M

1
Merck Company

• M A in Hong Kong

2
Risk, Return and RD in the U.S. Pharmaceutical
Industry

• RD Expenses
• Identification-introduction ?12 years
• Life ?23 years
• Evaluation ?35 years
• Costs
• Start of clinical trials
• Later stages of the clinical trials
• Accounting treatment of RD expenses

3
Risk, Return and RD in the U.S. Pharmaceutical
Industry

• Risk and return characteristics of RD
  investments
• Portfolio approach
• Similar to VC

4
Risk, Return and RD in the U.S. Pharmaceutical
Industry

• Pricing Demand
• Third-party payers
• Recession resistant
• Consolidation and Joint Ventures
• MA
• OTC
• Pharmaceutical benefit management companies (PBM)

5
Risk, Return and RD in the U.S. Pharmaceutical
Industry

• Marketing, Regulating Trends Managed Health
  Care
• Generic drugs
• Pricing
• Examination period
• Patients and more cautious
• Long patent period
• PBM

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Risk, Return and RD in the U.S. Pharmaceutical
Industry

• Intervention competition
• No restriction on price increase in U.S.
• Global market

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Risk, Return and RD in the U.S. Pharmaceutical
Industry

• Mercks leadership Corporate Culture
• Emphasis on research and creativity
• Strategic Objectives
• Strategic Alliances and Joint Ventures
• Managed Pharmaceutical Care
• Managed Health Care Affairs Dept
• Hedging of currency risk

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Merck Company

• Valuation Analysis

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1. Current Issues in Marketing

• Pharmaceuticals and their impacts on Earnings
• Historical growth will continue?
• The source of future growth
• Important issues
• Pricing
• Sales volume

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1. Current Issues in Marketing

• Historical trend shows pharmaceutical prices
  increased three times more than inflation, but
  recently shows price disinflation.
• Growth of managed health care programs
• Downward price pressure

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1. Current Issues in Marketing

• Action taken
• Creation of the Managed Health Care Affairs Dept.
• The purchase of Medco Containment Services

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1. Current Issues in Marketing

• Aging U.S. population
• Aging U.S. population suggests projecting growth
  in sales volume
• Changes in the role of the consumer / patient
• Patients are taking more active roles in the drug
  selection process
• Consequences affect price elasticity

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1. Current Issues in Marketing

• Changes in the U.S. regulatory environment
• Longer patent protection
• Shorter review process for new drugs
• Conclusion
• Future growth will grow in sales volume, not from
  price increases as in the past

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2. The competitive Structure of the U.S.
Pharmaceutical industry

• Buyers bargaining power
• Historically low
• But has grown in recent years
• Result
• Downward pressure on prices

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2. The competitive Structure of the U.S.
Pharmaceutical industry

• Threat of substitutes
• Increasing size of the generic drug market
• Consequences
• Joint ventures with Johnson Johnson, DuPont
  etc

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2. The competitive Structure of the U.S.
Pharmaceutical industry

• Rivalry among existing competitors
• Stronger competitors through M As
• Joint Ventures could create cartel effect
• Joint Ventures may
• Lower the barriers to entry for small firms
• Small firms may have to depend on the
  distribution network of large firms

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2. The competitive Structure of the U.S.
Pharmaceutical industry

• Competitive Strategies
• Not a price leader
• Differentiation by patent protection and R D
  expenditure
• Has started to focus on HMOs as customers

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3. Investment Implication of Mercks Acquisition
of Medco Containment Services

• Mercks acquisition is very valuable. PBM have
  contracts with HMOs, hospitals, large employers
  etc
• Reduce the threats of substitute
• Useful data
• Participation in the growing health care industry

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4. Implication of Mercks Non-U.S. Sales

• Non-U.S. sales decreased recently due to the
  increase of U.S. sales
• Implications
• Exchanges risk exposure declines
• However, 1994 has 1/3 of its sales from overseas

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4. Implication of Mercks Non-U.S. Sales

• Coordination and selectivity of Mercks approach
• Major currency risks are fully hedged
• Other currency risks are partially hedged
• Short-run exposure
• Use forward contract with maturity less than 1
  year

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4. Implication of Mercks Non-U.S. Sales

• Long-run exposure
• Partially hedge forecasted non-U.S. sales revenue
  for maximum 3 years. Use of put option is common
• Translation exposure
• Has little effect because of the movement in U.S.
  dollar

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5. Evaluation of Mercks ROE performance

• Two comparisons
• Time series analysis
• Peer comparison
• Mercks ROE declined from 1990-1994
• Reasons
• 1. Government regulation
• 2. Acquisition of Medco

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ROE Decomposition Analysis Merck Company,
Year-End 1987-91
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Comparative Financial Ratios Merck versus U.S.
Pharmaceutical Industry, 1987-91
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5. Evaluation of Mercks ROE performance

• ROAs result is similar to that of ROE, less
  volatile. Due to the variability of profit margin
• Merck is in favorable position in the peer
  comparison
• Assets-based liquidity does not compare favorably
  with peers
• Low asset turnover ratio
• Conservative leverage

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5. Evaluation of Mercks ROE performance

• Overstated in ROE
• Risk exposure
• Mercks ROE is more volatile
• More risk

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Five-Year Earnings Growth Rate Forecasts major
Pharmaceutical Companies
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Capital Asset Pricing Model Discount Rate Inputs
for Merck
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6. Intrinsic value using Two-stage DDM,
sensitivity analysis
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7. H-model

• high growth rate decays at a constant rate over
  2 x H period. The growth rate is expected to ke ½
  of its initial value at time H.

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7. H-model
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8. Three stage DDM approach

• High initial growth, growth declines, and stable
  but low growth

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9. FCF approach
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9. FCF approach
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9. FCF approach
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9. FCF approach
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9. FCF approach
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9. FCF approach
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DCF Valuation Model Inputs for Merck Most Likely
Scenario
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Recent Price Performance Merck and U.S. Ethical
Drug Industry (as of January 1993)
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END