Merck (MRK) essentially met analyst expectations with its first quarter earnings report, with earnings per share of $0.99, just above consensus estimates of $0.98. This has Merck stock edging higher to a current price around $39, despite high costs related to its integration with Shering-Plough. Merck is in the final stages of the integration in a worldwide restructuring program. It expects that the merger will be substantially completed by 2015. The cost of the merger has averaged about $1.6 billion dollars per year since 2009, and Merck expects that once the restructuring is complete it will realize annual savings of approximately $4 billion per year.
Struggling Pipeline
Merck is not as transparent as its competitors in releasing information about drugs prior to Phase II trials, but from the number of Phase II and III trials it is discussing, I think it's clear that Merck is maintaining a less than ideally robust pipeline. Merck has only two promising drugs under discussion for the next two years. It expects to file for FDA approval for a first in class insomnia treatment called Suvorexant in 2012, a novel compound that assists in sleep onset as well as sleep maintenance. It also is taking a novel approach to osteoporosis treatment, as it explores Odanacatib, a once-weekly treatment to increase bone density for possible registration in 2013.
By comparison, Pfizer (PFE) currently has a total of 90 projects in its drug pipeline. 35 of these projects are in Phase 2 trials, 18 are in Phase 3 trials, and 11 are in the registration phase. Like Pfizer, Merck is exploring drugs with the potential to treat Alzheimer's disease. In its pipeline Merck currently has a BACE inhibitor in Phase 1, which it calls "potentially transformative". However, given the information that both companies have released publicly, it appears that Pfizer is taking a more active approach towards novel treatments for Alzheimer's disease, which may give Pfizer the edge in this category.
Merck is devoting a portion of its research and development budget towards 'greener' and more efficient manufacturing processes, recently gaining FDA approval for an environmentally friendly process to manufacture its lucrative diabetes drug Januvia.
I am concerned that Merck is continuing to reduce its research and development costs. For 2011, research and development investments totaled $7.7 billion, versus $8.6 billion in 2009. This has driven an increase in free cash flow for the company, which stood just over $10 billion in 2011 compared to $9 billion in 2010. I don't think that this is the best strategy for Merck to adopt, as it is vulnerable to patent expirations on an accelerating basis past 2013; in order to overcome lost revenues caused by patent loss, Merck should be focusing heavily on research and development for new and novel therapies. From the information it released about its Phase III drug candidates over the past few months, few analysts are predicting that Merck has a blockbuster coming out in the near future that would justify such a cautious approach.
On The Legal Front
Sales of Merck's drug for male pattern baldness Propecia may decrease in coming months as the FDA mandated stronger label warnings over potential side effects including impotence and other sexual dysfunction in males taking the drug. Lawsuits over Merck's failure to adequately warn patients over the potential side effects are pending. These suits are similar to the first suits brought against Merck over its marketing of Vioxx, mentioned above.
Merck recently won two patent infringement lawsuits against generic drug manufacturer Mylan (MYL). Mylan wanted to make generics for Merck's popular cholesterol drugs Vytorin and Zetia, but with this ruling Merck will be able to continue to manufacture these drugs exclusively until the expiration of the patent in April 2017.
Outlook
Merck relies heavily on a core group of high-performing treatments to drive its revenue. Merck's top revenue drivers are Singulair, Januvia/Janumet, and Zetia. Merck is currently reporting average revenue of around $1 billion on sales per year of its once a day asthma medication Singulair. However, US patent protection for the drug will expire in August 2012, and Merck expects revenue to decline significantly in the quarters following.
Merck's business is negatively impacted by US health care reform, as is the business of its competitors. Negative factors introduced by the legislation include a mandated 50% discount to Medicare Part D beneficiaries in the coverage gap, the annual health care reform fee assessed by the federal government, and increased Medicaid rebates.
However, despite the negative reform environment and the loss of patent protection on key drugs, Merck's annual sales continue to increase. 2011 total pharmaceutical sales came in at $41.2 billion, compared to $39.2 billion in 2010 and $27.3 billion in 2009. I think that for the near term these increases are sustainable, but without strong drugs coming out of its pipeline it will be difficult for Merck to continue growing revenue.
Merck is currently trading around $40 per share with a forward price to earnings of 10.6 and a price to book of 2.2. Primary competitor Pfizer is trading around $23 per share with a forward price to earnings of 9.7 and a price to book of 2.1. Novartis (NVS) is trading around $55 per share, with a similar price to earnings to Pfizer, at 9.7, with a price to book of 2.1. Sanofi (SNY) is trading around $38 with a price to earnings of 9.4 and a price to book of 1.4. GlaxoSmithKline (GSK) is trading around $47 with a price to earnings of 13.9 and a price to book of 9.0, making GlaxoSmithKline the least desirable of this group for a value investor.
The major drug manufacturers are reliable about paying dividends, and are often attractive against high price to earnings ratios for this reason. GlaxoSmithKline is currently paying an annual dividend of 4.8%, which puts it in the lead here, but not by much. Current dividend payouts in the rest of the group include Merck with 4.3%, Novartis with 4.5%, Sanofi with 4.6%, and Pfizer at the bottom with 3.8%.
Merck is in a strong position now, but a failure to address the problems with its pipeline could combine with the US regulatory environment and the erosion of primary drugs revenue due to generics to substantially reduce Merck's revenues in the coming years. To me it appears that Merck is more concerned with cutting costs and completing its restructuring than rebuilding the drug pipeline at the core of its business, and for this reason I am not considering Merck a value at current prices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
