Novice Investing - Merck Co

Date: Friday 29th 2008f August 2008 02:00:21 AM

Mark your Calendar for Merck 07/10/2005

By: NoviceInvesting Staff

Background

Merck (MRK) was discussed as possible investment back on February of 2005. What is Merck? Merck is a giant pharmaceutical company that makes everything from cholesterol drugs to high blood pressures to arthritis drugs. At the time, we felt that MRK is fairly valued at $43.95/share. Since, we require 50% of return for our portfolio, we decide to wait until MRK reaches $ 29.3/share before buying it. Now that, MRK has fallen to $30, it is now time to ponder. Should you buy MRK if it falls to $29.30/share? What has changed since then?

What has changed?

MRK	Mar 05	Dec 04	Sep 04	Jun 04
Current Ratio	1.45	1.15	1.29	1.37

Let's review MRK's financial health. Current ratio still is under control. Nothing much changed since February 2005. MRK is also profitable, earning $ 1.3 Billion, for the first three months of 2005. The risk of bankruptcy due to inadequate cash flow is minimal here.

We predicted MRK to earn $ 3.14 in 2006. Please click here for more details. As noted, we believe that 2005 will be a transition year for MRK. We are focusing on 2006 and beyond. In the previous prediction, we exclude two of MRK's potential blockbuster; Gardasil and Muraglitazar . Gardasil is used as a vaccine to prevent HPV (Human Papillomavirus) with an estimated eligible 86 million women in the United States alone. Murglitazar is used to treat type-2 diabetes. It is the first type of drug that decrease glucose and triglyceride while increasing 'good' cholesterol HDL at the same time. The market for Murglitazar in the US is estimated to be 18 million people who suffered from type-2 diabetes. So far, these two drugs remain on track to be marketed in 2006. Therefore, let's narrow it down and obtain a revenue estimate for these two drugs.

Both of these drugs will reach $1 Billion sales for sure. The potential market is as huge as the cholesterol markets, albeit with less competition. Merck's cholesterol drugs, Zocor, reached a high of $ 6.8 Billion on 2001. There is no doubt that Muraglitazar can reach a sales as high as $ $ 5 Billion while Gardasil can eventually contribute $ 2 - $ 2.5 Billion for Merck's sales. This is a $ 7.5 Billion potential sales in both. Now, the question remains on how fast can these drugs reach its peak. Normally, a drug will peak within 5- 7 years. Vioxx reaches $2.6 B in 3 years. It is not unreasonable to assume that Gardasil can reach the same plateau as Vioxx while Muraglitazar can have more sales since it has a larger potential. Our assumption here is a $ 1 billion sales for Murglitazar and $ 500 M for Gardasil in 2006. This might proves to be conservative since there is a chance that both of these drugs can already be marketed in the 2nd half of 2005.

What else has changed? Let's talk about Vioxx update. As of March 31st, 2005, Merck informed investors that 2300 lawsuits has been filed regarding Vioxx. The picture looks brighter than our last Merck's discussion. Since then, Canadian Panel has recommended Vioxx to be sold in the market with a warning on the label. Here is the news. This echoes a similar vote from the FDA panel back in February. Gauging the potential liabilities from Vioxx lawsuit is hard. On one hand, this is the drug that may increase the risk of heart attack when used excessively. On the other hand, this drug helps people coping up with pain. Estimation for Vioxx Liabilities range from $5 to $ 55 Billion. We don't think MRK will pay $ 55 Billion for Vioxx, if any. Both Canadian and US panel feel that Vioxx can be sold back to the market. With these approvals, we peg MRK's liabilities to $ 10 Billion.

So far in 2005, MRK has not sold any single Vioxx. Our previous estimate calls for Vioxx sales to be $ 1 Billion in 2006. It is very possible for Vioxx to return to the market, especially after Canada Panel recommends it to be sold in Canada. To make it more realistic however, we now estimate Vioxx sales to be $0 in 2005 and $ 500 M in 2006.

EPS Estimation

For EPS estimation, we will make slight changes to our revenue estimation due to recent development. Everything else will remain the same. First, Vioxx sales will be $ 0 M in 2005 and $ 500 M in 2006. Secondly, We will now include the sale of Gardasil and Murglitazar in our estimate since they are big enough to be quantified. Our new revenue estimate for fiscal 2006 is $ 26, 619 M. The subsequent table shows Merck's revenue and its impact on EPS. For previous EPS assumption (which we still used), please click here.


Revenue	Growth rate '03-'04	Fiscal 2005	Growth rate 2004-2005	Fiscal 2006	Growth rate 2005-2006
Zocor	(5%)	$ 4,700 M	(9.6%)	$ 4,000 M	(14.9%)
Fosamax	18%	$ 3,600 M	12.5%	$ 3,960 M	10%
Cozaar/Hyzaar	14%	$ 3,200 M	12.5%	$ 3,520 M	10%
Singulair	30%	$ 3,200 M	23.0%	$ 3,840 M	20%
Zetia	53%	$ 960 M	74.5%	$ 1,440 M	50%
Vytorin	N/A	$ 325 M	90.1%	$ 569 M	75%
Prilosec & Nexium	Not found	$ 800 M	0%	$ 840 M	5%
Gardasil	-	-	-	$ 500 M	-
Murglitazar	-	-	-	$ 1,000 M	-
Vioxx*	-	$ 0 M	-	$ 500 M	-
Others	9%	$ 6,000 M	9%	$ 6,450 M	7.5%
TOTAL		$22,785 M		$26,619 M
* Vioxx is currently pulled out of the market due to safety concern

Pro Forma Income Statement for MRK	Fiscal year 2005	Fiscal year 2006
Revenue	$ 22,785 M	$ 26,619 M
Cost of Goods Sold	$ 5,012 M	$ 5,856 M
Gross Profit	$ 17,773 M	$ 20,763 M
SG & A	$ 6,820 M	$ 7,161 M
R& D expense	$ 4,000 M	$ 4,200 M
Interest Expense	$ -	$ -
Profit Before Tax	$ 6,953 M	$ 9,402 M
Income Tax Expense	$ 1,947 M	$ 2,633 M
Net Income	$ 5,006 M	$ 6,769 M
Shares Outstanding	2.08 Billion Shares	1.98 Billion shares
EPS Estimate	$ 2.41	$ 3.41

Fair value of the stock is 3% above current free risk interest rate (10 yr bond)

As of right now, EPS estimate for MRK is $3.41 for fiscal year 2006. This might change depending on the progress on Vioxx trial and the submission of new drugs among others. Currently, 10-yr bond yields around 4 %. For a fair value, we prefer MRK to yield 7%. Therefore, a fair P/E for MRK is 14.3 where 'P' here is the real price we are paying for MRK.

Real price for MRK is therefore $ 48.76 per share. Cash per share in MRK's balance sheet has grown to $ 4.25/share compared to $3.13 in our previous update. Of course! MRK is still a profitable company and the cash would have grown over time if it doesn't acquire other companies or assets. Long Term Debt in the balance sheet rises slightly to $ 2.55/share now. We will now add a $10 Billion charge for Vioxx litigation. This translates into $ 5/share. This $5/share will be included in MRK's overall long term debt. New long term debt is therefore assumed to be $ 7.55/share.

Real price = stock price - (cash+ short-term investment) + long-term debt.

Stock price = $48.76 + $4.25 - $7.55 = $45.46/share.

50% potential stock price appreciation within a year.

With a fair value of $45.46/share, MRK will provide a 50% appreciation at $ 30.31/share . Our previous estimate, MRK can only be bought at $29.3/share.

Other Catalysts

There are several assumptions that we exclude due to uncertainties and for conservatism. First, Vytorin and Zetia might steal market share away from Pfizer's Lipitor. So far, Vytorin and Zetia sales has increased enough to offset the erosion in Zocor sales. Lipitor is Pfizer's blockbuster drug estimated to have a 48.8% share in US cholesterol market. Zocor was number two with 18.6% market share. Here is the source. In 2004, Zocor had $ 5.2 Billion in sales. Using simple calculation, 1 % of market share is equal to $ 280 M in sales. Zetia and Vytorin are new types of cholesterol drugs, especially Vytorin. Taking Vytorin can reduce bad cholesterol LDL and it can also increase good cholesterol HDL and some research shows it is more effective than Lipitor.. It has a great chance of stealing a lot of market share from Lipitor. Stealing about 2-3% of market share means about $ 200 M more in annual profit. Furthermore, as the US population ages, cholesterol market will continue to grow. Conservatively, I think cholesterol market can grow about 5 % for the next 3-5 years. If MRK can maintain the same market share, then profits should be boosted by about $ 350 M

Secondly, Merck has been cutting cost in manufacturing since 2003. In the first quarter of 2005, MRK reported earnings that was a few cents better due to this initiative. If this continues and MRK can be more efficient, gross profit margin can increase by 1-2%. 1 % improvement will add about $ 200 M more in annual profit.

Thirdly, our estimate exclude other potential blockbuster drug that is currently on MRK's phase III trial. These include: Zostavax, a vaccine against the prevention of shingles, Proquad, a vaccine prevention against measles, mumps, rubella, and Rotateq, a vaccine to protect against rotavirus disease. They are all can be marketed in 2006 and might contribute to a $200 M in sales. While not much, it adds up. Also, it helps stabilize our own estimate should other assumptions in our estimation proofs to be wrong.

Combined, these three optimistic scenarios will bring in about $ 500 - $ 600 M or about 40 cents/share in annual profits. But hey, the odds are, all three won't happen at the same time. That is why we exclude it from our EPS estimation.

Conclusion

Merck's share price will be volatile as the trial for Vioxx goes on. However, volatility can be our friends.

We believe MRK represents a good buying opportunity should it dips to $30.31. We are well aware of the uncertainty regarding the Vioxx litigation but share price now is low enough for a good investment. MRK can fall to $25 or even to $20 on the news regarding Vioxx. However, our analysis already includes a $ 10 Billion litigations for MRK. Higher punitive damages appear unlikely at this point. We are basically looking for a turnaround in MRK in 2006.

For other related articles for our portfolio, please click here.

Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding Merck Co Inc.(MRK) or other securities.

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