Fitch Affirms Merck's Senior Unsecured Debt At 'AA'; Outlook Negative

Fitch has affirmed the ratings for Merck & Co. (Merck) as follows:
-- Issuer Default Rating (IDR) 'AA';
-- Senior unsecured 'AA'
-- Bank loan 'AA';
-- Commercial paper 'F1+'.
The Rating Outlook remains Negative. The ratings apply to approximately $7.32 billion of long- and short-term debt instruments.
Merck faces a host of business risks, most notably potential revenue and cash flow losses due to U.S. patent expirations of key products in the intermediate-term and litigation exposure arising from Vioxx product liability. The Negative Rating Outlook reflects these risks to cash flow generation in addition to possible penalties or fines from investigations by government and regulatory agencies worldwide.
Merck's intellectual property position will be significantly compromised in the 2006-2008 timeframe beginning with the U.S. base patent expirations of Zocor and Proscar in June 2006. Fitch estimates that the revenues and earnings losses from patent expirations (and the global Vioxx withdrawal in September 2004) will not be offset by key product sales and commercialization of the R&D pipeline until 2008, notwithstanding significant business development activity. However, income is expected to be boosted by equity income from Merck's partnerships, especially from the joint venture with Schering-Plough driven by strong sales of Vytorin and Zetia. Fitch will monitor Merck's ability to stabilize total revenues and cash flows, which Fitch anticipates to occur in 2008.
Approximately 9,650 cases alleging personal injury from the use of Vioxx have been filed against Merck by the end of 2005. Fitch favorably views Merck's intention to individually litigate the claims as opposed to offering a global settlement. As a result of this approach, only three cases have been tried over the past six months, with no damages paid by Merck to-date. However, final Vioxx damages and timing of cash outflows are highly uncertain. Fitch will continue to collect information as the litigation progresses through the legal system to ascertain a range of possible exposure which may be significant.
Merck's superior liquidity and light long-term debt maturity schedule will serve to support the company's credit profile in the midst of the operational challenges in the intermediate-term. At the end of the third quarter of 2005, Merck had greater than $14 billion in cash and short-term investments, a $1.5 billion U.S. credit facility, a $3 billion foreign commercial paper program, and free cash flow generation of $2.71 billion (cash flow from operations of $7.71 billion less dividends of $3.49 billion and capital spending of $1.51 billion) for the latest 12-month period ending Sept. 30, 2005. Although free cash flow generation has weakened considerably since the Vioxx market withdrawal, Fitch believes that free cash flow will approximate or exceed $1 billion annually in the intermediate-term, despite Merck's commitment to maintaining its large dividend.
Liquidity is supported by a large domestic cash balance given Merck's repatriation $15.9 billion of foreign earnings in 2005 under the Jobs Creation Act of 2004. Merck had cash, net of debt, of $6.71 billion at the end of the third quarter of 2005. Merck does not have a significant debt maturity until 2008, at which time a $1.38 billion note payable to AstraZeneca matures. Additionally, Merck has the option in 2008 to require a guaranteed payment of $4.7 billion (approximately $3.3 billion, net of the AstraZeneca loan) from AstraZeneca for certain rights and interests pertaining to their joint venture agreement. Fitch estimates that Merck will have cash, net of debt, exceeding $6 billion in the intermediate-term, barring significant acquisition activity and recognizing a commitment to actively repurchasing common shares.
Merck continues to consummate a higher degree of external licensing deals to bolster the late-stage R&D pipeline, which is weaker compared to its peers. Given Merck's expected large domestic cash balance by the end of 2005, large acquisition opportunities may be considered that may assist in strengthening the R&D program and/or transforming a maturing product portfolio. The acquisition strategy of the new CEO, Richard Clark, departs from the anti-merger philosophy of his predecessor, Ray Gilmartin. Fitch anticipates that a large corporate acquisition target may be sought in the intermediate-term.
Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site. The issuer did not participate in the rating process other than through the medium of its public disclosure.