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Turning Merck Around -- Again

When Raymond V. Gilmartin took over as chief executive of Merck & Co. in 1994, the pharmaceutical company netted $3 billion on $15 billion in sales. A decade later, Merck (MRK) boasted profits of $6.8 billion on $22.5 billion in sales -- and that's after the mid-2003 spin off of wholesale drug-distributor Medco Health Solutions (MHS), now a $34.3 billion company of its own. Not bad. Yet whenever Gilmartin visits Wall Street, it's as if he has stuck a "Kick Me" sign on his back.

So why do industry analysts and investors want to give Gilmartin the boot? Merck's profits have sunk for two years in a row, dragging its share price down to 1998 levels. Granted, Gilmartin promises that earnings will rise by at least 7% in 2004. Even if he's right, Merck will still be falling short of his long-term target of double-digit growth.

And the turnaround may be brief. Gilmartin himself concedes that Merck's results could crater in 2006, when it loses U.S. patent protection for its No. 1 drug, Zocor. Last year alone, the cholesterol-reducer brought in $5 billion in global sales.

NEW VACCINES. The Zocor issue points to a deeper problem at the Whitehorse Station (N.J.) company: its weak drug-development pipeline. Merck has only two prescription compounds under final review by the Food & Drug Administration, and neither is fresh. One is Vytorin, a blend of Zocor and Zetia, another cholesterol drug made in partnership with Schering-Plough (SGP). The second is Arcoxia, a pain reliever in the Vioxx family.

To be fair, Merck has other products in last-stage testing, including a vaccine for human papillomavirus, which causes cervical cancer, and a drug to treat Type II diabetes. But it's no sure bet that any of these products will ever hit the marketplace. In 2003, Merck had to give up on two other once-promising molecules in last-stage testing.

Disappointed by these prospects and the consequent drop in Merck's stock price, many analysts and investors have urged Gilmartin to buy another drug company with a better-stocked medicine cabinet. Some have also said Gilmartin should leave. He isn't in favor of either strategy.

While in Chicago recently, Gilmartin had a cup of coffee with BusinessWeek Senior Correspondent Michael Arndt and talked about the challenges he and his company face. Edited excerpts of their conversation follow:

Q: As you know, there has been a lot of discussion about Merck's pipeline. One thing that a lot of people have advised you to do is an acquisition. Why not do one?

A: We think that the superior way to create shareholder value is investing in internal growth and recognizing the amount of innovation that's going on outside the company in the biotech field and to have access to that as well.

Let's look at what we actually have been doing: We've been continuing to invest in internal research. Last year, our research budget went up 19%. At the same time, we have significantly expanded the number of outside partnerships that we have. For example, in 1999, we signed just 10 deals. In 2003, we signed 47, and we've already announced four this year.

We look at a large-scale merger the same way we look at any smaller deal: Is this going to add to our pipeline? And our long-term growth rate? And there is no large-scale merger out there that has those attributes. We're not interested in buying something and popping short-term earnings by laying people off.

We have a very robust early-stage pipeline. And through our partnerships, we're getting access to leading-edge stuff. You're not going to get that by buying a large company.

Q: But you've spent upward of $10 billion in the last four years on research and development, and to hear the analysts tell it, you don't have a heck of a lot to show for it.

A: I joined the company in 1994, and the take on Merck at that point was that it had nothing in the pipeline and had sort of lost its touch. Then we went on introduce 17 medicines and vaccines over the next five years. The perception of Merck and its research changed quite dramatically.

Our opportunity to start turning around that perception again is when the two drugs that we have before the FDA right now get approved, Vytorin and Arcoxia.

Investors are forward-looking. When you have a drug like Zocor go off patent, the impact on you is finite and predictable. Their interest is what kind of rebound growth are you going to show, and that's measured by your pipeline. You look at that snapshot of '06: Arcoxia and Vytorin should be just past their launch phase. We'll be introducing to the market three important vaccines -- that's a pretty strong indictor of what the long-term growth potential of the company is.

Q: Investors will have to weather a bit of a rough spell, though, before then, won't they?

A: Next year, you could see things starting to pick up. What people will be looking to is getting these next drugs approved and launched.

Q: Let me turn a bit more personal. Analysts have been critical not only of Merck, they've been critical of you. Some have said, maybe it's time for somebody else to be running Merck. Do you have any plans to leave anytime soon?

A: No. I have two years before retirement. My focus and the board's focus is on my successor. The expectation is that we will have a successor from inside. In order to ensure that, we had to start some years back to make sure that our high-potential people advanced through the ranks and found themselves on the management committee reporting directly to me. We clearly have more than one person on the management committee who has the ability to lead Merck when I retire.

Q: You were an outsider. Why not go outside again?

A: I was, in fact, the only CEO ever from the outside. The advantage of an insider is that you have people who are steeped in the values of the company and who have in-depth knowledge about how the company gets work done.

Q: Some of the criticism has been very personal. How do you cope with that?

A: When I joined the company in 1994, it was seen as not having much growth potential. People were asking, "Who is this guy?" I've been through a chaotic, difficult period before, and then enjoyed a period in the late 1990s when we were introducing all these new drugs. So I guess part of my answer is that it's experience that conditions you.

The other thing is, I have a great deal of confidence in the future of the company. To me, we're very much on the right track. I also have a great deal of confidence in the management team around me. Taking some hits is part of the job. And my response to that is to become even more public and more visible in terms of engaging with the media and investors, and with critics as well, to talk about what Merck is doing. Because I think we've got a good story to tell.

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