Rating Agencies Turn Negative On Merck

| About: Merck & (MRK)

Merck & Co.'s (NYSE:MRK) plans to expand its share buyback program have placed its long-term debt ratings under pressure, which is just one more obstacle the pharmaceutical company will be challenged by this year, if not longer.

Fitch Ratings and Moody's Investors Service warned that the expansion of the program is worrisome because Merck wants to cover at least half of it with new debt. Specifically, Merck wants to expand the program by $15 billion to $16.1 billion. It pins the amount of shares to be repurchased with debt at $7.5 billion. Those shares will be bought back over the next 12 months.

So Fitch slapped the company's debt with a negative outlook. It had been positive. Fitch affirmed Merck's A-plus rating, however. Fitch zeroed in on the effects of Merck funding two-thirds, or $10 billion, of the buyback program. Total debt leverage could increase to more than 1.5 times next year, and that could lead to a one-notch downgrade. Of note is that more than $6 billion of Merck debt matures within the next two years.

"The pacing and financing of the share repurchase program could drive debt leverage to a level that is no longer reflective of [an A-plus rating]," Fitch noted in its ratings release that came out Friday.

Moody's took similar action last week. It placed Merck's long-term, senior unsecured ratings under review for downgrade. It rates the debt Aa3. Moody's senior vice president Michael Levesque said debt-financed share repurchases are not in line with Merck's previously conservative financial policies.

Both Moody's and Fitch took issue with the impact that drug patent expirations are taking on Merck. It, along with other drug makers, are dealing with popular drugs they developed losing their patents as generic drug manufacturers are making them and offering them for much cheaper prices.

When Merck reported its first quarter revenues last week, market players got a real look at how impactful these patent expirations have affected Big Pharmas' bottom lines.

Consider this. Merck makes the popular asthma and allergy relief drug Singulair, which lost its patent in August. It was Merck's best seller. Its sales were off 75% during the first quarter, coming in at just $337 million. They were roughly $1.3 billion during the first quarter of last year. Officials had to admit they had not seen such a rapid loss in a popular product like Singulair in the U.S.

Total pharmacy sales were down 12% to $8.9 billion. Other drugs that contributed to the decline include Clarinex, which is also an allergy pill. Maxalt, used to treat migraines, and Propecia, used to treat baldness, also saw declines in sales.

Things won't get better anytime soon, either. Merck also cut its guidance for the remainder of the year.

While the news of the disappointing first quarter, coupled with the pressures on its debt ratings are worrisome, there are some positives that can be pointed out about Merck. For example, Fitch noted that it managed to maintain strong free cash flow generation to cover the debt maturing within the next two years. It should stay above $5 billion each of those years, with a margin above 10% through 2016.

Merck's strong liquidity is supported by cash and short-term investments of $16.1 billion; and $7.3 billion of long-term investments at the end of 2012. In addition, Merck had full capacity under a five-year, $4 billion revolving credit facility due May 2017, according to Fitch.

Also positive for Merck are two promising drugs: Januvia and Gardasil. With sales of $884 million during the first quarter, Januvia is Merck's top selling drug now. Used to treat Type 2 diabetes, its sales suffered a 4% decline. Gardasil, which is a vaccine used to prevent the human papillomavirus (HPV), sales have been strong. The drug has been controversial because young girls are encouraged to use it if they are sexually active. Though controversial, the drug saw its sales rise by almost 40%.

Then there is Liptruzet, which Merck announced Friday had received marketing approval from the U.S. Food and Drug Administration to treat cholesterol.

Even with these drugs adding to the company's bottom lines, its debt issuance plans to soothe investors with its share buyback program will remain under pressure.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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