Recruiting in China

Merck (NYSE:MRK) has announced that it will cut its workforce by 20% over the next two years, which could result in the loss of close to 16,000 jobs. This will leave the company with less than 65,000 employees which is in stark contrast to its peak strength of close to 100,000 employees following its acquisition of Schering-Plough in 2009. [1] With this restructuring, Merck intends to save $2.5 billion annually which can boost its free cash flows by almost 20%. However, the impact will be mitigated by the expected restructuring costs of roughly $2.5 billion to $3 billion. [1]

The company’s move highlights the broader problems that Merck and other big pharmaceutical firms are facing today. The R&D (research and development) productivity has declined over the years, and the strategy of developing drugs for major diseases is not working. The landscape of the global pharmaceutical industry is shifting towards more niche, innovative and genetically targeted medicines. In addition, Merck is suffering from the loss of patent exclusivity for some of its major drugs and may look for acquisition of some promising medicines to offset the failure of some of its research projects.

What Is The Problem That Merck Is Facing?

Like other major pharmaceutical companies, Merck is also battling the impact of patent expiry of its several major drugs including Singulair, Propecia, Clarinex, Maxalt, Cozaar and Hyzaar. Out of these, asthma drug Singulair has had the biggest impact and has continually weighed on Merck’s growth for the past few quarters. Worldwide sales of Singulair, a once-a-day oral medicine for chronic treatment of asthma and relief of symptoms of allergic rhinitis, stood at $5.5 billion for 2011. However, this figure declined to $3.85 billion in 2012 following its patent expiry in August same year. Merck expects that within two years following the patent expiration it will lose substantially all U.S. sales of Singulair, with most of those declines coming in the first year.

In addition, Merck’s cardiovascular division has also been hurt by the patent cliff as its drugs Cozaar/Hyzaar, which garnered over $2 billion in revenue in 2010, lost patent exclusivity in large markets including the U.S. and Europe in late 2010. As a result, sales fell by roughly 35% to $1.3 billion in 2012. Additionally, Propecia, Clarinex and Maxalt together accounted for roughly $1.5 billion in revenues in 2012. Due to patent expiries, we expect their combined sales to go down to about $1-1.1 billion in 2013.

While the big drugs are losing their sales, there is little chance for new blockbusters replacing them. The R&D productivity has significantly declined over the last decade. Although the industry’s R&D spend has increased, the number of new drugs approved by the FDA has come down. In fact, Merck is planning to terminate certain drugs in late stage development and intends to focus on acquiring experimental drugs.

What Is Merck Likely To Focus On?

There has to be a shift from developing blockbusters treating major diseases to focusing on niche therapeutic areas where although the patient population is low, pricing is quite high due to high specificity and efficacy. Major therapeutic areas are getting flooded with generics and there haven’t been any major advancements to thwart the competition. Merck has mentioned that it plans to continue investing in vaccines and diabetes, where it already has successful products.

Diabetes

Merck’s type 2 diabetes treatment drugs Januvia and Janumet saw strong volume growth in international markets and retained their market leadership with 70% share in the second quarter. [2] Excluding the impact of currency movement, Januvia saw its sales jump by 7% while Janumet’s revenues surged 17%. [3] In addition, the company is working with Pfizer to develop and commercialize its investigational SGLT2 inhibitor, Ertugliflozin, for the treatment of type 2 diabetes. With obesity on the rise, diabetes is affecting more people globally. In the U.S. alone, roughly 26 million people suffer from the condition. [4] China’s problem is even worse, as a report suggests that 11.6% of Chinese adults have diabetes and around 40% of adults between the age of 18 and 29 are on the verge of developing it. [5] That puts China’s diabetes patient count at 114 million individuals, and this figure is likely to go higher. According to IMS health, China’s diabetes market is expected to grow 20% annually and reach $3.2 billion by 2016. [6]

We currently account Januvia’s revenues under Alimentary & Metabolism drugs division, which constitutes roughly 15% to our price estimate for Merck. Januvia’s importance can be gauged from the fact that the exclusion of the drug’s sales from Merck’s revenue forecast leads to downside of about 5-10% to our price estimate. That’s a lot of value for a single drug in a diversified company like Merck.

Acquisition Strategy

It appears that Merck will trim down its R&D expenses, and instead focus on acquiring drugs externally. This way, the company will assume the role of pharmaceutical private equity/venture capitalist firm to a certain degree. In addition, we believe that it can pursue orphan drugs, and novel therapies including higher focus on gene therapy, stem cell research etc.

Cancer Treatment

Cancer treatment is a growing market for the pharmaceutical industry. The opportunity comes from the fact that global incidence of Cancer is likely to increase from about 12.7 million in 2008 to 21.3 million in 2030. [7] In addition, the number of deaths are likely to show a similar growth trajectory as depicted in the chart below. Cancer is a not a single disease, it has in fact more than 200 types and thousands of subtypes affecting more than 60 organs. That gives an opportunity for Merck to develop novel therapies and capture niche markets.

Our price estimate for Merck stands at $51.60, implying a premium of about 5-10% to the market price.

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Notes:
Merck to Cut Staff by 20% as Big Pharma Trims R&D, The Wall Street Journal, Oct 22013 [?] [?]
Merck’s Q2 2013 Earnings Transcript [?]
ref:1 [?]
National Diabetes Fact Sheet, 2011, CDC [?]
China ‘Catastrophe’ Hits 114 Million as Diabetes Spreads, Bloomberg, Sept 4 2013 [?]
China Diabetes Triples Creating $3.2 Billion Drug Market, Bloomberg, Nov 5 2012 [?]
J&J’s Investor Presentation [?]