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Ailing Merck Defies Cure

Robert Steyer

You know something is strange when an analyst describes a venerable company like Merck(MRK Quote) as a turnaround story -- for 2007.

Despite a top-notch credit rating and strong reputation, Merck's stock is stuck in a rut. It is reeling from the recent failure of several experimental drugs. And it is starting to feel the impact of patent expirations on important existing products.

Clearly, this can't be what Raymond V. Gilmartin, Merck's chairman and CEO, was looking forward to approaching the company-mandated retirement age of 65 in March 2006. But disappointing test results, bad timing, and what some analysts say was a slow response to the changing marketplace have put Merck -- and Gilmartin's successor -- in an uncomfortable position among its peers and investors.

Under the leadership of Gilmartin, who assumed the role of CEO in June 1994, Merck's market performance has been good, but not great. From July 1, 1994, to Aug. 31, 2004, for example, Merck outpaced the S&P 500 but trailed the Amex Pharmaceutical Index of 15 big drug stocks (which includes Merck). A $1,000 investment in Merck would have yielded $3,190, better than the S&P's $2,490 but worse than the drug index's $4,000.

For short-term investors, Merck's returns aren't impressive. From the beginning of the year through Sept. 14, that $1,000 investment in Merck was down to $986, better than the drug index (down to $966) but worse than the S&P 500 (up to $1,015).

Still, it's the next few years that really worry analysts. They're forecasting serious sales doldrums as Merck struggles to make up in new-product revenue what it will lose in sales due to generic competition. Perhaps this wouldn't have been an issue if clinical trials hadn't been cancelled on four products last year, including late-stage tests of drugs to treat diabetes and depression. "It's unusual to have two [late-stage] testing products blow up like that," said Albert Rauch of A.G. Edwards, who has a neutral rating on Merck.

And although there are some interesting prospects in the pipeline, analysts like Rauch simply can't make up their minds about how well and how fast the company can recover. Right now, Merck has so many neutral recommendations on Wall Street that it could change its name to Switzerland. Thomson First Call lists 23 hold or neutral ratings compared to four buys and three sells.

Analysts also aren't sure if Gilmartin's successor will be an insider or an outsider. (He was the first outsider in Merck's history to become CEO, although he had been the chairman and CEO of medical-equipment maker Becton Dickinson (BDX Quote).)

A review of several recent analysts' reports plus interviews with several Merck-watchers by TheStreet.com suggests that Merck will change by small steps rather than by leaps and bounds, regardless of who succeeds Gilmartin.

"The board is saying 'Let's get the pipeline rebuilt,'" said Rauch, who forecasts a turnaround in 2007. "That would seem to favor an insider as the next CEO. They seem confident in their abilities and don't feel it's necessary to go outside [for a new CEO]. They are looking to get back to their roots." (Rauch doesn't own shares; his firm doesn't have an investment banking relationship.)

And despite constant Wall Street speculation, analysts doubt Merck will make a big acquisition. Merck continues to emphatically eschew the prospects of a big buy in its conversations with analysts and investors.

"A big acquisition will not provide an answer," said Sena Lund of Cathay Financial, an investment research firm, who has a neutral rating on the stock. "A big acquisition will be out of frustration -- not a strategic move."

Bad News Approaching

Merck has had plenty of frustration. The back-to-back-to-back-to-back canceling of its experimental drugs last year illustrated to some analysts that Merck should have been more prepared.

"I think it was a little more than bad luck," said Lund who owns shares but whose firm doesn't have an investment banking relationship. "There was a miscalculation on the part of management. They did not prepare themselves for a worst-case scenario."

The worst-case scenario will be a big erosion in revenue, says a recent study by the SG Cowen brokerage. Among nine Big Pharma companies, Merck has a frightening 29% of 2003 revenue at risk due to product patents expiring between 2004 and 2008. The biggest shock will come in mid-2006 when Zocor, which has started losing patent protection in some foreign markets, succumbs to generic competition in the U.S. The cholesterol drug produced $5 billion in sales last year, or 22% of corporate revenue.

The Cowen study noted that the average generic risk during 2004-2008 among the Big Pharma companies was 16% of total 2003 sales. Merck also placed well below average among its peers in projected revenue growth and earnings per share growth. Between 2003 and 2008, Cowen projected a compound annual revenue growth of 3% for Merck, which tied for seventh place. The group average was 5%. For the same period, Cowen pegged Merck's EPS growth at 3%, or eighth place, and below the group average of 5%.

And for all you fans of the oft-rumored Merck purchase of Schering-Plough (SGP Quote), please note that Cowen predicts a 1% revenue growth rate and 5% EPS growth rate for that drugmaker.

The logic of the phantom dealmakers goes like this: Merck and Schering-Plough comarket the well-regarded cholesterol drug Vytorin. Because Schering-Plough is trying to dig out from problems far worse than Merck's, and because Merck needs a hit product to offset the generic assault on Zocor, a takeover would benefit shareholders of both companies. As an added attraction, Fred Hassan, the Schering-Plough CEO, could succeed Gilmartin.

But many analysts say such a deal is illogical. "It's hard to keep growth continuing after the first big acquisition," said Rauch of A.G. Edwards. "You find that you need to buy again. I don't think they'll look outside to buy a [big] company."

Not Invented Here

The biggest criticism of Merck is that it didn't move fast enough to make deals with traditional drug and biotech companies -- copromotion, codevelopment and product licensing deals -- to create a wider portfolio of scientific opportunities.

"Merck was a little late to the game," said C.J. Sylvester of Schwab Soundview Capital Markets, who has a neutral rating on the stock. "There was a lot of 'not invented here,' but that's changing." (He doesn't own shares; his firm doesn't have an investment banking relationship.) Although Merck's earnings and revenue will remain torpid for the next two to three years, Sylvester said the newly aggressive licensing strategy will eventually pay off. The increased licensing prompts him to speculate that Merck will choose an insider to succeed Gilmartin.

Gilmartin has indirectly admitted that Merck had been slow to react. "We are identifying and entering into external partnerships and alliances that complement and supplement our own R&D efforts," he told shareholders on April 27. "In 2003, we closed on 47 significant transactions. Compare that with just 10 such transactions only five years ago."

Recent partners have been as big as Bristol-Myers Squibb(BMY Quote) for a diabetes drug in late-stage testing or as small as Alnylam Pharmaceuticals(ALNY Quote) for preclinical work on eye disease treatments.

Analysts say Merck's altered approach is better late than never. "'Not invented here' is now a core strategy," said David Moskowitz of Friedman Billings Ramsey, in a recent report to clients. (He rates the stock as market perform; he doesn't own shares and his firm doesn't have an investment banking relationship.) Moskowitz and other analysts note that a number of Merck's recent licensing deals are being signed when clinical tests of drugs haven't begun or are in their early stages. That's riskier -- but less expensive -- than making deals involving drugs that have entered late-stage testing.