Over the last few weeks, I have been discussing the problematic future for healthcare insurer Cigna (CI) and overvalued drug company Eli Lilly (LLY) given a Democratic party sweep to power in Washington DC. Assuming Joe Biden wins the Presidency and Democrats take both the Senate and House, little stands in the way of massive changes to healthcare delivery in America. And, this shift will not be welcomed by big pharma names like Merck (MRK).
Price fixing by the government for prescription drugs, especially for the popularly prescribed and high-profit patented-kind developed, manufactured, and offered by Merck would undoubtedly become reality next year. With the odds increasing this summer (based on mainstream voter polls) of an attack on its business model in early 2021, smart investors appear to be running from Merck shares the last month or two. Technical upside momentum has all but disappeared in July, and a turn lower in the stock price during August could bring an onslaught of nervous liquidations into the November election.
Biden was one of the main architects of the Obamacare changes to our health insurance marketplace in 2010. In addition, the odds of Democrats taking both houses of Congress are rising above 50/50, as I pen this article. The Democratic platform in coming weeks will surely include language about increased government participation in the healthcare industry to reduce overall costs (profits for drug companies) and expand coverage for more Americans.
The Kansas primary battle next week for an important Senate seat being vacated by retiring Republican Pat Roberts illustrates the difficulties Republicans will have retaining control of Congress. The party is split between conservatives with personal and voting issues beating up each other, pitted against a moderate Democrat with high levels of popularity and voter confidence. Other races across the country could easily move into the Democratic column in 93 days, if the coronavirus pandemic worsens or new stresses for the U.S. economy pop up. Only a small turnover of 4 seats in the Senate will alter the levers of power in that chamber.
For the purpose of this article and Merck’s trading future, I am assuming Democrats take control of Washington. If you believe Republicans will keep the White House and Senate, I fully understand an argument to keep your holdings in the healthcare and biotech/pharmaceutical areas. However, if a worst-case scenario for government meddling in big pharma sales and income is around the corner, which names should investors avoid (all of them is another good answer)?
Merck’s Low Growth Future
Global pharmaceutical revenues at the company fell -6% in Q2 ended in June, with total sales backtracking -8%. The COVID-19 pandemic has greatly affected the writing of new prescriptions, and many consumers have let minor medical condition fixes lapse. This past week’s Q2 cash earnings beat was largely an accounting function of accelerated depreciation and lower head counts from layoffs (Table 1A and 2A from the Earnings Supplement).
Image Source: Company Q2 Report
During 2020, Wall Street analyst revisions and projections for earnings and revenues have been in sharp retreat. Using Seeking Alpha’s scoring system, Merck has a close to failing ‘D’ grade for 2020-21 guidance trends against other healthcare corporations and the market generally.
Analyst estimates for future profitability are quite subpar also vs. the largest drug peers by capitalization listed by SA. And, stock performance the last 12 months has largely mimicked expected growth rates. Below you can see the three worst growers, using Wall Street consensus expectations, were also the worst yearly trailing performers for investors. Merck, Pfizer (PFE) and Novartis (NVS), each fell in price over the latest 52 weeks against strong gains in the other four, including Eli Lilly, Bristol-Myers (BMY), AstraZeneca (AZN), and AbbVie (ABBV). AbbVie is a stock I mentioned positively in May, as one of my favorites in the sector.
A low growth future going into a radical negative change in how the drug industry functions is worrisome. Government mandates on drug pricing will surely bring lower margins and overall profitability, even if the number of prescriptions filled rises with better patient access. On top of the direct attack on pharmaceutical business margins/returns, Biden has promised a rollback of Trump’s corporate tax cuts. Upping the tax rate from 21% to 28% (with a 15% payout minimum for all large companies), and changing many of the drug industry’s tax write-offs could double and triple Merck’s tax liability on diving profits starting in 2021-22. The company’s trailing 12-month tax expense was 12.5% through March. Effectively, a Biden/Democratic win on November 3rd means Merck’s already low EPS growth expectation is way, way overstated vs. reality.
Going into the election, shares are not exactly cheap or already discounting a Biden/Democratic win. On price to trailing sales, cash flow, book value and free cash flow, pictured below, Merck has a valuation in the 80th percentile or higher vs. the last decade of trading.
Technical Momentum Fading
Wall Street has been nervous about Merck’s low growth future since March. Using the combination of relative strength vs. the S&P 500 equivalent gain, the Negative Volume Index (NVI) and On Balance Volume (OBV) indicator, Merck holds one of the weakest looking charts the last four months in the U.S. blue-chip universe. Below you can review the rotten technical health picture for the stock.
The green circles pinpoint the ultra-weak price performance for Merck. While the stock has underperformed the S&P 500 by -7.5% the last year, it is down -22.5% from March. The stock quote has also had difficulties getting above its simple 200-day moving average, today just under $81 a share.
The red arrow points to the horrific reversal in the NVI starting in March. The trend went from consistently rising to a straight down condition. NVI looks only at trading action on lower volume days vs. the previous session. Basically, if buyers exist on slow news days and price rises nicely, overhead supply is said to be low. Conversely, the latest falling trend could be symptomatic of aggressive selling on low volume days or a total lack of buying interest when good news from the company isn’t present.
OBV, marked with the blue arrow, has been excessively weak since January. A well-followed indicator of daily price change, multiplied by trading volume, OBV is an excellent signal of accumulation/distribution trends. While not the best predictive indicator on its own, the OBV decline is more evidence something isn’t quite right in the supply/demand setup for Merck in the middle of 2020.
Taken together with a number of other indicators I track not pictured, Merck’s technical arrangement on the last day of July is far from positive. My read of the situation is the stock is looking and waiting for a reason to decline dramatically into 2021. Biden and the Democrats may be the catalyst for a continuation of underperformance of the market, and perhaps an oversized decline in the quote.
The horrible technical momentum outlined by Merck in 2020 is a company specific issue related to its lack of operating business growth. Then coronavirus showed up hurting sales and income for the year. Now investors in the company may have to deal with higher tax rates and government controls on the prescription drug business in 2021, given a big Democratic win in a few months. Certainly, management and investors are not happy with all the bearish developments.
The truly bad news is Merck’s business fortunes may be peaking this year, before a multi-year slide in results. Wall Street is taking note, and the stock quote is having problems gaining traction this summer. I rate the shares an Avoid or Sell currently. Until the macroeconomic backdrop has better clarity into early 2021, Merck’s share price could come under pressure and decline in the 10-50% range, depending on the election and the public debate on our healthcare system’s future over the next 12 months.
On the plus side of the equation, investors are receiving a generous 3.0% dividend yield, well above the S&P 500 average of 1.8% currently. Nevertheless, I doubt it will support the stock quote much given a Biden win. Modeling EPS of $3 or $4 into 2022 may become the norm on Wall Street by January, if Democrats also take the Senate and House. Using these assumptions, the cash dividend payout will not rise much in coming years.
A vast number of healthcare-related stocks have come under increasing sell pressure this summer, as Biden’s poll numbers have risen. Merck is one of many to avoid, if you feel a change of power toward progressive and liberal healthcare delivery ideas is at hand. Don’t say it cannot happen – socialized medicine is commonplace throughout the western world. America has been one of the few holdouts. Maybe its time has arrived to the detriment of the high-flying, super-profitable drug companies. Food for thought anyway.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is suggested before making any trade.
Disclosure: I am/we are short MRK, CI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I/we may initiate a short position in LLY over the next 72 hours.
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