NYSE: MRK

Merck & Co., Inc.

St Andrews Investment Society 15 Nov 2016

Merck & Co., Inc

NYSE: MRK Merck is a well-established and respected pharmaceutical company in the healthcare industry with a long history of bringing successful products Price (15 Nov 2016) to market to target unmet consumer needs. Market Cap (bn) EV (bn)

Company Overview Merck develops health solutions delivered through prescription medicines, vaccines biologic therapies and animal health products. Merck has core product categories to target significant health challenges and underserved patient populations where often times no current treatments exist. Furthermore, Merck is a global leader in vaccines and well respected among healthcare providers with a strong reputation for developing and delivering effective, reliable products.

$63.45 $176.3 $191.2

HEALTHCARE AND PHARMACEUTICALS Price Target Investment Horizon

$68.00 12m

24m performance: 80 60 40

Investment Rationale Merck is a company with high integrity and well-established legacy products. As a global leader in vaccines and operating on the forefront of cancer care, Merck develops reliable products to address unmet consumer needs. It has a track record of bringing innovative products to market that are frequently prescribed by doctors. Merck publishes manuals that are widely used as references by healthcare professionals further exemplifying the company’s well-established relationship with the medical industry. Built on a foundation of integrity and transparency, Merck has gained the trust of healthcare providers, an essential step in the development of safe and effective products. In addition to multiple, successful products already marketed, Merck has a promising pipeline with drug candidates in the late stage of their development that are the first of their kind for currently untreatable diseases. Rather than chemotherapy, Merck has focused on immunotherapy, using new technology for the body to fight cancer. Merck’s newest product, Keytruda, is likely to become the standard of care in lung cancer and is transforming the way the disease is approached in the clinical setting. Similarly, Zepatier, a treatment for Hepatitis C, was recently launched and is also gaining momentum in global markets.

20 0

Market Data: 52- Week Range Shares Out. (bn) EV/EBITDA EV/OpFCF P/E Div./Yield

48.0-65.6 2.77 12.62x 17.4x 32.53x $1.84/2.82%

Financial Data: Revenue (bn) Revenue growth EBITDA (bn) EBITDA growth EBITDA margin

39.7 2.4% 13.8 0.4% 34.8%

Leverage: Net Debt (bn) Net Debt/EBITDA EBITDA/Interest

41.3 3.0x 3.4x

Compared to its peers, Merck is not so diversified that it has many average products competing in areas where other treatments exist, and yet it has more than just a few products to sustain growth and revenue. Strategic management decisions and directed research and development efforts form a strong platform for Merck to succeed in the current market.

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NYSE: MRK

Merck & Co., Inc.

Market Position Merck is a US pharmaceutical company with a global reach. It specializes in chronic disease treatment and vaccination. Over 75% of the US healthcare spending is toward the treatment of diabetes, obesity, and lung cancer, which positions Merck in a lucrative market. Keytruda is one of Merck’s drugs currently operating in the market for cancer. Keytruda has been upgraded to first line treatment (first drug prescribed to patients) in one form of lung cancer and second line in other forms of lung cancer. Keytruda has also been approved for use in curing advanced melanoma and head and neck cell cancer and is anticipated to be approved in numerous other cancers. In these markets, Merck competes with Opdivo, a drug produced by Bristol-Myers Squibb. Merck also competes in the diabetes industry, with their drug Januvia being a large competitor in this market. Merck is one of the global leaders in this industry, with Januvia being the second highest seller in the diabetes market behind Sanofi’s drug Lantus. Merck is also a global leader in HPV vaccination. HPV is the most common cervical cancer and vaccination for boys and girls is currently only 21% and 40% respectively. However, the CDC currently aims to boost vaccination rates to 80% for both boys and girls by the year 2020. This is a major opportunity for Merck and it has monopolized this market with Gardasil, which generated $1.9bn in revenue in 2015. Merck’s Zepatier, a treatment for Hepatitis C, is currently being launched in the EU. It was given breakthrough therapy status after its release in the United States due to its effective mechanism of action. Bristol-Myers Squibb also have a competitive Hepatitis C combination treatment.

Financial Position Merck’s financial performance over the period from FY13 to FY15 shows significant decreases in revenues of -6.2% per year. This decline is primarily driven by product divestitures (e.g. Merck’s Consumer Care business in FY14), loss of exclusivity rights, and negative foreign exchange effects. LTM figures however show an increase in sales by 2.4%. Reductions in COGS and R&D expenses were not extensive enough to compensate for the mentioned revenue decline, leading to decreasing EBITDA and EBIT margins. However, the comparatively limited reduction of R&D expenses (-3.7% CAGR) can be considered rather favourable with regard to potential future product releases, resulting from successful developments, and by that, additional future cash flows. Total assets ($102bn as per Dec15) decreased by -1.8% per year on average, with the most significant decline in buildings and machinery/equipment of -$1.5bn and -$2.8bn respectively (w/o consideration of depreciation). Additionally, management achieved a significant reduction of trade working capital levels, from c. $11.4bn in FY13 to c. $8.7bn in FY15. Goodwill (intangible assets) increased in FY15 by $4.7bn, resulting from anticipated synergies expected from the acquisition of Cubist Pharmaceuticals, Inc. (leading developer of treatments of bacterial infections) in that period. Liabilities of the company have been shifted towards increased leverage, with an increase in long-term debt of $3.4bn. Hence, net debt (long and short term debt less cash and cash equivalents) has increased to $43.6bn as per Dec15 ($41.3bn as per Sep16). During the period under consideration, Merck has increased its treasury stock with extensive buyback programs, leading to a decrease in equity of $7.6bn. The company’s debt-to-equity-ratio was at 1.3x as per Dec15, with interest coverage of c. 11.0x. This capital restructuring led to a significant increase of ROE from 8.4% to 9.9%. With a quick ratio of 1.5x, asset turnover of 0.4x, and receivables turnover of 5.9x, Merck shows a robust performance amongst its peer group.

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NYSE: MRK

Merck & Co., Inc.

The stock has increased by 19.0% y-o-y, resulting in a P/E ratio of 32.5x, and currently depicting a beta of 0.78 (within a usual range for the industry). Recent and expected developments are primarily driven by Merck’s latest successes with Keytruda, as well as other promising drugs in the pipeline. Expecting a growth for the next 12 months between 28.6% and -7.7%, the stock still bears a significant upside potential.

Merck & Co., Inc. - Financial Summary FY2013A

FY2014A

FY2015A

LTM1

13A-15A CAGR

Revenue

44,086

42,109

38,773

39,699

(6.2%)

Growth

(6.9%)

(4.5%)

(7.9%)

2.4%

EBITDA

16,298

15,882

13,780

13,834

Margin

37.0%

37.7%

35.5%

34.8%

9,310

9,191

7,405

n/a

Margin

21.1%

21.8%

19.1%

n/a

OpFCF

11,654

7,860

12,421

10,991

Margin

26.4%

18.7%

32.0%

27.7%

4,404

11,920 ²

4,442

5,490

10.0%

28.3% ²

11.5%

13.8%

$m, FYE Dec

EBIT

Net income Margin 1

(8.0%) (10.8%) 3.2% 0.4%

LTM figures are preliminary | ² FY14 amounts reflect the divestiture of Merck’s Consumer Care Business in Oct-14

Merck & Co., Inc. – Competitors Competitors

Gross Margin

ROE

P/E

Price target

Merck

63.3%

12.3%

32.53

+6%

Eli Lilly

73.7%

15.9%

33.72

+27%

Allergan

78.7%

-2.4%

n/a

+28%

AbbVie

78.6%

107.3%

16.97

+10%

Pfizer

76.6%

9.52%

32.53

+16%

Source: Reuters; Financial Times; Factiva; Thomson One; Annual reports

Growth Prospects & Risks Increasing government scrutiny as a result of recently uncovered price hikes of drugs has created some uncertainty in the market around pharmaceutical companies. Government officials have spoken out against pharmaceutical companies making unjustified profits on products. However, Trump as president-elect has a favorable effect on the pharmaceutical markets, which were originally threatened by stricter regulations proposed by a Clinton administration. Moreover, the pharmaceutical industry overall is one of the highest margin sectors in the US. This means that it would be very difficult for increased regulation to permanently damage Merck and the industry as a whole.

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NYSE: MRK

Merck & Co., Inc.

In addition, growth in the American drug market will only continue due to the US’ rapidly aging and insured population. This demographic accounts for roughly 33% of industry sales. The current rise of obesity, diabetes, cardiovascular disease and other chronic diseases further strengthens Merck’s position of offering products for these patients. However, it should be said that IMS health expects a decline in European drug markets at a compound annual growth rate of 1-2%. It should be recognized that US drug markets are said to grow at a compound annual growth rate of 1-4% over the same period according to IMS. Merck’s growth is based on the global launch of Keytruda and Zepatier, which are both currently ongoing. One of Merck’s primary vaccines, Gardasil, is anticipated to also bring in more revenue. Although a new prescribing program has lowered the dose from 3 vaccines to 2, the Center for Disease Control is starting an initiative to increase the vaccination rates for cervical cancer. Currently, boys and girls have 21% and 40% vaccination rates, respectively, which the CDC is looking to increase to 80% by 2020. Merck’s pipeline has some promising candidates expected to bring in more revenue after development. For example, the BACE-1 inhibitor verubecestat is in Phase III trials for testing for the first ever treatment of Alzheimer’s disease. Merck is ahead of Lilly in the race to first-to-market in this area. Risks to Merck include biosimilar competition for Remicade, the product marketed along with Johnson and Johnson, which would decrease sales significantly. Furthermore, patent loss of Zetia would result in less revenue generated. It is crucial for pharmaceutical companies to balance the loss of exclusivity on drugs with successful product launches in order to maintain steady revenue. However, it is always a possibility, with any new drug marketed, that safety or efficacy issues arise even after FDA approval. Furthermore, pipeline candidates can fail, resulting in loses from investment in the research and development sector.

Management Structure & Integrity Merck strives to fulfill its commitment to being a leading, research-intensive biopharmaceutical company. The firm is overseen by Kenneth C. Frazier: chairman of the board and chief executive officer since 2011. Mr. Frazier has worked at Merck and Co. in some form since 1999. He is assisted by the executive committee, which directly oversees key aspects of the business and meets regularly to review the progress made in reaching the company's goals. With an average tenure of over 8 years, the board of directors is a qualified and competent group of individuals. Merck’s board of directors is highly diversified, with members holding MD’s or Ph.D.’s, and others with business backgrounds. This experience allows members to not only understand the scientific knowledge required for effective drug development but also the tools necessary to bring a novel product to market.

Shareholder Structure Merck has 2.8bn shares outstanding without par value. 74.7% of its shareholders are institutional investors. Shares of Merck are held by several institutions with Wellington Management Group holding the largest amount at 8.5%. Between them, the top ten largest investors hold 42.7%. Its five largest stockholders after Wellington Management Group are Vanguard Group – 8.5%, Capital World Investors – 6.5%, State Street Corp – 5.6%, and Blackrock Institutional Trust Company – 3.6%.

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