Gut Check: Stock Pickers Say Patent Problem Puts Merck in a Pickle

What's the 2001 prognosis for Merck (MRK Quote), now that it has posted a 14% rise in fourth-quarter earnings?

The Merck File

Business: Pharmaceuticals

Current P/E: 29.4

Stock Price: $79.56

52-Week Range: $96.63- $52

Change From 52-Week High: -17.7%

Shares Outstanding: 2.3 billion

Source: Morningstar, First Call/Thompson Financial

Earnings are up. The nation's second-largest drug maker reported fourth-quarter earnings of $11.4 billion, up 28% from the year-earlier quarter. Sales are up: Merck reported year-end sales of $40.3 billion, up 23% from $32.7 billion in 1999. And the stock is up: In 2000, it rose 41.8%, trouncing the gloomy broader market.

But what's also up for Merck is five key patents, and that's got some Merck watchers down. Even fund managers and analysts who are bullish on Merck tell this week's Gut Check they don't foresee any compelling new drugs in development to replace five blockbuster Merck drugs coming off patent protection this year. (After Merck's report, Merrill Lynch cut earnings forecasts and slashed its rating to accumulate from buy, saying Merck couldn't sustain the outperformance of the past two quarters.)

The stock fell $2.75, or 3.3%, to $79.56 Tuesday, putting it 17.7% off its 52-week high. While it had a solid run-up in '99, the stock's price-to-earnings ratio of 28 is lower than the average pharmaceutical stock's P/E of 33. The stock also lagged behind other pharmaceutical stocks' average 53.2% return in 2000, according to Morningstar.

Gut Check on Merck
Pros	Cons
Merck delivered a 41% return in 2000 and is expected to post earnings growth of 18% in 2001.	Five key Merck patents are expiring in 2001, while earnings growth is projected to slow to 11%.
Merck spent about $2.4 billion on R&D in 2000 and has eight products in the pipeline.	None of the pending products has caught the attention of Wall Street analysts, who are looking for $1 billion-plus blockbusters to replace the five drugs going off patent.
Health and biotech funds were up 55% in 2000 and have provided one of the market's only bright spots of late.	Pharmaceutical stocks, which rose in 2000 in inverse relationship to tech stocks, may pull back as the tide shifts.
Source: Lipper, Merck, Morningstar, Wasserstein Perella

Analysts surveyed by First Call/Thomson Financial see Merck's earnings slowing to 11% in 2001. Its Merck-Medco Managed Care division, which provides outsourced prescription drug management to HMOs and contributes 51% of revenue, is expected to be a drag, says Amy Arnott, a senior analyst with Morningstar.

But more important, fund skippers' and Wall Street analysts' biggest apprehension right now is expiration of five critical drug patents, each of which pulls in well over $1 billion in sales a year. The five drugs coming off patent are Vasotec, Mevacor, Pepcid, Prinivil and Prilosec. These products, currently the foundation of Merck's product revenue, help combat blood pressure, cholesterol, ulcers and the like. Once a drug goes off patent, generic drugs are free to compete with it and its sales typically decline 75%, Arnott says.

That leaves five other drugs that analysts and Merck say will keep up the sales momentum. These are Zacov for cholesterol, Cozaar and Hyzaar for high blood pressure, Singulair for asthma and Fosamax for osteoporosis.

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In addition, Merck has eight drugs in the pipeline, but analysts don't see any of them becoming a standout. "Two, one an antibiotic and the other an antifungal, have the potential to pull in $400 million to $500 million a year each in gross sales," says Adam Greene, vice president with Wasserstein Perella. "But for a $40 billion company, you need billion-dollar products. There's not a lot of visibility in their pipeline as to what is going to be the driver" replacing the five key products going off patent, he says.

In addition, decelerating growth rates for drugs that enjoyed 20%-180% growth rates in their early years is another reason Richard Welsh, co-portfolio manager of the (EFONX Quote)Evergreen Foundation fund, sold off his entire position in Merck in December. Evergreen Funds expects that Merck's arthritis drug Vioxx, whose sales soared 183% in 2000, will slow to 33% in 2001, Welsh says. Less dramatic but equally important, Welsh says, is a projected decline in the sale of cardiovascular drug Cozaar from 20% in 2000 to 15% in 2001.

Steady Dosage The percentage of funds holding Merck since the beginning of 2000 has remained the same
Date	Number of Domestic Funds Owning MRK	Percent of Domestic Funds Owning MRK
Jan. 1, 2000	774 out of 2,662	29%
Jan. 1, 2001	845 out of 2,911	29%
Source: Morningstar

Allan Rudnick, manager of a fund with one of the biggest holdings in Merck, the (KARDX Quote)Kayne Anderson Large Cap fund, couldn't disagree more with Welsh. Merck's revenue, earnings and free cash flow may slow somewhat in the near term, but continue to be strong, maintains Rudnick, president and chief investment officer of Kayne Anderson Rudnick Investment Management. While Merck may not currently have any fantastic drugs in the works, the company spent $2.4 billion on research and development in 2000 and will spend more than that in 2001, Rudnick argues.

Naturally, fund managers who are bullish on Merck point to the fact that drug stocks are insulated from an economic downturn, because people dependent on drugs will continue to buy them, no matter what the economy is doing. They also cite the bright future an aging population will bring drug manufacturers. "Over half the drugs are purchased for people over 50, and the number of these people is growing enormously," says L. Roy Papp, co-manager of the (PAAFX Quote)Papp America-Abroad fund, the third-biggest holder of Merck.

"Merck is ready to capitalize on an increase in drug demand created by all of us getting older by the day," adds Bill Van Alen, president of (NOAHX Quote)Noah fund.

Some Merck watchers say there are other short-term concerns besides the patent expirations. Akber Zaidi, manager of StockJungle.com Market Leader Growth, points out the recent phenomenon of technology and pharmaceutical stocks trading inversely to one another. In fact, year-to-date, Merck and the pharmaceutical sector are off more than 10% while technology stocks are up 26.5%, according to Morningstar.

If further Federal Reserve rate cuts continue to help technology stocks, that could drive investors away from Merck and similar stocks, Zaidi says. "That could lead to a selloff in pharmaceuticals," he warns.

The Right Prescription These funds have made big commitments to Merck
Fund	Total % of Fund	Date of Portfolio
(RYHIX Quote)Rydex Health Care	9.22%	June 30
(SWHFX Quote)Schwab Health Care Focus	9.20	Sept. 30
(PAAFX Quote)Papp America-Abroad	9.17	Sept. 30
(LRPSX Quote)Papp Stock	6.87	Sept. 30
(USGLX Quote)U.S. Global Leaders Growth	6.82	Oct. 31
Source: Morningstar

Canceling Their Refills These funds sold big stakes in Merck last year
Fund	Shares Sold	Date of Portfolio
(FGRIX Quote)Fidelity Growth & Income	6,803,000	July 31
(FEQIX Quote)Fidelity Equity-Income	6,142,000	May 31
(PVOYX Quote)Putnam Voyager	5,018,000	June 30
(FBGRX Quote)Fidelity Blue Chip Growth	1,438,000	July 31
(FPURX Quote)Fidelity Puritan	1,350,000	July 31
Source: Morningstar