Is Merck Built to Last?

In the best-selling business book Built to Last, James Collins and Jerry Porras research the world's strongest companies to determine what made them prosper over long periods of time and through multiple product lifecycles. Merck (NYSE: MRK) is one such company the authors identify, but the drug giant has seen better days. Wall Street is wary about the company's future because its pipeline looks bare and five of its best-selling drugs are expected to lose their patents this year.

The Rule Maker Portfolio, which owns Pfizer (NYSE: PFE), Johnson & Johnson (NYSE: JNJ), and Schering-Plough (NYSE: SGP), has always had a soft spot for the pharmaceutical industry. I've long believed that with the exception of software companies, the financial and business model advantages -- including excellent margins, low Foolish Flow Ratios, and tremendous cash flow -- make drug companies ideal Ruler Maker candidates. And with the market discounting Merck, this might be the perfect buying opportunity for investors with a long-term horizon.

As I said earlier, the characteristics of the pharmaceutical industry are very attractive. The upfront costs for R&D are very high, but manufacturing and selling costs are low, resulting in extremely high margins. Pharmaceuticals are also a repeat-purchase business because illnesses typically don't go away with one or two pills. The industry should also benefit from favorable demographic trends. The percentage of people over 65 is expected to exceed 20% of the U.S. population by 2010, with the rest of the world not far behind. This is significant because people over 65 use three to four times more prescription drugs than people in their 30s.

This industry clearly deserves representation in the Rule Maker Portfolio, but I'm wondering if Merck is truly worthy. After all, we might be better served by adding to one of our current pharmaceutical positions or even buying another drug company like Bristol-Myers Squibb (NYSE: BMY). I like Merck because it has a long history of success through multiple product cycles and leadership changes. Investing in companies that have operated through multiple business cycles is essential to Rule Maker investing, and Merck has been around for more than 100 years.

Built to Last attributes much of Merck's success to its focus on innovation over profitability. The authors say profits are not the primary goal, but the result of the company's ability to develop innovative products. This goes against conventional business wisdom, but Merck's commitment to innovation has been its biggest strength. In recent months, however, that characteristic has been criticized as investors question the strength of the company's pipeline. Still, even seven years ago when Built to Last was first published, the authors wrote that the company's longstanding commitment to innovation has and could lead to the pipeline situation that Merck finds itself in today.   

"Unlike its more diversified competitors, Merck adopted the unconventional strategy of being one of the least diversified pharmaceutical companies, placing all bets on its ability to innovate new, breakthrough drugs," wrote the authors. "Merck believes with the self-imposed requirement that new products must be significantly better than the competition, else they cannot be introduced to the market -- a highly risky strategy that can produce long droughts if nothing good comes down the pipe."

The finding of Built to Last -- that Merck's self-imposed requirement that new products must be significantly better than the competition can produce long droughts if nothing good comes down the pipe -- rings true today, but it's also clear that the strategy has paid off over the long haul. I admire that Merck remains focused on developing breakthrough drugs rather than blockbusters, but as a recent Fortune article points out, that strategy has left some investors to question the company's future. According to the article, Wall Street argues that Merck's current pipeline problem may have been avoided through a number of strategic moves:

• Partnering with biotechnology companies to get their research;
• Licensing promising new drugs from smaller companies;
• Having less contempt for copycatting other pharmaceutical companies' blockbuster drugs. Put another way, focusing less on developing medicines that treat Alzheimer's, AIDS, and Parkinson's, and putting more emphasis on developing the next billion-dollar antihistamine, for example; and
• Being more aggressive on the mergers and acquisitions front to snatch a competitor's research. 

It would be great to know whether or not any of those scenarios would have actually had a positive impact on the company's business or pipeline, but Wall Street's opinions are better left alone, and we're better served looking at the facts.

Merck has a solid portfolio of top-selling drugs. Vioxx (pain), Singulair (asthma), Fosamax (osteoporosis), Zocor (cholesterol), and Cozaar/Hyzaar (hypertension) posted combined revenues of $11.1 billion last year, an increase of 54% from 1999, and made up 27% of total sales. True, there are worries because Zocor and Cozaar/Hyzaar face increased competition, but the two drugs are expected to grow combined sales from $6.8 billion in 2000 to $8 billion this year. While that 14% growth might seem modest compared to Singulair and Fosamax, for example, which are expected to grow almost 35% this year, the drugs are coming off a much larger revenue base and will still chip in more than $1.2 billion in new sales.

Singulair and Fosamax have the greatest growth potential of the group, but it appears sales of the other drugs will get tougher. While Vioxx grew sales a whopping 600% last year to $2.2 billion, it faces stiff competition from Pfizer and Pharmacia's (NYSE: PHA) co-promoted Celebrex. Pfizer's Lipitor is also dominating the cholesterol-lowering drug market, which has hurt Zocor sales, and Novartis' (NYSE: NVS) Diovan has caught up to Cozaar/Hyzaar in prescriptions written. Both Vioxx and Singulair are seeking broader indications, but the financial impacts are unclear. 

I'm also concerned that Merck is becoming more of a pharmacy benefit manager (PBM) than a drug maker. Its PBM unit, Merck-Medco, administers and controls prescription benefits for 65 million Americans, and made up 50% of sales last year. Merck's total sales grew 23% last year, but without this unit, revenues would have grown 16%. Merck-Medco benefits the drug business by promoting Merck's products, but it also has lower margins than the drug business. The company's gross margins have already fallen from 46.4% in 1999 to 44.4% in 2000, but a growing PBM unit combined with upcoming patent expirations should depress margins further.

Clearly, there are issues we'll need to learn more about, but Merck makes for an interesting study. The company has a long history of success through multiple product cycles and a host of big-selling drugs already on the market. The latter point has even more significance because companies are finding the Food and Drug Administration approval process takes longer than in years past. This could mean that drugs already on the market won't lose their market share as quickly as some had once thought. Still, while Merck is facing some key patent expirations at a time when its pipeline looks bare, the characteristics of the pharmaceutical industry are very attractive and Merck has shown it's built to last.