Stock of the week: Merck Group

Summary:
- Merck Group (MRK.DE) is one of the leading drug and chemical companies in the world
- Leader of liquid crystals market but competition from China takes its toll
- New acquisition will enhance focus on business with high margins
- Significant debt reduction achieved in 2018
- Merck (MRK.DE) has been trading within an uptrend since early-2018

With over 350 years of history of operating as going concern Merck Group is the oldest among the current DAX members.The company has a strong position in both chemicals and pharmaceutical sectors. However, operations in the former sector may be set to get a boost further thanks to the newest acquisition. In this analysis we will take a look at the operations of Merck Group as well as how new purchase would fit into its portfolio.

Drug business was for a long time the main source of Merck Group’s revenue. However, dominance in the liquid crystals sphere pushed Chemical Product sales to the top. Source: Bloomberg, XTB Research

For centuries drug manufacturing and distribution was core of Merck Group’s business. The company currently markets 11 drugs and has over 30 more in its pipeline on the various stages of clinical trials. Company’s products address a number of oncological and dermatological diseases as well as problems with fertility. Drug business accounted for 42% of the Group’s 2018 revenue. However, share of this segment in the company's sales have been declining for a few years in favour of Merck’s Chemical Product division. In this segment one can find operations focused on performance materials, like liquid crystals, or process solutions, including services aimed at supporting life science research. Merck Group was unquestionable leader in the field of liquid crystals development and manufacturing for a long time. The company held over 60% market share before it began to decline on the back of competition from China. Profits from liquid crystals declined along with the market share but the segment remained crucial part of company’s business.

Versum Materials’ stable revenue growth and higher EBITDA margin may boost Merck Group’s overall profitability. Short data history is used as the company earlier operated as division of Air Products&Chemicals and therefore only a few reports are available. Source: Bloomberg, XTB Research

However, it was not Merck’s solid drug portfolio or strong position in liquid crystals market that encouraged us to pay the company more attention this week. Merck recently submitted a revised takeover offer for Versum Materials, the US chemical company. It should be noted that Merck’s earlier offer not only was rejected but Versum even entered a merger agreement with Entegris, the US company manufacturing microelectronic materials. However, premium that Merck offered over Entegris bid was too attractive to ignore. Entergis takeover offer was worth $3.8 billion while Merck offered $5.8 billion, an over 50% higher bid. As Merck is over 10 times as big as Entegris and can more easily acquire funding, the latter unsurprisingly backed out of further bidding.

However, one may ask what is the rationale behind the takeover as Versum Materials does not operate in any of Merck’s core businesses? Amid deteriorating outlook for its liquid crystal business Merck Group decided to expand into other performance materials. The company decided to take advantage of high demand for semiconductors and enhanced its portfolio with assets producing materials needed for semiconductor production. 2018 was the first full year of such operations and they accounted for around 4% of Merck’s total revenue. However, this is likely to change as Versum Materials, the company Merck is set to acquire, specializes in the production of materials needed for semiconductor manufacturing. Versum Materials has higher and more stable EBITDA margin than Merck Group therefore an acquisition has a chance to boost Merck’s overall profitability.

While Merck’s earnings experienced major fluctuations over the past 15 decades the company upheld its dividend policy. Moreover, even at times of severe plunge in earnings the German company’s dividend payout ratio did not exceed 100%. Adjusted EPS data was used as including abnormal gains and losses would cause the picture to be blurry. Source: Bloomberg, XTB Research

Last but not least, let us pay some attention to the Merck Group 2018 annual report. Merck generated €14.836 billion of revenue against expected €14.734 billion. However, this was the only headline measure that saw the company outperform. When it comes to EBITDA (company’s preferred measure of earnings), operating income or net income - Merck missed analysts’ forecasts. While failure to meet expectations is not desired at all, looking at the details of the report provides some relief. Namely, major part of 2018 losses in every business segment were due to FX headwinds. In fact, organic sales in some segments, like for drugs, rose in 2018. Apart from that, there is one more thing we should highlight in Merck’s annual report. Namely, in spite of a drop in EBITDA the company still managed to reach its goal of reducing debt to below 2xEBITDA. The company reduced its debt load from €10.1 billion in 2017 to €6.7 billion putting its debt/EBITDA ratio at 1.8. Missing analysts’ estimates did not discourage Merck management from sharing profits with shareholders and the company still plans to propose a dividend payout of €1.25, the same as in 2017.

Merck (MRK.DE) has been trading within an uptrend since early-2018 and trades over 10% higher YTD. Note that the stock has reacted positively a few times to both, the upward sloping trendline and the 200-session moving average, therefore it may be wise to keep track of this technical levels. While the performance was stellar during past year Merck shares still trade some €15 below its all-time high. Source: xStation5