume additional significant potential business development transactions.

MRK now expects revenue of $58.6B - $59.6B which is a $0.8B increase at the midpoint. This range reflects underlying YoY revenue growth of 10% - 11% which is offset by the expected lower sales of Lagevrio; Lagevrio is an oral antiviral used to help fight the coronavirus infection by stopping the coronavirus from replicating in the body. It was developed by MRK in collaboration with Ridgeback Biotherapeutics.

Management estimates Lagevrio's FY2023 revenue will be ~$1B which is well below the $5.684B generated in FY2022.

Operating expenses are now estimated to be ~$34B - ~$34.6B. This range includes ~$11.6B of acquisition and upfront collaboration research and development expenses associated with Prometheus, Imago, and Kelun. MRK completed the acquisition of Imago in January 2023. In December 2022, MRK and Kelun-Biotech entered into an exclusive license and collaboration agreement to develop seven investigational preclinical antibody-drug conjugates (ADC) for the treatment of cancer.

Other expenses of ~$0.1B  includes incremental financing costs related to Prometheus.

The FY2023 tax rate is expected to be 30.5% - 31.5%. This reflects an increase due to the Prometheus transaction of ~15%.

Previous guidance of $6.88 - $7 excluded the Prometheus acquisition. Had MRK included the $4.02 one-time charge and an estimated $0.14 to advance the assets and financing costs, the prior guidance range would have been $2.72 - $2.84.

The revised non-GAAP EPS of $2.95 - $3.05 includes the one-time charge for Prometheus and a negative impact from foreign exchange.

Credit Ratings

MRK's unsecured long-term debt is investment grade.

• Moody's: A1 (stable outlook)
• S&P Global: A+ (stable outlook)
• Fitch Ratings withdrew MRK's ratings in early December 2022 for commercial reasons.

The ratings are the top tier within the upper-medium grade category and define MRK as having a STRONG capacity to meet its financial commitments. The company, however, is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

Dividends and Share Repurchases

Dividend and Dividend Yield

MRK's dividend history reflects October 6 as being the distribution date of the 4th consecutive $0.73 quarterly dividend.

When I wrote my November 4, 2021 post, MRK shares were trading at ~$90 and it had recently distributed its 4th consecutive $0.65 quarterly dividend for a ~3% dividend yield.

At the time of my January 13, 2022 guest post at Dividend Power, MRK had recently distributed its first quarterly $0.69 dividend. With shares trading at ~$79, the dividend yield was ~3.5%.

Shares traded at ~$100 when I wrote my October 28, 2022 post and MRK had just distributed its 4th consecutive $0.69 quarterly dividend on October 7, 2022. Given that dividends are MRK's 3rd priority when it comes to capital allocation, I anticipated a ~$0.03 - $0.05/share increase in the quarterly dividend in mid-December. As it turns out, MRK increased the quarterly dividend by $0.04 to $0.73. In mid-December 2023, I anticipate MRK will increase the quarterly dividend by ~$0.03 - $0.05/share.

One more $0.73 quarterly dividend is to be distributed in October. If we use the $0.04 mid-point of the range by which I expect MRK to increase the dividend, the following 4 dividend distributions will total $3.04 ((1 x $0.73) + (3 x $0.77)). With shares currently trading at ~$105, the forward dividend yield is ~2.9%.

MRK has historically generated ample Cash Flow from Operations and Free Cash Flow thus enabling it to easily service its declared dividends.

Share Repurchases

In FY2011 - FY2022, MRK's average shares outstanding (in millions) were 3,094, 3,076, 2,996, 2,928, 2,841, 2,787, 2,748, 2,679, 2,580, 2,541, 2,538, and 2,542. The total was 2,539 for the first half of FY2023.

Management seeks to provide a competitive return to shareholders through a growing dividend and share repurchases. This is balanced with the need to invest in the business to drive growth and business development. The desire is not to create excess cash on the balance sheet. MRK, therefore, looks opportunistically at share buybacks based on the assessment of the business development pipeline.

In October 2018, MRK's Board authorized purchases of up to $10B of MRK's common stock for its treasury. The treasury stock purchase authorization has no time limit.

In May 2021, MRK restarted its share repurchase program, which the Company had temporarily suspended in March 2020. It did not, however, purchase any shares of its common stock for its treasury during 2022 under this program.

During Q1, MRK repurchased $149 million (1 million shares) under this program. As of March 31, 2023, the remaining share repurchase authorization was $4.9B. MRK anticipates making modest share repurchases under this program in the remainder of FY2023.

Valuation

When I reviewed MRK in my November 4, 2021 post, management's FY2021 diluted EPS guidance was $4.71 - $4.76. With shares trading at ~$90, the forward diluted PE was ~19.

Management's FY2021 adjusted diluted EPS guidance was $5.65 - $5.70. With shares trading at ~$90, the forward adjusted diluted PE was ~16.

Using the adjusted diluted EPS estimates from the brokers who cover MRK, the forward adjusted diluted PE levels were:

• FY2021: mean of $5.86 and a low/high range of $5.64 - $6.78 from 11 brokers. The forward adjusted diluted PE using the mean estimate is ~15 and ~13 if I use $6.78.
• FY2022: mean of $7.34 and a low/high range of $6.35 - $8.60 from 13 brokers. The forward adjusted diluted PE using the mean estimate is ~12 and ~10 if I use $8.60.
• FY2023: mean of $7.26 and a low/high range of $6.59 - $7.95 from 9 brokers. The forward adjusted diluted PE using the mean estimate is ~12 and ~11 if I use $7.95.

When I wrote my January 13, 2022 guest post, MRK's shares were trading at ~$79.50. Based on the forward-adjusted diluted earnings estimates available at the time, MRK's forward-adjusted diluted PE valuations were:

• FY2021: mean of $5.78 and a low/high range of $5.60 – $6.40 from 19 brokers. The forward adjusted diluted PE using the mean estimate is ~13.8 and ~12.4 if I use $6.40.
• FY2022: mean of $7.23 and a low/high range of $6.35 – $8.19 from 23 brokers. The forward adjusted diluted PE using the mean estimate is ~11 and ~10 if I use $8.19.
• FY2023: mean of $7.22 and a low/high range of $6.35 – $7.88 from 19 brokers. The forward adjusted diluted PE using the mean estimate is ~11 and ~10 if I use $7.88.

At the time of my October 28, 2022 post, shares were trading at ~$100. Management's updated FY2022 GAAP EPS guidance was $5.68 - $5.73 thus giving us a forward diluted PE range of ~17.6 - ~17.5. Furthermore, management's FY2022 adjusted diluted EPS guidance was $7.32 - $7.37 thus giving us a forward adjusted diluted PE range of ~13.6 - ~13.7.

Based on the current forward-adjusted diluted earnings estimates available from the brokers which cover MRK, MRK's forward-adjusted diluted PE valuations were:

• FY2022: mean of $7.37 and a low/high range of $7.28 – $7.59 from 22 brokers. The forward adjusted diluted PE using the mean estimate is ~13.6 and ~13.2 if I use $7.59.
• FY2023: mean of $7.47 and a low/high range of $6.71 – $8.11 from 22 brokers. The forward adjusted diluted PE using the mean estimate is ~13.4 and ~12.3 if I use $8.11.
• FY2024: mean of $8.59 and a low/high range of $7.76 – $9.47 from 18 brokers. The forward adjusted diluted PE using the mean estimate is ~11.6 and ~11.6 if I use $9.47.

Using the current ~$105 share price and management's current Non-GAAP EPS guidance of $2.95 - $3.05, the forward adjusted diluted PE is ~35.

Based on the current forward-adjusted diluted earnings broker estimates, MRK's forward-adjusted diluted PE valuations are:

• FY2023: mean of $3.03 and a low/high range of $2.80 – $3.54 from 21 brokers. The forward adjusted diluted PE using the mean estimate is ~34.7.
• FY2024: mean of $8.46 and a low/high range of $6.83 – $9.18 from 26 brokers. The forward adjusted diluted PE using the mean estimate is ~12.4.
• FY2025: mean of $9.57 and a low/high range of $8.21 – $10.85 from 22 brokers. The forward adjusted diluted PE using the mean estimate is ~11.

The FY2023 forward adjusted diluted PE is grossly distorted because of the Prometheus one-time charge. If we take the $3 mid-point of adjusted guidance and add back the:

• $4.02/share charge related to the acquisition;
• an additional $0.14 to advance the assets and finance the transaction; and
• a $0.02 FX headwind

then the forward adjusted diluted EPS amounts to $7.18. Divide the current ~$105 share price by $7.18 and the forward adjusted diluted PE is ~14.6. This valuation is slightly higher than that at the time of my January 13, 2022 and October 28, 2022 posts.

I am very reluctant to rely on earnings estimates beyond FY2023; much can change in the short term given that MRK is actively looking to bolster its product pipeline through acquisitions.

Final Thoughts

The success of a pharmaceutical company is heavily dependent on obtaining FDA approval for new drugs. Pharmaceutical companies invest a considerable amount in R&D only to have most drugs under development failing to receive FDA approval. Given this, I expect MRK to continue to actively pursue M&A opportunities to bolster its pipeline. The patents on its Keytruda blockbuster drug begin to expire in 2028. In addition, the Gardasil patents expire in 2028 in the US.

Growth through M&A, however, is not without risk.

MRK completed the ~$11.5B Acceleron Pharma acquisition in November 2021. In June 2023, it completed the $10.8B acquisition of Prometheus Biosciences, Inc.. That is $22.3B spent to acquire 2 companies with no guarantee the drugs under development will receive FDA approval! Even if the drugs do receive FDA approval, there is always the risk a competitor's drug will be superior.

It is no wonder drugs that have patent protection are so expensive!

My 414 shares were insufficient to have made MRK a top 30 holding when I completed my Mid-2023 Investment Holdings Review. I currently have no plans to increase my exposure other than through automatic dividend reinvestment; these shares are held in one of the 'Core' accounts in the FFJ Portfolio.

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long MRK.

Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decisions without conducting your research and due diligence. You should also consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.