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Merck & Co. Case Study

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Executive Summary

In 2000, Merck & Co., Inc., a global research-driven pharmaceutical company, was facing a threat that patents of their most popular drugs would expire in two years. Following by the patents’ expiration, company’s sales and profits would decline dramatically since generic substitutes would take place. The only way to recover the loss caused by patents’ expiration was to develop new drugs and refresh the company’s portfolio.

LAB Pharmaceuticals, who specializes in developing compounds for treatment of neurological disorders, offered Merck to license a new developing drug, Davanrik, which had functions to treat depression, obesity or both. At the time of the offer, Davanrik was in pre-clinical development, which would need to pass the three-phase clinical tests approved by the FDA. Testing would last seven years, which would appear to be high failure and costly. Under the licensing agreement, Merck would be responsible for the approval of Davanrik from the FDA, its manufacturing, and its marketing. As return, Merck would pay LAB an initial fee, a loyalty on all sales, and make additional payments as Davanrik completed each stage of the approval process.

As Merck’s financial evaluation team, we analyzed this offer through decision tree analysis, and estimated the expected value from each possible outcome and the expected payments to the LAB. We concluded the expected value of licensing Davanrik is around $13.69 million, which included the expected payments to the LAB of $16.68 million.

Our recommendation is that Merck should bid on licensing Davanrik no more than $13.69 million. First, the company is facing a serious situation that most of their patents are going to expire soon, and the company’s value and profits are declining, so it is necessary to invest in new drug developments. Second, the FDA approval tests are seven years long with a high failure rate. If Merck fails tests in the middle way, the company would not only loss the opportunity to produce and market the drug, but also face huge loss caused by failure, so the bid can not be set too high. Third, Merck had rich experience and technology source with drug development process, so the company should have financial and technical abilities to support Davanrik’s approval process with the FDA. We estimated the project’s expected value by sum up expected values from positive outcomes and negative outcomes, and concluded that it is worth to bid but with caution as the project will be subject to high risk. Our analysis details are as following.

The Problem

Merck

Merck was a successful research-driven pharmaceutical company, which discovered, developed, manufactured and marketed a broad range of human and animal health products. Over the last three years, Merck had achieved close to 20% profit from sales of executive patent drugs. However, most of the revenue generators, patented drugs, were going to become generic drugs in two years. There was a sign that goodwill and intangibles were declining from 26% to 21% for 1998 to 1999, and we anticipated a deeper drop when more patents get expired in 2002. If there would be no substitutes which could take place to generate revenue after patents get expired in two years, the company’s profit and EPS would decrease, which would make it less attractive to investors, so the company’s value would decline.

The only way to counter the loss of sales form drugs going off patent was to develop new drugs and constantly refresh the company’s portfolio. From the analysis of company’s common - size financial statements, it appeared that the firm was financially healthy. Moreover, Merck was able to fund new drugs’ development through both internal and external funding.

From the common size balance sheet: All three year’s current ratios were greater than 1, which indicated that the company has high liquidity. The debt to equity ratios were great than 1, which seemed the company had a heavier debt than equity, but it was not the truth. Current liabilities, deferred income taxes and non-current liabilities, and minority interests had a larger percentage than the long-term debt in total liabilities. Additionally, there was high percentage of treasury stock in stockholders’ equity, which reduced the total equity.

From the common size income statement: Over the last three year, the company had a high gross margin from 46% to 50%, which indicated company efficiently utilized assets to earn substantial profit. Moreover, profit margin, ROA, ROE and EPS all indicated the company was profitable, which should be attractive to both creditors and investors. Since the retention ratio was pretty high, the company was able

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