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.

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