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DBL%20Hendrix%20small.png College chemistry, 1983

Derek Lowe The 2002 Model

Dbl%20new%20portrait%20B%26W.png After 10 years of blogging. . .

Derek Lowe, an Arkansan by birth, got his BA from Hendrix College and his PhD in organic chemistry from Duke before spending time in Germany on a Humboldt Fellowship on his post-doc. He's worked for several major pharmaceutical companies since 1989 on drug discovery projects against schizophrenia, Alzheimer's, diabetes, osteoporosis and other diseases. To contact Derek email him directly: derekb.lowe@gmail.com Twitter: Dereklowe

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April 29, 2011

Merck: How to Spend the Money

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Posted by Derek

So Merck has announced that they're spending another $5 billion to buy back their own stock. How does this square with the CEO's recent refusal to give detailed earnings guidance, on the grounds that R&D spending comes first and is inherently unpredictable?

"Not too well" is my first response. Wall Street liked the news, taking it as a sign that the company has put its J&J problems behind it, and has (let's lapse into Streetspeak) "the visibility to deploy its capital". And stock buybacks help keep up the share price, and help the earnings-per-share, so what's not to like, if you're holding the stock?

Well, what's not to like is that there are other places for the company to deploy all that capital, now that it's so visible and everything. Like, for example, on their business. (Note that I'm not just saying that they should spend it on R&D alone - I've addressed the whole "how come Big Pharma spends so much on marketing" question, and if Merck wants to spend some of this on marketing, that's fine by me. Short explanation: marketing is supposed to bring in even more money; if it doesn't, you're doing it wrong).

I think that if Ken Frazier really wanted to stand out from the crowd, he could say that Merck is not going to spend all this money buying their own stock - that he feels that the best thing that they could do for their shareholders is to redouble their efforts to find, discover, buy, in-license, develop, and sell drugs. That, after all, is what they're on this planet to do, when you get down to it. Isn't it?

Comments (35) + TrackBacks (0) | Category: Business and Markets


COMMENTS

1. rogi on April 29, 2011 8:40 AM writes...

Classic Bunker Mentality. Like a bunch of musk oxen pressing their butts together in a circle to protect themselves from their enemies [ their own myopia and stupidity].

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2. shouldbeatthebench on April 29, 2011 9:18 AM writes...

Could it be that nirvana for a pharmaceutical company is to get to a point where you are no longer publicly held? If you can get there, you are no longer beholden to anyone to show year-on-year growth in profits – you merely need to stay profitable and competitive. That might actually be sustainable.

One could argue that buying back stock is a step in that direction.

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3. Hap on April 29, 2011 9:32 AM writes...

What #2 said. If we think that investors are overly focused on the short-term (to the point where it prevents companies from doing what they were created to do), then the only alternative seems to be to take the company private and deal with your private owners rather than stockholders.

It seems like paying your mortgage faster rather than investing the money - you can't make as much money perhaps, but if you perceive a greater risk in having fixed expenses in uncertain times, then mitigating that risk (or decreasing your exposure to it) might make sense.

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4. Bunsen Honeydew on April 29, 2011 9:45 AM writes...

@2 Isn't that the case with Boehringer-Ingelheim?

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5. canchem on April 29, 2011 9:52 AM writes...

I believe there’s great merit to privately held corporations. While it is difficult to foresee enough individuals having the financial capacity to personally fund large-scale clinical trials (Mr. Mann being a notable exception) to maintain the current pace of research, I feel the longer-term investment of private ownership enables companies to focus on strategic growth in spite of the potential neutral (or negative) returns short term, for long term success. The requirement that a stock continue to appreciate in value on a quarterly basis doesn’t always mesh with the realities of research and development, and the market is disinclined to support a 10-year development plan. If a shift away from public listing forces a contraction in average company size, but an expansion of total number of companies, I believe we’d see a greater diversity of ideas and products emerge and while perhaps not a higher percentage of approval, a higher absolute number of new drugs.

But that’s probably not going to happen any time soon.

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6. David Formerly Known as a Chemist on April 29, 2011 10:00 AM writes...

You gotta love the comments from all the armchair CEOs on this blog. Don't you think if Merck felt they had R&D/marketing opportunities that were higher value potential than buying back stock, they would invest in those opportunities? Like it or not, the management of a public company's principle job is to maximize value for their shareholders. Why do people who have no insight whatsoever into Merck's boardroom discussions, financial options, partnering options, and non-public research pipeline, immediately conclude that this is a stupid decision? Sheesh.

You're really reaching on this one, Derek.

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7. Rick on April 29, 2011 10:58 AM writes...

While I think that there are compelling arguments for research-based pharmas to be privately held, you can rest assured that this is categorically NOT what these stock buy-backs are about. This is happening in all industries right now and it is all about doing the corporate equivalent of putting all their money under their mattresses, not investing in their core business and most definitely not about weaning themselves off the Wall Street teat. It is maximally risk-averse behavior. That's why the stock prices respond favorably to this move; their mentally defective children are being docile and obedient.

At the risk of getting too political here, this is a big reason why the U.S. is experiencing a jobless recovery: companies have more faith in the safety of their money in mattresses than they do in their core activities, much less their "human capital".

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8. Rick on April 29, 2011 11:19 AM writes...

David (#7),
I agree with you that, in the world we live in, where "the management of a public company's principle job is to maximize value for their shareholders.", Merck's move is not stupid. In fact, it is impossible to get an MBA if you don't fervently believe the logic that makes their move the only sensible one. It is indeed good modern economic orthodoxy.

However, I believe there is a different, far better, question that is raised: WHY is it that "the management of a public company's principle job is to maximize value for their shareholders."? Specifically, two questions arise. First, why is "maximize" the goal? Economics is the only "science" in which the concepts "maximal" and "optimal" are synonymous. Second, why is it that only returns to shareholders are contemplated? After all, customers and society at large also invest heavily in various ways in companies and yet returns to them are considered secondary or ignored altogether. I realize this is where a good capitalist is supposed to label me a communist and dismiss these thoughts as crazy-talk, but sooner or later, we have to seriously answer these questions unless we want to repeat the senseless and altogether avoidable economic fiascos of the recent past.

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9. A. Chemist on April 29, 2011 11:42 AM writes...

Rick's comment #8 rings true to me, but I was wondering if hypothetically it would be a smart move for a company to buy its own stock if it feels it is significantly undervalued, just as it is a smart move for any investor to buy a stock which they believe is undervalued.

Regarding the "how much Pharma spends on marketing" question, that's an important enough question that I wish Derek had provided a link to his discussion of that topic.

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10. Anonymous on April 29, 2011 11:53 AM writes...

I am a long term holder of Merck stock. I am a very patient investor with very long time horizons which has served my portfolio valuation quite well through the ups and downs. I bought shares of Merck in 2001 at $75, a valuation not seen since. Now TEN years later the cream of the pharmaceutical industry has a share valuation of $36 giving a ten year return of -52%. I look at what little mostly derivative stuff those really smart guys in Merck's labs have produced and wonder what the hell is going on? Merck has bought most of their big products, so exactly why am I investing in high risk research? As an investor, I see no value in my fancy drug research investment. Merck should flush its research down the toilet, give the investors the money and figure out some new pharmaceutical business model. For now, I just want my money back, so whatever management needs to do to make that happen is just fine by me.

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11. Jeffrey Soreff on April 29, 2011 11:57 AM writes...

Agreed re Rick's "corporate equivalent of putting all their money under their mattresses" and re Hap's "It seems like paying your mortgage faster rather than investing the money"

To put it another way: I was once at a startup. Startups (at the IPO stage and past it) finance investing in the business by issuing stock, selling it, and using the cash to expand the business - which presumably the management expects to bring in future revenues larger than an average market return on the same cash. A public offering is at least a signal that some combination of the managers of the company and the investors buying its stock think it can usefully invest the money in the business.

A stock buyback is precisely the inverse of this. It may be a rational business move - but it says rather dire things about what the management thinks of its business.

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12. Hap on April 29, 2011 12:00 PM writes...

7: Do you think that if the non-armchair CEOs were doing such a bang-up job, there would be so many people criticizing them? Making lots of money to deflate your stock prices doesn't seem like all that novel a skill (and if their job is to maximize shareholder value, then they're really not doing a good job).

The job losses/shifts to elsewhere give lots of people an axe to grind, but if pharma's production were actually even subpar, they'd have a lot less ground to stand on.

Shareholders in theory invested in companies for a reason, and it seems self-destructive to destroy those reasons for short-term gain. (I guess eating the seed corn is always profitable for the eater if they're not going to be around later). If they wanted to liquidate, why couldn't they have just done a hostile takeover and be done with it?

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13. Derek Lowe on April 29, 2011 12:03 PM writes...

David (was #7, now #6):

I don't doubt for a minute that Merck thought carefully about this. But what does it say when buying back your own stock is a better business move than running your business? Especially after you've made a big deal out of wanting to have a free hand to spend money on R&D?

So I'm not necessarily saying that the buyback is a stupid move - just a depressing one, and perhaps a hypocritical one as well.

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14. Ed on April 29, 2011 12:05 PM writes...

#11 Well, they could easily give your money back to you as a special dividend, but that doesn't please Wall Street, so they don't (no mirage-like "bump" in EPS by reducing shares in issue).

What you as a small investor think, is totally irrelevant to management. You have no power. Your voice counts for squat. They (Merck management) know how to spend your money (shareholders funds) better than you, and have decided that you want to buy more Merck shares with it.

Wouldn't you rather decide what to invest in?

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15. Fishy Fish on April 29, 2011 12:08 PM writes...

#7
Well said. As a Merck shareholder myself, share buyback is just like paying dividend, returning the money to shareholders. Merck, as a public company, not a charity, is in business to make money for shareholders - pure and simple. Shareholders want nice returns with their investments.
On the other hands, as a chemist, I would also love to see that money in R&D, marketing, etc. But in the end, Wall Street lives quarter-by-quarter. They (big shareholders) are the whales - they set the rule of the game. Or be like Boehringer-Ingelheim, go private.

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16. Ed on April 29, 2011 12:14 PM writes...

#15 Stop being so obtuse, it is nothing like a dividend. A dividend would give you a choice where to invest your cash in your hand. Merck doesn't give you this choice, they know better and have decided for you.

They know what you want to do with your money better than you do. Demand "a nice return"!

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17. Yoda on April 29, 2011 12:18 PM writes...

@ #10 Anonymous - You are forgetting dividends. I haven't done the math, but when you calculate TOTAL (capital gains + dividends) return since 2001, I doubt your investment netted -52%.

I agree with many of the posters, it is a sad day when a pharma company decides it can make better use of its money by investing in its own stock than reinvesting in the business. They are basically saying they cannot find any projects that beat the return on just buying their own stock. How can this be as there are so many uncured diseases out there? Cancer, Alzheimer's, HIV/AIDS, parkinson's, etc. can't they just fund research in these areas? I bet they have some bean counter or finance guy telling them it won't make money.

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18. Fishy Fish on April 29, 2011 12:22 PM writes...

#13 Derek,

Merck's revenue is larger than many countries in the world. In a sense, running Merck is like running a decent sized country. When a country has a surplus, it should return the money to its citizens in form of tax cut. Merck's money is actually shareholders' money, just like government's money is tax payer's money. Return to us, and let us figure out how to spend it.

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19. Yoda on April 29, 2011 12:27 PM writes...

@ #10 Anonymous - You are forgetting dividends. I haven't done the math, but when you calculate TOTAL (capital gains + dividends) return since 2001, I doubt your investment netted -52%.

I agree with many of the posters, it is a sad day when a pharma company decides it can make better use of its money by investing in its own stock than reinvesting in the business. They are basically saying they cannot find any projects that beat the return on just buying their own stock. How can this be as there are so many uncured diseases out there? Cancer, Alzheimer's, HIV/AIDS, parkinson's, etc. can't they just fund research in these areas? I bet they have some bean counter or finance guy telling them it won't make money.

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20. Derek Lowe on April 29, 2011 12:34 PM writes...

#18 Fishy,

Interesting analogy, but it breaks down. Investment in a company is a voluntary activity - unlike paying taxes - and there are a lot of other options for a person's money. I don't have a lot of other options about where to send my check to the IRS. Also, the great majority of a government's operating revenues come from taxes, while a company's revenues do not come from people buying its stock, unless they issue more of it.

By opting to purchase stock in a given company, I've put money on the performance of its managers and its business operations. I might have some tiny, tiny voice in things (once a year), but overall, it's like an extreme republic versus a democracy: I've told the experts to go to it, and I'll sit back and reap what rewards may come. Ed (#16) is correct.

So in this case, Merck's experts have decided that buying their own stock is the best choice. We can either conclude that they are fools (in which case we should sell their stock), or that they're not (in which case we should reconsider our investments, if what we thought we were buying into was drug research and sales).

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21. Kuujuarapik on April 29, 2011 12:39 PM writes...

I worked at Merck from 2001 to 2007, when I got there in 2001, we were still restricted to using faxes to communicate with the outside(!). At the time they threw money at problems but invested poorly in their operations. I presume that this culture still persists, along with a penchant for slavishly following ephemerous management fads and poorly evaluated IT technologies. Investing in research is one thing, what to do with the fruits of this labor is another and I have no confidence that they have the right people at the helm to use it properly, so why not buy back shares or increase dividends? Long-patient shareholders deserve better.

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22. Zippy on April 29, 2011 12:43 PM writes...

Two comments relating to the recent stock repurchase plans following the CEO's statement that research investment was a priority.
1. All indications are that Merck still believes that there is “overcapacity� in the pharma industry.
2. It’s a bit late to decide to make research a priority. Pretty hard to unscramble an egg.

Permalink to Comment

23. Andy on April 29, 2011 1:36 PM writes...

Ed says, "Wouldn't you rather decide what to invest in?"

Don't be silly Ed. Buying back the stock will increase the share price, so if you'd rather put that money somewhere else, sell MRK stock to maintain constant dollar value of your MRK holdings and go ahead and invest it somewhere else.

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24. David Formerly Known as a Chemist on April 29, 2011 1:42 PM writes...

#13 Derek,

Perhaps Merck concluded they were already spending a sufficient amount on R&D. Perhaps they had no existing projects waiting for more funding that looked more attractive than buying back stock. I don't know, nor does anyone here. But, buying back shares and investing a sufficient amount in R&D are not two mutually exclusive activities.

Merck's R&D budget is $8.5 billion this year, up from $8.1 billion last year. I wouldn't call that neglecting the core business.

Permalink to Comment

25. Fishy Fish on April 29, 2011 1:50 PM writes...

#20 Derek,

1. My point is once the government has our money, what should a government do about the money. It is not about how they get the money, rather how to spend it (I like paying tax as much as you do). Do you want them to build a "bridge-to-nowhere" or do "something good for environment"? Or you want them to return the money to John Q. Taxpayer.
2. Buyback has a collective effect on share price. Sure, you do not have "direct" say about the decision (vs. dividend). Everything being equal, you get a lower P/E, which is generally good for your investment.
3. Being a small investor, sure you get a tiny voice (once a year). But that would be same thing as your vote in an election in a democracy. For president, you only get a say once every four years. Does your vote count? Well, to win Massachusetts' electoral vote, all you need is 50% + 1 vote. That one vote could be yours.

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26. Ed on April 29, 2011 1:52 PM writes...

#23 increase the share price??? Says who? Your belief in rational markets is highly amusing

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27. Jim on April 29, 2011 3:21 PM writes...

One one hand, Merck will take this cash and purchase shares at the expense of creating jobs and on the other will request a tax holiday to repatriate even more income stashed offshore. No jobs in the US, companies reporting record incomes, the rich get richer, the unemployed get nothing.

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28. Anonymous on April 30, 2011 7:09 AM writes...

MRK, like other Big Pharma already have some of the largest dividend yields in both the S&P500 and the Dow. They are a perennial member of the "Dogs of the Dow". There is a track record of slow growth as measured by EPS. They gain nothing by massively increasing that dividend.

I think most of you are missing the big point of them buying back their stock. It is a textbook way of artificially increasing their earnings per share (EPS) in future quarters to compensate for a lack of real earnings growth. Most institutional investors i.e. the investors that really matter invest in companies with the expectation of seeing increases in EPS (earnings divided by total number of shares outstanding). The most obvious ways to show EPS increases is to have products which bring in more earnings or cut costs (fire employees to reduce costs) which is why stocks pop when either are announced. Simple math indicates that the same effect can be achieved by buy back your own stock (i.e. reducing the total number of shares outstanding). The problem with the latter gimmick is that it only buys you so much time. Once the buy back is complete, the artificial EPS pump is turned off and the company is left exposed with having to show low or no EPS growth (assuming the pipeline hasn't kicked in to correct the problem). They are just buying time.

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29. Anonymous on April 30, 2011 7:26 AM writes...

@27 Did you not get the 2 memos?

Memo#1. The rich are the job creators in this country. If you don't make their tax cuts permanent or lower the corporate tax rate they will not create jobs.

Memo#2. The unemployed have only themselves to blame. They need to "pull themselves up by their boot straps". There are millions of jobs out there begging to be filled but the unemployed would rather receive $600 per month in unemployment than take one of the millions of available jobs.

My unanswered question about Memo #1. GE paid no US income taxes last year. Would they then get a big refund check if the corporate tax rate was lowered even further?

My unanswered question about Memo#2. How many of you know unemployed people who would rather sit at home and pay their mortgage, health insurance premium and feed their family using $600 per month instead of accepting a job that pays a livable wage?

Permalink to Comment

30. Rick on April 30, 2011 9:09 AM writes...

Anonymous #29,
re: your memos. Do you really believe that or are you just messing with us? I'd like to comment further, but my comments depend on your answer.

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31. srp on April 30, 2011 9:24 PM writes...

Oy.

If Merck thinks its stock is undervalued (i.e. they think the market is not strong-form efficient), then a buyback might make sense for current shareholders. If outside investors believe that the management has positive information about Merck that has not been revealed, they might take this repurchase offer as a signal and the stock price would then go up. (I'd like to see if Merck insiders were buying shares at the same time as the corporate repurchase--that would increase the credibility of the signal.)

Second, Merck might have decided that the cash flow from its ongoing operations exceeds the investment needs of its business, i.e. the marginal project that just clears their hurdle rate occurs at a level of investment below their expected cash flow. In that circumstance, and given managers' incentives and psychological drives to waste money on bad investments rather than return the cash back to the owners, it seems almost saintly for them to go ahead and do the repurchase.

(Note that a dividend bump accomplishes almost the same thing, but the tax advantages of capital gains on repurchased shares versus the tax rate on dividends tilts the decision that way. Also, dividends come to be expected on a regular basis, while repurchases can be irregular without spooking the market.)

The idea that institutional investors are fooled by EPS manipulations as simple as reducing the number of shares outstanding is nuts. If anything, I believe the research literature shows that stock splits, if anything, have a small positive effect on (corrected) share prices.

As for private versus public firms: There is some merit to the idea of private ownership having advantages over public ownership. Read Michael Jensen for some extended meditations on the topic. The problem in a pharma context is how to raise the capital to fund research and approval before the revenues can come in. A deep-pocketed individual or entity could do it (the way Jeff Bezos is doing his Blue Origin space company), but the number of candidates is pretty small. The usual substitute for equity is debt, and that has obvious problems in any business with erratic returns and little tangible collateral--most high-tech businesses operate with very low debt/equity ratios.

Permalink to Comment

32. Anon on April 30, 2011 10:32 PM writes...

#10. Anonymous on April 29, 2011 11:53 AM writes...

I look at what little mostly derivative stuff those really smart guys in Merck's labs have produced and wonder what the hell is going on?

Why don't you inquire about the rationing of computer drug development tools like CAS SciFinder and CrossFire when you bought your stock?

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33. Rick on May 1, 2011 5:35 AM writes...

srp (#31)
You had me at Oy. Your post seems as close to correct as one can get when trying to explain this kind of move. It also reaffirms my belief that we need for a more accurate term than "investment" to apply to moves along or south of the border between investment and speculation (or just plain gambling). How about "specuvestment"?

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34. Old Timer on May 2, 2011 8:41 AM writes...

Berkshire Hathaway has never issued a dividend or stock buyback. But I guess Warren is not interested in maximizing value for his stock holders.

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35. srp on May 2, 2011 2:07 PM writes...

Old Timer: A stock buyback or a dividend is not some magic elixir, good for all problems. I gave two specific rationales for when a stock buyback might be a good idea; neither one probably applies to Berkshire Hathaway.

It is unlikely that the stock is systematically undervalued, given Saint Warren's reputation, so rationale 1 goes by the boards.

Rationale 2 might be true (note Buffet's recent complaints about having cash that burns a hole in his pocket), but given Buffet's ability to get access to good deals, it's not crazy to think he can play mutual fund manager better than anyone else his shareholders could give the money to.

Finally, note that the kinds of deals BH does are exactly the kinds of unrelated M&A that the commenters here would (rightfully, in my view) decry if big pharma companies engaged in them. Do you really want Pfizer buying up insurance companies and candy companies a la Warren Buffet? If not, then don't cite his practices as critiques of pharma management.

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