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Buy into US big pharma with Merck

INTERNATIONAL TIP OF THE YEAR 2016: The US pharma sector has had a rough year, but we think the growth on offer at Merck will see it emerge a winner in 2017
January 5, 2017

The US undoubtedly boasts the world's best pharmaceutical industry. Leading universities excel in lifescience innovation, financial support is readily available for high-potential companies and the extensive healthcare system pays big money for the best new medicines. This ideal breeding ground for strong pharmaceutical companies is unmatched anywhere else in the world, which means it's hardly surprising that half of the world's top 10 pharma and biotech companies are American.

IC TIP: Buy at $61.94
Tip style
Growth
Risk rating
Medium
Timescale
Long Term
Bull points
  • Global leader in a new class of cancer treatment
  • Extensive drugs pipeline
  • Low US pharma valuations
  • Potential for further acquisitions
Bear points
  • Clinical trial risks
  • US drug pricing concerns

But the sector has recently faced a political minefield. Drug price inflation at some of the less innovative companies has hurt sentiment and first Hillary Clinton and now President-elect Donald Trump have pledged to reduce drug prices - something that would hurt the notoriously high earnings of companies in the sector. Share prices have struggled as a result and the sector now trades at a 2017 earnings multiple discount of over 10 per cent compared with the S&P 500 index.

While the pricing risk is real, we think the depressed shares of some of the sector's most innovative and exciting companies offer an excellent buying opportunity. Scientific development in recent years has progressed faster than ever before and pharmaceutical companies are at the cusp of launching drugs that could revolutionise the way many diseases are treated. And leading the way in commercialising the best new science is Merck (US:MRK).

The group's most exciting new drug is cancer therapy Keytruda, which has the potential to be the first successful immunotherapy, a completely new way of treating cancer that stimulates the body's own immune system to attack cancerous cells and which has been billed as potentially the biggest cancer development since chemotherapy. The quest to be the first company to successfully launch such a drug has been a hard fought race between Merck and Bristol-Myers Squibb (US:BMY) and for a long time the latter looked as though it was on to a winner with its drug, Opdivo. But in August this year Opdivo failed a major clinical trial, opening the gates for a Merck victory.

 

 

In 2016 Keytruda's clinical development programme progressed rapidly. It is now approved as the first choice medicine for non-small-cell lung cancer and as the second-line treatment for advanced melanoma as well as head and neck cancer. Recently, Merck presented data at the European Society for Medical Oncology, which indicated that Keytruda has the potential to be used as therapy in 23 different cancers. In its third-quarter results, Merck reported a 128 per cent increase in Keytruda sales to $356m, but this is still just a fraction of its potential. Broker Jefferies believes the market for immunotherapy drugs could reach peak annual sales of $51bn - giving Keytruda the potential to be among the most successful drugs ever developed.

Outside of oncology, Merck has a strong pipeline of drugs in a wide number of diseases. Recently the US Food and Drug Administration accepted the group's application for Isentress, a once-daily formulation for previously untreated HIV patients. Like Keytruda, the approval of Isentress as the 'first line of attack' against a prolific disease is a major bonus for Merck. As the first choice drugs Keytruda and Isentress have access to massive patient populations, which will be an enormous boost to revenue in 2017.

Late-stage clinical trials do come with risks, but Merck has been very sensible in the way it executes its drug development. By targeting specific patient populations and executing multiple small trials rather than a single massive one, the group has ensured that any failure in the clinic would not be a major financial loss or completely destroy the potential of the drug in question. Plus, the group isn't just relying on these high-risk, high-reward products for growth. Merck has a strong cardiovascular and diabetes portfolio and is an expert in vaccines, an area of the market less disrupted by the patent laws that place exclusivity limits on traditional medicines.

Financially there's a lot to like about Merck, too. With $7.9bn of cash on the balance sheet and $5.2bn of short-term investments, it is in an excellent position to acquire new drugs. This type of consolidation looks a good way forward as small innovative biotech companies are generally much better at finding exciting new drug ideas and taking them through the early stages of development, while pharma giants have the finances and commercial platforms to make them successful. We expect Merck to undertake some noteworthy acquisitions in 2017.

MERCK (MRK)

ORD PRICE:6,194ȼMARKET VALUE:$171bn
TOUCH:6,194-6,195ȼ12-MONTH HIGH:6,546ȼ4,797ȼ
FORWARD DIVIDEND YIELD:3.1%FORWARD PE RATIO:16
NET ASSET VALUE:1587ȼ*NET DEBT:27%**

Year to 31 DecTurnover ($bn)Pre-tax profit ($bn)***Earnings per share (ȼ)***Dividend per share (ȼ)***
201344.013.5349173
201442.213.6349177
201539.513.0359181
2016***39.713.5375185
2017***39.813.7387189
% change+0+2+3+2

Beta: 0.76

*Includes intangible assets of $38.8bn, or 1,406ȼ a share £1=$1.23

**Excludes $11.7bn of investments subject to significant tax payments if repatriated as dividends

***JPMorgan forecasts, adjusted PTP and EPS figures/Bloomberg consensus DPS forecasts