Will Merck Use “Fuzzy” R & D Expense Rates — To Improve EPS In 2011 and 2012?


I said yesterday that it was possible that some of New Merck’s “beat” on Q1 2011 earnings was not a pure fundamental sales and gross margin improvement. That seems true, given these comments on the call, courtesy of SeekingAlpha:

. . . .Q: Tim Anderson — Sanford C. Bernstein & Co., Inc.

My guess is you’re going to resist answering this, but I’m hoping you can share your thoughts. On R&D spending, if you could potentially keep it flat or slightly down in 2011, is it possible that R&D spend might contract further beyond 2011? Just looking for a directional answer on this. . . .

A: Kenneth Frazier — CEO, Merck & Co., Inc.

Yes. On the R&D question, I would say that as I’ve tried to say all along, the R&D spending that you see at this time in Merck is a function of the assets that we have at various stages of development in the pipeline. I don’t think you should consider it to be a number going forward. I think it will all depend on what we have. We’re pleased to have the assets that we have in late-stage development inside our company. And going forward, we are going to be looking for ways to produce efficiencies in our R&D, including prioritization decisions. We’ve been reducing the number of R&D sites. So we are committed to ensuring that whatever we spend on R&D going forward is about quality, not about quantity. So we have no dogma about an $8 billion spend in R&D. It’s really about making sure that we maximize the assets because we’re committed to growth long term, and we believe that R&D is the predominant driver of long-term growth in this industry. . . .

So, if R&D spending will be moved back and forth, quarter by quarter, there is a real probability that any earnings “beats” will come from below the sales and gross margin lines (by staging the indirect expenses, like R&D, that do not come out at the “cost of sales” line).

So, were I you, given that the R&D spending goal for 2011 just dropped from $8.5 billion to something south of $8 billion (said another way, adding about 16 cents a share, at the EPS line — on the 3.08 billion shares outstanding — and more like 18 cents a share, if Merck quickly repurchases all of the $6.4 billion of stock it is suddenly authorized to repurchase). . . I’d take Merck’s generally good news of yesterday with some significant salt. It is not going to be primarily a fundamental improvement in gross margins. It is going to be R&D expense savings, in part — and thus not clearly sustainable, longer term.

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