Merck’s Chief Ex. Faces a US Senate hearing

posted on:
November 18, 2004

author:
Christopher Bowen nad Simon London

When Roy Vagelos stepped down 10 years ago as Merck’s chief executive the company had, in his words, “become the largest pharmaceutical company in the world based on an unprecedented flow of important new products”.

“It was ‘most admired’ not only in the annual Fortune survey for many years but also in the minds of biomedical scientists, patients and physicians around the world,” recalls Mr Vagelos in Medicine, Science, and Merck, his memoirs. “Year after year, it had the highest market capitalization and the highest price-earnings ratio of all the major firms in the industry.”

Merck today is barely recognizable from that description. In an ignominy Mr Vagelos could scarcely have imagined, Raymond Gilmartin, its current chief executive, will appear at a US Senate hearing today to answer allegations that the company delayed pulling Vioxx, its blockbuster painkiller, from the market even though it was aware of concerns that prolonged usage increased the risk of heart failure.

Since the scandal broke six weeks ago Merck’s shares have fallen about 40 per cent, cutting the company’s market value by about $40bn. It has lost its AAA debt rating, a badge of its former blue-chip status. Its price-earnings ratio âe” a measure of the company’s prospects – is the lowest among the big US pharmaceutical companies.

The company is under criminal investigation by the US Department of Justice EL.l1d the subject of a civil inquiry by the Securities and Exchange Commission, the US securities regulator. Lawyers acting for Vioxx users are preparing massive legal actions. Some alarmist observers are even asking if Merck could go bankrupt.

The descent into a morass of legal attacks, regulatory scrutiny and ethical doubt must rank as one of the hardest and most sudden corporate falls from grace in recent memory. The proximate cause, without doubt, is Vioxx. But there are larger doubts – about the quality of Merck’s once-vaunted research and its pipeline of new drugs coming to market, and about whether the company has the right management to get it back on track.

Over Vioxx, Merck is accused of dragging its feet to eke as many years as possible of sales and profit from a drug with questions over its safety.

The anti-inflammatory drug, in the category called cox-2 inhibitors, was developed as a medicine that did not cause stomach bleeding in the way that older generic analgesics such as aspirin, ibuprofen and naproxen could. Often used to treat arthritis, Vioxx became hugely successful.

But Merck withdrew Vioxx after a company study found it doubled the risk of heart attacks and strokes after 18 months of daily use in some patients. The move eliminated its second-biggest selling drug with $2.5bn in annual sales, or about

11 per cent of its total.

The drug’s critics and plaintiffs’ lawyers claim that Merck allowed marketing to trump its scientists, who acquiesced by not asking the right questions in the right studies on Vioxx’s dangers.

Yet if the scandal over Vioxx were not enough, the other products on which Merck depends are also giving cause for concern. Zocor, a cholesterol reducer and Merck’s biggest earner with about $5bn a year in sales, is set to lose patent protection in mid-2006. Drugs in the development pipeline are probably not enough to make up for Zocor’s loss, leaving Merck with uncertain prospects for profit growth until 2008. This follows at least three years of stagnant earnings.

A year ago two experimental drugs – one for depression, another for diabetes – failed within weeks of each other in late stage experiments. This marked one of the most significant failures in decades for Merck and stunned investors who believed that, once the company progressed to that stage of product development, marketing approval was almost a sure thing.

Merck’s prior record of success produced an arrogance that its science was best. Some staff from rival US drug groups referred to Merck’s researchers as the “high priests of science”. Merck focused primarily on selling drugs made in its own laboratories, pumping out numerous 15l0cRbusters including vaccines, treatments for high blood pressure, HIV drugs and cholesterol reducers.

But key scientists left the company, including Roger Perlmutter, now chief researcher at biotech company Amgen, and Emilio Emini, now head of vaccine development at the International Aids Vaccine Initiative.

Some link increasing scientific arrogance to Edward Scolnick, the hard- charging former chief scientist who left in 2002. Mr Scolnick oversaw Vioxx’s development and approval in the 1990s. And the group’s reliance on its own vaunted laboratories left holes in its new drug pipeline. Under Peter Kim, Merck’s new chief scientist, the company has

scrambled to license promising experimental drugs from research institutions and small companies. From having 10 such alliances in 1999, Merck struck 47 last year and plans a similar number this year.

“My dissatisfaction with Merck’s management started a little while ago with Scolnick,” says John Farrall, a money manager at National City’s private client division, who has been selling Merck shares over the past year and a half.

Nevertheless, it has not escaped investors’ notice that Merck’s falling success rate in scientific research has occurred on Mr Gilmartin’s watch. Pressure on the chief executive, who will reach mandatory retirement age of 65 early in 2006, is mounting. Today’s testimony in Congress is an important opportunity to answer critics in Washington and on Wall Street.

“Merck management has gone into the broken-record mode, which is not an encouraging sign,” says Carol Levenson, bond analyst for Gimme Credit, a boutique researcher.

Lawsuits claiming injuries from Vioxx are piling up. In a recent regulatory filing Merck said it was named in 375 suits from 1,000 plaintiffs’ groups. Hundreds of lawyers led by Andy Birchfield of Beasley Allen met last week in California to, in Mr. Birchfield’s words, “jump start the legal drive against Merck”. Mr. Birchfield expects the first

case to come to court next year. Some analysts estimate Merck’s Vioxx liability could exceed $10bn.

However, there is an argument that the sense of crisis may be overdone. According to Tony Butler, an analyst with Lehman Brothers, the stock market reaction to the Vioxx withdrawal suggests that investors expect a liability of $25bn$ 30bn. He believes that is a significant exaggeration.

Similar cases involving pharmaceutical companies – over Pfizer’s Trovan and Rezulin, Johnson & Johnson’s Propulsid and Bayer’s Baycol – resulted in about $1bn each in payouts, and plaintiffs had trouble pursuing class-action cases, Mr Butler says. One exception, however, is Wyeth’s trouble over litigation involving its fen-phen diet drug. That has cost the company $16bn and the total is still rising.

Moreover, the case against Merck’s handling ofVioxx is not as clear as the company’s critics suggest. Many analysts believe Merck will be able to show that it did not withhold damaging data from regulators or the public. And it will be difficult to prove how Vioxx caused a heart attack or stroke.

“Dollar amounts that have been proposed for legal liability seem to be wide and varied,” Mr Butler says. “We have done a reasonable analysis of these factors …which concludes that the market appears to be far too aggressive on Merck’s legal liability.”

In spite of its bond rating downgrade Merck is on a sound financial footing, and will generate an estimated $7bn in net cash each year until the end of 2006. Its dividend is safe.

Along with solid blockbuster treatments for allergies, osteoporosis and hypertension, it has a promising cholesterol treatment: Vytorin, co- marketed with Schering-Plough, another US pharmaceuticals company, which is expected to reach at least $3bn in annual sales. And the company hopes some key experimental drugs could start to generate

revenue in 2006.

Highest hopes have been placed on Merck’s cervical cancer vaccine.
Merck has also formed an alliance with BristolMyers Squibb to develop muraglitazar, a diabetes treatment.

“We still believe that there is value in Merck’s pipeline but this will likely get lost in the negativism from ongoing Vioxx coverage,” notes Timothy Anderson, analyst at Prudential Equities.

The current crisis over Vioxx, then, may not be the whole story. But much evidently depends on how the company responds.

According to Mr Vagelos’s memoirs, Mr Gilmartin was hired as Merck’s fust chief executive from outside the company because of his strategic vision and team-building skills. Even after Vioxx’s withdrawal Mr Gilmartin has the unequivocal support of the board, says William Bowen, a Merck director. “Ask me a hard question,” he says.

But for others, the faster Mr Gilmartin is replaced, the sooner Merck can return to former glory.

The board had been preparing the search for a new CEO when the Vioxx news hit. Although Mr Gilmartin originally said Merck could find his replacement inside the company, the board said it also planned to look outside.

One executive search expert believes the company will choose an outsider, saying: “There are executives better equipped to handle [the current situation] than Merck has internally.”

Mr. Gilmartin has been a custodian of Merck’s conservative culture and a strong believer in the company’s exceptionalism. He remains steadfastly against a large acquisition to boost growth and cost savings, saying such moves add nothing to long-term shareholder value and do not assist the quest for new drugs.

The choice of his successor is likely to speak volumes about the company’s near-term direction. Quick selection of a charismatic dealmaker would transform Merck and its staid culture, a move many see as desperately needed.

“I think it requires a person of vision and savvy who disrupts what is going on right now,” says National City’s Mr Farrall. One radical succession plan, discussed often on Wall Street, is for Merck to buy Schering-Plough, which is struggling with manufacturing problems, a weak pipeline and competition for its key drugs. This would give Merck

two things: 100 per cent ofVytorin’s profits and Fred Hassan, Schering-Plough’s CEO and a renowned turnround boss.

Other subjects of industry speculation include Myrtle Potter, a quick- rising chief operating officer at Genentech, the biotechnology company, and a former star Merck executive; Christine Poon, at Johnson & Jolmson; and Lodewijk de Vinle, former CEO of Warner-Lambert and now in private equity at Blackstone.

The urgency of any shift in strategy could depend on Mr. Gilmartin’s Senate performance today. His doubters believe that if he is to leave the company with his reputation intact – and at the time of his choosing – he must vindicate his strategy and leadership.

A dose of Capitol punishment

Raymond Gilmartin, the chief executive of Merck, will follow in some famous footsteps when he appears before the Senate committee on commerce, science and transportation today.

Who could forget Jeff Skilling’s “I’m not an accountant” defense when the former chief executive of Enron denied all knowledge of the shenanigans at his company? Or the tobacco executives who in 1998 professed themselves amazed to

learn that smoking was bad for your health?

Congressional committee hearings provide some of the best theatre in American public life. So it is no surprise that big corporate chieftains try to avoid such appearances.

The commerce committee’s witness list for the last five years shows that chief operating officers or vice-presidents for legal affairs are more likely than their bosses to be sent into the political cockpit.

“These hearings are not really meant to give you a chance to say anything. They are held to give committee members an opportunity to make speeches,” says Dick Martin, until 2002 executive vice-president for public relations at AT&T, the telecommunications group.

In matters of life and death for the public – such as the Vioxx affair – however, chief executives cannot deputise. They must appear in person.

In 2000, Jacques Nasser and Masatoshi Ono, then chief executives of Ford and Firestone respectively, were asked to account for rollover accidents that were linked to more than 100 deaths involving Ford Explorer vehicles. Mr. Nasser used his testimony to blame Firestone, saying that it had supplied defective tyres. Mr. Ono offered a brief apology in

halting English before, through a colleague, pointing out that only 10 per cent of Ford Explorer rollover accidents involved tyre defects. Both men lost their jobs soon after.

So what is Mr. Gilmartin’s best strategy for survival? If the experience of other big companies is any guide, Merck’s lobbyists will brief him on the voting record and likely stance of each committee member. From Merck’s legal affairs department will come explanations of the company’s potential liability and cautions against saying too much. From public affairs will come warnings against appearing evasive by saying too little.

“Executives get overwhelmed with conflicting advice in these circumstances,” says Joseph Vranich, a California-based executive coach. “I always ask them: ‘Regardless of what everyone else thinks, what do you think needs to be done?’ They have to accept responsibility and speak from the point of view of authenticity.”

But an honest, authentic testimony alone is unlikely to turn the tide of opinion in Merck’s favour. Effective damage limitation demands concrete action. Gary Winnick, former boss of Global Crossing, the once high-flying telecoms group, announced during a Congressional hearing that he was giving $25m to employees who lost money when the

company’s stock price collapsed.

“You have to respond by doing something, whether it is firing senior executives or giving money to the families affected. It is not enough to manage the message,” says Mr. Martin, formerly of AT&T.

Yet, however well prepared he is for today’s hearings, it is likely that Mr. Gilmartin will have to think on his feet. Unexpected questions could be asked and attacks could come from unlikely quarters.

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