Once regarded as safe havens for their exceptional profitability and consistent growth, today's major drug companies are eyed with suspicion. Throughout the 1980s and 1990s, the major players traded at multiples, on average, 30% higher than the S&P 500. Not anymore.

Today, even the elite players in the industry trade at multiples at or slightly below the index. While a number of issues have plagued the big drug companies over the past three years, virtually every industry player has suffered to some degree from the symptoms of the same disease.

Blockbuster dependence
A perfect case study in blockbuster dependence is Schering-Plough (NYSE:SGP), which I discussed in my last column. For all the creative ways that Schering-Plough has managed to shoot itself in the foot, its biggest problem has been an inability to replace its blockbuster Claritin allergy drug, which at its peak represented almost one-third of the company's total revenues and half of its profits.

But Schering-Plough isn't the only recovering blockbuster addict. Despite being larger and more diversified, Bristol-Myers Squibb (NYSE:BMY) ran into a similar wall when it lost patent protection for three blockbuster drugs in 2000 and 2001. Eli Lilly (NYSE:LLY) is still struggling to recover from the loss of its biggest seller, Prozac, which lost exclusivity in late 2001. As a group, the big drug companies just haven't been able to develop enough new blockbuster drugs to replace the dying franchises.

An industry jewel
This brings us to Merck (NYSE:MRK), a jewel of the pharmaceutical industry and one of the world's most admired companies. Coming into the new millennium, Merck appeared vulnerable, facing patent expirations on some of its most successful drugs. In 2000, the patents on $2.3 billion high blood pressure drug Vasotec expired. Another billion-dollar drug, Pepcid, lost exclusivity that same year. Merck then experienced two more blows when big sellers, Mevacor and Prinivil, lost patent protection in 2001. In aggregate, these products represented 20% of the company's drug sales in 2000.

Merck managed to sail through this nasty stretch with its sales and profits largely intact. Pharmaceutical sales even grew a little, from $18.6 billion in 2000 to $19.7 billion in 2001 and $20.1 billion in 2002. The company has done even better from a cash-flow standpoint, growing operating cash from $7.7 billion in 2000 to $9.1 billion in 2001 to $9.5 billion in 2002.

Merck has accomplished this almost entirely through sales growth from newer products. From 1995 to 2001, the company introduced 17 new medicines and vaccines. It enjoyed an especially strong year for new product launches in 1998, introducing five new medicines. Among the 1998 crop was arthritis drug Vioxx, which has become a $2.5 billion seller, and asthma drug Singulair, which has grown into a $2 billion blockbuster. And then there is the rise of cholesterol-lowering Zocor, which has become one of the world's best-selling drugs. With 2002 sales of $5.6 billion, Zocor is now a mega-blockbuster.

A growth story, again
Now that Merck has spun off its pharmacy benefit management unit, Medco Health Solutions (NYSE:MHS), the company is back to being a drug pure play, and a growing one at that. Standard & Poor's expects the core pharmaceuticals business to grow 9% to $23.4 billion in revenues in 2003. S&P's "core earnings" forecast, which strips out a lot of the fluff, is a respectable $3.01 per share. The spinoff also will show off the profitability of Merck's drug business, with net profit margins hitting about 30%.

Trading below $49, Merck sells at only 16 times the S&P's 2003 core earnings estimate. The company also will maintain its $1.48-per-share dividend, which translates into a healthy yield of 3%. Given that Merck has always been a phenomenal business and now appears to be growing again, one has to wonder why the multiple is so low.

The $6 billion question
Despite Merck's massive size and scale, the company isn't as diversified as one would like. Five key products comprise almost two-thirds of its revenues: Zocor ($5.6 billion in 2002), Vioxx ($2.5 billion), hypertension drugs Cozaar and Hyzaar ($2.2 billion), Fosamax for osteoporosis, ($2.2 billion), and Singulair ($1.5 billion.) Zocor alone accounts for some 24% of expected 2003 revenues. Now comes the bad news: Zocor will lose its patent protection sometime in 2006, and has already lost its patent protection in some big international markets -- Canada, the U.K., and Germany, to name the biggest.

You'll recall that Schering-Plough's troubles stemmed from the loss of its Claritin franchise, which had represented about a third of total revenues. Zocor isn't quite that big for Merck -- but one-fourth isn't that far from one-third. And percentages aside, it won't be easy to find $6 billion in annual sales to replace Zocor's lost revenue. Getting growth on top of that is almost too much to ask. While Merck is counting on continued strong growth from its Fosamax and Cozaar/Hyzaar franchises to offset some of those lost sales, the company will have to come up with some new hit drugs in a hurry if it hopes to avoid a rough patch in 2007.

Zetia to the rescue?
Unlike Schering-Plough, which relied far too heavily on a brand-extension strategy to protect its Claritin franchise, Merck will continue to bank on its ability to bring truly novel medicines to the market. Merck has three years to bridge the gap, and has already got a couple of bullets firing. The first is Zetia, the novel cholesterol drug from a joint venture with Schering-Plough.

Approved in December of last year, the drug has already produced $123 million in sales in the first half of 2003. Some analysts are projecting peak sales as high as $4 billion, but before you get too excited, remember that Merck only gets half the profits from the joint venture. Merck also has a new COX-2 inhibitor, called Arcoxia, which has been approved in over 20 countries. Merck expects to file for approval in the U.S. by the end of this year.

If the past few years are any indication, Merck is likely to get at least a couple of new drugs on the market every year between now and 2006. Nevertheless, there's a pretty good chance that Merck will hit a little rough patch in 2006 and 2007 before resuming growth again. The stock price clearly reflects this possibility.

That's why you can buy shares of a world-class company at a substantial discount to the S&P 500 multiple. Merck is a company built to last, and the time to invest in such a company is often when the market discounts a known, but temporary, problem. While not an obvious slam dunk, Merck represents an interesting value proposition at the current price.

Guest columnist Zeke Ashton has been a longtime contributor to The Motley Fool and is the managing partner of Centaur Capital Partners LP, a money management firm based in Dallas, Texas. At the time of publication, Zeke owned shares of MRK and BMY in some client accounts. Please send your feedback to zashton@centaurcapital.com.