5 Key Points You May Have Missed in Merck's Q2 Report

By Markets Fool.com


Source: Merck.

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Pharmaceutical giant Merck issued its much anticipated second-quarter earnings results on Tuesday, July 28, and overall they did not disappoint investors or Wall Street.

Merck stock, which has an exceptionally low beta (a measure of volatility), has gained approximately 3% since its numbers were released. Not surprisingly, given the lift in Merck's stock price, its profit results handily surpassed expectations for the sixth consecutive quarter.

Sizing up Merck's Q2
For the quarter, Merck reported revenue of $9.79 billion, a 10.5% year-over-year drop. Pharmaceutical sales tumbled 11%, and the animal health segment saw sales shrink by 4%. However, investors were made well aware that 7% of the worldwide sales decline was based on negative currency translation -- a stronger U.S. dollar and the need to report in dollars means Merck and other U.S. multinationals have had to convert weakening foreign currency back into U.S. dollars. In addition, another 7% was directly related to the divestiture of its consumer care business, and was partially offset by the acquisition of acute hospital care drug developer Cubist Pharmaceuticals.

Profit-wise, adjusted net income fell 2% to $2.44 billion, but on an adjusted per share basis Merck's profit increased by 1% to $0.86.

In comparison, Wall Street had been expecting Merck to report a profit of just $0.81 per share on $9.8 billion in sales. While Merck's revenue met the mark, its per share profit blew by the Street's estimates by a clean $0.05.

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Looking ahead, Merck's guidance also fell in-line with analyst expectations. Merck's full-year view of $38.6 billion-$39.8 billion in sales and $3.45-$3.55 in EPS matches up nicely with the current consensus of $39.7 billion in sales and a profit of $3.44 per share on Wall Street.

Five key points you may have missed in Merck's report
Headline numbers are great because they quickly sum up how a company performed over the prior three-month period. However, they do nothing to explain why a company did so well, or poorly, unless you dig deeper. If you only glanced at the headlines, chances are you missed these five key points in Merck's Q2 report.


Source: Merck.

1. Merck is actually growing
One of the easiest ways to get lost when reading the earnings report of a U.S. multinational like Merck is to get caught up in one-time benefits and costs, such as foreign currency translation, divestments, and tax benefits, for example.

Merck's latest headline number wasn't pretty: an 11% decline in sales. But, excluding its divestment expenses and currency movements, which it has no control over, Merck actually grew on an operational basis by 3% on a year-over-year basis. This isn't exactly growth worthy of popping open the champagne bottle, but the headline figure isn't giving a totally accurate story to the health of Merck's operations.

Additionally, sans currency effects, Merck's animal health division grew by a whopping 10%. Merck made a decision to hang onto its animal health division rather than sell it or spin it off, which may prove wise as the trend of household pets becoming members of the family could push companion animal revenue significantly higher in the coming years.

2. Gross margins are on the rise
Once again, if you didn't dig below the surface, you probably just assumed Merck's 61.6% gross margin was notoriously weaker than what you're used to from a Big Pharma company. However, Merck's gross margin was negatively affected by divestiture-related costs and restructuring costs, which knocked 13.8 percentage points off its gross margin in Q2 2015. Without these costs we're looking at a very healthy 75.4% gross margin.

Furthermore, excluding these costs from the year-ago quarter, Merck has delivered a 280 basis point improvement in its gross margin. Merck cited lower inventory write-offs as a primary reason for the improved margins, but a 2% decrease in research and development expenses compounded with its restructuring should mean a steady improvement in EPS.

3. Keytruda is rocking, but lost ground to Opdivo
In terms of Merck's future, cancer immunotherapy Keytruda, which works by supercharging the body's immune system to efficiently locate and kill cancer cells, is arguably its most important drug.

Source: Merck.

Keytruda sales officially jumped 33% from the sequential first quarter to $110 million, and very easily could top $500 million this year despite having only limited indications thus far. The real allure of Keytruda is the potential for new label indications in treating solid tumors, and this is what makes most investors believe Keytruda has multi-billion in annual sales potential.

But, the battle between Keytruda and rival immunotherapy from Bristol-Myers Squibb, Opdivo, tightened up in Q2. After more than doubling Opdivo's sales in Q1 ($83 million vs. $40 million), Opdivo surged to $107 million in U.S. sales in Q2, and $122 million in total worldwide sales. As expected, it's still too early to tell if there will be a clear winner or preference among physicians between these two anti-PD-1 immunotherapies.

4. Januvia is holding its ground
One major sigh of relief in Merck's Q2 report that you might have missed is that blockbuster diabetes drug Januvia (known as Janumet in overseas markets) is still holding its ground (and growing). In Q2, Januvia/Janumet generated $1.6 billion in sales, up 1% year-over-year, but up 9% on an apples-to-apples basis when currency fluctuations are taken out of the picture.

Following fears that a next-generation class of diabetes drugs known as SGLT-2 inhibitors might garner market share, as well as just tougher overall competition, Merck beefed up its marketing campaign on Januvia/Janumet. The campaign appears to be working well, with Merck's best-selling drug looking as if it still has legs.

5. Three of Merck's mainstays are on the decline
On the other side of the coin, three of Merck's blockbusters appear to be on the downswing, which isn't such great news for investors.

Source: Merck.

Cholesterol-lowering drugs Zetia and Vytorin, as well as HIV antiviral medicine Isentress (all three of which are blockbuster drugs) are on the decline as competition increases and newer therapies enter the cholesterol and HIV space. Combined, Zetia/Vytorin delivered a 16% sales decline, which was a slightly less horrifying 8% decline on an operational basis, while Isentress sales declined 17%, or 10% on an operational basis.

These are high-margin and well-established products for Merck, so it'll need its new therapies to step up in a big way if it has any chance of counteracting ongoing sales weakness.

Should you buy Merck?
The real question following Merck's quarterly results is whether or not you should consider buying its stock.

As with most Big Pharma, Merck is still smack dab in the middle of a multi-year turnaround. In other words, Merck is still in the process of defining its new path to growth. Current and prospective investors will relish in Merck's 3% yield and its below-average volatility. Merck's substantial cash flow also allows for the possibility of buybacks and, of course, bolt-on acquisitions.

But, the real wild card is Merck's hepatitis C combo therapy grazoprevir/elbasvir. I don't mean that in the context of efficacy, because Merck's clinical trials would suggest the combo has a better chance of being approved than not being approved. The question is how well with Merck's combo stand up against the likes of Harvoni from Gilead Sciences. In the early going Gilead has been a nearly impenetrable wall in HCV, so it remains to be seen if Merck can make a significant dent.

Thus, my answer is more of a "maybe" when it comes to whether or not you should buy Merck. If you're seeking solid dividend income and low-risk, then Merck might be a good bet. If you want steady growth now, you might be sorely disappointed, as there are clear question marks and challenges lying ahead.

The article 5 Key Points You May Have Missed in Merck's Q2 Report originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool owns shares of and recommends Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.