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The Best Medicines

Merck invests billions in drug R&spamp;D every year, and it&spamp;rsquo;s up to CFO Peter Kellogg to ensure that the money is spent wisely.

21Mar

Few if any industries have as much uncertainty in their product-development processes as the pharmaceutical industry does. It takes 10 to 15 years, on average, for a new compound to end up as a commercial drug on the pharmacist’s shelf. And only a few compounds complete that journey; the vast majority fall by the wayside, whether in the laboratory or during the extensive clinical trials required by the Food and Drug Administration. Pharmaceutical companies, in short, make many expensive bets and lose most of them.

“Our industry invested more than $49.5 billion last year in discovering and developing new medicines,” says Peter N. Kellogg, executive vice president and CFO of Merck & Co. Biopharmaceutical companies, he says, invest more than 10 times the amount of research and development per employee than do manufacturing industries.

When a new-drug bet wins, however, the payoff can be great. Make enough successful wagers and you can end up with a company like Merck, the world’s third-largest pharmaceutical company. Last year Merck recorded revenues of $47.3 billion, thanks to strong products in categories such as vaccines and cardiovascular and diabetes medicines.

Even when uncertainty is vanquished, victory isn’t final. Merck’s sales fell 2% in 2012, due in part to a 3% unfavorable impact from foreign exchange, but also to the expiration of U.S. patent protection for Singulair, its blockbuster asthma drug. Other branded drug companies took big hits from generic competition during the “patent cliff” of 2011 and 2012, as protection ended for best-selling medicines like Pfizer’s Lipitor, AstraZeneca’s Seroquel, and Bristol-Myers Squibb’s Plavix. To keep a pharmaceutical company growing is to keep its drug pipeline flowing.

Finance plays an indispensable role in that effort, Kellogg recently told CFO. The finance chief came relatively late to big pharma, spending 13 years at PepsiCo (including a stint as CFO of Frito-Lay International) before joining Biogen as finance chief in 2000. He oversaw Biogen’s merger with Idec in 2003, and describes his 7 years at the biotech firm in part as “a great learning opportunity.”

Indeed, Kellogg proved an apt pupil, accepting the top finance post at Merck in August 2007 and earning Institutional Investor’s recognition as top pharmaceutical CFO in 2009 and 2010, based on the magazine’s surveys of portfolio managers and research analysts. (ExecRank, an executive ranking service, went even further in 2012, rating him the top finance chief in any sector.) But Kellogg is quick to credit his success to his staffers; the word team is never far from his lips. “You have to make sure you have great teams and great people around you,” he says, “and give them the resources they need to do their work. I think I’ve got the best finance team in the world.”

A good thing, too, since Kellogg has a lot on his plate — everything from accounting and controls to business planning and development, treasury, tax, and more. A few years ago he had his hands doubly full with the design, negotiation, and financing of Merck’s $41.1 billion merger with Schering-Plough, which vaulted the company to the top ranks of the industry.

But Kellogg’s chief preoccupation is supporting Merck’s R&D programs, as he explained in a conversation with executive editor Edward Teach. A condensed and edited version of that conversation follows.

Can you give us a big-picture view of the role of finance at Merck?

Merck is founded on innovation in science; we have a long history of that. Our pharmaceutical pipeline is a huge investment. We spend in the range of $7.5 billion to $8 billion annually on research and development. In the world of R&D, that’s a big number.

Accordingly, what finance does — and has to do really well — is help the company think through the enormous investments that we’re making. Of course, we do everything else: we have sophisticated accounting systems, tax and treasury operations, internal audit. We have a global footprint in all those areas. We support the commercial and manufacturing operations; we’re very integrated throughout the company. But the big thing we have to do is make sure that there’s tremendous financial literacy and value creation behind all our investments in R&D.

How do you ensure that everyone in the company is on the same page regarding value creation?

At the highest level, we run Merck with a company scorecard, which I think is typical for a lot of companies. The scorecard has 100 points, and 60 points are financial — 20 points are revenue related, 20 are earnings-per-share related, and 20 are related to the return on investment and net present value of our pipeline. So the pipeline ROI and NPV have equal standing with revenue and EPS.

Calculating those metrics requires close collaboration with the different functions of the company. We spend a lot of time helping the scientific, commercial, and manufacturing teams think about the financial ramifications of their work.

Do you supply any tools or benchmarks for this?

Yes. When we calculate the net present value of the pipeline or the return on investment for the whole company, we then break that down by franchise area. So the cardiovascular team, for example, knows the NPV and ROI of its portion of the pipeline, and each individual program knows how it is stacking up.

Naturally, everyone wants to understand what they can do to improve those scores — through better returns, or more efficient investment. So I spend a fair amount of time talking with our teams about value creation, and that gets into how investors model the cash flow of the company.

How much attention do you pay to Merck’s stock price?

We don’t watch the day-to-day gyrations. We do spend a lot of time thinking about the models that investors are building for us, and what that means in terms of what they understand about the company. So we do a fairly rigorous assessment of our valuation versus the stock price.

We always like to have a feel for the value that is imputed in our stock price over time, because it tells you a lot about whether or not investors are understanding what comes after a patent expiry or how well you can expand in emerging markets, or what the revenue potential is for some of the products you already have in the market.

How many research programs does Merck currently have, and what role does finance play in those programs?

We have more than 100 preclinical and clinical research programs under way. This includes about 36 compounds in late-stage development, 20 Phase 2 programs, and 16 Phase 3 programs. We build a financial model for every program until the end of its patent life. We work closely with commercial operations on the commercial potential. We work with the R&D organization modeling out what the development plan and costs will look like, and then we work with manufacturing in terms of what the cost of supply and distribution will be.

Then, we take the entire portfolio of R&D projects and rank the potential of the programs. On that basis we conduct integrated meetings where all the different divisions are present, and we collaborate with them to think through which programs should be prioritized, or deprioritized.

You say Merck spends up to $8 billion a year on R&D. What does it cost to develop a successful drug? Do you track that?

Not only do we monitor the cost with our own statistics, we also watch all the industry publications, because there are a lot of different institutes that publish surveys across the pharma industry. We look at it in two ways. One, what is the cost, on average, of getting a program to the finish line? Two, we model in the cost of failures that you have to get one successful molecule.

The cost of developing drugs has risen dramatically in recent years. Independent research has determined that the cost of developing a single successful compound, including the cost of those that fail along the way, is in the billions. That’s an important factor in thinking about driving the return on investments: you have to make sure you’re working on something that meets a significant need in the marketplace and has the potential to be commercialized on a global basis.

How long does it take to turn a molecule into a new drug approved by the Food and Drug Administration?

New medicines pass through several crucial stages on their way from the research lab to the pharmacy shelf. Winning approval from the FDA takes 15 years on average, according to the Pharmaceutical Research and Manufacturers of America. What’s more, a PhRMA analysis found that only one of every 10,000 potential medicines investigated by pharmaceutical companies is approved for patient use by the FDA.

Given the enormous sums involved, you must put a lot of emphasis on calculating a compound’s odds of success.

It’s a key component of how we evaluate the programs. We arrive at those probabilities based on what we know about the molecule and the disease states, and many times with input from an independent scientific board. We assign an independent probability of success for each program.

Because so much is being invested and there is so much uncertainty, having the entire organization develop a certain level of financial literacy in terms of how you sequence your work, how much of a risk you take, is there a good return on investment, what are the trade-offs you have to make as you’re developing or commercializing drugs — that’s tremendously valuable.

We’re surrounded by very smart and accomplished people, and they love learning about this. I am often asked to speak at dinner after an all-day meeting of scientists, or at our annual leadership conference. We have a business of science course that we provide internally to our top research-and-development professionals, and I’ve spoken there on the process of creating value. And it works both ways: I end up learning a tremendous amount about the science and the R&D process.

How do Merck’s cash flow and capital structure support its research spending?

Our cash flow is very strong; we generate more than $10 billion a year. And our capital structure is very balanced: we have about $23 billion in cash and about $20 billion of debt. From a credit-rating standpoint, it’s one notch above where we need to be [Aa3 from Moody’s Investors Service, AA from Standard & Poor’s], to give us resilience. We want to make sure our capital structure can withstand different impacts, whether it’s an economic crisis or a legal issue or a strategic investment we want to make. We want to guarantee that the R&D pipeline is never interrupted.

Beyond that, we focus on returning cash to shareholders. We have a very competitive dividend program, and we do a fair bit of share repurchase as well.

Where do joint ventures and external partnerships fit into drug development?

While we have a big internal pipeline, we regularly evaluate and bring in additional molecules to complement the pipeline. We do somewhere between 50 and 60 business-development and licensing deals a year. Some are straight technology licensing and some are specifically bringing a molecule into the pipeline. My team works with the R&D organization, or with commercial teams if it’s more of a commercial asset, to both manage the economics and help negotiate the deal.

Does Merck invest in start-up firms?

We have started two venture funds in the last couple of years. One, the Merck Research Venture Fund, was set up specifically to place equity investments behind small, early-stage companies; it’s a complement to the discovery research and early-stage pipeline that we do internally. The fund is not yet fully deployed, but it has $250 million open to invest.

A second fund, the Global Health Innovation Fund, also has an allocation of $250 million open to invest. It’s focused on investing in small companies that can bring together different technologies and capabilities to create “ecospheres” with tremendous potential. Think of the iPod and iTunes: that was a combination of digitized music, increased disk capacity, broad Internet capacity, and access, put together in one environment that created tremendous value. Similarly, you can think about improving patient outcomes in different disease areas by combining science and technologies and services to form a health-care ecosphere.

Success in the pharmaceutical industry has a finite life. How do you prepare for patent expiry?

To be successful in this business, you constantly have to be innovating and developing new, high-value-added products that can replace products that lose market exclusivity.

Singulair, for example, went off patent in the United States last August, and lost patent exclusivity in many markets in Europe in February. That was a big product — about five and a half billion dollars a year — before it went off patent. But if you look at our full-year 2012 results, we still maintained our top line on a constant-currency basis. The rest of our drug portfolio, as well as our businesses like animal health and consumer, filled the gap.

You have to have an underlying growth engine that can drive through these patent expiry periods. It’s as simple as that. When we review our financials internally in our employee business briefings, we look at what our underlying growth is, excluding products that are about to go off patent or that just went off patent. The most important thing is to continually focus on innovation and on bringing the next wave of technology to market.

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