Admittedly, I’m late to the party. Merck shares are up 42 percent over the past year. Even so, I think there’s upside from here. Let’s review the key issues.
Earlier this month, Merck’s multiblockbuster asthma drug Singulair lost U.S. patent exclusivity. As the market is flooded with inexpensive generics, U.S. sales of the branded version will rapidly disappear. European patents for Singulair expire early next year, although ex-U.S. generic erosion curves tend to be somewhat more gradual.
The Singulair patent “cliff” is not a surprise to Wall Street, but that doesn’t mean it won’t have an impact on the company’s income statement. Despite retaining “rest of world” — non-U.S. and non-European — exclusivity, I expect nearly 75 percent of the drug’s $5.5 billion in worldwide sales to disappear over the next six months.
Importantly, Singulair’s operating profit margin likely far exceeds the company’s other major franchises, since it doesn’t require as much marketing as less well-entrenched products. As a result, the loss of exclusivity hurts both sales and profit margins. That’s the downside to a dominant pharmaceutical franchise, and explains why investors often underestimate the impact of a generic “cliff.” In Merck’s case, Wall Street analysts and investors seem to have modeled Singulair’s erosion well enough that the impact has been correctly built into consensus earnings.
I like Merck for two reasons. First, the company pays a 3.8 percent dividend, slightly higher than those of Pfizer or Johnson & Johnson. Even with repeated R&D screw-ups, like those at competitorEli Lilly, investors seem unwilling to let the dividend yield creep much above 4.5 percent. That provides a valuation floor for Merck around $37 per share.
Second, I think investors underestimate Merck’s pipeline. Although several Wall Street analysts have highlighted the company’s R&D optionality — Tim Anderson at Sanford Bernstein and Mark Schoenebaum at ISI have done particularly good work — the investment community still has an overly skeptical view.
The Future of Dyslipidemia?
Veteran investors will remember the epic failure of Pfizer’s torcetrapib, a drug intended to boost levels of high-density lipoprotein (HDL, or “good” cholesterol) that failed in late 2006 due to adverse events. More recently, Roche announced the failure of a Phase III trial of dalcetrapib, a drug in a closely related cholesteryl ester transfer protein (CETP) modulator class that had fewer side effects.
Merck has a CETP inhibitor of its own, called anacetrapib, in Phase III trials. Despite the history of failure for this drug class, I think anacetrapib might work. Here’s why.
1. Anacetrapib has a much more pronounced effect on low-density lipoprotein (LDL, or “bad” cholesterol) and HDL than did either torcetrapib or dalcetrapib. In earlier studies, anacetrapib lowered LDL by 40 percent and raised HDL by 138 percent. This impact is far greater than for Pfizer’s torcetrapib, which lowered LDL by only 25 percent and raised HDL by 72 percent. Roche’s dalcetrapib was even less effective than torcetrapib.
I view anacetrapib’s LDL benefit as a “safety net” for the HDL hypothesis. Multiple studies show that reducing LDL has a beneficial impact on cardiovascular outcomes, even when the patients’ baseline is low. That means anacetrapib could show improved clinical outcomes even if the HDL hypothesis proves false.
2. Merck’s Phase III trial of anacetrapib, named REVEAL, has enrolled roughly 30,000 patients. Roche’s failed OUTCOMES Phase III study enrolled only half as many patients. The study size gives the company more statistical power to detect an effect.
3. Early anacetrapib data show hints of efficacy and a reasonable safety profile. In Merck’s Phase II trials, anacetrapib didn’t show any significant toxicity. Further, the drug has no impact on levels of aldosterone, a steroid secreted by the adrenal gland that may have contributed to torcetrapib’s downfall. Intriguingly, anacetrapib recipients also had a trend towards fewer cardiovascular events. In much larger studies, this benefit could prove statistically significant.
I’m not convinced REVEAL will show a clinically meaningful effect for anacetrapib, but I think there’s a reasonable chance. If it does, Merck would have a novel drug with mega-blockbuster potential. Most importantly, investors might not even need to wait for the data. Merck shares will likely gain ground in anticipation of the results, which should be available in 2015.
Merck is also conducting Phase III trials of Tredaptive, a niacin-based HDL booster, for the treatment of atherosclerosis. Results from this study, named HPS2-THRIVE, should be available within the next six months. Although I doubt HPS2-THRIVE will succeed due to the failure of other niacin-based HDL studies, positive data would be a meaningful near-term upside surprise. If nothing else, Tredaptive is another low-expectation, high-impact arrow in Merck’s HDL quiver.
Other Drugs to Watch
Large-cap pharma companies usually have massive R&D pipelines and multiple marketed products, so it’s impossible to discuss everything in such a condensed format. Nonetheless, there are a few other products worth watching.
Merck recently announced that a Phase III trial of odanacatib, a novel drug candidate for the treatment of osteoporosis, had demonstrated sufficiently robust efficacy to warrant early stoppage. Odanacatib works by blocking cathepsin K (cat-K), an enzyme responsible for bone resorption, which is a fancy medical term for the process by which the body breaks down bone. In osteoporosis, unbalanced resorption leads to a steady decline in bone density. Merck expects to submit for global regulatory approval in the first half of next year. If approved, odanacatib could easily generate sales of $1 billion to $2 billion.
The company’s diabetes franchise remains anchored by Januvia, the dominant DPP-4 inhibitor class drug. I expect sales of Januvia and related drugs — Merck has a combination product with metformin on the market and several other variants in the pipeline — will continue to grow rapidly. Notably, despite the recent acquisition of Amylin Pharmaceuticals byBristol-Myers Squibb and AstraZeneca I doubt Bydureon will be a major impediment to Januvia’s growth.
A few other notable mentions: Merck plans to resubmit Bridon, an agent for anesthesia reversal, for FDA approval this year. Despite some safety concerns, Bridon could do better than expected should it reach the market. Finally, I’m skeptical of the company’s novel insomnia drug suvorexant, which will also be submitted for regulatory approval this year, due to my dislike of orexin modulation as a mechanism-of-action — orexin is a neurotransmitter that regulates sleep-wake cycles and appetite — and the abundance of adequate generic alternatives. However, management seems very excited about the product, so it’s probably worth keeping an eye on going forward.
Merck currently trades at less than 12 times consensus earnings for 2013, the company’s “trough” EPS year. I think this multiple could expand as the company returns to earnings growth, especially if excitement about the pipeline builds. In exchange for a little patience, investors also collect nearly 4 percent in annual dividends. It’s not the most exciting recommendation, but Merck seems like a solid long position in turbulent times.
—By TheStreet.com Contributor Nathan Sadeghi-Nejad
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