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Merck & Co., Inc. (NYSE:MRK) is a $137 billion healthcare company that creates and distributes human and animal vaccines, drugs, and other products. Their best-known consumer products (in my opinion) are CLARITIN, DR. SCHOLL'S, and COPPERTONE. Merck is currently trading at a 22.34 P/E (GAAP earnings), with an EPS of $2.03. Its price of $44.98 is near the top of its 52-week range of $37.02 and $48.79.

Merck's growth over the past few years have been stagnant. Although gross margins have slightly increased, organic growth has not picked up. We can see that Merck has been unable to increase sales year over year. Moreover, "Merck expects full-year 2013 revenues to be near 2012 levels" (2012Q4 earnings report). After Merck's 2013Q1 earnings report on May 1, 2013, Kenneth Frazier, CEO, acknowledged that patent expirations and negative economic factors were "even tougher" than anticipated, and the company adjusted 2013 EPS guidance downwards from $2.03-$2.26 to $1.92-$2.16.

Sales, Net Income, Gross Margins Year-Over-Year

(billions)

2009

2010

2011

2012

Sales

$23.64

$45.99

$48.05

$47.27

GAAP Net Income

$7.95

$0.86

$6.27

$6.17

Gross Margin

33.63%

1.87%

13.05%

13.05%

Pre-tax Non-GAAP Net Income

$11.37

$13.04

$15.18

$15.08

Non-GAAP Gross Margin

48.10%

28.35%

31.59%

31.90%

Sales, Net Income, Gross Margins Quarter-over-quarter

(billions)

2012Q1

2011Q1

2012Q1

2012Q4

2013Q1

Sales

$11.42

$11.58

$11.73

$11.74

$10.67

GAAP Net Income

$0.30

$1.04

$1.77

$1.40

$1.62

Gross Margin

2.63%

8.98%

15.09%

11.93%

15.18%

Non-GAAP Net Income

$2.61

$2.86

$3.04

$2.54

$2.59

Non-GAAP Gross Margin

22.85%

24.70%

25.92%

21.64%

24.27%

Non-GAAP net incomes added acquisition-related, restructuring, and litigation costs to GAAP net income. This eliminates the effects of large one-time acquisition costs to help us observe a more accurate view of growth trends. Neither sales nor non-GAAP net incomes have increased significantly over the last three years. Merck has also gotten off to a sluggish start in 2013, with sales decreasing 9.1% and 6.6% from 2012Q4 and 2012Q1, respectively, further supporting the negative sales trend from 2011 to 2012.

Inefficient Business Model

Two growth strategies frequently used by pharmaceutical companies are research and development and acquisitions. However, the amount of money spent by Merck in R&D and acquisitions has been decreasing. Their cash has been used to pay dividends-specifically, a $0.43 quarterly dividend currently yielding 3.8% on an annual basis. The dividend has increased from $0.38 in September 2011 to $0.42 in December 2011. Merck raised its dividend again by one cent starting with the payout in December 2012. Dividends may increase stock value in the short-run, but it reduces Merck's potential for growth. Similarly, Merck expects to repurchase $7.5 billion in common stock throughout 2013, financed through debt and operating cash flows.

R&D and Acquisitions Spending Year-Over-Year

(billions)

2009

2010

2011

2012

R&D

$5.14

$11.11

$8.47

$8.17

Acquisitions

$0.37

$6.34

$7.85

$6.34

Total

$5.51

$17.45

$16.32

$14.51

R&D and Acquisitions Spending Quarter-Over-Quarter

(billions)

2010Q1

2011Q1

2012Q1

2012Q4

2013Q1

R&D

$2.05

$2.16

$1.86

$2.22

$1.91

Acquisitions

$0.44

$1.73

$1.58

$1.55

$1.43

Total

$2.49

$3.89

$3.44

$3.77

$3.34

There is a decreasing trend in R&D and acquisitions spending year over year. These revenue-driving activities, proxied by their respective costs, have decreased over the first quarter of each year since 2011, reducing growth prospects for Merck. This trend was sustained through 2013Q1, as R&D spending fell 14% and acquisitions costs dropped 7.7% from the previous quarter. Management's reluctance to increase R&D and acquisitions are expected to slow Merck's revenue and profit growth.

Merck's Drugs

Over the previous year, Merck's pharmaceutical sales, which make up almost 90% of total sales, declined 12% from 2012Q1 to 2013Q1. However, Merck's stock price increased 20% since January 2012. Although some of the difference can be attributed to the positive market returns and share repurchases, the wide divergence in revenue and stock price growths signals that Merck is overvalued.

Ten percent of Merck's sales come from JANUVIA, a drug for type 2 diabetes. Unfortunately, Merck faces stiff competition in this market; there are already many brand name and generic type 2 diabetes medications. Over the past quarter, sales of JANUVIA fell 22%, from $1.1 billion to $884 million. The emergence and success of competitors' type 2 diabetes medications demonstrate Merck's declining market presence-another sign of Merck's slowing growth.

Up to 2012Q2, SINGULAIR, an asthma medicine, was the biggest contributor to Merck's revenues, making up 9.5% of sales in 2012. Sales of SINGULAIR declined 97% in the U.S. between 2011Q4 and 2012Q4 due to the expiration of its patent in August 2012. This decrease was sustained through the first quarter of 2013, when sales declined another 75% from 2012Q4 due to SINGULAIR's European patent expiration in February 2013. These effects were not fully felt in the first quarter (since Merck still had exclusivity in January), so I expect SINGULAIR's sales to keep declining in the second quarter.

The recent approval of OXYTROL, the only over-the-counter treatment for overactive bladders for women, may give Merck a slight boost in growth. However, there are already several drugs in the market targeted to that demographic.

Finally, Odanacatib, a drug targeting osteoporosis going through Phase III trials was pushed back from an expected filing in early to 2013 to 2014, further reducing Merck's growth.

Merck's Products

(millions)

2013Q1

2012Q4

2012Q3

2012Q2

2012Q1

2011Q4

Total Sales

$10,671

$11,738

$11,488

$12,311

$11,731

$12,294

Pharmaceutical

$8,891

$10,085

$9,875

$10,560

$10,082

$10,755

JANUVIA

$884

$1,134

$975

$1,058

$919

$960

ZETIA

$629

$676

$645

$632

$614

$640

REMICADE

$549

$549

$490

$518

$519

$511

JANUMET

$409

$452

$405

$411

$392

$386

VYTORIN

$394

$435

$423

$445

$444

$475

GARDASIL

$390

$442

$581

$324

$284

$274

NASONEX

$385

$292

$293

$375

ISENTRESS

$362

$381

$399

$398

$337

$387

SINGULAIR

$337

$480

$602

$1,431

$1,340

$1,461

PROQUAD, M-M-R II and VARIVAX

$272

$306

$396

$316

$255

$276

Animal Health

$840

$898

$815

$865

$821

$868

Consumer Care

$571

$395

$451

$552

$554

$361

This chart separates Merck's total sales based on the main pharmaceutical drugs, animal health, and consumer care sectors for each quarter starting in 2011Q4. Total sales have decreased 13.2%, while pharmaceutical sales fell 17.3%. The only drug that increased in sales from 2011Q4 was GARDASIL, but sales have been falling since 2012Q3. Merck has been finding difficulty maintaining their market shares with their products. If this trend continues, revenues will continue to fall.

Merck's consumer care unit has grown 58%, but the growth only represents 5.4% of total sales as of 2013Q1. No new drugs representing significant sales have been introduced since before 2011Q4, and given Merck's low R&D and acquisitions spending, sales may keep declining.

Currency Exposure

European sales between 2012Q1 and 2013Q1 increased from 25.4% to 27.7%. Furthermore, sales in Japan make up 11.6% of total revenue. These regions, Europe and Japan, have currencies which are devaluing compared to the U.S. dollar, which will help to decrease Merck's total U.S. income. Merck blamed 2 out of the 9 percent decrease in worldwide sales of $10.7 billion from foreign exchange. I expect this downward trend for the Euro and Yen to persist as negative interest rates for bank deposits in the EU are discussed and Japan continues its stimulus and inflationary-led growth policies.

Valuation

Merck's P/E of 22.34 is slightly higher than other large diversified pharmaceutical companies. The average P/E for similar companies, specifically Sanofi (21.62), Pfizer (20.34), GlaxoSmithKline (19.57), and Johnson & Johnson (23.10) is 21.16. These companies are not as troubled by diminishing R&D and acquisitions spending and stagnant growth forecasts caused low expected drug sales.

The Bottom Line

Merck's stock was one of the top performers in the Dow year-to-date, increasing over 19% at its high of $48.79 on April 23, 2013. Defensive sectors, including healthcare and pharmaceutical stocks have led the rally this year. This may have formed a defensive-sector bubble where highly risk-sensitive retail investors flocked into high-dividend yielding blue chip stocks. As investors' risk appetite increases, they may sell their holdings in defensive stocks like Merck in favour of more cyclical stocks. Thus, I believe the defensive sectors will underperform the market after the first quarter in 2013, and shorting Merck will allow investors to take advantage of this change.

I do not think it is unreasonable to see Merck's price drop such that its P/E will be 20, or even lower since Merck is no longer a growth stock. This translates to a price target for Merck of $40. Merck is currently on a downward trend, trading below the 50-day moving average of $45.10, and I believe a further price decrease is warranted given the company's poor fundamentals.

Recommendation: Short Merck.

Merck's current price is $44.98.

Source: Merck: A Negative Growth Story