Merck Cuts 2005 Guidance (We warned you!)

Just to follow-up the piece I put out here about a month ago on embattled pharmaceutical giant Merck (MRK), here’s an update on what the company said this morning. Merck cut its 2005 earnings guidance to $2.47 per share (their range is $2.42-$2.52), citing the withdrawal of Vioxx. Consensus estimates had been for a profit of $2.57 for next year.

Last month, I suggested that 2005 estimates might prove tough to hit (analysts estimated $2.60 per share at that point). During today’s conference call, the Company failed to mention anything about setting aside reserves for Vioxx-related litigation. Merck will have to address this at some point in the new year and many believe they will have to allocate $10-$20 billion to settle claims.

The company remains adamant that it will not cut the dividend, which stands at $1.52 per share. This still seems unrealistic given the need for Merck to set aside reserves and also continue its R&D in order to replace, not only Vioxx revenue, but also Zocor when its goes off patent in 2006. Maintaining a payout ratio of 62% ($1.52/$2.47) seems like a poor use of cash flow. Once management realizes this, the dividend will be the first thing they cut.

Another Blown Analyst Call

The best performing equity group since President Bush won reelection last week has been the HMO sector. Stocks like United Health (UNH), Wellpoint (WLP), Anthem (ATH), and Aetna (AET) have been on fire. PacifiCare (PHS), a second-tier player and long-time Peridot holding, has also rallied, from a $34 close on election day to $44 as of yesterday. This morning, Banc of America Securities finally decided to cave and upgrade the stock from “sell” to “neutral.” The firm raised its price target on PHS shares from $25 (it’s 52-week low) to $44 (it’s current price). The report also pointed out, for those of us who are less than perceptive, that the “sell” rating had “not been a good call.”

As happens too often on Wall Street, we have another case of an analyst being completed wrong and having to throw in the towel and admit defeat. Why would anyone follow B of A’s advice on PacifiCare when they have been dead wrong on the stock for as long as the eye can see?

Merck’s Value Proposition Could Prove Dangerous

Analysts and fund managers are quick to point out that recently decimated shares of pharma giant Merck (MRK) present value to investors; with an unusually high dividend ($1.52 annually for a yield of more than 5%), a below-market earnings multiple, and a stock price not seen in about a decade. Merck CEO Ray Gilmartin has remained adamant that the dividend is safe and will not be cut, despite 2005 earnings per share estimates having been slashed from $3.40 to $2.60 since the withdrawal of Vioxx.

With $2.5 billion in annual Vioxx sales now gone, investors are focused on thousands of class action lawsuits which are sure to surface shortly. Settling all claims could cost the company billions of dollars. Another blockbuster drug, Zocor, which amounts to $5 billion of Merck’s $22 billion in revenue, is set to come off patent in 2006. So, in a span of less than 2 years, Merck will have lost $7.5 billion in sales, or about a third of its business, all while attempting to defeat thousands of lawsuits from patients who have taken Vioxx for years.

It appears possible that concrete evidence will surface that could prove Merck management knew of the increased heart attack risk that Vioxx presented, but chose to keep it in close confidence. Although not a probable result, it is not out of the question that this company could be in trouble if such a scenario played out. With its base business set to deteriorate, the longevity of a large dividend payout certainly comes into question. As does the “value” presented by Merck shares with a 2005 P/E of 11, when it could prove very tough to hit the reduced EPS estimates of $2.60 per share.

Investors should not assume the 5-plus percent dividend makes the stock a safe value play, even if the CEO insists it will not be cut. Shorting the shares is costly as long as the dividend remains, as those who borrow the shares will have to pay whoever bought their shares. As a result, the best way to play a further fall in Merck shares, if you are wary of the company’s future prospects, may be owning in-the-money puts.