Is Merck Stock a Buy?

With its portfolio of cancer medicines and one of the pharma industry's most recognizable names, it's no surprise that investors are curious about whether to buy shares of Merck (NYSE: MRK). But with a total return of just 54% over the last five years, far underperforming the S&P 500's gain of 107%, it's also natural to wonder whether its next half-decade is going to be one of outperformance, or more struggling.

In my view, based on what's coming up for Merck, it's likely that investors with some patience will find the stock to be more appealing.

A key challenge draws nearer

Understanding the investment thesis for Merck requires appreciating the importance of its blockbuster cancer drug, Keytruda, to its finances. Right now, in the U.S. the drug is approved for 40 different oncology indications, and where it doesn't already have them, Merck is in the process of seeking approvals for most of the same indications in major international markets like the E.U. and Japan.

In the second quarter, Keytruda brought in sales of $7.3 billion, 21% higher than a year prior. That made it the largest contributor to Merck's total quarterly sales of $16.1 billion. Ongoing clinical trials and further research and development (R&D) investment could see the drug approved for a slew of additional indications such as ovarian cancer and small cell lung cancer. It's currently under consideration as a first-line treatment for advanced or metastatic malignant pleural mesothelioma, among other indications.

So, at least for now, it is likely that Keytruda will continue to drive Merck's top-line growth. But the party won't last forever; Keytruda's manufacturing exclusivity protections will lapse in 2028. When they do, it is guaranteed that its market share will dwindle due to competition from biosimilars.

For shareholders, the question is whether there are other candidates in the company's pipeline that will be able to replace the sales that Keytruda will inevitably lose. Management's capital allocation strategy already heavily emphasizes investment in R&D over share repurchases or the dividend. The pharma giant has more than 30 programs in phase 3 clinical trials, with at least 80 more in phase 2 trials.

However, many of those programs are testing Keytruda, either alone or in combination with other drugs, so they won't fully address the problem of biosimilar competition. Furthermore, one of Keytruda's biggest strengths is that it's compatible with many other oncology therapies due to its broadly useful mechanism of action, which bolsters the body's immune system response against a wide variety of cancers. There simply isn't any one program in Merck's late-stage pipeline that has a similarly massive addressable market.

That makes buying Merck's shares and holding them for the long term a much riskier proposition than investors are probably looking for from a big pharma stock.

Reasons to be optimistic about Merck stock

Despite the upcoming headwind that will be generated by Keytruda's loss of patent protection, the odds are good that Merck will be able to provide decent returns to its shareholders up to the patent expiry and beyond.

As of the end of Q2, Merck had $11.3 billion in cash, cash equivalents, and short-term investments on its books, and $34.7 billion in long-term debt and capital lease obligations. It also produced $13.1 billion in trailing-12-month free cash flow. In other words, even after servicing its debts, it still has plenty of capital to deploy into R&D projects.

It also has plenty of capital with which to acquire biotechs with promising programs or platforms, or with which to forge collaborations or licensing agreements, as it has been doing already in October. At the start of the month, the company spent $750 million to buy an early clinical-stage treatment that aims to treat a pair of B-cell cancers from Curon Biopharmaceutical. Given Merck's extensive oncology pipeline, it could potentially seek acquisitions of candidates that would make for beneficial combination treatments when paired with its existing assets.

So while the programs currently in its pipeline don't exactly scream "big earnings growth ahead," it still has some time to build up its portfolio of mid and late-stage programs before the Keytruda patent cliff. The more progress it makes in commercializing and acquiring pharmaceutical assets between now and then, the less shareholders will suffer in 2028 and 2029.

For now, if you're willing to hold this stock for at least six years or more, it could be a good purchase, so long as you temper your expectations about how long it will take for the investment to bear much fruit.

If you're looking to invest for a shorter time horizon, or if you can't tolerate the somewhat higher-than-typical risk that the company will have a pipeline shortfall compared to its peers, steer clear. There will always be opportunities to circle back in a year or two to see if Merck has convincingly addressed its medium-term challenges.

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Alex Carchidi has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Merck. The Motley Fool has a disclosure policy.