A Call For Merck To Cut R&D

Aug.21.13 | About: Merck & (MRK)

This is just what people working in R&D at Merck (NYSE:MRK) don't want to see. According to FiercePharma, a prominent analyst is urging the company to get its finances in line with its competitors -- by cutting R&D.

Seamus Fernandez at Leerink Swann says that Merck should reduce their expenditures in that area by around a billion dollars, which is at least eight times deeper than the new R&D head, Roger Perlmutter, has talked about. Here's the whole analysis, which includes this:

We believe a major restructuring at MRK is necessary; movement here likely would be well-received. As pressure builds on MRK mgmt to: 1) improve R&D productivity, 2) maintain top-tier operating margins, and 3) continue returning cash to shareholders, we believe a deep restructuring should be seriously considered in light of the relatively lackluster 2013 top-line performance, disappointing Phase III/registrational pipeline evolution (odanacatib, suvorexant, Bridion U.S.), and overall industry challenges. We estimate that every $1B reduction of operating expenses would add $0.25/share to MRK's bottom line, and would bring MRK's absolute R&D spend closer to PFE's (MP) ~$6.5B but still be in line with several of its diversified competitors' spend at ~14% of sales. A 10% cut in overall operating expenses would equate to ~$2B of annual cost reductions.

If you read the rest, you'll see that the reasons Fernandez has for optimism are all on the financial side of the company: how much cash the company has on hand, its opportunities to do things like sell off animal health, sell off consumer care, and of course its opportunities to cut costs. There's absolutely nothing in there about the company doing better because of anything that's coming along in the pipeline. No, all that drug stuff is in the negative category: doubts about the big IMPROVE-IT trial in cardiovascular, competition for the existing drugs, regulatory uncertainties, and so on. Nothing but trouble.

At this point, it would be easy for me to get up on the lab bench and make a rabble-rousing speech about how short-sighted all this is, how Merck is a research-driven company, not some sort of bank or insurance operation, and so on. I'm tempted. But these points, while definitely not invalid, don't address whether Fernandez might be right about Merck's current situation. He knows as well as anyone that the only reason Merck got to be this size is by discovering and selling valuable medicines, and he knows that this is still the company's core business. Those ideas about selling off animal health and consumer products? Those are supposed to bring in more money to discover drugs. If Merck doesn't do that, they're toast; that's the engine of the whole company.

OK, so why cut R&D if that's the whole reason the company exists? Here's where we get down to it. Fernandez's take is that Merck is spending too much and getting too little back for it. He's not suggesting the of chopping most of the R&D department to make the bottom line suddenly bloom (for a while). This is more of a gas-mileage problem. In this view, Merck's engine is R&D, for sure, but that engine is burning too much fuel (money) while covering too little distance in the process. To stick with the engine analogy, does it really need 12 cylinders? Does it have to be as heavy and humungous as it is? After all, others are burning similar amounts of fuel (or less) and making more progress.

What Fernandez is saying to Roger Perlmutter, as I see it, is: "Throw us a bone, Roger. Show that you seriously realize that things have been going wrong at Merck, and that you understand that the company's gotten in the habit of spending too much money. Show us in the only way that you can, because just telling us that you're going to do things better and smarter isn't enough. Everyone says that, no matter how dumb they are. Even if you really can follow through on that better/smarter stuff, no one will see the results of it for years. Show us something that we can see happening right now."

The question then is whether this sort of cutting and re-engineering can be done without disrupting Merck's R&D even more, and now that is a tough question, and I'm glad I'm not on the hook to provide an answer. The problem is, a company can cut back like this, but still keep the same inefficiencies and bad processes that got it into trouble in the first place. That's what happens when a company lops off a whole division: "We still stink, but now we stink on a smaller scale." It's doing the same not-so-good stuff as it always did, but in fewer areas, and might therefore be even less likely to make anything of it. A company can also cut back in ways that might, objectively, be the right thing to do, but nonetheless end up disorganizing and demoralizing the remaining workers so much that things end up worse than before in that way, too.

These are the downside risks of taking the cut-back-your-expenditures advice, and they're very real. Not taking the advice has real risks, too, naturally. Running a company that size, or its R&D department, is not a low-pressure job with easy decisions. We'll see which way Perlmutter goes, and how he makes his case. Keep in mind, too, that these issues do not apply only to Merck. Not at all.

Disclosure: None.