Merck is one of the leading medical sciences companies in the world, with a total annual revenue of well in excess of 15B EUR. Don’t confuse the company with the American ‘Merck’ (MRK), which is the American part of German Merck, established during the Second World War. Merck KgAa is trading on the German stock exchanges with MRK as its ticker symbol.

MRK1 
Source: finanzen.net

A higher revenue and EBITDA…

Only happy faces at Merck, as the company continued to expand its business. In the first quarter of this year, Merck saw its total revenue increase from 3.67B EUR to 3.86B EUR and not only is this a nice increase, the company’s cost of sales actually slightly decreased as well, resulting in a 8.8% increase in its gross profit, to 2.57B EUR.

That’s great, but the EBIT did decrease by approximately 12% to 755M EUR, and this was entirely caused by a lower ‘other operating income’, which decreased by in excess of 200M EUR. The interest bill also increased slightly, and the lower tax payments only partly compensated for this. The end result? A net income of 523M EUR (down from 593M EUR) and an EPS of 1.20 EUR (down from 1.36 EUR).
 MRK2
Source: financial results

This isn’t really anything to be worried about, as last year’s strong performance in Q1 was entirely caused by one-time items. In Q1 2016, Merck was able to sell its rights to Kuvan and recorded a divestment gain of 324M EUR. If one would take these one-time items out of the equation, the EPS would have increased from 1.54 to 1.80 EUR.

Great, but let’s have a look at the cash flows generated by Merck in its first quarter.

The operating cash flow came in at 777M EUR, but after adjusting this result for one-time items and shifts in its working capital position (Merck’s inventory levels and accounts receivable increased), Merck actually generated 959M EUR as operating cash flow.

The total capex of 410M EUR seems quite high, but this included a surprisingly high investment in intangible assets. Is this weird? Not really. The cash outflow related to the acquisition of the intangible assets was paid to Vertex as Merck is purchasing two clinical stage and two pre-clinical stage programs for $230M. So, as this clearly isn’t sustaining capex, we shouldn’t really include this in our free cash flow calculations.
MRK3 
Source: financial result

The end result? A free cash flow result of approximately 750M EUR in the first quarter of the year, of which 68M was paid to E. Merck as a ‘preferred’ dividend. If we would divide the 750M EUR in free cash flow over the pro-forma amount of 435M shares (the general partner’s interest isn’t expressed in shares, hence the use of the ‘pro forma’ share count),  Merck would have generated in excess of 1.7 EUR per share in free cash flow.

… results in a continuously decreasing net debt

After the very expensive acquisition of Sigma Aldrich two years ago, Merck’s main task was to reduce its net debt. The net debt/EBITDA ratio was pretty high at 3.5 as of at the end of 2015, but was reduced to just 2.6 at the end of last year which is definitely more reasonable.
MRK4
Source: company presentation

As of at the end of Q1, Merck’s net debt was approximately 11.2B EUR, a strong decrease of almost half a billion euro compared to the previous financial year, and this confirms Merck’s management and board of directors is taking its task very seriously. This means we now have very little doubt the company will be able to meet its targeted net debt/EBITDA ratio of less than 2 by the end of next year. In fact, the net debt/EBITDA ratio at the end of this year will very likely already come close to the 2, and we would anticipate a ratio of 2.1-2.25 by the end of December this year.

Investment thesis

This means Merck could be chasing more potential acquisitions from 2019 on. The company has now been rejecting an larger (500M EUR +) acquisitions until it has its net debt position back under control, but with an anticipated EBITDA of 4.7-4.9B EUR in 2019 and a net debt position of just 6-6.5B EUR, Merck should be able to digest a 3-5B EUR acquisition by the end of this decade to continue its aggressive and impressive growth trajectory.

For now, Merck is a little bit expensive with an anticipated free cash flow yield of around 5% (based on our full-year expectations), but these cash flows will only increase in the future (thus increasing the free cash flow yield as well) thanks to continuous business growth and lower interest payments.

Disclosure: the author has no position in Merck KGaA

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