Merck and Vioxx- Is the Street Pricing the Liability Correctly?

Contingent liability is always a difficult aspect of analysis for investors. Tobacco liability, and asbestos liability had a huge impact on valuations for companies with these exposures. Resolution of these difficulties can result in stellar performance...ongoing uncertainty however, hangs like a cloud.

Similarly in the healthcare industry, the Dalkon shield IUD caused A.H. Robins to declare bankruptcy as it was overwhelmed with lawsuits. There were 12 deaths due to miscarriage-related infections in a population of 2.8 million women that had used the Shield, so the risk of death was infinitesimal...in fact, the rate of pelvic infection among IUD users was lower than that for women using no contraceptive at all. The cost of the anti-obesity drug Fen-phen liability for Wyeth was some $20 billion!

Contingent liability is no trifling matter.

Following this week's victory (known as the Doherty case) in Atlantic City, NJ, Merck (MRK) has won four of the seven cases that have been tried relating to Vioxx. Plaintiffs won two of the three cases in Texas, MRK won three of the four cases in NJ, MRK's home state. The company continues to face some 13,000 cases and had reported in its first quarter that cases had increased by some 19% versus the prior quarter, a deceleration from the fourth quarter rate of +51%.

Year to date, MRK is up 13.6%...it seems that most investors have put the Vioxx liability risk on the shelf. The Doherty case was important since Ms. Doherty had been taking the drug for three years, much longer than the adminsitration of the drug in prior cases. Consequently, MRK could not use its prior defense that anyone taking the drug for 18 months or less would not have elevated risk, based on its previous studies. The jury decided that there were other risk factors that could have contributed to Ms. Doherty's heart attack.

In some excellent work by David Moskowitz and Stephen Williams of Friedman Billings Ramsey, they point out that in two of the three cases that MRK lost, the cases were brought on behalf of a deceased plaintiff. In the third case that MRK lost, the plaintiff was confined to a wheelchair.Among the other four plaintiffs which lost their cases,three of them appeared relatively healthy. The exception was a deceased plaintiff who appeared to have taken Vioxx for less than one month.

In the FBR report, several scenarios are portrayed. Continued litigation is expensive, but many cases may not be deemed of merit...in one optimistic scenario, the analysts assume that only 25% of cases are "of merit" and MRK continues its 4 for 7 victory "batting average." The impact on per share basis is $6.36. A more bearish but equally plausible scenario ups the ante to $23 per share.
The analysts suggest that a class action settlement may be the preferred option for reducing the opaqueness and uncertainty of this case, as well as for limiting the damages. This still represents a $14.2 billion settlement, which includes some $750 million in litigation costs. According to the first quarter Q filing, MRK has already spent $285 million on its defense, which on a per share basis is 13 cents.

There is a full slate of upcoming product liability trials that will be in the news over the rest of this year. Some less friendly venues than TX and NJ will be seen, California, Louisiana, Mississippi, and Alabama.

It is also noteworthy that there may be a final rush to file last-minute lawsuits coming up on September 30th, the two-year anniversary of when MRK pulled Vioxx off the market. Please check link:
Latest Win Supports Merck Strategy of Fighting Each Vioxx Lawsuit

One item of information that seems to have been overlooked by most investors did arise from the Doherty case. Though the FBR report does mention it, few other analysts seem to have noticed. This is mentioned in a Boston Globe article (free registration required) as well as "The Settlement Channel," a highly readable blog of settlement cases.

"However The Globe also points out something that several other national publications failed to point out in their stories and that is the very surprising fact that Judge Higbee allowed the jury to decide the issue of whether Merck failed to warn the plaintiff about the risks of Vioxx. This is a departure from the usual question as to whether or not the company failed to warn doctors or medical personnel about the risks of the drug. The jury found 7-0 that the company in
fact did fail to warn the individual plaintiff/end user and in the word's of Mrs. Doherty's trial lawyer, Gene Locks, "this is a huge, major, precedential verdict for plaintiffs nationwide because this jury unanimously determined that Merck failed to adequately warn the users of this drug". Defense counsel objected to this charge being put to the jury, felt it never should have been allowed, but there now exists that precedent and I would expect this to get bigger headlines than the
actual case verdict as the weeks go past.
It's a win for Merck but might ultimately be costly in the long run."

Bottom-line, the resolution of the Vioxx liability remains moot and amorphous. Over the last year, MRK is the only US based large cap pharma stock with positive returns, ahead of BMY, LLY, WYE, ABT, JNJ, and SGP, and PFE all of which are negative for the TTM.

On a valuation basis, here is how MRK compares on an EV/EBIT basis for TTM EBIT:

MRK....13.87X
BMY.....11.30X
LLY......21.93X
WYE....12.05X
ABT.....16.56X
JNJ......12.05X
SGP.....38.55X
PFE.....12.27X

Needless to say, there is more to understanding these companies than purely citing this metric. Product pipeline and profitability as well as dividends and share repurchase are important aspects to understand and model.

I am certainly not holding myself out as an expert in tort liability. MRK has embarked on aggressive restructuring, which I have yet to address. MRK's three vaccines appear to offer some near term excitement. Other products address important needs such as Type-II diabetes. But the company continues to face some formidable patent expirations over the next several years.

Merck has unbelievable strength in its balance sheet. As of March 31st, the company had $10.2 billion in cash plus another $2.2 billion in marketable securities, totalling $5.66 per share. The company continues to generate very significant free cash of $1.37 per share for the last TTM.

In my view, investors have become somewhat cavalier about the litigation risks. Some tough sledding remains ahead of the company in some pretty tough if not notorious (at least from prior tobacco experience) jurisdictions. Given the great uncertainty, I would continue to avoid.

Disclaimer: Neither I, or my family have a current position in MRK, BMY, LLY, WYE, ABT, JNJ, SGP, or PFE. However, some clients do have a current position in MRK, BMY, JNJ, SGP, and/or PFE.