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Merck: Ready to Rise on New Drugs

April 18, 2012 | About:
Merck (MRK) has just announced that it has entered into an agreement with Endocyte (ECYT) to develop and commercialize the experimental cancer drug called vintafolide which is being developed by the latter. The drug is presently in Phase III trials for ovarian cancer that is resistant to platinum and Phase II trials non-small cell lung cancer. Under the deal, Merck will gain global rights to the drug and, in return, pay $120 million upfront. Endocyte will also be entitled to milestone payments that could total $880 million on the achievement of the appropriate goals. In addition, it will also be entitled to receive half the profits in the U.S. as well as a double-digit royalty on global sales outside the U.S.

Merck, which is known as MSD outside the U.S. and Canada, is the second-largest healthcare company in the world with a market capitalization in the region of approximately $115 billion and annual revenues of around $48 billion. It is extremely profitable and has operating margins in excess of 20% as compared to about 12% for the healthcare industry as a whole. In order to expand its business of ophthalmic medication, it acquired Inspire Pharmaceuticals in May 2011. To expand its over-the-counter business without the restrictions imposed by a joint venture, it has exited its joint venture for OTC drugs with Johnson & Johnson (JNJ). In order to cater to the rapidly expanding markets in Asia, an Asian research and development center was opened in Beijing, China in December 2011 to take advantage of the lower cost of operations. These moves have established a solid platform for the company in order to take advantage of future business opportunities.

The company is in the process of completing its extremely important Phase III of ZOSTAVAX which is its vaccine for shingles and has said that its research shows that the vaccine effectively reduces by 70% in the incidence of shingles (which is also known as herpes zoster) among patients between the ages of 50 years and 60 years. This is important equipment because ZOSTAVAX is the only shingles vaccine that is licensed by the FDA for sale and use in the United States. To gain an appreciation of the financial potential of this vaccine, you should take into account the information provided by the U.S. Centers for Disease Control (CDC) which estimates that there are approximately one million cases of shingles every year. It can affect one out of every three people at some stage in their life particularly if they have had chickenpox. Once the varicella-zoster virus which is responsible for the affliction is contracted by the patient, it stays in his body permanently.

The older the person in whom the virus flares up, the most severe the condition is likely to be and almost three-quarters of the cases in the U.S. are adults who are over the age of 50. From all this data, I would draw the conclusion that the potential market is huge (1 million potential customers every year is not to be sneezed at)

Merck is in a unique position to exploit the potential. Not only does it have a first mover advantage but the patent protection could result in large profits for Merck over an extended period of time. It is true that vaccines are generally not as profitable as drugs but this is compensated for by the sheer size of the potential market. Moreover, the initial indications are that health insurance would provide reimbursements for the vaccine which will not only boost the demand but also provide Merck with stable cash inflows.

It is now time to look at how Merck compares with its competitors and how it fits into the global healthcare industry. In terms of operating margins, Merck is slightly behind two of its major competitors namely GlaxoSmithKline (GSK) and Pfizer (PFE) but this is offset by its superior growth in revenues. The dividend yield offered by all three companies is certainly attractive in today's market where good yield stocks are hard to come by. Merck will lose its patent on its popular respiratory drug Singular in August 2012 and the drug currently contributes about 10% of its revenues.

However, the loss of sales should be offset by increased sales of Januvia and Janumet which are used to treat diabetes and Isentress which is used to treat HIV. In addition, there is also the blockbuster potential of ZOSTAVAX as well as other pipeline drugs. I must point out that the stock price of any major healthcare company is heavily influenced by the drugs in the pipeline. All three companies have good pipelines of drugs under development but Merck stands alone because of the market leadership position it could gain with ZOSTAVAX. Moreover, the acquisition of Schering-Plough provides an expansion of the drug pipeline.

I would also point out that Merck currently trades at a major discount to its competitors when it comes to price/earnings multiples. The discount is also evident in the P/B and price to cash flow ratios. I cannot understand the exact reason for this but can only suppose that the value of the Merck drug pipeline has been underestimated. Given the fact that the company is going to be the least affected by the loss of patent protection on drugs, I expect this discount to vanish as discerning investors start to look for undervalued stocks in the healthcare sector. Because of the relatively low beta, the stock price is going to be relatively stable even if the stock markets turn volatile.

For all these reasons, I would recommend a strong buy on Merck stock. Even if you are reluctant to buy right now, you should keep an eye on news and developments on ZOSTAVAX because favorable developments could create a good buying opportunity.

About the author:

Dividend King
I am primarily an investor interested in creating passive income streams through dividends. I focus on finding and analyzing dividend paying stocks, MLPs and REITs that are a good fit for income investors.

I practice Judaism and my faith is very important to me. I visit family in Israel once a year, but I am educated and work in the United States where I hold an MBA and a bachelor’s in English. I am a patient man, enjoy wine but am not a connoisseur, and I listen more than I speak.

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