The capabilities competitor.

In the 1980s Merck proved that a research-driven powerhouse could indeed work magic.

In addition to keeping the pipeline filled, the company in the 1990s will need to redirect its capabilities toward mastering global rollout and a changing distribution system, one that favors physicians less and managed care providers more.

Merck & Co. reached its centennial year in 1991 with a record enviable even in the fiercely competitive pharmaceutical industry. The $9 billion Rahway, NJ, drug maker commands the largest share--over 5 percent--of the world market for prescription drugs. Nineteen of its products in nine therapeutic categories each grossed over $100 million in annual worldwide sales. Two products, Mevacor and Vasotec, are megadrugs with sales topping $1 billion. Merck's annual compound growth rate in net income is 18 percent for the last 10 years and 26 percent for the last five. All of this continued during the last two years, a feverish period in which large pharmaceutical companies, including Marion/Merrell Dow, Bristol Myers/Squibb, SmithKline/Beecham, and Rhone Poulenc/Rorer, have joined the M&A party.

Although he is quick to attribute this performance to Merck's 32,000 employees, Roy Vagelos, 63, CEO since 1985, is widely considered to be the empowering leader and ultimate contributor to Merck's success. In affirming Vagelos as 1992 Chief Executive of the Year, Westinghouse Electric CEO Paul Lego, a selection committee member, was impressed by "Merck's longterm, consistently outstanding financial performance and Dr. Vagelos' personal qualifications, vision, articulation and implementation of strategy." Former Manufacturers Hanover President Tom Johnson, also a committee member, says, "Roy represents the best of American business leadership. He brings dedication to research and product excellence. Beyond the numbers, his contributions to industry issues and to the broader community make him a wonderful model for future business leaders."

"What is most striking to me," adds William Mayer, former dean of the Simon School of Business at the University of Rochester, "is the way he manages change in a complicated industry in a quiet but firm style."

A recognized authority on lipids and enzymes, the snowy-haired Vagelos is often described as "scholarly," but his first association with Merck was hardly donnish. Busing tables at his Greek immigrant parents' coffee shop six streets from the Rahway headquarters, the young Vagelos encountered and talked with Merck scientists about their research. After graduating from the University of Pennsylvania in 1950, he received his M.D. from Columbia University in 1954. He interned and was resident at Massachusetts General Hospital until 1956. For the next ten years, he held positions in cellular physiology and biochemistry at the National Institutes of Health, joining Washington University in St. Louis in 1966, where he chaired the institution's biochemistry department. In 1975, he decided to leave his formal teaching

career to become SVP of research at Merck, Sharp & Dohme Research Labs (MSDRL) because he felt he "could make a difference." A year later, he became president of MSDRL. He became SVP of the parent company in 1982, EVP in 1984 and, succeeding John Horan, became CEO a year later.

Operating in a collegial style, Vagelos is credited with forging a strong team of executives, any one of whom, theoretically, will be able to take over when he retires in 1994. The roster of possible heirs comprises Dr. Edward Scolnick, 51, who is also a physician and, like Vagelos, heads research; John Zabriskie, 52, the manufacturing chief; Richard Markham, 41, marketing director; Jerry Jackson, 50, who heads vaccines, and animal and agricultural drugs; and Francis Spiegel, 57, chief of finance and business development.

The personal talents of Vagelos and his team, and the company's vast research budget (roughly $1 billion, or 12 percent of sales, is spent on R&D), are typically cited as reasons for Merck's high-powered performance. This is partly true, but other drug firms spend prodigiously on research and have clever managers at the helm. What sets Merck apart is the system it employs for identifying opportunities, focusing on core capabilities, then matching the two to bring products to commercial success more quickly and consistently than its rivals.

In a study of global pharmaceuticals, The Boston Consulting Group called these building blocks of capabilities: "sets of organizational skills, such as speed in development or research innovation, that provide superior value to the customer." The study's co-authors--BCG Manager Craig Wheeler and Vice President David Matheson--analyzed the eight major drug categories of the 1980s (see chart) using patent activity as an imperfect but useful measure of activity. BCG found Merck had strengths in all eight categories reviewed. Others, such as Glaxo and Lilly, fared well in certain areas, but none was consistently competitive across the board.

In an industry that faces further consolidation, "the trick is to pick the right capabilities," says BCG's Wheeler. The choice of emphasis, he believes, will be critical. Just as research was the engine of the 1980s, clinical development (time to market) and global rollout (rapidly reaching global markets with new products) will become more critical in the 1990s. BCG reviewed the percentage of markets a company entered over the first three years of a drug's market life, and weighted the score for the size of market (e.g., Germany counts more than Switzerland) and for the timeliness of entry (a large market entered in year one counts more than if entered in year two: see chart). Glaxo, a lackluster rollout performer in the 1970s, pulled itself to the top, with Squibb not far behind. Merck was consistent but remains behind the leaders. Because Merck manages more compounds through development than most, this yardstick may not be definitive, but it does point to the challenges that lie ahead.

CE editor J.P. Donlon recently caught up with Vagelos in Merck's Rahway headquarters (which will soon be moved to Whitehouse, NJ, 30 miles away), to explore these and other challenges faced by this year's Chief Executive of the Year.

FUTURE SHOCK

What is Merck's core competency?

In the pharmaceutical industry, a company's growth and stature depend on the productivity of its research laboratories. So historically, Merck has been a research-driven company. But the novelty and importance of products is more important than their sheer number.

Historically, what have been Merck's most important products?

In the 1930s, the company gained a solid reputation in vitamins. But we quickly progressed to antibiotics and other drugs, including Sinemet, the first significant improvement in the treatment of Parkinson's disease.

Then there are our vaccines, which Merck has been producing for 35 years. We make vaccines for mumps, measles, and rubella, and a form of hepatitis Type B.

If infected with Hepatitis B, one can develop a chronic liver problem and die, or survive the initial infection and end up with liver cancer. That form of cancer is not common in the U.S., but in China, for example, it is the second most common cause of death in adult males.

What will be Merck's drugs of the future?

The future today is Proscar, a drug that will control prostrate enlargement, a common condition in the majority of males over age 50. That is exciting, because the drug could decrease the need for surgery and, essentially, change the way men face the aging process. We expect Proscar to be available in many major world markets later this year. One of them is Japan.

Another drug we're working on, Fosamax, is a drug for osteoporosis, a softening of the bones that takes place principally in postmenopausal females. We're also doing extensive research in the area of glaucoma.

RESEARCH FRONTIERS

So is the aging process one of your research frontiers?

Absolutely. Demographics suggest that there are going to be a lot more older people by the year 2000 and beyond. Older people come down with chronic diseases, so we're targeting that area.

These trends make pharmaceuticals a growth industry.

But the elderly aren't your sole focus. Aren't you also working on a vaccine for AIDS, which predominantly strikes younger people?

We have more research people working in AIDS than any project in our history, but progress has been slow. We've been frustrated partly because the AIDS virus is so clever. It actually changes the way it attacks the body and thus far has stayed one step ahead of our research efforts. Ultimately, this virus likely will be controlled by using two different drugs simultaneously, so that when one form of the virus becomes insensitive to a drug, the other drug will kill it.

Similarly, we're hoping to introduce a vaccine next year for chicken pox. That vaccine might also be used to treat adults with shingles. Another condition that afflicts many children--for which we've been working hard to improve treatment--is asthma.

In sum: Merck gains a competitive edge in the research laboratory. But our focus extends beyond the lab, because the marketplace is changing dramatically.

You're referring to the marketing side of the business. How will that change in the near term?

Marketing has become enormously important and more competitive. Therefore, one cannot pin hopes for success only on a flow of important products. The buyers in the U.S. are changing. A few years ago, one-third of our drugs went to managed care. By 1995, that figure will be one-half--and more than that by the turn of the century.

That tells you the way you market, sell and distribute your drugs has to change dramatically.

Ten years ago, we marketed our products directly to physicians through professional representatives. That was when more doctors were independent practitioners; they had time to listen. They were the boss, they made the decisions, they did the billing, they collected the money, and they were willing to learn from our people.

But three years from now, things will be different. If your drug is not listed on the formulary of a megabuyer, there's no point in talking to doctors, because they're not going to be able to prescribe it. Our No. 1 target has to be the decision makers, for example, those from a managed care system or hospital.

SALES STRATEGIES

What's the most effective way to get Merck's drugs listed?

That's a strategy we're refining all the time. But one thing is certain: We have to approach decision makers with the kind of scientific and economic information that convinces them the use of a Merck product makes sense economically and is the best selection in preserving and improving the quality of a patient's life.

Of course, we are working hard to develop new drugs so doctors and decision makers will be compelled to use them. Being first on the market with a class of drugs gives you an enormous advantage. Once your drug is listed on a megabuyer's formulary, the amount of marketing time--the need to make sales doctor by doctor--won't be as great.

Will this reduce your cost of sales in the long run?

Certainly.

Dramatically enough for you to change your pricing strategy?

In terms of pricing, there are many forces at work. Our prices are going to collide with much keener competition worldwide. In Europe, we're seeing our prices subject to more government regulation. And here in the U.S., in the public health sector, government also is demanding price restraints.

We hope these pricing pressures will be moderate. If they're not, that could crimp our research spending. I don't think anybody wants that. What would happen if a drug such as Proscar weren't developed? Costs related to surgery, hospitalization and post-operative complications would soar. I know nobody wants that.

Our R&D expenses this year will reach $1.1 billion. Overall in the U.S., the industry will spend $10 billion. But we will develop new drugs only as long as we're free to spend money and take risks. Similarly, our stockholders will only continue to fund our efforts as long as they can expect to receive a reasonable return on their investments. As corporations, that's the "carrot" we extend to them.

We plow our profits back into research and development. To be sure, that fills our product pipeline. But the fruits of our labor can help reduce overall health care costs.

CONSUMER RESENTMENT

In recent years, Merck has raised its prices to keep up with inflationary increases. Have you ever second-guessed that policy?

There are people in our company who aren't happy with the policy. Nonetheless, I think it's the wisest course, and I'm pleased that other companies have elected to follow our lead. In the long run, with competition getting stronger, I think the pharmaceutical industry will be lucky if price increases can keep pace with CPI.

Another point: There is tremendous resentment against the industry because of the perception that drug prices are too high. Contrary to popular opinion, drugs represent only about 5 percent of health care costs. But that is one part of the bill consumers actually pay. Medical insurance picks up hospitalization and many other costs.

How do you get the best out of Merck's stable of researchers and scientists?

We team highly talented people with others of like ability to maximize productivity. Then we promote them and give them more money--our scientists are paid well.

In addition, we give bonuses and awards, not only to executives, but to people in the laboratories, in our production organization, and in our sales and marketing departments.

We also provide the opportunity for people to hold shares in the company. Not long ago, we gave 100 stock options to every employee. Our people hold a significant portion of our $56 to $58 billion in market capitalization. Even before the stock option, some 80 percent of our employees owned a piece of Merck.

Does that drive them more? Do I work harder because I'm paid well? I'd like to think I'm motivated by a desire to eradicate disease. Nonetheless, money is not insignificant. I would resent making less than my peers.

However successful U.S. pharmaceutical companies have been, overall, you've been quoted as predicting their share of the global market will drift lower. What's the outlook abroad?

We forsee increasing, cutthroat compentition. One reason the EC wants to consolidate after 1992 is individual countries want their industries to be more competitive worldwide.

Moreover, to gain an edge, many companies here and abroad are consolidating. SmithKline Beckman was acquired by Beecham. Squibb was acquired by Bristol Myers. Companies want to compete in the U.S., which is the No. 1 market, and in Japan, which is the No. 2 market. Japanese companies, in particular, are getting bigger and looking to enter the U.S. market.

In Europe, we've had double-digit sales growth for a number of years. We're No. 3 there, behind Glaxo and Hoechst. And we will probably overtake Hoechst in the near future. But any gains will be painstakingly secured.

RIDING THE TIGER

What are your plans for Japan?

Merck is the largest foreign presence in Japan today, although our market share is small, currently about 3 percent. But we will grow. We are in the process of constructing a large laboratory in Tsukuba Science Park, a Japanese science center.

We'll also get a boost when Proscar hits the Japanese market in 1994 or 1995.

Also in the Far East, the Chinese are in the process of launching two plants--in Beijing and Shenzhen--to produce our Hepatitis B vaccine. We sold them the technology at a nominal cost. Actually, they are building a plant at our facility in West Point, NY, with American equipment. They are going to take everything apart, ship it home in boxes, and rebuild the factories there.

You've forged strategic alliances with AB Astra, Du Pont, and Johnson & Johnson.

With Merck's stellar research reputation, why not go it alone?

Research and development expenses are so high, if you can tie into another productive organization, you have everything to gain.

Prilosec, an anti ulcer medication, is an AB Astra discovery that's one of our major growth products. In the future, this joint venture will benefit from the products of an organization that is half the size of Merck.

Similarly, Du Pont was a young company more oriented toward discovery. We fill the development side of the equation. There's a symbiosis between the organizations.

Dollar for dollar, do you get more yield from the research of a joint venture than you would by simply adding money to your own budget?

Yes. We believe there is a finite growth rate for research spending, beyond which it becomes inefficient. For one thing, the number of good people you can bring on board is limited. So, as long as we're growing at a satisfactory rate, if we can take some of our gains from elsewhere and invest them in an Astra or a Du Pont, let them grow and feed those gains back into Merck.

The trick is to identify where you are on the curve.

What are the things that delight you and, conversely, what are the things that get under your skin?

At heart, I am a scientist. I take particular delight in identifying new molecular mechanisms to battle disease. But I am also a businessman: So it is similarly gratifying when such mechanisms give Merck a competitive edge.

And the flip side?

It's hard for me to tolerate people--especially senior managers--who aren't pushing in the ways I think they should. I select for excellence, but not everyone measures up.

Are you saying what I think you're saying?

Yes, we have some turnover as a result.

RALLYING THE TROOPS

My last question--a traditional one for our Chief Executive of the Year--goes to the heart of your having been selected by your peers who, evidently, feel you are a model to follow.

What advice would you give to your fellow CEOs, who are struggling with thinning profit margins, downsizing, the globalization of markets, and massive cultural changes?

Keep your eye on the competition. Never lose sight of where they are going--and where you'll have to be--five, 10 or 20 years from now.

And, particularly in the pharmaceutical industry, don't spread your research efforts too thin. It's a constant battle for me to identify the most important projects and funnel our money into them.

And remember: Running any organization is like being the general of an army. At Merck, I have to select our stategy, authorize tactical forays, and rally the troops to rush at--and overtake--certain targets.