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Merck & Co., Inc.
MRK Analysis

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By Caesium
December 9, 2003

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Am I nuts or is Merck a screaming buy? - Phoolish Philip 11/30/2003

An excellent thread and analysis of Merck, especially from Phoolish Philip.

There are two main issues here, one is the comparison of Merck as it was, including the Medco subsidiary, versus Merck as it will be going forward, minus the Medco operation, and the second issue is Merck's pipeline.

With the spin off of Medco although Merck loses over 50% of it's revenues it immediately gains in margins, gross margins up from an average of 36% to now be over 80%, and net margins up from approx. 15% to over 30%. That will have major benefits in its FCF compared to previously.

They continue to carry similar levels of debt to their historical norm the fact they are able to accumulate cash at a faster rate than previously reduces the pressure on their cash to debt ratio, seeing a 15% improvement in the last quarter and an 11% reduction in it's Foolish Flow ratio. This will continue to improve provided revenues remain constant (which we will discuss in their pipeline section).

With no more Medco their inventory turnover has been massively improved but their DSO has almost doubled. This is not good as it shows in their core business they are slow to get their bills paid and at this level are outside the industry norm, MRK at 72 days DSO compares to PFE, for example, runs at approx. 65-70 days outstanding and they are themselves working hard to improve it. (PFE's DSO has actually got worse since their absorbing of Pharmacia but they believe it to be temporary).

To compare historical P/E relative to the S&P P/E is meaningless as the comparison is of Apples and Oranges, when the previous P/E ratio was based upon the company as it was. However with it's current P/E of around 14 it is, as has been noted, historically very low and certainly below the industry norm for a pure play Pharmaceutical company. This is even more exaggerated with FCF with its P/FCF currently at its highest discount to the S&P P/FCF than it ever has been.

All of the above of course is historical and it is madness to buy based upon its history and even more so in the case of MRK when going forward it is relying solely upon it's ability to discover and market successful drugs which brings us to it's pipeline.

Firstly one point that has been overlooked, IMHO, relates to it's revenues of drugs coming off patent protection calculated by others as being $8B. The fact they come off patent and generics will swoop in is correct but the fact they will lose this revenue is only 75% correct. Generics historically take 50%-75% of the market share once drugs come off patent, therefore at most MRK will lose $6B, not $8B, from it's revenues and not until 2007 and 2008, i.e. minimum one year after patent loss for the full loss to be seen. Currently they produce, minus Medco approx. $24B, minus this $6B brings it to $18B. I will defer to Phoolish Philip's calculations in determining increased sales of current drugs where he quotes

As I noted in my original post, the future does indeed look grim with Zocor going off patent in 2006 and Fosamax of patent in 2007. These two drugs generated almost $8 billion in revenues in 2002. Their loss could be catastrophic, hence the current price. While it doesn't look like this lost revenue will be replaced immediately, all is not lost. Two new products, Cozaar/hyzaar and Singulair, are doing well since their introduction, with each growing revenues at 20% and 50% respectively. These two drugs are on pace to earn $4.5 billion this year, and have the potential to earn $7-8 billion by the time Zocor goes off patent. Which brings me to Zocor. The loss of Zocor may not be a complete disaster as Merck is filing to market a Zocor/Zetia combination therapy. Zetia is currently doing well, on pace to generate $500 million for Merck this year. If approved, the Zocor/Zetia combination has the potential to be a blockbuster.

If his forecast is close to accurate then from the loss of $6B in revenues, $2.5B to $3.5B will be met by the increase from Cozaar/Hyzaar and Singulair. So now we need to look for another $3B in revenues, simply to remain flat in revenues, i.e. no growth at all beyond 2006/07. Of course from now to then is 2-3 years away where already MRK have confirmed 9% growth next year. Outside of the Z/Z combo which might be a blockbuster or it might not, we need to find drugs currently in phase III trials to be able to predict what kind of revenue MRK might be looking at post 2006. Even drugs in Phase II now will not affect revenues in 2006. And there is the rub and we move to hope rather than hard facts or easily foreseeable estimates.

We can safely forecast around 10% growth in the next 2-3 years but beyond that from 2006-2009 little to no growth possibly averaging out over the next 5 year period at no more than 5% and quite possibly less and that is why the market is killing MRK right now.

However with the increased margins, even from lesser revenues, the dividend and consequent yield is under little to no threat IMHO at least in the next 2-3 years. Beyond that will Merck discover new drugs? Well they have done for the past 100 years and the last 2 failures not withstanding are likely to do so again. Clearly they are reportedly not going to be engaging in any mergers to provide a supposed "quick fix" and perhaps they are right to do so knowing as they do that they will be seen as the party that needs the merger more and hence will be forced to pay a premium for it.

So it is the "market", who loves their M&A's, after all is it not the brokerage houses banking arms who always profit regardless of how good the deal is for the 2 parties, that consequently have slashed MRK's valuation. It is almost like the "market" is baiting MRK into merging or placing it into "play" as it were.

To answer Philip's original question my best guess is no you are not nuts but no, it is not a "screaming buy" either based upon what we actually know. There are too many unknowables right now to be able to say it is a "screaming buy". We hope MRK R&D produces something (they might not), we hope its current drugs continue to grow and take up some slack (and are not superceded by competitors new offerings). But hope does not necessarily translate into dollars in bank accounts It is, IMHO, a very good buy for a long term investor, i.e. beyond 5 years out (but we would have to monitor their pipeline accordingly and verify they are filling it with phase III candidates) and there is a reasonable amount of safety at current levels, even with minimal growth. Meanwhile whilst we watch their pipeline fill up, or not, we can as Fortune says, pocket the money.

"Higher-growth companies get higher P/Es, but in my mind Merck's three bucks of earnings are just as good as anyone else's, at least in the short term."

Can't disagree with that, and there simply appears to be more far more upside than downside risk at these levels IMHO.

Would appreciate others corrections and criticisms of the above.

Caesium


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