Thursday, September 09, 2004

Merck - Positioning for a Sum-of-All-Fears Scenario

September 9, 2005 - Street Insight September 17, 2005 -

  • Recent clinical studies on Vioxx and Zocor do not bode well for the stock.
  • A negative FDA ruling and/or tight restrictions from insurance companies would hurt sales dramatically.
  • A 30% decline in sales could result in 45-65% lower earnings, according to my firm's estimates.

Recent news on Merck (MRK:NYSE) made us rethink our position in the stock. Kaiser Permanente's study showed that Merck's Vioxx, Cox-2 arthritis drug, may increase the risk of serious heart problems. If that was not enough, several days later a study showed that Merck's Zocor, a cholesterol-reducing (statin) drug, administered in high doses did not reduce the risk of heart attack when measured against a placebo (sugar pill) or lower dosage of the same drug. In addition, high dosage of Zocor increases chances of developing rare but dangerous side effects in a patient's muscles.

The street believes the news is priced in, but Merck's sales will take a hit. Surprisingly (considering that Vioxx and Zocor together represent approximately 30% of Merck's sales), neither of these headlines put even a dent in the stock price. The street's view is that both headlines are already priced into the stock's low valuation. Also adding fuel to the optimistic camp's fire were recent polls showing improving chances of Bush's reelection. The news drove Merck a little bit higher along with its other large pharma comrades. The main reason for the indifference in the stock's behavior, however, is the thinking that the above-mentioned studies will not impact Merck's sales significantly. We disagree.

It is very likely that doctors already are thinking twice about prescribing Vioxx and Zocor to new patients in addition to monitoring existing patients who are taking those drugs very carefully. Fortunately for doctors (and unfortunately for Merck), there are plenty of substitutes available on the market that are just a prescription away. Why prescribe a potentially dangerous and/or ineffective drug if there are plenty of good, clean substitutes in the market place? For Zocor, there is Pfizer's (PFE:NYSE) Lipitor, the highest selling drug in the world, and Bristol-Myers Squibb's (BMY:NYSE) Pravachol (although Pravachol has also had its share of problems). For Vioxx, there is the highly effective Celebrex, also manufactured by Pfizer. The FDA and insurance companies are still evaluating study results. Kaiser Permanente's study was sponsored by the FDA and it's very hard to predict the FDA's reaction to the study's results. Insurance companies are also still evaluating the results of both studies and have yet to make their decisions. The hidden risk brought closer to the surface by those studies may have a shocking impact on Merck's sales if either the FDA makes a ruling on the efficacy or safety of Vioxx and Zocor or insurance companies will put tight restrictions on drug prescriptions (which to some degree were already instituted on Vioxx). We call this the sum-of-all-fears scenario.

A decline in sales would result in a disproportionally higher earnings decline. Should this scenario materialize, the impact on Merck's bottom line could be devastating for two reasons. First, Vioxx and Zocor represent a very significant portion of Merck's sales. Second, most of Merck's costs (R&D, sales, general and administrative expenses, and a large chunk of cost of goods sold) are fixed; thus, a decline in sales would result in a disproportionally higher earnings decline. According to our estimates, a 30% decline in sales could result in 45-65% lower earnings.

Pfizer is likely to be a beneficiary of Merck's difficulties. It is not hard to imagine how the marketing and sales machines of Merck's competitors (especially Pfizer's) are likely already devising ways to capitalize on these studies at Merck's expense. Thousands of Pfizer's salespeople will be drumming on doctors doors, explaining in great detail the pitfalls of Merck' drugs. Pfizer is a likely to be a beneficiary of Merck's problems. Risk/Reward is unappealing.

Merck has a reputation of being a blue-chip stock; it has a very strong balance sheet, high return on capital, very strong cash flows and a nice 3.3% dividend. But all these factors could change overnight if this scenario -- which is a lot a less remote now then it was before the Vioxx and Zocor studies surfaced -- comes to fruition.

The risk in Merck's stock is very real. Though at 13 times "projected" 2004 earnings the stock appears to be cheap on relative and absolute basis, this cheapness could end up being a P/E trap if "projected" earnings are revised downwards. We therefore find the risk-reward in Merck's stock very unappealing.

Vitaliy N. Katsenelson, CFA Copyright 2004


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