Merck's New Drugs Offset Patent Losses

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 key blockbusters. All the drugs enjoyed monopoly positions at the time of launch. However, current and expected competition from other big drug firms will probably create a drag on these drugs' growth during the next few years. In fact, we recently reduced our fair value estimate for Merck to $65 per share from $67 as a result of strong competing data from Eli Lilly's Jardiance, which we expect will reduce prescribing trends for Januvia.

After several years of yielding mixed results, Merck's R&D productivity is improving as the company shifts more toward areas of unmet medical need. Owing to side effects or lack of compelling efficacy, Merck experienced major setbacks with cardiovascular disease drugs Tredaptive, Rolofylline, and TRA along with Telcagepant for migraines. Safety questions have delayed the filling of osteoporosis drug odanacatib. And key late-stage drug anacetrapib for atherosclerosis is chemically similar to drugs torcetrapib and dalcetrapib, which both failed to receive Food and Drug Administration approval, raising the risk for anacetrapib. Despite these setbacks, Merck has some solid successes, including early-stage data for its PD-1 drug Keytruda 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 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.

Patent Protection Is Bedrock of 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. 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 to maintain its leadership positions in drug discovery and development. The company's strong entrenchment in the emerging immuno-oncology area should strengthen its competitive position with drugs that carry strong pricing power.

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. In looking at the next five years, Merck faces much less patent exposure than in 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 R&D productivity and fight 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 highly needed areas 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. Third, the governments of 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 probably of success with regulatory agencies and support stronger pricing power as few alternatives exist.

Market Acceptance Is Key Merck's near-term risk largely centers on market acceptance of new products. Like all pharmaceutical companies, Merck faces regulatory risk from the FDA. Product delays or nonapprovals 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. Additionally, Merck faces some remaining legal risk with Vioxx. While the majority of plaintiffs participated in the $5 billion settlement, a few holdouts could ring up major additional settlements. Litigation risk remains from patients who took one-time blockbuster Fosamax for osteoporosis as the drug has been linked to infrequent but serious side effects.

Merck, like many of its large pharmaceutical peers, typically operates with a conservative balance sheet. Recently, its debt leverage was inflated somewhat by the Cubist acquisition. At the end of March, its debt stood at $30 billion (2.3 times trailing 12-month EBITDA), which is nearly covered by its $29 billion in cash and investments. EBITDA covers interest expense nearly 20 times. About 80%-90% of its cash and investments is typically held overseas, though, and the firm prefers to use U.S.-generated cash flow for general corporate purposes, including dividend payments and share repurchases, rather than repatriating those assets. The firm's U.S.-based business accounts for about two fifths of sales. Assuming U.S.-based cash flows are around the same percentage of sales, Merck's ongoing annual dividend of $5 billion drains its U.S. cash flow. We believe that ongoing cash drain will make debt financing key for large capital-allocation programs, which was the case for the $9.5 billion Cubist acquisition in early 2015. Also, this situation may make Merck more apt to refinance rather than redeem ongoing debt obligations, especially U.S.-denominated issues. During the next five years, key maturities include $2.4 billion due 2016, $300 million due 2017, $3.0 billion due 2018, $1.3 billion due 2019, and $2.0 billion due 2020. The company looks determined to boost share repurchases moderately from about $8 billion in the 12 months ended in March; it was authorized to repurchase $12 billion at the end of March.