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Merck & Co. (MRK - Analyst Report) reported second quarter 2012 earnings per share (excluding special items) of $1.05, 4 cents above the Zacks Consensus Estimate and 10.5% above the year-ago earnings.

Revenues for the quarter increased 1.3% to $12,311 million, just above the Zacks Consensus Estimate of $12,129 million. Revenues were negatively impacted by both currency fluctuations and the arbitration settlement agreement with Johnson & Johnson (JNJ - Analyst Report).

Including one-time items, earnings declined 10.8% to 58 cents per share.

The Quarter in Details

Merck’s Pharmaceutical segment posted sales of $10.6 billion, up 2%. Negative currency movement impacted Pharmaceutical segment sales by 3%. Products like Januvia, Janumet, Isentress, Singulair, Victrelis and Gardasil contributed to sales.

However, the strong performance of these products was partially offset by lower sales of Vytorin and Cozaar/Hyzaar and austerity measures in Europe. Remicade sales continued to decline during the quarter, most likely being impacted by austerity measures.

Singulair, indicated for the chronic treatment of asthma and relief of symptoms of allergic rhinitis, recorded $1.4 billion in sales, up 6% from the year-ago period. However, Singulair sales will experience a severe decline following its US patent expiry in August 2012. We note that Singulair will retain exclusivity in the EU until February 2013 and in Japan until 2016.

Meanwhile, with Merck transferring exclusive marketing rights for Remicade and Simponi to Johnson & Johnson, Remicade and Simponi combined sales fell 35% to $594 million. We expect Merck to focus on improving penetration rates and drive growth in Europe, Russia and Turkey.

Isentress, the company’s product for HIV infection, recorded an increase of 18% to $398 million during the reported quarter. Performance was driven by strong growth in the US and emerging markets.

The diabetes franchise, consisting of Januvia and Janumet, continued to perform well, and witnessed growth across all regions. Combined sales increased 33% to $1.5 billion. While Januvia sales increased 36% to $1,058 million, Janumet sales increased 28% to $411 million.

Merck is working on increasing sales of its diabetes franchise by gaining approval for additional indications. The diabetes franchise should benefit from the approval of Juvisync, which is a combination of Januvia and Zocor.

Gardasil, Merck’s cervical cancer vaccine, recorded sales of $324 million, up 17% year over year. Sales were driven by increased vaccination of males in the US and the launch in Japan.

Zostavax sales came in at $148 million, up 22%. Merck has initiated a TV advertising campaign in April to increase awareness about the risk of shingles. The company will launch a new branded print and online campaign later this year.

Meanwhile, Merck’s ProQuad, MMR II and Varivax vaccines recorded combined sales of $316 million, up 9%. Vytorin sales declined 3% to $445 million during the quarter.

Merck’s hepatitis C treatment, Victrelis (boceprevir) posted sales of $126 million, up from $111 million, $87 million, and $31 million reported in the last three quarters. We were encouraged to see the sequential improvement in Victrelis sales.

Victrelis was added to the VA formulary, which is the largest single provider of services to hepatitis C patients in the US. This represents a significant commercial opportunity for Victrelis.

Merck has an agreement with Roche (RHHBY - Analyst Report) for the global marketing of Victrelis as part of a triple combination therapy.

Emerging markets accounted for 18% of pharmaceutical sales in the second quarter of 2012 with China continuing to put in a strong performance.

Merck’s animal health segment posted sales of $865 million, up 8%. Increased sales of swine and cattle products helped drive growth.

Consumer Care sales increased 2% to $552 million in the second quarter of 2012, mainly due to Claritin, Coppertone and MiraLAX.

Total costs declined 2.4% to $7.9 billion. Marketing and administrative expenses declined 5.9% to $3.2 billion in the second quarter of 2012 due to productivity measures undertaken by the company. R&D spend increased 5.3% to $2.0 billion in the second quarter of 2012.

2012 Guidance Maintained

Merck reaffirmed its outlook for 2012 despite the negative impact of currency fluctuation. The company expects adjusted earnings in the range of $3.75 - $3.85 per share. Revenues are expected to remain flat or close to 2011 levels. The company expects full year revenues to be negatively impacted by 3% at current exchange rates.

Currency could cut third quarter sales by 6% at current rates. The Zacks Consensus Estimate currently stands at $3.83 per share on revenues of $47.1 billion.

Merck expects R&D spend to increase slightly from 2011. The company spent $7.7 billion on R&D in 2011. The company’s late-stage pipeline is advancing with six regulatory filings expected in the coming 18 months. These include odanacatib (once-weekly oral treatment of osteoporosis). Merck intends to file for US approval of suvorexant in 2012.

Merck is entering a challenging period with blockbuster drug, Singulair, slated to lose exclusivity in the US in August 2012. We expect Singulair revenues, which accounted for approximately 11.4% of total revenues in 2011, to decline significantly post August 2012.

We currently have a Neutral recommendation on Merck, which carries a Zacks #2 Rank (short-term Buy rating). Merck is currently facing issues such as the patent expiration of key drug, Singulair, EU pricing pressure, US health care reform, the Remicade/Simponi transition and pipeline setbacks.

We believe the company will continue resorting to cost-cutting initiatives to drive the bottom-line. Meanwhile, some of the company’s recent launches should start contributing significantly to the top line in the forthcoming quarters.

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