Reference no: EM133041122

Pat Harlow, chief licensing officer, was preparing for the next meeting of the KL-798 project team. KL798 was a new drug developed by Kappa Labs with the promise of treating obesity and, as a possible side benefit, lowering elevated cholesterol levels, a condition that often accompanied obesity. Merck had been approached by Kappa Labs, a small biotech research firm, with the proposal that Merck buy the rights to KL798 for an upfront payment of $30 million and royalty payments over the first 10 years of the product's market life.

Even though KL-798 was only partially through Phase I trials and a long way from commercialization, it had attracted considerable interest among Merck scientists. It represented an exciting direction for the development of other drug products; it might simultaneously address two medical conditions faced by a substantial and growing portion of the world's population; and it would provide an important new product for the research pipeline.

At its next meeting, the project team would have to develop its response to Kappa Labs. As team leader, Harlow would be expected to guide the discussion and shape the response. Harlow turned her attention to preparing for the meeting.

Merck

Merck was a global research-driven pharmaceutical company that discovered, investigated, developed, manufactured, and marketed a broad range of human and animal health products directly and through its joint ventures, and provided pharmaceutical-benefit services through Merck-Medco Managed Care.1 In 2000, sales exceeded $40 billion, and net income was nearly $7 billion. Over the preceding 10 years, Merck sales had grown at an 18.1% compound annual rate and net income at a 14.4% rate. (See Exhibit 1 for financial highlights.)

Merck's enviable performance was rooted in its focus on core values and on its cutting-edge science program. The company frequently recalled the words of George W. Merck, president (1925-50): "We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear."2 Those core values resulted in Merck's being listed among the 18 visionary companies in Collins and Porras's best seller, Built to Last, and a perennial member of Fortune's Ten Most Admired Companies and 100 Best Companies to Work For.

Over the last six years, Merck had introduced 16 new products, 5 of which had become the key drivers of its growth: Vioxx (osteoarthritis), Zocor (high cholesterol), Cozaar/Hyzaar (high blood pressure), Fosamax (osteoporosis), and Singulair (asthma). Together, these medicines accounted for 57% of global sales in 2000 and 46% in 1999.[1] During 2000 and 2001, five U.S. patents would expire: Vasotec (hypertension), Mevacor (high cholesterol), Pepcid (ulcers), Prinivil (hypertension), and Prilosec (heartburn); the U.S. market for these products exceeded $3 billion. Continued growth was predicated on an aggressive and successful research program. To that end, Merck spent more than 8% of its sales' revenue on internal research and development and complemented that commitment with collaborations with more than 40 companies, institutes, and universities around the world.

The Product-Development Process

The development of a new pharmaceutical product was a long and failure-ridden process. Ten to twelve years were generally required to bring a product from basic research to market; for every marketable product, between 5,000 and 10,000 substances were explored in the laboratory. The product-development process was driven by the multistaged approval process of the U.S. Food and Drug Administration (FDA).

-Preclinical testing (2-3 years): research and laboratory testing on animals to assess safety and to analyze biological effects.

-Phase I trial (1 year): testing on 20 to 80 healthy volunteers to determine safety and dosage.

-Phase II trial (2 years): testing on several hundred patient volunteers (some with the drug, some with the placebo) to evaluate effectiveness, and identify side effects.

-Phase III trial and regulatory-agency approval (5-6 years): testing on several thousand patient volunteers over several years to verify effectiveness on a broad mix of patients and identity adverse reactions from long-term use, culminating in approval from such agencies as the FDA.

The KL-798 Opportunity

Two months earlier, Kappa Labs had approached Merck with a proposal that Merck purchase the rights to KL-798 for an upfront payment of $30 million and royalty payments over the first 10 years of the product's lifetime. Because KL-798 was in Phase I trials and FDA approval, if granted, was seven to nine years in the future, the royalty payments would essentially span the remaining patent-protected life of any emergent product.

Obesity was a therapeutic area with huge potential. It was characterized by a large patient population and a small number of relatively ineffective (even life-threatening) drugs. According to the Centers for Disease Control and Prevention:

-The obesity epidemic spread rapidly during the 1990s across states, regions, and demographic groups in the United States. Obesity (defined as being 30% above ideal body weight) increased from 12% of the population in 1991 to 17.9% in 1998. Overweight and physical inactivity account for more than 300,000 premature deaths each year, second only to tobacco-related deaths.

For a number of years, the medical benefits of weight loss and the difficulty of losing weight (and maintaining that loss) had sparked interest in pharmacological solutions. The recent link between a popular prescription weight-loss drug (fen-phen) and heart disease had heightened concerns about this approach. Although over-the-counter drugs were generally harmless, they were of questionable effectiveness.

As a result of these market conditions, the successful commercialization of KL-798 would be enormously valuable to Merck. If the product could be marketed for the treatment of both obesity and cholesterol reduction, the project team estimated that the drug would have a market value of $510 million. (This and all subsequent market values represented the present value of the resultant cash flows, including royalty payments to Kappa Labs but excluding the costs of the clinical testing needed to gain approval and the initial $30 million licensing payment.) This $510 million market value assumed that physicians could prescribe this one drug for patients with both maladies as well as for patients with either malady. If the approval process limited the drug to just one malady, the present values would be $430 million if the drug were approved for obesity and $50 million if approved for cholesterol reduction.

The Phase I trial of KL-798 had been under way for nearly six months. To date, there had been no severe adverse reactions from the test population of 65 healthy volunteers. Based on its review of Kappa Labs's research notes and its own limited experience, the project team believed that KL-798 had a 60% chance of successfully completing Phase I. Were Merck to buy the rights to KL-798, the cost to the company of completing Phase I would be $5 million-half of the total cost. (This and all subsequent costs of approval are expressed as present values.)

In KL-798's Phase II trial, Merck would organize a group of several hundred patient volunteers to determine the compound's efficacy in the treatment of obesity and high cholesterol as well as to document any side effects. The final determination of efficacy would rest on the degree of statistical significance of the difference in effect on those patients with the condition (obesity and high cholesterol) who had been given KL-798 versus those who had received a placebo. The project team estimated that there was a 10% chance that KL-798 would show indications of treating obesity only, a 10% chance of treating high cholesterol only, and a 30% chance of effectively treating both conditions at the same time. Phase II would require two years to complete, and would cost $40 million.

If KL-798 succeeded in Phase II trials, the next step in the approval process would require that it be administered to several thousand patient volunteers over several years. The test population, the cost, and the success of this third phase of testing-and, ultimately, FDA approval-would depend on the results of Phase II. If the Phase II results indicated that KL-798 was effective in combating obesity only, the Phase III trial, leading to a product that treated obesity only, would cost $50 million and would have a 75% chance of ultimately receiving FDA approval. If the Phase II trial indicated that it was effective in treating high cholesterol only, the Phase III trial for the commercialization of a cholesterol-treatment product would also cost $50 million and would have a 70% chance of achieving final approval. If, however, the Phase II results indicated efficacy for both maladies, the required Phase III trial for the introduction of a single product that treated both obesity and high cholesterol would be more extensive and would be specifically tailored to the introduction of that single drug as treatment for both maladies. Because of the specialized population required for this trial and the additional complexity of testing for both multiple and joint indications, the cost would be $140 million, substantially more than the other two tests combined. The trial could lead to approval for the treatment of both maladies (60% chance), approval for the treatment of obesity only (15%), or approval for the treatment of high cholesterol only (10%).

Questions

1. Assume that Merck will follow the advice of George W. Merck, "We never try to forget that medicine is for the people. It is not for the profits. The profits will follow, and if we have remembered that, they have never failed to appear." (This means that if there is success with a phase, Merck pursues the next phase.)

a. Build a decision tree to evaluate the decision facing Harlow. What would you recommend? (Be sure to state all your assumptions and show all your analysis.)

b. To which assumption (other than Mr. Merck's) is your analysis most sensitive, and what might be done to manage the related risks?

c. Foresight Consulting has offered to conduct research that will enable it to predict KL-798's outcome in the Phase 1 trials. How much would this information be worth to Merck if Foresight's predictions were always correct?

2. Suppose we relax the assumption that we will always follow Mr. Merck's advice. How much does the expected value increase? Now what should we do with regard to KL-798?