Merck - on the Threshold of New Era

kalina
31 Jul, 2003
New York City

Despite the many concerns associated with Merck, the drug giant appears to be in good shape to offer gains in the long haul. The expected spin off of Medco Health could also give patient investors reasons to cheer.

The sentiment in the global pharmaceutical sector was generally negative throughout the first half of 2003, mainly due to the stringent conditions in world markets and dearth of new promising drugs. The new drugs were essential to supplement the drugs going off patent in order to maintain the annual earnings growth of 10% to 15% that investors have been accustomed to expect from 'Big Pharmas.'

According to many sector specialists, however, these negative trends should reverse in the second half of the year with large-cap pharmaceuticals regaining their traditional defensive characteristics.

Adding substance to these views, data provided by pharmaceutical-information provider IMS Health Inc. ((RX)) reveals that sales at pharmacies in thirteen leading world markets rose by 6% to $284.4 billion, for the year ended March 31, 2003. Also, favorable currency-exchange rates had a positive impact on foreign operations, especially considering that all major drug companies derive between 35% and 42% of their sales from abroad.

Furthermore, the American Stock Exchange (AMEX) Pharmaceutical Index (DRG), which reflects the performance of 15 top pharmaceutical companies, has risen 25.17% for the last twelve months ended July 24, 2003, from 259.64 to 323.74.

Meanwhile, fewer blockbuster drugs will go off patent this year and lose sales at the expense of cheaper generic drugs. During the last three years, for instance, drug giant Merck & Co. Inc. ((MRK)) was among the most severely hit companies by the loss to generic competition of five huge-selling drugs.

Now that the patent-expiration challenge has been dealt, the research-driven pharmaceutical products and services company is one of the few pharmaceutical bellwethers, which does not face such a threat until 2006 when its blockbuster cholesterol reducer {{Zocor}} (simvastatin) loses its patent.

On the positive side as well, Merck's research-driven strategy, rather than dealmaking, is poised to bear fruit in the near future. More specifically, the company's broad range of targeted therapeutic categories and diversified pipeline not only show a commitment to research and development (R&D), but also fuel consistent market optimism.

Currently, Merck has fourteen drugs and vaccines in Phase II and Phase III trials that are slated to hit the market in the coming years. Most impressive seems to be the fact that eight of these products represent new ways of treating disease. Raymond Gilmartin, the company's chairman and chief executive officer, recently declared that 'a whole new cycle of important product launches' lies ahead.

Turbulences Put Merck under Assault

Ten years ago, Merck was considered the leader of the pharmaceutical pack boasting a reputation of the best drug researcher backed with billions of sales. Back then, the Whitehouse Station, N.J.-based company beat archrivals both in size and stature.

But the success story went sour after five of the company's blockbusters - generating more than $5 billion in combined annual sales, - had lost patent protection since 1999, which hurt badly Merck's top line as generic versions ate solid chunks of market share.

Total sales for all of 2002 from products affected by patent expirations were $1.4 billion, or 38% lower than 2001, including antihypertension/heart failure products {{Vasotec}} (enalapril maleate), {{Vaseretic}} (enalapril maleate in combination with hydrochlorothiazide), {{Prinivil}} (lisinopril) and {{Prinzide}} (lisinopril in combination with hydrochlorothiazide), as well as anti-ulcerant {{Pepcid}} and cholesterol-lowering drug {{Mevacor}} (lovastatin).

Sales of {{Vasotec}} alone shot up $2.3 billion in 1999 before losing patent protection. Two months later, generic drugs grabbed 75% of the drug's U.S. sales. With its drugs under onslaught by generic competition, Merck's per-share earnings growth crashed from 18% in 2000 to 8% in 2001, to flat in 2002. As a result, the stock started sagging and the company's market value shrank. Shares now trade at 56.99, or 39.13% below its high of 93.625 hit Dec. 25, 2000.

The routine practice of 'Big Pharmas' in cases of major patent expirations is opting for mergers and cost cutting in order to maintain the traditional double-digit annual earnings growth - for example, Pfizer Inc.'s ((PFE)) acquisition of rival Pharmacia Corp. in July 2002. But such gambits boost profits only temporarily and do not cope with the productivity problem in effect.

Merck, in particular, doesn't take a liking for such deals as a means to bolster growth. In fact, resisting a merger is the management's credo as Merck relies largely on the fruit of its own laboratories. Although the industry top dog does have several joint ventures with big companies that aim at bringing together expertise on specific projects, the company's greatest strength has always been its own R&D efforts.

It is well known that successful R&D practices are the key driver for long-term growth in the pharmaceutical industry. The continued success of Merck's research endeavors proves it. The company has often been at the forefront of many medical breakthroughs. Merck has an excellent record of bringing products through the R&D process and into the marketplace. Since 1995, it has launched seventeen new drugs, such as {{Fosamax}} (alendronate sodium) against osteoporosis, asthma drug {{Singulair}} (montelukast sodium) and {{Crixivan}} (indinavir sulfate) for Acquired Immunodeficiency Syndrome (AIDS). However, investors should take note that the company is not expected to bring forth any new drugs to market until 2004, at the earliest.

The Medco Spin Off

In an effort to boost profitability, Merck is planning to spin off its pharmacy benefit management (PBM) unit, Medco Health Solutions Inc., in the third quarter. The move is expected to grant an insight into both Merck's businesses - the pharmaceutical and PBM - and bring more meaning to the valuation. The transaction is poised to allow Merck to commit fully to its priorities of turning cutting-edge science into blockbuster medicines.

Last year, the pharmaceutical company had intended to offer shares of Medco Health through an initial public offering (IPO), but now it will spin off the unit to Merck shareholders. The change of plans was attributed to weak market conditions. As part of the spin off, Medco Health will borrow $1.5 billion from Merck. The proceeds from the borrowing will then be paid to Merck as part of a dividend from Medco Health.

The prospects for a publicly traded Medco Health depend largely on its value at the time of the spin off of the unit, which will be set by Merck. If the valuation turns out to be too high, shareholders may see Medco Health's value decrease.

Looking forward, the outlook for the PBM industry as a whole is undoubtedly optimistic - besides the low-risk profile due to the ever-increasing use of prescription drugs, PBMs also seem to have hit upon a winning business model as is evident by the industry's heady annual revenue growth - 25% over the last five years.

As a PBM company, Medco Health manages drug benefits for large groups of people, such as enrollees in an insurance plan or employees of a self-insured company. Presently, the company controls the drug benefits of more than 65 million Americans.

By negotiating both discounts from participating pharmacies as well as rebates from manufacturers, PBM enables its customers to generally pay less than a drug’s average manufacturer price (AMP). The AMP in turn, is about 20% below the average wholesale price (AWP), which is the manufacturer’s list price. Simply put, PBMs negotiate drug discounts on behalf of consumers and their insurers.

Having realized that health-maintenance organizations would curb its drug sales, Merck purchased Medco for $6.6 billion in 1993 in an attempt to resist that threat and thus secured a distribution channel for its drugs.

Given that Medco Health is a subsidiary of the manufacturer, regulators insisted on PBMs' drug decisions to be taken independently of the parent drug company as patients' health rather than corporate profits should be of prime importance. Other pharmaceutical companies, such as Eli Lilly Corp. ((LLY)) had taken advantage of that tactic, acquired PBMs, subsequently suffered big losses and divested the units.

Meanwhile, Medco Health has grown rapidly under Merck's ownership and become one of the top players in the U.S. PBM sector along with rivals Advance PCS ((ADVP)), Caremark Rx Inc. ((CMX)) and Express Scripts Inc. ((ESRX)).

Sales exploded from $4.1 billion in 1994 to $30.2 billion last year, accounting for 58% of Merck's total revenue. At the same time, Medco's growth has also caused the company's net profit margin to shrink to 36.2% in 2002 from 39.3% in the previous year.

Although Medco accounted for more than half of Merck's revenue, it generated significantly less profit than the company's core pharmaceuticals business. Last year, Medco Health earned $361.6 million in net income versus $6.8 billion for the pharmaceutical business. Merck’s move to concentrate solely on its pharmaceutical franchise thus looks quite reasonable.

Latest Figures and Future

Merck reported a rise of 6.6% in its second-quarter net income, but cut its sales projections for the full year of {{Zocor}} - now a $6.7 billion-a-year drug, - and arthritis top seller {{Vioxx}}. However, the company lifted projections for blood pressure medicines {{Cozaar/Hyzaar}} combined, as well as for {{Fosamax}}.

Merck posted a second-quarter profit of $1.87 billion, or 83 cents per share, up from $1.75 billion, or 77 cents per share, in the year-ago quarter. Earnings missed Wall Street's consensus estimates by a penny.

Expenses at the company accelerated - marketing and administrative expenses grew 18%, while R&D expenses soared 25%. Merck now expects marketing and administrative costs for the full year to rise in the double digits, up from an earlier projection of mid-single digits.

For the quarter ended June 30, total sales climbed 4%, to $13.3 billion from $12.8 billion in the same quarter last year. Sales of Merck's five biggest drugs – {{Zocor}}, {{Vioxx}}, {{Fosamax}}, {{Singulair}} and {{Cozaar/Hyzaar}} combined - rose 7% to $5.52 billion in the quarter but would have risen only 2% excluding the positive impact of favorable currency-exchange rates.

On the bright side, Merck's new revenue source for 2003 cheered investors. Worldwide sales of cholesterol product {{Zetia}}, which is co-marketed with Schering-Plough Corp. ((SGP)), shot up $123 million in the second quarter, up almost 170% from $46 million in the first quarter. {{Zetia}} is designed to be used both as a stand-alone treatment and in a combination pill also containing {{Zocor}}. Merck and Schering plan to seek approval in late 2003 for the {{Zetia/Zocor}} combination pill.

Looking ahead, Merck lowered its estimate for 2003 sales of {{Zocor}} to between $5.4 billion and $5.7 billion from a previously projected range of between $5.6 billion and $5.9 billion citing a slowdown in the overall U.S. market for cholesterol-lowering medicines. According to IMS Health, {{Zocor}} is second only to Pfizer's {{Lipitor}} in terms of retail pharmacy purchases in April 2003 versus April 2002. {{Lipitor}} has also struggled to meet growth targets this year.

The company also said it is on track to meet its earnings forecast for the year of between $3.40 and $3.47 per share, which would represent growth of between 8.5% and 10.5% above last year when earnings amounted to $3.14 per share.

Though Merck's recent share price of $56.66 remains discounted to peers, investors should bear in mind that the company is in a transitory period trying to develop and hopefully launch more drugs while hanging on to the market share of its existing franchise. Besides, there appears no danger of further significant drops, especially in the light of Merck's extended patent-protected portfolio.

The company's risk profile is also very appealing. The overall performance of the S&P 500 Stock Index has a beta coefficient of 1.0 versus 0.42 for Merck. The beta coefficient is the measure of a stock's risk level. Since the stock has a lower beta than 1.0, it is expected to rise and slow down at a much more leisurely pace than the market as a whole. Thus, the performance visibility for Merck's stock is a major advantage as well.

Although some analysts do not see much potential for Merck, the stock continues to represent a long-term investment with a healthy dividend yield of 2.61% that could be a solace while waiting for the next upward cycle in the company's history. On final count, the introduction of new drugs and the spin off of Medco Health will ultimately combine to keep the drug giant on target and push it into another growth phase.