To truly appreciate the risk of investing in pharmaceutical stocks, one need only look at Merck (NYSE:MRK).
Business was going along swimmingly for this drug giant until it was hit with a financial and public relations nightmare known as Vioxx. The arthritis and pain-relief drug had to be pulled from the market in the fall of 2004, five years after its release, because of links to increased heart attacks. One researcher linked the drug directly to 27,000 heart attacks or cardiac arrests. At the time it was pulled, the drug was sold in 80 countries with annual sales of $2.5 billion.
Following the crisis, the stock price fell from $44 a share to under $30. Just as the stock was recovering, more bad news, though less scandalous than Vioxx, re-emerged in 2008, sending the stock price plummeting from over $60 a share to less than $25.
The cause of that drop was the announcement that trial-testing of its cholesterol-lowering drug Vytorin didn't reduce plaque in patients' arteries more than a cheaper generic. At the time, Vytorin was a major portion of the company's growing revenue stream.
Another common problem that befalls drug companies happened to Merck last fall when it lost market exclusivity for Singulair, an asthma drug, causing fourth-quarter sales of the drug to decline 67% year-over-year globally, and 97% in the U.S.
Merck stock is selling around $44 a share, and has traded between $37 and $48 in the past year. It's trading at a price-to-earnings ratio of 22.
Merck sells a variety of drugs, including Singulair for asthmatics, Januvia for diabetics, HPV vaccine Gardasil, and an HIV drug called Isentress. It also markets drugs for animals and consumer health products such as Coppertone sunscreen and Dr. Scholl's foot-care products.
During its fourth-quarter and full-year 2012 earnings report released in early February, Merck reported a slight drop in quarterly and annual sales. Fourth-quarter sales fell from $12.3 billion in 2011 to $11.7 million in 2012, while annual sales took a slight drop from $48 billion to $47.3 billion.
Quarterly net income decreased from $1.5 billion in 2011 to $1.4 billion in 2012, however annual net income grew from $6.3 billion to $6.6 billion.
Merck also announced in its earning statement that it is on track to file five products for regulatory approval in 2013. New key clinical trials were recently started for drugs to treat type 2 diabetes, psoriasis, mild Alzheimer's and advanced melanoma.
Merck expects full-year 2013 non-GAAP earnings per share to be between $3.60 and $3.70, and the GAAP EPS range to be $2.03 to $2.26. It expects full-year 2013 revenues to be near 2012 levels.
Like most of the industry, Merck boasts a healthy gross profit margin, 80% in the last year and a five-year average of just over 79%.
Strong Balance Sheet and Ratios
Its average return on assets (7.2%) and return on investments (9.1%), are slightly less than the industry average (8.6% and 13.6%, respectively).
The company had a cash balance of $13.45 billion at the end of last year. It has maintained a consistent level of long-term debt, currently at $16.25 billion, though it more than doubled its short-term debt in the last year to $4.32 billion.
It's long-term debt-to-equity ratio is 0.31, meaning it has more than three times the equity than its long-term debt. It also has a current ratio -- calculated by taking current assets / current liabilities -- of 1.9, meaning the company is fairly liquid.
Merck paid out an annual dividend of $1.72, which yields just under 4%. This is generous, as shown by a payout ratio of 85%, meaning the company disbursed 85% of its earnings back to shareholders. The current yield is superior to its key competitors, Johnson & Johnson (3.4%) and Pfizer (3.6%). Investors that bought near the 2009 lows of $22 have seen about 30% of their purchase price returned to them in the form of dividends.
Merck is experiencing delays in approvals for a key drug that it acquired early on in the development process when it bought Schering-Plough Corp. in 2009.
In mid-March, Merck announced that the U.S. Food and Drug Administration will not complete its review of sugammadex, an experimental medicine to reverse the effects of anesthesia, until the second half of 2013, representing a three-month delay.
Analysts and doctors believe this will be one of the biggest advances in anesthesia in decades. It would be the first in a new class of medicines in the United States known as selective relaxant binding agents, which would help patients recover far more quickly from anesthesia.
Merck is already selling this drug in 75 countries under the brand name Bridion. It had 2012 global sales of $261 million.
Potential Bright Spots
Yet for all the potential negatives of developing and marketing drugs, it sometimes only takes one success to turn things around. It was recently announced that an infant infected with HIV was cured of the disease after being given a combination of drugs within 48 hours of birth.
The news re-ignited the hope of finding a cure for the deadly virus. Last year, a small cancer fighting drug produced by Merck known as Zolinza flushed out HIV deposits in patients. This provided hope to the medical community that treating the disease early might make a sizable impact, which was reinforced by the news of an infant being cured.
And the future of Vytorin isn't over yet either. In mid-March an advisory board allowed a clinical trial of the cholesterol drug to go forward. While the trial will run through September 2014, meaning it will be a while before the company profits from it, it's still a positive sign for the future.
So while the risks remain for Merck, potential rewards may lie just around the corner.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was written by an analyst at Catalyst Investments.