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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

e=related

Management
Team and Capabilities
Kenneth C. Frazier Chairman of the Board, President and Chief Executive Officer

Willie A. Deese Executive Vice President and President, Merck Manufacturing Division Richard R. DeLuca Jr Executive Vice President and President, Merck Animal Health Cuong Viet Do Executive Vice President and Chief Strategy Officer

Industry Conditions
Socioeconomic, Legislative and Other

U.S. Health Care Reform Legislation


Patent grants

Technologic innovations
New product development

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

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. 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, entry to into specific drug markets is low when patents
expire

Porters 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

Product Line
Breadth, Depth and more

Mercks products list consists of at least four broad business groups Pharmaceuticals Vaccines Consumer Care Consumer Care

Merck currently has more than 100 products.


http://www.merck.com/product/home.html

Product Line
Breadth, 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, MUMPS, and RUBELLA VIRUS

VACCINE LIVE] and


PEPCID (FAMOTIDINE) TABLETS

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, retail drug and food chain, and mass merchandiser outlets in the United States and worldwide.

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

Profitability
Key Factors

MERCK took a hit in the 2008 recession In 2010: 1.46% ROCE, a drop of over 65% from 2009 1.87% Profit Margin, a drop of 45% from 2009 Costs grew to 40% of sales (industry competitors were around 20% in 2010)

In 2011, have regained some ground: ROCE was 11.5% 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, when they were reporting really high ROCE and PM in 2009 they had very low expenses

Liquidity and Solvency


Assessments

For an investor there are no significant issues with liquidity or solvency - comparable with Industry competitors Liquidity ratios indicate ability to cover current liabilities comfortably

Solvency ratios are a little high, but comparable with Industry

Industry Competition
Comparison

MERCK has had lower sales, and inconsistent ROCE and Profit Margins PFIZER and ASTRA ZENECA have had higher consistent sales, ROCE, PM, while bringing in lower COGS

Industry
COGS Trends

45.00% 40.00% 35.00% 30.00%

25.00%
COGS 20.00% 15.00% 10.00% 5.00% 0.00% 2009 2010 2011

MERCK PFIZER ASTRA ZENECA

Industry
RCOE Trends
80.00% 70.00% 60.00%

50.00%
ROCE 40.00% 30.00% 20.00% 10.00% 0.00% 2009 2010 2011
PFIZER MERCK ASTRA ZENECA

Industry
Profit Margin Trends

50.00% 45.00% 40.00% 35.00% 30.00% PROFIT 25.00% MARGIN 20.00%


MERCK PFIZER ASTRA ZENECA

15.00%
10.00% 5.00% 0.00% 2009 2010 2011

Accounting Analysis
Overall Summary No apparent red flags related to accruals since we see actually declines in accruals post 2009.
Accruals OCF FCF NI NI-OCF Assets
2011 12,383.00 14,106.00 6,272.00 -6,111.00 105,128.00 2010 10,822.00 12,500.00 861.00 -9,961.00 105,781.00 2009 3,392.00 4,852.60 12,899.00 9,507.00 112,314.00 2008 6,571.70 7,870.00 7,808.00 1,236.30 47,195.70

Accruals (NI-OCF/Assets)

-0.058129

-0.094166

0.08464

0.026195

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

5.92

6.28

5.24

6.66

Inventories Turnover

2.78

2.64

1.78

2.81

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. Percentage change in sales Exceeds in 2 out of 4 years Percentage Change in gross margin indicating possibility of red flag related to accounting .

Accounting Practices
Review Comments

Revenue Recognition: Revenue recognized once drugs delivered to customer.

No Bill and Hold and Channel Stuffing evident.


No Red flag for internal software capitalization. In Process R&D capitalized.

R & D expensed reasonably.


Depreciation method used for financials is straight line method and for tax purpose is accelerated.

No Red Flag related to Operating Lease Adjustments

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

Income Forecast
Method of forecast

Old-Merck

Merck acquired Schering-Plough in November 2009 for $41 billion. Makes using data from 10-Ks can not be used directly 1. 2. 3. Find all products. Used top 70% revenue contributing products for forecasting. 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.

New Merck

ScheringPlough

4.

5.

Balance Sheet
Assets
Other Long Term Assets, Total 4%

Long Term Investments 4%

Assets

Cash and Short Total Term Receivables, Investments Net 12% Total 7% Inventory 5% Other Current Assets, Total 3%

Considerations
Accumulated Depreciation 12% High % intangibles and Goodwill. Suspect for impairment. Highly liquid $ 15 B Cash and TCA is Very Low inventory and Receivables growing Total Assets 2011 - $105 B, 20176 $161B

Intangibles, Net 28%

Property/Plant/ Equipment, Total - Gross 27%

Goodwill, Net 10%

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 - Very Little portion LT Debt rolling off Total Liabilities almost 50% of the assets. Leading to assume that most of the equity is in Intangibles TL 2011 - $51B and 2016 $71B

Long Term Debt 31%

Other Current liabilities, Total 4%

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./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%

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

Valuation
Calculated Values

Model Residual Income Discounted Cash Flow Discounted Dividend (Basic)

Target Price $24.22 $23.69

$26.77 $22.37

Free Cash Flow to Equity

Valuation
Risk Free Rate, Cost of Equity and Cost of Capital

Estimates Risk Free Rate Cost of Capital using WACC Cost of Equity using CAPM 3.3% 7% 4%

Credit Outlook
Market Assessments and observations

Qualitative Risk Assessment - Medium


Risk assessment reflects challenges to branded patents, new drug development, and regulatory risks. In addition, MRK's Vytorin/Zetia franchise has been affected by disappointing clinical trial results

Debt Ratings
Long Term - BBB+ Short Term - A-2

Stock quality rating - B Outlook Cautiously positive

Recommendation

Our recommendation of Mercks investment position is HOLD at this time, with positive outlook

THANK YOU!