Dueling Fools
We Can Merck It Out
November 11, 1998

Merck Bull's Rebuttal
Paul Larson ([email protected])

Let me start by saying that my associate's concerns about patent expirations are valid, albeit overblown. There are some important mitigating factors to consider. First is the consideration that the company is only losing its patents in the United States in that timeframe. Other countries, Canada being one of many, give drugs significantly longer periods of time in which the products are under patent protection. Plus, just because the drugs are going off patent does not mean that revenue from their sale completely disappears; only the company's monopoly evaporates. There are measures available to ensure continued sales that the company can initiate, granted in all likeliness they include lower prices.

It's ironic, but the "patent expiration" argument would have been just as valid three, five, or ten years ago. Buying into the theory would have left those investors out of significant gains in the stock. The modus operandi of the drug industry has always been, "Out with the old, in with the new." Anyone remember Diuril, Aldomet, or Clinoril? There is a long list of Merck's compounds that have already gone off-patent or have been replaced with drugs of higher efficacy, yet the company has been able to maintain its impressive growth.

Not only are some of Merck's newest products, such as Singulair and Fosamaxx, showing vibrant growth, but the company also has nearly three years with which to research and introduce new compounds. Chris states that one of these drugs in the pipeline named Vioxx, "is no Viagra." He's right. It could be much larger. The market for an aspirin-like substance that does not cause gastric ulceration absolutely eclipses the smaller but higher-profile impotence market.

The speedier FDA approval process was mentioned in the bearish argument as an advantage for Merck's competitors. Allow me to counter that it also allows Merck on their competitors' turf with new drugs faster, too. In other words, this is a factor that flows both ways. On the competitive front it is a wash, but companies across the board, Merck included, benefit from the quicker time to market.

Chris goes on to make a big deal about Merck's supposed lack of R&D spending as a percentage of revenue. Errrr, try again. Sure, Merck's R&D expenditures as a percentage of total revenues sat at 7.1% last year, but my associate is forgetting one key point when attempting this analysis. Merck gets a significant amount of revenue from its Medco managed care subsidiary, and Medco is more like an insurance company than a pharmaceutical company. In other words, to get a true apples-to-apples comparison of R&D spending you need to back out the revenue generated from Medco. This is not at all insignificant since 40% of the top line was contributed by Medco in 1997.

Look at Merck's R&D spending as a percentage of pharmaceutical revenue and the picture looks a bit more logical.

 
              6-mo 1998    1997     1996    1995 
 Drug Sales     $7.040B $14.197B $12.671B $10.964B 
 R&D Spending   $0.830B  $1.684B  $1.487B  $1.331B 
 R&D % Spending   11.8%   11.9%    11.7%    12.1%

Chris then said, "Zocor... got clobbered this year by Lipitor." Oh really? How does Chris explain the fact that Zocor's sales are actually increasing with 10% growth between the second and third quarter of this year? Zocor's sales were actually $990 million last quarter versus $803 million in the first quarter. If that's what Chris calls getting clobbered, I hope he shows me some other businesses that use this definition!

It doesn't stop there. Chris then insinuates that Crixivan's sales are also declining due to competition from Viracept. Look to the numbers and yet again we find Chris off the mark. In the most recent quarter, sales of Crixivan actually rose 17% versus the second quarter. This is not versus the previous year but is quarter-over-quarter growth, mind you.

My associate then goes on to compare Merck's margins to those of Pfizer. I don't know about you, but I'll gladly give up 2 percentage points of operating margin (especially when they're both in the high-20's) when I can buy Merck at roughly half the multiples of sales, earnings, cash flow, and book value as well as double the dividend yield. Pfizer is a great company without a doubt, but Merck is not exactly a slouch. More importantly, the valuation price tag Merck carries is much less expensive than its peers.

Since my opponent here likes to take things out of context and warp them for his use, let me leave you with these quotes...

"Merck is a great company."
"Merck still has plenty going for it."
--Chris Rugaber
Dueling Fools, Nov. 1998

Next: The Bear Responds