Berkshire Hathaway
What History Suggests About Merck

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By Grahamified
November 8, 2004

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One of the really poignant aspects of Benjamin Graham's The Intelligent Investor is that work's sense of history and historical parallel. Amongst other things, Graham teaches his readers to seek and exploit historical parallels while looking at new investment opportunities. Graham often was compelled to go back decades. In the case of Merck, investors need only go back to Wyeth as it was in 1997.

When Wyeth was propelled by Phen-Phen into its black hole of litigation in the late 1997, management sand-bagged $4 billion for its legal woes "just in case." Thus far, the legal repercussions of Phen-Phen have been some $16 billion. Given Wyeth's revenues of a little over $14 billion when the plaintiff suits starting flushing in, this is a harrowing figure (even today, Wyeth's annual revenues manage to topple that figure). While Wyeth is recovering, it has taken 7 years to do so, at a cost four times larger than initially estimated. History suggests Merck investors are in for a long wait. But what about that tantalizing dividend?

Phen-Phen's American customer base was estimated at 6 million, whereas Vioxx's customer base was 20 million. Given Merck's revenues of $24 billion or so (down from $51.7 billion in 2002), Wyeth's precedent really makes a pickle of any efforts to estimate earnings and the sustainability of Merck's dividend regardless of what CEO Raymond Gilmartin says.

Those investors of a value bent who are licking their chops over Merck are probably likening the potential of Merck to that of tobacco stocks several years ago, but that comparison does not strike me as an especially helpful historical parallel. Unlike brand-fanatical cigarette addicts, Merck's customers buy the generic equivalent as soon as these are available and they'll be available sooner and more frequently given Merck's anemic pipeline.

Notice that the numbers above only include the American market. We tend to see the litigation issue as a primarily American undertaking, but Merck must also defend itself against the 15-nation European Union, an even larger, litigiously powerful, multi-nation welfare state. Thus far, it appears the European Union is at least as interested ?and hostile towards? Merck's perceived obfuscation of research that detailed Vioxx's deleterious effects. In 1997, The European Union wasn't really the legal body that it is now, so how that body ultimately mediates with Merck is an unknown that will probably make Merck's legal foray substantially more costly and protracted than Wyeth's.

A contrarian's view of potential value is hopefully shaped by what history suggests will ultimately happen to an "undervalued" business. Merck's current predicament does have a precedent. Yet what's measurable about Merck's troubles suggests the outcome will be substantially worse than its already awful precedent.

While solvency may not ultimately be an issue, history really suggests shareholders may be waiting about 7 years for a recovery that's weighted as much, or more, to legal bodies as to internal operations. How "cheap" Merck's shares are now depends on how these legal bodies behave in coming months and years, and thus an investment here seems really to be a speculation that legal costs will be much less than the market's current discount suggests. That speculation isn't supported by the historical evidence.

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