Merck can't keep it going

By Robert Walberg

What a difference a year can make.

Last year, Merck (MRK, news, msgs) was left for dead amid costly controversy over the painkiller Vioxx. Today, the stock jumped to a 52-week high after a better-than-expected report of quarterly earnings. The stock is up 73% this year.

Can Merck keep it going? No.

Despite surprising Wall Street with earnings of 51 cents per share -- a penny above expectations -- Merck faces many hurdles ahead.

Vioxx costs

The company said it was setting aside an additional $598 million for future legal costs surrounding Vioxx, bringing the total to a staggering $1.57 billion. Unfortunately, that figure is likely to rise even higher because Merck still faces nearly 14,000 lawsuits, covering almost 30,000 people who claim that they or their relatives suffered strokes or heart attacks after taking Vioxx. The company’s 50/50 record in cases so far isn't encouraging, especially considering that the average payout in those cases it has lost is close to $90 million.

You don’t have to be a math whiz to realize that $90 million times 7,000 (half the cases) is considerably more than Merck has set aside. The company is appealing the decisions it lost, jury awards might be reduced, and the percentage of cases lost might also drop. But, any way you slice it, the company’s legal risks remain enormous.

However, my major concern isn’t the legal front, but Merck’s sluggish sales. Sales for the current quarter were flat compared with a year ago. This year's sales are projected at $21.35 billion, down from $22.01 billion. Two years ago it generated sales of nearly $35.6 billion.

Pressure from generics

The bearish trend is expected to continue in fiscal year 2007, with sales slipping to $20.92 billion. Revenues are declining despite the Merck's success with newer products such as Vytorin and Zetia, which combined for global sales of over $1 billion last quarter. Merck also received approval for Januvia, a once-daily and first-in-class treatment for type-2 diabetes, and Zolinza, a T-cell lymphoma medicine.Yet the ongoing pressure from generic drugs continues to eat into the long-term sales potential of Big Pharma companies, Merck included. In the third quarter, Merck’s cholesterol drug Zocor saw sales drop by 65%, after it lost its U.S. patent protection in June. Drug costs contribute to double-digit increases in health care costs, so the pressure from generics will only grow as Congress considers ways to reverse the trend. Shorter patent-protection terms remain a key risk to the industry.

Looking for a lower valuation

Given the sluggish sales picture and the ongoing legal risks, there’s no way Merck’s stock should be sporting a forward valuation of 17.5-times fiscal year 2006 earnings of $2.58 per share. It doesn’t matter that the company upped its earnings guidance by a dime, not when the stock’s multiple is more than three times the company’s long-term projected growth rate of 5%. Until earnings gains can come from renewed sales growth and not cost cutting efforts, Merck doesn’t warrant a multiple any higher than 13 to 14 times estimated earnings.

Considering that earnings are also projected to slip slightly in 2007, Merck’s fair value is closer to $35 to $36 per share -- or about 20% below today’s price.

There's no question that Merck was oversold when it hovered around the $26 level a year ago, but there is also no question that the stock is overbought today. Investors should take advantage of today’s earnings-related pop to cut their exposure to the stock.

I’ll take it a step further and initiate a short position on Merck in my Street Patrol portfolio after today’s close. I’ll also close my positions in National Semiconductor (NSM, news, msgs), Texas Instruments (TXN, news, msgs) and QLogic (QLGC, news, msgs).

Robert Walberg is a financial writer based in Chicago and a regular guest on CNN's "Moneyline." He was formerly chief equity analyst at Briefing.com and ran for Congress in Illinois in 1994.

At the time of publication, Robert Walberg did not own or control shares of any companies mentioned in this article.