Merck KGaA: Moving To A Hold As 2025 Targets Are Now Doubtful (OTCMKTS:MKGAF)

Introduction

Merck KGaA (OTCPK:MKGAF) is the “original” of the two Merck companies. Established as a pharmacy in 1668 in Darmstadt, the company has since grown to be one of Europe’s dominant companies in the healthcare and life sciences industry with exposure to the semiconductor space. The company had a plan to generate 25B EUR in revenue by 2025, which was the main reason why I rated the company a ‘buy’ in my previous article, but given the mildly disappointing guidance for 2024, I don’t really expect the company to reach its previous targets for 2025.

Readers are warned that Merck (MRK) and Merck KGaA are not the same company. The ‘American’ Merck was a division of the German company but was expropriated after the first world war and continued as a standalone subsidiary. This article is about Merck KGaA, the German company, which has its primary listing in Germany where it is trading with MRK as its ticker symbol. The average daily volume in Germany is just over 300,000 shares, resulting in a market cap of approximately 68B EUR, as there are approximately 435M shares outstanding on a pro forma basis. This article is an update to previously published articles on Merck KGaA.

2023 was a transition year and growth will be back in 2024

When the company published its results for the first semester of 2023, it was already pretty clear we shouldn’t expect too much from 2023. And indeed, the organic revenue and organic EBITDA before special items decreased in FY 2023 on the back of a lower demand for COVID-19 related items and the inventory destocking pace by its customers in the Process Solutions division which produces filtration devices, resins and processing chemicals.

Additionally, there was a cyclical slowdown in the demand for semiconductor materials, as Merck’s Semiconductor Solutions division supplies products used in different steps of the production process. The revenue decreased by almost 9% in the Electronics division due to a 5.1% organic revenue decline and a 4.1% impact from FX changes. The EBITDA in that segment decreased by 17.1% on an organic basis, while the FX changes had an additional negative impact of 5.6%. Despite that, the EBITDA margin (before exceptional items) in the electronics segment still was a very robust 25%, but that is lower than the 30%+ margins in the Life Sciences and Healthcare divisions.

The total revenue in the third quarter came in just under 21B EUR, which resulted in a gross profit of 12.4B EUR. The company did try to cut some costs and the marketing and selling expenses decreased while the admin costs increased. The R&D expenses remained at a pretty high level as they continue to fluctuate around 2.5B EUR per year.

Due to the pressure on the top line and the margins, the EBIT decreased by almost 20% to 3.61B EUR, while the pre-tax profit fell to 3.5B EUR.

The net income attributable to the shareholders of Merck came in at 2.82B EUR, which represented an EPS of 6.49 EUR. That clearly is a decrease from the 7.65 EUR per share it reported in 2022 but the reported earnings contain some non-recurring items and the net income adjusted for those items was 8.49 EUR per share.

In the previous article I focused on Merck’s cash flows as those ultimately determine the company’s ability to reinvest in its future (the 2.5B EUR in annual R&D expenses are obviously being expensed, but the cash flows are important to determine the company’s ability to pursue M&A).

The total reported operating cash flow in 2023 was 3.78B EUR but adjusted for working capital changes, the operating cash flow was 4.49B EUR and 4.48B EUR after taking the dividend payments to non-controlling shareholders into account. We should also deduct approximately 120M EUR in lease payments.

Although I didn’t immediately find the exact amount of lease payments, the footnotes to the financial statements clarify the anticipated lease payments for 2024 are 120M EUR, so I will assume that is a fair representation of the lease payments. This results in an adjusted operating cash flow of 4.36B EUR.

As you can see above, the company spent a total of 2B EUR on investments, which indicates it was a relatively capex-heavy year as the total capex in the preceding year was just 1.8B EUR and the combination of capex and lease payments of 2.12B EUR in 2023 exceeded the total depreciation and amortization expenses by almost a quarter of a billion euros.

Despite the relatively high capex result, the total net free cash flow attributable to the shareholders of Merck was 2.36B EUR, resulting in an underlying free cash flow of approximately 5.43 EUR per share. The proposed dividend of 2.20 EUR per share (stable compared to 2022) is thus pretty handsomely covered by both the earnings as well as the net free cash flow. Hardly a surprise, as Merck applies a target payout ratio of 20-25% of its earnings before exceptional items.

While Merck proudly announced its ‘return to organic growth’ in 2024, there are a few nuances that should be applied here. As you can see below, the FX will continue to be a headwind and on the EBITDA level, the fluctuating currencies are expected to have a negative impact of 1-4%. So even if you can post an organic growth rate of 5%, if 3% of that gets eaten away by FX pressure, your reported results won’t look that much better than what was reported over FY 2023.

That being said, the total free cash flow should increase as the company is guiding for a 1.6-1.8B EUR to be spent on tangible elements. The capex spent on tangible assets came in at just over 1.8B EUR in 2023, so the midpoint of the 2024 guidance indicates a 100M EUR capex reduction which will integrally boost the free cash flow.

Investment thesis

One of the main reasons why I rated Merck a ‘buy’ in the previous article was the anticipated 10% CAGR on the EBITDA level for 2024 and 2025. Unfortunately, these implied targets, part of the ’25 by 25’ strategy whereby Merck wants to generate 25B EUR in revenue by 2025, were not reiterated during the presentation of the 2023 results. One analyst enquired about the status of the plan on the Q4 conference call, but only received a vague answer from the Merck management:

Let me finalize with the EUR25 billion, by ‘25 question. We call this ambition in 2021 during our Capital Markets Day. And since then, we have many moving parts and plenty of assumptions making or driving that ambition positively or negatively. The pandemic, mostly the challenges that I mentioned for 2023 has been extremely important on that trajectory.

That’s why I’m reducing my rating to a ‘hold’ as I wanted to see a more firm commitment towards achieving the 25B EUR revenue by 2025. I hope Merck can effectively meet its own targets, but right now, trading at 18 times the adjusted earnings, I don’t think the company is cheap enough to initiate a long position as long as the management doesn’t want to firmly commit to the 2025 targets. I am on the sidelines.

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