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No. of Recommendations: 8
I had pretty much written Merck off the list of anything I might want to buy for the dividend. I have been in and out of them a couple of times since 2004. I lost money when Vioxx took them down, wrote calls for income, lost the shares when it took off in 2007. My call was at $35 and I thought that was a fair price—market thought otherwise and the shares got called. Oddly the market now agrees with me—a couple years too late.

I have a bad history with Merck and it perhaps colors my views.

A SeekingAlpha article made me look again

<SNIPS>

Could Merck Be the Top Dow Stock in 2011?

….it time to look for a new top Dow dividend stock for 2011 and the pick may surprise some investors.

Our top Dow dividend stock for 2011 is Merck (MRK). Sure Merck was the antithesis of McDonald’s in 2010 when the pharmaceutical stock dropped 1.4%. And they certainly won’t be one of the top growth stocks for 2011 with revenues expected to breakeven at best. However, Merck appears poised to reward investors in 2011.

Merck shares currently trade at only 9.5x consensus 2011 earnings. While that is a premium to competitor Pfizer’s (PFE) 7.5x multiple, Merck is expected to grow their earnings by 13% next year. Pfizer is only expected to generate a modest 3% growth in net earnings.

The acquisition of Schering-Plough in 2009 has helped Merck rebuild its product pipeline. Merck now has several drugs in late-stage trials that could prove to be the compelling buy catalyst for the stock in the second half of 2011.

Wall Street analysts are fairly bullish on Merck as well. The pharmaceutical stock has a consensus price target of $42. While price targets are generally unreliable, it does indicate that Wall Street sees nearly 20% upside in Merck shares as we start 2011.

Maybe most importantly for dividend investors, Merck offers an impressive 4.2% dividend yield. That makes it the 3rd highest yielding stock in the Dow Jones index and could greatly enhance Merck’s total return in 2011.

There is also an outside chance for a dividend increase from Merck in 2011. Merck hasn’t increased their dividend since 2004, but improving product forecasts and strong cash flows could lead to a surprise dividend announcement in 2011.


There is information missing from the article. Merck like almost every other big pharmaceutical is facing significant loss of revenue from expirations of its blockbuster drugs. There is also the Damoclean loss of Remicade overhanging the merger. Remicade is valued at around $2 billion per year in revenue and that was maybe the best part of its Schering Plough reverse merger. The loss of its own drugs might not be too devastating at around 25% of revenue over the next five years. But after spending $41 billion for SGP, Merck needs to keep Remicade. If they lose the arbitration with JNJ, that takes lost patented revenue up to 28%.

Some history

Merck was a fiercely independent pure science-based pharmaceutical company, dedicated to research and bringing to market their own in-house drugs. They dismissed the growth by acquisition model as inferior. Science and innovation were its watchwords and marketing and cost cutting were for competitors. Pride in its own R&D made it a great company that brought breakthrough classes of drugs to market.


"Merck used to have such contempt for people who suggested it would buy Schering-Plough," says Michael Krensavage, principal at Krensavage Asset Management. "The about-face is stunning."
This concession by acquisition of SGP marks the end of an era for Merck.

The last few years have brought hard times to pharma as blockbusters expire and new drugs become increasingly hard to bring to market

Regulators cleared 21 medicines, the fewest since 2007, for sale last year. It was the first time in a decade that Pfizer, Merck, Eli Lilly, and Bristol-Myers were shut out at the same time, according to agency records.

The FDA is "trying to cover their butts," said Simos Simeonidis, a senior biotechnology analyst at Rodman & Renshaw in New York. "Overall you have seen an increased conservatism from the FDA and an increased emphasis toward safety."


Delayed regulatory decisions are critical to pharmaceutical and biotechnology companies. The Pharmaceutical Research and Manufacturers of America, a Washington-based trade group, estimates that it costs $1.3 billion on average to bring a new drug to market, and that only one in 10,000 medicines tested may reach commercialization.

The FDA approved 25 new medicines in 2009 and 24 the previous year, according to data on the agency's website. Nineteen new drugs were cleared in 2007, the fewest in 24 years.

Having an expensive pipeline and bringing all product up through in-house R&D isn’t working anymore; no matter how good the science is, a company’s chances of getting a medication approved and marketed get slimmer every year.

For Merck, the coffin nail was Vioxx followed by two failed trials of new drugs. There was a brief resurgence in 2007 when its blockbuster Januvia came to market followed by HPV vaccine Gardasil for cervical cancer. It was a short-lived victory as blockbuster hopeful Vytorin/Zetia prescriptions fell sharply after studies showed no advantage over older statins.

Merck went on to see its share price drop 50% between January-November 2008. In 2009, the reverse merger with SGP was announced and consummated November 2009.


SGP’s key drugs are

• Remicade at $2.1 billion annually
• Nasonex for allergies $1.2 billion
• Temodar for brain tumors $1 billion.

Merck cannot easily afford to lose Remicade

In order to circumvent the JNJ/Centocor agreement, SGP could not undergo a change of control in the form of acquisition or owner acquiring more than 50% of outstanding shares or change in board of directors resulting in a loss of majority. The merger then was structured as Schering acquiring Merck and Merck becoming the wholly owned subsidiary. JNJ has of course challenged this. No resolution has been reached.

That’s where it sits at present —- a lot of uncertainty.

Pipeline

SGP did bring a few good drugs in late stage development to the pipeline—doubled Merck’s late stage pipeline to 19.

The new combined pipeline is composed of small molecules, vaccines and biologics targeting:

atherosclerosis and thrombosis, cancer, diabetes, hepatitis C infection, insomnia, and schizophrenia. Merck's pipeline is particularly strong in cardiovascular disease and infectious diseases and has eight drugs in each of these two categories:

Cardiovascular: anacetrapib (atherosclerosis); acadesine (ischemia reperfusion injury); betrixaban (thrombosis); MK-524A (atherosclerosis); MK 524B (atherosclerosis); MK-0736 (hypertension); vernakalant (atrial fibrillation) and vorapaxar (thrombosis).

Infectious Disease: boceprevir (hepatitis C); MK-3009 (Staphylococcus); MK 3415A (Clostridium difficile); vicriviroc (HIV); vaniprevir (hepatitis C); V419 (pediatric vaccine); V503 (Human Papilloma Virus vaccine) and V710 (Staphylococcus aureus vaccine).

Since March 2009 SGP received regulatory approvals for Simponi for psoriasis, Saphris for bipolar depression and fertility drug Elonva.
Unfortunately, Simponi will go to JNJ if Merck loses arbitration

Notable recent pipeline progress includes the initiation of Phase III trials for MK-4305, being evaluated for insomnia, and an allergy immunotherapy tablet for ragweed allergies . Most promising in my opinion are a hepatitis C drug and one for blood clots.Also of interest is vernakalant for atrial fibrillation. This is a pervasive heart arrhythmia especially in the elderly. At present the anti-arrhythmics available are loaded with side effects and not always effective. A-fib requires lifetime coumadin treatment that is not without its own risks of bleeding and coumadin requires frequent blood test to monitor coagulation that adds to cost and is burdensome to the patient. This may prove to be a good alternative if it survives testing

There are 19 drugs in Phase III and six under review. The six under review are not particularly strong.

In addition, a Phase II study evaluating MK-6913 for the treatment of hot flashes in postmenopausal women has been initiated.

Link to pipeline

http://www.merck.com/research/pipeline/home.html?WT.svl=cont...

If Merck loses Remicade, patent expirations in 5 years will represent around $12 billion in revenue. I am unconvinced the pipeline is good enough to replace all of this and the $37 price per share no doubt has factored in some loss of revenue. It may eventually be replaced. What concerns me more is the dividend

Recent results

The last 9 months have seen GAAP earnings hitting new lows after the merger in November 2009. The company has been taking accelerated D&A, restructuring costs and seeing SG&A expand disproportionately-- all related to the business combination

Q3/10 Q2/10 Q1/10 Q4/09 Q3/09 Q2/09 Q1/09
===============================================================
Diluted EPS 0.11 0.24 0.09 2.62 1.61 0.74 0.67

Revenue was $11.1 billion for Q3 compared with $6.0 billion in 2009 and $33.9 billion for the first nine months compared to $17.3 billion in 2009. The increase was of course due to SGP

SGP brought Remicade, Nasonex, Temodar, PegIntron and Clarinex, and 100% of Zetia and Vytorin.

Materials and production costs were a huge $4.2 billion for Q3 compared with $1.4 billion in 2009 and were $14.0 billion in for nine months compared to $4.1 billion in 2009.The big jump in these costs destroyed gross margins and includes expenses related to Schering-Plough products. It also includes $1.1 billion in 2010 and $3.4 billion in 2009 for the amortization of intangible assets and $266.0 million and $2.1 billion, respectively, of amortization of purchase accounting adjustments for Schering-Plough’s inventories. There were also restructuring costs

Gross margin was 62.3% compared with 76.4%in 2009. The amortization of intangible assets and purchase accounting adjustments and the restructuring charges cut gross margin by 13%.

This is important because these expenses will stop and Merck’s margins will recover making the bottom line look better.

Cash flow was good and substantially improved over the same 9-month period in 2009. CFFO in 2009 was decreased by $4.1 billion in payments into the Vioxx settlement funds and a $660 million payment made in connection with the previously disclosed settlement with the CRA. CFFO was $7.3 billion for the first 9 months of 2010 and $1.2 billion in 2009 including the settlements.

The Vioxx litigation has been largely settled and the payout in 2009 should not be repeated

Patent expirations

Merck lost Cozaar/Hyzaar in April 2010 -- 6 months ago. Revenue was cut in half for Q3 and 35% YTD [not lost until Q2]


Q3/09 Q3/09 9 mos 2010 9 mos 2009
================================================================
Cozaar/Hyzaar 422.9 860.9 1,689.5 2,605.7
Zocor 114.0 141.2 347.2 419.3

I compare that to the blockbuster Zocor that lost patent in 2006. It is now less than half a million in sales per annum from its $4.4 billion. That is why shareholders and investors fret ceaselessly about expirations -- $4 billion in revenue vanishes in 4 years. Cozaar is headed down the same trail and Singulair will follow in 2012—two short years. Cozaar was a $3.5 billion drug and Singulair is $4.7 billion

You often see companies continue to produce the branded drugs regardless, because hundreds of millions of dollars in annual sales can still be gleaned from patients who prefer the brand name.and they find a decent market overseas especially in developing nations prices.

patents expiring next 5 years

in millions
    
2009
Product Expiration (in U.S.) Revenue
=========================================

Cozaar 2010 3560.7
Hyzaar 2010
Crixivan 2012 (compound)/
2018 (formulation) 206.0
Maxalt 2012 (compound)/
2014 (other) 574.0
Singulair 2012 4659.7
Cancidas 2013 (compound)/
2015 (composition) 616.7
Propecia 2013 (formulation/use) 440.3
Emend 2015 313.0
Zolinza 2015 na
Invanz 2016 (compound)/
2017 (composition) 292.0
Zostavax 2016 277.0
==========================================
Total $10,370.4

That is 24% of the estimated combined company revenue.
Remicade would go a long way towards fixing the hole. Remicade is worth $2 billion.

This is not as dire as it looks since one big hit from Cozaar has already started and the biggest pain will be 2010 and the first half of 2011. Losses will continue but probably decelerate

Singulair is the other big drug and will hit in 2012 or in 2 years. Zocor was also a $4 billion loss. Revenue stalled at $23 to $24 billion, but there was no big decline The company was helped by Januvia that now does $1.9 billion per year in just two years after approval.

Point is, Merck will likely not see a huge hole shot through revenue as they have 6 drugs under review and 18 drugs in Phase III trials They are in somewhat better shape than Glaxo or Lilly in this respect. Just one big drug left to come off patent and two years to get new product to market

If they lose Remicade, then revenue may do more than stall and perhaps could decline by $2-$3 billion.

Cash flow, dividends and debt

Cash flow is good after the merger. The biggest claims on free cash flow going forward are going to be dividends and debt. It is highly unlikely Merck will find it necessary to make another major acquisition any time soon. Until SGP, they made very few and will likely return to that course

The following looks at how much the company has to spend on dividends after capex.

Annual

12/2009 12/2008 12/2007 12/2006 12/2005
===============================================================
CFFO 3,384.80 6,571.70 6,999.20 6,765.20 7,608.50
Capex (1,294.30) (1,298.30) (1,011.00) (980.20) (1,402.70)
================================================================
Rough FCF 2,090.50 5,273.40 5,988.20 5,785.00 6,205.80
Dividends (3,215.00) (3,278.50) (3,307.30) (3,322.60)(3,349.80)

Diluted
Shares 2,273.20 2,145.30 2,192.90 2,187.70 2,200.40

Cash 6,632.80 4,368.30 5,336.10 5,914.70 9,585.30


Quarterly

These numbers are cumulative


09/2010 06/2010 03/2010 12/2009 9/2009
==================================================================
CFFO 7,282.90 4,691.00 1,366.10 3,392.00 1,149.50
Capex (1,017.70) (679.80) (342.80) (1,460.60) (903.60)
==================================================================
Rough FCF 6,265.20 4,011.20 1,023.30 1,931.40 245.90
Dividends (3,559.20)(2,377.90)(1,188.60) (3,479.10)(2,410.80)
------------------------------------------------------------------

Short Term Debt 4,116.00 4,147.30 3,822.40 1,379.20 866.80
Long Term Debt 14,031.90 13,835.30 15,281.10 16,074.90 8,204.70
===================================================================
total debt 18,147.90 17,982.60 19,103.50 17,454.10 9,071.50


Debt is now at $18 billion.

In 2011 there is $1.2 billion coming due; in 2013, $1.4 billion comes due and $2.3 billion is due in 2014. In 2015, $2.1 billion is payable.

The debt/capital ratio is 24% and most of the debt is between 5% and 6%

Interest coverage ratio is approximately 6X

Merck does not appear to be overleveraged if revenue remains at least stable. They may choose to refinance some rather than repay all of it as it matures.

They have not raised the dividend since 2006, but were not forced to cut it as Pfizer was for the mega-merger.

The payout ratio was trending down into 2009 and was at 26%. It is difficult to calculate the last three quarters with all the one-time merger expenses. Q3 non-GAAP earnings were 85¢ and that would be a payout ratio of 44% and not excessively high.

The dividend looks secure. I would not look for any increases in the next year or two as the company works through the merger, debt and loss of patents. But at a 4.2% yield, it would be acceptable for a couple of years

Loss of capital is of some concern if the pipeline does not result in some approvals and if they lose the Remicade arbitration.

Value???

The crystal ball is in the shop so what I can do is see what the market is pricing into the current price

Using average EBIT margins, working capital and capex [including the SGP acquisition] I can get $36 per share if I give them negative 3% growth over 5 years with a gradual improvement to +2% by year 10.

That gives some interesting revenue numbers

Revenue decreases to a low of $36 billion [around $8 billion down from current levels] by year 8 and by year 10 it is $37.7 billion. That would allow for nearly all of the patent expiration revenue of around $10 billion. Of course, not all of that would be lost immediately and some will be retained. There will also be some revenue from new drugs coming onto the income statement.

If they lose Remicade, things might look slightly worse

If I plan for a (4%) growth for 5 years that takes another $2 billion from revenue by year 8 and Merck is valued at $33

It’s clear that the company makes enough cash flow to pay the dividend for now. It is also apparent that the price per share is factoring in some poor growth prospects and these may materialize.

I would say as a dividend investment the 4.2% yield looks safe but I would not expect much in the way of increases

The capital structure is stable even though debt has increased. It is still a relatively low debt ratio with sufficient interest coverage.

The per share price is valued for some worst case scenario outcomes. Loss of capital will probably not be devastating. Value could drop 10%-15% according to the DCF if they lose Remicade and that may decrease the price per share.

All in all not the basket case I thought they were
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