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Why Merck Missed the Mark

Investors received a few unpleasant surprises from Big Pharma stalwart Merck (MRK) in its third-quarter earnings report, released Oct. 22. The Whitehouse Station (N.J.) drugmaker reported weak results, with earnings per share of 83 cents -- 2 cents shy of Wall Street's consensus estimate. Merck also lowered its earnings guidance for the fourth quarter to a range of 49 cents to 54 cents a share -- sharply below the consensus forecast of 92 cents.

And Merck offered another bombshell in its earnings release, outlining plans to eliminate approximately 3,200 positions and 1,200 contract or temporary employees. It also announced it will boost efficiencies in its wholesale distribution program -- a move that will result in a one-time hit to revenues of between $650 million and $750 million and to earnings per share (EPS) from continuing operations of 18 cents to 21 cents, in the fourth quarter.

Wall Street expressed its disappointment with Merck in its usual manner, and the 6.5% plunge in the share price -- closing at $45.72 -- paced a steep decline in the stock market on Oct. 22.

CEO Raymond Gilmartin acknowledged the difficulties his outfit faces in the earnings release: "In an environment driven by increasing competition, cost-containment pressures, and greater customer demand for value, we have examined every aspect of our business, at every level, to identify ways to more effectively address these challenges."

Why did Merck's results come up short? Will its moves help rejuvenate growth? And how should investors react in the wake of the price drop? BW Online's Will Andrews asked Standard & Poor's equity-services analyst Herman Saftlas, who follows the pharmaceuticals sector, for his views on the future prospects for Merck -- and its shares -- in a phone interview (both Standard & Poor's and BusinessWeek Online are units of The McGraw-Hill Companies). Edited excerpts follow:

Q: Merck's third-quarter earnings per share came up 2 cents short of your estimate and the Street's consensus forecast. What was the main reason for the shortfall?

A: Weaker-than-expected sales in some product lines, specifically Zocor and Vioxx. Zocor was down 2%, while Vioxx was down 32%. Zocor was particularly weak in terms of foreign sales, down 29%, because of patent expirations overseas.

Q: Does Merck have any products in the pipeline that, in your opinion, could help spur future growth?

A: It has two products that it will file for Food & Drug Administration approval in the fourth quarter: Arcoxia, the second-generation COX-2 inhibitor for rheumatoid arthritis. That would be competing directly with Pfizer's (PFE) Bextra, which pretty much has the market [to itself] right now; and the combination of Zetia and Zocor, which could potentially be a major product.

They both work with different mechanisms of action, so there can be a combined potency for tough-to-treat, high-cholesterol patients. Those are the two near-term opportunities. A number of vaccines and other things are in the pipeline, like Substance P for depression. But there's nothing that looks like it could match any of Merck's major products today.

Q: The other eye-popping thing about today's release was Merck's announcement of layoffs. It says it can generate approximately $250 million to $300 million of annual savings that way. Do you think that's achievable? Could further cuts be on the horizon?

A: I certainly think this is just a start in terms of layoffs. It looks like they may continue this program, and some facilities may be [mothballed]. They're looking to get their cost structure in line with the reduced level of sales, so they're going to take additional measures in the cost-cutting area.

Q: Merck is taking a hefty charge to implement a new distribution program for U.S. wholesalers -- effectively lowering existing limits on average monthly purchases of its drugs. What's behind the move, and do you think it will help Merck's bottom line?

A: Merck especially has been highly impacted by fluctuations in inventory "buy-ins" and "buy-outs". Wholesalers "buy in" in anticipation of price increases. After they do that in a big way one quarter, the next quarter can be a dry spell. There can be huge swings in orders, and it's very difficult to line up manufacturing with that kind of shifting activity. So Merck wants to smooth out the high fluctuations. Therefore, it started this new program, which limits the amount of buying by wholesalers in any given period to prevent them from stocking up.

Other drug companies have not seen the need the do this. I think with Merck it was a very serious problem. In their release, they mentioned how each drug was affected by this situation. We'll see how it works out. I think the Street is a little cautious about it.

Q: You recently said Merck shares "offer some merger appeal." Do you think that with the company's reduced prospects for growth, it may finally abandon its go-it-alone strategy?

A: I think that when things get really tough, and they really see attrition in their major drugs, the need to merge could become urgent. I don't know if they've reached that stage yet.

I know a lot of European [drug] companies are looking to merge or partner with American companies. There are deals that can be done. Merck has a tremendous infrastructure in terms of marketing and production, and a lot of European companies would like to get into that space. I think something may happen there, or perhaps with a biotech company. I think Merck is going to do something.

Q: Who would likely merger partners be?

A: It could be one of the major European companies -- Novartis (NVS), Aventis (AVE), GlaxoSmithKline (GSK), or the like. Schering Plough (SGP) is out there, but I don't know if that would work. What would Plough bring to a deal with Merck? You would think they'd want a strong partner.

Q: Given the moves announced in today's release, do you think Merck is on the right strategic track?

A: Well, I think they're taking a correct first step. They're cutting costs aggressively, whereas they're not cutting back on research and development. Which is also smart, considering that that's their lifeline.

I don't have to tell you how savvy Merck has been over the last 20 years. They're up against a tough macro situation now, along with everybody else. But they're more vulnerable because their products are weakening. So they have to take some more drastic measures. But I think they're on the right track.

Q: Finally, what's your opinion on the shares?

A: I have a 3-STARS [hold] rating. Our 12-month target price is $49, which we reduced on Oct. 22 from $59.

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