Merck Is Showing Its Age

To give visitors an idea of how easy it is to slip up in drug development, finan`cial wizards at Merck & Co. in 1987 developed a novel computer simulation called DRUG--the Drug Research Uncertainty Game. Spend enough money and hit a few breakthroughs? Balloons and confetti color the screen. But run into a dry stretch? A little Pac-Man creature, labeled Devour Inc., snaps up the player, Drugs-R-Us.

Lately, there have been few balloons and little confetti at Merck. Efforts to develop new drugs for complex diseases, combined with a reluctance to embrace new research methods through biotechnology, have significantly emptied the product pipeline that once fueled Merck's staggering growth. Adding to the drug giant's research-and-development woes is a bureaucracy that has slowed the scientific process. Says Hemant K. Shah, a Merck marketing veteran who now works as an independent industry analyst: "There are no billion-dollar drugs in Merck's pipeline that I can see."

While Devour Inc. isn't about to gobble up Merck, the R&D shortfall is taking a toll. The heady 27% annual earnings growth of the late 1980s has slowed. Analyst Mariola B. Haggar of Salomon Brothers Inc. estimates that profits at the White House Station (N.J.) company may rise only 9% this year, to $2.7 billion, as sales rise just 6.4%, to $10.3 billion (chart). Merck says its 1993 earnings are being depressed by health-care cost containment, the effects of unfavorable currency rates, and startup costs for Proscar, its new prostate-shrinking drug.

CEO P. Roy Vagelos' announcement on July 28 that Merck intends to acquire fast-growing drug distributor Medco Containment Services Inc. has done little to soothe anxious investors. Already upset at the unexplained departure of Vagelos' hand-picked successor, Richard J. Markham, investors have reacted coolly to the costly deal. Indeed, Merck's stock has fallen almost 7%, to around 30 since the deal was disclosed, despite a 12% dividend hike. Since early 1992, the stock has slipped nearly 47%. On Aug. 5, some Medco shareholders filed lawsuits to block the merger. One of their biggest gripes: Medco Chairman Martin J. Wygod could pocket $60 million in fees if the deal goes through.

BROAD RANGE. Merck competitors also question whether the deal makes sense. Says David Barnes, chief executive of British drugmaker Zeneca Group PLC: "If I had $6 billion to spend, I'd be looking in another direction." Vagelos, other senior executives, and members of

Merck's board declined to be interviewed for this article. But the company responded to written questions.

Vagelos' boosters argue that the deal represents a shrewd positioning of

Merck for sweeping changes in the nation's health-care system. But it was R&D, not marketing, that made the drugmaker one of America's most successful corporations. In 1993 alone, the company is expected to spend $1.2 billion on R&D, second in the industry only to Hoffmann-La Roche Inc. That kind of investment has paid off. Merck boasts the broadest product line in the industry, with some 16 drugs that each bring in more than $100 million in revenues a year. Among the top sellers: Vasotec, a drug to control hypertension, and cholesterol-reducer Mevacor.

But lately, Merck's labs have been letting it down. For instance, Proscar was to have been its next billion-dollar seller. But annual sales may eventually peak at around $500 million, analysts say. The year-old drug shrinks swollen prostates in about half of prostate-disease sufferers. But it's a bust with urologists and many patients because it doesn't ease uncomfortable symptoms for most users. Merck says it's counting on a massive education program to ensure Proscar's success.

How did this venerable scientific leader get on the ailing list? Partly, it's feeling the impact of a slowdown in advances in its traditional chemistry-based research. The drugs Merck won big with in the 1980s were the result of efforts in the 1970s to find chemical combinations to combat diseases. Mevacor was developed from basic research done over 25 years ago. But fewer big discoveries occurred through traditional approaches in the 1980s. The breakthroughs then were in biotech, which Merck only dabbled in. Biotech was seen as a way to make injectable drugs rather than pills, which have more sales potential.

What's more, the diseases that Merck is setting out to conquer are far more complex. In the past, the company has thrived by developing treatments for relatively well-studied ailments, such as cardiovascular problems and gastrointestinal difficulties. Now, Merck is trying to perfect drugs for far tougher ills, such as schizophrenia and cancer. As long as the causes of such ailments remain murky, treatments will be elusive.

Still, not all of Merck's R&D woes can be blamed on the exigencies of science. The company's culture has also slowed its research efforts. Merck's labs span the world, yet decision-making is centralized and bureaucratic, say ex-Merck researchers. "The bigger you get, the more dinosaur-like you become," says Joshua Boger, a former senior director of basic chemistry at Merck who left in 1989 to found Vertex Pharmaceuticals Inc. in Cambridge, Mass.

Defectors from Merck say the slow-moving bureaucracy has driven much scientific talent to competitors over the years. And worse, say the former Merck scientists, by the time prospective projects percolate up through rigorous reviews nimbler rivals have passed the company by. For instance, startup Praxis Biologics, now part of American Cyanamid, beat Merck in developing a meningitis vaccine in the late 1980s.

Merck, however, insists that its research department is more entre-preneurial and flexible than most. The company also says it can develop drugs far faster than its competitors.

To preserve its fading growth rates, Merck has pressed its researchers to pursue blockbuster drugs, in effect shunning drugs with smaller sales potential. By contrast, innovative rivals such as Rh ne-Poulenc Rorer have been helped mightily by hefty collections of small drugs. Scientists at the National Cancer Institute complain that Merck has rebuffed suggestions that it develop a promising bladder-cancer drug because sales would likely fall short of $100 million annually. For all its focus on blockbusters, though, Merck now has few potential drugs in its pipeline that could approach the popularity of its current big sellers (table).

SALES SLOWDOWN. That R&D sluggishness leaves Merck struggling to boost sales of an aging product line. By analyst Shah's count, sales are flat or declining for 15 Merck drugs that together account for about $3.5 billion in annual sales. Merck disputes that tally, but even Vagelos has conceded that sales can't grow fast enough to sustain Merck's dizzying growth of past years. And the company can't get any help from price hikes, since it pledged to keep price increases in the U.S. below the inflation rate. Prices are also being curbed abroad. Germany, for example, mandated a 5% cut in drug prices in January.

Vagelos, 63, has taken steps to change Merck's ways. The company is belatedly trying its hand at biotech, for one. It recently broke ground on a biotech manufacturing complex in West Point, Pa., to work with its vaccine operations. Merck is also developing a line of generic drugs to appeal to health-maintenance organizations and third-party payers such as insurance companies and corporate benefit plans, which are replacing physicians as the drug industry's chief customers.

Still, nothing has sparked as much debate within the industry as Merck's decision to buy Medco, which distributes pharmaceuticals by mail. The drugmaker will have to borrow $2.4 billion and issue 112 million new shares to make the acquisition. Merck concedes that the deal will further depress earnings growth for up to three years. But Vagelos argues that Medco will help Merck's R&D and sales efforts. The data on patient use and misuse--such as lapses in taking medication--may help in designing new drugs. He envisions a dazzling electronic information link from patients to Merck marketers and labs.

BUYING TO BURY IT? But it isn't clear that Medco is the right medicine for Merck. A key problem: The two have some directly opposing interests. Medco has risen from $20 million in annual sales 10 years ago to $2.2 billion because it excels at hammering away at drugmakers for discounts, which it passes on to its clients--corporations, unions, and health-care outfits. Merck's interest, by contrast, is to move as much medicine at the highest prices it can. "I don't see how Merck can aggressively pursue that strategy through Medco," says Erin Anderson, a marketing professor at the Wharton School who studies vertical mergers.

The folks who buy Medco's services may doubt over time if they're getting the best deals. Indeed, Medco had been urging doctors to switch from Merck's Mevacor cholesterol-reducer to Bristol-Myers Squibb Co.'s cheaper rival, Pravachol, earlier this year. But such calls stopped this spring while Merck and Medco worked on their deal, says an executive close to Medco. Medco didn't reply to questions on the Pravachol telephone calls. Merck says only that it negotiated a contract with Medco to distribute all its drugs. "We're watching very carefully," as a result of the merger, says Michael Hirsch, a benefits executive at the International Ladies' Garment Workers' Union, a Medco client.

Merck is clearly setting out for uncharted territory. In explaining the Medco deal, Vagelos has spoken of Merck's need for flexibility "and the ability to change rapidly." With the marketplace for drugs in tumult thanks to the rise of managed care, big buying groups, and deal-making distributors, Merck will have to change fast. But whether it's making the right changes is another matter.

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