Wednesday, February 3, 2016

The Deeper Dive -- How F/X Affects Merck's Gross Margins: 2015 Full Year Results

I'll take just a moment here, to discuss something I don't see other life science analysts talking about -- buried in Merck's full year results call, this morning. It is a bad news/good news sort of item (and it manifests itself at Pfizer, J&J, Abbott, Baxter, BMS and Lilly -- and all the others, to varying degrees). By now, regular readers know that (generally speaking) a strong dollar decreases reported revenue growth, in a US multinational like Merck. Kenilworth does a very good job of mitigating those gyrations with currency hedges. That's all true.

The more nuanced (and interesting) effect is -- when you look at Merck's two percentage point improvement in its full year gross margins, over 2014 levels -- the company attributes the bulk of that to F/X. [See toward the bottom of the press release -- last several paragraphs.] Decoded, that means that Merck is receiving asset-hedge "leverage" at the operating income line. Said another way, Merck's non-US operating assets are increasing in local value even a little more than reported US dollar sales (when reported back into the US, from non-US sources) are declining. Or, the non-US operating expenses are decreasing, more -- due to F/X gyrations -- when reported back into US dollars.

This (per force) leads me to three conclusions -- in turn: (i) Merck's continued gross margin improvements -- in the year 2016, and beyond -- may not appear in full, without continued strong dollar gyrations (i.e., unpredictable, non-recurring, largely external macro factors); (ii) with Congress and essentially all the credible candidates for President howling about price increases, Kenilworth will have tough sledding -- on any program of continual price increases, as a way to boost margins domestically; and so. . . (iii) without more bolt-on M&A deals, Merck is not likely to get significant gross margin improvement -- in the next (election cycle) year. The M&A will have to be for premium priced opportunities -- not the "also rans".

For what it is worth, this is true of the whole list of multinationals I rattled off, at the top, here. Of course, Merck is lucky to have Keytruda (a clear premium price garnering franchise), just as BMS is lucky to have Opdivo. But we already see that Merck is slashing prices, in the Hep C space, to try to take share from Gilead's premium priced Harvoni (and Sovaldi). This makes Merck's less than stellar full year 2015 sales numbers -- on Januvia and Janumet -- more than a little worrisome. And growth in Zetia now faces generic entrants in 2016 -- so that will not be of much help, either. Merck is still a great stock to own, at the mid $49-level (i.e., today's NYSE price), but that's my rather acidic take, on the press release, this morning. Onward -- with a huge grin!

No comments: