Citigroup : MRK: VIOXX LIABILITY HIGHLY MANAGEABLE; KEY PANEL
TAKEAWAYS
HOLD (2)
Medium Risk (M)
Mkt Cap: $77,703 mil.
March 5, 2006 SUMMARY
* On March 1, we hosted a Vioxx litigation panel, which included two prominent plaintiff attorneys & one defense attorney. Our panelists: (1) generally agreed MRK will face ~30K cases in total (far less than Judge Fallon's expectation of up to 100K); (2) estimated 35%-40% of the cases were for short-term use; (3) noted that up to 5% of cases were "clean" (w/ few co-morbidities).
* In light of our important panel findings, we introduce our Vioxx litigation model and estimate MRK's liability to be ~$2 to $10 bill (base case of $5 bill). Accordingly, we believe MRK's total exposure appears highly manageable (and dividend secure), especially if the costs are distributed over several years.
* That said, we maintain our Hold rating on MRK shares, but raise our price target to $37 to incorporate a higher degree of comfort with this litigation. With multiple long-term use cases to be tried in the coming months, we would look to become opportunistic w/ the stock on Vioxx litigation related pullbacks.
FUNDAMENTALS
P/E (12/06E) 15.0x
P/E (12/07E) 15.6x
TEV/EBITDA (12/06E) 11.8x
TEV/EBITDA (12/07E) 13.3x
Book Value/Share (12/06E) $9.00
Price/Book Value 3.9x
Revenue (12/06E) $21,135.0 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 (3/3/06) $35.19
Rating (Cur/Prev) 2M/2M
52-Week Range $36.05-$25.85
Target Price (Cur/Prev) $37.00/$31.00
Shares Outstanding(a) 2,208.1 mil.
Expected Share Price Return 5.1%
Div(E) (Cur/Prev) $1.52/$1.52
Expected Dividend Yield 4.3%
Expected Total Return 9.5%
OPINION
On March 1, we held a Vioxx litigation panel at our annual Citigroup Healthcare
Conference. Our panelists included two prominent plaintiff attorneys in the
Vioxx litigation (one of whom co-leads the Federal MDL and NJ Vioxx
litigation), as well as one defense attorney. The defense attorney does not
represent MRK in the Vioxx litigation, but he has years of experience in
product liability litigation. Our defense attorney panelist offered his
opinion on MRK's position based on publicly available information and
discussions with MRK counsel.
Our panelists were generally in agreement that MRK will face approximately
30,000 Vioxx cases in total, which is far less than Judge Fallon's expectation
of potentially up to 100,000 lawsuits. They also noted that short-term use
cases (in which patients used Vioxx for less than 18 months) represented about
35%-40% of the total cases in the litigation. One plaintiff attorney (who is
handling more than 1,000 Vioxx cases) added that there were up to 5% "clean"
cases with few co-morbidities in his caseload.
We estimate MRK liability to be $2 billion to $10 billion, with a base case of
$5 billion.
In light of our important panel findings, we introduce our Vioxx product
liability model and estimate MRK's liability to be approximately $2 to $10
billion in this litigation; our base case assumes a $5 billion liability (see
Figure 1). Our model calculates the estimated Vioxx product liability using
several parameters: (1) total number of cases; (2) duration of Vioxx use, (3)
number of risk factors; (4) probability of success, and; (5) payout rate.
While our model is a "best guess" estimate, we believe it offers investors a
useful range of scenarios for the Vioxx liability based on what we believe is
the best information available. We note that our estimates may even have an
inherent upward bias since many of the key inputs to our model are derived from
plaintiff attorneys.
The attorneys noted that at least 6-10 more cases will be needed to get a
strong sense for how this litigation will play out
Bottom Line: While the Vioxx litigation remains in its early stages, the
plaintiff attorneys noted that at least 6-10 more cases will be needed to get a
strong sense for how this litigation will ultimately play out (after 3
cardiovascular injury related trials, MRK has prevailed in 2, and lost 1).
However, we believe MRK's total exposure in this litigation appears highly
manageable based on our Vioxx product liability model (which incorporates key
plaintiff attorney insights).
We look to become opportunistic with MRK shares.
That said, we maintain our Hold rating on MRK shares, but raise our price
target to $37 (from $31) to incorporate a higher degree of comfort with this
litigation (and to reflect relative drug P/Es drifting higher). We believe
MRK's pipeline appears increasingly promising with potentially several product
launches in 2006-07 (Gardasil, Rotateq, Zostavax, Januvia), which should
largely offset the loss of sales from blockbuster patent expirations (Zocor in
June 2006; Fosamax in February 2008). With multiple long-term use cases to be
tried in the coming months (April NJ state court case may be challenging -- see
section "Upcoming Cases"), we would look to become opportunistic with the stock
on Vioxx litigation related pullbacks. As for our sector view, we continue to
believe US Drug stocks will experience a trading rally in 1H06 (please see our
October 4, December 18, January 12 notes).
KEY PANEL TAKEAWAYS
The panelists expect MRK will face a total of approximately 30,000 cases in the
Vioxx litigation (as of December 31, MRK faced 19,100 cases). The panelists
stated that Vioxx cases are being filed at a steady trickle, and they noted
there was not as much activity at the grassroots level to take in these cases
as was seen previously. One attorney noted that he expects a flurry of cases
to be filed by September 2006, because of the expiration of the NJ statute of
limitations. We note that a similar spike in filings occurred when the statute
of limitations expired in the diet drug litigation. However, another attorney
pointed out that he didn't expect a flurry of cases because there hadn't been
the same level of 3rd and 4th round advertising by plaintiff attorneys for
these cases. Nevertheless, the panel was generally in agreement that MRK will
face approximately 30,000 Vioxx cases in total, which is far less than Judge
Fallon's expectation of potentially up to 100,000 lawsuits.
Short-term use cases represent approximately 35%-40% of the total Vioxx cases.
One prominent plaintiff attorney, who has more than 1,000 Vioxx cases, stated
that approximately 35%-40% of his cases are short-term cases (in which Vioxx
has been used for a period of less than 18 months). He added that the majority
of the New Jersey cases involved long-term use cases (in which Vioxx has been
used for a period of more than 18 months). The low proportion of short-term
use cases likely stems from plaintiff attorneys screening for cases with a
potentially higher likelihood of success.
Approximately 5% of the total number of cases may be "clean", with few or no
co-morbidities. Out of a possible 30,000 cases, one prominent plaintiff
attorney stated that one could expect 1,000-1,500 "clean" cases that involve
few or no confounding factors.
The plaintiff attorneys noted they would be satisfied if they win "2 out of 10
cases". In our Vioxx liability model, our base case assumes a win rate of
approximately 20%. Interestingly, regarding win rates, the plaintiff attorneys
also noted that cases after the label change in April 2002 were less robust
than cases prior to the label change. The plaintiff attorneys also felt
disadvantaged in the NJ state court cases because: (a) MRK is litigating in its
NJ "backyard" (many residents work for MRK in the state); (b) the debate over
tort reform is negatively changing attitudes toward plaintiff attorneys; (c)
there is no "voir dire" privilege in NJ, which means attorneys have limited
interaction with potential jurors in the jury selection process.
OTHER VIOXX LITIGATIONS: THIRD PARTY PAYERS AND SECURITIES CLASS ACTION
LAWSUITS
The third-party payer class-action lawsuit is underappreciated by the Street.
One panelist stated that Wall Street had not given much attention to the
lawsuit against MRK filed by third-party payers. He underscored that if MRK
were to lose this case it may cost them several billion dollars. However,
another attorney pointed out that these types of fraud cases are typically
difficult to prove, even though they don't involve causation (in contrast to
product liability cases). Importantly, the class action lawsuit has been filed
in New Jersey, which is considered to have the most liberal interpretation of
the law in these cases.
We don't expect the securities class-action lawsuit to have a meaningful
financial impact on MRK. One attorney noted that the securities class action
litigation would not be of significant financial consequence for MRK. He
pointed out that BMY's recent Vanlev settlement of $185 MM was the largest
payout in comparable litigation (which would exclude outliers like Enron or
Worldcom). However, another panelist noted that Edward Scolnick's (MRK's R&D
head in 2000) internal emails could be damaging to the case for MRK because he
was a board member at the time.
SETTLEMENT PROSPECTS
We believe a settlement will likely occur after a representative sample of
cases has been tried, despite Merck's comments to the contrary. While MRK has
stated it would try every case, this strategy conflicts with the goal set forth
by the Federal MDL and New Jersey consolidated proceedings. Regarding the
Federal MDL, Judge Fallon stated, "I will sit with both sides and make some
sense out of what the juries have been doing with these cases. Hopefully, out
of that discussion will come some programs to resolve the entire litigation
without the necessity of trial in every particular case. That's the aim of the
MDL, or at least one aim of the MDL."
In the New Jersey consolidated proceedings, Judge Higbee commented, "There's
going to be a point, if we actually have to try every case, where we're going
to have to take some drastic measures to get every case tried"; Higbee added
that she would get other New Jersey judges involved and go to the head judge
and "tell him I need 50 judges from the state, and I need 50 Vioxx trials to
start the same day". We also note that Judge Higbee has been scheduling more
long-term use (18 months or more) cases, which should be more difficult for MRK
to win.
We believe that these pressures in the Federal MDL and New Jersey litigation
will push MRK to consider a settlement, even though the company will argue that
it is entitled to due process. However, if MRK were to continue litigating
every case, its legal resources would be spread thin and star witnesses like
Dr. Alise Reicin would not be able to represent MRK everywhere, which could
translate to more losses in court. Additionally, the legal fees associated
with litigating 50 cases simultaneously would likely increase substantially (vs
the current run rate of approximately 1 case per month).
IMPACT OF A VIOXX RETURN
In our opinion, a Vioxx return to the marketplace would be a setback for
plaintiff attorneys. Our plaintiff attorneys had difficulty admitting that a
Vioxx return to the marketplace would be an important setback, but they
recognized that this would be "one more thing to deal with". One panelist
stated that he couldn't see Vioxx back on the market because he felt there was
no need for the product, which limits the potential threat to the plaintiff
attorneys' cases. As a reminder, in February 2005, an FDA advisory panel voted
that Vioxx has a favorable risk/benefit profile.
UPCOMING CASES
* Cona and McDarby (February 27th): Mark Lanier, who won the first and only
Vioxx case in favor of the plaintiff(s), will be representing Thomas Cona.
Mr. Cona is a 59-year-old New Jersey businessman who used Vioxx for 22 months
prior to suffering a heart attack. The other plaintiff in this consolidated
New Jersey case is 77 year old John McDarby, who claims he took Vioxx for
four years and then suffered a heart attack (after which he fell and broke
his hip). One MRK attorney we spoke with noted that Cona had high
cholesterol and used Vioxx intermittently; he added that McDarby was a
diabetic, former smoker, and suffered from hypertension.
* McFarland (April 24th): One plaintiff attorney at our panel, who will be
representing Mr. McFarland, said that he was very comfortable with this case.
McFarland used Vioxx for 19 months and has little or no risk factors
(according to the plaintiff attorneys). He was 51 years old when he suffered
the injury and was a New Jersey police officer. This case will be litigated
in a New Jersey consolidated proceeding.
TIMELINE UPDATE
Time Frame Event
March Cona and McDarby consolidated case in NJ (Atlantic County,
February 27th)
April Guerra case in Texas (Hidalgo County, April 17th)
Hatch, McFarland, & LoPresti consolidated case in NJ
(Atlantic County, Apr. 24th)
May Kozic case in Florida (Hillsborough County, May 1st)
June Borowicz case in Louisiana (2nd Federal MDL case, June
12th)
1st California MDL consolidated case expected (Los Angeles
County, June 21st)
Doherty and Klug consolidated case in NJ (Atlantic County,
June 5th)
August Anderson case in Tribal Court of Mississippi Band of
Choctaw Indians (Aug. 7th)
Source: Vioxx MDL-1657, Monthly Pretrial Conference Minute Entry (February 2,
2006) and Mealey's Vioxx Litigation Conference.
VIOXX LIABILITY SENSITIVITY ANALYSIS
In light of our important panel findings, we introduce our Vioxx product
liability model and estimate MRK may pay out approximately $2 - $10 billion in
this litigation; our base case assumes a $5 billion liability (see Figure 1).
Our model calculates the estimated Vioxx product liability using several
parameters:
* Total number of cases;
* Duration of Vioxx use;
* Number of risk factors;
* Probability of success, and;
* Payout rate
We also include estimates for the third party insurer and securities litigation
cases as well as considerable legal fees. While our model is a "best guess"
estimate, we believe it offers investors a useful range of scenarios for the
Vioxx liability based on what we believe is the best information available. We
note that our estimates may even have an inherent upward bias since many of the
key inputs to our model are derived from plaintiff attorneys.
Figure 1: Vioxx Liability Model-Sensitivity Analysis
Figure 2: Vioxx Litigation Tracker
OTHER CITIGROUP VIOXX LITIGATION RELATED NOTES
* November 9, 2004, "MRK: Vioxx Litigation In Focus; Downside Limited But Still
on the Sidelines"
* April 12, 2005, "MRK: Vioxx Litigation Panel Takeaways" (from Citigroup
Healthcare Conference)
* June 27, 2005, "MRK: Insights from the Vioxx Litigation Conference"
* August 21, 2005, "MRK Loses First Vioxx Trial; One Down, Several Thousand To
Go..."
* November 3, 2005, "MRK: Vioxx Win in NJ; Two Down, Several Thousand To Go..."
* December 8, 2005, "MRK: More Negative Vioxx Headlines"
* December 13, 2005, "MRK: Highlights from Plaintiff Attorney Conference"
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.
VALUATION
We raise our price target to $37 from $31 based on our higher degree of comfort
with the Vioxx litigation as well as relative drug P/Es drifting higher. Our
$37 target price (previously $31) for Merck is 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 $35 assumes Merck will trade at a 5%-10% premium
(previously 0%-5% discount) with the 2007E drug multiple of 14.3x on our 2007
EPS estimate. We note this trading range is 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 a premium to the 2007E drug
multiple for Merck shares is appropriate given its increasingly promising
pipeline, encouraging restructuring program ($4.5-$5.0 billion in savings
expected from 2005-2010), and our belief that the Vioxx liability is highly
manageable.
Applying our residual earnings model to Merck, we calculate a value of $39. 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 2009 to estimate future residual earnings,
and discount our 2010 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 8.4% (previously 9%), which assumes a beta of 1.10 (previously 1.25), 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 versus Merck; August 19, 2005), we observe a Merck beta of
1.63 (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 1.10 (higher than its historical average) to better
capture the company's present risk profile and expected volatility going
forward. We have lowered Merck's beta to 1.10 from 1.25 to recognize our
belief that the Vioxx liability is highly manageable.
RISKS
We rate Merck Medium Risk because of its strong balance sheet and cash-
generating ability (approximately $2 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). Additionally, we 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 further, 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.
I, George Grofik, research analyst and the author of this report, hereby... |
