Merck Investors Consider Future Liabilities Despite Company's Legal Victories

| About: Merck & (MRK)

Merck (NYSE:MRK) today won another court case in the slew of Vioxx allegations thrown upon it. That marks a victory in 8 of 12 trials brought before a jury.

That may seem like great news, but I think it’s important for investors to keep in mind the potential future liabilities from the case, which, notably, the company does NOT include on its balance sheet. They understandably do not feel comfortable establishing an estimated reserve given the uncertainties of these sorts of trials. Furthermore, the company is currently only insured for less than $800 million as an upper limit, and their carriers are arguing for canceling the policies. Meanwhile, the company refuses to settle, and insists on handling all liabilities case by case.

So I took it upon myself to dig deeper into the numbers and get a feel for the present value of estimated future liabilities. With over 27,000 parties naming Merck a defendant in the Vioxx case and a wide range of possible payouts in trial losses, it’s clearly an estimate that will be very sensitive to inputs. Nonetheless, we can take a stab and try to figure a range.

Let’s assume the following: 50% of the 27,000 filings will NOT be thrown out, and a further half of those remaining make it to court. Of those that make it to trial, one third result in a loss [as extrapolated from the 12 that went to trial already], with the average loss of these being $4 million. Trials will be ongoing for 15 years, and each year the number of filings increases by 3%. Using a straight line method, that means payments will be around $600 million per year. Discounting this at 8% [close to Merck’s weighted average cost of capital] for 15 years and tagging on the approximate $1 billion reserve the company has set apart for estimated legal costs gives a present value of $7 billion in liabilities.

That’s a lot less than the approximately $50 billion one firm estimated back in August 2005 and it is surely overly pessimistic [the chance that around 6000 cases make it to court is very slim given the frivolity of some of the suits], but it’s still no bargain. I personally feel the liability ranges anywhere from $3-20 billion, and investors should proceed with caution, especially given the run-up in price since the original filings.

MRK 1-yr chart

I also question whether a blanket settlement is not really the best move given the protracted battles and legal expenses that may well be incurred. But then again, I’m sure that was done at the recommendation of the company’s lawyers, who would love nothing more than 15 years worth of professional fees.

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Tagged: , Drug Manufacturers - Major
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