Merck & Company: Evaluating a Drug Licensing Opportunity Risk Management and Finance, GM0415 March 2019 Group 14: Oliv
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Merck & Company: Evaluating a Drug Licensing Opportunity
Risk Management and Finance, GM0415 March 2019
Group 14: Olivia Pivén - 960704 Jeffrey Fleischle - 871105 Ellinor Joelsson - 941218 Max Sundgren - 950430 Marcus Olsson - 940425 Johan Horn - 941226
Course Coordinator: Evangelos Bourelos
1. How has Merck been able to achieve substantial returns to capital given the large costs and lengthy time to develop drug? The pharmaceutical industry is one of the largest industries in the world in terms of sales, profits, market capitalization, and R&D (Metrick & Yasuda, 2010). Furthermore, drug development is carefully regulated by government agencies which in turn forces drug companies to take their R&D projects through well-defined stages. For this reason, companies have to invest large amounts of money and resources in the development procedures. However, to make the lengthy process and expensive procedures for pharmaceutical companies advantageous, they are given the opportunity to apply for patents. An approved patent gives the pharmaceutical firm exclusive rights to the drug in terms of manufacturing, marketing and making profit on the compound. Since Merck has managed to hold several approved patents, they have been able to achieve substantial returns and competitive advantage on previously developed drugs. Those drugs have generated a substantial source of income and returns. However, the approved patent does not give exclusive rights to the drug for eternity. The granted patent eventually runs out which gives competitors allowance to compete for the customers producing the same generic drug. Thus, when the patent expires the unit price of the drug is severely lowered and potential financial returns is reduced. The patent for Merck’s most popular drugs would expire by 2002 which therefore obligates them to invest in new products which can yield in profitable revenues. According to Metrick & Yasuda (2010), alliance and licensing is the major source of funding (much more than VC) for private and small public biopharma companies. It is therefore not surprising that Merck’s business strategy consists of developing partnerships and initiate licensing deals with smaller biotech companies and develop, manufacture and market new drugs through internal research. Another factor of importance related to the competitive advantage of Merck is the interchange of knowledge that is made when partnering with smaller pharmaceutical firms. Merck can piggyback on the smaller firms R&D and in return provide them with their expertise taking the drug to market, and getting the FDA approval. The know-how which have evolved over time also helps Merck evaluate when a drug has potential and when it does not, i.e. the capability to make better investments. It is not only the single investment in a new drug that should be evaluated, but the portfolio of investments previous experience of the firm has generated the capability to evaluate many investments and balancing them to achieve a diversified portfolio of drug-projects (as described in the case: “refreshing the portfolio”).
2. What is the strategic importance of this project? What is the initial asset in which the future success is expected? Why people are putting money to this project? There are several factors that highlight the strategic importance of this project for Merck. To begin with, the company’s portfolio is in a need of a refresh due to the fact that the patents for many of their most popular drugs expires in 2002. After the patents’ expiration date competitors will start to sell substitutes, which probably will lead to a huge loss in sales. The best way to counter this loss of sales is to find new, innovative drugs to refresh and broaden Merck’s portfolio. The drug Davanrik seems to have a high potential to be the next strategic move for Merck. Davanrik is expected to generate sales and is also an interesting product since it might be able to cure two different disorders, which can be seen as the initial asset of future success of the drug. The new drug also fits into Merck’s current product portfolio, since it aligns with the overall objectives of the company - to be of the leading edge of therapeutic categories. Furthermore, Merck is in a good position to negotiate and could potentially make this deal advantageous for their part. Their good position to negotiate is mainly because of LAB’s financial situation, which is currently unstable due to failed FDA approval which caused their stock price to fall by 30%. LAB is also a small pharmaceutical concern, with no proven track record, lacking the resources to manufacture and market the drug themselves, which put them in a certain position of dependency. LAB was also the one who approached Merck first and gave them an offer, which usually gives Merck a better starting point and a higher bargaining power which rises the incentives to invest in this project further. In addition to that, this project is a good investment opportunity, people would reasonably be interested in putting money into this project because Davanrik could cure many people’s terrible diseases and contribute to the public health. 3. How should we evaluate the attractiveness of this opportunity? At first glance, Davanrik seems to be a good investment since the compound has the potential to possibly treat both depression and obesity. However, making an investment decision of this size based on just a first impression or gut-feel could be a fatal and costly mistake. Especially in the pharmaceutical industry which is characterized by long time horizons and high failure rates due to the high regulations and fixed stages for reaching an FDA approval. In every stage there are many risks which the project is exposed to and must be accounted for. According to Metrick & Yasuda (2010) there are three types of risks that a project like this can be exposed to; technical risks, business risks and competitive risks, which are unique in each of the three clinical stages. To properly evaluate the opportunity of investing in
Davanrik the following quantitative financial measurements could be used and appraised, in combination with qualitative aspects: Qualitative methods for evaluating the attractiveness of the investment that could be performed are: 1. Due diligence - especially looking into why LAB’s FDA approval was denied, since it could potentially expose important information and insights to consider, 2. Evaluation of the stakeholders of LAB and 3. Competitor analysis and comparison of recent licensing agreements of other companies. The quantitative financial measurements and methods that should be applied in this case are: 1. Calculate the cost of capital (COC) using the Capital Asset Pricing Model (CAPM), 2. Expected return on investments, to find out if the return on the investment is higher than the COC, 3. Net Present Value (NPV), through using a Monte Carlo Simulation, 4. Discounted Cash Flows (DCF) analysis to determine the value of a company by forecasting future cash flows and discount them back at a discount rate, 5. Real Options analysis, by spotting and valuing options, 6. Decision tree evaluation and probability. However, one must acknowledge that these financial values are quite hard to calculate since they will be based on estimates, assumptions and forecasts about the future. Söderberg (2018) has emphasized that the only thing that is true about a forecast is that it will be wrong. Thus, to mitigate the risk of putting too much effort into making accurate estimations for risks that is not really that high, a tornado analysis is helpful. The tornado analysis visualizes variations and sensitivity of NPV attributable to uncertainty in the forecast assumptions which gives the key value drivers of the project. The key drivers are useful for setting up different scenarios i.e. best case, worst case and basic/normal case. A Monte Carlo simulation and real options analysis can be used more broadly to get better estimates for the total valuation. 4. What type of information asymmetry problem could take place in this case? Find and present one example in the business literature where asymmetry problem was a crucial factor of a joint project's failure. Information asymmetry is a problem that creates an imbalance of power in transactions due to that one party has more or better information than the other party. Moral hazard and adverse selection are common examples of this type of condition. (Lecture 3 Entrepreneurial finance, Mallios). In this case, a potential problem with information asymmetry could be spotted. LAB has an advantage since they most likely hold more information and knowledge about the development process, quality and the potential success rate of the drug Davanrik than
Merck does. One can reasonably assume that LAB hold on to any negative attributes regarding the new drug in order to make this deal go through, which creates an imbalance of power in the transaction. Thus, the problem of adverse selection seems to be relevant to consider. An example of a joint venture that has failed primarily because of an information asymmetry problem is the joint venture between Danone and Hangzhou Wahaha Group. The Hangzhou Wahaha Group is the largest beverage producer in China and Danone is one of the world's largest food conglomerates. They initiated the Joint Venture during 1996 when Danone acquired 51% of Hangzhou Wahaha. The dispute between the two companies started in 2007 when Danone discovered that Hangzhou Wahaha had started a parallel firm to market similar products as their Joint Venture (China Economic Review, 2007). Danone later accused Hangzhou Wahaha of secretly creating and operating a series of companies that sold the same products as their Joint Venture with the Hangzhou Wahaha trademark. This serves as an example for a classical moral hazard dilemma. Also it was the start of a long-running legal dispute since it turned out that both parties had broken their initial agreement. (China Economic Review, 2007) Thus, the starting point of the failure was an information asymmetry problem since Hangzhou Wahaha withheld important information that threatened their collective business. 5. List the risks for LAB and Merck respectively. Which corporation you think is taking higher risk, LAB or Merck and why? Find and present one example in the business literature where two companies collaborate and take different types of risks. In the case of an eventual collaboration between Merck and LAB, one has to consider the potential risks that comes with the collaboration, and consequently could affect the parties (see appendix A1). According to the literature there are three different types of risk connected to a R&D investment like the one in this case; the technical risk, the business risk and the competitive risk. The first is present during the whole development process and concerns efficacy and safety; factors that directly affects market size and share as well as growth. The second concerns the last half of the development process, phase 3 and an eventual FDA approval, and is related to changes in consumer preferences for example from pricing and reimbursements. Lastly, the third risk type concerns first half of the development process, phase 1 & 2, with its focus on the behaviour of other companies. (Metrick & Yasuda, 2011) This could be intellectual property, pricing and increase in sales efforts however it is not considered since LAB in our case has received a 17-year patent on their drug.
Considering the risks for each party in the collaboration between LAB and Merck, the risks will look a little different for each company. Following the terms of the license agreement, Merck will be responsible for the approval process of Davanrik, its manufacturing and the marketing activities. Moreover, Merck will pay an initial fee for the agreement, royalty on all future sales as well as additional payments as Davanrik advance in the approval process. With this in regard, LAB has let go off all control of Davanrik which is a risk itself since they have no power to control future events of the development and will be heavily dependent on Merck. Thus, a failure in developing Davanrik could become a huge blow for LAB whom does not have a drug portfolio to fall back on, which is the case of Merck. Considering this factor, LAB is undoubtedly the most exposed party in the collaboration. On the other hand, LAB lack both resources and capital to proceed, and also has a history of failing in FDA approvals which makes it a must to find a partner. Moreover, one has to consider the risk of asymmetry of information between the two companies. Since two actors are involved in the collaboration, there is always a risk that one of the parties have essential information that they do not share with the other party, which could affect the development process. LAB might be more exposed in case of a failure, however Merck is taking a substantial financial risk by investing and putting more money into the project which originates from another company. LAB is already out of capital so the financial risk for them is minor. Thus, in case of financials, Merck is clearly taking a much larger risk than LAB. In addition to that, LAB displays a history of several approval failures which makes this project uncertain and risky for Merck. Also, to increase the uncertainty, one could argue that the chances of getting approval through three phases over a period of seven years are small or even close to minimal. All together it could be argued that Merck is the most risk exposed party of the two in this collaboration, even though LAB is the party most dependent of a positive outcome. An example of a collaboration between companies is the one between Repsol and Burger King who formed a strategic alliance to profit from individuals coming to the gas stations not only for filling up the tank. The Spanish gas station company thereby holds the exclusive rights to have Burger King restaurants in gas stations in the country. Burger King sends directives to Repsol’s staff while Repsol stations act as franchises. The collaboration has resulted in a significant growth for Burger King and the aim is to reach 150 restaurants, with an investment of $50 million. With this investment and aim, Repsol will hire around 1500 new employees. (Tureira & Cros, 2013) This collaboration has turned to be effective, however there are still risks to consider. Firstly, Burger King will send directives to the
Repsol restaurants which decreases Repsol’s control of their own restaurants. That said, by acting on distance Burger King also take a risk of losing control since they give access to their brand to an external actor. Even though directives are sent to Repsol, there are no insurances that they are fully followed. Moreover, by investing $50 million into the project, Burger King takes a major financial risk if the success would stop. 6. Which factors mitigate the risks you listed previously for LAB and Merck? Naturally, when it comes to mitigating risks, it is about mitigating what is related to the actual type of risk. For example, in technical risks one has to consider the efficacy and safety in order to mitigate the risk and this is done by asking certain question. These questions will answer for the efficacy and safety and could for example be ‘is this product equivalent to the standards’? These questions will be asked over the entire process since the technical risks are present from phase 1 to FDA approval. (Metrick & Yasuda, 2011) Since Merck is taking over the approval for Davanrik this risk will consider them, hence it is up to the management of Merck to continuously ask these questions in order to ensure the quality of the product, and mitigate the technical risk. When it comes to mitigate the business risk it is important to consider the factors that affect the business part; consumer preferences. Therefore, it is crucial to ensure that there is no gap between expected consumer preferences and the reality. Furthermore, pricing could be a decider dependent on how sensitive consumers are for price changes in the particular category. (Metrick & Yasuda, 2011) In Merck’s case they must find ways to get a grasp of their future customers’ preferences and behaviour. This is done for example through market surveys or by creating prototypes for the consumers to try. In order to mitigate the competitive risk, is more complex since there will always be actors coming up with substitutes. Therefore, the market awareness is crucial, to follow trends and be in the forefront to ensure strategies for a competitive product. Moreover, besides a competitive product focus lies on protecting one’s intellectual property to maintain the position on the market. (Metrick & Yasuda, 2011) Davanrik is successfully patented over 17 years so the risk is already mitigated to some extent. That leaves Merck to focus on protecting that patent from potential lawsuits and creating a strategy to be competitive in the market with competitor’s strategy and pricing in regard. All the mentioned risks are connected to the approval process, hence do not really relate to LAB since they give Merck all the control in this process. The risks related to LAB is rather
the case of asymmetry of information. Clearly, it will be impossible to avoid asymmetric information since LAB and Merck never entirely will know each other’s company. In order to mitigate this risk one suggestion would be to be as transparent as possible during the complete approval process, so LAB gets insight in Merck and in return gives Merck equal information in order to keep the information flow symmetric. That could be done for example by having representative groups for each company meet during the approval process. Moreover, LAB is heavily dependent on a positive outcome in this approval since the risk of failure could mean a huge blow to their company. This risk is mitigated to some extent already by reaching a license agreement with an experienced company as Merck, with a history of several FDA approved drugs. 7. Are these risks (related to questions 5 and 6) associated with higher expected returns? In general, risk and return is correlated in a sense that higher risk should also yield higher average return. That is, without any risk, no return. In relation to this is the concept of firmspecific and systematic risk. Firm specific or idiosyncratic risk, also known as diversifiable risk, is the risk directly related to the company or project at hand, like the compound Davanrik in this case. This means this risk can be diversified towards zero by holding a portfolio of the underlying asset like stocks or companies in the case of venture capital firms. In contrary to firm-specific risk, we have systematic risk. This kind of risk is also known as market risk or non-diversifiable risk. As the name implies this risk cannot be diversified in a portfolio. It reflects broader risk that cannot be affected, for instance economic downturn that affects the whole market (Berk & DeMarzo, 2017). With this in mind, relating back to question 5 and 6 and the discussion of the three types of risks involved in an R&D investment like Davanrik: technical risk, business risk and the competitive risk, it can now be concluded that the risks identified are solely firm-specific risks. That is, related to either Merck or LAB (Davanrik) depending on which perspective one take. From Merck’s perspective, the listed risks (firm-specific) associated to investing in Davanrik will be diversified when the compound is added to the portfolio of Merck consisting of 15 other drugs they have. From LAB’s perspective, the same diversification of the risk associated to Davanrik cannot be achieved since this compound seems to be the only promising project that LAB has in their pipeline. However, by licensing the compound to Merck, who is an established and leading actor on the market, this will most likely increase the chances of success of commercialising Davanrik. In total, joining forces as Merck and LAB aim to do by entering a licensing agreement of the compound Davanrik, will imply a
project full of risks as discussed above. However, based on the calculations that will be presented below and previous answers, our assessment is that Davanrik has a proven potential and thus can expect a higher return of commercialising it (since LAB on their own lacks the resources of doing it at all). 8. What would be your ideas in order to improve the opportunity? In order to elaborate on ways to improve the opportunity given, the business roles of Merck and LAB Pharmaceuticals need to be clarified. Merck is a global research-driven pharmaceutical company and has commercialised 15 products. However, the patents on some of their best selling drugs will expire in coming years leading to a “substantial” drop in sales. Therefore, Merck is in need of adding new promising project to their portfolio in order to maintain the leading position of therapeutic categories. LAB pharmaceuticals on the other hand is a small concern. Despite the fact that LAB has had a few promising compounds in phase II and III none of their products have been approved by FDA. Recently the FDA denied a compound which made LAB’s stock price of 30 %. This has put LAB into a position desperately in need of capital which is also why they have approached Merck with the licensing proposal of their pre-clinical platform of Davanrik. Now, once the business roles of the two companies and their motives have been established, it can be concluded that there are obvious incentives for both parties to make an agreement on this project. According to the proposed licensing agreement, Merck with its know-who and resources would be responsible for funding, approving, manufacturing and commercialisation of Davanrik while LAB develop the compound. However, an alternative to the proposed licensing agreement, is if Merck acquire LAB as a whole entity instead. This would improve the opportunity and create a win-win situation for both Merck and LAB for several reasons. First, it would limit the risks involved with information asymmetry that would be present if Davanrik was only licensed while Merck and LAB remained separate companies. Second, potential synergies between the pharmaceutical companies could be captured and exploited. Merck has successfully developed numerous products and can thus add “know-who” and complementary assets to LAB who has not yet. Thirdly, LAB would receive a solid ownership in Merck and much needed capital in order to continue its operation. Merck would get LAB and their research portfolio, including the patent of Dvanrik, at a discount price since the stock price has fallen with 30 % recently due to FDA denial. The actual bid amount Merck would propose for acquiring LAB is difficult to establish since we lack enough information. Logically, summing the present value of the intended initial fee,
the milestone payments and the expected royalties (during the 10 year period) is the first step. Then Merck could offer this amount minus a discount for acquiring LAB. The discount should reflect the probabilities that Davanrik does not make through all phases of FDA approval and the fact that they pay the total amount up front (time value of money). Given a reasonable price tag, Merck could acquire LAB and the promising patent of Davanrik at a substantial discount and LAB would receive much needed capital and a strong owner with proven “know-who” enabling them to continue operation and commercialise Davanrik which is the main goal. 9. Build a decision tree that shows the cash flows and probabilities at all stages of the FDA approval process. The figure in appendix A2 is a decision tree for Davanrik where the costs (including licensing fee) and present values (PV) are in millions of dollars discounted to time 0, as given by the case. The probabilities (P) are indicated as percentages. The only decision included in this decision tree is the one to license or not. Hence, further decisions to potentially abandon the project sometime during the process is not shown in the decision tree, although it’s a possible decision. Thus, the rest of the tree consists of events. An assumption made is that the FDA has an approval rate of 100%, since it was not specified in the case. Although this might not be completely realistic, it is a simplification made. 10. Should Merck bid to license Davanrik? How much should they pay? To answer this question, it is important to discuss the main decision criteria first. A first and very important factor is the net present value (NPV) under which Berman & Knight (2006) understand “the present value of cash flows at the required rate of return of a project compared to an initial investment”. In this section, we focus mainly on NPV as it is a proven decision tool when choosing among alternatives (bid or no bid). The logic decision rule for investments calculated with NPV is to take the alternative with the highest NPV and only invest in projects with positive NPVs and reject negative ones (Lecture 7 - Investment decision, Bourelos). As mentioned earlier, Mercks most popular drugs are about to expire which is anticipated to affect the sales negatively. Seeing as the NPV of licensing Davanrik for Merck is 13.98 million dollars (excluding the royalty fees that are coming in questions 11), we argue that they should bid to license (see appendix A3). Moreover, we also argue that they should pay maximum 13,98 million dollars based on the NPV. However, if we would assume a royalty fee of 5% on the given cash flows after the launch, the price would instead be maximum 7.1 million dollars (see appendix A4). To construct a tornado analysis (see
appendix A5), a discount rate of 5% has been used to re-discount the values form the case. After that, the different factors have been applied to create a best and worst case NPV compared to the main one of 13,98 million dollars. In this sensitivity analysis, you can see how changes in these four variables have a big impact on the NPV. In this way, Merck can get a hint of how sensitive the project is, e.g. a change of 20% in commercialization present value could result in a very high NPV or in worst case a negative one. 11. What is the expected value of the licensing arrangement to Lab? Assume a 5% royalty fee on any cash flows that Merck receives from Davanrik after a successful launch. First, there is an intangible value of the licensing arrangement to LAB which has already been described in question 6. That means, LAB could profit a lot from the experience and the name (reputation) of Merck in the FDA approval process. It is of high importance to get the drug through this process and Merck could have better ways and options as an experienced player in the market. If we look now on the calculations attached in appendix A6, we have calculated an expected present value of licensing agreement to LAB on 16.7 million USD, taking 5% of royalty fees into account. This amount can be divided into licensing fees (9.8 m USD) and royalty fees (6.9 m USD). The licensing fee is the sum of fixed initial licensing costs (5m), plus probabilities multiplied with licensing milestone payments to LAB for each scenario. The royalty fees are calculated as probabilities of each scenario multiplied with royalty fee and present value. Our assumption is that the drug Davanrik successfully passes FDA approval process which leads to the payment of the 5% royalty fees. 12. Conclusion It is evident that this license agreement could be a strategically important and valuable opportunity for both LAB and Merck. LAB is in desperate need of resources and funding to realize Davanrik while commercializing the drug would give Merck a cash flow for the future. Although the risk of losing control is apparent for LAB, it is argued that Merck is the one taking the largest risk by investing in a drug facing a long process of approval steps. The project has a positive NPV of 13.98 million dollars indicating that the investment would increase the value of the firm. Nonetheless, with regards to the positive NPV, tornado analysis, and the analysis of qualitative measures we recommend that Merck should make the investment.
Appendix A1. List of risks in case of a collaboration between LAB and Merck. Perspective LAB
Perspective Merck
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Losing control to Merck
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Financial risk (responsibility)
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Risk of failure (nothing to fall back on)
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No FDA approval
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No FDA approval
Long process (3 steps) with no guarantees, partner with bad record.
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Asymmetry of Information
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Major investment into nothing
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Asymmetry of Information
A2. Decision tree
A3. Project NPV, excl. royalty fee. Question 10 Assumption: The accumulated costs of every phase is spent in the beginning of that phase. E.g. The cost for the first phase happens in year/time 0 and the launching cost is hence occurring in year 7. Moreover, all numbers are taken from the case and already discounted to time 0.
A4. NPV including royalty fee of 5%
A5. Tornado analysis (excl. Royalty fee) - Question 10)
*Present Value is the commercialization present value.
A6. Calculations on Value of Licensing Agreement incl. Royalty fee of 5% (Question 11)
Reference list Berman, K. & Knight, K. (2006). Financial Intelligence: A Manager’s Guide to Knowing what the Numbers really mean. New York: HBR press.
Berk, J. & DeMarzo, P. (2017). Corporate Finance. 4. uppl. Harlow, Essex, Pearson Education Limited. Bourelos, E. (2019). Investment decision. Lecture at Handelshögskolan, 2019-02-27 China Economic Review (2007). Danone v. Wahaha. September 01, 2007. Retrieved 201903-07 from https://chinaeconomicreview.com/danone-v-wahaha/ Investopedia (2018). Asymmetric Information. Retrieved 2019-03-07 from https://www.investopedia.com/terms/a/asymmetricinformation.asp
Mallios, A. (2019). Entrepreneurial Finance. Lecture at Handelshögskolan 2019-01-28
Metrick, A. and Yasuda, A. (2011). Venture capital & the finance of innovation. 2nd ed. Hoboken, NJ: Wiley. Söderberg, Magnus (2018). Forecasting, Lecture at Handelshögskolan, 2018-01-16. Turiera, T. & Cros, S. (2013). CO Business 50 examples of business collaboration. Barcelona: Infonomia.