5 Reasons To Avoid Merck

| About: Merck & (MRK)

Merck (NYSE:MRK) has come up with its 4Q12 and FY'12 numbers. Although with $47.3 billion full-year worldwide sales Merck saw a drop of 2 percent in its topline, yet the results were better than we expected. In the last two weeks of trading, the stock appreciated from $41 to $43, a gain of about 5 percent. And at the current price level MRK has crossed the 200 DMA (days moving average).

However, analyzing different parameters, I have (5) reasons to believe investors should avoid Merck at this time.

Lowering R&D Investment

MRK has been improving upon its dividend payout since the year it started dividend distribution. Dividend payout (dividend/earnings per share) ratio has been consistently high for Merck in recent years. In 2012 and 2011 this ratio was 73% and 77% respectively. In 2010, its dividend payout ratio was more than 500 percent (EPS: 0.28; dividend: 1.52). Their retained earnings were down substantially that year, implying that the retained earnings were utilized to pay dividends.

It can give a very positive indication to shareholders in a way that the company puts a lot of efforts to keep them happy, but it is also important to know what is being compromised in order to do so.

Research and Development expenditures of Merck in the years 2010, 2009 and 2008 were approximately $10, $6 and $5 billion respectively. This shows a clear growth in investment. But during 2011 and 2012 R&D expenditures were $8.4 and $8.1 billion with a fall of 23% and 4% respectively. In Biopharmaceutical industry R&D is the key to growth. In this regard, Merck's continual shift of focus from investment in research to dividend- payout is in fact a matter of concern. What adds to the gravity of this analysis is the fact that this shift is coming at a time when most of the important patents of the products from the company's portfolio have expired or are on the verge of expiry.

PATENTS: Expiration and Arrival

The patent on SINGULAIR, Merck's once-a-day oral medicine for the treatment of chronic asthma and the relief of symptoms of allergic rhinitis expired in the United States on August 3. 2012. It will expire in major European markets later this year. This expiration came as a major blow to the company's earning as the total contribution of Singulair to Merck's coffers was around 12 percent last year. Its sales declined $932 million or 97 percent in the United States in the fourth quarter. Next year contribution is expected to be less than a percent.

Regarding getting new licenses, Merck is in a Phase III trial of Odanacatib, the company's investigational medicine for osteoporosis. Merck now anticipates that it will file application for approval of Odanacatib in 2014, with additional data from the extension trial.

Though it's a kind of unique product to address unmet medical needs in patients with osteoporosis, its total potential market size is not big enough to compensate Singulair. Barclays Capital has previously estimated Odanacatib could generate $2 billion in annual sales by 2020, which is far less than previous year's sales of Singulair that stood at $4 billion.

Slow down of activities at inorganic growth front

Overall acquisition related costs of the company in the years 2009, 2010, 2011 and 2012 were $5.939, $5.344, $1.479, and $1.298 billion respectively. In other words, acquisition expenditures were reduced by 10, 72 and 12 percent in the year 2010, 2011 and 2012. This shows a steep fall in the inorganic growth of the firm.

Implication of these numbers is worse in today's scenario. In pharmaceutical sector, growth in terms of both organic and inorganic is very important to maintain and/or grow a firm's competitive positioning. Today's pharmaceutical trend is to go on an acquisition spree in the developing nations. These countries not only provide low-cost labor and resources but also are helpful in maintaining price competitiveness, especially after a product patent expires and generic drugs are available in the market.

In the case of Merck, one can see the situation getting worse as they have already reduced their research and development expenses. So, overall at both the fronts the investment is way too low to give a brighter future picture.

On a similar strain, the company has reduced its restructuring expenses over the years. Expenses were reduced by 48, 31 and 63 percent in the year 2010, 2011 and 2012 respectively

Dismal revenue guidance for FY'13

2013 Full-Year EPS target is set in a range of $3.60 to $3.70, excluding certain items; GAAP EPS range of $2.03 to $2.26. Merck expects full-year 2013 revenues to be near 2012 levels on a constant currency basis, which is once again not a growth data. Company's focus is to maintain the sales level rather than to increase it.

Considering Obama administration's resolve for maximum medical inclusion of United States citizens under PPACA, it is assumed that both market size and demand for biopharmaceutical product will increase substantially. In such a scenario, a guidance to maintain status quo in sales is not encouraging.

The Patient Protection and Affordable Care Act (PPACA)

Commonly called Obamacare or the federal health care law, is a United Statesfederal statute signed into law by PresidentBarack Obama on March 23, 2010. It represents the most significant government expansion and regulatory overhaul of the U.S. healthcare system.

PPACA is aimed primarily at decreasing the number of uninsured Americans and reducing the overall costs of health care. It provides a number of mechanisms- including mandates, subsidies, and tax credits-to employers and individuals in order to increase the coverage rate. Additional reforms are aimed at improving healthcare outcomes and streamlining the delivery of health care. PPACA requires insurance companies to cover all applicants and offer the same rates regardless of pre-existing conditions or sex. The Congressional Budget Office projected that PPACA will lower both future deficits and Medicare spending.

Besides, Merck's percentage of international sales has been increasing. Percentage contribution of International sale to the company's total revenue is more than 57 percent. Increase in international sales increases translational risks. Considering current exchange rates, next year sales would be affected unfavorably up to a very significant extent.

Products under FDA scanner

Januvia, which is the largest contributor to the revenue of Merck, is being considered to cause pancreatitis in patients using it for their diabetes treatment. According to the analysis in the journal JAMA Internal Medicine, patients hospitalized with pancreatitis are twice as likely to be taking Januvia as a control group of diabetics that does not cause pancreatitis.

With $4 billion in FY'12, JANUVIA's contribution to total sales was 10 percent. This was a jump from previous year's 4 percent contribution. This shows the importance of the product to the company.

If FDA rulings will go against Merck, its earnings will face a serious blow.

To sum up, Merck is pharmaceutical firm with

  1. Decreasing investment in research and development that affects organic growth of a company
  2. Decreasing acquisition appetite that affects inorganic growth of a company
  3. Expiring key products' patent
  4. Poor guidance for FY'13
  5. Some of the major product under FDA scanner, which increases uncertainty of the company's future performance.

These factors in the pharmaceutical sectors do not bode well for any company. It will be a matter of time before these things will start coming into the picture and will start affecting the company's performance as well as stock price. I, for one, will not be investing in Merck anytime soon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.