Merck & Co. ($MRK) and Keytruda’s Patent Cliff: Risk or Opportunity?

Assessing the impact of Keytruda’s patent expiry and the road ahead for Merck & Co...

Mar 13, 2025

Hi, Investor 👋

I’m Jimmy, and welcome to another free edition 🔓 of our newsletter. Today, we’re diving into Merck & Co. ($MRK) and the potential impact of Keytruda’s patent expiration - a pivotal moment for the company’s future valuation.

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The Pharmaceutical Market and the Role of Patents

Since the 1940s, the global pharmaceutical industry has centered its business model around the discovery, development, and launch of new drugs and active ingredients.

This framework ensures improved treatment efficacy while relying on patents as the primary mechanism to safeguard against competition and generate returns on substantial research and development (R&D) investments (Caves et al., 1991).

However, once a drug’s patent expires, generic and biosimilar competition enter the market, leading to significant shifts in pricing dynamics and market share…

In the prescription drug market, physicians play a crucial role in influencing - if not outright determining - the choice of medication. Pharmaceutical companies invest heavily in brand-building and promotional activities to create lasting trust among prescribers, thus maintaining a competitive advantage even after patent expiration.

While the original brand name retains some value post-expiration, generic and biosimilar entrants rapidly erode market share by offering lower-cost alternatives. This dynamic is particularly pronounced in the U.S., where generic penetration following a patent loss is rapid and pricing pressure intensifies significantly.

Historically, the impact of generic competition in the U.S. pharmaceutical market has been profound. The 1984 Waxman-Hatch Act facilitated the rapid approval and market entry of generics, increasing their share of the total pharmaceutical market from 18% to 75% over 25 years (Berndt & Aitken, 2011).

When a brand-name drug loses its exclusivity, generics typically enter the market at 50% of the original drug’s price, quickly capturing at least 25% of the market share (Caves et al., 1991).

Over time, as more generics enter, prices drop even further, intensifying competition and making it difficult for the original manufacturer to maintain revenue levels.

Additionally, historical data suggests that within 12 months of patent expiration, the cost of treatment for the affected molecule decreases by an average of 27%, with a 37% reduction observed within 24 months (Berndt & Aitken, 2011).

Notably, leading pharmaceutical brands often respond to patent expiration by maintaining or even increasing their prices instead of competing directly with generics.

This strategy aims to retain a segment of the market willing to pay for the brand name and reduce reliance on costly promotional activities.

However, the overall decline in prescription volume for the brand-name drug—caused by the growing preference for lower-cost alternatives—results in a substantial revenue decline.

This phenomenon underscores the broader trend in the industry: while a blockbuster drug can generate massive profits during its exclusivity period, the post-patent phase brings inevitable erosion in both pricing power and market share (Grabowski & Vernon, 1992).

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The Case of Keytruda’s Patent Expiration

Merck’s Keytruda (pembrolizumab) has been one of the most significant oncology drug successes of the past decade, generating $29.48 billion in revenue in 2024, accounting for 46% of Merck’s total sales.

However, its main patents are set to expire in 2028, making it one of the most critical patent cliffs in recent pharmaceutical history.

Historically, blockbuster drugs losing exclusivity experience a steep decline in sales as biosimilar competition intensifies. For traditional small-molecule drugs, generic versions can quickly gain over 70% market share within the first two years post-expiration, leading to price declines of 50-80%.

For biologics like Keytruda, the entry of biosimilars typically results in a slower erosion, but the impact is still substantial. Industry data suggests that, in the U.S., biosimilar competitors often capture 30-40% market share within 12 months, with price reductions ranging from 25-50% depending on the competitive landscape.

Merck has acknowledged this challenge and anticipates a significant impact on revenue post-2028. The company has been actively seeking to offset these losses through:

Life-cycle management strategies – including the development of next-generation formulations and combination therapies to extend Keytruda’s market dominance.
Expansion into new indications – Merck is conducting clinical trials to secure approvals for Keytruda in additional oncology settings, prolonging its commercial relevance.
Strategic acquisitions – In 2023, Merck acquired Prometheus Biosciences for $11 billion, a move aimed at bolstering its immunology pipeline and diversifying revenue sources beyond Keytruda.
Biosimilar defense strategies – The company is expected to employ tactics such as authorized biosimilar launches and aggressive contracting with payers to slow revenue attrition.

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Financial Impact

Given historical patterns in the industry, the post-2028 revenue decline for Keytruda could range from 30-60% within the first three years following biosimilar entry.

Analysts estimate that Merck’s earnings per share (EPS) could decline by approximately 6.4% in the year following the loss of exclusivity. However, Merck’s diversified pipeline and strategic acquisitions could partially mitigate this impact.

While the loss of Keytruda’s exclusivity presents a major headwind, Merck’s proactive R&D investments and business development efforts suggest that it is well-positioned to navigate the transition.

Investors should closely monitor the company's success in expanding Keytruda’s indications, the competitive landscape of biosimilars, and the performance of newly acquired assets in the immunology and oncology segments.

The ultimate impact of the patent expiration will hinge on Merck’s ability to execute its defensive strategies effectively.

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Scenario Analysis:

As investors, it is our duty to model future scenarios - testing how the loss of Keytruda’s patent could impact Merck & Co.’s net revenue.

In this simulation, I have assumed that there will be no major portfolio substitutions within Merck & Co. In other words, the company’s recent R&D investments will not lead to the emergence of another blockbuster drug of the same magnitude.

1. Best Case: What if Keytrude did not expire?

In the hypothetical scenario where Keytruda's patent did not expire, Merck & Co. would continue enjoying above-average returns (@ IRR / ROIC) driven by the current patent.

Net revenue would keep growing over the years, and the total return between 2027E and 2032E would be 15% (a conservative 2.8% CAGR per year). Consequently, Keytruda's net revenue would increase from $41bn to $48bn over this period (vs. $30bn in 2024FY).

Considering a WACC of 8.6% and a perpetual growth rate of 1.8%, we would arrive at a fair value of $130/share, representing a 40.5% upside compared to the current market price of $93/share.

2. Base Case: 40% Revenue Decline

In the base case scenario, Merck & Co. loses Keytruda’s patent in 2028. This is a given. The key question now is the percentage decline in revenue over this period - arguably the most valuable question in understanding the company’s true value today.

As previously mentioned, biologics like Keytruda typically face a slower erosion upon the entry of biosimilars, but the impact remains substantial, with price reductions ranging from 25% to 50%, depending on the competitive landscape.

Let's assume a base case scenario of a 40% decline in net revenue between 2027E and 2032E. By the end of the period, net revenue would stand at $25bn, reflecting a -9.7% CAGR over the period.

EBIT margin, in turn, will also contract - either due to increased R&D investments (to discover and develop new drugs) or higher marketing expenses (to maintain brand relevance).

Considering the same discount rate and growth assumptions as before, we would arrive at a fair value of $107/share, representing a 14.4% upside compared to the current market price of $93/share.

The EPS decline in the initial years would be -4.8%, -2.4%, and -2.2%.

3. Bear Case: 70% Revenue Decline

In the worst-case scenario, we simulate a volume and price decline of around 70%. This would result in net revenue of $12.5bn in 2032E - a true destruction of value. A decline beyond this level becomes highly unlikely, as the cost of manufacturing the product remains uncertain. Returns would be too low, likely deterring competitors and even established players.

Without an immediate replacement, the impact on Merck & Co.'s net revenue would be immense - a decline of more than 20% between 2027E and 2032E.

In this scenario, with EBIT contraction and assuming the same growth and discount rate assumptions as before, we arrive at a fair value of $92/share - 1% below the current market price of $93/share.

The EPS decline in the first years after the patent expiration would be -10.4%, -6.7%, and -5.3%.

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Sensitivity Matrices:

Sensitivity matrices help analyze the impact of key variables on valuation. In this case, we can evaluate how changes in revenue decline (%) and EBIT Margin (%) affect the fair value per share.

In the first matrix, we outline the spectrum of possible share prices for Merck & Co. under different scenarios. In the second, we present the respective upsides and downsides.

In the worst-case scenario, the fair value per share would be $80 (-13.1% downside), while in the best-case scenario (realistically assuming 0% growth), the fair value would be $134/share (+44.5% upside).

Measuring the full impact of Keytruda’s patent expiration is challenging given the wide range of possible outcomes. However, the asymmetry appears to favor Merck & Co. shareholders, with fair value estimates suggesting limited downside and meaningful upside potential.

It’s also important to note that our analysis assumes no immediate replacement of similar magnitude for the company.

Additionally, Merck & Co. is trading at just 10.5x P/E 2025E, a bargain compared to key peers - though none of them face a patent cliff of this scale.

What’s your take on Merck & Co. ($MRK)? Do you own shares of the company?

Drop your thoughts in the comments - I’d love to hear your opinion.

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