Is Merck Stock Undervalued After Its Colossal Earnings Growth?

Merck & Co., Inc. (NYSE: MRK) is one of the largest pharmaceutical firms in the world. The firm ranks fourth behind giants like Eli Lilly (NYSE :LLY) and Novo Nordisk (NYSE: NVO), with a market capitalization of $294 billion.

The company’s forward price-to-earnings (P/E) ratio sits at 13x. Compared to a peer group of the world's 10 largest pharma companies, this is well below the average of 20x. According to FactSet Earnings Insight, the healthcare sector has experienced the fourth-largest earnings growth in the past 12 months among all eleven sectors.

Which company has contributed the most to this earnings growth? The answer is Merck. The company has experienced a massive inversion in its adjusted earnings per share (EPS). In Q2 2023, the number stood at -$2.06; as of Q2 this year, it has flipped to $2.28.

Earnings in the entire healthcare sector have increased by 17%. However, without Merck’s contribution, the sector’s earnings would have declined by nearly 2%. Thus, the company has not only been able to vastly grow its own earnings but also keep its entire sector’s earnings from declining.

Due to this, Merck’s shares have surely appreciated greatly over the past 12 months, right? That’s not the case at all. Over that time, the price of Merck’s shares has appreciated just 8%. Despite this colossal earnings growth, a relatively low forward P/E ratio, and the modest rise in shares, it seems fair to ask: is Merck undervalued?

To add some color to this question, let's get a better idea of Merck’s most important business lines and other aspects of the company to figure out what might be going on.

Merck: Two Drugs Dominate the Massive Firm, and Their Growth Is Slowing

Merck breaks down its business into two segments: Pharmaceuticals and Animal Health. Pharmaceuticals makes up the vast majority of total revenue, coming in at 88% in 2023. Looking further into sales from individual drugs, we see the firm is highly reliant on two treatments: Keytruda and Gardasil/Gardasil 9. They made up 43% and 15% of total revenue, respectively, in 2023.

Keytruda treats a litany of different cancers. Gardasil/Gardasil 9 is a vaccine that protects against multiple strains of the human papillomavirus (HPV). Since 2021, sales growth for both these drugs has slowed significantly.

In 2022, Keytruda grew by 24%, but then fell to 3% in 2023. However, sales growth recovered nicely to 16% in Q2 this year. Gardasil/Gardasil 9 grew by 21% in 2022 and 29% in 2023, but growth was just 1% in Q2.

What’s Going on With Merck’s Earnings?

Turning to the shift from negative EPS to positive, we see that Merck’s loss of $2.06 per share in Q2 2023 was due to the acquisition of Prometheus Biosciences. This resulted in a one-time charge of $4.02 per share. So, without the acquisition, adjusted EPS would have been $1.96.

In Q4 2023, adjusted EPS was $0.03, driven by a one-time charge of $1.69 for its collaboration with Daiichi Sankyo (OTCMKTS: DSNKY). So, it's evident that these massive drops in EPS weren’t due to the company performing badly internally. Rather, the company had to record huge and abnormal increases in its research and development (R&D) costs to account for these events. The company did not stage a huge turnaround in its operations but made large investments, which it had to account for.

Taking out these one-time charges, the company’s average adjusted EPS over the past five quarters would be $2.03. The company’s current EPS is $2.28, about 12% higher than this average.

Final Thoughts on Merck’s Earnings and R&D

Although Merck doesn’t have a turnaround story, it has still been outperforming expectations. Despite making large investments in its future, it has beaten both revenue and adjusted EPS estimates over each of the last five quarters.

However, it may not be getting much credit for these investments because they won’t provide revenue benefits in the short term. Prometheus had no approved drugs, and there haven’t been any updates on its flagship drugs since the acquisition.

The Daichii collaboration also failed recently in June, with the first drug the two firms are partnering on being rejected by the Food and Drug Administration (FDA). This rejection will extend the time it could take Merck to make sales through the partnership.

Although the stock could still be upside, the average Wall Street price target for Merck is $139, implying an upside of 17%.

Source MarketBeat