Dueling Fools
We Can Merck It Out
November 11, 1998

Merck Bear's Den
Chris Rugaber ([email protected])

Merck is a great company, but like a veteran athlete it is past its prime and living off nostalgia. Its past performance has been fantastic, but that's exactly what limits its future: everything has to fall in place in order for Merck to just keep up.

The primary challenge the company faces is the pending loss of patents on five of its most lucrative drugs. While this is a predictable criticism that has been leveled at Merck before, it is still a legitimate concern, especially when one considers Merck's relatively low level of research and development (R&D) spending. Meanwhile, other Merck products are facing increasingly effective competition, its margins are declining, and its pharmaceutical benefits manager, Medco, is unlikely to sustain its recent growth. Given Merck's high valuation, all this combines to make an overpriced, overly risky stock.

Let's take these in turn. First, there are five Merck products -- Prilosec, Vasotec, Pepcid, Mevacor, and Prinivil -- that are losing their patent protection between February 2000 and December 2001, representing over $6.3 billion in sales. (Remember those names -- there'll be a quiz later). Merck's newest drugs will not be able to fully replace the revenue: Propecia, for hair-loss replacement; Maxalt, for migraines; Singulair, an asthma drug; Aggrastat, an anti-coagulant; Vioxx, an anti-arthritic pain reliever, and Cosopt, for treatment of glaucoma, will be lucky to generate $3.5 billion in sales by 2001. You do the math.

Second, one has to wonder what Merck's management was thinking, since patent expirations are not exactly hard to predict. They must have seen this coming, yet their R&D expenditures are low for the pharmaceutical industry. In 1997, they spent $1.68 billion for R&D, which is a lot of money but only 7.1% of that year's $23.6 billion in sales. Pfizer <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PFE)") else Response.Write("(NYSE: PFE)") end if %> spent $1.93 billion, out of $12.5 billion in sales. In percentage terms, Pfizer's R&D was 15.4% of sales, more than twice Merck's. And Merck's R&D as a percent of sales has actually declined -- in 1995, the company spent 8% of sales on research.

What's really noteworthy is that despite Pfizer's significantly higher R&D spending, its margins are also higher: a 26.8% operating margin in 1997 to Merck's 24.8%, and an 81.8% gross margin compared to Merck's 50.1%. In addition, Merck's gross margin has been declining in recent years -- it was 55.3% in 1995.

Merck's other major products aren't losing their patents, but its is losing market share as their rivals develop competing, and in some cases better, drugs. The Food and Drug Administration (FDA) has sped-up its approval process, and improved technologies have quickened the development of new compounds. As a result, Merck's cholesterol-reducing drug Zocor, a major powerhouse that brought in almost $3.6 billion in world-wide revenue in 1997, got clobbered this year by Warner-Lambert's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WLA)") else Response.Write("(NYSE: WLA)") end if %> Lipitor, which was marketed by Pfizer and won accelerated approval by the FDA and now has 31% market share to Zocor's 24.5%.

In the same vein, Merck's Crixivan was the first of the new, powerful AIDS drugs known as protease inhibitors. Crixivan produced $582 million in revenue in 1997, but it's now facing major competition from Agouron's <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AGPF)") else Response.Write("(Nasdaq: AGPF)") end if %> Viracept, which is not only equally effective but requires less-frequent dosing (a significant concern for AIDS patients who sometimes have to take as many as 20 pills a day).

Even Merck's potential future powerhouse, the pain reliever and arthritis drug Vioxx, which is supposed to be kind of a "super-Advil," will face competition the minute it hits the market from a drug developed by Monsanto <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MTC)") else Response.Write("(NYSE: MTC)") end if %> and marketed by Pfizer. Merck is counting on Vioxx to replace much of the revenue it will lose from patent expirations, and it apparently is a significant advance in its field, but given the competition, it's no Viagra.

Of course, Merck is not just a drug-maker. Its pharmaceutical benefits manager, Medco, provides 40% of its income and has contracts with a wide range of managed-care plans. But few people have considered whether the growth of this unit can last. In 1997, Merck-Medco posted revenue of $9.44 billion, a 32% increase over 1996's $7.16 billion, which in itself was a 25% jump over 1995. Yet in the first two quarters of '98, Medco's revenues increased barely 20% over the year-earlier period. While 20% is nothing to sniff at, this slowdown in growth is not surprising. Medicare has been shoving its recipients into managed care but doesn't have many more to add, and managed care growth overall can only slow now that most people are in some kind of managed care plan. As a result, Merck is unlikely to see the kind of growth in this division that it has previously.

Of course, this is not to overstate the case: Merck still has plenty going for it. Unfortunately, that includes a hefty price tag. While it's cheaper than other pharmaceutical stocks, that's not saying much given the multiples we see for companies like Pfizer. As of this writing, Merck is trading at approximately 27 times 1999 earnings, and since earnings growth is very likely to slow from 16% to as low as 8% two or three years from now, such a multiple hardly seems justified.

Especially when one considers the field Merck is in -- it competes with a lot of great companies. As a result, it should be judged by very exacting standards. Here in Fooldom, for example, between the Cash-King Portfolio and the Drip Portfolio, the Fool portfolios have purchased three pharmaceutical companies, none of them Merck (the three are Johnson & Johnson, Pfizer, and Schering-Plough). Given that Merck may soon see growth slip into the single digits, perhaps other investors should follow our portfolios' example.

Next: The Bull Responds