Merck KGaA May Benefit From the Recent Life Science Reset Period Ending Soon

Senior Equity Analyst

Julie Utterback

Merck KGaA has made a series of acquisitions and divestitures in the past decade or so to position the group for solid long-term growth in three key segments: life sciences, electronics, and healthcare. So although Merck is in the middle of a reset period following the pandemic boom years and although the biopharmaceutical pipeline has experienced a setback with evobrutinib (multiple sclerosis), we continue to have a positive view of the company's long-term prospects.

In life sciences, Merck aims to continue growing above market after the 2023 reset period subsides following the boom years of the pandemic. After this reset period, we expect growth will return to more normalized levels in the midsingle digits during the next five years. Overall, we think the life science business will continue to benefit from decent pharmaceutical pipelines in the industry, Merck's own innovative capabilities, and the company's expansive reach as one of the top-tier life science tool providers. 

In electronics, the acquisition of Versum was sound strategically and greatly reduced Merck’s dependence on the contracting liquid crystal operations while boosting its exposure to the attractive semiconductor materials business. Overall, we expect this segment to grow in the mid-single digits during the next five years organically. 

In healthcare, we expect low-single-digit top-line growth annually during the next five years, despite expected declines in some legacy products and the setback with evobrutinib (multiple scleroris). For example, top product Rebif continues to decline moderately as new multiple sclerosis treatment options—such as Ocrevus, Gilenya, Aubagio, and Tecfidera—have stolen market share in recent years. With approval of the highly convenient although side effect-challenged oral MS therapy Mavenclad in the EU (2017) and US (2019), we expect Merck to continue gaining share in the MS market. Another key product, Bavencio (cancers, particularly bladder), is ramping up as well, which could help the growth trajectory of this segment offset weakness in mature product lines.

Business Strategy & Outlook

We believe a narrow moat surrounds Merck KGaA’s diversified business of life sciences, electronics, and biopharmaceuticals. While Merck’s acquisition activities have cut into its economic profit generation somewhat, our narrow moat rating recognizes the attractive fundamental qualities of its core businesses, which appear likely to maintain returns over capital costs for at least the next 10 years. Specifically, we see significant intangible assets and some switching costs in its key business segments that inform our view of its competitive advantages. 

In life sciences and in electronics, we believe Merck benefits from both intangible assets and switching costs for end users. We think the basic argument surrounding these competitive advantages are similar for each segment. Generally, the company offers proprietary technology (intangible assets) that enables the essential operations of its clients, and switching to another supplier of that technology could change the outcome of those operations, which would be undesirable for those users once Merck’s products are incorporated into their practices. 

The company’s primarily consumable life science products enable a wide variety of scientific research and benefit from intangible assets and switching costs as moat sources. We see a particularly sticky business in its process solutions division (a little less than half of the life sciences segment) that serves biopharmaceutical firms from the discovery of a new molecule to the production of that medicine. Once Merck’s products are chosen by the end user as part of the production process of a molecule near the beginning of the clinical trial process, the client is unlikely to switch due to regulatory and reproducibility factors. Additionally, if that molecule is successfully marketed, the revenue stream would likely continue through the life cycle of that product. From discovery to patent expiration, Merck could generate recurring revenue for up to 20 years on small molecules and even longer for difficult-to-manufacture biologics, which bodes well for the maintainability of its economic profit generation in the process solutions division of the life science segment. Generic and biosimilar producers typically seek to replicate the branded production process, too, which can extend revenue streams for Merck's life science tools. 

We think Merck leans on intangible assets more heavily than switching costs in its other life science tools that enable basic scientific research and other real-world applications, such as testing food and water quality. While much less constrained by regulatory forces, these divisions’ customers also require reproducibility of test results, creating some switching inertia for those technologies, as well.

Intangible assets and switching costs surround some of Merck’s electronics business, too, particularly its semiconductor solutions that represents about two thirds of this segment’s sales, including the Versum products. We generally view the semiconductor material business as attractive due to several factors. First, intangible assets in this business include patent protection on innovative materials, Merck’s favorable reputation related to being a reliable supplier in a dynamic end market, and its collaborative abilities with leading chipmakers and semiconductor equipment manufacturers. Additionally, meaningful switching costs for customers surround electronic materials in critical chip production processes. Switching costs relate most directly to a customer's unwillingness to disrupt high value production processes at its major facilities in order to utilize an untested alternative product or supplier for a relatively low-cost component of the chip’s production process. 

Within the healthcare segment, Merck relies on intangible assets, such as patents, brand names, and reputation, as its moat source. Like most branded biopharmaceutical firms, Merck’s products possess unique safety and efficacy profiles that inform prescriber and end user decisions. Some of its products are protected by patents, ensuring exclusivity of those unique therapies during a long period of time, which can help the firm generate economic profits. Beyond patent protection, some of its products are biologics (about half of this segment by our calculations) that can also benefit from difficult manufacturing processes and other factors that keep competition at bay. So even after its patent protections expire, biologic therapies can face limited competition. For example, Rebif (multiple sclerosis) and Erbitux (oncology) lack patent protection, but they have enjoyed long runways of relatively moderate declines since their patent expirations due to the lack of direct competition, which compares favorably with small molecules that typically drop precipitously once generic competition enters the fray. The company sells branded generics in emerging markets, too, that continue to grow at a healthy pace as consumers in these markets seek out trusted brands. Going forward, while Merck’s R&D productivity has been below-par in the past, two recently approved drugs (Mavenclad in MS and Bavencio in a variety of cancers) and its other pipeline candidates look likely help Merck's healthcare business grow somewhat, despite expected declines in some of its top products.

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Merck KGaA is a science and technology company, which engages in the manufacture of pharmaceutical and chemical products. It operates through the following sectors: Healthcare, Life Science, Performance Materials and Corporate and Other. The Healthcare sector discovers, develops, and produces prescription medicines used to treat cancer, multiple sclerosis, and infertility. The Life Science sector provides scientists with laboratory materials, technologies, and services. The Performance Materials sector offers specialty chemicals and materials for demanding applications. The firm offers pharma and biopharma manufacturing, pharmaceutical research, pharma quality control, and government and academic research services. The company was founded by Friedrich Jacob Merck in 1668 and is headquartered in Darmstadt, Germany.

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