Zocor Sales To Take $500 Mil. Hit In 2003 From Merck Inventory Program

Merck's change in inventory management practices will reduce Zocor sales in 2003 by $500 mil.

Zocor sales are now expected to be in the range of $4.9 bil.-$5.2 bil., a decline of 7% to 13% versus sales of $5.6 bil. in 2002.

During its third quarter conference call Oct. 22, Merck announced a new inventory management plan that will result in a reduction in fourth quarter revenues by $650 mil.-$750 mil. Zocor will represent the majority of that total as a result of Merck's decision to time implementation of the initiative late in the year.

Zocor sales are skewed in the third and fourth quarters as wholesalers buy extra inventory in anticipation of a January price increase, followed by a buy-out early in the year. Merck typically takes an annual 4% price increase for Zocor.

"We had a buy-in here in the third quarter, so you're getting the buy-out next quarter, as well as you won't have the large buy-in in the fourth quarter," Investor Relations Senior Director Mark Stejbach explained. "It's working through all of these things that comes out with the net effect."

Merck is changing its inventory practices against the backdrop of a disappointing year overall. Merck acknowledged that its performance for the year would fall short of its projected double-digit earnings growth even without the distribution changes.

Going forward, the inventory program is intended to "moderate the fluctuation in product sales that are currently affected by wholesale investment buy-in, and also importantly, to improve the efficiency and distribution of Merck pharmaceutical products," CEO Ray Gilmartin said.

While Merck's "wholesaler inventory levels remain within a range customary for Merck products," the "sales of our products will be more in line with the underlying demand on an ongoing basis," he added.

Effective Dec. 1, Merck will pay fees to wholesalers in exchange for managing inventory through purchasing restrictions. "We're going to be looking in the new program to...lower existing limits on our average monthly purchases of Merck products by U.S. customers," CFO Judy Lewent said.

"In concert with that, we'll be providing fees to wholesalers for the value they provide in the distribution of Merck products, and we'll also include performance-based fees to keep inventories at our below targeted levels."

Historically, Merck's "normal range" of inventory has been one month or less, and "even with buy-ins, we typically don't see more than two months on any individual product," Lewent told analysts. Going forward, Merck will maintain levels at less than one month.

Merck is the latest drug manufacturer to announce an inventory management program; similar initiatives have been implemented by Bristol-Myers Squibb, Johnson & Johnson and Genzyme.

Trade management issues have taken on a much higher profile since Bristol restated its earnings for 1999-2002 based on inventory accounting issues (¹ (Also see "Bristol Restates, But Reforms Continue; Q3 Charges Show Old Habits Die Hard" - Pink Sheet, 17 Mar, 2003.), p. 32).

The move toward inventory management agreements has raised its own issues on the wholesaler side. Bristol renegotiated its new inventory program with Cardinal after the wholesaler complained that it undervalued its services (² (Also see "Cardinal Wants New Deal With Bristol; Inventory Practices Reduce Rx Growth" - Pink Sheet, 28 Apr, 2003.), p. 15).

Cardinal struck a more conciliatory tone three months later, declaring that inventory programs are not a threat to wholesaler profitability (³ (Also see "Wholesalers “Secure” Despite Changes In Inventory Practices, Cardinal Says" - Pink Sheet, 4 Aug, 2003.), p. 19).

Merck is taking steps to avoid wholesaler push-back; the company describes its program as a "partnership" with the major distributors. "We have spent quite a bit of time working with the key wholesalers to explore what makes sense for them and what makes sense for us," Lewent said.

"What you're seeing here is a result of continuing dialogue, and I think it's a program that is being well received, because it does meet both of our objectives in a very effective way," she added.

Cardinal and McKesson expressed enthusiasm for Merck's program during separate Oct. 23 conference calls, with Cardinal declaring that Merck's program precisely fits with its new business model of fee-for-service wholesaling (see ⁴ (Also see "Cardinal “Fee-For-Service” Model Includes Rx Product Integrity Payments" - Pink Sheet, 27 Oct, 2003.) ).

Merck maintains it has never encouraged wholesalers to stock up in order to meet quarterly sales targets. "We do not provide any incentives for any kind of buy-ins," Gilmartin declared.

"What we're really describing is actions by the wholesalers taken in their own anticipation of price increases, but they're not pre-announced," he said. "There are no incentives or discounts."

Merck's announcement sparked questions from investors during the third quarter conference calls about other companies' inventory programs.

Pfizer CEO Henry McKinnell used a question about inventories to contrast the company's careful management of trade stocking with "other companies."

"We don't have incentives for trade distribution. In fact, many of you are looking at this issue in other companies I'm sure," McKinnell said during an Oct. 22 call. "We've always stood out on this issue, with managing wholesaler inventory levels to about .6 months...and that's exactly where we are today."

Pfizer has long had a reputation in the trade for limiting forward buying opportunities.

McKinnell explained that tight inventory management does not always mean that reported sales trends match up exactly with underlying prescription demand.

"This is always an exceptionally difficult analysis when you are looking at growth rates," McKinnell said. "We don't actually match growth rates every quarter. We get ourselves to the targeted inventory levels every quarter."

As a result, there are "minor" fluctuations between sales growth and script trends, depending on "whether we were trending down or trending up in the prior year."

During 2003, Pfizer is seeing a significant impact from working down Pharmacia's trade inventory to harmonize with its practices.

Lilly also downplayed the impact of quarterly inventory fluctuations on its results. While Lilly experiences "some swings from quarter to quarter," the fluctuations "naturally sort of work themselves out within a quarter or so," Investor Relations Executive Director Simon Harford told analysts Oct. 22.

"We do not have any sort of excessive stock at the wholesaler level," Harford added. "Our underlying demand is pretty much our underlying demand, bar those sort of minor swings from quarter to quarter."

AstraZeneca may be the next company to switch to the fee-for-service model.

"We are and have been looking at implementing inventory management agreements and we've got a form now that we're comfortable with, with most of the large U.S. wholesalers, some of which could be implemented in the fourth quarter," CFO Jonathan Symonds said during an Oct. 23 conference call.

"Then hopefully we'll start to see a flattening or a more predictable trend of sales that might line up more closely with underlying prescription trends." AstraZeneca's inventory swings have been most pronounced for Nexium and Seroquel .

For Merck, reporting inventory fluctuations has become a routine part of quarterly earnings calls.

For example, in the third quarter, Merck reported buy-ins for Zocor ($110 mil.), Singulair ($120 mil.) and Fosamax ($10 mil.), and buy-outs for Vioxx ($145 mil.) and Cozaar / Hyzaar ($15 mil.). Merck reported a net $60 mil. buy-in across the entire product line.

Apart from the inventory issues, Merck is having a difficult year. In addition to Zocor, the company is revising downward its 2003 sales guidance for Singulair and Fosamax.

The top end of Singulair guidance has been lowered by $100 mil. to $2 bil.-$2.2 bil., reflecting a smaller upside impact from the allergic rhinitis indication. Fosamax guidance was reduced by $100 mil. to $2.6 bil.-$2.8 bil., due to a lower-than-expected benefit from the Women's Health Initiative study.

Merck also announced a 7% headcount reduction, or 4,400 employees. Related restructuring costs will be roughly $140 mil. to $200 mil. in the fourth quarter with an additional $75 mil.-$125 mil. in charges next year. Merck expects $250 mil.-$300 mil. in annual savings.

Taken together, the restructuring, inventory program and lower product sales will prevent Merck from meeting double-digit earnings growth guidance. Earnings per share is now expected to be $2.90-$2.95, versus prior guidance of $3.40 to $3.47.