Dueling Fools We Can Merck It Out
Merck Bear's Den
by Chris Rugaber (tmfrfk@aol.com)
Merck is a great company, but like a veteran
athlete it is past its prime and living off nostalgia.
Its past performance has been fantastic, but
that's exactly what limits its future: everything has
to fall in place in order for Merck to just keep
up.
The primary challenge the company faces is the
pending loss of patents on five of its most
lucrative drugs. While this is a predictable
criticism that has been leveled at Merck before,
it is still a legitimate concern, especially when one
considers Merck's relatively low level of
research and development (R&D) spending.
Meanwhile, other Merck products are facing
increasingly effective competition, its margins are
declining, and its pharmaceutical benefits
manager, Medco, is unlikely to sustain its recent
growth. Given Merck's high valuation, all this
combines to make an overpriced, overly risky
stock.
Let's take these in turn. First, there are five
Merck products -- Prilosec, Vasotec, Pepcid,
Mevacor, and Prinivil -- that are losing their
patent protection between February 2000 and
December 2001, representing over $6.3 billion in sales. (Remember those
names -- there'll be a quiz later). Merck's newest drugs will not be able to
fully replace the revenue: Propecia, for hair-loss replacement; Maxalt, for
migraines; Singulair, an asthma drug; Aggrastat, an anti-coagulant; Vioxx,
an anti-arthritic pain reliever, and Cosopt, for treatment of glaucoma, will
be lucky to generate $3.5 billion in sales by 2001. You do the math.
Second, one has to wonder what Merck's management was thinking,
since patent expirations are not exactly hard to predict. They must have
seen this coming, yet their R&D expenditures are low for the
pharmaceutical industry. In 1997, they spent $1.68 billion for R&D,
which is a lot of money but only 7.1% of that year's $23.6 billion in sales.
Pfizer (NYSE: PFE) spent $1.93 billion, out of $12.5 billion in sales. In
percentage terms, Pfizer's R&D was 15.4% of sales, more than twice
Merck's. And Merck's R&D as a percent of sales has actually declined --
in 1995, the company spent 8% of sales on research.
What's really noteworthy is that despite Pfizer's significantly higher R&D
spending, its margins are also higher: a 26.8% operating margin in 1997 to
Merck's 24.8%, and an 81.8% gross margin compared to Merck's
50.1%. In addition, Merck's gross margin has been declining in recent
years -- it was 55.3% in 1995.
Merck's other major products aren't losing their patents, but it is losing
market share as their rivals develop competing, and in some cases better,
drugs. The Food and Drug Administration (FDA) has sped-up its
approval process, and improved technologies have quickened the
development of new compounds. As a result, Merck's
cholesterol-reducing drug Zocor, a major powerhouse that brought in
almost $3.6 billion in world-wide revenue in 1997, got clobbered this year
by Warner-Lambert's (NYSE: WLA) Lipitor, which was marketed by
Pfizer and won accelerated approval by the FDA and now has 31%
market share to Zocor's 24.5%.
In the same vein, Merck's Crixivan was the first of the new, powerful
AIDS drugs known as protease inhibitors. Crixivan produced $582
million in revenue in 1997, but it's now facing major competition from
Agouron's (Nasdaq: AGPF) Viracept, which is not only equally effective
but requires less-frequent dosing (a significant concern for AIDS patients
who sometimes have to take as many as 20 pills a day).
Even Merck's potential future powerhouse, the pain reliever and arthritis
drug Vioxx, which is supposed to be kind of a "super-Advil," will face
competition the minute it hits the market from a drug developed by
Monsanto (NYSE: MTC) and marketed by Pfizer. Merck is counting on
Vioxx to replace much of the revenue it will lose from patent expirations,
and it apparently is a significant advance in its field, but given the
competition, it's no Viagra.
Of course, Merck is not just a drug-maker. Its pharmaceutical benefits
manager, Medco, provides 40% of its income and has contracts with a
wide range of managed-care plans. But few people have considered
whether the growth of this unit can last. In 1997, Merck-Medco posted
revenue of $9.44 billion, a 32% increase over 1996's $7.16 billion, which
in itself was a 25% jump over 1995. Yet in the first two quarters of '98,
Medco's revenues increased barely 20% over the year-earlier period.
While 20% is nothing to sniff at, this slowdown in growth is not surprising.
Medicare has been shoving its recipients into managed care but doesn't
have many more to add, and managed care growth overall can only slow
now that most people are in some kind of managed care plan. As a result,
Merck is unlikely to see the kind of growth in this division that it has
previously.
Of course, this is not to overstate the case: Merck still has plenty going for
it. Unfortunately, that includes a hefty price tag. While it's cheaper than
other pharmaceutical stocks, that's not saying much given the multiples we
see for companies like Pfizer. As of this writing, Merck is trading at
approximately 27 times 1999 earnings, and since earnings growth is very
likely to slow from 16% to as low as 8% two or three years from now,
such a multiple hardly seems justified.
Especially when one considers the field Merck is in -- it competes with a
lot of great companies. As a result, it should be judged by very exacting
standards. Here in Fooldom, for example, between the Cash-King
Portfolio and the Drip Portfolio, the Fool portfolios have purchased three
pharmaceutical companies, none of them Merck (the three are Johnson &
Johnson, Pfizer, and Schering-Plough). Given that Merck may soon see
growth slip into the single digits, perhaps other investors should follow our
portfolios' example.
Merck Bull's Rebuttal
by Paul Larson (tmfparlay@aol.com)
Let me start by saying that my associate's
concerns about patent expirations are valid, albeit
overblown. There are some important mitigating
factors to consider. First is the consideration that
the company is only losing its patents in the
United States in that timeframe. Other countries,
Canada being one of many, give drugs
significantly longer periods of time in which the
products are under patent protection. Plus, just
because the drugs are going off patent does not
mean that revenue from their sale completely
disappears; only the company's monopoly
evaporates. There are measures available to
ensure continued sales that the company can
initiate, granted in all likeliness they include lower
prices.
It's ironic, but the "patent expiration" argument
would have been just as valid three, five, or ten
years ago. Buying into the theory would have left
those investors out of significant gains in the
stock. The modus operandi of the drug industry
has always been, "Out with the old, in with the
new." Anyone remember Diuril, Aldomet, or
Clinoril? There is a long list of Merck's
compounds that have already gone off-patent or
have been replaced with drugs of higher efficacy, yet the company has
been able to maintain its impressive growth.
Not only are some of Merck's newest products, such as Singulair and
Fosamaxx, showing vibrant growth, but the company also has nearly three
years with which to research and introduce new compounds. Chris states
that one of these drugs in the pipeline named Vioxx, "is no Viagra." He's
right. It could be much larger. The market for an aspirin-like substance that
does not cause gastric ulceration absolutely eclipses the smaller but
higher-profile impotence market.
The speedier FDA approval process was mentioned in the bearish
argument as an advantage for Merck's competitors. Allow me to counter
that it also allows Merck on their competitors' turf with new drugs faster,
too. In other words, this is a factor that flows both ways. On the
competitive front it is a wash, but companies across the board, Merck
included, benefit from the quicker time to market.
Chris goes on to make a big deal about Merck's supposed lack of R&D
spending as a percentage of revenue. Errrr, try again. Sure, Merck's R&D
expenditures as a percentage of total revenues sat at 7.1% last year, but
my associate is forgetting one key point when attempting this analysis.
Merck gets a significant amount of revenue from its Medco managed care
subsidiary, and Medco is more like an insurance company than a
pharmaceutical company. In other words, to get a true apples-to-apples
comparison of R&D spending you need to back out the revenue generated
from Medco. This is not at all insignificant since 40% of the top line was
contributed by Medco in 1997.
Look at Merck's R&D spending as a percentage of pharmaceutical
revenue and the picture looks a bit more logical.
6-mo 1998 1997 1996 1995
Drug Sales $7.040B $14.197B $12.671B $10.964B
R&D Spending $0.830B $1.684B $1.487B $1.331B
R&D % Spending 11.8% 11.9% 11.7% 12.1%
Chris then said, "Zocor... got clobbered this year by Lipitor." Oh really?
How does Chris explain the fact that Zocor's sales are actually increasing
with 10% growth between the second and third quarter of this year?
Zocor's sales were actually $990 million last quarter versus $803 million in
the first quarter. If that's what Chris calls getting clobbered, I hope he
shows me some other businesses that use this definition!
It doesn't stop there. Chris then insinuates that Crixivan's sales are also
declining due to competition from Viracept. Look to the numbers and yet
again we find Chris off the mark. In the most recent quarter, sales of
Crixivan actually rose 17% versus the second quarter. This is not versus
the previous year but is quarter-over-quarter growth, mind you.
My associate then goes on to compare Merck's margins to those of Pfizer.
I don't know about you, but I'll gladly give up 2 percentage points of
operating margin (especially when they're both in the high-20's) when I can
buy Merck at roughly half the multiples of sales, earnings, cash flow, and
book value as well as double the dividend yield. Pfizer is a great company
without a doubt, but Merck is not exactly a slouch. More importantly, the
valuation price tag Merck carries is much less expensive than its peers.
Since my opponent here likes to take things out of context and warp them
for his use, let me leave you with these quotes...
"Merck is a great company."
"Merck still has plenty going for it."
--Chris Rugaber
Dueling Fools, Nov. 1998
Merck Bear's Rebuttal
by Chris Rugaber (tmfrfk@aol.com)
If Merck is like an aging veteran athlete past his
prime, Paul Larson is the old guy in the stands
reminiscing about all the athlete's glory years,
while his grandchildren wonder if that recent
knee injury just might be a problem.
Merck is certainly cheaper than its
pharmaceutical industry cohorts, but there are
reasons for that, most of them listed in my
opening arguments. But let me quote a
pharmaceutical trade publication on the main
reason why: "Merck is the only major U.S. drug
company likely to sustain decelerating earnings
per share momentum." Sales growth may slow
from 19% in 1997 to 8-10% by 2001.
Clearly, losing patent protection is no fun. It
doesn't mean you lose all your revenue from the
product, but you will lose most. For example,
Glaxo Wellcome, the world's largest drug
company, grew only 3% the year their big gun,
Zantac, lost its patent. As Jeff Fischer pointed
out in the Fool's Industry Focus 1998, generic
drugs -- the kind that can be made when a
patent expires -- are different than other generic
products because they have to be of equal
quality; they're not hit-or-miss knock-offs. (Industry Focus 1999 will be
on sale in December -- watch for it!) And by 2001, Merck's five
patent-losing drugs may be providing as much as a third of its operating
earnings, which gives you an idea of the company's impending troubles.
So regardless of what the rest of the industry looks like, paying 27 times
next year's estimated earnings for a company that is likely to end up with
growth in the single digits 2-3 years from now is not my idea of a good
investment. You pay a premium on a company because you think it will
continue to grow strongly, which Merck is unlikely to do.
Let's look at the recently released third quarter results, which in my
opinion pretty well summarize both the good and bad of Merck.
On the good side, the company did grow revenues by 15%. Its leading
drug, Zocor, did slow its loss of market share. And its new drug for
asthma, Singulair, did "exceptionally well," according to a Hambrecht &
Quist analyst, producing $55 million in revenue for the quarter. Other
drugs, such as Fosamax, which treats osteoporosis, and anti-hypertension
drugs Cozaar and Hyzaar also increased sales.
But then there's the bad side. Without Merck's Medco managed care
business, and a shift in accounting related to the restructuring of their joint
venture with Astra AB, a Swedish concern, sales growth would have
been in the single digits.
In addition, Merck sold only $24 million worth of its new anti-hair loss
drug, Propecia, despite an extensive TV ad campaign; plus, its new
migraine treatment, Maxalt, sold only $15 million. These numbers are
below analysts' expectations. Given the need for products like these to
replace soon-to-be-lost revenue, these results are not reassuring.
Merck's drugs that aren't losing patents do not reassure one either. While
Zocor's loss of market share may have been slowed, according to the
Dow Jones Newswire its 15% growth rate is down from previous growth
rates of 25% to 30%. And Vasotec, another anti-hypertension drug,
dropped 22% in sales. Ouch! This simply increases the pressure on
Vioxx, and investors ought to be wary of a company that has too many
eggs in one basket.
Merck has been a great stock for those smart or lucky enough to buy it
during the days of the proposed Clinton health plan, when it was at a low
point. But its glory days may be over. Investors in Merck may need its
migraine medicine, Maxalt, over the next few years, which ironically
would at least help its sales.
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