You Better Be Careful with Merck Stock, Especially at These Highs

Merk stock - You Better Be Careful with Merck Stock, Especially at These Highs

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Health care stocks including pharmaceutical giant Merck (NYSE:MRK) have gone on a nice run of late. Merk stock has gained over 20% just since early April, touching an all-time high this week. That’s a huge move for what generally is a low-volatility stock, and a stock that’s been pretty much rangebound since mid-2014.

That said, it’s not hard to argue for more upside ahead. Merk stock remains reasonably cheap, at 15.5x the midpoint of 2018 EPS guidance. Keytruda appears to be a winner, as Tom Taulli pointed out back in April. Q1 earnings that month seemed mixed, but the market reacted positively, and Merck raised guidance in the Q2 report late last month.

That said, Merk stock definitely has benefited from changing sentiment toward the industry. Fellow giant Pfizer (NYSE:PFE), which I recommended in June, has gone parabolic of late and trades at a 16-year high. Hospital stocks like HCA Healthcare (NYSE:HCA) have rallied.

There seems to be a “no news is good news” attitude toward health care as a whole right now. Save for President Trump’s tweet against Pfizer last month, regulatory pressure has been minimal. That’s allowed some of the stronger stocks in the sector like Merk to rally. The key question, however, is: How long will it last?

Valuation Concerns

One of the issues with drug stocks and valuation is that earnings multiples often seem low and stay low. The often-short length of patent protection and the risks involved in making blockbuster drugs limits what investors will pay for drug manufacturers.

Procter & Gamble (NYSE:PG) presumably will still make profit from Tide laundry detergent and Bounty paper towels 15 years from now. That’s not necessarily the case for current Merck products like vaccine ProQuad or diabetes treatment Januvia, which will face generic competition in the coming years.

And in that context, Merk stock might not be as cheap as it looks. Yes, it trades for 15.5x the midpoint of guidance. But PFE trades at less than 14x.

Smaller manufacturers like Eli Lilly (NYSE:LLY) and Bristol-Myers Squibb (NYSE:BMY) are getting bigger valuations but also are driving bigger growth.

At the least, Merk stock is pricing in relatively consistent, if moderate, growth. The history of majors in the drug space suggests that’s about right – and that Merk may not exactly be a steal, even with an earnings multiple below that of the market as a whole.

Industry Concerns

And from a long-term standpoint, there are reasons to give drug stocks a below-market multiple even beyond patent issues. This is not a particularly well-liked industry from a public standpoint, either in the U.S. or overseas.

In response to Trump’s tweet,  Merck already has cut prices on seven drugs, and agreed to limit price increases elsewhere in its portfolio.

To some extent, that was simply a PR move (several of the drugs had low sales anyway). The gains in Merk stock show the market isn’t terribly concerned. But from a longer-term standpoint, that pressure isn’t going away.

No matter which party controls which branch of government, “lower drug prices” likely always will satisfy voters. Given that overseas governments, many of whom have centralized healthcare management, already have squeezed manufacturers, there aren’t too many places left to hide.

Indeed, that’s the core question surrounding the rally in healthcare of late. Are investors correctly starting to anticipate that the worst has passed – and a “new normal” is rising? Or is the market stretched enough that investors are seeking ‘value’ anywhere – including in an industry under pressure?

The Bull Case for Merk Stock

There are risks here. But there are rewards, too. Merck is becoming a leader in cancer treatments, with sales of Keytruda nearly doubling in Q2 to $1.67 billion. More indications and approval in more countries should drive more growth in that key product.

Merck’s Zepatier has lagged in the growing hepatitis C market, trailing treatments from Gilead Sciences (NASDAQ:GILD).  Zepatier revenue in Q1 actually was zero, when accounting for rebates.

But a 60% price cut has made Zepatier a “preferred product” at Express Scripts (NASDAQ:ESRX) ahead of that PBM’s acquisition by large insurer Cigna (NYSE:CI). That move could boost sales and profits, even at the much lower price.

Meanwhile, Merk does look like one of the best, if not the best, performer of the giants. It’s outperformed PFE for over a decade, as well as Novartis AG (NYSE:NVS), though AbbVie (NYSE:ABBV) has been the clear star.

I didn’t particularly like ABBV back in January, but it has pulled back. Still, there’s a case that among the giants, Merk is the best play at the moment.

The question then becomes whether an investor wants exposure to large-cap drug stocks, and it’s a tough question.If the answer is “yes,” Merk’s reasonable valuation and 2.9% dividend yield are worth it. I’m simply not sure that it is.

As of this writing, Vince Martin has no positions in any securities mentioned.

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