Morningstar - Q3 2020 - 55

A High Bar
Strong pricing power and pipeline reinforce Merck's wide moat.

BEST IDEAS: EQUITY

Damien Conover

Merck MRK

This article is adapted from a Morningstar equity research report dated
June 2, 2020.

Stats 06/30/2020

At the American Society of Clinical Oncology virtual annual meeting in May,
new immuno-oncology data in non-small-cell lung, small-cell lung, bladder,
liver, and triple-negative breast cancer showed continued support for our
above-consensus expectations. Importantly, we are seeing efficacy differences
between the leading immuno-oncology drugs by cancer indication, which is
likely to enable stronger pricing power. We believe the more unique the drugs
are in response rates across cancer types, the less ability payers have
to negotiate prices. The strong pricing power in areas of unmet medical needs
like oncology should reinforce the wide moats for leading companies
Bristol-Myers Squibb BMY, Merck MRK, Roche RHHBY, and AstraZeneca AZN.
We expect the PD-1/PDL1 immuno-oncology drugs to collectively generate
$54 billion by 2024, ahead of consensus expectations of $44 billion. Within this
group, we view Merck and Roche as the most undervalued.

Morningstar Rating
QQQQQ

Sector
d Healthcare

Industry
Drug ManufacturersGeneral

Price
$77.33

Fair Value Estimate
$100.00

Uncertainty
Medium

Economic Moat
Wide

Stewardship Rating
Standard

Market Cap
$198.7 Billion

Price/Fair Value 06/30/2020

$120
Fair Value Estimate Per Share
100.00 100
77.33

Month-End Closing Price

Merck's combination of a wide lineup of high-margin drugs and a pipeline
of new drugs should ensure strong returns on invested capital over the long
term. Further, Merck is through the worst of its patent cliff, which should
remove the heightened generic competition the company has experienced over
the past years. And after several years of only moderate research and
development productivity, Merck's drug development strategy is yielding
important new drugs.
Merck's new products have mitigated the generic competition, offsetting
recent major patent losses. In particular, Keytruda represents a blockbuster
with multibillion-dollar potential: It holds a first-mover advantage in one of the
largest cancer indications of non-small-cell lung cancer. Also, we expect new
cancer drug combinations to propel Merck's overall drug sales. However, we
expect intense competition in the cancer market with several competitive drugs
likely to report important clinical data between 2020 and 2021. Other
headwinds include generic competition, notably to diabetes drug Januvia,
which is likely to create a drag on overall growth.
After several years of mixed results, Merck's R&D productivity is improving.
Owing to side effects or lack of compelling efficacy, Merck experienced major
setbacks with some cardiovascular disease drugs and a migraine drug, and
safety questions ended the development of osteoporosis drug odanacatib. But

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Merck has some solid successes, including a successful launch for Keytruda.
Merck is shifting its focus toward areas of unmet medical need in specialtycare areas, and Keytruda is leading this new direction. We expect Keytruda will
be a key driver of growth for the company over the next several years.
In May, we slightly lowered Merck's fair value estimate to $100 from $103
based on strong competitive data from Roche's tiragolumab. While the data
needs to be confirmed in phase 3 studies (with data likely in 2022), we
believe the strong results will increase Roche's market share in nonsquamous
NSCLC, largely at the expense of Merck. However, Merck is developing
an anti-TIGIT drug, which has a similar mechanism of action as tiragolumab;
it is likely at least a year behind Roche. Meanwhile, Merck's Keytruda
combination data with chemotherapy still holds excellent data, setting a high
bar for new therapies. K
Damien Conover, CFA, is director of healthcare equity research for Morningstar.

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Morningstar - Q3 2020

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