Making Sense of Merck's Pharmaceutical Business

Pharmaceutical giant Merck (MRK 0.44%) slumped on Monday after the company reported mixed third-quarter earnings that revealed its ongoing struggles following the patent expiration of its blockbuster asthma drug, Singulair.

Over the past 12 months, Merck has woefully underperformed its industry peers, as well as the overall market. 

Source: YCharts.

Let's dig deeper into Merck's third-quarter earnings to identify the company's strengths and weaknesses.

A mixed third quarter
For its third quarter, Merck reported earnings of $0.38 per share, down from $0.56 per share in the prior-year quarter. Excluding one-time items, the company earned $0.92 per share, topping the Thomson Reuters' consensus estimate of $0.88. However, revenue declined 4% to $11.03 billion, missing the consensus estimate of $11.12 billion.

All four of Merck's business segments posted year-over-year declines. Its animal health segment was dragged down by a cattle feed recall, and its consumer segment was hurt by weak demand for Dr. Scholl's footcare products.

Source: Merck's third-quarter earnings report.

However, Merck's pharmaceutical segment, which accounts for the lion's share of its top line, remains the top concern for investors.

In that crucial segment, Merck's main problem continues to be the loss of patent exclusivity for its top-selling asthma medication, Singulair, which generated $3.3 billion in annual sales last year. Moreover, a delay of its osteoporosis drug -- along with the rejections of its insomnia and anesthesia drugs -- exacerbated concerns that Merck was about to plunge off a patent cliff without a parachute to slow its fall.

Analyzing Merck's pharmaceutical strengths
Five of Merck's treatments and a group of vaccines, which together accounted for 34% of the pharmaceutical segment's sales, reported positive sales growth in the third quarter.

Sources: Merck's third-quarter earnings, author's calculations.

Merck reported strong sales of Remicade, the best-selling rheumatoid arthritis treatment it co-markets with Johnson & Johnson (JNJ 1.49%). However, J&J retains a much larger portion of global sales than Merck, and reported $1.7 billion in revenue from Remicade last quarter -- nearly triple Merck's share.

Remicade's patent is protected across most of the EU until 2015, but a biosimilar version of Remicade known as Inflectra was approved by the European Commission in September. Inflectra, manufactured by Hospira (NYSE: HSP), could hurt worldwide Remicade sales if it gains approval in other markets. Remicade is patent protected in the United States, its largest market, until 2018.

Merck also reported strong growth with Gardasil, one of the two most widely used HPV vaccines in the world -- the other one being GlaxoSmithKline's (GSK 1.22%) Cervarix. Gardasil is handily outperforming Cervarix, which only generated $66.4 million in global sales last quarter for GlaxoSmithKline, by a wide margin.

In addition, Merck's MMRV (measles, mumps, rubella, and varicella) vaccines are developing into a reliable pillar of growth for the company, and Isentress continues to post slow but steady growth in the HIV market dominated by Gilead Sciences.

Analyzing Merck's pharmaceutical weaknesses
Meanwhile, four other top drugs -- Januvia, Vytorin, Nasonex, and Singulair -- posted sales declines from the prior-year quarter. Together, these drugs accounted for 20% of the pharma segment's total sales.

Sources: Merck third-quarter earnings, author's calculations.

Singulair is the biggest dead weight on Merck's top line. The fading drug faces an onslaught of generic competitors, which include Dr. Reddy's Laboratories, Mylan, and Teva Pharmaceutical.

The increasingly crowded diabetes market
To offset Singulair' losses, Merck has been counting on its two top diabetes drugs, Januvia and Janumet, to pick up the slack. However, this strategy could face three major problems -- uneven sales, rising competition, and peaking sales. Janumet is a combination drug that combines Januvia with metformin, which controls blood sugar levels.

During the third quarter, sales of Janumet rose 9%, but sales of Januvia slumped 5% -- which could become a problem since Januvia generated more than twice the sales of Janumet during the third quarter.

Januvia was the first treatment in a new class of enzyme-inhibiting diabetes treatments known as DPP4 inhibitors. Although Januvia's sales improved substantially since its approval in 2006, the drug now faces competition from similar treatments such as Onglyza from Bristol-Myers Squibb (BMY 1.30%) and Tradjenta from Eli Lilly and Boehringer Ingelheim.

Therefore, rising competition and peaking sales figures are now casting serious doubt on the idea that Merck's diabetes franchise will solve its Singulair woes.

The bumpy road ahead
In March, Merck tried to rectify its pipeline problems by replacing R&D chief Peter Kim with Amgen R&D chief Roger Perlmutter.

Perlmutter has emphasized the importance of Merck's oncology pipeline, specifically MK-3475, a potential skin cancer treatment that could compete against Roche's Zelboraf and Bristol-Myers' Yervoy. Another oncology treatment to keep an eye on is MK-1775, a new ovarian cancer drug that it is co-developing with AstraZeneca.

During the quarter, Merck received a breakthrough designation for its combination treatment for hepatitis C. Merck also completed a phase 3 trial of a new HPV vaccine, which is now on track for a new drug application.

Another project to keep an eye on is Merck's collaboration with Pfizer to bring a new SGLT2 inhibitor to the market to compete with Johnson & Johnson's Invokana and Forxiga, co-developed by Bristol-Myers and AstraZeneca. SGLT2 inhibitors are a lucrative new class of diabetes treatments, which help patients excrete excess blood sugar through their urine.

The Foolish takeaway
In closing, slumping Singulair sales are still weighing on Merck's top line, sales of its diabetes drugs are slowing down, and its upcoming products are still too far away to make a difference.

For now, Merck will have to hope that its plan to reduce annual operating costs by $2.5 billion, which includes a 10% reduction of its global workforce, will keep its head above water long enough for new products to get approved and balance out its drug portfolio.