1. How has Merck been able to achieve substantial returns to capital given the large costs and lengthy time to develop drug?

1.      How has Merck been able to achieve substantial returns to capital given the large costs and lengthy time to develop drug? Why are they moving in the direction of licensing compounds from other pharmaceutical firms?

Merck & Company: Evaluating a Drug Licensing Opportunity case

Rich Kender, Vice President of Financial Evaluation & Analysis at Merck, was working with his

team to decide whether his company should license Davanrik, a new drug with the potential to treat

both depression and obesity. The small pharmaceutical concern that developed the drug, LAB

Pharmaceuticals, lacked the resources to complete the lengthy approval process, manufacture the

compound, and market the drug. LAB had approached Merck with an offer to license the compound.

Under this agreement, Merck would be responsible for the approval of Davanrik, its manufacture,

and its marketing. The company would pay LAB an initial fee, a royalty on all sales, and make

additional payments as Davanrik completed each stage of the approval process.

Merck

In 2000, Merck & Co., Inc. was a global research-driven pharmaceutical company that discovers,

develops, manufactures and markets a broad range of human and animal health products, directly

and through its joint ventures, and provides pharmaceutical benefit management services (PBM)

through Merck-Medco Managed Care. Since 1995, Merck had launched 15 new products including

Vioxx™ for the treatment of osteoarthritis, Fosamax™ for the treatment of osteoporosis and

Singulair™ for treating asthma. The Company earned $5.9 billion on 1999 sales1 of $32.7 billion,

about a 20% increase from 1998. Exhibits 1 and 2 contain Merck's Income Statement and Balance

Sheet.

A handful of Merck's most popular drugs, Vasotec™, Mevacor™, Prinivil™, and Pepcid™,

generated $5.7 billion in worldwide sales. The patents for these drugs, however, would expire by

20022. Once the patents expired, Merck anticipated that the sales of these drugs would decline

substantially as generic substitutes became available. The only way to counter the loss of sales from

drugs going off patent was to develop new drugs and constantly refresh the company's portfolio.

The company develops new compounds primarily through internal research, but complements this through initiatives with biotechnology companies to ensure Merck is on the leading edge of select

therapeutic categories.

Davanrik

LAB Pharmaceuticals originally developed Davanrik to treat depression. Antidepressant drugs

work by affecting certain parts of the central nervous system. Various receptors in the human brain,

when stimulated or blocked, create or inhibit various moods. The serotonin system controls

nervousness, depression, insomnia, hunger, sexual dysfunction, nausea, and headaches. Through a

combination of chemical compounds, the receptors in this system of cells can be stimulated or

blocked to treat a patient with one or more of the given symptoms3. Davanrik seemed not only to

stimulate the receptor that promotes antidepression, but also to block the receptor that causes

hunger.

At the time of LAB's offer, Davanrik was in pre-clinical development, ready to enter the threephase

clinical approval process required for pharmaceuticals in the United States. In Phase I, the drug

is given to a small number of healthy volunteers to test for safety. This usually takes about 1½ years.

In Phase II, a larger number of patients are tested to determine if the drug is effective in treating a

certain condition and to measure potential side effects. This usually takes about 2½ years. Finally, in

Phase III, a large number of patients are tested for safety and efficacy. This phase takes about 3 years

to complete. Exhibit 3 summarizes the FDA approval process.

LAB Pharmaceuticals specializes in developing compounds for the treatment of neurological

disorders. While the company was only 15 years old and though it had a few drugs in Phase II and

Phase III testing, none had successfully completed the FDA approval process. In fact, the FDA had

recently denied approval of another of LAB's compounds that had completed all three phases of

clinical testing; LAB's stock price fell by over 30% in response to this decision. As a result, LAB was

hesitant to issue additional equity to finance the testing of Davanrik and was seeking a larger

pharmaceutical company to license the drug and provide LAB with some much-needed cash. The

licensee would design, administer, and fund the clinical testing of the compound, its manufacturing

and its marketing. The licensor, LAB, would receive an initial payment followed by additional

payments as Davanrik completes each clinical testing phase. LAB would also receive a royalty on the

eventual sales of Davanrik.

Davanrik's Potential Cash Flows

Rich Kender assembled a team to evaluate the potential profitability of Davanrik. Senior

researchers evaluated scientific aspects of the compound, and marketers evaluated the market size,

potential competition, and requirements to successfully launch the drug. Meanwhile, manufacturing

managers determined the capital required to produce the drug, and people in Kender's own

department built a financial analysis of the licensing decision.

The evaluation team determined the costs and likelihood of completing each stage of the FDA

approval process along with a forecast of profitability of the drug if it successfully completed the

approval process. Overall, the approval process was expected to consume about seven years. LAB

obtained a patent on the product which is estimated to have a remaining life, including all possible

extensions, of 17 years. Therefore, the product would have a 10 year period of exclusivity, beginning

in 7 years.

Phase I Davanrik would be administered to 20-80 healthy people to determine if the drug was

safe enough to continue into the efficacy stages of clinical testing. Phase I would take two years to

complete. It was expected to cost $30 million, including an initial $5 million fee to LAB for licensing

the drug. There was a 60% chance that Davanrik would successfully complete Phase I.

Phase II In this phase, Davanrik would be given to 100 - 300 patient volunteers to determine its

efficacy for treating depression and/or weight loss and to document any side effects. To complete

the efficacy tests, Davanrik would have to demonstrate a statistically significant impact on patients

suffering from depression, obesity, or both. The Merck team estimated a 10% probability that Phase II

would show that Davanrik would be efficacious for depression only, a 15% probability for weight

loss only, and a 5% probability that it would be efficacious for both depression and weight loss at the

same time.4 Like Phase I, Phase II would require two years of clinical testing to complete. Phase II

was expected to cost $40 million, including a $2.5 million licensing milestone payment to LAB.5

Phase III In Phase III, Davanrik would be administered to 1000-5000 volunteers to determine

safety and efficacy in long term use. Because of the number of volunteers and nature of testing, this

was the most costly of the phases and was expected to take three years to complete. The costs and

probabilities of success depended on the outcome from Phase II. If Davanrik was effective for only

depression, Phase III trials would cost $200 million including a $20 million payment to LAB, and

have an 85% chance of success. If it were effective for weight loss only, it would cost $150 million

(including a $10 million LAB payment), and have a 75% chance of success. If, however, it was

efficacious for both weight loss and depression, more specialized trials would be required to

determine efficacy for the dual indication. The total cost of the Phase III clinical tests for the two

separate indications together with the dual indication was expected to be $500 million, including a

$40 million licensing payment to LAB, and had a 70% chance of successful outcome. Under this

scenario, there was a 15% chance of a successful outcome for depression only, and a 5% chance of a

successful outcome for weight loss only. The probability of complete failure of the dual indications or

either separate indication was only 10%.

Davanrik had substantial potential profits, especially if it was effective both as a treatment for

depression and weight loss. If the drug were approved only for the treatment of depression, it would

cost $250 million to launch, and had a commercialization present value of $1.2 billion. If Davanrik

were only approved for weight loss, it would cost $100 million to launch, and would have a PV of

$345 million. However, if Merck could launch the product with claims for both indications, it would

cost $400 million to launch and have a PV of $2.25 billion.