High-Priced Sale of Consumer Business Strengthens This Big Pharma Firm's Moat

On Tuesday, May 6,  Merck (MRK) announced the sale of its consumer unit to  Bayer (BAYRY) for $14.2 billion, which is higher than our $10 billion valuation for the unit. Based on the strong sales price, we have increased our fair value estimate for Merck to $60 per share from $58 per share. However, we don't expect much change to our Bayer fair value estimate, as cost and revenue synergies for Bayer should help offset the high purchase price. Strategically, the deal should strengthen both companies' moats by further entrenching the companies in their highest-return businesses.

Merck makes pharmaceutical products to treat conditions in a number of therapeutic areas, including cardiovascular disease, asthma, cancer, infections, and osteoporosis. The company also has a substantial vaccine business, with treatments to prevent hepatitis B and pediatric diseases as well as HPV and shingles. Following the Schering acquisition, about 45% of the company's sales are generated in the United States.

We believe the sale of the consumer unit should strengthen Merck's core prescription drug business. The divestiture not only monetizes the consumer unit at a strong valuation, but also removes Merck from an area where it lacks scale. Further, Merck plans to use the proceeds to support the pipeline with a focus on its immuno-oncology platform. Also, in tandem with the consumer sale, Merck and Bayer announced a cardiovascular collaboration to jointly sell Adempas and other key drugs. The shift toward focusing on the highest-return business of prescription drugs should strengthen Merck's wide moat. However, the divestiture does reduce Merck's diversification, which may increase the volatility of future cash flows.

New Products Mitigate Generic Competition
Merck's combination of a wide lineup of high-margin drugs and a pipeline of new drugs should ensure strong returns on invested capital over the long term. Further, Merck is through the worst of its patent cliff, which should remove the heightened generic competition the company has experienced over the past five years. However, Merck's research and development strategy has yielded only moderate results, which will likely reduce the company's near-term growth rate.

Still reeling from the patent loss on hypertension drugs Cozaar/Hyzaar in early 2010, Merck is facing the loss of its next top drug in terms of revenue generation: Singulair for respiratory ailments, which lost patent protection in mid-2012. Singulair represented more than 10% of total sales of Merck before the patent loss. While losses in international markets should not fade as fast as in U.S. markets, the patent expirations create major roadblocks to Merck's growth.

Offsetting the recent major patent losses, Merck's new products have mitigated the generic competition. In particular, Januvia for diabetes, Isentress for HIV, and the Gardasil vaccine against human papillomavirus represent new blockbusters. All of these drugs enjoyed monopoly positions at the time of launch. However, current and expected competition from other big drug firms likely will create a drag on these drugs' growth during the next few years.

Merck's efforts to develop a reliable late-stage pipeline have yielded moderate results as the company has focused more on incremental improvements in diseases with several treatment options instead of areas of unmet medical need. Owing to side effects or lack of compelling efficacy, Merck has experienced major setbacks with cardiovascular disease drugs Tredaptive, Rolofylline, and TRA, along with Telcagepant for migraines. Further, safety questions have delayed the filing of osteoporosis drug odanacatib. Lastly, key late-stage drug anacetrapib for atherosclerosis is chemically similar to drugs torcetrapib and dalcetrapib, which both failed to receive FDA approval, raising the risk for anacetrapib. Despite these setbacks, Merck has some solid successes, including early-stage data for its PD-1 drug in oncology. Following on this success in 2013, Merck is shifting its focus toward areas of unmet medical need in specialty-care areas, and the PD-1 drug is leading this new direction.

On the bottom line, Merck has been cutting costs. The 2009 merger with Schering-Plough, which Merck acquired for about $40 billion, opened the door for close to $5 billion in annual savings, which should be realized by 2015. The cost-cutting efforts should help reduce the impact of recent patent losses on high-margin drugs.

Stabilizing Competitive Advantages Support Merck's Wide Moat
Patents, economies of scale, and a powerful intellectual base buoy Merck's business and keep it well-shielded from the competition. As the bedrock of Merck's wide moat, patent protection should continue to keep competitors at bay while the company strives to introduce the next generation of drugs. Further, the company's enormous cash flows support a powerful salesforce that not only sells currently marketed drugs, but also serves as a deterrent for developing drug companies seeking to launch competing products. As a result, Merck offers a powerful partnership opportunity for externally developed drugs. The cash flows also put the company in the rare position of supporting the approximately $800 million in R&D needed on average to bring each new drug to the market. Also, while not as powerful as in the 1990s, Merck's research laboratories still hold a vast database of knowledge that should help the company maintain its leadership positions in drug discovery and development.

After facing a deteriorating moat trend over the past five years, Merck's competitive advantages are stabilizing. Patent protection still shields the majority of its drugs from competition and the company is now developing enough new drugs to offset eventual patent losses. The moat trend shift is based on a combination of fewer upcoming patent losses along with a stronger pipeline. In looking at the next five years, just less than 15% of Merck's total sales are subject to patent losses, compared with close to 25% over the past five years. On the pipeline side, Merck made a strategic shift in 2013 to accelerate its move to focus more on unmet medical needs in specialty care (areas of debilitating or lethal disease). The strategic shift should help increase research and development productivity and fight back against the following three negative trends. First, in the post-Vioxx era, the FDA has grown increasingly risk-sensitive, tending to approve only very safe drugs or drugs in areas of high need, such as cancer. Second, insurance companies are steadily reducing coverage for follow-on drugs, forcing drug firms to push for true innovation and reducing the power of their distribution networks. Lastly, the governments of the developed markets are increasingly using comparative effectiveness programs and more aggressively pushing for price negotiations. In response to these challenges, Merck's strategic focus toward unmet medical needs should increase the probability of success with regulatory agencies and support stronger pricing power as few alternatives exist.

Increased Focus on Specialty Care Should Improve Management's Performance
At the beginning of 2011, Ken Frazier took over the helm of Merck as CEO from Dick Clark and was also appointed as a chairman of the board in late 2011. With Clark nearing the age of retirement, we view the new leadership as a continuation of Merck's past strategy and not a red flag or shift in the leadership approach, as Frazier was part of a succession strategy guided by Clark. Frazier's almost two decades of experience at Merck across most major divisions should position him well to lead the company. He also deserves much of the credit for the successful handling of the Vioxx litigation, as he held Merck's general counsel position during the majority of the litigation. Peter Kellogg has held the CFO post since June 2007, having replaced Merck veteran Judy Lewent, who announced her retirement in early 2007. Kellogg's resume also includes the CFO role at Biogen Idec. Merck's board is packed with current and retired CEOs, which can lead to quid pro quo compensation packages for top executives but lends valuable strategic-planning experience.

Overall, we rate the company's stewardship as Standard, as Merck has shown reasonable use of capital with the purchase of Schering-Plough at a fair price, which brought in several important pipeline products and allowed for cost-cutting opportunities. However, Merck's heavy funding of R&D over the past decade has produced mixed results with several important new drugs, but also many failures. However, the company is finally shifting its research and development focus toward areas of specialty care (away from primary care), which should lead to higher productivity.

Fair Value Estimate is $60 per Share
We recently increased our fair value estimate to $60 per share from $58 per share, based largely on the strong sales price Merck received for its consumer division from Bayer. In looking at the remaining business, over the next decade, we expect that Merck will post 3% annual top-line growth. Potential game changers to the growth rate include the company's pipeline cancer drug PD-1 and BACE inhibitor Alzheimer's drug. Though we increased our peak sales estimate for the PD-1 drug from $3 billion to $6 billion in early 2014, further upside could emerge in other cancers beyond the leading indications in melanoma, renal, and lung. Further, Merck's acquisition of Schering-Plough should yield several billion dollars in annual cost savings by 2015, which should help mitigate the patent losses on high-margin drugs. On the patent side, Merck still faces major patent losses on Nasonex and Zetia over the next few years. However, we believe pipeline drugs and growth from existing drugs will offset the near-term generic headwinds.