Roche (OTCQX:RHHBY) was a good name to own throughout 2011 in large part because so little was expected from the company. Investors still looking to position their portfolio for 2012 may want to consider Merck (NYSE:MRK) for similar reasons. Not only does Merck have a pretty tolerable patent cliff over the next three years, but the company's pipeline may yet be undervalued and under-appreciated.
Q4 Results: Good Margins On So-So Sales
Merck's fourth quarter was more or less fine. Revenue grew 2%, but came in about 2% light of average Wall Street guesses. Januvia was quite strong (revenue up 42%) and Singulair did well for a drug that is long in the tooth (up 8%), but Remicade was a little weak and the company did have to swallow a 15% drop in sales of Vytorin. Animal health and consumer sales were up 7% and 5%, respectively, but are relatively small businesses for Merck.
Merck continues to show some of the benefits of the Schering merger, as well as the restructuring efforts that are so common in Big Pharma recently. Gross margin rose almost two and a half points, while operating income rose 9% for the quarter.
Little To Lose Over The Next Three Years
Merck is unusual among the American pharma companies in how little it has at risk from patent expirations in the near term. Apart from a patent dispute with Mylan (NASDAQ:MYL), Merck has only about 15% of its 2011 sales vulnerable to generic competition, with the single largest component being Singulair (which goes in 2012). Compare that to the more than 40% exposure of Lilly (NYSE:LLY), the greater than 60% exposure of Bristol-Myers (NYSE:BMY), or even the nearly 30% exposure of Pfizer (NYSE:PFE).
With little to lose, Merck doesn't have to worry about chopping heads in marketing or in R&D just to preserve margins.
But How Much To Gain?
Certainly patent losses are only part of the equation of a successful Big Pharma investment. The strength of the company's patent is also critical. Here Merck is in a weird twilight zone.
Although the company has a much larger number of potential launches between now and 2015 (17) than AstraZeneca (NYSE:AZN), Lilly, Pfizer, or even Bristol-Myers, analysts are not expecting a lot from them. In fact, it looks like the incremental contribution to sales in 2015 from the pipeline will be less than 10% of today's revenue.
The good news here is two-fold. First, analysts may be seriously underestimating some of these drugs. Second, there's a timing artifact in the analysis, as many of its more promising drugs will be launching closer to 2015 and not showing their full potential by that point.
Suvorexant (insomnia), odanacatib (osteoporosis) and anacetrapib (atherosclerosis) could all be significant winners for Merck in time. Granted, Pfizer is a great case-in-point for the risks of trying to develop a new insomnia drug, but the safety data on suvorexant is encouraging so far. Likewise, while anacetrapib may have to contend with Roche's dalcetrapib in the market (or see the risk of an unsuccessful Phase 3 study cast doubt on the whole class), it has multi-billion dollar potential if successful.
Merck also has a toehold in the burgeoning Hep C market. It currently markets Victrelis against Vertex's (NASDAQ:VRTX) Incivek, and also has a pan-genotype protease inhibitor. Diabetes, too, is a chronic condition where Merck has more than casual interest - including a once-weekly oral DDP-4 inhibitor in the pipeline.
The Bottom Line
Unlike a lot of drug companies, Merck has a pretty good shot of showing growth over the next five years and beyond. Better still, it looks quite cheap on the basis of both potential earnings in 2015 and 2020. So not only can an investor buy what looks like a stable pharmaceutical franchise and an undervalued pipeline, but also collect a better-than 4% dividend at the same time.
Merck could be as much as 30% undervalued today on moderate pipeline assumptions; strong phase 3 data from compounds like anacetrapib would definitely boost that value calculation, as would success in pipeline long shots like Hep C and Alzheimer's. There are actually a few good ideas out there in Big Pharma right now, but Merck definitely deserves serious consideration among them.
Disclosure: I am long OTCQX:RHHBY.