Will 1 Patent Destroy This Dow Dividend Stock?

When looking at the Dow Jones Industrial Average (^DJI) by sector, healthcare is one area that’s easily overlooked. After all, the sector accounts for only three of the Dow’s thirty components, and the three combine for only 8% of the sector’s weight. While that means that healthcare isn’t significantly moving the needle for the broader index, one specific company, Merck (NYSE: MRK), has outperformed the index considerably in the past year. Its shares are up nearly 14% year to date versus less than 7% for the blue-chip index let’s take a look at what’s been driving the stock to this point, as well as where the company’s headed.

Merck, the grandfather of the pharmaceutical industry, showed encouraging signs of recovery after trumping Wall Street’s expectations in the latest quarter. Its blockbuster asthma drug breathed life into the company’s total sales, and the stock reached a 52-week high at the end of July. This spike was brief, however, and Merck’s share price has since eroded. This may be a mere hiccup in Merck’s turnaround, but the company is confronting a new challenge that could put the kibosh on its progress and crush its revenue in upcoming quarters.

Is there still long-term value in this pharmaceutical giant, or are Merck’s days as a dominant Dow stock numbered?

One Singulair Sensation
Asthma medication Singulair has been Merck’s top-selling therapeutic for more than six years. The drug’s annual sales have exceeded $4 billion since 2007, and it has accounted for more than 11% of Merck’s total revenue in fiscal 2011. Singulair continued its solid performance last quarter, with a year-over-year sales increase of 6%; but, unfortunately, this was the drug’s last time in the spotlight.

Singulair’s U.S. patent expired in August, and the FDA approved 10 different generic versions of the drug this month. Companies such as Mylan Pharmaceuticals and Endo Health Solutions are already marketing their less expensive, off-brand versions of the medication. In the latest earnings call, Merck’s CEO Kenneth Frazier suggested that Singulair could lose 90% of its revenue in the next couple of months, as generic competitors gobble up market share.

Will Singulair leave Merck breathless?
The loss of Singulair’s market exclusivity will undoubtedly hurt Merck’s revenue this year, but the company has a number of other growing brands that can partially pick up the slack. In the last quarter, sales of Merck’s diabetes drug Januvia topped more than $1 billion, and increased 36% year over year. Sales of Merck’s second diabetes pill Janumet also popped 28%, and took in $411 million last quarter. Both drugs, which are patent protected until 2022, look poised to continue their strong growth, and can help to fill the void left by Singulair in the long-term.

Merck will also seek FDA approval for six new drugs in the next couple of years, including treatments for insomnia and osteoporosis. There is a lot of hype surrounding Merck’s upcoming insomnia medication, Suvorexant, and it’s possible that this will be the company’s next blockbuster. However, with existing insomnia drugs like Sanofi’s Ambien, GSK’s Lunesta, and generic counterparts to each drug already available, Merck’s drug must be clinically superior to capture a significant portion of this market.

Marginal loss or loss of margins?
The real pain from Singulair’s patent expiration will be felt through decreasing margins. Mr. Frazier stated in the earnings call that Singulair had a remarkably high profit margin. Considering that Merck’s margins currently lag behind many of its competitors, this is troubling news for investors:

Source: Author, data from Yahoo! Finance, TTM = trailing twelve months

Merck has the lowest operating margin in this group and, excluding Johnson & Johnson, also trails the rest of the pack with a profit margin of only 13.9%. Margins are certain to drop from bad to worse as Singulair’s sales decline this month.

Merck has previously resorted to propping these numbers up through lay-offs and an ongoing “Merger Restructuring Program” that aims to root out inefficiencies from its 2009 merger with Schering-Plough. These are only short-term strategies, however, and investors are eager for new therapeutics that can improve these figures for the long-term.

Merck’s outlook
Like many big pharma players, investors have to wait and see how Merck deals with its key drug’s patent expiration. Merck’s stock does have an attractive 3.9% dividend yield, but keep a close watch on the sales growth of the company’s key diabetes drugs, upcoming FDA decisions, and how Merck improves margins in upcoming quarters before jumping into this investment.

While it’s difficult to p redict the trajectory of this pharmaceutical stock at present, there are three Dow stocks that our analysts recommend you think about investing in today. You can find out more with a single click by reading their free report: The 3 Dow Stocks Dividend Investors Need.