Can Merck Produce a Growth Stimulant?
By Amy Tsao
Pharmaceutical giant Merck (MRK ) has made plenty of headlines over the past year, but not the kind that make investors smile. The company posted no growth in 2002 and growth is expected to be modest in 2003. And Merck has been plagued by controversy over the selling practices of Medco, its division managing pharmacy benefits. It appears that Merck has no drugs in the pipeline that look like potential blockbusters -- and that has investors wondering what will replace revenues lost to patent expirations over the next several years.
Shares in this venerable blue chip are trading at around $53. At a 2003 price-to-earnings (p-e) ratio of 16, its valuation looks cheap, near its 5-year low of about 15. Yet to some, that still seems too expensive for the short-term. "I don't feel enough confidence with what the earnings will be in a couple of years," says Steve Paspal, senior research analyst at Sovereign Asset Management. "Right now, the [business] momentum is idling along. I'm not sure if it firms up." Paspal doesn't personally own Merck stock, though his company does.
The next couple of years look to be a period of flux for Whitehouse Station (N.J.) -based Merck, the world's third-largest drugmaker. To Wall Street's relief, it plans to spin off 100% of Medco, which should soon put the pricing controversy behind it. But cholesterol-lowering Zocor -- Merck's No. 1 seller -- loses patent protection in 2006, and Fosamax, an osteoporosis treatment goes off patent a year after that. Meanwhile, the most promising new drugs -- the ones that could compensate for Zocor and Fosamax's lost revenues -- aren't sure bets. "That's the major concern in most investors' minds," says Shaojing Tong, analyst at research boutique Mehta Partners. Tong doesn't own shares, but Mehta Partners' hedge fund has a short position on the stock.
The news isn't all downbeat: Liu-Er Chen, portfolio manager at Evergreen Healthcare Fund, is optimistic that the loss of the Zocor patent won't inflict severe pain, even though Zocor accounted for 12% of Merck's total sales of $51.8 billion in 2002. The reason: Merck has plans to combine Zocor with Schering-Plough's (SGP ) Zetia to make a new power cocktail, which is expected to hit the market sometime in 2004. Chen figures Zocor-Zetia could reach $2 billion in annual sales, helping to offset the lost Zocor sales. (Evergreen Healthcare Fund holds a position in Merck.)
Zocor-Zetia has many champions because it is expected to reduce levels of LDL -- the so-called bad cholesterol -- more than any single treatment could achieve on its own. But its impact will depend on Merck's ability to convince physicians to prescribe it. "We have been quite bullish on the combo," Tong says. "And we expect doctors to switch a significant amount of patients." Still, Tong realizes that Zocor-Zetia won't be enough to "save" Merck. He thinks Merck will need more new drugs to restore the sparkle to investors' eyes.
Three of Merck's five biggest drugs now on the market are meeting modest sales expectations, says Bill Sandow, pharmaceutical analyst at Pimco RCM. (Sandow doesn't own Merck shares.) He sees earnings growth in the range of 8%-10% annually in 2004 and 2005. "It won't be one of the highest growth names, but I feel it could be one of the more steady," he says, adding that he expects the stock to be trading in the mid-$60 range a year from now. Notes Sandow: "Usually, on a name like this, the time to buy is when pessimism is high."
Perhaps. But Merck will have to demonstrate that there is blockbuster potential in its pipeline. Arcoxia, its new arthritis drug, is only expected to be a modest help. Merck says it will submit an application to the Food & Drug Administration before the end of the year, but analysts fear the drug's potential is limited since, by the time of its expected approval in 2004, it would be the fifth arthritis-fighting drug in an already crowded field.
One or two promising new research projects will have to pan out to give Merck a significant lift when Zocor's patent expires. Some cutting-edge projects include Merck's dual ppar, a novel product for treating diabetes, which Tong calls "a very exciting area that several companies are trying." Rather than just treating glucose levels, dual ppar alsos helps to improve cholesterol levels, which tend to be elevated in diabetes patients. The risk is high, however. Several other outfits already have already failed to win approval with similar drugs, including Novo-Nordisk (NVO ) and Novartis (NVS ).
Merck's drug for depression, Emend, is in late-stage trials, although the data has come from only small groups so far. Emend, which works on the central nervous system, is already approved for treating chemotherapy-related nausea. Merck also has three vaccines for treating rotavirus, human papilloma virus (the main cause of cervical cancer), and shingles, each in advanced testing and all likely be approved in the next four years to five years.
What really would tip the scales for the long term, many Merck watchers believe, is a shift in the approach to research and development. The pharmaceutical industry has increasingly shifted its focus from research to marketing, with many outfits willing to buy rights to sell new products developed elsewhere. More than others, Merck has held to its strategy of discovering and developing drugs inhouse. "Our position has remained steadfast," says spokeswoman Janet Skidmore. "We've tried to discover novel medicines and vaccines. We are not interested, and never have been, in 'me-too' drugs."
As they've watch companies such as Pfizer (PFE ) expand through mergers and drug licensing, some investors want Merck to take a more flexible approach. Merck uses the inhouse approach, says Daniel Hoffman, industry consultant at Pharmaceutical Business Research Associates in Glenmore, Pa., adding: "This has become an object of derision among biomedical researchers and it remains a question whether the approach is really going to be able to continue." Chen thinks CEO Raymond Gilmartin should have been more acquisition-minded. Notes Chen: "That's something Merck definitely missed."
LONG-TERM BLUE CHIP.
Gilmartin's planned in three years may be a catalyst for change. Already, Merck has begun discussing successors, indicating so far that the main candidates are from within. Gilmartin has mentioned U.S. co-presidents Margaret McGlynn and Bradley Sheares, but Hoffman believes CFO Judy Lewent is the most likely choice.
Getting the Medco unit out of its operations will do a lot to calm Wall Street. And Merck looks to remain a steady blue-chip for investors with a long-term horizon. To really get investors excited, it wouldn't hurt for Merck to have new blockbusters, a change in leadership, and a rethinking of its acquisition policy.
Tsao covers the markets for BusinessWeek Online