Citigroup MRK: Prevails in First Federal Court Case
February 20, 2006
George Grofik, CFA
george.grofik@citigroup.com
HOLD (2) Medium Risk (M)
Mkt Cap: $79,602 mil.
SUMMARY
* On Feb. 17, MRK prevailed in a retrial of the first Federal Vioxx Crt Case (Plunkett v. MRK). As a reminder, this case originally resulted in a hung jury in December, although the jury overwhelmingly leaned in favor of MRK.
* While this decision is encouraging, it is not surprising given the original trial result (8-1 for MRK), the stricter Fed. ct. trial standards,& short length of Vioxx usage by the plaintiff (less than 1 mo.). Upcoming long-term use (18 mos.+) cases will likely prove to be more challenging for MRK.
* With a sample size of n=3, we believe it is premature to establish an est. for MRK's Vioxx liability & await a more representative sample of cases. MRK currently faces ~9,650 prod. liability lawsuits (incl. ~19,100 plntf. groups). We continue to stay on the sidelines w/ MRK given restructuring execution risk, our expectation of modest LT EPS gr. & expected volatility from Vioxx trials.
FUNDAMENTALS
P/E (12/06E) 15.4x
P/E (12/07E) 16.0x
TEV/EBITDA (12/06E) 12.1x
TEV/EBITDA (12/07E) 13.7x
Book Value/Share (12/06E) $9.00
Price/Book Value 4.0x
Revenue (12/06E) $21,072.0 mil.
Proj. Long-Term EPS Growth 0%
ROE (12/06E) 26.7%
Long-Term Debt to Capital(a) 13.6%
MRK is in the S&P 500(R) Index.
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (2/17/06) $36.05
Rating (Cur/Prev) 2M/2M
52-Week Range $36.05-$25.85
Target Price (Cur/Prev) $31.00/$31.00
Shares Outstanding(a) 2,208.1 mil.
Expected Share Price Return (14.0%)
Div(E) (Cur/Prev) $1.52/$1.52
Expected Dividend Yield 4.2%
Expected Total Return (9.8%)
VALUATION
We arrive at our $31 target price for Merck based on the average of two
valuation methodologies: 1) relative P/E ratios compared to the U.S. large-cap
drug industry, and 2) a residual earnings model. Our relative P/E value of $30
assumes Merck will trade at a 0%-5% discount with the 2007E drug multiple of
14.2x on our 2007 EPS estimate. We note this trading range is slightly higher
than Merck's historical mean of a ~10% discount to the drug multiple over the
past decade (range = 25% discount/15% premium). However, we believe that Merck
trading at roughly a 2007E drug multiple is appropriate given that it is now
more aligned with the industry's growth profile than it has been historically.
Applying our residual earnings model to Merck, we calculate a value of $32. Our
residual earnings model incorporates the company's current book value and
present values of the company's future residual earnings. We use our earnings
and dividend expectations through 2008 to estimate future residual earnings,
and discount our 2009 estimate to perpetuity. Our residual value is calculated
by adding the company's current book value to the present value of the future
residual earnings. We assume a constant growth rate of 4.25%, a required return
of 9%, which assumes a beta of 1.25, and a market risk premium of 3.9%. While
Merck has a 3-year beta of 0.67 (according to Bloomberg), the company's beta
has increased significantly in recent months as a result of the ongoing Vioxx
litigation. We note that following the first Vioxx ruling (Ernst versus Merck;
August 19, 2005), we observe a Merck beta of 1.58 (according to Bloomberg),
which is significantly higher than the company's historical beta. Based on this
recently observed increased volatility (associated with the Vioxx litigation),
we believe it is intuitively reasonable to assign Merck a beta of 1.25 (higher
than its historical average) to better capture the company's present risk
profile and expected volatility going forward.
RISKS
We rate Merck Medium Risk because of its strong balance sheet and cash-
generating ability (approximately $1.8 billion in free cash flow after the
dividend). However, we note Merck is exposed to a fair amount of generic risk
with 31% of its 2005 sales exposed to generic cannibalization over the 2005-
2010 time frame, due largely to the Zocor (June 2006) and Fosamax (February
2008) patent expirations, which could result in greater-than-expected margin
erosion. With respect to the Vioxx withdrawal, Merck faces approximately 9,650
product liability cases, which include roughly 19,100 plaintiff groups. We
expect Merck's caseload will continue to grow in the future, albeit at a slower
rate than before. At this time, we believe it is premature to establish an
estimate for Merck's Vioxx liability, given the lack of visibility in the
litigation. However, we note the litigation could put the dividend at risk
and/or result in reduced financial flexibility. We also note that Merck's
restructuring program includes a fair amount of execution risk. Mitigating the
above concerns are Merck's significant financial flexibility and resources. If
Merck's Vioxx product liability were diminished, the stock could appreciate
above our target price. Importantly, if the impact on the company from any of
these factors proves to be greater/less than we anticipate, it may cause the
stock to fall below our target price or could cause our target price to be
materially outperformed.
Investment risks related to the pharmaceutical industry include: ongoing
political risks, product development risks, regulatory risks, and various
pricing pressures.
INVESTMENT THESIS
We rate the shares of Merck Hold/Medium Risk (2M). Merck's earnings growth is
largely driven by four key franchises: its cholesterol franchise (Zocor, and
the Schering-Plough JV products Zetia and Vytorin), Fosamax for osteoporosis,
Cozaar/Hyzaar for hypertension, and Singulair for asthma/allergic rhinitis.
However, Merck's long-term EPS growth is pressured largely by rolling patent
expirations for Zocor in non-U.S. markets (2005 non-US sales of $1.2 billion),
which began in 2Q03; U.S. Zocor (2005 U.S. sales of $3.1 billion) losing
exclusivity in June 2006; and Fosamax losing exclusivity in February 2008.
Mitigating these challenges is improving visibility of the company's pipeline
and a major restructuring program (which is expected to yield $4.5-$5.0 billion
in savings from 2005-2010). Merck is expected to launch three vaccines in 2006
-- Gardasil (for cervical cancer), Zostavax (for shingles), and Rotateq (for
rotavirus). The company's next wave of product launches includes Januvia for
Type-II diabetes and MK-0524 for cholesterol reduction. All considered, we
expect Merck will return to earnings growth in 2008 and estimate the company's
2005-2010E EPS CAGR to be 2%. Potential product liability charges from the
global withdrawal of Vioxx due to cardiovascular safety risks will also create
stock volatility. Despite these challenges, we believe downside should be
limited given Merck ~5% dividend yield. Accordingly, we rate Merck Hold.
I, George Grofik, research analyst ... |
