When Chris Scalet arrived at Merck in March 2003, he knew he had a lot to learn. His immediate predecessors at the pharmaceutical giant had backgrounds in scientific computing and intimate knowledge of the information technology needs of the drug makers all-important research and development arm—the organization that turned out blockbuster drugs such as anti-cholesterol treatment Zocor and painkiller Vioxx.
Unlike former chief information officer Hassan Dayem or acting CIO Irene Qualters, Scalet knew almost nothing about drug development. He describes the education he got in his first few months as "like drinking from a fire hose."
But coming from International Paper, where he had been CIO since 1997, he also thought he had a few things to teach Merck about operational efficiency. That was becoming increasingly important for Merck. Last year, sales were up just 5% over 2002, compared with the 16% growth Merck had enjoyed in its drug business in 2000. Back then, earnings had been climbing 17% per year since the mid-1990s. Now, profit margins were falling. In fact, Mercks net income of $6.8 billion on sales of $22.5 billion in 2003 was down 4.5% from $7.1 billion on sales of $21.4 billion in 2002.
But what’s really making Merck investors nervous is the scarcity of new products, combined with looming patent expirations on drugs such as Zocor, Merck’s top seller. The anti-cholesterol drug brought in sales of $5 billion last year, or nearly a quarter of Merck’s total revenue. Once generic alternatives become available in 2006, Merck expects them to take away more than $4 billion within a year. Another potential problem is a report that says Vioxx may carry a higher risk of heart problems than competing products. A pharmaceutical company, on average, needs 10 years of work and nearly $1 billion to bring a significant new drug to market, according to a study by Tufts University. A new drug is considered significant if it rings up at least $1 billion in annual sales.
For Merck and many other big companies, particularly in pharmaceuticals, it’s often hard to focus on pinching pennies when you record billions in profits. But Merck’s sheer size means that if it operated more efficiently, it could regain the profitability of the past. Toward that end, Merck is putting more effort into "operational excellence," including the efficiencies information technology can bring.
That’s where Scalet comes in.
"I think they were looking for someone who had a different background, from an industry that didn’t have the margins we enjoy here and had done some things more aggressively in the area of operational excellence," Scalet says. At International Paper, "we had to in order to survive," he says, because paper and packaging is more of a commodity industry.
It isn’t that Merck is profligate. Indeed, when Merck’s earnings were growing 17% per year, it was lauded in academia for the way it managed its information systems. Even now, the benchmarking firm Alinean considers Merck a "frugal leader" in the pharmaceutical industry, spending conservatively on information technology yet enjoying the highest rate of return on systems spending of any large drug company.
So what’s at stake? A lot.
Once the biggest and richest drug maker, Merck is now the fifth largest in market capitalization, worth $105 billion to its shareholders. Pfizer, now number one, is valued at $270 billion.
If Merck wants to sustain high profits, while retaining the ability to invest in drug research, it can only do so by operating with greater efficiency. If, for instance, the company can run its marketing, drug development, distribution and other operations 5% more efficiently, as much as $635 million could make its way to the bottom line. Get that to 15%, and you’re beginning to get somewhere.
Scalet knows Merck is in a pinch, needing to maintain profitability for its shareholders during lean times.
"There are things we could afford to do five or 10 years ago that we can’t necessarily afford to do today," Scalet says.
But if there’s anything he knows, it’s how to operate efficiently in a pinch. When you’re coming from International Paper, Merck’s after-tax margin of 30 cents on the dollar is mammoth. Scalet’s former employer earned just 1.2 cents on each dollar of sales. At International Paper, for instance, Scalet declined to outsource the hosting of its Web operations, figuring his information systems crew could host and operate Web services for less.
Doubling Paper’s net income, though, would mean finding only another $302 million. For Merck, that’s just 4.4% of its net income.