This Pharma Firm Passes the Test

Patents, economies of scale, and a powerful intellectual base buoy

The TECOS study showed positive safety data for Type 2 diabetes drug Januvia. A similar drug, Onglyza from

In the quarter, total sales increased 4% year over year (excluding changes in currency and normalized for divestitures and acquisitions) as new products offset slowing mature-drug sales. In particular, immunology drug Remicade is holding up well (down only 3%) despite biosimilar competition in Europe, but we expect sales declines to eventually accelerate. Strong Januvia and Janumet sales (up 10%) helped buoy Merck's results, and together with strong U.S. sales overall, this led to outsize margin expansion. Given the strong relative pricing in the United States, we expect this trend to continue through the year.

Getting Past the Patent Cliff 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.

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 the 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 is making solid strides, led by its immuno-oncology platform. Keytruda sales were $83 million in the quarter, but we believe this is just the tip of the iceberg as the drug expands into new indications. We expect the addition of the lung cancer indication later in 2015 to bring an additional $5 billion in Keytruda sales at peak.

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.

Our Fair Value Estimate Is $69 per Share In February we increased our fair value estimate to $69 per share from $63 based largely on increased expectations for pipeline drug Keytruda. We expect the drug to reach peak sales of over $9 billion based mostly on strong efficacy in the large lung-cancer market. 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 immuno-oncology drugs and BACE inhibitor Alzheimer's drug.

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

We Like Management's R&D Shift to Specialty Care At the beginning of 2011, Ken Frazier took over the helm of Merck as CEO from Dick Clark and was 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 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. 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. On the other hand, the $8 billion acquisition of Cubist seems like a stretch to make the valuation work, especially after the announcement of the sooner-than-expected patent loss on key drug Cubicin. Turning to internal capital deployment, 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.