Litigation risks remain

Shares of pharmaceutical giant Merck (MRK) enjoyed an uplift recently as a general re-pricing of risk buoyed defensive sectors such as healthcare and the success of the company's ongoing restructuring program bolstered earnings.

"...the uncertainty regarding the outcome of legal proceedings prevents us from recommending buying more shares at this time."

This is a welcome turnaround for the company which had several lean years following the withdrawal of its major drug Vioxx in 2004. Adding fuel to the fire during this difficult period, litigation and competition from generic drugs following patent expiries also combined to weigh on the shares.

However, the five year restructuring plan spearheaded by CEO Richard Clark in 2005 drove the company to recoup margins while revenue growth was boosted by the company's development and production of new and established drugs.

Merck's quarterly results throughout this year reflect these successes and the most recent third quarter result is no exception.

Third quarter earnings rose 60 percent in the period to reach $0.70 per share, on the back of a 12 percent increase in revenues and a substantial increase in operating margin. A major part of this margin improvement, however, was explained by high litigation costs incurred in the previous period. Stripping out these costs revealed a small but encouraging margin increase.

The solid revenue growth was driven by double-digit increases in Merck's range of drugs - particularly related to asthma and cholesterol control. Vaccine sales, mostly sold through the company's joint ventures, also recorded double-digit increases.

Expenses (excluding Vioxx legal costs) increased slightly but this reflects the necessary support provided to new and anticipated product launches. Research and development expenses rose strongly largely due to a Phase III heart failure drug. Other costs including restructuring, materials and production fell slightly in the period, reflecting the company's cost cutting initiatives.

On the back of these favorable developments, the company increased its full year earnings per share (EPS) guidance by around 7 percent and is now looking for earnings of between $3.08 and $3.14 per share. Merck looks on track to achieve its longer term outlook of double digit EPS growth up to 2010.

And in addition, Merck's component HIV drug gained FDA approval in mid October and is now progressing towards regulatory filings outside the US.

All this indicates that the company is recovering well from its past problems. Despite this, we remain wary of the non-operational risk Merck faces. Our main concern remains the unquantifiable financial liability embedded in the future legal costs and damages relating to the Vioxx withdrawal.

Vioxx was one of Merck's major drug offerings before its recall in 2004 after allegations of its link to heart attacks. Since then, the company has incurred significant legal costs in defending against plaintiff claims and has since built up a provision of $720m for future legal defense fees.

We are particularly concerned that the company has provisioned for estimated legal costs only up to the end of 2008.

Even though the provision may appear insignificant compared with the company's market capitalization, the possibility of litigation proceedings extending beyond 2008 means Merck could face further provisioning in the future.

Furthermore, the company has not provisioned for, or insured against, damages that it could face in the event of an unfavorable verdict.

So far 10 percent of claims from plaintiff groups have been dismissed, but the bulk of these are still open to appeal. In addition, any punitive damages or product liability relating to the Vioxx case have not yet been determined.

While this litigation risk is worrying, the company's operational improvements provide a mitigating effect.

The stock valuation lends some support to this view. According to Bloomberg consensus forecasts, Merck trades on a 2008 forward price to earnings ratio of 17.7 times. Whilst this may be in line with the broader market, it is at a substantial premium to its peers.

From a charting perspective, the outlook for Merck looks buoyant. Following seven months of consolidation between April and October, prices have broken higher over the past two weeks, reaching $58.26. This is the highest level since July 2003 and the upward trend has persisted for two years.

Although we cannot rule out a temporary pause for consolidation in the near term, initial support in the region of $54 limits downside risks. Additional support at $48 underpins the broader upward trend.

However, the uncertainty regarding the outcome of legal proceedings prevents us from recommending additional purchases at this time.

Accordingly, Merck will remain held in the Fat Prophets Portfolio.