S&P: Merck No Longer Triple-A

The drugmaker's credit rating was lowered as it faces shrinking revenues and significant Vioxx-related litigation

On Nov. 16, 2004, Standard & Poor's Ratings Services lowered its corporate credit and senior unsecured debt ratings on pharmaceutical giant Merck (MRK ) to 'AA-' from 'AAA'. The rating action reflects the continued deterioration expected of Merck's business profile in the intermediate term and the challenges the company faces to revitalize its product pipeline following the withdrawal of its blockbuster pain medication Vioxx, a drug that generated $2.5 billion in annual sales.

The ratings on Merck have been removed from CreditWatch, where they were placed Nov. 1, after the company announced the delay of pain medication Arcoxia and amid growing concern regarding Vioxx-related issues. The 'A-1+' short-term corporate credit and commercial paper ratings on the company have been affirmed. The outlook is negative.

The lower rating incorporates the uncertain magnitude and timing of possible Vioxx-related litigation after the drug's withdrawal. While researching the use of Vioxx in treating colon polyps, Merck found an increased risk of cardiovascular events, such as heart attack and stroke, among patients taking the treatment longer than 18 months.

Such litigation uncertainty is not present in the ratings of other 'AA' pharmaceutical companies. We are also concerned about the delay of the company's now-leading drug prospect Arcoxia, which, like Vioxx, is a COX-2 inhibitor.

Whitehouse Station, N.J.-based Merck continues to maintain a very strong business profile, despite the recent loss of Vioxx and the scheduled loss of market exclusivity on the drug Zocor by mid-2006. At the same time, the company maintains a very conservative financial policy, with cash and investments exceeding debt, and it continues to generate funds well in excess of ongoing needs.

Merck's business profile is highlighted by its solid and diverse core pharmaceutical portfolio, consisting of Zocor, Singulair, Fosamax, and Cozaar/Hyzaar. Collectively, these four products account for more than 50% of total sales, a diversity similar to that of Merck's major pharmaceutical peers. Zocor, Merck's very important cholesterol-lowering franchise, generates more than $5 billion in annual sales, even though it has lost patent protection in several major foreign markets. Recent data in the U.S. suggesting that patients are still very under-treated for high cholesterol means that sales growth opportunities remain.

Meanwhile, Singulair, Fosamax, and Cozaar/Hyzaar are all recording solid sales growth that is expected to continue in the near term, despite the heightening competition in their therapeutic categories. Each of the three drugs generates roughly $3 billion in annual sales.

However, Merck stands to lose more than $7.5 billion, or 33% of its total annual sales, in a two-year period. Not only will the company lose the $2.5 billion from Vioxx, but Zocor is scheduled to lose market exclusivity in the U.S. by mid-2006. Moreover, with the delay of Arcoxia, the company's near-term new product pipeline is inadequate to replace sales expected to be lost from patent expirations.

The withdrawal of Vioxx also raised the specter of major product liability litigation. An estimated 20 million U.S. patients have taken Vioxx and the number of prospective lawsuits is mounting. Standard & Poor's believes it is not possible to quantify the financial impact of the litigation. Given Merck's still-substantial liquidity position and internal funds generation, the company can withstand significant cash outflows over a sustained period. Also, Standard & Poor's expects the litigation settlement process to be protracted.

Still, these challenges put considerable pressure on Merck's existing and newer franchises, as well as the product development pipeline, to preserve the company's superior business profile. Merck's remaining blockbuster franchises, Fosamax, Singulair, and Cozaar/Hyzaar, all still enjoy long patent protection and growing sales. The breadth of Merck's portfolio also blunts concerns about the increased competitive pressure on any one product. One bright spot is Vytorin, a cholesterol-lowering drug recently approved by the FDA that will be marketed by a joint venture between Merck and Schering-Plough (SGP ). The Vytorin/Zetia franchise holds high sales potential, especially as the cholesterol-lowering market shifts toward newer, more potent treatments. Preliminary data has suggested that Vytorin is both safer and more effective at lowering cholesterol than other leading statins on the market, such as Lipitor and Merck's own Zocor, and Merck's long experience with this market should benefit the franchise. However, Merck will have to share the earnings of Vytorin/Zetia with Schering-Plough, and the drug will have to compete against generic versions of both Zocor and another statin, Pravachol.

Meanwhile, Merck continues to spend heavily on pharmaceutical R&D, as its 2004 funding is expected to exceed $3.5 billion. Despite this high level, the near-term product pipeline appears relatively light, and Arcoxia, a second-generation COX-2 inhibitor more potent that Vioxx, has the highest sales potential.

However, the withdrawal of Vioxx has led the FDA to scrutinize the long-term safety of the entire COX-2 class. Consequently, the FDA has recently further delayed the marketing approval of Arcoxia, and it remains to be seen what Arcoxia's sales prospects are in light of Vioxx's withdrawal from the market and the strong presence of rival treatments.

Merck's other products in development include a series of vaccine treatments in Phase III clinical trials, including an HPV vaccine (for prevention of cervical cancer) that holds blockbuster sales potential. Moreover, Merck has increasingly turned to in-licensing and targeted modest acquisitions to supplement its internal drug-development efforts.

Merck continues to maintain very conservative financial measures and has considerable financial capacity to fund investments that bolster its product pipeline. The company has eschewed the major debt-financed acquisitions pursued by some of its peers. However, Merck is facing a change in management, as its current CEO, Raymond Gilmartin, is scheduled to retire in the first half of 2006. Merck recently began its search for his successor. The new CEO will be challenged to cope with the significant business issues and still maintain the company's past conservative financial posture.

In the meantime, Merck continues to generate strong profitability and cash-flow protection measures. Operating margins on an earnigs before interest, taxes, depreciation, and amortization (EBITDA) basis for the 12 months ended Sept. 30 were approximately 41% and funds from operations for the period was $8.1 billion. Return on capital approximates 40%. These measures will be significantly hurt by the sudden loss of Vioxx and the legal costs associated with defending it against product-liability litigation.

Also, while Vytorin/Zetia appears to be on its way to becoming a major sales success, the high costs associated with launching the product will also mean that the franchise will not contribute significantly to earnings and cash flows until 2006, when higher-margined Zocor loses patent protection. Still, Standard & Poor's expects Merck's operating performance and credit protection measures to remain consistent with its current ratings.

Short-term credit factors: The short-term rating on Merck is 'A-1+'. Merck maintains a high level of liquidity that enables it to conduct share repurchases and acquisitions without affecting the ratings. Its strong liquidity and significant access to capital are demonstrated by:

• Cash and investments totaling $14.2 billion as of Sept. 30, 2004. Essentially all the cash and investments are held at foreign subsidiaries and may be repatriated at a tax-advantaged rate under recent legislation;

• Free cash flow of $7.5 billion for the 12 months ended Sept. 30, 2004. The magnitude of net free cash flow provides the company ample resources to repay future maturities; and

• Merck's cash and marketable securities, which serve as a more-than-adequate backup to its commercial paper program.

Outlook: The ratings outlook is negative. Standard & Poor's cannot quantify the legal uncertainties related to Merck's withdrawal of Vioxx. At the very least, the litigation will be a major distraction for Merck management and require significant legal expenditures. Given its financial capacity, Merck could absorb most conceivable costs related to the issue within the next few years within the context of the current rating.

Still, the unpredictable legal process, as well as investigations regarding the propriety of company actions related to Vioxx, creates the potential for further deterioration of the company's credit risk profile in the foreseeable future.

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