"Jury Awards Widow $253.4M in Vioxx Trial"

This, my friends, is what we call "headline risk," and it sent Merck (NYSE:MRK) stock down significantly on Friday, then a bit more on Monday. Proving that things are indeed bigger in Texas, a jury in the Lone Star State awarded $253 million in damages in a case where the plaintiff claimed that Vioxx led to a man's death from heart arrhythmia.

The first of what could be more than 4,000 cases, this trial certainly didn't go the way that Motley Fool Income Investor pick Merck had hoped. Although Texas law will limit the damages to a maximum of just over $26 million (and Merck will appeal the rest), it's not a good omen for future trials across the country.

For those who've been living in a cave or under a rock for most of the past year, the hoopla here concerns the dangers of the painkilling drug Vioxx, and what Merck may have known about those dangers. While company emails and memos suggest that Merck employees were aware of (and concerned about) the cardiac dangers associated with Vioxx for a few years, the drug wasn't removed from the market until September of 2004.

With so many lawsuits already filed, this battle will be going on for years to come. Some cases will take place in federal courts (where there is generally a higher standard of evidence and a lower willingness to award gonzo-sized settlements), but others will take place in state courts, where juries may opt to send similar "messages" with their award judgments.

This is all exceptionally ugly, but let's step back a moment and take a look at some numbers. Merck has generated more than $7 billion in free cash flow for each of the past three years, and about $6.5 billion in the past 12 months. It also takes a bit more than $3.3 billion to continue making Merck's annual dividend payments, and the company has about $14 billion in cash and investments on the balance sheet.

Accordingly, even with the loss of patent protection on Fosamax and Zocor, Merck should be in fair shape to continue paying dividends and socking away cash to pay off victorious plaintiffs. Remember, not all plaintiffs will win, many of those who do will see their judgments reduced upon appeal, and it will be years before Merck starts cutting checks. On the very crude assumption that it could take up to 10 years to resolve all of this litigation, Merck would seem to have something in the neighborhood of $40 billion to spend before it would be forced to cut the dividend.

Only time will tell what the ultimate impact will be. Merck will likely fight the lawsuits aggressively, at least until September of 2006, when the statute of limitations expires and the company can get a fairly firm grasp on the total number of plaintiffs. At that point, Merck may start discussing settlements. It's also possible that the company could slug this out and hope to wear down the plaintiffs -- after all, some people may be willing to accept lower damages and a check today in the face of years of ongoing legal battles.

This Vioxx verdict is yet another shock to the pharmaceutical sector, and a lesson about the dangers of product liability litigation. Given some problems reported with Bextra, Pfizer (NYSE:PFE) too could face suits. And then there are GlaxoSmithKline (NYSE:GSK) and Novartis (NYSE:NVS), which are both developing new COX-2 drugs, but may change their minds if they're not 100% convinced that their drugs are perfectly safe.

I wouldn't buy Merck just yet, but it's getting more appealing. This sort of announcement (and the stock reaction) is precisely why I was holding off on these shares. With the first trial results in, though, it may be time for intrepid investors to begin gradually building a position in this battered drugmaker.

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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).