Pharmaceutical maker Merck (MRK) spun-off 100% of its Organon & Company (OGN), explains Bruce Kaser. Here, the editor of Cabot Undervalued Stocks Advisor reviews both the parent company and the spinoff.
Merck — which focuses on oncology, vaccines and antibiotics — sell at a significant discount to its peers, as Keytruda, a blockbuster oncology treatment representing about 30% of total revenues, will face generic competition in late 2028.
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Also, hanging over the stock is possible generic competition for its Januvia diabetes treatment starting in 2022, and the possibility of government price controls.
Keytruda remains an impressive franchise that is growing at a 20+% annual rate. The company is becoming more aggressive about replacing the potentially lost revenues, even though it has nearly seven years to accomplish this.
The new CEO, previously the CFO, will likely accelerate Merck’s acquisition program, which adds both risk and return potential to the Merck story.
Merck is highly profitable and has a solid balance sheet with $9 billion of fresh cash from its Organon dividend. The low valuation, strong balance sheet and sturdy cash flows provide real value. The attractive 3.3% dividend yield pays investors to wait.
Post-spin-off, Merck’s revenues will have faster growth. Its profit margins will initially decline, but should fully recover, plus some, helped by the gradual elimination of redundant Organon stranded costs. We reduced our Merck price target by $6/share, from $105 to $99, to reflect the spin-off and to incorporate a slightly more conservative valuation multiple.
Merck reported healthy second quarter revenues, led by strength in Keytruda. The company raised its full-year revenue growth guidance by 2-4 percentage points to reflect an encouraging growth outlook. Profits were essentially in-line with estimates. Valuation is an attractive 13.9x estimated 2021 earnings of about 5.52/share.
Merck produces generous free cash flow to fund its current dividend as well as likely future dividend increases, although its shift to a more acquisition-driven strategy will slow the pace of increases. The shares have about 27% upside to our $99 price target.
Looking more closely at Organon, the United States-based global pharmaceutical company has sales of $6.3 billion. About 80% of its sales are produced outside of the United States.
In June 2021, 100% of Organon’s shares were spun-off from Merck. The company has three segments. Established Brands (68% of revenues) is a collection of nearly 50 mostly off-patent cardiovascular, respiratory and other therapies. Women’s Health (23%) includes contraceptives and fertility products.
The Biosimilars segment (9%) includes five approved treatments for autoimmune, arthritis and other diseases through a joint venture with Samsung Bioepis. Biosimilars are FDA-approved alternatives to patented biological drugs, which, unlike chemical pharmaceuticals, are created from living cells.
Shares of Organon have fallen sharply since their debut at around $38. One reason is technical: many Merck shareholders likely have little interest in holding a small pharmaceutical company facing patent erosion risks, and thus have sold their shares regardless of price.
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More fundamentally, investors worry about patent-related revenue erosion in the Established Brands segment and the 2025-2027 patent expiration for its Nexplanon women’s health product (11% of total sales).
Also, revenues from the Chinese hospital channel may continue to be pressured by government buying programs. The market sees many years of 3-4% revenue decay at best, amid fears of a sharper decline, for Organon.
While acknowledging the revenue risks, we have a more optimistic view of Organon’s future. The marquee Nexplanon product is a highly valuable franchise, with solid 10% growth potential for years.
There is a strong possibility that it can extend its patent to as late as 2030. Its complex production process could easily ward off generic competitors afterwards. And, as it is implanted under the skin, women may be hesitant to opt for a discount version. Organon’s fertility treatments are well positioned to grow, particularly in China.
The Biosimilars segment offers double-digit growth potential: the industry is in its early innings, Organon has a solid portfolio, and the company has plans for new launches every 1-2 years, including a Humira biosimilar this year in international markets.
Organon’s management team has deep leadership, operating and financial experience. The CEO, Kevin Ali, led Merck’s international business. The CFO previously was Allergan’s and Catalent’s chief financial officer. Other senior executives and the board of directors, bring valuable capabilities, as well.
Given that the company’s products were neglected within Merck’s enormous operations, there are plenty of opportunities for this management team to rejuvenate Organon’s business.
Like all turnarounds, OGN shares carry risk. Yet, the shares’ discounted valuation, at 7.2x estimated 2021 EBITDA and 4.6x estimated 2021 earnings, more than adequately reflects this.
With improved revenue visibility (we model only 2% cumulative 3-year growth), incrementally wider margins from better oversight, plus the value of interim free cash flows, the shares have considerable upside potential.
Additionally, Organon will likely pay out about 20% of its free cash flow in dividends, providing what we estimate will be a 2.7% yield. The shares trade at 4.9x estimated 2021 earnings of $6.25 and 5.0x estimated 2022 earnings of $6.08. These are remarkably low valuations. OGN shares have about 51% upside to our new $46 price target.
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