Once viewed as the world’s premier pharmaceutical company, Merck & Co. now finds itself confronting a number of problems for which there are no easy remedies. The company faces a dearth of new drugs to replace top sellers due to lost patent protection in the next few years, and it has canceled work on a highly anticipated depression drug that failed in late-stage trials.


Merck’s shares are trading at one of their lowest points in six years, and the company is planning to lay off 4,400 employees, or about 7% of its workforce, to save $250 million to $300 million a year. Merck’s recent woes have raised questions about its strategy to remain fiercely independent while nearly every other major competitor has gone through one – or more – mergers in the past decade.


“Merck is starting to look less like the gold-plated pharmaceutical firm and more like an average big pharma firm,” says Wharton health care systems professor Mark Pauly, adding, however, that Merck and the entire drug industry have a long way to go before being placed on the critical list. “There’s still a lot of other big pharma companies that are no better off than Merck, and they are all still in pretty good shape.”


The drug industry, which has enjoyed growth of up to 20% in recent years, was due for a slowdown, Pauly notes. “It’s gone from terrific to merely good. But if you are staffed up for terrific, you have to lay off for merely good.”


The Blockbuster Bind

Reliance on big blockbusters – drugs bringing in more than $1 billion in revenues – has made the industry a high-stakes game with companies’ fortunes rising and falling on a single hit product.


Merck benefited from this strategy as the first company to introduce a drug in the revolutionary class of cholesterol-lowering statins, Mevacor, in 1992. It followed that up with another cholesterol drug, Zocor, now its largest selling product with sales of more than $5 billion, or about 25% of the firm’s revenues. But Zocor is due to lose patent protection in 2006, opening the way for generic competition. Generics usually drive down the price of a drug by at least two-thirds.


“Coming up with blockbusters seems to be the most important thing that distinguishes the hyper-successful from the merely successful drug company,” says Pauly, noting that several years ago Eli Lilly and Co. was wrestling with patent expirations, but has overcome that with new products. “The pendulum swings and now Lilly is favored. Merck was the premier company, and I would say it still has more to contribute than the average big pharma, but these things do tend to ebb and flow.”


Sean Nicholson, a Wharton health care systems professor, agrees. Merck saw enormous success during the late 1980s and early 1990s in introducing new products, he says. “Now the company is experiencing the ugly side of the lifecycle. Until it launches a new drug, it won’t be out of the woods.”


According to Nicholson, while Merck’s earnings growth is running at 6% to 8% a year, investors have expectations of double-digit growth. Shares fell 7% when Merck announced that third quarter earnings from ongoing operations were up 6%, to $1.86 billion. Sales in the quarter were also up 6%, to $5.8 billion. Marketing and administrative expenses were up 4% for the quarter, and research spending rose 15%. Merck also warned it would not meet earlier forecast profits for the year, and said that net income would fall to within a range of $2.90 to $2.95 a share, from $3.14 last year.


Merck, it seems, is “coming clean” on the reality of future earnings growth, suggests Nicholson. “One way to cushion the blow is to cut costs by $250 million a year. Ultimately it is just trying to buy time until research and development produces a new blockbuster. It’s the kind of thing we should expect to see one or two big pharma firms do. Everyone should fess up as to why double digit growth is not going to return.”


Explanations abound for drug makers’ recent disappointments, Nicholson says. One is that all the easy drugs have been discovered, requiring more effort from researchers to find the more elusive molecules. Another explanation might be that the industry’s investments in new technology, including genomics, have not paid off — at least for now.


“But plenty of companies – the Genentechs and Amgens of the world – seem to be getting big earnings increases and are able to produce new drugs,” Nicholson notes. “We’re always going to have some winners and losers. Merck, in this case, has gone several years without having anything substantial.”


Resisting the Urge to Merge

In an industry marked in recent years by mega-mergers, Merck has stood alone, staunchly defending its independence. The cost cuts are, in effect, savings that shareholders would likely reap in a merger, says Nicholson. “Most people agree a merger is not going to make scientists more productive,” in part because mergers are distracting for workers as they are forced to focus on a corporate reorganization rather than product development. “Merck seems to have the stomach to cut costs without a merger, which then reduces the need to merge,” he says.


Yet Shaojing Tong, an analyst with Mehta Partners, a pharmaceutical research firm and hedge fund manager, suggests that the recent cuts may not be enough to stave off the pressure to merge. “Under these circumstances, I think a merger is something Merck is going to be looking at.”


The ideal merger candidate would be Johnson & Johnson, which like Merck, is headquartered in New Jersey, Tong says, noting that Johnson & Johnson’s strength in diagnostics and other health-care products would provide little overlap with Merck’s pharmaceutical portfolio. “They would really create a powerhouse in the health-care industry.”


While it has not gone for a full-blown merger, Merck, like other drug companies, has increased the number of collaborations with outside firms. This year it signed 34 deals with research partners, compared to 10 in 1999. Merck has also teamed with Schering-Plough to develop respiratory drugs, and plans to market a cholesterol-lowering cocktail combining Zocor and Schering’s Zetia next year.


Heather Brilliant, who follows Merck for Morningstar, says the company’s biggest problem is the lack of new products in the pipeline to replace Zocor when its patent expires. Patents on the company’s second-largest seller, the osteoporosis drug Fosamax, are due to expire in 2007. “Merck faces a daunting task – to come up with new products to compensate. I think its pipeline looks like it might not be able to [do that].”


Merck’s determination to focus on breakthrough blockbuster drugs, rather than imitate competitors with so-called “me-too” therapies, may be at the root of the company’s current drug drought, says Tong. “The company’s strategy has been quite rigid. Its R&D program is much riskier than others.” The latest bad news at Merck – the failure of its depression drug known by the chemical name arepitant – came as a surprise just weeks before an annual analyst meeting, he adds, noting that the drug’s failure will not only hurt the company’s finances, but its timing may damage management’s credibility.


Analyst Barbara Ryan of Deutsche Bank has already called for Merck’s chief executive Raymond Gilmartin to resign. “The company needs a plan that works and a new CEO,” she wrote in a report after the layoff announcement. Tong says it is unlikely that Gilmartin will be forced out. “That would not change the company overnight and I think most of the board members are not [in favor of] forcing him out, so he will probably have the choice to stay another three years or so.”


In the long run, however, Brilliant predicts that Merck’s emphasis on quality research will revitalize the firm. Peter Kim, who joined Merck as head of research two years ago from the Massachusetts Institute of Technology, is a well-respected scientist, she adds. “In the long-term Merck looks positive because it has an excellent R&D team.”


Shedding Medco

This summer Merck did respond to complaints from analysts and spun off its pharmacy benefits subsidiary, Medco Health Solutions. Nicholson says analysts had been disturbed by the business because it made it difficult to evaluate the company as a whole.


Meanwhile, in August, the U.S. Attorney in Philadelphia accused Medco of destroying patients’ mail-order prescriptions and switching patients to Merck drugs or to drugs from companies that gave rebates. Merck, according to Nicholson, is not likely to be tainted by the charges against Medco because investors viewed the two companies as separate. Medco has denied the charges.


Brilliant says Medco, which has a profit margin of 3%, was a drag on Merck, which she says has pharmaceutical margins of 45%. Merck got into the pharmacy benefits business as a hedge against managed-care driven drug-cost containment, she suggests, adding that Medco was “not the smartest thing” Merck executives ever did. “They did it because of the political environment. They thought having a pharmacy benefits manager was the thing to do, and at the same time they were slashing their sales force. Now that’s coming back to bite them. Pfizer has double the sales force they have.”


In announcing third-quarter results and the layoffs, Merck also says it will lower limits on the amount of drugs distributors can buy each month. The company will take a hit of up to $750 million in the fourth quarter as a result, but it says the new rules will stop distributors from hoarding supplies prior to price increases.


Merck was more susceptible to such hoarding than other companies because it typically raises prices in a methodical, predictable way, according to Brilliant.


The Medicare Reform Factor

Merck’s problems are aggravated by larger forces pressing down on the entire drug industry, including more cost-consciousness on the part of consumers and insurers, according to Pauly. “The big unknown, and what I would lie awake at night worrying about if I were running a drug company, is what the government will do about Medicare drug coverage.”

Meanwhile, a joint House and Senate committee has reached compromise on a Medicare drug benefit that would provide coverage to 40 million Medicare recipients for the first time since the federal medical plan was created 38 years ago. The legislation is scheduled to take effect in 2006 and cost an estimated $400 billion over 10 years.

The proposal has been viewed as a victory for drug makers because it would expand their markets yet provide protections against government price controls by encouraging competition among private insurers. The industry had resisted a Medicare drug benefit for years, fearing the government would drive prices down by acting as a single, powerful bulk buyer. The compromise plan is expected to face a vote in both houses of Congress before Thanksgiving.

So far, it’s not exactly clear how the new program will work and whether private insurers will choose to participate. “It is a period of great uncertainty for pharma in general,” says Pauly.