More To Merck Than Meets The Eye?

The past few years have been a rough stretch for pharmaceutical companies, as patent expirations and a lack of exciting new products have led to lower revenue growth, rampant mergers and extensive restructuring. With a relatively manageable patent cliff and some interesting new products, Merck (NYSE:MRK) may be worth a second look from value-oriented investors.

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A Solid Franchise in Cardiology and Inflammatory Disease
Like virtually all of the major pharmaceutical companies, Merck sells a large number of branded pharmaceuticals but focuses most of its attention on a few particular segments. For Merck those areas of focus include cardiology (with drugs like Zetia and Vytorin), immunology (Singular and Remicade) and diabetes (Januvia and Janumet).

Although Merck has had some issues developing its own late-stage pipeline, the acquisition of Schering-Plough helped address some of those issues. At the same time, the company has restructured its operations and in doing so it has given its salesforce the ability to act with more independence - a move that could pay dividends in the long run.

Low Growth and a Few Key Gaps
Growth is relatively scarce in the pharmaceutical space, and Merck is no exception. Still, Merck is in better shape (at least in terms of analyst expectations) than rivals like Pfizer (NYSE:PFE) or Lilly (NYSE:LLY). While the loss of Singulair to generic competition in 2012 will reset revenue lower, that is the only major oncoming cliff (as the company is already dealing with the loss of Cozaar/Hyzaar) and good sales from drugs like Januvia and Isentress are helping fill some of the gap.

One other worthwhile concern regarding Merck is in the nature of its business. Unlike most large pharmaceutical companies, Merck has little business in oncology and not an especially robust portfolio in the pipeline. Oncology is a popular area, as the FDA is generally a little less demanding and the reimbursement is so solid.

Exciting New Drugs Should Stimulate Some Growth
One of the most interesting drugs at Merck is the recently-launched hepatitis C drug Victrelis (also known by its chemical name of boceprevir). While expectations seem to be higher for Vertex's (Nasdaq:VRTX) Incivek, investors should not sleep on Victrelis. True, Vertex's drug has an appealing risk/benefit profile and there is potential competition from Bristol-Myers (NYSE:BMY), Pharmasset (Nasdaq:VRUS), Abbott (NYSE:ABT), and perhaps Achillion (Nasdaq:ACHN), but Merck has some solid marketing expertise that should not be underestimated.

Beyond Victrelis are drugs for osteoporosis and cholesterol; even with the recent bad news from an Abbott trial of a similar drug, Merck's Tredaptive could still succeed.

Risks and Catalysts
On the plus side, there is upside from Merck's new HIV drug Isentress as well as that aforementioned pipeline. On the flip side, there are some risks for investors to consider. There is always a risk that an approved drug will show severe long-term side effects that result in withdrawal and legal settlements, as well as the risk of clinical failures for drugs in the pipeline.

More specific to Merck are risks of severe competition in diabetes (where Lilly, Bristol-Myers, and Novo Nordisk (NYSE:NVO), among others, are fierce competitors with new drugs of their own). There is also a risk that the company may be tempted to fill its gap in oncology - a move that will almost certainly involve an acquisition. Under such a scenario Merck could be tempted to buy a company like Dendreon (Nasdaq:DNDN) for a hot product or a company like Exelixis (Nasdaq:EXEL) for platform technology.

The Bottom Line
For Merck to be fairly valued today, investors have to expect practically no rebound in revenue post-Singulair, little contribution from new drugs, and a relatively high discount rate. Assuming a rate of revenue growth inline with population growth, a gradual return to traditional cash flow yields, and a historically normalized discount rate, Merck looks undervalued by at least 20%. With a break-out hit (like Victrelis), there's even more potential and even at 20% undervaluation Merck is worth a look for patient value and/or income-oriented investors. (For related reading, also take a look at Investing In The Health care Sector.)

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