I was shocked by the $253.4 million verdict announced yesterday for the first Merck (MRK) Vioxx trial. I’ve never heard of any one death resulting in even close to $100 million in damages. I am sure that Robert Ernst, a 59-year-old Wal-Mart produce manager, was well loved but did his death really cause his wife Carol Ernst over $253 million in damages. What was this Texas jury thinking?

According to AP, the jury wanted Merck to listen and that larger studies are needed for drugs. Would they also like to pay more for their drugs too?

Derek Lowe over at Corante’s In the Pipeline made a great comment on the size of the award. He commented, “If you’d like a strictly utilitarian, economic response to that award, start by pricing out what $253 million dollars of life insurance will cost - that is, if you can get anyone to not hang up the phone on you.” I thought that was a fairly insightful way of looking at the economic reasonableness of the damage award.

Another way to look at this is to consider that there about 4,200 additional claims against Merck. If each of these claims resulted in similar damages to those for the death of Robert Ernst, the total liability resulting from Merck’s Vioxx debacle would reach over $1 trillion dollars! Looking at that total potential liability, you would think Merck caused a nuclear meltdown disaster in a major city. I understand that the purpose of punitive damages is to send a message to the company that it should be more careful before it releases a potentially lethal drug. However, this measure of damages goes above and beyond this message. The repurcussion of this financially crippling award (not to mention the attorneys’ fees Merck will have to shell out over the next few months/years) may very well be that the cost and availability of other life-saving drugs will be put in jeopardy.

Imagine if Carol Ernst actually got 66 percent of that award, or $152 million. She would instantly become a member of the top 1 percent of the wealthiest people in the U.S. She would also have a heck of a time managing her money to avoid buying Merck stock, since Merck is standard component of many stock indexes and mutual funds. Every scam artist, charity, and financial planner will be hounding her day in and day out for the rest of her life. Even if she gets a smaller award, I hope she and her family are prepared for tremendous stress and turmoil that any windfall will cause them. God forbid that she or her family members will ever be in need of any Merck drugs. This includes any drugs that they could have been able to produce had they not faced tremendous financial liability.

I know it is likely that on appeal the damage award will be reduced substantially or even thrown out. However, the jury’s verdict does affect my estimate of the potential total financial liability Merck will face as a result of Vioxx. I originally felt that it was very unlikely that the total damages from Vioxx could exceed $10 billion; however, I’m not so confident now. I will also be a lot more cautious in the future when looking for value investments in companies with medical liabilities. I think I remember Charlie Munger also recently warning of the dangers of huge legal costs associated with medical liabilities. I should have taken his warning a bit more seriously. Maybe that is why we haven’t seen Warren Buffett and Charlie Munger investing in depressed stock of drug companies. For now, I will be holding on to the Merck stock I purchased last year, and I’ll be waiting to hear how the appeal of this case turns out.

I learned a few other important things from this event. These include:

1. If I need an attorney for a jury trial, I would hire a Christian minister or reverand like Mark Lanier, who is an ordained Baptist minister. (Now if I could only invest in a law firm specializing in providing attorneys that are Christian ministers. Now that is a competitive advantage that would give a firm a wide moat.)
2. I need to learn how to make PowerPoint presentations as effective as Mark Lanier using the techniques he used that are detailed in the book Beyond Bullet Points written by Cliff Atkinson.
3. Never underestimate the power of persuasive speaking even when the facts do not appear to support an arguement. Emotions are often much more powerful than reason. As value investors, we want to focus on rational reasoning, but we have to remember that emotions play a much larger role in the decision making of many around us.

Last week there was an interesting article in Barron’s regarding Unilever (UN & UL). Apparently, some bankers in London are thinking about unlocking Unilever’s value by splitting it up, similar to Viacom. One option would be to separate out the food business from the personal care operations. It might be difficult for Unilever to identify the best way to split up, since some of its slow growing brands such as detergents are now rapidly growing in emerging markets.

The interesting item of note was that the article pointed out that Unilever trades at a discount of as much as 30 percent compared to Procter & Gamble, Danone and Nestle. That is similar to my finding as well. I’ll have to keep on eye on Unilever’s moves over the next couple of months. Unilever’s value may start to attract attention and it might be unlocked in the near future.

Back in the Golden Age of the Internet (circa 1999-2000), I used to enjoy posting free auctions and classifieds on Yahoo. It was a great way to save money by selling unwanted items. Then the Internet Dark Ages hit in 2001 when many online companies had to struggle for survival. Many .com companies tried to charge for services that used to be free in order to survive and justify their business plans.

Recently, things have started to change. Online advertisement expenditures have been increasing, and it looks like some of those old Golden Age business plans are getting dusted off. Yahoo! Auctions recently announced that it will no longer charge sellers listing fees or closing costs. In addition, I noticed Yahoo! Classifieds, an old favorite of mine before Craig’s List grew, is also providing free listings again. It will be interesting to see if they will be able to revive their markets.

This development will be a direct challenge to Ebay. It currently has a massive competitive advantage with its large network of buyers and sellers, its rating system, and its brand name. Having a large concentrated market of buyers and sellers increases the overall auction experience, since it is most efficient to list items for sale where the most buyers will be looking to bid on items. Sellers with high ratings also face high switching costs, since they have to rebuild their reputation if they move to another auction provider. It will be interesting to see if Yahoo! Auctions will be able to attract enough users to make its auctions worth while.

I don’t think there is an investment opportunity here, but if Yahoo! Auctions gets enough traffic, it might be a money saving opportunity to list your “junk” for free with them. I’ll have to check on how close the closing prices on Yahoo! Auctions compares to those for similar items on Ebay.

Last Thursday Merck (MRK) announced that it was pulling its Vioxx drug from the market. Mr. Market was not at all happy with this development and dropped Merck’s market value by 27 percent. This was an eight year low for Merck’s market value.

Merck was proactive in informing the FDA of its research concerning the increased risk for cardiac problems associated with Vioxx. I believe Merck made the right decisions in voluntarily removing Vioxx from the market even though it will cost the company in the short term. I believe the market has over reacted to this setback, and I don’t believe the loss of Vioxx will impact the long term value of Merck. I agree with Barron’s assessment this weekend that investors have clearly overreacted. Vioxx only accounted for 11 percent of the company’s sales this year, so a 27 percent hit that Merck’s shares took is a bit excessive.

However, there is some danger that lawsuits will cut into future earnings. However, given Merck’s proactive measures and the fact that it had earlier put a warning label on Vioxx warning of cardiac risk, I think Merck will be able to manage the lawsuits. There is also the issue that Merck’s drug pipeline seems rather thin. I think the struggles that Merck has faced this year will cause the company to focus on new product development and strategic partnerships.

Looking at Merck’s free cash flow, I find that using fairly conservative estimates that Merck shares have an intrinsic value between $40 and $50. Given Merck’s 4.6 percent dividend that should be safe for quite some time, I am interested in buying Merck at this time with all of its warts and bruises. I will patiently await better days and new drug discoveries in the future while collecting a handsome dividend now.

I’m adding Merck to my Marketocracy fund Monday morning, so we can track the performance of this analysis.

In my last post, I discussed the competitive advantage that Unilever has in its global brands. But in addition to having a wide moat, we need to buy stocks at the right price to ensure a wide margin of safety. Today I’d like to share my estimate of Unilever PLC’s (UL) intrinsic value and compare it to the current price of the stock.

To determine intrinsic value, I often like to know how much cash the company is generating for me. Unilever reports what they call “ungeared free cash flow“, and I give them points for using this metric as a target to maximize their value. The ungeared cash flow is equal to the cash flow from operating activities less capital expenditures, less taxation on profit, and taxation on interest and financing income from pensions and similar obligations. Basically this is free cash flow free of tax benefits.

In 2003, Unilever generated €3,939 million in ungeared free cash flow. I estimate that the company will safely grow 3% to 5% in the long term. Assuming a 4% growth rate and using a 10% discount rate, the present value of free cash flows is €65.7 billion. Adjusting for cash and long term debt, the total value to shareholders is €59 billion.

Since Unilever has two classes of shares (PLC and NV), the intrinsic value for PLC shares must be calculated by dividing total value by 6459.4 million combined PLC shares as stated in the Unilever FAQ. Each PLC share is equal to 4 UL ADR shares and the Euro currency needs to be converted to US dollars (1€ = 1.2US$). After crunching these numbers, I get $44 per share as the intrinsic value of UL stock. Using a 25% margin of safety, I am comfortable buying UL at $33 a share.

I actually purchased UL on Tuesday at $33.58 per share. I set up a Marketocracy fund to track this purchase and any future purchases that I make at Fat Pitch Financials. Sorry about the delay in getting this posted, but I’ve been tight on time this week.

Unilever (UL & UN) recently popped up on one of the value screens that I follow, and I was a bit surprised that this brand name giant might be selling for a discount price. Then this morning I spotted several news items concerning Unilever, and they didn’t sound very promising. They all revolved around a news release by Unilever that revises their earning guidance down from double digit to single digit growth for the year. The cause for the slow down was blamed on poor weather in Northern Europe this summer and weaker consumer confidence in Western Europe. Mr. Market was not happy at all with that announcement and sent share prices down over six percent this morning. Could this possibly be our first fat pitch to come over our plate? Let’s take a closer look.

Business Basics
My first stop was over to Unilever’s investor relations center to learn a little more about this large European consumer products conglomerate. I was a bit amazed at the number of high quality brand names in Unilever’s stable of products. Here are a few of their many (400 plus) high quality brands:

• Hellmann’s
• Knorr
• Wishbone
• Bertolli
• Becel
• Country Crock
• Slim*Fast
• Lipton
• Breyers
• Ben & Jerry’s
• Klondike
• Popsicle
• Birds Eye
• Snuggle
• Surf
• Dove
• Pond’s
• Suave
• Close Up
• Calvin Klein fragrances

Many of these strong brands dominate their product sector and command premium prices. Unilever’s global brands provide the company a major competitive advantage against new entrants in the market.

The company appears to be free of any major legal problems.

Unilever does have substantial pension obligations. They are accounted for using reasonable assumptions. There is also the accounting of stock options, which thankfully have been expensed and are fully included in the financial statements. This is a good indicator that the company practices good conservative accounting.

Return on invested capital has improved from 2002, where it was 9.8%, and in 2003 was 12.5%.

There is still quite a bit more to write about, but I’m out of time. I’ll continue the discussion later today. However, I plan on buying this stock this morning while the price is still a bargain.

Apparently I’m not the only one thinking about Coca Cola (KO). I was reviewing the Safe Haven website today, and I discovered a new article that focuses on Coca Cola’s stock price. As of this moment KO is still above $40, so I’m not too excited yet. However, I found it interesting to read what Brady Willett of FallStreet.com thought of Coca Cola’s stock price:

To better understand how the longest bull market in history has severely change the expectations of Coke investors look at it this way: if you had invested $1 in Coca-Cola in 1983 you would have purchased a company with 54 cents/share in net equity and you would have earned 9 cents a year in earnings. For a $1 investment today you get 13 cents in net equity and 4 cents/share in earnings annually.

My general speculation is that at 15 times earnings Coke is an excellent stock to look at. At $30/share this would only bring the price to free cash flow ratio on Coke down to 23 times. However, remember that dividends will continue to be dolled out by the company.

I tend to agree with Brady’s analysis. We’ll have to wait and see if Coca Cola presents itself as a real fat pitch in the coming months. For now, it’s time to move on and look at other opportunities.

Coca Cola’s (KO) third quarter earning were a big disappointment to the market today. Shares of Coke dropped below their 52 week low today and ended the day at $41.16. If prices drop a bit more, there could be a real opportunity here to own a piece of a company with one of the most powerful brands in the world. If the price drops below $40, I will be doing some serious research on Coca Cola. Stay tuned.