Ah, Merck
For those of you who've been living in a cave since last Thursday, I'll elaborate. On that day, Merck announced a voluntary worldwide withdrawal of its second-bestselling drug, Vioxx, which is used to treat arthritis and acute pain. Its decision to pull the product came on the heels of new data from a three-year study that suggests the drug increases the risk of heart attack and stroke in patients who have taken the medication for longer than 18 months.
The risk of such side effects are still categorized as "very low," but Merck felt the study warranted the removal of the drug from the market given that other treatments that have not yet demonstrated these drawbacks are readily available.
Initial signs of these risks surfaced as early as 2000, and eventually resulted in Merck including the possibility of such side effects on the product's warning label in April 2002. However, the company denied the drug was unsafe -- based on a lack of conclusive data showing otherwise -- until last week.
When I recently told readers that I was hoping for some news from the company that would move the stock, this is most certainly not what I had in mind. Indeed, I was thinking of something more along the lines of a positive announcement. Alas, that's not what we got.
The surprise news resulted in the absolute pummeling of Merck's shares, reducing their value by more than 27%, and placing them more than 30% below the price at which I recommended the stock in my dividend-oriented newsletter, Motley Fool Income Investor.
That's right. Though rather unfortunate in retrospect, Merck was one of the two picks in the March issue. My subscribers don't appear ready to lynch me quite yet, though, as overall they're still enjoying a total return more than twice that of the S&P 500. However, my misstep with Merck demonstrates an important point: Despite the fact that my recommendations have tended to outperform the market while experiencing just half its volatility, they are not without risk.
Though Merck has now become one of just two picks out of 26 total recommendations that have declined materially -- the other being American Financial Realty
Still, we Fools don't shy away from discussing our failures in addition to our successes, since we can sometimes also learn more from the former than the latter.
The impact
So, what does all this mean for the future of Merck and its stock, and what should you do now? Well, we can basically count on the evaporation of the $2.55 billion in revenue associated with Vioxx at this point. Given that the earlier announcement of the possibility of these side effects already signaled trouble for Vioxx, I had previously discounted my expectations for the drug. However, I certainly did not anticipate the complete removal of this revenue stream.
I was also factoring in that Merck has been very close to gaining approval for a new arthritis drug called Arcoxia, which has been approved in 47 countries (Vioxx had been approved in 80) and is pending FDA approval in the U.S.
Much like the situation with the blockbuster drug Zocor -- where I've been anticipating that newly approved Vytorin will replace a material amount of lost Zocor revenue by 2006 -- I have been estimating that Arcoxia will reduce Merck's reliance on Vioxx.
However, at this point, though no data exists to suggest that it does, Merck cannot assure the market that Vioxx's troubles will not extend to Arcoxia (or to all Cox-2 inhibitor pain relievers for that matter, which would also mean that Pfizer's
The FDA was originally slated to make a decision on Arcoxia in October, but that could be delayed given this new development. In any case, this news will put added pressure on the FDA to either clear other Cox-2 inhibitor pain relievers or increase the required risk disclosures. In effect, this news could be a blow not just to Merck but to the pharmaceutical market at large.
The numbers
The impact of the loss of Vioxx coupled with a dramatic reduction in my expectations for Arcoxia will reduce my 2004 EPS estimate by approximately $0.70, or 22%, from $3.14 to $2.44. Though it could be slightly lower, I'm currently anticipating a similar drop in free cash flow (FCF), which will reduce FCF per share for 2004 to $2.48.
Numbers for 2005 will be further affected by the combination of lost sales and possible legal expenses associated with the drug's withdrawal. I'm taking a worst-case-scenario approach for future periods, and reducing my 2005 EPS target of $3.35 by $1.20 -- $0.10 beyond the high end of the impact range given by the company -- which will result in an EPS of $2.15.
Though potentially conservative, that approach would leave the company trading at 15.5 times forward earnings and 15.3 times FCF. These are very low multiples when compared to the levels at which Merck has traded in the past, but they seem fairly reasonable given all the unknowns facing the company at present.
Dividend dilemma
Merck is currently paying an annual dividend of $1.52 per share, which means the payout ratio will increase from 51% of EPS to 62%, and from 47% of FCF to 61%. These are acceptable levels, and, along with Merck's specific statement that it has no plans to cut the payout in 2004, the dividend is sustainable for now.
However, the payout ratio will worsen to nearly 70% of FCF if my 2005 estimate comes to fruition. That will mean, at best, zero dividend growth for the foreseeable future and a possible cut sometime next year if litigation expenses stemming from the news are higher than anticipated.
I fought the law...
Clearly, the litigation issue is the real wild card here. Merck certainly generates a very large amount of FCF, but an immediate, unexpected drop of this magnitude will have dramatic repercussions throughout the business.
For instance, Merck's substantial free cash is what allows it to fund its $3.5 billion research and development program, which is a necessity for future expansion of its pipeline. Given the drop-off in cash flow, and the lack of new products in the pipeline to offset this decline, the short-term outlook is not terribly compelling, and I don't think anyone can say with absolute certainty that the dividend will be sustained at its current level over the next two years.
The sunny side
Now, it's not all doom and gloom here. We're still talking about a company that has more than $6 billion in net cash and short-term investments on the books, and -- despite this setback -- will generate more than $6 billion in FCF per year.
Further, there are glimmers of hope in the drug pipeline. Though the short-term pipeline leaves much to be desired, its head of research, Peter Kim, continues to lead a premiere R&D staff, and I certainly wouldn't count them out. A promising new diabetes treatment in phase 3 trials, several additions to the vaccine portfolio, and a new sleeping pill are all notable bright spots.
Merck's coffers are substantial enough to fund any short-term hurdles, and it will likely have plenty of time to fund a reserve for coming legal woes. Again, I'm simply taking a worst-case picture of the business because I feel that's what you have to evaluate when faced with news like this.
Initially, plugging these new expectations into my model for Merck resulted in a valuation estimate of $45 per share. However, I've since been able to review the results of some comparative legal rulings, which has led me to introduce the cash flow reduction that would result from the funding of a substantial legal reserve over the next three years. This new model suggests a value of $42 to $43 per share.
Though legal woes should never be taken lightly, I believe the predictions by some journalists that the company could be put out of business by potential lawsuits are vastly overstated. This situation is hardly comparable to Dow Corning's bankruptcy resulting from its breast-implant crisis or Wyeth's
The extent to which Merck may be liable is hard to estimate at this point, but given its quick action on the warning labels and the prompt removal of the drug once definitive results were available, I would say it's likely on the line for far less than the doom-and-gloom numbers being tossed around.
Though it's true that an estimated 84 million patients have taken Vioxx, it's believed that the vast majority of them used the drug for less than 18 months -- again, the minimum time period that resulted in increased health risks. Until we can get a better indication of the true number of patients who were possibly affected, the apocalyptic predictions being whispered are largely meaningless.
The Foolish bottom line
The end result of sifting through this substantial data is that I believe existing shareholders should stand pat for now. The short-term damage has already been done, and it's simply too early to tell whether the recent plunge in the shares is a true overreaction or an accurate reflection of the new risks facing the company.
This is a complex situation. Its full impact could be far-reaching, and it will take time to fully evaluate the long-term effect of this news. As such, Income Investor will continue to hold the shares for now. But again, I'm not comfortable advising a buy at this point to anyone besides the most aggressive investors. They may choose to use this as an opportunity to gain a modest foothold in the stock. Keep in mind, however, that the shares will almost certainly remain volatile in the short term, so don't assume they can't go lower from here.
Indeed, it's possible that -- should the stock recover somewhat in the short run and begin to more accurately reflect the company's intrinsic value -- we'll use that as an exit opportunity due to the large unknowns we're facing here. In the end, though, our action will depend on how quickly we can quantify the full legal impact of the withdrawal.
If you've been taking Vioxx and have questions, Merck has posted an online FAQ here.
Mathew Emmert understands that you have to break a few eggs in order to make an omelette, and he plans to keep cooking up market-beating returns as the chief analyst of Motley Fool Income Investor. He owns shares of American Financial Realty. The Motley Fool has adisclosure policy.
