2 Upgrades In 1 Day for Merck -- and 3 Things You Need to Know

By Rich Smith Markets Fool.com

Thursday is dawning bright for shareholders of Merck (NYSE: MRK), as the stock gains 2% in response to two separate upgrades on Wall Street.

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This morning, StreetInsider.com reported that first Morgan Stanley ("outperform"), then Guggenheim("buy") have issued new upgrades on Merck stock. Merck currently costs about $63 per share, but in the opinion of Morgan Stanley, progress on the drug company's new Keytruda cancer treatmenthas the potential to lift Merck stock to $71. Guggenheim is only slightly less optimistic, predicting that Merck will hit $70 within a year.

Here are three things you need to know about why.


Merck is taking aim at lung cancer. Image source: Getty Images.

1. Where to start?

Let's begin at the beginning, with Morgan Stanley's bold prediction that Merck stock -- up 17% last year already, will tack on a further 13% gain in 2017. According to Morgan, having already received first approval for "monotherapy" with Keytruda, Merck is set "to extend its lead in first-line lung cancer."

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The market for non-small cell lung cancer (NSCLC, estimated at85% to 90%of all lung cancer) drugs is estimatedto grow from a recent value of $5.1 billion to as much as $7.9 billion by 2020. Morgan believes that as early as May, Merck will receive FDA approval to begin treating NSCLC with a combination of Keytruda and chemotherapy. Calling early results with Keytruda "highly compelling," Morgan believes that approval will be granted "conditional on Phase 3 1L lung success," giving Merck "at least several months' head start vs. competitors in first-line covering almost all patients."

2. Define "almost all"

That last phrase could be important, because as Guggenheim also argues, Merck now has the "potential" to "capture the entire non-squamous non-small cell lung cancer market, regardless of PD-L1 expression," as early as Q2 of this year.

3. Dollars and cents

What does this opportunity mean for Merck stock? According to Guggenheim, "if we assume approval of Keytruda plus chemotherapy in front line NSCLC occurs, our global numbers for Keytruda in 2017 and 2018 move from $3.1B to $3.69B and from $4.84B to $5.29B." And while $5.29 billion sounds like a lot of money, if Merck can capture and keep control of this market, those sales could conceivably rise as high as $7.9 billion by 2020.

That would be more than twice the Keytruda sales Guggenheim was previously projecting for Merck this year -- 155% growth in just four years.

The most important thing: Context

Of course, even if all of this is true, it's important to put Keytruda into context within Merck's overall business.

Currently, Merck is pulling down annual sales in the range of $39.9 billion. At Guggenheim's new estimate, Keytruda could comprise more than 9% of those sales in 2017. And if Merck still controls the whole market in 2020, that could add a further $4.2 billion in sales for the company four years from now, contributing about 2.5% annually to the company's overall growth rate. (And to put that in context, analysts polled by S&P Global Market Intelligence believe Merck's overall growth rate over the next five years will be 8.8% -- so 28% of the company's growth will come from just this one product.)

Obviously, Keytruda is big news for Merck. But is it big enough news to make the stock a buy? Here's where I become less certain -- and I'll tell you why.

At its present valuation of $63 a share, Merck stock carries a valuation of 34.6 times earnings. Guggenheim estimates that 2017 earnings will explode much higher, however, to as much as $3.91 per share. Even if it's right, though, this boost in earnings will only suffice to drop the P/E down to 16 -- which still seems expensive assuming a sub-9% growth rate. What's more, even with Keytruda, Guggenheim estimates that 2018 earnings will grow only from $3.91 to $4.15 per share, which works out to just 6% growth.

After crunching the numbers, I'm forced to conclude: Keytruda may be a great product with great prospects -- but it's still not big enough news to justify buying this overpriced stock.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 358 out of more than 75,000 rated members.The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.