On the mend

Pharmaceutical companies traditionally offer several attractive characteristics to investors. High barriers to entry usually mean a well protected market position, strong margins and a solid return on capital. Because of this, the sector has historically been valued on a high price earnings multiple.

Of course, if it were all plane sailing for the drug companies, stock prices would remain permanently high, denying value investors any opportunities.

Fortunately for value investors, the sector comes with its own brand of risk. And 'perception of risk' is something that always fluctuates, regardless of the sector. When investors place too much weight on risk relative to reward, valuations can become far more attractive. We believe this has certainly been the case in the pharmaceutical industry over the past few years as drug stocks have lost popularity amongst investors.

Merck (MRK) is amongst the world's largest pharmaceutical companies, with annual sales of over $20 billion. As with industry peers, Merck's business is continually evolving. The company must spend significantly on research and development (R&D) to produce effective and innovative drugs, followed by expenses for patent protection and marketing.

Combined with the need to hire and retain highly specialised individuals, it becomes clear that the vast expense of competing creates enormous barriers to entry. Fortunately, such barriers to entry mean the industry generally enjoys strong margins and cash flows, more than enough to cover the considerable costs.

As can be seen on the weekly chart, Merck's share price has declined persistently over the past five years. We attribute the prolonged weakness to a number of factors, not least being the sky high valuation investors placed on Merck a few years ago. For reasons that will become apparent, we believe the worst is now behind the industry and Merck in particular.

The poor performance of the Vioxx drug is one of the primary reasons behind Merck's miserable performance. Considered one of the company's 'blockbuster' drugs, the anti-arthritis pill was taken off the shelves during 2004. The association of Vioxx with heart problems has led to a long line of lawsuits that are yet to come to trial. The uncertainty of these compensation claims has introduced additional negative sentiment toward the stock.

Other factors have weighed down heavily on Merck. The recent expiry of patent protection for key products, Zocor and Proscar has seen the emergence of new competition from generic brands. This will likely erode margins for newly 'off-patent' products.

Exacerbating the loss of revenue from key products, Merck experienced a disproportionate increase in costs versus sales over the last five years, which has also pressured margins. Since 2000, sales have experienced average annual increases of 2 percent. This compares to a 5 percent rise in marketing costs and around a 10.5 percent increase for both production and R&D.

It is therefore not surprising that Merck's share price has been under pressure throughout this period, declining around 70 percent from the 2000 peak. In our opinion the risk to Merck's future prospects is now largely priced in. Indeed, with the stock trading well above recent lows, we believe the worst is now behind the company.

While patent expiry will reduce revenues from affected products, drugs still in the pipeline have the potential to become new 'blockbusters'. This also applies to recently approved products which may initially have smaller revenue, but offer tremendous future growth. These new and pipeline drugs should help to offset the margin erosion on those losing patent protection.

Revenue from Merck's current product range is reasonably diverse. It is true that the company's first and fifth largest selling products recently came off patent protection. Revenues for Zocor and Proscar amounted to $4.4 billion and $741 million respectively in 2005. However, Merck's remaining sales came to almost $17 billion, spread across more than ten separate products.

Moreover, we expect both approved products and Merck's R&D pipeline to deliver new revenue growth over the longer term.

Gardasil is one example with potential. Gardasil is the only vaccine available in the U.S. for certain types of cervical cancer. The product was approved by the Food and Drug Administration (FDA) in June. The U.S. Centers for Disease Control (CDC) subsequently recommended that females between 11 and 26 be routinely vaccinated with Gardasil.

The HPV virus targeted by the drug is the leading cause of cervical cancer. The CDC estimates there are 6.2 million new HPV infections annually in the U.S., leading to almost 10,000 new cases of cervical cancer diagnosed every year.

There are also drugs already in production that are generating strong sales growth. Merck's anti-fungal drug Cancidas was first approved in 2001, but revenue has begun to accelerate in recent years. Average annual growth in sales from 2003 to 2005 was 44 percent, with 2005 revenue at $570 million.

Many drugs in the development pipeline also hold promise to lift future sales. Januvia is a prime example and is another promising product. Januvia is one of a new class of diabetes treatments known as DP-IV inhibitors. The drug has displayed positive results in recent studies on controlling blood glucose levels.

Weight gain is a common side-effect of diabetes treatment using existing drugs and this can raise the risk of heart disease. Januvia actually has a positive side effect of triggering weight loss. We believe this could boost the take-up rate of the new drug after FDA approval.

Merck has many other drugs in the pipeline, including over 40 that are currently undergoing trials. Two new drugs in the key area of cholesterol reduction are slated for approval in 2007.

With a number of newly approved and pipeline drugs, Merck is in a good position to rebuild revenue growth in our opinion. However, the company's reorganisation of the business model is perhaps more important than any individual product.

In the past, Merck pursued all areas of medical need, aiming to 'win' in each area. Management have decided to refocus R&D efforts on nine priority areas based on commercial opportunity and value to customers. These are: Alzheimer's disease, atherosclerosis (cholesterol-related), cardiovascular disease, diabetes, vaccines, obesity, cancer, pain and sleep disorders.

With a greater focus, we believe management is ready to commit the necessary resources to build leadership in these market segments. Efficiency across the business is a key goal for Merck, from R&D activities to sales and marketing. Management plans to increase productivity by outsourcing or using licensing where appropriate.

For example, Merck has several agreements in place involving collaboration with other companies that is mutually beneficial. These range from smaller companies offering specialised technology, to larger competitors where each can leverage the other's sales or R&D capabilities to mutual advantage.

We expect such arrangements to increase efficiency and reduce costs. Merck is also making a more direct assault on the cost base of operations, with plans to close five manufacturing sites and eliminate around 7,000 jobs by the end of 2008.

Efficiency is also the key word in the restructuring of the sales force. Management has halved the number of sales staff promoting the same product and limited the number of products carried by each representative to just two. Merck is also redeploying 1,500 sales staff from existing products to support newly launched drugs.

We are encouraged by this decisive plan of action which aims to cut spending per brand by 15 to 20 percent by 2010.

Management's strategy also covers marketing and communication. The success of pharmaceutical companies relies greatly on the recommendation of industry professionals and organisations, as well as product acceptance by the end consumer.

The controversy surrounding drugs like Vioxx has increased cautiousness amongst medical professionals when endorsing new products. Recognising that communication is vital to distribution, management is committing additional resources to improve dissemination and accessibility of such information. The reorganisation of the sales force should also help greatly in this regard.

Merck's restructuring program will take time. There will also be ongoing costs of restructuring as the initiatives progress. However, the plan is expected to yield significant pre-tax savings of around $5 billion by 2010. Moreover, we believe the result will be a leaner and more efficient organisation with an improved competitive edge.

We are mindful of the risk associated with ongoing Vioxx litigation and uncertain legal outcomes. Of the cases tried so far, Merck has won four and lost three. We believe that much of the negativity surrounding this issue is factored in to the historically low share price.

While the threat of litigation is a concern, it is important to remember that Merck is a huge, high margin, cash generating business. Over the last three years, free cash flow has averaged $6.9 billion. While conditions may be somewhat tighter over the near term, cost savings should help to shore up earnings over time.

Merck boasts a strong balance sheet with cash of around $10 billion exceeding total debt by $3.5 billion. Consensus forward price to earnings multiples are 15.3 for 2007, falling to 14.8 and 12.7 for the following two years. With the restructuring initiatives underway, we expect solid earnings growth over the next five years.

Given this outlook, we are comfortable with the valuation. Furthermore, on a price to earnings basis, Merck is currently trading below the peer group average and at the lower end of its own historical range. The 26 percent return on equity and 4 percent dividend yield also better the peer group averages.

From a charting perspective positive investor sentiment toward Merck has recently seen the stock break above $36.65 to extend the nine month upward trend. The latest gains indicate a re-rating of the stock following a period of depressed prices.

With a firm upward trend and buoyant investor support, we believe further gains will be achieved in the months ahead. Accordingly, Fat Prophets recommend buying MRK around $37.