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How murky is Merck?
The stock is cheap and Merck pays a big dividend. But Vioxx lawsuits could cripple the company.
December 6, 2004: 2:07 PM EST
By Paul R. La Monica, CNN/Money senior writer

NEW YORK (CNN/Money) - Unless Merck invents a miracle cure for a sagging stock price, the company is going to wind up as the worst performer in the Dow Jones Industrial Average this year.

But are shares of Merck (Research), which have plummeted nearly 36 percent in 2004, nearing a bottom?

The stock trades at a bargain valuation: only 11 times 2005 earnings estimates. That's a 26 percent discount to the S&P Pharmaceutical sector.

What's more, Merck pays a healthy dividend, yielding 5.3 percent.

And it's tempting if you follow the so-called Dogs of the Dow strategy -- buying Dow laggards with high dividend yields on the theory that big established companies in trouble eventually rebound.

Last year's biggest pooch, Eastman Kodak, has had a superb 2004...although Kodak is no longer in the Dow. (For more, see our Stock Spotlight on Kodak.)

But there's a big difference between Merck and Kodak. Kodak didn't have to pull any of its digital cameras off the market because of health risks.

I want a new drug

For Merck, lingering concerns about the recall of its arthritis drug Vioxx in September because of studies linking the medication to heart attacks will likely weigh on the stock for the next year.

It has been a bad year for drug stocks but Merck has really taken a pounding since recalling Vioxx.  
It has been a bad year for drug stocks but Merck has really taken a pounding since recalling Vioxx.

Merck is going to be giving an updated forecast for 2005 on Wednesday morning.

Dr. John LeCroy, an analyst with Natexis Bleichroeder, said he thinks that many analysts haven't fully baked in the effect of the Vioxx recall.

What's more, LeCroy isn't optimistic that any blockbusters will be ready for next year. He said Merck's most promising one is Muraglitazar, a drug it is co-developing with Brystol-Myers Squibb to lower blood sugar and cholesterol in diabetes patients. The drug is still in late-stage clinical studies.

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"Merck's pipeline in recent history hasn't been that strong," said LeCroy. "And the loss of Vioxx will have a bigger impact than Wall Street is expecting." As such, his earnings estimate for next year is $2.44, about 5 percent below the current consensus of $2.57.

If Merck does lower its forecast, it's tough to see the stock heading higher, regardless of valuation, said James Denney, president of Mohawk Asset Management.

Denney owns Merck in the Electric City Dividend Growth and Electric City Value funds, but said he would not look to buy more of the stock just yet because of these near-term concerns.

"I don't think it's going to run away on the upside any time soon. Fallen angels tend to take awhile to get some confidence built back up," Denney said.

Legal limbo to keep a lid on the stock

Of even bigger concern is the legal risk from Vioxx lawsuits.

"It really comes down to the issue of liabilities and that's difficult to predict. The market is still trying to gauge that," said one analyst who asked not to be named.

Better medicine
Merck is the cheapest big pharma stock and has the highest yield...but rivals have better growth prospects and their dividends aren't shabby either.
Company Dividend Yield P/E Est. 2005 EPS Gr. Est. LT EPS Gr. 
Merck 5.3% 11.2 -2% 3% 
Eli Lilly 2.6% 17.5 11% 12% 
Pfizer 2.4% 12.0 9% 11% 
Abbott Laboratories 2.4% 17.3 11% 12% 
Wyeth 2.2% 14.4 8% 10% 
Johnson & Johnson 1.8% 18.5 9% 12% 
 * based on prices and estimates as of 12/3/04
 Source:  Thomson/Baesline

But some analysts have made an attempt to measure the impact. Sanford Bernstein analyst Richard Evans published a report on Friday that said that it could cost Merck $38 billion to settle Vioxx lawsuits.

LeCroy thinks that the company's legal settlement costs won't be nearly that high since it is going to be tough for some patients to definitively prove that Vioxx was the cause of heart problems. Plus, he thinks Merck will be fairly aggressive in defending itself.

"In Merck's case, it's tough to prove that if you had a heart attack it was solely due to Vioxx since there are a whole list of things that cause heart attacks," said LeCroy.

Still, the threat of the Vioxx lawsuits will make it hard to justify Merck as a legitimate takeover candidate, LeCroy said.

There were some rumblings last week about Merck being a target since the company disclosed in a filing with the Securities and Exchange Commission that it had adopted lucrative severance plans for top executives in the event of a change in control at the company.

YOUR E-MAIL ALERTS
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"Clearly Merck is positioning itself as if it were a takeover candidate but until the litigation risk is more solidified it will be tough for a company to come in and buy them," LeCroy said.

So Merck shareholders are staring at a potentially staggering legal blow and declining earnings estimates. The only thing that Merck appears to really have going for it is the dividend.

But Denney said that investors looking for high yielding drug stocks would be better off betting on other beaten down names that don't have the legal risk.

"Looking closer at the entire group, I think the clouds will clear on drug stocks sooner than on Merck as an individual company," Denney said. "Yields are attractive for the entire group."

Analysts quoted in this story do not own shares of Merck and their firms have no investment banking relationships with the company.  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.