Merck has been able to improve its long-term outlook with the acquisition of Schering-Plough. Indeed, before the acquisition it was facing increased competition, patent losses and a pipeline of late-stage drugs with almost no chances of approval at all.
Merck's new products during the last few years have helped to offset recent patent losses.
Merck acquired Schering-Plough in $40 billion. Schering brings a very strong pipeline of late-stage drugs and faces limited patent losses.
The combination of the two businesses will yield more than $3 billion in annual cost savings.
The Schering acquisition definitely places Merck in a stronger strategic position.
Merck has had a steady growth in the last quarter thanks to steady gains in its principal drugs. This trend is expected to continue next year. Unfortunately, in August 2012, the loss of US patent on respiratory drug Singulair will bring risks to the company. Singulair represents more than 10% of total sales.
Rapidly growing drugs will mitigate the loss of Singulair. A single-digit negative growth is expected for 2012.
Lower research and development expenses offset an increased tax rate, boosting EPS growth faster than sales growth.
Merck’s free-cash-flow margin has averaged about 16.5% during the past three years. The cash flow generation is relatively strong. Actually, cash flow from operations increased 62% from prior years while capital expenditures expanded about 29% over the same time period.
There are particular risks that Merck may face. In terms of near-term headwinds, Merck may face risks on product acceptance. The FDA is permanently controlling. Product delays or non-approvals could hurt the stock.
Also, the growing power of managed care and a more price-sensitive U.S. government may reduce Merck's pricing power.
Last quarter results
Total sales increased 3% vis-à-vis total sales of the prior-year period. Furthermore, EPS increased 11% year over year thanks to a reduction in research and development costs.
Merck is deemed financially strong, despite the $8.5 billion debt burden that it incurred to acquire Schering acquisition. However, this debt burden will surely be repaid. It is expected that the combination of the two entities will generate free cash flow of about $12 billion.
Peter Kellogg, CFO, is very clear: “…This was a very good quarter characterized by continued operational sales growth and cost efficiencies, which enabled us to fund strategic investments in new product launches and emerging markets, and still grow non-GAAP EPS by 11%. At the same time, we returned more than $2 billion to shareholders this quarter. So we anticipate that 2011 will end up as a strong year on both top and bottom line performance. We are focused on continuing this good performance in the fourth quarter…”
The fair value estimate is of $46 per share. Merck's acquisition of Schering-Plough will yield enough earnings to make a steep purchase price.
In terms of patents, Merck will face competition due to the future loss of Singulair.
Therefore, management anticipates a high degree of volatility in sales growth as the patent expires.
However, sales of marketed products and products still under development will eventually offset Singulair patent expiration
The fair value for Merck represents a P/E ratio of about 166.7 times last year's earnings and an implied EV/EBITDA multiple of about 14.1 times last year's EBITDA.
Management & Stewardship
At the beginning of 2011, Ken Frazier took over the helm of Merck as CEO. Frazier has almost two decades of experience at Merck as he has been in the major divisions.
Merck's board is made up of current and retired CEOs, which can lead to quid pro quo compensation packages for top executives but lends valuable strategic-planning experience.
Also, Merck no longer holds annual elections of its board members. It has empowered minority shareholders by granting cumulative voting for board members.