WATCH RAY GILMARTIN'S Second ACT.

The threat from generic drugs, fast-changing technology, the fight for scale at all costs, and managing inflated expectations promise to turn the world pharmaceutical industry into an even fiercer battleground. Will Merck CEO Ray Gilmartin meet the challenge?

Six and half years ago, Merck & Co., then the world's largest drug company, surprised the business world by tapping a relative unknown to succeed CEO P. Roy Vagelos, arguably the pharmaceutical industry's answer to Jack Welch. Equally surprising--for the few in the know--was the fact that said successor, Ray Gilmartin, CEO of the relatively small medical devices company Becton Dickinson, didn't leap at the chance to take Merck's helm. In fact, Gilmartin turned the job down flat.

"I said no at first because I felt a sense of responsibility to the people I was working with," reflects Gilmartin, 58, who rebuffed approaches by Spencer Stuart's Tom Neff not once, but twice. "But later I realized Becton Dickinson wouldn't collapse behind me, that I already had a successor there and, in fact, if I moved, he would move and everyone would move."

As it turned out, Merck would move as well. Despite mixed reactions from Wall Street analysts relieved that Vagelos had at last anointed a successor, but dubious about Merck's future in the hands of a CEO with no drug industry experience, Gilmartin proved a clear-sighted strategist. He began by preparing Merck for the pricing pressures being wrought by fast-growing managed care, flattening the organization, and eliminating an entire layer of management.

Faced with completing the integration of Medco Containment Services, the pharmacy-benefits management business acquired earlier that year, he took an unconventional tack. He positioned Medco not as the distributor the press had dubbed it, but as a managed care organization that could help Merck grow through its formulary management programs.

In an industry mad for consolidation, Gilmartin, the son of a construction foreman, chose instead to build by developing breakthrough drugs internally--a philosophy to which he remains committed. "The fundamental assessment that we made in the mid-'90s was that we had the pipeline to achieve our growth objectives," he asserts. "If you have the wherewithal to achieve your objectives by investing in internal growth, your odds of creating shareholder value are better on that path than on the merger path, which is risky and much of the time doesn't pay off. We were, and continue to be, in the fortunate position of having the necessary pipeline and growth potential."

By 1998, Gilmartin had pulled Merck out of its joint ventures with Sweden's Astra, which has since merged with Britain's Zeneca, as well as its seven-year-old deal with Dupont Merck Pharmaceuticals. He sold off the company's generics business at a time when generics were said to be poised to dominate the industry.

The strategy worked, spurring Merck's revenues from $10.5 billion in 1993 to $32.7 billion in 1999, and pushing the stock price from $22 to $83. Gilmartin's success at Merck came as no surprise to his former B-D colleagues, says Al Battaglia, a retired group president who worked alongside Gilmartin in the late 1980s. "He's thoughtful and, I'm not afraid to say, a wise individual with a strong sense of values and ethics."

But today the company faces yet another set of industry upheavals. In recent years, the Whitehouse Station, NJ-based powerhouse has been overtaken by Pfizer, which was--even before its acquisition of Warner-Lambert--already the uncontested marketing gorilla of the industry. The merger of Glaxo Wellcome and SmithKline Beecham has created another mega-pharma, GlaxoSmithKline, which aims to become the industry leader with 7 percent of the world market (see chart, page 27). (GSK's combined market cap is around $188 billion, well below Pfizer's $284 billion, but just ahead of Merck's $178 billion.)

In addition to this mega-competitor challenge, Merck also faces a cluster of major patent expirations during the next three years, including Vasotec, Pepcid, Prilosec, Mevacor, and Prinivil. These drugs account for 28 percent of Merck's drug sales and 35 to 40 percent of EPS, according to Salomon Smith Barney. Patent expirations are likely to depress Merck's annual earnings growth to about 10 percent in 2001 and 2002 from 17 percent last year, observes Mike Krensavage, pharmaceutical analyst with Raymond James, who worries that the company is unlikely to launch a significant new drug until 2002 or beyond. "This leaves Merck highly reliant on Vioxx, a new painkiller that costs about $2.35 a pill, yet offers no more pain relief than medicines selling for 20 cents."

These challenges are not unique to Merck. Last August, Eli Lilly was caught off-guard when a court stripped almost three years of patent protection from Prozac, the company's legendary anti-depressant. It now faces a $5 billion hole in its projections.

Further complicating matters is the thorny issue of international pricing. Critics in the U.S. argue that high domestic prices are subsidizing drug discounts in other parts of the world, where lack of patent enforcement requires brand name pharmaceuticals to compete on price with generics. At the same time, health care providers in some impoverished countries argue that their governments' compliance with patent laws is blocking access to affordable generic drug treatments for AIDs and other life-threatening diseases available from companies in India and Thailand.

Such arguments, Gilmartin counters, arise from emotional rather than economically informed interpretations of the facts. "For example, [discounting] AIDS drugs in Africa does not disadvantage U.S. consumers, because the competitive environment here means we don't have the ability to cost shift," he points out. "Admittedly, that's a difficult economic concept to get across."

Adding to the anti-pharma fervor, the industry as a whole has been under sharp attack for contributing to the rising costs of healthcare--and seniors' inability to afford prescription drugs--a fact hammered home during the recent presidential campaign. The cost of drugs represents just 8 percent of the total healthcare spending in the U.S. Nonetheless, in the minds of bureaucrats in Washington, drug prices are out of control, and require capping.

"The charges have reached a near-hysterical pitch," Sid Taurel, CEO of Eli Lilly recently told the City Club of San Diego. "We find ourselves exhibited in a lineup of public enemies along with 'Big Tobacco' and 'the big polluters.'"

In its defense, the industry points to the hefty cost of developing new treatments--which run an average of $600 million and can approach $1 billion, according to Taurel. In 2000 alone, U.S. pharmaceuticals spent about $26.4 billion on R&D. Yet only 30 percent of drugs earn the average cost of development, leaving a few blockbusters to carry the day.

The pressure to squeeze more out of each moneymaker before the onslaught of generic competition will require not only more products, but higher yields, which is prompting stepped up marketing campaigns and mergers for scale. Acknowledging that Merck cannot continue to rely on its science alone, Gilmartin is in the process of expanding its marketing and sales force by 30 per-cent in an effort to boost sales of existing drugs and prepare for a host of new product introductions. Among those in the pipeline are substance P, a new drug for treating depression; a super aspirin, etoricoxib; and a next generation version of Vioxx.

Yet the question of competing on scale is by no means settled. Pfizer has transformed itself in the last decade from an also-ran to the "partner of choice" by marketing other companies' drugs. GSK may now do the same. While both will need to prove to investors that size can translate into real growth, Merck also has much to prove, including whether Gilmartin's assurance about Merck's labs and pumped-up sales effort is justified. Fiercer competition, a changing technological environment, and inflated investor expectations promise to test Gilmartin's wisdom.

J.P. Donlon

What Price Health?

What's your view of the concern that the pharmaceutical industry has been "gouging" consumers?

What's driving the rate of increase of the drug bill is the rate of innovation in the industry in terms of the number of new drugs introduced in the last five to 10 years, arid the increasing recognition of the importance of pharmaceuticals as an essential part of medical care. Today, as opposed to five or six years ago, every physician is aware of the importance of lowering cholesterol in someone who has heart disease. Then you add on top of that the aging population. So, yes, the drug bill has been going up significantly, but so have the health benefits.

We can use economics to show that there are no excess profits in the industry when you measure profitability properly. But if you're a senior without coverage, good explanations don't help you. The answer is coverage. Seniors on Medicare should have access to prescription drug coverage; and the way to get there is to transform Medicare as a program that would look a lot like the federal employee health benefits program.

One Congressional proposal would allow importation of U.S.-produced drugs from other countries, another would forbid any company from selling drugs for different prices around the world. Both effectively mean price control. How will that affect you and the industry?

It's been demonstrated in Europe or in Japan that indirect or direct price control has a very damaging effect on innovation in the industry, because it distorts incentives as to what things people spend research dollars on. Economic theory will tell you that selling at different prices according to ability to afford benefits everyone. But there's a lack of understanding about pricing around the world and what its true economic implications are. Having a very competitive market in the U.S.--which we do because competition has been enhanced dramatically by the emergence of managed care--means that prices in the U.S. are set by buyers assessing the value of what they're buying. In Mexico, where people have purchasing power that's 20 percent that of a U.S. consumer, matching prices to address the fact that they have lower purchasing power maximizes the social good and maximizes the profitability of the firm. Does pricing drugs differently in different markets mean that open markets like the U.S., Hong Kong, or Sw itzerland are funding R&D?

If you just restrict yourself to the U.S. market and refuse to do business with someone who's setting price controls on you, you're basically sub-optimizing your ability to do additional research. So what you do is you try not to import those price controls into the U.S., which would just mean we would just do less business outside the U.S. U.S. consumers would not benefit. There would be less money to spend for research.

There's an erroneous impression that Americans are subsidizing other parts of the world. It's just not feasible to think that if you're charging a lower price in one part of the world, you're going to be able to shift that back to a highly competitive market such as the U.S. They do not pay a higher price here, because the competitive environment sets prices.

Merck faces a cluster of major patent expirations during the next two years. What's in your pipeline?

First, drugs scheduled to go off patent went from 58 percent of sales in 1995 to 30 percent by third quarter 2000. Second, we've got more new chemical entities in the early stages of development than ever before. Plus we've got eight major products or programs in late stages of development. And we also have five drugs--Zocor, Vioxx, Singulair, Fosamax, and Cozaar/Hyzaar--that account for close to 60 percent of our sales and are showing strong growth.

I think investors see that that kind of momentum will carry us through the patent expiration period and still allow us to show fully competitive growth rates. The skepticism out there was understandable because to show the kind of growth projection we express comfort with has not been done before, plus we're going to increase R&D 17 percent from $2.4 billion to $2.8 billion and add 1,500 more sales reps. We outperformed analyst expectations last year, and are comfortable meeting the expected EPS range of $3.15 to $3.25 for 2001.

What's the thinking behind increasing your sales force to 6,500, still shy of Pfizer's 8,000-plus?

In the late '80s you could be alone on the market for four or five years with a pioneer drug. Now you're lucky to be on the market for a few months before you have a competitor, which means that you've got to be more sophisticated in your marketing to differentiate your offering. So it looks a lot more like a conventional market and requires sophisticated marketing skills that are probably more similar to what you have in consumer packaged goods. This latest sales force expansion is really to set up the platform for the launch of new products that we're coming out with.

What's your objective with the Medco acquisition?

When I came here, Medco was being described outside sort of as a distribution strategy, but we recognized it collectively as really a pharmacy services managed care type entity. A key decision we made was to keep the two companies independent. The key here is to preserve the strengths of both cultures because they're superbly matched to the businesses they're in. Medco's timeframe is about six months of innovation before someone's on their heels, as opposed to 10 or 12 years.

It's a different fight, and it's a high-turn business with low margin, whereas pharmaceuticals are high-margin, lower-turn business. The philosophy was to grow both companies together faster than either company could grow on its own. It's worked and that, I think, we all feel pretty good about.

What's your view of the claim that the direct-to-consumer advertising trend has driven people to request costly prescriptions from doctors when an OTC product would be sufficient?

Direct-to-consumer advertising is now an important part of any pharmaceutical company's marketing mix, particularly for new therapeutic categories we're developing, to let the patient know that there are new treatment options. In the case of osteoporosis, for example, our consumer advertising is basically directed at women who may be at risk and suggests that they go have a bone density measurement.

If you ask physicians how they feel about direct-to-consumer advertising, they'll say they're seeing patients they should be seeing that they otherwise wouldn't. We make sure that the physicians are informed and are aware of the drug, and, through our detailing efforts, we phase that according to what we do in terms of direct-to-consumer advertising so there's self interest involved as well. From our standpoint, having the patient walk in to see a doctor who's unaware of the drug is wasted effort.

Do you see the human genome project and the technological revolution in drug discoveries as a threat?

Just knowing that a gene is associated with disease, while necessary information, is not sufficient. How do you reduce this information to a target and design a drug to hit that target? The length of time for a new drug, if you had a concept today, is anywhere from 10 to 17 or 20 years, so some of the new knowledge being discovered today is still 10 to 15 years out. On the other hand, we do have more new chemical entities in earlier stage development than we've ever had before. So there are already some near-term incremental benefits accruing. But it's going to be more of a continuum rather than a step function where all of the sudden we have new things.

What concerns do you have about the scale of some of your competitors?

It's the creativity and the talent of your scientists that enables a company to discover drugs, not the brute force of how much money you're spending or scale. Two of our most recent blockbuster drugs, Vioxx and Singulair, came out of a laboratory of about 300 people in Montreal. That's a key indicator that lab size or how many labs you have are not good indicators of what kind of success you'll have in drug discovery.

Over the last decade, Merck has not been the leading spender in research, but Merck has been the most productive in terms of the new drugs discovered and introduced. The kind of success we've had in the marketplace in our ability to compete, to discover and introduce new drugs, reinforces our belief that we're far beyond what you need for critical mass to be successful.

                   How Merck Stacks Up With Mega-Pharma
                Fundamental comparison of pharmaceuticals.
                        Based upon 1999 performance
                                Bristol
                 Abbot American  Myers   Glaxo-  Johnson &  Eli
Company          Labs    Home   Squibb  Wellcome  Johnson  Lilly Merck Pfizer
Sales Growth [*]  6.0     0.3    10.0      8.7      9.0    11.4  17.5   13.3
EPS Growth [*]   10.0    11.0    13.7     15.3      7.5    21.5  14.5   20.6
Gross Margin     55.9    72.7    72.6     80.0     69.3    79.0  46.3   84.4
SG&A/Sales       21.6    37.2    35.0     35.2     38.2    27.6  15.9   39.2
R&D/ Sales        9.0    12.8     9.1     14.9      9.5    17.8   6.5   17.1
Operating Margin 23.9    22.7    28.5     33.2     21.6    33.6  23.9   28.1
Tax Rate         28.0    24.8    27.7     29.0     29.0    22.0  31.9   30.3
Net Margin       18.6    17.2    20.6     23.0     15.2    25.8  17.8   19.0
ROA              14.0    11.1    25.0     38.3     14.6    20.7  17.3   15.8
ROE              28.4    34.0    51.4     64.9     27.5    55.6  44.7   34.7
Debt/Cap         16.7    39.2    13.4     28.6      8.7    36.7  19.2    5.6
                                      Smith
                           Schering-  Kline
Company          Pharmacia  Plough   Beecham Average
Sales Growth [*]   17.4      17.5      1.9    10.3%
EPS Growth [*]     23.2      20.3      8.4    15.1%
Gross Maaargin     73.9      80.4     73.2    71.6%
SG&A/Sales         38.6      37.4     37.3    33.0%
R&D/ Sales         19.4      13.0     12.1    12.8%
Operating Margin   15.9      30.5     23.2    25.9%
Tax Rate           30.0      24.5     27.0    27.7%
Net Margin         12.0      23.0     16.9    19.0%
ROA                 9.0      29.0     15.8    19.1%
ROE                16.9      46.0     42.4    40.6%
Debt/Cap            5.8      16.2     16.3    18.8%
Source: Raymond James Financial, company
reports and FactSet Data Systems.
(*.)Growth rates are historical
three-year averages.
                Merck's Performance Under Gilmartin's Watch
Merck           503.24
S&P 500         186.60
Dow Jones       183.79
S&P Drugs Index 522.03
Source: Elias Management
                           What's Merck's Share?
                   Pharma Market Share in Year End 2000
Lilly    3.1
Roche    3.2
J&J      3.6
BMS      4.1
Novartis 4.1
Merck    4.4
Aventis  4.4
AZ       4.6
Pfizer   6.7
GSK      7.0
Source: Finanical Times and GMC