Merck Business Strategy:

Expanding Through Open Innovation Case Report

MGT 6125
Strategic Managment
Spring 2010

Stanislav Komsky
“The ability to remain innovative is what makes companies rise and fall... All our ideas have one thing in
common: They not only safeguard the future of Merck, but above all that of our customers” says Dr.
Plaumann, a Merck project manager. Merck, or Merck Sharp & Dohme, is the 9th largest pharmaceutical
company in the world by revenue. Merck, headquartered in New Jersey, has recently been in the news
for its merger with Schering-Plough in a $41 billion deal. Although the two companies have had a strong
partnership in the past, it is believed that this merger will create a truly global company with a stronger
research and development pipeline.

The pharmaceutical industry currently ranks 3rd in the fortune 500 list of most profitable industries with
19.3% of 2008 revenues counting as profits. Historically, the pharmaceutical industry is known for
blockbuster drugs and high margins. The competitive environment in the pharmaceutical industry began
changing in the late 1980’s due to a decrease in sales volume, a decrease in innovation, and an increase
in drug-specific industry competition. The market began a decline in annual growth rate and had
dropped 10% between the 80’s and 90’s, but manufacturers fought the 15% drop in sales volume by
increasing prices 132%. Starting in 1987, the cost of a new drug had risen $250 million because of
increasing regulatory procedures and complexity of the compounds developed.

In the United States, rigorous product quality regulations by the FDA compelled drug companies to
invest in more advanced production technology to guarantee untainted drug manufacturing. Also, the
EPA began a more stringent supervision on manufacturing emissions, requiring expensive pollution
control and waste treatment equipment, as well as containment facilities for more complex drug
production. Regardless of government regulations, there were internal factors affecting the conditions
of pharmaceutical production stemming from competition within the industry. Exhibit 1 shows the
difference that regulations created on the pharmaceutical value chain. Drug exclusivity was in rapid
decline because more companies were developing similar products. Companies are quicker to develop
competitive product lines, and this change has led to lower sales of novel drugs. This competition within
drug classes takes a heavy toll on pharmaceutical companies’ profit margin, especially considering that
the peak of drug sales comes around the fifth year of commercial production due to a continual
increased in customer demand after product launch, and competitive products are being launched after
two or three years.

Most new drugs that are released are not able to reap the benefits of the fifth year of sales because
similar drugs are being distributed after two or three years. Alongside large company competition of
drug classes were the steadily increasing generic substitutes. By 1993, approximately 50% of all
prescriptions were filled with generic products of brand name drugs, and by 2008, this number was
increased to about 72%. These generics were generally 30% to 60% lower priced because the generic
companies had no need to recoup R&D or marketing costs. Also, it only took a single generic alternative
to subject an entire drug class to price reduction equaling the generic price, crippling multiple drug
companies simultaneously. Since all of these new pressures were taking such a large toll on major
pharmaceutical companies and their production, the industry began to reconsider its development and
innovation strategies.

Alongside the increased regulations, research costs, and pressures from generic drugs comes increased
competition. Although any high profit industry attracts strong competition, the pharmaceutical industry
has an especially competitive landscape. Exhibit 2 displays the increased growth of players in the
pharmaceutical industry, along with the total number of drugs released for commercial production per
year. Exhibit 3 shows the cost to develop a new drug over time, which includes the costs of the tens of
thousands of drugs that never make it to market for every 1 that does. In 2006, the cost per new drug
was 1.318 billion and takes between 10 to 15 years. Exhibit 4 shows a drug development timeline,
including FDA approval and clinical trials.

Through this increasingly harsh environment, Merck has kept profits up or something. Merck’s main
core competency is its employees’ competence and skills, as Merck hires top of the line researchers.
Another core competency is its research and development pipelines. Although Merck can gain a
competitive advantage with the intellectual property that comes with the patent, any competitive
advantage of this nature will go away with the expiration of the patent and the introduction into the
market of generic substitutes. With an inflation of competitors on the market and a much tougher path
of research and development to create a drug, a competitive advantage in the pharmaceutical industry
cannot be sustained beyond a patent lifeline.

In 2008, Merck spent $4.8 billion in research and development, filed 216 patents and only had 1 product
approved by the FDA as shown in exhibit 6. Merck estimates that “1 out of every 5000-10,000
compounds screened becomes an approved drug” and that “it takes an average of 10 to 15 years at an
average cost of more than US$1 billion to develop a successful medicine.” There is no question that
Merck’s research and development and innovation engine needs a boost, and this boost can come from
open innovation.

Exhibt 5 shows Business Weeks top 50 most innovative companies of 2007 of which Merck is ranked
46th. It is important to note that 31 of the 50 use an open innovation strategy. Open Innovation is a new
paradigm which assumes that in order to gain a competitive advantage, firms should use external ideas
in addition to internal ideas. This treats a research and development pipeline as an open and global
system, rather than a closed in-house system. Henry Chesbrough, a professor at Haas School of
Business, states that “open innovation is the use of purposive inflows and outflows of knowledge to
accelerate innovation. With knowledge now widely distributed, companies cannot rely entirely on their
own research, but should acquire inventions or intellectual property from other companies when it
advances the business model.”

This business model, in the words of Chesbrough, can “create value by leveraging many more ideas, due
to their inclusion of a variety of external concepts, and can also enable greater value capture, by using a
key asset, resource, or position not only in the company's own business model but also in other
companies' businesses.” This business model has taken effect in the United States’ leading companies,
including Google, Apple, and Microsoft. Merck claims in its annual report that “to deliver important
products to the people who need them, we need a global environment” and that “the sharing of ideas
across scientific disciplines enables Merck to continue to build on our culture of innovation.” Although, a
pro-innovation and pro-global development culture exists at Merck, it has not yet taken? to be an open
innovation company.

Open Innovation can indeed help Merck “meet the needs of its customers in creative and cost-effective
ways that also bring value to its shareholders.” Exhibit 7 shows the increase of alliances in the
biopharmaceutical community. Companies are realizing that in order to survive and thrive in these
harsher times, it is important to share and collaborate on ideas. Open innovation can let companies
bring their individually unique strengths to research and development in the pharmaceutical industry,
and can be mutually beneficial to the corroborators. For Merck, open innovation can increase its
research and development pipelines. Merck would be able to take ideas from the outside scientific
community for new innovative products.
For a company the size of Merck, any large change can be both time consuming and costly. Merck needs
to keep on its current track of external research and development, but to compliment this track, needs
people that are in charge of bringing in the outside technology and research. For Merck to change from
its old innovation paradigm to the new open innovation paradigm, as shown in exhibit 9, it will need to
begin sharing knowledge and research with the outside. Merck can do this by letting their unused
pharmaceutical ideas be used by others and by making greater use of external ideas and developments.
According to Chesbrough, “this could include the greater use of purposive outbound knowledge flows by
companies, the emergence of a secondary market for intellectual property, and the creation of new
organization roles and practices for identifying, incorporating, and adding value to external knowledge
sources.” As exhibit 8 shows, the research and development funnel for the open innovation model has
many more pathways for ideas to come in and more processes on the outside of the funnel when a
product needs to be taken to market.

Overcoming resistance to change and selling the new open model to Merck’s employees could prove
difficult. The first step would be to get research to give equal importance to both internal and external
knowledge and begin to realize a competitive advantage from e. They also need to be more intone with
the scientific community and create an outbound flow of knowledge, for example begin publishing more
journals and studies with previously internalized Merck data. With this increased sharing of knowledge
and data, Merck needs to step up its intellectual property management. Strategic partnerships need to
be made and maintained carefully with universities, small pharmaceutical and biopharmaceutical
startups, and the pharmaceutical research community.

Merck should be careful not to begin engaging externally without a clear innovation strategy. With more
industry experts recommending an open innovation strategy, it might be tempting for Merck executives
to being its path into externality without first overlooking its goals and strategy. As large part of this is
having a clear view of how to handle its intellectual property, it might be advisable to Merck to hire
lawyers that are open innovation intellectual property experts. Another area that Merck should be
careful in is its relationships with potential partners. Merck needs to make sure it clearly evaluates the
needs and goals of potential outside partners as well as the values and opportunities created by working
with them.

The next steps for Merck to pursue in order to enter into the open innovation world include human
resource spending. Not only should Merck hire intellectual property experts and lawyers to protect itself
in the sharing and collaborative environment, it should hire project managers that research staff that
can expose the company to outside opportunities. Merck needs to develop strong partnerships with the
leading scientific universities, and create a mutually beneficial environed that includes learning and
development on both sides. The first step, however, is to officially formulate its strategy of how to
approach open innovation both internally and externally before opening its research gates to the
outside world.

Exhibit 10 shows a SWOT analysis of Merck. Although pharmaceutical companies are historically very
profitable, increased laws and government regulations, an increased flood of generic drugs, and
increased competition have all lowered the market potential. Merck needs to explore new strategy to
widen its research and development strategy, and open innovation could be the answer. Open
innovation, the new collaborative development concept that is being used by several of today’s most
innovative companies, can help Merck by exposing it to outside knowledge and resources. Taking on
open innovation could be both timely and costly, but might be necessary for Merck to not get
leapfrogged by the incoming dynamic generation of pharmaceutical copies.
Exhibit 1. The Pharmaceutical Value Chain After 1990.
RESULT HAS BEEN DECONSTRUCTION
OF THE PHARMA VALUE CHAIN
Manufac- Sales &
1980’s - Research Development Trials Registration
turing marketing
Early 1990’s

Increased development costs

Role of global launches increasing
Quality outsourcers leverage scale advantages
in individual layers of value chain (specialized)
Easier IT enabled coordination and knowledge management

Manufac- Sales &

Research Development Trials Registration
turing marketing
PBMs HMOs
Academic labs JVs/
CMOs licensing
Late 1990’s -
Early 2000’s
Biotech firms
CSOs
Contract research organizations

Note: PBM=Pharmaceutical benefit management,

HMO=Health maintenance organization,
CMO= Contract manufacturing organization,
CSO=Contract sales organization
Source: BCG analysis
Exhibit 2. Number of drugs and companies per year in the pharmaceutical industry.
Exhibit 3. Cost to Develop a New Drug Over Time.
Exhibit 4. New Drug Development Timeline.
Exhibit 5. Business Week World’s Most innovative Companies of 2007.

*Red Implies Practice of Open Innovation

Exhibit 6. Merck R&D Pipeline 2005-2008 Performance Data.
Exhibit 7 . Number of Biomedical Alliances 1990 to 2005.

Number of Bio Medical Alliances 1990 to 2005

2500

2000

1500

1000

500

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Drug-Biotech Biotech-Biotech Drug-Drug Uni-Biotech Uni-Drug

Exhibit 8. The Open and Closed Innovation Paradigms.

Closed Innovation

Open Innovation
Exhibit 10. SWOT Analysis.

Strengths Weaknesses
 One of the largest players in a high profit  Currently using an old closed innovation
industry methodology and missing outside
 Strong Research and Development opportunities.
Pipeline with 200+ pharmaceutical patents  Close expiration of patents of top selling
a year drugs
 Temporary patented protection of  Larger difficulty creating a competitive
intellectual property advantage from intellectual property
because of increased government
regulations

Opportunities Threats
 An open innovation methodology with  Increasingly competitive market with
information sharing and increased use of many new players coming into the
outside resources pharmaceutical industry every year
 Larger collaboration with universities,  Generic drugs are becoming a large part of
pharmaceutical startups, and the the market, with an estimated 72% of
pharmaceutical community pharmaceutical sales
 Increasingly more expensive and a longer
time to market for newly developed drugs
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http://www.eclipse.org/org/foundation/membersminutes/20070920MembersMeeting/07.09.12-
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