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Merck Isn't Converting the Skeptics

By Amy Tsao On Dec. 9, investors attending Merck's (MRK) annual business meeting in Whitehouse Station, N.J., hoped to hear about shifts in direction and up-and-coming drugs that would calm their worries over the pharmaceutical giant's prospects. In an unusual move for the tight-lipped company, Peter Kim, president of Merck Research Laboratories, came through -- sort of -- by actually discussing some early-stage drugs, though without giving many details.

There were no oohs and ahs from shareholders, however. Indeed, to many investors, Merck increasingly resembles a grand, old ocean liner that's having trouble changing direction. While rivals have merged and gotten bigger,erck has remained firmly on course, staying independent and doing much of its research in-house.

Among Merck's problems is that in 2006 it'll lose its biggest drug, the cholesterol fighter Zocor, to generic competitors, and it has few foreseeable new products to provide growth. The scant information Kim gave about early-stage drugs did little to assuage investor jitters that the pipeline may be running too shallow. Indeed, some analysts concluded that opening up on the subject at all suggests, "increasing desperation," as Raymond James analyst Michael Krensavage put it in a report analyzing the meeting.

UNDER PRESSURE. Merck's stock certainly reflects the anxiety. News of two major drug-development disappointments and its first-ever layoffs have pummeled its price. Shares have settled at about $43, or a price-earnings ratio of about 14 times 2004 consensus per share earnings of $3.15. In sharp contrast to the rest of the industry, since August, Merck's share price has fallen 25%, while the broader pharmaceutical sector has remained about flat.

Cheap as it now is, the stock may remain under pressure until Merck makes some bolder moves. It has forecast that it'll cut costs further in 2004 -- which could help juice earnings. But getting revenue growth back on track will require something more dramatic, such as a major acquisition.

Yet Merck doesn't agree with that assessment -- at least not yet. "A large-scale merger would provide, at best, a short-term boost with an expensive long-term cost," said Ray Gilmartin, chairman and CEO as he pooh-poohed the idea at the recent meeting.

"MAXIMIZE" SALES. Failing a change of heart on Gilmartin's part, Richard Evans, analyst at Bernstein Research, sees earnings growth as a problem probably through 2007. Furthermore, he questions how Merck's next potential blockbuster drugs -- a combination of Zocor and Zetia for cholesterol and Arcoxia for arthritis and other conditions -- will fare next year. Merck has filed an application for Zocor-Zetia, which is co-marketed with Schering-Plough (SGP), to the Food & Drug Administration, and it'll file for painkiller Arcoxia in coming weeks.

Zocor is now one part of an increasingly crowded market that includes Pfizer's (PFE) Lipitor and the newly introduced Crestor from Astra-Zeneca (AZN). According to Brad Sheares, head of U.S. Human Health at Merck, as patent expiration approaches, it plans to "maximize" sales of the $5 billion-a-year Zocor, which generates about one-fifth of total revenues. (In 2002, Merck reported earnings of $6.8 billion on

revenues of $21.4 billion.)

Bernstein's Evans, though, worries that such a strategy could hurt marketing efforts for the combination pill, which is due out around the end of 2004 or early 2005, "We can't help but think that the only way for Zocor-Zetia to grow is to cannibalize Zocor," says Evans. (Evans doesn't own the stock. Bernstein has no banking business with Merck.)

A HALF STAKE. Yet the magnitude of Zocor's inevitable loss "could be worse when it really comes," warns Shaojing Tong, analyst at Mehta Partners. He points to Schering-Plough's loss of Claritin and the protracted period of earnings decline from which it's still recovering. Tong says he's bullish on Merck's combination drug. Even so, his forecast that Zocor-Zetia sales will peak at about $3 billion a few years after it's launched, only half of which would be Merck's to keep, would make up a fraction of Zocor's current revenues. (Neither Tong nor his firm owns the stock.)

Merck has another headache in painkillers. The U.S. approval of Arcoxia, which was long delayed, is producing relatively low expectations. Because Merck's Vioxx is also used as a pain treatment, "they'll be competing with themselves," figures Ted Cho, managing director at Grandfield & Dodd. (Cho's firm owns Merck stock.)

Krensavage estimates that in 2005 revenues for both drugs will total about $2.3 billion. That would reflect a fall in Vioxx and a rise in Arcoxia, but a total sales figure that's unchanged from his 2003 projection for the drugs. (Krensavage's firm intends to seek compensation for investment-banking services from Merck in the next

three months.)

DELAYED GROWTH? Merck considers analysts' worries overblown. For instance, Kim notes that Arcoxia, which is already sold outside of the U.S., will be differentiated by having approvals for use in conditions that similar drugs, including Vioxx, aren't cleared for. Merck also predicts that in 2005 it'll file to the FDA for three vaccines -- for HPV (the virus that causes cervical cancer), infant diarrhea, and shingles. And it expects to file an application for a diabetes drug in 2006.

What worries analysts is that none of these efforts seem likely to add significantly to growth until 2008, at the earliest, says Tong. That's assuming that Merck succeeds at fending off patent expirations on osteoporosis drug Fosamax. If it fails there, "2008 will be another difficult year."

The main glimmer of hope analysts see is Merck's increasing willingness to at least consider mergers. Though Gilmartin essentially dismissed the idea of a big combination, some observers at the New Jersey meeting viewed the inclusion of the topic in his speech as a signal that he might be thinking about it. Merck said several times during the meeting that it's reviewing deals with 80 potential outside partners.

Gilmartin, who has received much of the blame for Merck's recent worries, has a little over two years left before he's due to retire. Most analysts emphasize that they see little reason a successor would take over sooner. But if Merck has any more major disappointments before 2006, Gilmartin could be in for an early departure. If nothing else, that certainly would change Merck's course. In the meantime, it'll likely keep steaming ahead, to nowhere particularly exciting. Tsao covers financial markets for BusinessWeek Online in New York

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