We think that Merck Inc. (NYSE : MRK) currently is a better pick compared to Johnson & Johnson (NYSE: JNJ). MRK stock trades at about 4x trailing revenues, compared to around 5.4x for JNJ. Does this gap in Merck’s valuation make sense? We don’t think so. While Merck’s near term revenue growth has been impacted by fewer hospital visits, owing to the pandemic, its blockbuster drug – Keytruda – continues to gain market share. On the other hand, positive developments around J&J’s single-dose Covid-19 vaccine, as well as continued market share gains for Darzalex and Imbruvica, has aided JNJ stock growth over the recent past. While J&J will provide the Covid-19 vaccine shots for a not-for-profit basis, it will likely be important in helping the company rebuild its brand image after it faced setbacks amid lawsuits relating to contamination of its baby and other talc products. However, there is more to the comparison. Let’s step back to look at the fuller picture of the relative valuation of the two companies by looking at historical revenue growth as well as operating income and operating margin growth. Our dashboard Johnson & Johnson vs. Merck: JNJ stock looks overvalued compared to MRK stock has more details on this. Parts of the analysis are summarized below.
1. Revenue Growth
Between 2017 and 2020, Merck’s revenues grew by about 13%, from around $42.3 billion to $48.0 billion, primarily led by its oncology drug – Keytruda – which saw its sales double from $7.1 billion to $14.4 billion over the same period. Looking at J&J, total revenue grew a mere 1% from $81.6 billion in 2018 to $82.6 billion in 2020. J&J’s revenue growth has been impacted by multiple factors, including biosimilar competition for its blockbuster drug, Remicade, a decline in medical devices business due to deferment of elective surgeries in 2020 owing to the pandemic, and lawsuits around its talc products impacting its consumer business sales.
2. Operating Income
Merck’s operating income grew from $8.3 billion in 2018 to $11.6 billion in 2019, before falling to $8.0 billion in 2020. The decline in 2020 can largely be attributed to a contraction in margins from 19.6% in 2018 to 16.5% in 2020. Merck increased its investments into R&D in 2020, impacting its overall margins. R&D expenses as a percentage of revenue grew over 500 bps from 23.1% in 2018 to 28.2% in 2020. Looking at J&J, the operating income declined from $19.8 billion in 2018 to $19.5 billion in 2020. J&J’s operating margins declined slightly from 24.3% to 23.6% between 2018 and 2020, partly due to higher operating costs during the pandemic.
The Net of It All
Although Merck’s revenue growth compares favorably with J&J over the recent years, J&J’s operating margins are better and stable around the 24% mark. However, Merck may continue to see steady revenue growth led by market share gains for Keytruda, and it will also benefit from its robust pipeline, which includes expansion of existing drugs, such as Keytruda, Lynparaza, and Lenvima for other treatments. Barring the increased R&D investments in 2020, Merck’s operating margins have actually been on an upward trajectory, and it will likely trend higher going forward. Merck’s stock has been weighed down partly due to a higher reliance on a single drug – Keytruda – which accounts for 30% of the company’s total sales. Also, the company’s Diabetes portfolio of Januvia and Janumet (accounts for 12% of Merck’s total sales) is expected to see a slowdown in sales going forward, as it nears the end of the exclusivity period.
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That said, Keytruda has established a dominant position in lung cancer, the largest oncology drugs market, and it will be difficult for other drugs, such as BMS’ Opdivo to challenge it. The company has been focused on increasing its market share for some of the other blockbuster drugs and vaccines, including Gardasil, which will aid the overall top-line growth over the coming years. Better top-line growth along with margin expansion means Merck will likely post better earnings growth over J&J over the coming years, boding well for its stock. As such, we think the difference in P/S multiple of 4x for Merck versus 5.4x for J&J will likely narrow going forward, implying better returns for MRK stock.
While Merck stock looks undervalued, 2020 has also created many pricing discontinuities that can offer attractive trading opportunities. For example, you’ll be surprised how counter-intuitive the stock valuation is for Pfizer vs Merck.