Citigroup MRK: Solid 4Q05 EPS
January 31, 2006
HOLD (2)
Medium Risk (M)
Mkt Cap: $76,091 mil.
SUMMARY
* On January 31, MRK reported 4Q05 EPS of $0.64, which was $0.03 higher than our estimate and $0.02 above the consensus.
* MRK included a $295 MM (~$0.09) Vioxx litigation reserve in its earnings, which was not reflected in the consensus estimate. However, non-op. income. experienced a positive +$275 MM variance vs our ests. (~$0.09), due largely to higher than anticipated interest income and equity income from affiliates.
* MRK maintained its 2006 EPS guidance in the range of $2.28-$2.36 (excluding restructuring charges), and reiterated all components of its financial guidance.
* With respect to the Vioxx litigation, we note that the caseload increased by +450 (to 9,650) cases since the company's last update on December 15, 2005.
* Bottom Line: Overall, 4Q05 EPS were solid. However, we continue to stay on the sidelines with the stock given restructuring execution risk, our expectation of modest long-term EPS growth, and the Vioxx litigation overhang.
FUNDAMENTALS
P/E (12/06E) 14.7x
P/E (12/07E) 15.3x
TEV/EBITDA (12/06E) NA
TEV/EBITDA (12/07E) NA
Book Value/Share (12/06E) NA
Price/Book Value NA
Revenue (12/06E) $20,887.0 mil.
Proj. Long-Term EPS Growth 0%
ROE (12/06E) 26.1%
Long-Term Debt to Capital(a) 13.1%
MRK is in the S&P 500(R) Index.
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (1/30/06) $34.46
Rating (Cur/Prev) 2M/2M
52-Week Range $34.93-$25.85
Target Price (Cur/Prev) $31.00/$31.00
Shares Outstanding(a) 2,208.1 mil.
Expected Share Price Return (10.0%)
Div(E) (Cur/Prev) $1.52/$1.52
Expected Dividend Yield 4.4%
Expected Total Return (5.6%)
OPINION
* Revenues of $5,766 MM were flat year/year, but were $154 MM higher than our
estimates (+3% variance), despite a -1% FX drag. MRK included a $295 MM
Vioxx litigation reserve (translates to ~$0.09) in its 4Q05 EPS, which was
not reflected in the consensus estimates. However, non-operating income
experienced a positive +$275 MM variance relative to our estimates
(translates to ~$0.09), due largely to higher than anticipated interest
income and equity income from affiliates. We note MRK's 4Q05 EPS excluded a
$0.12 charge related to the global restructuring program and a ~$0.01 tax
charge pertaining to foreign earnings repatriation. MRK has repatriated
$15.9 billion, which was $900 MM more than it had anticipated (as a result of
favorable IRS guidance).
* Global Restructuring Update: MRK announced it had eliminated approximately
1,100 positions (out of 7,000 expected terminations), as of YE2005.
* Key Products (MM): Zocor sales of $1,074 (-18%year/year; -1% variance) were
impacted by the introduction of generic simvastatin (ex-US), in addition to
continued uptake of generic lovastatin. Fosamax revenues of $789 (-7%
variance) sales declined -5% year/year due to the availability of generic
alendronate in several key markets (ex-US). Proscar sales of $192 (-1%
year/year; -9% variance) fell below our expectations. Singulair revenues of
$819 (+8% variance) and Arcoxia $55 (+22% variance) were both above our
estimates, while Cozaar/Hyzaar sales $782 (-2% variance) were in-line with
our forecast.
* Pipeline Update: Januvia (sitagliptin), a DPP-IV inhibitor for type II
diabetes remains on track for an NDA filing in 2006; MK-518 (for HIV) study
data in the treatment-naive patient population is expected to be presented in
1H06. MRK stated that it is in discussion with more than 40 companies
regarding potential in-licensing transactions.
* Guidance update: MRK maintained its 2006 EPS guidance in the range of $2.28-
$2.36 (excluding restructuring charges), and the company reiterated all
components of its financial guidance. The company also provided 1Q06 EPS
guidance in the range of $0.62-$0.66 (excluding restructuring charges related
to site closures and position eliminations). We also note that $7.5 billion
(previously $7.7 billion) remains under current buyback authorizations (as of
December 31, 2005).
* Vioxx Litigation Update: MRK is now facing approximately 9,650 product
liability lawsuits (including approximately 19,100 plaintiff groups), which
is an increase of 450 cases since its last update on December 15.
Additionally, MRK also increased its reserves by $295 MM for future Vioxx
legal costs (the reserve was at $685 MM as of December 31, which MRK believes
will be spent through 2007). In 2005, MRK stated it spent $285 MM in
aggregate on worldwide Vioxx legal expenses. As a reminder, the Garza vs.
Merck case is ongoing in Texas and the next scheduled case is the re-trial of
Plunkett vs. Merck (1st Federal MDL case) on February 6 in New Orleans).
Table 1: Variance Analysis
NVESTMENT 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 (non-US sales of $1.2 billion in
2005) which began in 2Q03; U.S. Zocor (2005 U.S. sales of $3.1 billion) losing
exclusivity in mid-2006; and expected sluggish U.S. scrip trends for Fosamax
due to new competitive entrants. Fosamax is also anticipated to lose
exclusivity in February 2008. Mitigating these challenges is improving
visibility of the company's pipeline. Merck is expected to launch three
vaccines in 2006 -- Gardasil, Zostavax, and Rotateq. All things 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 its ~5% dividend yield, and we rate Merck a Hold.
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 14.1x 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). Moreover, 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 target price 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 4.2%, a required return
of 9%, which assumes a beta of 1.35, and a market risk premium of 3.9%. While
Merck has a 3-year beta of 0.68 (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 vs. Merck;
August 19, 2005), we observe a Merck beta of 1.61 (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 1.35 (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 $2 bn in free cash flow after the dividend).
However, we note Merck is exposed to a fair amount of generic risk with 29% 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 Vioxx, 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. 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. Additionally, new
competition from Sanofi-Aventis' once-weekly Actonel and
GlaxoSmithKline/Roche's once monthly Boniva has pressured Fosamax scrips.
Investment risks related to the pharmaceutical industry include: ongoing
political risks, product development risks, regulatory risks, and various
pricing pressures. 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.
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 price target.
I, George Grofik, ... |
