Will a Drastic Workforce Reduction Get Merck Back on Track?

Merck (NYSE: MRK  ) , which has struggled with generic competition, slower revenue growth, and increased R&D expenses, has been a laggard compared to its big pharma peers over the past year.

It appears to be caught in a catch-22 -- to offset lost revenue from generic competition and failed pipeline products, it must invest more heavily in R&D, which in turn drags down earnings and forces the company to make further cuts to reduce expenses.

MRK Chart

Source: YCharts.

Merck scrambles to slash expenses
On Tuesday, Merck announced that it will eliminate 8,500 jobs on top of the 7,500 jobs it already cut in 2011 and 2012 -- reducing its global workforce by approximately 20%. Merck intends to reduce its annual operating expenses by $1 billion by the end of 2014 and $2.5 billion by the end of 2015. A look at the growth of Merck's total expenses over the past five years in comparison to Johnson & Johnson (NYSE: JNJ  ) , GlaxoSmithKline (NYSE: GSK  ) , and Pfizer (NYSE: PFE  ) reveals the problem.

MRK Total Expenses TTM Chart

Source: YCharts.

Comparing Merck's most recent quarterly earnings to its industry peers also doesn't inspire much confidence.

Company

Qty. Revenue (most recent quarter)

Revenue growth (YOY)

Earnings growth (YOY)

Merck

$11 billion

10.6%

(48.3%)

Johnson & Johnson

$17.9 billion

8.5%

13.8%

GlaxoSmithKline

$10.2 billion

2%

(20.7%)

Pfizer

$13 billion

(7%)

(5.1%)

Source: Company quarterly earnings reports.

The trouble all started for Merck when its top-selling asthma medication Singulair, which generated peak sales of $5 billion in 2010, lost its patent exclusivity last August. In the first half of 2013, Merck only generated $618 million in Singulair sales -- down from $2.8 billion in the first half of 2012. Singulair sales fell to $281 million last quarter, accounting for 2.5% of Merck's total revenue.

Merck's two diabetes drugs, Januvia and Janumet, are considered its best hope in offsetting those losses. However, sales growth has been slow, only edging up 5% year over year to $1.5 billion. The two products have also been overshadowed by concerns that they may cause pancreatic cancer.

Some other products, such as its arthritis treatments Remicade and Simponi (co-marketed with J&J), reported solid growth thanks to rising demand in Europe, Russia, and Turkey. Merck's cervical cancer vaccine and HIV franchise reported positive growth, as well, but none of these products could offset the loss of Singulair revenue. The patent expirations of allergy treatment Clarinex and blood-pressure medication Cozaar/Hyzaar also exacerbated the decline.

Fixing the broken pipeline
To make matters worse, Merck's pipeline has been hit repeatedly by bad news. In February, Merck delayed its application for its osteoporosis drug odanacatib. In July, insomnia drug suvorexant was rejected by the FDA on grounds the recommended dosage was dangerous. Merck's anesthesia drug sugammadex was also rejected last month. The only good news was the timely approval application for its blood clot treatment vorapaxar, which is currently being reviewed by the FDA.

As a result of these blunders, Merck replaced R&D chief Peter Kim with former Amgen R&D chief Roger Perlmutter in March. Perlmutter explained his plans for the company last month, stating that the company needed "major surgery" to simplify a division that had become too large, complex, and expensive for its own good. As seen in the following chart, Merck's R&D expenses take a bigger bite out of its top line than expenses at J&J, GlaxoSmithKline, and Pfizer.

Company

R&D expenses (most recent quarter)

Percentage of total revenue

Merck

$1.9 billion

17.2%

Johnson & Johnson

$1.9 billion

10.6%

GlaxoSmithKline

$1.7 billion

15.9%

Pfizer

$1.5 billion

11.5%

Sources: Quarterly earnings reports, author's calculations.

As part of Merck's restructuring, the company is creating a new oncology unit to focus on immunotherapy treatments, which stimulates patients' immune systems to fight back against cancer cells. Perlmutter sees tremendous promise in MK-3475, an immunotherapy treatment that could treat metastatic melanoma. During a phase 1 trial, 38% of patients dosed with MK-3475 reported a reduction in their tumor cells. The drug is currently in phase 2 trials, and will eventually be compared to Bristol-Myers Squibb and Roche's respective melanoma treatments, Yervoy and Zelboraf. Merck is also partnered with AstraZeneca to develop a new ovarian cancer drug, MK-1775.

Another product that has growth potential is ertugliflozin, a SGLT2 inhibitor that Merck is developing with Pfizer. SGLT2 inhibitors are a new class of orally administered drugs that help diabetes patients excrete more glucose through the urine, possibly reducing the amount of necessary insulin injections per day. Ertugliflozin is intended to compete against J&J's Invokana, the only FDA-approved SGLT2 on the market.

The Foolish bottom line
In closing, Merck is not a lost cause yet. Although the company has been hit hard by the double whammy of generic competition and pipeline failures, its drastic workforce reductions and restructuring efforts should help it maintain its top and bottom line balance for now.

Looking forward, investors should pay close attention to Merck's pipeline to see if Roger Perlmutter's restructuring efforts are paying off. If Merck can rectify its R&D problems and make progress in its oncology and diabetes treatments, it might be able to get on the right track over the next two years.

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