First, its drug pipeline is plainly anemic. Sure, it has a few potential big winners in there, including Invanz, a new antibiotic that some sell-side folks think could tack on $200 million in sales in 2003, and Zetia, an anticholesterol drug that could generate north of $400 million in annual sales in 2003. However, the rest of its pipeline is stuck in the mud.

No News Is Bad News

In fact, according to J.P. Morgan analyst Carl Seiden, no less than four of its high-profile drugs are expected to report lower sales in 2003 because of recent patent expiration: Vasotec and Prinival (for hypertension and heart failure, respectively), Mevacor (for cholesterol) and Pepcid (for ulcers).

Boeing Glenn Curtis and Odette Galli Toys 'R' Us Tim Arango and Glenn Curtis J.C. Penney Odette Galli and Glenn Curtis L-3 Communications Jim Cramer and Arne Alsin

Then there's the issue of Merck's new painkiller Arcoxia. Wall Street had been betting that the company would receive approval for the drug later this year and begin marketing it by mid-2003. But the Food & Drug Administration sidetracked those plans when it requested additional safety and efficacy data before entertaining an approval submission. Put simply, even if the company satisfies the FDA request and the product wins approval, Arcoxia won't hit the shelves until late 2004 at the earliest. This could cost Merck $200 million or more in lost sales in both 2003 and 2004.

Even beyond its pipeline, Merck must contend with earnings issues. In conjunction with its second-quarter earnings release, the company lowered its full-year 2002 guidance for research-and-development expenditures from $2.9 billion to the range of $2.7 billion to $2.8 billion. Bear Stearns analyst Joseph Riccardo figures that this reduction will add as much as a nickel to the bottom line in 2002 and allow Merck to generate earnings in line with management's forecasts of $3.14 a share. Although I like the fact that Merck is cutting costs, I'd rather see some top-line growth. Over the long haul, that's the only way it will drive earnings.

Valuation and Other Worries

Over the past five years, Merck's median price-to-earnings multiple was 26.5, well above the roughly 15 times forward earnings at which it now trades. At least by historical standards, this stock looks cheap, but as we all know, looks can be deceiving. Fact is, when it sported its once-lofty multiple, it was also growing earnings at an annual clip of 13% or better. Now, however, its earnings are at a standstill. Based on its lackluster pipeline and profit outlook for the next few years, I contend that multiple will have to go even lower before investors start to find it attractive again. The stock closed Wednesday at $48.95.

However, my biggest concern about Merck is its unwillingness to adapt to the changes going on in the pharmaceutical sector. On numerous occasions, CEO Ray Gilmartin has said that Merck would be better off focusing on its internal R&D efforts and licensing new products rather than merging with another big pharmaceutical company in order to save money and grow earnings.

But that sounds like a contradiction to me, especially because the company has stated publicly that it plans to curtail R&D spending. In short, Gilmartin needs to come up with a game plan and plunge more money into R&D or merge with another big pharma. I see no other way out.

Bottom line: Merck has potential to get its corporate culture together. But its low P/E multiple just isn't a compelling enough reason to buy it.

For Arne Alsin's take on Merck, please click here.

FaceOff: Aug. 8
Who won this FaceOff?
	Arne Alsin
	Glenn Curtis