Image Source: Merck
Merck simply blew away the competition–the results are simply incredible. Keytruda is a gamechanger, and we think it will become the top-selling pharmaceutical once the patent lapses on Humira.
By Alexander J. Poulos
Key Takeaways
Merck has solidified its lead in non-small cell lung cancer, which should power revenue growth well into the future.
Merck will become increasingly more dependent on Keytruda for top-line growth, however, as we think its clinical pipeline remains uninspiring.
The company’s dividend is a head-turner, but there are long-term risks to big pharma payouts. Shares look fairly valued to us.
What is Immuno-Oncology?
Immuno-oncology is the innovative field which seeks to augment the body’s own immune system to fight and hopefully eradicate cancer. The goal is to lessen the use of chemotherapy, which has a host of drawbacks namely the side-effect profile of the treatment. The field has gotten off to an audacious start, but as we have seen with past breakthrough therapies, the leader in the field can be usurped by a better molecule.
Keytruda Now Dominates Non-Small Cell Lung Cancer
Merck (MRK) recently posted the results of its pivotal KEYNOTE-043 trial, which studied the effects of Keytruda as monotherapy for the treatment of Non-squamous Small Cell Lung Cancer (NSCLC), one of the most prevalent forms of cancer. The results are a knockout win for Merck as Keytruda posted an overall survival rate of 16.7 months versus 12.1 months via chemotherapy. The results dramatically improved depending on the amount of PD-1 expressed by the patient. For those who are considered a “high expresser” which is classified as PD-L1 tumor proportion score (TPS) of ≥50 percent, Keytruda posted an OS of 20 months versus 12.2 in the control arm of the study. The stepwise increase in effectiveness based on TPS is confirmed as the group with a TPS >20% posted an OS of 16.7 versus 12.1 in the control arm.
What are the Implications of this Study?
We think we’re in the midst of a shift in the way clinicians will now go about treating NSCLC. Keytruda has garnered approval as a first-line agent for those afflicted with NSCLC with a PD-L1 score above 50 along with those with a score greater than 1% after platinum-containing chemotherapy, but clinicians had remained loath to switch gears versus the tried and true methods until definitive data proving an increase in effectiveness was released, which has now occurred. We fully expect usage of Keytruda in NSCLC to ramp significantly based on these results, a real win for Merck and NSCLC patients.
Impact on Merck’s Intrinsic Value
We remain lukewarm towards Merck’s prospects as the company this decade hasn’t had a stellar record of bringing forth new novel treatments prior to Keytruda. One of the key indicators of future success for big pharma is the productivity of the clinical pipeline, an area of notable weakness for Merck which has suffered from some high-profile phase 3 flameouts this decade.
We feel Keytruda is a gamechanger thanks in large part to owning the NSCLC market. Unfortunately, lung cancer is responsible for more deaths than breast, prostate and colon cancer combined–NSCLC comprises 85% of the total cases of lung cancer.
To add further context to the overall size of Merck’s opportunity, the following numbers from the American Cancer Society are very sobering. ACS reports roughly 234,000 new cases of lung cancer are diagnosed very year in the US, with lung cancer the cause of death in approximately 154,000 patients annually.
Merck is in prime position to reap the rewards of its good fortune, but it cannot rest idly by. Its primary rival Bristol-Myers Squibb (BMY) was originally thought to be in the pole position, but a critical failure in NSCLC has diminished its opportunity as its main product OPDIVO is now relegated to second line status. We believe Keytruda is poised to become the top-selling pharmaceutical once the patent lapses for current champion Humira.
The grim reality is most are diagnosed with lung cancer when it is at an advanced stage, which diminishes the overall prospects for survival. The overall five-year survival rate irrespective of stage in the US is estimated to be approximately 18% with stage 4A estimated at 10%. As with most cancers the earlier the detection the better the prognosis. Even with the stellar results posted by Keytruda, additional work is needed to advance the overall survival rate. The key will most likely come from combination therapies, but a combo that is effective with an acceptable safety profile remains elusive.
Bristol attempted to shift the equation back into its favor with a combo of Yervoy and OPDIVO, but the toxicity of the product will preclude it from mass adoption. Merck must remain ever-vigilant for a novel PD-1 to come to market which may knock it off its perch. We are heartened with Merck’s aggressive approach in forming partnerships to potentially develop viable combination therapies, but whenever a company becomes over-reliant on one product such as Merck has become with Keytruda, an entrant with a superior clinical profile may have an outsized impact on the valuation of the company.
Role of the Dividend
One of the main appeals of an investment in Merck centers on the generous dividend. Merck rewards shareholders with a quarterly payout of $0.48 per share ($1.92 annualized; ~3.2% yield). The company has an enviable track record of consistent dividend increases, but as is always the risk with pharma giants, its portfolio is highly exposed to a revenue cliff once a product losses patent protection. Unlike its Dow 30 peer Pfizer (PFE), Merck has generally refrained from active M&A to fill any expectations of lost revenue. The loss of patent exclusivity on Lipitor, once the world’s best-selling product, forced Pfizer to cut its dividend in 2009, in conjunction with the Wyeth deal–much to the anger of Pfizer shareholders. Merck did not take as drastic of a step, but the company did “freeze” the dividend from 2004 through 2011.
Be careful resting one’s investing decision on the perceived “generous dividend” in the world of pharma as the dividend can be cut or eliminated if revenue declines as a result of the loss of patent exclusivity. Even the best capitalized companies such as Pfizer and Merck have resorted to cutting or freezing the dividend in the past, respectively. In addition to their respective Dividend Cushion ratios, for example, diversity of a company’s product line-up is key to the sustainability of dividends in the pharma space.
In the present case of Merck, outside of Keytruda, the top selling product is Januvia, its novel diabetes treatment, which is facing an intense pricing environment as numerous new entrants have begun to make inroads. As Keytruda begins to aggressively ramp sales thanks to the recent data, Merck may become similar to AbbVie (ABBV), namely a company that is highly dependent on one product for the bulk of its revenue. Thankfully for Merck shareholders, Keytruda remains patent protected well into the next decade, giving the company a long runway to reap the rewards of this breakthrough treatment.
We currently rank Merck’s dividend via our proprietary Dividend Cushion Ratio as a 1.7, with dividend ratings as generally good. We do expect Merck to become more aggressive in rewarding shareholders with a more generous dividend payout in the near future as the spate of clinical trials begins to wind down. We fully agree with Merck’s decision to “go easy” on the dividend increases to utilize the cash to fund additional R&D to fully capitalize on the promise of Keytruda.
Concluding Thoughts
We remain very impressed with the progress shown by Merck in capitalizing on the promise of Keytruda. We are not ready to add the name to the Best Ideas Newsletter portfolio, however, primarily because of the weakness in the rest of Merck’s product line-up, which will dampen the overall top-line revenue growth. We will continue to monitor the clinical data as it evolves. Our fair value estimate of Merck stands about where shares are trading hands at the time of this writing.
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Alexander J. Poulos does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.