Does Merck's R&D Program Need a Wake-Up Call?

Let's begin with a quiz. Does "FDA" stand for:

1. Food and Drug Administration
2. Frequently Denying Applications

Okay, that's an easy one. But if you're an investor in Merck (MRK -0.11%), you may hesitate. The company announced that it received a Complete Response Letter from the regulatory agency on its New Drug Application for sugammadex sodium injection, an innovative drug for reversing neuromuscular blockades, or anesthetic agents. In other words, the FDA rejected the drug -- for the second time since 2008. If the company has to conduct another study to make up for the error, then it could be quite some time before sugammadex lands in the toolbox of anesthesiologists in the United States.

Unfortunately, the problems don't end there for Merck. Investors have already witnessed setbacks with two strategic drug candidates in 2013: odanacatib for osteoporosis and suvorexant for insomnia. Oh, uh, it's kind of a big deal, too. Analysts at Barclays Capital and ISI estimated peak sales for the drugs at $2 billion (2020) and $650 million (2018), respectively. Various analysts have modeled sugammadex peak sales at $700 million with approval in the United States.

With so much potential firepower facing developmental delays, is there something fundamentally wrong with Merck's approach to R&D? Or is this just a string of bad luck?  

One way to look at it
Fellow Fool Sean Williams recently wrote about R&D spending throughout the pharmaceutical industry. At $8.5 billion, Merck spent more on R&D than all but two of its peers -- Roche and Pfizer (PFE -0.12%) -- in 2012 and notched a 52% increase since 2009. The pipeline had the following breakdown as of July 31:

Source: Merck.

How does a 22/13/8 stat line stack up in the industry? For perspective, let's compare to peers Pfizer, AstraZeneca, Sanofi (SNY -1.56%), and Eli Lilly (LLY -0.64%).

Source: Company websites.

Things look relatively even, but there are two trends worth noting. As R&D spending decreases down the column, so, too, do the number of ongoing phase 3 trials, while the ratio of ongoing phase 2 to phase 3 trials increases. We can come up with metrics for evaluating R&D budgets all day long, but without an ultra-deep dive into the commercial potential of all 178 compounds above in mid- and late-stage development it's pretty pointless. I think the quick analysis above can support an argument that Merck's spending isn't outrageous or out of line.

But let's be honest here -- an $8.5 billion R&D program that racks up three high-profile delays will surely draw the ire of analysts. What can Merck do to silence its critics?

Possible solutions
Merck could look to cut unnecessary spending from its research budget, but only those on the inside have knowledge of any potential inefficiencies. One short-term move that may appeal to shareholders would be a spin-off of its animal health business, Merck Animal Health. Pfizer performed a similar move with Zoetis earlier this year that went over pretty well with investors. Why spinoff? It could fetch a nice premium for its parent company, especially during a hot biotech IPO market. Merck's business is the second largest in the industry in terms of annual sales and notched growth of 4.5% last year -- higher than Zoetis and Merial (Sanofi). Only Elanco from Eli Lilly grew sales faster -- at 21% -- although it had less than 60% of Merck Animal Health's sales. 

Foolish bottom line
I wouldn't hit the panic button -- or listen to those who do -- just yet. Late-stage trials for odanacatib were stopped early due to incredible effectiveness. Sure, the company gaffed by originally circling the first half of 2013 as the filing target for a New Drug Application, but pushing it to early 2014 while waiting for additional safety data won't hurt the drug's potential. Similarly, the FDA's extreme caution with sugammadex is disappointing, but not related to the drug's effectiveness. It isn't approved and ramping sales in 50-plus countries for nothing.

Merck may have taken one on the chin with insomnia drug suvorexant, since the FDA recommended an initial dose that the company already proved isn't effective. Nonetheless, I don't think a spinoff is necessary -- and management has previously snuffed out the idea. Consider that Merck gained approval of 16 new drugs from 1997 to 2011, which was second only to Novartis. I don't think a broken R&D program could enjoy that much success. My advice is to sit back and take it easy: Merck will be just fine.