Could Merck Be The Next IBM?

In 1992, shortly after joining Tocqueville Asset Management as President, Robert Kleinschmidt dragged me up to Armonk (NY) to visit with the management of IBM.

At the time, if my memory serves me right, the stock of this former institutional favorite was down more than 60% from its 1987 peak. During the same period, the shares of Dell Computer (which had become public in 1988) had roughly tripled, as had those of Intel, while those of Microsoft had quadrupled or more. The newspapers were full of articles on how IBM had lost its ways, was in the wrong segments of the industry at the wrong time and was essentially finished as a leader in the information technology industry. Financial analyst reports were even direr.

Neither Robert nor I really understood technology. But what we saw was a company with ample technological talent (research, etc.), powerful finances, an extraordinary marketing machine – and a willingness to change and adapt – in short, the wherewithal to survive and possibly thrive again. After hitting a more than twenty-year low in 1993 (about 80% below its previous peak), IBM shares began to recover and eventually reached a major new peak.    By that time, in 1999, Wall Street pundits and technology experts unanimously praised the company’s skilled transformation and re-discovered leadership.

In the 1970s and 1980s, the great hope on Wall Street was to discover “the next IBM.” At the time, of course, the dream referred to the discovery of IBM when it was a mere manufacturer of adding machines and winding up with the world’s leading manufacturer of computers. But, frankly, our own dream is rather more modest: to discover the next IBM as it was in 1992 -- a powerful leader which has tumbled and needs a little time to adapt -- and winds up as a re-discovered giant.

For many years, we have been eschewing major pharmaceutical companies. First, and for a long time, their stock prices were simply too expensive for us. When their price-earnings ratios finally began to fall in line with those of the general market, we remained concerned that their profit margins had climbed to levels that were unsustainable. To give an example, I still remember the times when a major pharmaceutical company was deemed overpriced once its total capitalization reached 4 times its revenues. By the late 1990s, the major pharmaceuticals were routinely selling at 6 or 7 times sales. This was made possible by an extraordinary – and unsustainable – expansion of their profit margins. Merck’s net margins, for example, rose from 20% in the mid-1990s to about 29% last year, even on a relatively full tax rate.

The shares of the “big pharmas”, as they are called, peaked in 2000 and have been in a downtrend ever since. Merck, for example, had declined from over $96 in early 2000 to $45 a few weeks ago.  Then, Vioxx hit. After a number of studies revealed more serious side effects than had been known or publicized, Merck decided to voluntarily withdraw Vioxx from the market. The stock collapsed to $30.

At less than one third of the stock’s peak price, it is the duty of a contrarian-value investor to have a look. This is especially true when the stock has been in a downtrend for four years – a stretch that allows groupie investors and other closet or announced momentum players plenty of time to have bailed out.

Although we now have partners and analysts who are quite savvy about the pharmaceutical industry, it is fair to say that Robert Kleinschmidt and I are about as knowledgeable about the drug industry today as we were about the computer industry in 1992. But, in a way, if you are a contrarian-value investor, it helps to stay some distance from immediate problems of molecules, details of new-product pipelines and FDA approval schedules.

So, what do we see in Merck today?

·        A one-time icon of the pharmaceutical industry that is now viewed as a fallen angel.

·        A stock that is down two-thirds from its high.

·        A price-earnings ratio, based on the company’s post-Vioxx earnings guidance, of less than 12.

·        $5 billion of cash on a balance sheet with reasonably little debt.

·        Free cash flow (after dividends and capital spending) of about $2 billion.

·        $3 billion of R&D spending per year.

·        One of the most effective sales and marketing organizations in the industry.

Neither Merck nor the industry as a whole is without problems, of course. Merck’s known pipeline of new products and the loss of Vioxx almost guarantee that earnings won’t make any progress from the lowered indication of about $2.65 per share for at least a couple of years – although Robert points out that, from a lower base, growth may actually look faster, in percentage terms.

Net profit margins for the whole industry are bound to decline in coming years, especially if Senator Kerry is elected and pushes through a bill allowing the importation of lower-priced drugs from Canada into the United States. Note, however, that almost half of all the big pharmaceutical companies, Merck included, are outside the United States.

At least, this is an industry with powerful long-term fundamentals. It helps save lives and promotes prevention, which is a desirable alternative to later hospitalization and surgery. Moreover, populations in most large, advanced economies are aging and consuming more and more medicines, while those in less-developed economies are only beginning to implement modern health care.

In addition to the uncertain political environment for the industry, the near term promises to be challenging for Merck:

·        Potential lawsuits are sure to follow the withdrawal of Vioxx -- especially in the United States, which is heaven to tort lawyers. Some analysts believe that lawsuits could reach as high as $10 billion over a number of years. This, however, is a worst-case scenario and it still could be easily handled by the company’s balance sheet and cash flow.

·        A number of patent expirations loom over the next few years, which should facilitate competition from generic drugs, and would put pressure on the margins of some of the company’s products.

·        Merck’s research is generally viewed as having been rather unproductive in recent years, resulting in an unexciting pipeline of known future drugs.

I have been through cycles before when analysts vilified one pharmaceutical company or another for having poor R&D and empty pipelines. In fact, I remember Pfizer being classified in that category, ten or fifteen years ago, just before being re-discovered as a favorite by financial analysts. If the $3 billion Merck spends on research annually does not yield major new molecules, it should at least help the company wisely choose promising small acquisitions or joint ventures, which is its stated policy.

And, with $2 billion of free cash flow annually and a good balance sheet, it certainly can afford to pursue that policy.

If one looks beyond the 2-3 year horizon of most financial analysts (the conservative ones, that is), it is not far-fetched to envision a reacceleration of sales, perhaps to a higher rate than in recent years. While we fully expect profit margins for the industry to trend down toward more sustainable (and politically acceptable) levels, the combination of these two trends might well yield earnings per share of $5.00 or more in seven or eight years. Assuming this achievement restored the financial community’s esteem for Merck, the shares might then sport a price-earnings ratio of 13 or 14 (we expect price-earnings for the stock market at large to trend down in coming years).

On these relatively conservative assumptions (we think), the stock might be worth over 60 in about seven years, a double from current levels and a compound annual rate of about 10% from capital appreciation alone. But there is a $1.45 dividend, which is unlikely to be cut and might actually be increased, later on. At today’s stock price, that represents a 4.8% yield. Now, we are talking about a potential total return of almost 15% per year!

Of course, we might be wrong – almost certainly on the appropriate timing of the purchases and possibly altogether. But, against a hoped for 15%-plus annual return, that’s a risk a contrarian-value investor should be willing to consider. At Tocqueville, we take this kind of calculated risk as often as we can, and that is why our portfolios are properly diversified and why we monitor our investments even more closely after we make them.

François Sicart

October 14, 2004

^© Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.