The Market Has Already Discounted Merck's New Drug

| About: Merck & (MRK)

Merck (MRK) issued an announcement last week that its phase III trial for osteoporosis drug, Odanacatib, would end ahead of schedule, as the drug has shown to be highly effective. The Data Monitoring Committee for the study has said that it has completed its analysis and recommended that the study be closed early due to robust efficacy and a favorable benefit-risk profile. As a result of this, Merck will begin taking steps to close trial.

This oral drug is considered to have better effect than its older class of osteoporosis drug known as bisphosphonates. Since the emergence of generic competitions, Merck's drug Fosamax has experienced declines, coming from annual sales of $3 billion in 2007. Odanacatib is formulated to block capthesin K, the major enzyme in osteoclasts. These enzymes are responsible for the breakdown of existing bone tissue.

The committee conducted the phase III randomized, placebo-controlled trial to more than 16,000 patients. It concluded the safety and efficacy of the drug in the reducing fracture risk in post-menopausal women with osteoporosis. This was a positive surprise to the investors, as well the company. It previously announced that it will conduct a blinded extension trial which will allow further monitoring of these issues and continue measuring the efficacy of the drug.

From these results, it will take months before it can complete and close out the trials. The final assessment will include large and multi-center trials at 387 sites in 40 countries. The data from these trials will be collected and reviewed to allow a comprehensive analysis. It will then submit the final results for presentation and publication in 2013. It expects to submit regulatory applications for approval of the drug in the United States, European Union and Japan in the first half of 2013.

Relief from Different Headwinds

Like any other pharmaceutical companies, Merck faces several headwinds. Increased competition from generic drugs has taken a toll on its revenues. The company also has several late-stage drugs in its pipeline that have poor chances of approval. I believe that this drug will definitely provide relief to investors, hoping that the chances of approval for its future drug pipeline will increase.

Despite this operating environment, revenues have increased by 19% a year to $48 billion for the last 5 years. For the next 5 years, analysts are bearish on the stock. Estimates project the company to grow its earnings by 3% a year.

This is in line with the estimates of other pharmaceutical companies affected from generic drug competition. For instance, Pfizer (PFE) is expected to grow its earnings by 2% a year for the same period. Another drug maker, Eli Lilly (LLY), has forecast that its 5-year average earnings will decline by 7.94% a year. GlaxoSmithKline (GSK) has a growth rate of 5% for the same period.

In contrast, drug makers that are insulated from generic competition have better growth potential. Abbott Laboratories (ABT) is expected to grow its earnings by 9% a year for the next 5 years. Meanwhile, Merck's 5-year average operating margins of 16% would yield $176 million a year. I believe this to be a conservative estimated, as a similar drug, Amgen's (AMGN) Prolia operating margin is north of 27%. Assuming a 20% to 25% margins, the drug could yield operating income of around $220 million to $275 million.

However, most analysts appear lukewarm on the future prospects of Merck's new drug. The reason is that Prolia has consistently performed in successive quarters. The bull case is that these two drugs will control the osteoporosis market. According to research and markets, the osteoporosis market will grow to $9.2 billion in 2020 from $6.6 billion in 2010. This translates to a compounded annual growth rate of 3.3%.

The novel pipeline products is expected to address market unmet needs. It also said that the uptake of drugs Prolia and Odacanatib will offset the strong competition as all major brands prepare to lose patents for this year.

Impact to Merck's Value

Assuming operating income of $275 million from this drug, Merck's value will increase by $1.62 per share. This assumes that the market will use earnings multiple of 18 times. This is in line with the stock's highest earnings multiple ranges. Following the announcement, the stock gained $1.30, equivalent to 3.2% from the previous price levels. I believe that the future prospects of the drug are already discounted from the viewpoint of an investor.

The stock is currently trading at 16 times earnings. Based on the earnings multiple band, the stock is fairly valued. It also has a dividend yield of 3.90%. This is lower than its 5-year average dividend yield of 5.78%.

In contrast, other pharmaceutical stocks are trading lower, with the exception of Pfizer. Pfizer is valued at 21 times earnings. It also carries a dividend yield of 3.90%. Sanofi trades at 12 times earnings and has a dividend yield of 4.6%. On the other hand, GlaxoSmithKline is valued at 14 times earnings. It also carries a dividend yield of 3%.

Over the last 6 months, Merck's stock performance has improved due to a change in market expectations. Recently, analysts have upgraded their ratings on the stock. Citigroup upgraded shares from Neutral to Buy. Citigroup also set its price target to $50, implying an upside of 15% based on current levels.

However, major concerns still exist. The market is wary of the lack of business diversification and further loss of patents. At present, Merck is trading near its 52-week high, and shares have gone up by 22% during the period. As a conservative investor, I would suggest that one should accumulate shares on dips. Investors should also wait for confirmation that there will be earnings surprise in the succeeding prices. Otherwise, I expect shares to remain flat over the next few months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.