February, 2003 Update and Company Reports

 

Important notice for all our Pharmacia shareholders:  On July 29, 2002 Pharmacia Corporation distributed shares of Monsanto Company to its shareholders.  The Internal Revenue Service has ruled this a tax-free distribution.  However, under Treasury Regulation Section 1.355-5(b), shareholders should report this transaction by attaching a “Shareholder Statement” to their tax return for the year that includes the distribution date above.  The statement does not need to be filed for non-taxable accounts, such as retirement accounts.

 

We have prepared this statement for our clients who own Pharmacia, and it is enclosed.  Please sign and attach it to your 2002 tax return or give it to your tax preparer.  Obviously, if you did not own Pharmacia on July 29, 2002 you will not receive the statement.

Merck (MRK $52) was last discussed in our August 2000 report.  At that time I noted a number of its drugs were losing patent protection and said, “Merck shareholders have to hope Merck has something big up its sleeve.”   Well it didn’t, and the stock declined from $72 to the present price.  However, that period has largely passed.  Merck has five drugs that are selling over a billion dollars per year that will drive growth over the next several years.  Also, some new drugs are on the way.

 

Drug	Therapeutic category	2002 sales	2003 Merck projection	Notes
Zocor	Arteriosclerosis, cholesterol-modifying	$5.6	$5.6-5.9	Adding statin drug Zetia to form a combination therapy should reinvigorate the growth of Zocor.
Vioxx	Cox-2 non-steroidal anti-inflammatory	$2.5	$2.6-2.8	Market share declined last year after Pharmacia’s competing drug, Bextra, was launched.  Merck plans to refile follow-on Arcoxia with the FDA, and hopes it firms up the sagging Cox-2 franchise next year.
Cozaar/Hyzaar	Hypertension	$2.2	$2.4-2.6	FDA advisory committee recommended new stroke indication – final FDA approval not granted yet.
Fosamax	Osteoporosis	$2.25	$2.6-2.8	New once per week dosage just launched.
Singulair	Asthma	$1.5	$2.0-2.3	#1 asthma controller; recent approval for allergic rhinitis should drive growth.
Zetia	Arteriosclerosis, cholesterol lowering.	Approved Oct. 2002	Big	This could be another $1 billion drug for Merck, and will strengthen the Zocor franchise.

 

Two very promising new drug candidates Merck is talking about are a Human Papillomavirus vaccine and a neurokinin-1 receptor antagonist called EMEND for the treatment of chemotherapy-induced nausea and vomiting.

 

Merck intends to complete the spin-off of Medco Health in mid-2003; until then I will look at Merck and Medco as one company.  By the time the spin-off is complete, both companies should look strong and healthy.

 

Merck’s earnings were down in 2002 compared to 2001, when adjusted for comparability.  However, the company has guided towards 10% e.p.s. growth in 2003: $3.40-$3.47 compared to $3.14 in 2002.  High single digit e.p.s. growth is a reasonable guess for the next several years.  Merck generates a lot of cash, and repurchased $2.1 billion of its stock last year.  It pays a 3% dividend.  I estimate its intrinsic value in the mid-$60’s range.  Although the stock sells at a nice discount to this number, a clear view of Merck and Medco as two separate companies is needed to make an intelligent investment decision.  Hopefully, that visibility will be available later this year.

 

QUALCOMM (QCOM $34) has declared its first cash dividend, to be paid at a rate of 20 cents per year, and announced a $1 billion stock repurchase program.  With 3G CDMA2000 opening everywhere in the world except Western Europe, the company will reliably produce somewhat over $1 billion of free cash flow.  QUALCOMM is one of a handful of successful technology companies that earns more money than it knows what to do with.  We can expect estimates of handset sales and earnings to be increased later this year.

 

In a continuation of the blocking of CDMA2000 competition in Europe, Matthias Kurth, the EU’s head telecom regulator, has preserved the sanctity of the European 3G spectrum auctions of 2000.  The exorbitant prices brought a windfall to the governments, but destroyed the solvency of Europe’s oldest, and once strongest, telecom monopolies.  He has decreed that incumbents who paid for auctioned 3G licenses must be defended from smaller players that seek to build 3G networks without buying expensive spectrum.  These players happen to include those who would like to build CDMA2000 networks.  Efficient CDMA2000 does not require the bandwidth of European 3G technology, eliminating the expense of spectrum purchases.  Matthias Kurth told me face-to-face last year that EU regulators are technology agnostic – they would not tell operators which technology to use.  Clearly, the regulators have other ways of accomplishing the same task.  In the end, the European cellular consumer pays the price.

 

Church and Dwight (CHD 30) has successfully completed and integrated two very large acquisitions that will fuel superior earnings growth over the next five years.  These acquisitions doubled Church and Dwight’s size, creating the market power and the critical mass necessary to wring out operating efficiencies, while funding increased marketing and new product development.  At this point, Church and Dwight is a margin improvement story.  An annual increase in gross margin of 1% - 1.5% is the primary driver of projected earnings growth of 12.5% - 15% over the next five years.

 

The acquisition of U.S. Detergents in 2001 doubled its laundry business, and added the Xtra Laundry Detergent and Nice ‘N Fluffy Fabric Softener brands.  The acquisition of Carter-Wallace’s consumer brands in 2002 added Arrid Anti-Perspirant, Trojan condoms, Nair depilatories, Lambert-Kay pet care, and First Response pregnancy kits.  These newly acquired brand names join Brillo pads, Scrub Free bathroom cleaners, and Arm & Hammer baking soda, detergent, kitty litter, and personal products as trademarks with very high household recognition ratings.

 

This management stands out for its proven ability to grind out sustainable growth, be it through revenue growth, watching expenses, or creating a new product.  Brillo provides an example.  Management is capitalizing on a brand name that has over 97% household recognition, by expanding its market.  The scratchless pad market is about 3 times as large as the steel wool pad market, $177 million versus $55 million, but Brillo has no offering in that category.  And, there is a trend towards disposables in household cleaning.  So, management is launching a new invention, a non-abrasive pad called “Brillo Scrub ‘n’ Toss.”  At 10 cents per pad, it could eventually eclipse sales of old Brillo pads.

 

Since this management took over in 1995, revenues, earnings, and share price have grown at 14%, 26%, and 17% compounded, respectively.  Management expects annual e.p.s growth of 12.5% to 15% over the next several years to be driven by 5% organic revenue growth, new product introductions, 1-1.5% gross margin improvement, reduced interest expense, and the acquisition of the remainder of a 50% owned joint venture.

 

Earnings expectations have been guided to about $1.80 this year, compared to $1.61 in 2002.  However, as I analyze the numbers, I see numerous opportunities for even better results; pushing $1.90 would not be a surprise.  Cash flow generation is strong, and the present value of the economic profit stream is in the middle $30’s.  The stock is attractive under $30.

 

Steven L. Ré, CFA                                                                  February 13, 2003

 

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The above information is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results.  Earnings projections often miss, and markets sometimes go down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.