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Executive Summary

The pharmaceutical company Merck has traditionally sold medicines and products that have been developed through its internal research. So, it is not surprising to see that the company spends quite a large amount of money on research. This is reflected in its financial statement as given in the exhibit 1. The R&D expenditure is about 7% of Merck's revenues. The life cycle of a drug takes it from the research labs to three phases of testing, each increasingly complex, then through a rigorous Food and Drug Administration (FDA) approval process before it can be marketed and sold. The entire cycle of testing from the time the drug has been lab tested to market can take up to seven years. And, there is inherent risk involved in any drug making through this rigorous process of testing.

The most popular and most profitable drugs from Merck include Vasotec, Mevacor, Prinivil and Pepcid, generating $5.7 billion in worldwide sales, in the year 2000. The patents for these drugs stand to expire in 2002, making the formula for these drugs available for generic drug makers. This would cut into the anticipated sales of these drugs, since Merck would no longer be the sole manufacturer of these drugs. Any new drug will take longer than the two years to become marketable. In order to offset this, Merck is considering the purchase of the licenses for Davanrik from LAB Pharmaceuticals. Davenrik has just completed pre-clinical development and is ready for the clinical approval process of 7 years. If purchased, Merck would be responsible for the clinical trial process.

Merck has hired us to determine if it should buy the licenses of Davanrik from LAB Pharmaceuticals. Merck has retained us to determine the financial viability of entering into the licensing agreement. We used the Net Present value of the Future Cash Flow and the effective payoff method to determine if Merck should to go ahead with purchasing the licenses.

Merck should follow the trend of acquiring research it set in 1998, given that its internal research is taking longer, and bid for the licenses for Davanrik. Merck is better positioned financially and has the experience of clinical trials than LAB. Merck also stands to gain an effective payoff of $26.9 Million, given the risk of 2.1% overall success of the clinical trial of Davenrik being effective for both depression and weight loss. We will show how we arrived at this conclusion.

Drug Manufacturers - Life Cycle

Merck's primary business model is to researches and develops various drugs for different medical illness. The initial research for developing these drugs can take any where between 2 - 10 years. This is called as the Discovery stage. As part of the discovery stage, the drug manufacturers perform pre-clinical testing in a controlled environment and on animals to determine the basic efficacy of the drug. Once these drugs are developed and tested in the controlled environment, Merck, like any other pharmaceutical company, has to undergo a clinical trial to test the potency of the drug before getting approval from the Food and Drug Administration (FDA) to commercially manufacture and market this drug. This clinical trial process is divided into three phases. All the three phases combined takes an additional 7 years to complete and the trial can fail during any one of the three phases, in which case, the company has to go back to its research. Let us look at the composition of the 7 year clinical trial.

During Phase 1, the drug is administered to 20 - 80 healthy people to determine if the drug is safe enough to continue the other stages of clinical testing. This phase takes 2 years to complete.

During Phase 2, the drug is administered to 100 - 300 patient volunteers. This test is used to document any side effects. During this phase, the drug should demonstrate a statistically significant impact on patients suffering from the ailment the drug is expected to cure. If the drug is expected to cure multiple symptoms, its effectiveness for each symptom is documented. This clinical trial takes an additional 2 years to complete. The probability of success for each symptom is calculated and documented.

During Phase 3, the drug is administered to 1000 - 5000 volunteers to determine the safety and efficacy in long term use. This is the most expensive of all the phases due to the number of trial volunteers and the length. This phase starts where phase 2 left off. The cost and probabilities of success is documented for this phase too. If the drug is efficient for multiple symptoms, this phase starts only for those symptoms the drug was successful for in phase 2. This phase also gives the choice of choosing the financially optimal and viable symptom to market the cure for. It is during this phase that the probability of complete failure of the drug is documented.

At the end of these clinical trials, the drug manufacturer can choose to get FDA approval to market the drug for one or more symptoms based on the success factors in the clinical trials. If approved by the FDA after the 7 year clinical trial, Merck holds the rights to be the sole manufacturer of the drug. The patent is generally valid for 10 years after which generic drug makers enter the fray. This considerably reduces the sale price of the drug, bringing the price down, making it next to impossible for Merck or any patent holder to see financial gains from the drug. The drug continues to undergo post market testing to revalidate and improve its efficacy.

Merck - and its Financial Position

Merck has been a very successful pharmaceutical company. It has done a very good job of keeping its operating cash flow on the positive by timing its release of various drug products to the period of exclusivity for its drugs, and by improving its drugs to continue to keep its exclusivity. It has also diversified into biotechnology initiatives to ensure its shareholder value. With its history of developing and marketing successful drugs, Merck has the experience and the financial cushion to take on the cost associated with the clinical trial of drugs it acquires from other companies. Appendix 1 contains the financial ratios for Merck based on the income statements and balance sheets for the years of 1998 and 1999 as given in Exhibit 1 and 2 of the case.

This trend is clearly reflected in the financial statements of Merck for the most recent 3 years. Merck continues to have excellent cash reserves, in the year 1999, its cash reserves were 0.23 and .43 in 1998. Its ROE in 1999 was 44%. This shows the value it returns to its stock holders. Its debt to equity ratio is well within manageable margins of .45

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