MERCK HAS MADE BIOTECH WORK The company changed its methods of doing research in the Seventies. The result -- a shelf's worth of new drugs -- has put it at the top of the pharmaceutical industry.
(FORTUNE Magazine) – HOLLYWOOD honors its stars by casting their footprints in cement. Wall Street firms put portraits of their founders in gilt frames. But at the New Jersey headquarters of Merck & Co., office corridors are lined with microscope photographs of molecules that make up the firm's blockbuster drugs. Sales of compounds whose pictures cover the walls fund the company's massive research efforts to find new candidates to memorialize. Lately Merck is running short of display space. Chief executive P. Roy Vagelos, 57, a physician and biochemist, would have it no other way. Since taking over Merck's research labs in 1976, he has pushed the company to the front ranks of the surging biotechnology business. Just as the arrival of the computer age elevated IBM to the pinnacle of corporate stardom in the Fifties, the biotech revolution has enthroned Merck, the king of the medical molecule makers, at the summit of FORTUNE's list of America's most admired companies. The flood of innovative prescription drugs from Merck's labs is the talk of the pharmaceutical industry. Drug manufacturers typically launch important new products about as often as the Navy commissions aircraft carriers. But in the past twelve months, Merck introduced five in the U.S.: treatments for hypertension, ulcers, and urinary tract infections, a powerful multipurpose antibiotic, and a genetically engineered hepatitis B vaccine. Other promising experimental drugs, including a widely hailed family of compounds that lower cholesterol in the blood, are coming down the development pipeline. ''Drug companies are engines fueled by research, and right now Merck is humming on all cylinders,'' says longtime director John K. McKinley, former chief of Texaco. Merck is also mesmerizing Wall Street. After boosting its dividend 13% in November 1985, the company declared a 2-for-1 stock split last May and then raised the dividend another 22% in July, to $2.20 a share. Merck's stock, the only health care-related one in the Dow Jones industrial average, jumped more than 80% last year, to $120 in late December. Always among the most profitable drug companies, Merck is now one of the fastest growing. Revenues rose 15% in 1986 to more than $4 billion, vs. the industry average of 10%. Profits were up about 25% to $675 million. Return on equity was a stellar 25% for the 12 months ended September 30, vs. a median of 11.6% for the FORTUNE 500 in 1985. The dollar's drop helped this performance, since nearly 50% of revenues come from overseas. But Vagelos insists that the future looks even brighter than the present. At a recent Merck presentation to security analysts, the main topic of conversation was whether the company could fully exploit its formidably rich line of new products. Says Neil B. Sweig of Prudential-Bache: ''What Merck has now is what all pharmaceutical companies fantasize about -- more drugs coming onto the market than the sales force can effectively handle.'' Vagelos, a lean jogger and tennis player, deserves a large share of the credit. The son of Greek immigrants, Pindaros Roy Vagelos literally grew up in the shadow of Merck. As a boy he helped out at the family luncheonette in Rahway, New Jersey, six blocks from the company's headquarters. Employees often walked over for lunch, and Vagelos recalls his fascination with chemists who talked enthusiastically about the wonder drugs they were developing. Although he resolved to make a career in medicine, Vagelos never intended to sign on with a drug company. He worked his way through the University of Pennsylvania and Columbia medical school and then won prestigious research jobs, first as a senior surgeon at the National Institutes of Health and later as head of the biological chemistry department at Washington University in St. Louis. But then Merck offered the local kid a job he couldn't refuse: senior vice president in the research division. The family restaurant was no longer there when Vagelos returned to Rahway, but little had changed in the way the chemists did their research. It was largely a trial-and-error process. Lab technicians created thousands of compounds and then tested them to see if they produced any useful medical results. People in the industry euphemistically described the quest for new drugs as a process of discovery. Impatient investors called it a crap shoot. Inevitably every major drug company suffered new-product droughts. And in the mid-Seventies, Merck was in the middle of a sickeningly long one. Vagelos, who combines a calm bedside manner with aggressive determination, arrived with a bold vision: to exploit the new discoveries in medical science for pharmaceutical research. He argued that the key to developing new drugs is understanding how diseases affect the chemistry of the body. Instead of the old grind-it-up-and-test-it approach, he ordered researchers to target the biochemical reactions that a disease triggers and then devise a chemical bullet to stop them. Merck was not the only company looking for magic bullets, but it was the most committed. ''We stopped doing the other kinds of research,'' says Vagelos. ''That's not to say you cannot find another great drug by screening thousands of compounds. It was possible once, and probably is still possible. But the odds are better with the methods we have in our laboratories.'' To some outsiders the odds still seemed unreasonably poor. In the early Eighties Wall Street skeptics complained that Merck was dropping its dollars down a black hole. The company was pouring hundreds of millions each year into research. And it was spending heavily to build plant capacity for drugs still in development. Analysts hoisted more red flags in 1983 when Vagelos's predecessor, John J. Horan, paid $314 million to buy a struggling Japanese pharmaceutical company. The purchase came as Merck was losing patent protection on two top-selling drugs that accounted for more than 30% of profits. The company looked like anything but a safe bet. But Merck steadily increased its commitment to research. Already one of the least diversified pharmaceutical firms, it concentrated still further. Having sold its consumer products business -- which made over-the-counter items like Sucrets throat lozenges and Calgon bubble bath -- in the Seventies, Merck dumped chunks of its specialty chemicals division. Now more than 90% of revenues come from drugs. Partly to appease shareholders, Merck undertook a batten-down restructuring. It closed subsidiaries in half a dozen countries where returns were low. Says Vagelos: ''We cut back expenses as best we could, but not the muscle. We continued to pump more money into research because we knew the new products were coming.'' Merck also got tough in labor relations and sweated out a four-month strike by the Oil, Chemical, and Atomic Workers union in 1984 to push through a two-tier wage structure similar to those in the airline industry. ''Management really had to pay its dues,'' recalls director Frank T. Cary, former chairman of IBM. BY THE TIME Vagelos became C.E.O. in July 1985, the drugs coming out of his labs already were remaking Merck's image as a biotech powerhouse. ''Today the transformation is complete,'' says Bear Stearns drug analyst Joseph P. Riccardo. ''Here's a company that in 1982 had one-third of its product line as old, tired, mature items. By the end of this year those products will likely represent less than 10% of sales. Seven drugs introduced since 1982 each will account for more than $100 million in sales.'' The success of Vasotec, Merck's new drug to reduce hypertension, is particularly gratifying for Vagelos. In development for seven years, the compound works by blocking a chemical reaction that causes blood pressure to rise. Sales exceeded $250 million last year. Even before Merck's research payoff was so visible, most of its competitors were moving in the same direction. But no other company -- not even Genentech Inc. -- has so many pieces of the biotechnology puzzle so firmly in place. Merck's research operation is among the best. Last year the company spent $460 million on R&D. Its research teams are at the leading edge of science in many fields, including biochemistry, neurology, immunology, and molecular biology. Says Pablo Valenzuela, head of research at Chiron Corp., a California biotech company that collaborated with Merck on its hepatitis B vaccine: ''They're awesome. They have the resources to carry out the biggest research programs in the industry.'' Merck consistently attracts and keeps top young academics. Many are drawn by the chance to work at high pay in the lavishly equipped facilities at Rahway, which some liken to a college campus in heaven. Staffers publish some 450 papers a year in scientific journals. ''The whole atmosphere at Merck makes an academic scientist feel very much at home,'' says Richard S. Ross, Johns Hopkins University medical dean. Hundreds of young biotech companies also promise the excitement of research projects aimed at important medical discoveries. But few start-ups can marshal the $100 million it costs to develop, test, and produce a new drug. Merck, by contrast, has nearly unlimited cash, decades of experience getting drugs through the Food and Drug Administration's approval process, and highly efficient manufacturing plants. ''It's very hard to put it all together,'' says Vagelos. ''You can build a computer in a garage. You can have a great idea for a drug. But to get the ultimate molecule takes enormous effort, and it's not going to be done in a garage.'' Development is only half the story in the life of a drug. Marketing is the other half, and Merck has the largest and most intensively trained sales force. When calling on physicians, salespeople carry portable lap-top computers loaded with summaries of articles from medical journals about the effectiveness of various drugs. Vagelos insists that his salesmen present balanced evaluations because ''that way the physician gets to trust our representatives.''
OTHER pharmaceutical veterans can muster the resources and marketing muscle to make good on their biotech research. But none of them offer Merck's total orientation to biomedical science. Eli Lilly and Squibb also make everything from pesticides to perfume. Schering-Plough and Johnson & Johnson depend on over-the-counter health care products. Big chemical conglomerates such as Du Pont and Monsanto like biotech, but get less than 10% of their revenues from pharmaceuticals. Asks Prudential-Bache's Sweig: ''How can you focus 100% on the latest developments in molecular biology when you're trying to deal with a product-tampering crisis, slumping oil sales, or the upcoming ad campaign for Coppertone?'' Because Merck needn't worry about mass merchandising or managing other businesses, it could afford to appoint a chief like Vagelos, whose business background consists of a two-week course at Harvard. He is the first to admit that the circumstances at Merck are unique: ''I'm a biomedical scientist. If the board wanted to diversify, I doubt they would have chosen me. The beauty of Merck is that the head of the company can talk to the head of research, and we talk the same language.'' To the surprise of some insiders -- and even to members of Merck's high- powered board, which includes the chairman of TRW and former chief officers of IBM, GE, and Texaco -- Vagelos also has been a quick study in the language of business. Says one director: ''We were used to leaders who came up through sales or the legal side. It's fun watching a scientist like Roy dealing with these giants of industry. They ask tough questions. The thing I like is, he uses slides and a pointer at the board meetings. I feel like I'm at a very well prepared lecture.'' Adds Texaco's McKinley: ''Roy's a good manager. He believes in planning. It's like research in the way he approaches it.'' Analysts give Vagelos high marks in two other crucial areas. The first is international marketing. ''We were having varied results around the world,'' says Vagelos. ''Our products are great assets. You control them for the duration of the patent, and that has to be optimized. To get a big market share in one country and a trivial market share in another is unacceptable.'' Now a newly established global marketing organization is making solid gains, particularly in Japan, whose $25-billion drug market is second only to that of the U.S. VAGELOS also has been successful in propping sales of drugs whose patents have expired. When that happens, the market usually is inundated with low-cost generic products. Drug companies typically respond with deep price cuts and volume discounts for large customers. Merck steadfastly adheres to a one-price policy, even at the risk of losing big accounts. Says Vagelos: ''We don't want to cut prices because we would just begin a downward spiral. Generic companies have nothing to offer but price. You can follow them down, but you'll never make it up in volume. All you do is lose your revenue faster.'' Many large buyers predict that Merck will soon be forced to offer volume discounts. Says Don Holloway, who negotiates drug purchases at Humana, the Louisville-based hospital management company: ''The industry is changing, and the large buying groups will have to be dealt with.'' For now Vagelos is relying on a less costly strategy of product differentiation. For example, new long-acting capsules have bolstered sales of the arthritis drug Indocin. Before its patents expired at the end of 1981, the product brought in $235 . million a year. Security analysts estimate that 1986 Indocin sales were $200 million, a more than respectable performance. Prolonging the life of aging mainstays like Indocin keeps investors happy. It also lets Merck spend more money on research, particularly for new drugs aimed at heart disease, cancer, and neurological disorders like Alzheimer's disease. ''My excitement today is not over the products we have,'' says Vagelos, ''but the products I know are coming. They've got to succeed because they're all rational. And the excitement permeates the company.'' Such optimism seems natural for Merck's idealistic leader, and for a company at the peak of success.
BOX: INVESTOR'S SNAPSHOT MERCK & CO.
SALES (LATEST FOUR QUARTERS) $3.9 BILLION CHANGE FROM YEAR EARLIER UP 11%
NET PROFIT $ 638.3 MILLION CHANGE UP 22%
RETURN ON COMMON STOCKHOLDERS' EQUITY 25% FIVE-YEAR AVERAGE 19%
RECENT SHARE PRICE $119.75
PRICE/EARNINGS MULTIPLE 26
TOTAL RETURN TO INVESTORS (12 MONTHS TO 12/23) 83%
PRINCIPAL MARKET NYSE