Fat Prophets take profits

In our last review, we painted a relatively benign picture of Merck's (MRK) operations but warned that litigation risks remained with regard to the much publicized Vioxx withdrawal. Since then, the company has taken up a charge which at least provides some certainty over its liability on this matter.

"Given the risks the company now faces with regard to the failure of the Enhance trial and the threat of further litigation costs, we believe it is appropriate to take some profits on the stock."

More recently however, Merck has experienced a different development, which led to the recent selloff of the stock. As evident on the daily chart, since reaching a high of $61.62 in December the share price has broken sharply lower, resulting in a break of rising trendline support.

Before we delve into reasons for the recent selloff, let us first consider Merck's recently reported full year results. The company appears to have made relatively healthy progress in 2007 before exceptional items, with adjusted earnings per share (EPS) reported ahead of consensus at $3.20.

This came off the back of a robust 7% rise in group sales to $24.2 billion, driven by double digit growth in Merck's range of drugs particularly in asthma and cholesterol control, and also helped by a surge in the company's vaccine sales.

However, unadjusted full year EPS was reported much lower at $1.49, mainly due to a Vioxx settlement charge of $4.85 billion that was recognized in the fourth quarter. The charge represents a fixed amount to be paid by the company to settle all qualifying litigation claims as of 9 November 2007. Given that the vast majority of claims will relate to periods before that date, we expect that future charges in relation to Vioxx will be relatively small.

However, the resolution of one issue has been met with the emergence of another. Earlier this month, Merck and joint venture partner Schering-Plough disclosed that their closely watched study involving the Vytorin cholesterol treatment had failed to reach its main objective.

The so-called Enhance trial tested Vytorin (a combination of the companies' Zetia drug with Merck's older Zocor drug), against Zocor alone. The trial found that, with the main goal being a lowering in the level of arterial plaque, there had been no difference between the treatments. In other words, the combination Vytorin drug fared no better than one of the components.

Although Merck and Schering-Plough have defended the efficacy of their drugs with regards to the secondary goal, being the lowering of 'bad' cholesterol, its failure to meet the main goal of reducing arterial plaque has been the focus of investors.

Furthermore, the New York Attorney General has now issued a subpoena against Merck and Schering-Plough, saying that it would hold an investigation into the marketing of Vytorin and scrutinize the sale of company stock to investors before the study's negative results were revealed. Given this development, we believe the litigation risk attached to Merck is considerably increased.

Vytorin and Zetia are crucial drugs for Merck and it is reasonable to believe that negative publicity as a result of this failed study could have an impact on future sales. Indeed, new prescriptions for Vytorin have plunged, while those for competing drug Lipitor (produced by Pfizer) have risen.

Merck has not accounted for any such impact in its guidance for 2008, saying that it is too early to change guidance because of limited data. Hence, Merck's guidance for 2008 adjusted EPS stays at the $3.28 to $3.38 range. However, we believe that a reduction in Vytorin sales as a result of the failed study is likely to transpire, bringing a significant downside risk to Merck's 2008 earnings.

In respect to the research and development pipeline, the outlook is hardly exciting. Following Food and Drug Administration (FDA) approval of an intravenous therapy for nausea in January, Merck only has a small number of New Drug Applications and one Phase III program in place for this year.

Looking now at the valuation metrics, the stock does not looks expensive, trading at a price to earnings ratio of 13.9 times, which is a discount to its peers. However, we believe the discount is justified given the downside earnings risk and the ensuing litigation threat.

And our fundamental view is supported by the technical picture. Based on the charts, the outlook for Merck has deteriorated considerably over the past month. Given the speed and magnitude of the recent correction, it is not surprising that numerous daily technical indicators have recently been exploring oversold territory. In our opinion, this implies a near-term pause for consolidation between the recent low of $42.32 and the $51 region.

From a longer-term perspective, the January pullback has clearly broken the two-year upward trend. While we anticipate a period of volatile consolidation in the near-term, we cannot yet rule out the potential for a deeper fall in the months ahead.

As such we recommend Members sell half MRK at around $46.10.