Citi: MRK: NJ VIOXX VERDICTS MODESTLY NEGATIVE
HOLD (2)
Medium Risk (M)
Mkt Cap: $79,469 mil.
April 6, 2006 SUMMARY
* On Apr. 5, a NJ jury reached mixed verdicts in 2 Vioxx prod. liability cases. In both cases, the jury found MRK failed to warn consumers about Vioxx's safety risks. In only 1 case, the jury ruled Vioxx was a substantial contributing factor in causing the pntf's injury; $4.5 MM in compensatory damages were awarded.
* We believe this outcome is modestly negative for MRK. The plaintiffs (1) successfully argued MRK failed to warn in both cases; (2) won a case in which pntf. had multiple co-morbidities; (3) received high compens. damages. On the positive, MRK won a long-term use case against Mark Lanier (widely considered a persuasive trial attorney).
* We remain comfortable with our $2-$10 bill. Vioxx liability est. We emphasize the litigation tracks slightly higher than our base case, but the sample size remains exceptionally small (n=5; 20K+ cases). With multiple LT use cases to be tried in the coming months, we look to become opportunistic with the stock on Vioxx litigation-related pullbacks. Maintain Hold and $37 price target.
FUNDAMENTALS
P/E (12/06E) 15.4x
P/E (12/07E) 16.0x
TEV/EBITDA (12/06E) 12.1x
TEV/EBITDA (12/07E) 13.6x
Book Value/Share (12/06E) $9.00
Price/Book Value 4.0x
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 (4/5/06) $35.99
Rating (Cur/Prev) 2M/2M
52-Week Range $36.23-$25.85
Target Price (Cur/Prev) $37.00/$37.00
Shares Outstanding(a) 2,208.1 mil.
Expected Share Price Return 2.8%
Div(E) (Cur/Prev) $1.52/$1.52
Expected Dividend Yield 4.2%
Expected Total Return 7.0%
OPINION
On April 5, a state court jury reached mixed verdicts in the New Jersey Vioxx
product liability consolidated proceedings, which involved the plaintiffs Cona
and McDarby. In both cases, the jury found that MRK failed to warn consumers
about Vioxx's safety risks. However, only in the McDarby case, the jury ruled
that Vioxx was a substantial contributing factor in causing the plaintiff's
heart attack. Accordingly, the court held MRK liable for $4.5 million in
personal-injury damages ($3 million for McDarby, $1.5 million for his wife); no
damages were awarded to Cona. The second phase of the trial to assess
McDarby's punitive damages is scheduled to begin on April 6. Interestingly,
the jury also found that MRK violated NJ state consumer fraud laws in both the
Cona and McDarby cases, although damages for this verdict are not material.
MRK will almost certainly appeal the court's verdicts.
We believe this outcome is modestly negative for MRK. The plaintiffs (1)
successfully argued MRK failed to warn consumers in both the Cona and McDarby
cases; (2) won a case in which the plaintiff had multiple co-morbidities and
risk factors; and (3) received high compensatory damages for McDarby. On the
positive for MRK, it was able to win a long-term use case against Mark Lanier,
who is widely considered to be a persuasive trial attorney. We also point out
that state court cases are more plaintiff friendly than cases litigated in the
Federal MDL (4,350 Federal MDL cases and 4,200 NJ state cases as of December
31, 2005).
In the context of our Vioxx liability model, our base case assumes MRK could be
held liable in 55% of the total long-term use cases (18+ months) and 20% of the
long-term use Vioxx cases in which the plaintiffs have multiple co-morbidities
(30% at the high end). Including today's verdicts, the Vioxx litigation is
tracking slightly higher than our base case, although we emphasize the sample
size remains exceptionally small (n=5 out of over 20,000+ cases filed). MRK
has now lost one out of two long-term use cases and two out of five cases that
went to trial in the overall litigation. As a reminder, leading plaintiff
attorneys in the Vioxx litigation stated at our March 1 Vioxx litigation panel
that they would be satisfied with the litigation if they win "two out of 10
cases." The plaintiff attorneys also noted that at least 5-10 more cases will
be needed to get a strong sense for how this litigation will ultimately play
out (implying volatility for the stock for at least the balance of the year).
Bottom Line: We remain comfortable with our $2-$10 billion Vioxx liability
estimate and $5 billion base case. We make no changes to our model given the
exceptionally small sample size of cases. That said, we maintain our Hold
rating on MRK shares with a $37 price target. 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, 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).
VIOXX LIABILITY SENSITIVITY ANALYSIS
Our Vioxx product liability model estimates MRK could pay out approximately $2
billion to $10 billion in this litigation, with a base case of approximately $5
billion liability (see Figure 1 below and our March 5 note). 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. We also
include estimates for the third-party insurer and securities litigation cases
as well as considerable legal fees.
Plaintiff attorneys we've spoken with expect MRK will face a total of
approximately 30,000 cases in the Vioxx litigation (as of December 31, MRK
faced 19,100 cases). They expect Vioxx cases to be 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. We expect a flurry of cases to be filed
by September 2006, because of the expiration of the NJ statute of limitations.
Additionally, 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.
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 one case per month). We would also be remiss if we didn't
highlight that a Vioxx return to the marketplace would be a setback for
plaintiff attorneys.
VIOXX LITIGATION TIMELINE:
Time Frame Event
June Doherty and Klug consolidated case in NJ (Atlantic County,
June 5th)
1st California MDL consolidated case (Los Angeles County,
June 21st)
July Barnett case in Louisiana (Federal MDL case, July 24th)
Kozic case in Florida (Hillsborough County, July 31st --
August 25th trial docket)
August Anderson case in Tribal Court of Mississippi Band of
Choctaw Indians (Aug. 7th)
September Smith case in Louisiana (Federal MDL case, September 11th)
Hatch and McFarland consolidated case in NJ (Atlantic
County, September 11th)
October Crook case in Alabama (Jefferson County, October 26th)
Mason case in Louisiana (Federal MDL case, October 30th)
November Miller case in Texas (Harris County, November 8th)
Dedrick case in Louisiana (Federal MDL case, November
27th)
December Slatton case in Alabama (Jefferson County, December 11th)
Source: Vioxx MDL-1657, Monthly Pretrial Conference Minute Entries.
Figure 1: Vioxx Liability Model-Sensitivity Analysis
VALUATION
Our $37 target price for Merck is based on the average of two valuation
methodologies: 1) relative price/earnings (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 to
the 2007E drug multiple of 14.4x on our 2007 EPS estimate. We note this trading
range is higher than Merck's historical mean of an ~10% discount to the drug
multiple over the past decade (range: 25% discount to a 15% premium). However,
we believe a premium to the 2007E drug multiple for Merck shares is
appropriate, given its increasingly promising pipeline, encouraging
restructuring program ($4.5--$5 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. We assume a constant growth rate
of 4.25%, a required return of 8.4%, which assumes a beta of 1.10, and a market
risk premium of 3.9%. While Merck has a three-year beta of 0.68 (according to
Bloomberg), we note that it has increased significantly in recent months as a
result of the ongoing Vioxx litigation. Following the first Vioxx ruling (Ernst
versus Merck, August 19, 2005), we observe a Merck beta of 1.63 (according to
Bloomberg), 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.
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 that 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, largely due 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 the company's caseload will continue to grow in the future, albeit at
a slower rate than before. Additionally, we note 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 prevent the stock
from achieving our target price or could cause our target price to be
materially outperformed.
Investment risks related to the pharmaceutical industry include ongoing
political, product development, and regulatory risks, as well as various
pricing pressures.
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 joint venture 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 largely pressured 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 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's ~4% dividend yield. Accordingly, we rate Merck Hold.
ANALYST CERTIFICATION APPENDIX A-1
I, George Grofik, research analyst and the author of this report, hereby
certify ... |
