MERCK – Analysis and Valuation – MBA 701

Mandar, Nathan, Boyd, Tom, Manosij, Sandeep

Agenda

1 2 3 4 5 6 7

Overview Business Analysis

Financial Analysis
Accounting Analysis Forecasting

Valuation
Recommendation

Overview

• Merck, one of the world's largest drug makers. • Their business is preserving and improving human life. • Major competitors are Pfizer, GlaxoSmithKline and Novartis • http://www.youtube.com/watch?v=5PtnvFeqgWQ&featur

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Merck Manufacturing Division Richard R. Deese Executive Vice President and President. DeLuca Jr Executive Vice President and President. Frazier Chairman of the Board. Merck Animal Health Cuong Viet Do Executive Vice President and Chief Strategy Officer • • . President and Chief Executive Officer • Willie A.Management Team and Capabilities • Kenneth C.

Industry Conditions Socioeconomic. Health Care Reform Legislation • Patent grants • Technologic innovations • New product development .S. Legislative and Other • U.

Competitive Strategy • Research and Development/ Technological Advancements • Quality Control • Technological advanced distribution systems • Meeting the customers’ demands • Marketing and acquiring products through strategic alliances • Possible price reduction strategy .

Recent News • Introductions/rejections of new drugs • Cost cutting measures • Lawsuit settlements • Joint ventures and deals for growth .

Competition Summary .

• Various barriers to entry-initial barriers to entry into the pharmaceutical market is very high at first. as the resources and technology are very costly and hard to acquire.Competition Summary • Monopolistic competitive • Many companies who produce drugs • No one drug company has control of the whole the industry • Firms act as monopolies in the short-run • Firms do not compete directly on price for new drugs. entry to into specific drug markets is low when patents expire .

Porter’s Five Our Assessments • Threats of New Entrants: Moderate to Low • Bargaining Power of Buyers: Medium • Bargaining Power of Suppliers: Low • Threat of substitutes: Medium • Rivalry Among Existing Competitors: High .

com/product/home.merck.Product Line Breadth. • http://www. Depth and more • Merck’s products list consists of at least four broad business groups • Pharmaceuticals • Vaccines • Consumer Care • Consumer Care • Merck currently has more than 100 products.html .

Product Line Breadth. and RUBELLA VIRUS VACCINE LIVE] and – PEPCID® (FAMOTIDINE) TABLETS . MUMPS. Depth and more • Commonly known products are – CLARINEX® (Desloratadine) for oral use – CLARITIN® – DR. SCHOLL'S® – MIRALAX® (polyethylene glycol 3350) – M-M-R® II [MEASLES.

. and mass merchandiser outlets in the United States and worldwide. retail drug and food chain.Drug Manufacturing Process Quick Overview • Process of identifying and developing medicines is long and challenging • Merck has a robust pipeline. with a wide range of product candidates across each phase of development • Merck provides its products through wholesale.

Process Map Simplified version .

Financials Overview • Slightly undervalued compared to industry competitors • But – still not making as much profit. and costs are too high in comparison • Good liquidity • Acceptable solvency for Pharmaceutical company .

5% Profit Margin was 13% Costs dropped 5% to 35% of sales • In 2010 saw over 300% increase in operating expenses  Raises a few red flags.46% ROCE. have regained some ground:    ROCE was 11. a drop of 45% from 2009 Costs grew to 40% of sales (industry competitors were around 20% in 2010) • In 2011.Profitability Key Factors • • MERCK took a hit in the 2008 recession In 2010:    1. a drop of over 65% from 2009 1.87% Profit Margin. when they were reporting really high ROCE and PM in 2009 they had very low expenses .

but comparable with Industry .comparable with Industry competitors • Liquidity ratios indicate ability to cover current liabilities comfortably • Solvency ratios are a little high.Liquidity and Solvency Assessments  For an investor there are no significant issues with liquidity or solvency .

and inconsistent ROCE and Profit Margins • PFIZER and ASTRA ZENECA have had higher consistent sales. ROCE.Industry Competition Comparison • MERCK has had lower sales. PM. while bringing in lower COGS .

00% 40.00% 5.00% 2009 2010 2011 MERCK PFIZER ASTRA ZENECA .00% 0.00% 10.Industry COGS Trends 45.00% COGS 20.00% 30.00% 25.00% 35.00% 15.

00% 60.00% 0.00% 10.00% 2009 2010 2011 PFIZER MERCK ASTRA ZENECA .00% ROCE 40.00% 30.00% 20.Industry RCOE Trends 80.00% 50.00% 70.

00% 30.Industry Profit Margin Trends 50.00% 0.00% PROFIT 25.00% MARGIN 20.00% 45.00% 5.00% 2009 2010 2011 .00% MERCK PFIZER ASTRA ZENECA 15.00% 40.00% 35.00% 10.

500.852.Accounting Analysis Overall Summary • No apparent red flags related to accruals since we see actually declines in accruals post 2009.00 2010 10.00 2009 3.128.70 Accruals (NI-OCF/Assets) -0.026195 . Accruals OCF FCF NI NI-OCF Assets 2011 12.00 861.808.781.00 12.870.00 7.094166 0.195.00 6.272.00 2008 6.00 14.00 9.00 1.00 4.383.08464 0.00 105.392.314.899.00 -6.571.70 7.058129 -0.822.111.00 112.106.30 47.00 -9.961.236.00 105.60 12.507.

78 2.92 6.66 Inventories Turnover 2.28 5.64 1.24 6.78 2.81 .Accounting Analysis RED Flags • No Significant changes (especially declines) in AR and Inventory Turnovers (no red flag here) Metric 2011 2010 2009 2008 A/R Turnover 5.

. • Percentage change in sales Exceeds in 2 out of 4 years Percentage Change in gross margin indicating possibility of red flag related to accounting .Receivables & Inventory Observations • Percentage Changes(+/-) in Receivables and Inventory compared to Percentage Change in Sales • The Percentage Change in AR exceeds Percentage change in sales (that can be a red flag) • The Percentage Change in Inventory turnover exceeds Percentage change in sales(red flag) in 3 out of 4 years.

• No Red Flag related to Operating Lease Adjustments . • • R & D expensed reasonably. No Red flag for internal software capitalization.Accounting Practices Review Comments • Revenue Recognition: Revenue recognized once drugs delivered to customer. Depreciation method used for financials is straight line method and for tax purpose is accelerated. In Process R&D capitalized. • • • No Bill and Hold and Channel Stuffing evident.

Revenue Trends Sales 60000 50000 40000 30000 20000 Sales 10000 0 2005 2006 2007 2008 2009 2010 2011 .

Free Cashflow Quarterly Trends .

Net Income Quarterly Trends .

5. Found out growth trends for these products For products with 5 year revenue Random walk model is used and forecasts are generated For distorted growth patterns last year data is used. Makes using data from 10-Ks can not be used directly 1. Used top 70% revenue contributing products for forecasting. 3. 2.Income Forecast Method of forecast Old-Merck Merck acquired Schering-Plough in November 2009 for $41 billion. . New Merck ScheringPlough 4. Find all products.

Total 3% Considerations • Accumulated Depreciation 12% • High % intangibles and Goodwill.Gross 27% Goodwill. • Highly liquid – $ 15 B Cash and TCA is • Very Low inventory and Receivables growing • Total Assets – 2011 . Total . Suspect for impairment. Investments Net 12% Total 7% Inventory 5% Other Current Assets. Net 10% . 20176 – $161B Intangibles.$105 B. Total 4% Long Term Investments 4% Assets Cash and Short Total Term Receivables.Balance Sheet Assets Other Long Term Assets. Net 28% Property/Plant/ Equipment.

Total 4% .Very Little portion LT Debt rolling off • Total Liabilities almost 50% of the assets.Balance Sheet Liabilities Minority Interest 5% Liabilities Considerations Accounts Payable 5% • 32% differed income Tax • 31% Long Term Debt Deferred Income Tax 32% Accrued Expenses 19% Current Port. of LT Debt/Capital Leases 4% • In 2011 . • Leading to assume that most of the equity is in Intangibles • TL – 2011 .$51B and 2016 $71B Long Term Debt 31% Other Current liabilities.

/Ending LTD Dividend/Sales 6% 12% 16% 28% 3% 5% 11% 2013 6% 12% 16% 28% 3% 5% 11% 2014 8% 12% 16% 28% 3% 5% 11% 2015 11% 12% 12% 28% 3% 5% 5% 2016 13% 12% 12% 28% 3% 5% 5% Other Current Assets/TA 19% 19% 19% 19% 19% .Growth Rates Assumptions and Calculations 2012 Effective Revenue Growth Rate Target Inventory Balance/Next Years Sales Target AR Balance / Current Years Sales Target AP Balance / COGS Capital Expenditure /Next Years Sales Interest Exp.

Income Forecast 2012-2016 Considerations Income Statement 90000 80000 70000 60000 50000 40000 30000 20000 10000 0 2009 2010 2011 Revenue 2012 2013 2014 2015 2016 2017 Net Income COGS • The synergies of merger hold • The products which are major contributors today stay contributing • Current litigations do not have extreme adverse effects • No new drug that is under approval becomes major contributor in next 3 to 5 years timeline • Mean Reversion will occur only after the effects are acquisition are gone which does not seem to happen in next 5 years .

Valuation Estimation Of Fundamentals • Models  Residual Income Model  Discounted Cash Flow (DCF) Model  Free Cash Flow Model .

37 Free Cash Flow to Equity .77 $22.69 $26.Valuation Calculated Values Model Residual Income Discounted Cash Flow Discounted Dividend (Basic) Target Price $24.22 $23.

3% 7% 4% . Cost of Equity and Cost of Capital Estimates Risk Free Rate Cost of Capital using WACC Cost of Equity using CAPM 3.Valuation Risk Free Rate.

new drug development. In addition.BBB+  Short Term . and regulatory risks. MRK's Vytorin/Zetia franchise has been affected by disappointing clinical trial results • Debt Ratings  Long Term .B • Outlook – Cautiously positive .A-2 • Stock quality rating .Medium – Risk assessment reflects challenges to branded patents.Credit Outlook Market Assessments and observations • Qualitative Risk Assessment .

Recommendation Our recommendation of Merck’s investment position is HOLD at this time. with positive outlook .

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