Healthy Skepticism Library item: 1661

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Publication type: news

Harris G.
Merck will be spinning off Merck-Medco.
Wall Street Journal 2002 Jan 29
http://online.wsj.com/article/SB1012254175800950080.html?mod=googlewsj

Abstract:

Merck Will Shed Drug-Benefits Unit In an Effort to Boost Its Stock Price

Full text:

Merck & Co., under heavy pressure as five of its biggest drugs are ravaged by generics and as the growth of a newer one stalls, will shed its pharmacy-benefits-management subsidiary, Merck-Medco.

Merck plans an initial public offering of part of Medco by summer. It is weighing alternatives for distributing the remaining shares and intends to complete the separation of Medco within 12 months. Executives hope the move will revive Merck’s sagging share price, on the theory that the drugs and the pharmacy-benefits businesses are worth more apart than together.

“This transaction will allow Merck to focus more fully on its priorities of turning cutting-edge science into breakthrough medicines,” says Raymond V. Gilmartin, Merck’s chairman and chief executive. “We also believe that providing investors with ‘pure plays’ in the pharmaceutical and PBM businesses, respectively, will allow full valuation of both businesses.”

Wall Street Pleadings

The move may also blunt Wall Street pressure for Merck to do a huge merger, a strategy Mr. Gilmartin has staunchly resisted. Mr. Gilmartin says the Medco move and Wall Street pleadings for a mega-merger are unrelated. He says Merck’s board has been studying a Medco divestiture for four months. “The timing is based on the fact that the whole market situation and how Merck is positioned in these markets is totally different than it was,” he says.

Merck bought Medco for $6.6 billion in 1993, as part of its response to the then-emerging managed-care threat. As a pharmacy-benefits manager, or PBM, Medco is hired by managed-care companies to authorize and fulfill drug purchases for patients. Merck figured it could harness managed care’s ability to sway prescription decisions by buying a big PBM and using it to switch some prescriptions to Merck drugs. Other drug companies followed the strategy, acquiring PBMs themselves.

But regulators, wanting to make sure patients’ health wasn’t sacrificed to corporate profits, quickly insisted that PBMs’ drug decisions be kept independent of the parent drug company. Soon some drug companies unloaded their PBMs for big losses. Eli Lilly & Co. sold its PCS Health Systems for a $2.4 billion loss in 1997, and SmithKline Beecham PLC sold Diversified Pharmaceutical Services in 1999 for a $1.6 billion loss.

Medco has grown rapidly under Merck’s ownership despite regulators’ limits. Medco’s annual revenue since 1993 has climbed 12-fold to $26.4 billion — 55% of Merck’s total revenue. An independent Medco would rank among the 70 largest companies in the world in revenue, ahead of Walt Disney Co. and BellSouth Corp.

What is forcing Merck to move is the loss to generic competition of five huge-selling drugs. The five — Vasotec and Prinivil for hypertension, Pepcid and Prilosec for ulcers, and Mevacor for high cholesterol — will all have lost patent protection by June. Just as unnerving are the sagging fortunes of Vioxx, an arthritis drug launched in 1999 amid hopes that it would fill in the gap. Safety worries have brought Vioxx’s explosive growth to a halt.

Merck’s shares have lost a third of their value in the past year, and the company’s market capitalization has shrunk to $130 billion from $200 billion. Merck jolted investors last June when it said its earnings wouldn’t grow as fast as expected in 2001 — and probably wouldn’t grow at all in 2002. Merck achieved an 8% rise in per-share profits in the fourth quarter by squeezing costs and buying back a lot of stock. But its price-to-earnings ratio, a reflection of investor confidence in future growth, at 18 is the lowest of the seven major American drug companies and about half that of rival Pfizer Inc.

Pressure has been steadily building on Merck to do a big merger, as drug makers often do when key drugs lose patent protection. Such pressure led to the mergers that created GlaxoSmithKline PLC, AstraZeneca PLC, Aventis SA and Bristol-Myers Squibb Corp. But resisting a big merger is almost a religion at Merck. Mr. Gilmartin describes some possible mates as albatrosses. “It would have only made sense to do a merger if you’d lost confidence in future growth,” he says. “You don’t do a merger just to fill in one or two years.”

Merck’s chief of research, Edward Scolnick, describes Merck’s research labs as a national treasure that must be protected intact. Merck’s chief financial officer, Judy Lewent, is also an acolyte. “What we’re all here to do is to address major human health concerns through pharmaceuticals and maximize shareholder value,” she said in a recent interview. “You don’t do that by rationalizing two separate organizations’ favorite projects or merging separate organizations’ different cultures.”

Instead of a big deal, Mr. Gilmartin says he is pursuing a string of small ones. “Our efforts … will include a continuing, intense focus on the entire spectrum of product licensing, from early- to late-stage opportunities, as well as targeted acquisitions,” he says.

Aggressive Push

Mr. Gilmartin held on to Medco and pushed its growth aggressively when he became chairman and chief executive shortly after the Medco purchase. Medco now has 1,700 managed-care customers. It directs drug purchases for 65 million Americans and oversees 537 million drug purchases per year. In sales dollars, its Internet site, where patients order drug refills, is among the world’s busiest.

And the PBM business is once again in favor. Most proposals in Congress to offer a Medicare drug benefit involve one or more PBMs. Medco started a national drug discount-card program with Reader’s Digest that has spawned a raft of imitators.

In the four years after its 1993 purchase, Merck drugs’ share of Medco’s sales grew to 15% from 10%, Merck says. It says the reason wasn’t that Medco was favoring Merck’s drugs but rather that Merck had changed from a company hostile to managed care to one that was among the friendliest. Still, the fit was an awkward one, and Mr. Gilmartin has signaled from time to time that Merck was evaluating its relationship with Medco. “What we have to answer,” he said in a recent interview, “is if both businesses can grow faster together than they can separately.”

While Merck’s huge resources have allowed Medco to build two giant automated pharmacies, Medco’s growth has posed some problems for Merck. Medco’s margins are razor thin. So Medco’s growth has caused the company’s overall profit margin to shrink.

PBMs increasingly get their profits from drug companies, which pay them to push doctors to switch prescriptions to their drugs, according to AdvancePCS chairman David Halbert. But drug companies may worry that Medco pushes their drugs with less vigor than Merck’s own.

Medco’s competitors have long told potential managed-care clients that Medco serves Merck’s interests and not theirs, a charge Medco hotly denies. Lawyers have sued Medco on behalf of patients, contending its selections favor Merck drugs and hurt patients and managed-care programs.

Merck executives have tried for years to convince Wall Street that Medco was a good fit. Now, they concede it’s a distraction, at a time when their attention is needed in the core medicines business.

Merck’s troubles in that business mirror those in the rest of the pharmaceutical sector. Bristol-Myers Squibb, Schering-Plough Corp. and Eli Lilly have all warned recently that earnings will disappoint. All are also struggling to overcome patent expirations of major drugs.

Lab Inefficiency

The industry is suffering for several reasons, but the most important is the inefficiency of its labs. Drug discoveries often come in waves, and the industry is in a terrible trough. Through much of the 20th century, drug companies came up with new medicines largely through lucky breaks. They synthesized hundreds of chemicals and gave them to sick animals, hoping something would happen. Good results moved the drugs to human tests.

By the 1970s, scientists realized how much certain crucial body chemicals such as enzymes and neurotransmitters affected health. They sought to interrupt or enhance the work of these chemicals. Merck found a compound that slowed the work of a liver enzyme that creates cholesterol. The development of what is now Mevacor led to a class of drugs, statins, that now includes the world’s biggest sellers.

In the 1970s and early 1980s, Merck developed an unparalleled array of medicines. But the easy pickings are over, and this kind of science now often leads to chemicals that don’t produce enough benefit to justify their side effects. Biologists hope gene and stem-cell discoveries will solve the mysteries of diseases that remain intractable, but drug breakthroughs based on this science appear a long way off.

Companies are scrambling to manage their way through the drought. Some have scoured the world’s labs for molecules to license or co-market. Merck, proud of its history of developing its own drugs in house, has largely focused on the fruit of its own labs. Given its track record, it felt it could beat the patent-expiration challenge. Since 1995, Merck has launched 17 new drugs, such as Fosamax for osteoporosis, Singulair for asthma, Crixivan for AIDS and Propecia for baldness.

Yet even Merck’s skills haven’t been enough to fill in the huge gap left by the five expiring drugs. In 1999, about a third of Merck’s $14.4 billion in medicine sales came from those five. It’s as if McDonalds had to give up selling a third of its Big Macs and come up with something just as popular.

Sales of branded drugs used to drift downward after patent expiration. Now they fall off a cliff. Within two months after the August 2000 patent expiration for Vasotec, generics grabbed 75% of the $2 billion hypertension drug’s U.S. sales.

Merck marketers may also have underestimated competitors. Merck pioneered the anticholesterol market and used to dominate it. But in 1997, tiny Warner-Lambert Co. launched a pill called Lipitor with a clever marketing strategy: a lower price and an initial starting dose that was more powerful than that of Merck’s Zocor. By the time Merck had increased Zocor’s own starting dose and done trials proving Zocor just as effective, Lipitor had become the dominant pill. Lipitor and Warner-Lambert are now owned by Pfizer. Failing to anticipate the impact of Lipitor was a multibillion-dollar mistake.

“No one can say on the marketing front that everything has gone perfectly,” says William Bowen, a Merck board member who is a former Princeton president and now heads the Andrew W. Mellon Foundation. “But major lessons have been learned.”

Adds Mr. Gilmartin: “You’d like things to go as planned, but the real question is how do you respond when they don’t?”

Generic Threat

Merck has also declined to play the delay game. Almost every other drug company that has faced the loss of big-selling drugs has fought generics in court with patents on such things as the color, scoring and coating of pills. They generally lose these battles ultimately but often win months or years of delays — and billions in added revenue. Just filing suit can winnow the number of competitors for the first six months of generic competition from 10 to one.

Had Merck tried this for four of its five drugs, it might have been able to meet analysts’ profit estimates for 2001 and 2002. (The fifth drug is Prilosec, sold by AstraZeneca with Merck getting 32% of U.S. revenue. AstraZeneca has sued generics makers.) The company could still fight generic versions of Prinivil, a heart medication whose patent expires in June. But Merck executives see such tactics as a distraction to their mission.

“To extend the life cycle of our drugs undermines the intensity and commitment to create that next blockbuster,” says Mr. Gilmartin. Medco boasts that it substitutes nearly all of its customers from Merck’s branded drugs to cheap generics within weeks of the generics’ launch.

Instead of delay tactics, Merck is betting its business on the famous productivity of its labs. Indeed, it seemed to be returning to its old glory in 1999 with Vioxx.

Along with rival Celebrex, Vioxx belongs to a new class of painkillers that are supposed to ease painful inflammation with a lower risk of stomach bleeding than from, for instance, aspirin. Though Celebrex came first in 1999, Vioxx had nearly overtaken that Pharmacia-Pfizer drug by last year. Marketers for the two fought viciously. As Merck marketers pointed to Celebrex shortcomings, their rivals from Pharmacia and Pfizer pointed to an anomaly in Merck’s data: Vioxx patients had a higher rate of heart attacks than those taking naproxen, a nonprescription painkiller.

Merck’s scientists said that Vioxx users’ heart-attack rate was no higher than would be expected among the normal population and that naproxen had simply provided aspirin-like heart protection. But Merck’s pivotal study didn’t include a placebo group, so this couldn’t be proved. Vioxx’s sales growth nearly stopped.

Merck’s CFO, Ms. Lewent, asked every division for cost cuts, but the numbers didn’t add up. One morning in early June, she printed out five charts and walked to Mr. Gilmartin’s office, where she gave him the bad news: Merck would never meet analysts’ forecasts for 2001 profits, and results for 2002 would be grim as well. On June 22, Merck issued a statement saying 2001 earnings would grow no faster than 10% instead of the 12% hoped for. The stock fell 9% in a day.

Worrisome Profiles

Then in August, a study in the Journal of the American Medical Association concluded that the cardiac profiles of both Vioxx and Celebrex were worrisome. Although other experts criticized the study’s methodology, it hurt Vioxx still more. Celebrex sales suffered, too. Since neither drug cures pain any better than older pills costing pennies apiece, the only reason doctors prescribe them is their perceived safety benefit. Once that perception was muddied, doctors stuck with older and far cheaper remedies.

Vioxx’s 2001 sales came to $2.55 billion — a blockbuster level, yet still far off the $3.5 billion Merck projected last February. Merck executives slashed expenses to the bone. Marketing departments were consolidated, advertising cut, construction groups slashed.

“The organization had to turn on a dime,” says Mr. Gilmartin. “We’re already spending money thinking expenses will rise by double-digits, and we put on the breaks to bring spending growth down to the low single digits.”

Meanwhile, more patent losses loom. The cholesterol reducer Zocor, with nearly $7 billion in annual sales, will lose patent protection by 2006.

Merck expects to extract itself from these problems as it always has, by getting new drugs out of its labs. By next year, the company expects earnings to grow again at double-digit levels with the expected launches this year of two new drugs. In fact, Merck expects to launch or seek approval to sell 11 new medicines over the next five years.

Peter Kim, deputy chief of research, says gene discoveries will accelerate research productivity. “People ask me, ‘How come the company is in such bad shape?’” Dr. Kim says. “But it’s in great shape. … After a hiccup, Merck continues to come back.”