The Rule Maker Portfolio began its study of Merck (NYSE: MRK) two weeks ago. Given the message board activity and array of emails I received it's clear there's lots of interest in this pharmaceutical giant. The article was merely an introduction, however, which means we've still got lots to learn. Today we'll shift our focus to Merck-Medco, the company's pharmacy benefit manager (PBM) unit. PBMs, the largest purchasers of drugs in the healthcare system, contract with entities such as your employer, for example, to handle the prescription drug needs of you and your co-workers.

Merck-Medco is an important part of Merck's business. Between 1997 and 2000 the unit's percentage contribution to the top line was 40%, 43%, 47%, and 50%, sequentially. In the most recent quarter, that figure jumped to 55%. Hence, it's important we have a good understanding of the PBM industry and Merck-Medco.

With the acquisition of Medco Containment Services for $6.6 billion in 1993, Merck-Medco became the largest PBM in the country, administering and controlling prescription benefits for 65 million Americans. The unit manages prescription drug programs through its mail service and retail pharmacy networks for corporations, insurance firms, federal and state employee plans, Blue Cross/Blue Shield organizations, government agencies, labor unions, and other organizations.

Merck-Medco also offers health management programs that help payers, providers, and patients reduce healthcare costs. According to the company's website, each week it dispenses nearly 1.2 million prescription drugs through its mail service pharmacies, and manages another 6 million more drug claims from retail stores that are part of the Merck-Medco Managed Care Network. Together, these services cut healthcare costs by arranging discounts with the drug makers and retail pharmacies.

Unlike some other pharmaceutical companies, however, Merck has found success in the PBM business. Drug maker Eli Lilly (NYSE: LLY), for example, bought PCS Health Systems from McKesson (NYSE: MCK) for $4 billion in 1993, only to later sell the PBM unit to Rite Aid (NYSE: RAD) for $1.5 billion in 1999. Merck-Medco, on the other hand, has reaped the benefits of increasing pharmaceutical expenditures, which have grown to represent a larger piece of the total healthcare pie.

Merck-Medco is important because it provides Merck with badly needed revenue growth, something CEO Raymond Gilmartin recently told Barron's Online the company was very focused on. In the most recent quarter, Merck-Medco grew revenues 48% over the year-ago period to more than $6.5 billion. Last year, revenues grew 32% over the previous year to $20 billion, and while Merck's sales increased 23% last year, without the unit revenues would have gained only 16%.

Unfortunately, while Merck-Medco has helped the company maintain top-line growth, the business has significantly hampered Merck's profitability. Merck-Medco's operating profit margins range between 3% and 5%, compared to margins of more than 30% at the company's pharmaceutical business. Take a quick look at the table below: Merck's gross profit margins have steadily declined as Merck-Medco has grown to represent a larger part of the company's overall business.

Year   Merck-Medco      Gross Margin  
1997       40% of sales     51%
1998       43%              48%
1999       47%              46%
2000       50%              44%

Merck-Medco can improve its profitability by increasing sales and finding more efficient ways to fill prescriptions, such as increased use of mail order. After my last Merck column, however, a pharmacist wrote to me claiming, "every retail pharmacist in America hates Merck and Merck-Medco for trying to force their customers to go mail order." The pharmacist said he took extra time to call doctors to change a patient from Merck products, but thus far Merck-Medco seems unaffected.

Despite Merck-Medco's uninspiring margins, there's nothing wrong with having a PBM unit. Lots of other drug companies have diversified beyond the pharmaceutical industry into lower margin businesses -- Johnson & Johnson (NYSE: JNJ), for example, sells less profitable consumer products like Band-Aids. Merck-Medco can also benefit Merck's drug business by advocating the company's products, a concept that originally motivated drug makers in part to enter the PBM business.

That type of discretion can potentially lead to conflicts of interest, however, which explains why the Federal Trade Commission (FTC) has investigated drug makers for their dealings with PBMs in the past. One FTC investigation ultimately forced Merck to create a "Chinese wall" that cut off communication between the two businesses, and there's a pending investigation related to PBM pricing practices. Skeptics have charged, for example, that while PBMs are hired to cut costs and medication errors, they have been guilty of pushing branded drugs over less profitable generics.

The controversy over Merck-Medco won't likely go away anytime soon, but it's also doubtful to have a significant impact on the company's operations. With the purchase of Pro Vantage Health Services last year, according to a recent article in Praxis Post magazine, Merck-Medco now controls about one-third of the PBM industry, a market that covers 71% of the volume of outpatient medications covered by third-party payers. Given this dominance, Merck-Medco will continue driving revenue growth, while Merck experiences some patent expirations in key drugs.

Would we be comfortable owning Merck, given such a larger part of its business comes from Merck-Medco? I'm not convinced the answer is yes. The PBM market is not nearly as profitable as the drug business, and while it might be able to sustain the company's top-line growth, it will continue hurting margins. Still, we've got lots to learn and I welcome your thoughts on the Rule Maker message board. Next time, we'll take a look at potential winners in Merck's pipeline and its top marketed drugs.  

Mike Trigg spends his days offering readers what Gordon Gekko called "the most valuable commodity": information. To see other his holdings, view his profile. The Motley Fool is investors writing for investors.