Merck: A "Scandalous" Buy
11/19/2004 12:00 am EST
With its focus on long-term value and growth opportunities, the top-performing team at the Al Frank Fund often takes "unpopular" positions. One of their latest favorites, Merck, is a clear example. Here, analyst Jessica Chiaverini looks at this controversial situation.
"Merck (MRK NYSE), despite its current problems, is one of our current favorite stocks. The soap opera surrounding the Vioxx story continues to unfold. What started as a seemingly noble gesture of pulling a $2.5 billion drug, cascaded into a circus of class action lawsuits, personal liability claims, justice department inquiries, SEC investigations, clandestine corporate e-mails, allegations of competitor drugs, and corporate debt downgrades. And the Senate Finance Committee has just held a hearing on the withdrawal of Vioxx, on Capitol Hill with both the FDA and Merck to testify.
"We certainly do not mean to belittle the seriousness of the situation, and as investors we are obviously aggravated by the 40% plus drop in the share price of Merck and the resulting $40 billion evaporation in market cap. Still, the lawyers and the media seem to have flocked to this story and are doing their best to spin it as evil corporate empire versus unsuspecting consumer. What is interesting is that the heart risks of Vioxx and other Cox-2 drugs have been known for years. One Wall Street Journal editorial commented, 'Vioxx wasn't a better pain reliever. Its unique selling proposition was simply a lower incidence of stomach bleeding, a real benefit but one mainly relevant to the 15% of arthritis sufferers who can't safely take conventional pain relievers. We're not trying to let Merck off the hook. Go ahead and blame the company for over-marketing the drug. But all this was well known. Merck is in hot water now not because Vioxx was excessively risky but because the wrong people were taking it; a problem for which doctors and the insurance system are also to blame.'
"That may be overstating the case somewhat, but the point is that there are many sides to this story and many constituencies involved. How it all plays out in the courts and elsewhere is anyone's guess. As of this writing, Merck vigorously defends any accusation of intentional wrongdoing. Meanwhile, t he laundry list of problems created by the Vioxx scandal are material and severe. Aside from the obvious, i.e. the loss of a key revenue source, the company could see its cash flow dramatically impacted by liability payouts and government fines. Management turmoil and the delay of the company's second generation COX-2 inhibitor, Arcoxia, are also real obstacles. And all of this comes at an already particularly thorny time for the pharmaceutical giant as patent expirations, generic competition, and a weak product pipeline, continue to plague the company.
"Fortunately, the company's financial strength still allows for a bullish case to be made. As of September 30, the company had $2.7 billion in cash, $4.3 billion in short-term investments, and $7.3 billion in long-term investments. Operating margins stand at a respectable 38% and according to Fitch Investors, free cash flow for the trailing 12 months ended September 30 works out to $4.2 billion (cash flow from operating activities of $9.3 billion less capital spending of $1.8 billion and dividends of $3.3 billion). So far the dividend is safe (a 5.7% yield) and the company has said that the recent debt downgrade "doesn't in any way change the conservative financial management profile that the company has had for many, many years." The shares are likely to be volatile over the near-term, but we continue to believe that Merck has the financial wherewithal to weather the storm. Our buy limit on MRK is $32.50."