Merck (MRK): No Patent on Dividends!

The world’s largest pharmaceutical companies have for years been cash machines, increasing earnings and dividends to their stockholders year on year. These businesses were protected by high barriers to entry and long-term patents, which protected them against competition. In the case of pharma companies, this was the golden ticket to high returns on investment and distributions to shareholders. That was until the patents expired.

A patent expiration allows generic drug manufacturers to replicate a product usually at lower cost. Such competition essentially entails opening up the market to competition where the lowest cost producer usually has the upper hand, given that products are generic (they all do the same thing).

Merck (MRK) is a company that for years generated large swathes of cash and returns, and is now is sitting on a handy 4.29% dividend yield.

Merck (MRK) is a global health care company that delivers health solutions through its medicines, vaccines, biologic therapies, and consumer and animal products, which it markets directly and through its joint ventures. The Pharmaceutical segment includes human health pharmaceutical and vaccine products marketed either directly by the Company or through joint ventures. Human health pharmaceutical products consist of therapeutic and preventive agents, sold by prescription, for the treatment of human disorders. Merck publishes the The Merck Manuals, a series of medical reference books that includes the Merck Manual of Diagnosis and Therapy, the world's best-selling medical textbook. The company’s most well known drug is Zocor.

Merck’s (MRK) dividend over the past five years has stayed at $1.52 per share, representing a decreasing payout ratio (income over the same period is up 167%). While the yield at the current dividend of 4.29% is high compared to the Dow, it’s increasing as the company faces more and more risks over the sustainability of revenues and dividends.

The biggest problem, as mentioned above, is the expiration of patents. What is Merck going to do about this?

As we’ve seen in the pharma sector, companies are trying to protect and defend their revenues by merging and acquiring with competitors. Pfizer (PFE) recently spent $68 billion buying Wyeth, while Merck (MRK) has also splashed out by buying Schering-Plough for $41 billion. The reason why such a high price is necessary for Merck was best summarized in the report of the Schering-Plough deal:

“Merck is faced with significant patent cliffs over the next 4 years while Schering-Plough has very little exposure to patent expirations. The proposed deal is clearly an attempt to address Merck’s patent issues. Patents on Merck’s Cozaar and Singulair will expire in February 2010 and August 2012, respectively, exposing about $8.2 billion worth of sales to generic competition. This equates to about 35% of Merck’s forecasted revenue in 2012 [and 29% of 2009 revenues]. By contrast, Schering only has about 6% of its forecasted 2012 revenue exposed to patent expirations. The combined company will have about 21% of forecasted 2012 revenues exposed to patent expirations.”

The company’s former best selling drug Zocor went of patent in 2006, and interestingly did not suffer a massive loss in sales as was expected. This is chiefly because Merck (MRK) decided to drop the price of the drug to generic levels – sales were maintained, but margins and net income was crushed.

Merck (MRK), like other companies in the pharmaceutical industry, is facing the prospect of declining revenues, declining margins and hence declining earnings and dividends. Merck (MRK) has shown by acquisition and price cutting that they intend to compete with the generic manufacturers. It’s also important to bear in mind that Merck spends 21% of its revenues on research and development, and while the probability of a breakthrough drug emerging in the next few years is small, it shouldn’t be totally discounted.

In saying that, there are clear risks and headwinds for Merck (MRK), and the dividend seeking investor is in essence speculating that Merck (MRK) can overcome these challenges to ensure the dividend remains stable.

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