The Frugal Leader

By Edward Cone  |  Posted 2004-06-18 Print this article Print

The Frugal Leader

The company Scalet entered last year thought it knew how to run an efficient technology shop. And by pharmaceutical industry standards, it did.

Alinean estimates that in 2002, the year before Scalet was hired, Merck’s information technology spending equated to 2.6% of revenues, compared with an average of 4.4% for other big pharmaceutical firms.

That may be a distortion, however, since more than half of Merck’s revenues that year came not from drug sales but from its high-volume, low-margin pharmacy benefits management business, Medco.

Last year Merck spun off Medco, and Alinean revised its estimate of Merck’s information technology spending to 4.8% of revenues, compared with 5.1% for its major competitors.

Still, while spending a little less than average, Merck gets more for its money, according to a metric Alinean calls return on information technology (ROIT).

Here, Merck’s high ranking is driven largely by profitability. By standard accounting, for instance, last year Merck generated far more profit, $6.8 billion, than its far larger rival Pfizer, which netted $3.9 billion on revenue of $45.2 billion.

To calculate ROIT, Alinean uses a profitability metric called Economic Value Added (EVA), which rewards conservation of capital and investment in research and development. Merck’s EVA of $5.9 billion last year compares with $599 million for Pfizer.

In effect, companies with high EVA ratings are achieving more profit with less use of capital—doing more with less—which implies superior use of information, which implies superior information systems. And if you accept that string of assumptions, EVA divided by information technology spending yields ROIT. Merck’s ROIT of 538% compares with 28% for Pfizer and 295% for Eli Lilly, the next best performer in Alinean’s analysis of Merck’s competition.

"I would still classify Merck as a frugal leader, one of the best in our database," says Tom Pisello, a former Gartner Group analyst who is Alinean’s CEO and founder. "They’re not merely making decisions based on features and functions and technical specifications." What seems to make the difference, Pisello says, is "how far down in the organization they’ve driven the knowledge of wanting to do financial analysis and the capability of doing it. This is not just some executive edict."

Of course, Alinean’s metrics look only at the past. "One of the challenges they face is revenue sustainability and revenue growth," Pisello says. "This is an issue for any frugal leader: You’re being penny-wise today, but are you investing enough in the future?"

The Pipeline Problem

When Scalet goes to work every day, Merck is judged not by the output of its computer systems but by the productivity of its drug development.

The problem is that even if Merck’s scientists found an all-in-one cure for impotence, baldness and bad eyesight today, years would pass while the drug made its way through toxicity testing, three phases of clinical trials, and approval by the U.S. Food and Drug Administration. Merck is constantly seeking ways of accelerating this process, which is one of the areas in which better information systems can help. There are also parts of the process that can’t be rushed, such as the scientific study of how a drug affects a test subject over time.

Last year, Merck canceled four drug candidates. Two of those, a diabetes drug and a depression treatment, made it all the way into large-scale human testing and had been thought to have potential for sales of $1 billion or more per year. But during clinical trials, the diabetes drug was shown to cause cancer in laboratory mice, and the depression treatment proved no more effective than a placebo.

Since 2000, Merck has introduced just six new drugs. Other companies faced with similar dry spells have reacted by merging with or acquiring another big pharmaceutical firm. Cases in point: Last year, Pfizer spent $56 billion to acquire Pharmacia; in 2000, Glaxo Wellcome and SmithKline Beecham entered into a $75 billion merger and created GlaxoSmithKline.

Merck CEO Raymond Gilmartin steadfastly refuses all pressure to execute his own mega-merger, arguing it would be a distraction. Merck will research its way out of this slump, as it has done before, he says. He hedges this bet only by stepping up the pace at which Merck is making smaller acquisitions, forging partnerships and cutting licensing deals as a way of fortifying its product mix.

Merck has a long-standing reputation for capitalizing on its research: It pioneered the manufacture of penicillin in the 1940s. More recently, Merck earned international acclaim for giving away its patented cure for river blindness, a devastating water-borne disease afflicting millions in the world’s poorest countries. Under long-time chief executive Roy Vagelos in the ’80s and early ’90s, Merck was praised for achieving high returns, even though it would spend large sums on fighting certain diseases when it could not recoup costs.

But Vagelos, who retired in 1994, was also responsible for the $6.6 billion purchase of Medco in 1993. In retrospect, it looks like a mistake—a defensive overreaction to what turned out to be the illusory threat of the Clinton health-care plan. Other big pharma firms bought similar companies, which operate as middlemen between drug makers and the insurers and corporate benefit plans that distribute prescription drugs to end users.

But while other pharmaceutical companies sold these businesses after the Clinton plan died, Merck held onto Medco for a decade before spinning it off last year. Ultimately, Medco was a distraction—a high-volume, low-margin business prone to raising thorny regulatory issues about whether Medco was unfairly promoting Merck products. To make matters worse, the Internal Revenue Service is now alleging that Merck owes as much as $2 billion in back taxes related to the merger.

Gilmartin joined Merck in 1994, having been recruited from medical equipment maker Becton, Dickinson and Co. Some observers questioned whether someone from outside the drug industry was the right man for the job, since that was another time when the drug pipeline seemed to have run dry.

But that drought didn’t last. Merck introduced drugs such as Singulair for asthma and hay fever and Fosamax for osteoporosis. Earnings growth from the time Gilmartin took the job through 2000 averaged 17%, making him look like a hero—even if the development of those hit drugs began long before he arrived.

Next Page: The project of governing.

Senior Writer and author of the Know It All blog

Ed Cone has worked as a contributing editor at Wired, a staff writer at Forbes, a senior writer for Ziff Davis with Baseline and Interactive Week, and as a freelancer based in Paris and then North Carolina for a wide variety of magazines and papers including the International Herald Tribune, Texas Monthly, and Playboy. He writes an opinion column in his hometown paper, the Greensboro News & Record, and publishes the semi-popular weblog. He lives in North Carolina with his wife, Lisa, two kids, and a dog.

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