Analyst downgrades Merck after assessment and R&D re-alignment

Bernstein Research analyst Tim Anderson, who has graduate degrees in medicine and business, has long told clients of the great history of Merck research and development and even upgraded his outlook on the stock as late as 2009, after it bought Schering-Plough.

But on Monday, he told clients he has downgraded the outlook from "outperform" to "market-perform."

Merck is based in Whitehouse Station, N.J. On Oct. 1, the drugmaker announced 8,500 more layoffs by the end of 2014 and a narrowing of focus of R&D. MRK is Merck's ticker symbol.

As Anderson wrote to clients, the downgrade is predicated on:

  • The company seems to have only average long-term revenue and earnings per share growth prospects.
  • A full third of the company's in-line franchises remain (or will come under) under attack including Januvia, Isentress, Remicade, PEG-Intron/Victrelis, and Vytorin/Zetia. Collectively these drugs sell ~$15B/yr (34% of total company revenues).
  • While the company is embarking upon a series of maneuvers to “fix” R&D, this will likely take years to accomplish. Part of our original investment thesis with MRK was that its legacy as a best-in-class R&D organization would predict meaningful future new product flow, but as investors are well aware, MRK's execution in R&D since 2006 has been disappointing.
  • There seem to be few near- and intermediate-term catalysts, with the exception of additional data on PD-1 cancer drug lambrolizumab (Oct 26-30th) and other related news flow that investors are already watching closely. We forecast lambrolizumab sales in 2020 of $3B.
  • MRK's announcement last week of a larger, new round of cost-cutting does little to bolster the investment case. It is, of course, good to slim down, but it simultaneously supports the notion that MRK is under-performing on its execution versus prior plan. Cutting R&D, like MRK will be doing, may or may not be a good thing over the longer-term.
  • MRK's valuation is not exceedingly low – it has a P/E multiple nearly in-line with the group average (Exhibit 4). There is still upside on a DCF basis (Exhibit 5), but this holds true across all of the drug companies we cover.
  • We are lowering our price target on MRK from $53 to $50 which reflects an unchanged PE multiple of ~14x our slightly lower 2014 EPS estimate, following last week's analyst meeting. Merck is still a quality “blue chip” company in many regards, but one that does not warrant an Outperform rating at present, in our view.

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