Merck & Co., Inc. Recommendation

Sell

Yuqian(Annie) Zhang

Nov. 4th, 2004

                                                 

Our position

Own 300 shares Purchased at $70.5 on Dec. 2nd, 1999 9.4% of the portfolio (cost) Closed at $27.87on Nov.3rd, 2004 The loss up to -$12,793.26 (-60.48%) 2.7% of the portfolio (market value) Present P/E: 9.39 Present EPS: 2.97 Market Cap: 61.84B

Company profile

A global research-driven pharmaceutical products company with history back to 1887 Ranked 83 in Fortune 500, 15 in FT Global 500 Operations in the United States, Europe, Middle East, Africa and Japan with 63,200

employee 59% of sales came from the US vs. 41% outside the US in 2003.

Product Therapeutic Category 2004 Net Sales  ZOCOR Cholesterol modifying $4.9 to $5.1 billion FOSAMAX Osteoporosis $3.0 to $3.2 billion COZAAR / HYZAAR Hypertension $2.7 to $2.9 billion Coxibs Arthritis and Pain $2.8 to $3.0 billion (VIOXX and ARCOXIA)

SINGULAIR Asthma and Seasonal Allergic Rhinitis $2.4 to $2.7 billion Source: Merck &Co. 04 Q2 release

Pharmaceutical Industry overview

Global sales of prescription (including both branded and generic drugs) and over-the-counter (OTC) remedies is around $300 billion annually.

Many large US employers have seen a doubt digit annual increase in their employee health-care costs for the past more than five years.

Traditional top three markets are the US, Western Europe and Japan, while the rising living standards in other regions/countries increase the demand for better health care and sophisticated drugs.

The world's increasing aging population is another factor driving the industry.

Focus on products for chronic rather than acute diseases. The world's two best-selling drugs, Merck's Zocor and Pfizer's Lipitor, both treat high cholesterol.

Increasing M&A in the industry.

Pharmaceutical Industry Issues

Pressures on sales growth:

Aging population requires cheaper drugs. Impact from imported prescription drugs. Impact from any change of corporate health-care budget. Increasing patent expiration issues. Impact from any change of FDA policies.

Pressures on profit as well as cash flow:

Huge R&D cost: In 2003, the Pharmaceutical Research and Manufacturers of America member companies invested an estimated $33.2 billion, 17.7 % of domestic sales on R&D.

Increasing cost to handle legal issues.

Pharmaceutical Index DRG vs. SP500 –two years

MRK vs. DRG two year

Peer group- five year key ratios

 Profitability

0.00

10.00

20.00

30.00

40.00

12/31/03 12/31/02 12/31/01 12/31/00 12/31/99

RO

IC

Merk

Pfizer

Eli Lilly

Leverage

0.00

20.00

40.00

60.00

80.00

12/31/03 12/31/02 12/31/01 12/31/00 12/31/99D

ebt

to E

qu

ity

Merk

Pfizer

Eli Lilly

Liquidity

0.00

0.50

1.00

1.50

12/31/03 12/31/02 12/31/01 12/31/00 12/31/99

Qu

ick

rati

o Merk

Pfizer

Eli Lilly

Peer group- R&D to Sales

1

10

100

1,000

10,000

100,000

0.00%4.00%8.00%12.00%16.00%20.00%24.00%28.00%32.00%36.00%40.00%

Sales ($M)

R&D to sales Sales ($M) 22,486 45,188 12,583

R&D to sales 14.13% 15.56% 18.70%

Merck Pfizer Eli Lilly

• Merck: kept a well below industry average R&D to sales ratio from 1996 to 2003. Has struck 145 deals, of which only 21 for products.

• Pfizer: the world's largest pharmaceutical research effort with more than 13,000 scientists supported by $7.1 B in 2003; pipeline includes 234 deals, of which 63 for products.

• Eli Lilly: R&D to sales at the top of industry; has launched five new products in past 15 months; pipeline includes 130 deals, of which 49 for products.

Merck Issues Update

According to SG Cowen brokerage, a frightening 29% of 2003 revenue at risk due to product patents expiring between 2004 and 2008, vs. 16% among the Big Pharmaceutical companies.

In Feb., Apr. and Aug. 2003, discontinued three phase I or II clinical trails; In Nov. 2003, discontinued two phase III clinical drug development program for treatment of depression and diabetes.

Sept. 30, 2004, announced the withdrawal of Vioxx, share closed down $12.07, nearly 27 percent, to $33, resulting in market capitalization loss $26 billion.

A.G. Edwards analyst predicted that FDA may want 18-month safety studies like they wanted for Vioxx for the successor to Vioxx, Cox-2 inhibitor Arcoxia.

Oct. 11, 2004, began a search to replace CEO Raymond Gilmartin.

Nov 1, 2004, share price plunged more than 10 percent, after a media report said that documents show Merck hid or denied evidence for years. Law suit cost is estimated up to 12B.

Valuation -DCF

Sales growth

EBIT margin

Vioxx sales

Discount rate 7.77 8.46 9.16

Target price(constant growth) 48.1 41.9 37.1

Target price (P/E) 39.1 35.8 32.6

2003 2004 2005 2006 2007 2008

4.85% 4.00% 3.50% 3.00% 3.00% 3.00%

40.25% 36.00% 33.00% 30.00% 30.00% 30.00%

(1,250) (2,588) (2,665) (2,745) (2,827)

Sensitivity analysis-scenario one

EBIT in 2004 & 05, $ billions

7.77 8.46 9.16

0 48.1 41.9 37.110 45.0 38.9 34.012 44.4 38.3 33.514 43.8 37.6 32.3

Litigation cost hurts EBIT in S-T

WACC

Sensitivity analysis-scenario two

EBIT margin after 2006

7.77 8.46 9.16

30% 48.1 41.9 37.127% 43.9 38.3 33.924% 39.8 34.8 30.821% 35.7 31.2 27.718% 31.6 27.6 24.515% 27.4 24.0 21.4

Generic competition hurts EBIT in L-T

WACC

Sensitivity analysis- scenario three

Constant grow th

7.77 8.46 9.16

3% 48.1 41.9 37.12% 40.8 36.4 32.81% 35.7 32.3 29.50% 31.9 29.2 26.9

-1% 28.9 26.8 24.9-2% 26.7 24.8 23.2

Lack of breakthrough products in L-T

WACC

Recommendation: Sell

Short to medium term Voixx withdrawal hurts sales & cash flow Potential litigation cost will hurt profit & cash flow Management uncertainty

Long term Long term growth will decrease due to the lack

of pipelines Long term profit will shrink due to increasing

generic competition Industry uncertainty Competition from peer group

Q&A