Merck & Co: Blockbuster Drugs - [Business Breakdowns, EP.189]
01:06:25 Share

As an investor, I'm always on the lookout for tools that can truly transform the way that we work as a business. AlphaSense has completely transformed the research process with cutting-edge AI technology and a vast collection of top-tier, reliable business content. Since I started using it, it's been a game-changer for my market research. I now rely on AlphaSense daily to uncover insights and make smarter decisions.

With the recent acquisition of Tegas, AlphaSense continues to be a best-in-class research platform delivering even more powerful tools to help users make informed decisions faster. What truly sets AlphaSense apart is its cutting-edge AI. Imagine completing your research five to ten times faster with search that delivers the most relevant results, helping you make high-conviction decisions with confidence.

AlphaSense provides access to over 300 million premium documents, including company filings, earnings reports, press releases, and more from public and private companies. You can even upload and manage your own proprietary documents for seamless integration. With over 10,000 premium content sources and top broker research from firms like Goldman Sachs and Morgan Stanley, AlphaSense gives you the tools to make high conviction decisions with confidence.

Here's the best part. Listeners can get a free trial now. Just head to alpha-sense.com slash invest and experience firsthand how AlphaSense and Tegas help you make smarter decisions faster. Trust me, once you try it, you'll see why it is an essential tool for market research. The entire idea of business breakdowns is to focus on businesses, how they operate, and when they have the opportunity to invest in something that will return significant results, they should do it.

On a personal level, you should be thinking about this as well. And it's hard to find something more important than sleep. Eight Sleep has legitimately been a game changer for me. I've lived for decades just saying I was a bad sleeper. But what I quickly learned is that I've been living a lie. The Eight Sleep Pod has climate control capabilities, and it's hard to emphasize just how impactful they are for getting deep sleep.

You can go as low as 20 degrees below room temperature to knock you out. And then it gradually adjusts during your sleep to enhance the REM cycle, the deep sleep cycles, all that scientific stuff, which is, I can tell you, insanely important and wakes you up insanely refreshed. It fits right over your existing mattress, so it's very easy to install. And you have two separate climate controls. So my wife doesn't have to turn into an icicle form of Walt Disney while I'm cooling off on the other side.

You may have heard of 8sleep from friends, a couple guys I know, Elon, Zuckerberg, they're rumored to be 8sleep users. The hype is real. You can head to 8sleep.com slash breakdowns and use code breakdowns to get $350 off a Pod 4 Ultra, which is what I've been using. The pod currently ships to the United States, Canada, United Kingdom, Europe, and Australia. And you will thank me later. This is Business Breakdowns.

Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you.

To find more episodes of Breakdowns, check out joincolossus.com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers, or affiliates may maintain positions in the securities discussed in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

I'm Zach Fuss, and today we are breaking down one of the world's largest and oldest pharmaceutical companies, Merck. The company has been shaping medicine and fostering innovation for over 130 years. From its humble beginnings as a small family pharmacy in Germany, today's iteration of Merck has transformed into a near 300 billion market cap business with a particular strength in oncology. At the heart of Merck's recent success is Keytruda,

arguably the world's most important cancer drug. This single medication now generates over $25 billion in annual revenue and comprises nearly 50% of Merck's total revenue. The future of Merck will be highly dependent upon its ability to navigate an ensuing patent cliff for Keytruda in 2028 by successfully commercializing combination therapies and via a robust R&D and M&A pipeline.

But Merck's story is not only about Keytruda. It's about a company that's consistently pursued innovative science combined with a handful of bold decisions, which resulted in the development of some of the world's first vaccines and breakthroughs in diabetes treatment. It's a story about the high-stakes world of drug development, where billions are spent on research and patents are fought over the world's next blockbuster drugs.

To break down Merck, I am joined by Ashwin Varma, who is currently a medical student at UT Health San Antonio. Today, we will unpack Merck's business model, explore their industry-leading oncology franchise, examine their pipeline of future drugs, and understand how they've navigated the complex world of pharmaceutical patents and regulation. We hope you enjoy this conversation on Merck.

All right, Ashwin, looking forward to this one. Pharmaceuticals and biotech are a complicated space, but this is a pretty interesting company that's at a bit of a crossroads in its evolution.

Typically, we kind of start these things with a high level about the business we're speaking about, in this case, Merck. But given your background and experience, I think it would be helpful to the audience to maybe provide a bit of an introduction to yourself. I understand that you're pursuing a medical degree and have experience in the oncology space. So maybe just tell us a little bit about what's topical as we dive into Merck here today. Yeah, super happy to.

I'm a huge fan of the podcast. I listen to it pretty religiously, have learned a lot. So happy to now be given something back to it. I am currently a medical student. I'm about to be done, actually, and move on to residency. But before coming to medical school, I worked in pharma. So I worked at Celgene, which is now part of BMS in their immuno-oncology business development group, where I was evaluating external drugs that were being developed by other companies that

cell gene may want to either acquire outright or build some sort of partnership with. So that was sort of my big first introduction to the pharma industry. Worked with some great mentors there, learned a ton. I then switched over to the academic side, still in immuno-oncology though. I worked with a guy whose name is going to come up later in the podcast, Jim Allison, who is one of the pioneers of immuno-oncology, and his wife, Pam Sherma, to run some clinical trials at MD Anderson down in Houston.

again, focused on immuno-oncology before coming to med school. And then interspersed in all of that, I've done a little bit of consulting for some VC firms here in the biotech space. So trying to put together different vectors of attack for understanding the space, both industry-wise, venture-wise, as well as on the academic side.

Perfect. I think it makes you well-suited to explain this one. If I kind of zoom out on Merck, in my work on the business, I came to learn that it's a business that's dominated by one blockbuster drug and an extremely rich history of blockbusters. Perhaps to kind of set the table here, if you can just take us through the history and evolution of Merck, and then we'll dive deeper into the current iteration of the business and where it finds itself today.

Yeah, yeah. It's a very rich history that Merck has. It's probably the most famous, I would say, of the big biopharmaceutical companies.

Not that I think your average person knows what any of them are, but if they're likely to know one, it's probably Merck. All the big pharma companies, so Merck, Pfizer, Bristol, they all have their history sort of in the late 1800s. In Merck's specific case, it's actually a branch of a German company. There was a German Merck, too, that was started in like the 1600s. And then they opened a branch office in America in the early 1900s. And I

And at that point, they were basically just a manufacturer of small, fine chemicals. So in this case, opioids, which were a known drug class at that time. The separation between German Merck and American Merck happened around World War I when Germany was sort of the enemy and the U.S. government nationalized all the U.S. properties of the big German chemical and pharmaceutical companies. George Merck, who was the U.S. founder, bought back the company at auction from the U.S. government.

and founded what we know today as the U.S. company, U.S. Merck. There is still a German Merck. It's a completely different company, though. The company kind of went along in this interwar period. The modern pharma industry was born in World War II, and it was born out of the penicillin project.

So penicillin was, many people might know about it, it's a very, still to this day, very widely used antibiotic. It was discovered in the UK in the 1920s and then rediscovered in the 40s, but it was really, really hard to produce. And so UK scientists who discovered it came to America and recruited a bunch of companies to try to help mass produce penicillin. And the US government

enlisted the existing pharmaceutical industry to help produce it. They were really wildly successful with that. If you read off the names of the companies who were at that meeting, it's the modern pharmaceutical industry. It's Merck, it's Pfizer, it's Squibb, it's all the companies that you know about today. I mean, what the penicillin project really made these companies realize is that you could actually discover new medicines.

You could do rational research and development efforts and discover new products that would be very useful for medicine and make you a lot of money. And so when you think of the modern pharmaceutical industry as this research and development oriented, product development oriented industry, that's where the origin really starts. Merck was a pharmaceutical, a really great pharmaceutical firm for a couple of decades. But then the modern Merck that got this reputation for being maybe the best drug development organization of all time

really came in the 80s. They had had this dry spell for drug development for about 10 years, and then they hired a guy named Roy Vagelos.

probably the most famous biopharma CEO of all time. And he joined the company and he oversaw it during the 80s and the 90s when they released just an incredible string of blockbuster medications. And so these are things like the statins, the ACE inhibitors, proton pump inhibitors, bisphosphonates for osteoporosis. These drugs may not mean anything, but they're still drugs that I learn about in medical school today. They're still drugs that are prescribed by the millions. And

It's really hard to overstate how successful Merck was during the 1980s. Most of these drugs made over a billion dollars in net sales. Merck's profits and sales tripled and doubled, respectively. They had less than $2 billion of sales in 1980. They had $40 billion in 2000.

And so this was the period where Merck really became known as this excellent drug development organization. That period came to a really abrupt end in the early 2000s. And from about 2000 to 2010, the stock actually declined about 40%. And sales were down from about $40 billion in 2000, like I said, to over just $27 billion in 2010. And the reason was that their pipeline of new drugs really dried up. They had a bunch of really big clinical trial failures.

And then they ran into a big lawsuit, which people might have heard about in the Vioxx lawsuit, where there was some alleged malfeasance with clinical trial results. And so all of that compounded into a really bad decade for the company. But then in 2010, the current iteration, as you referred to, of Merck was spilt. We can talk about that later.

I think a few weeks back, Matt hosted the folks from RTW, which I think served as a great compliment to this conversation as you think about the biopharma industry at large. And it kind of seems to me like the landscape for these companies is somewhat similar in that

They have a cohort of highly revenue generating drugs. I'm speaking to kind of a large cap multinationals, which they have, of course, fostered over decades of research and development. And then kind of a longer tail of new R&D efforts or call options within their portfolio backfill the portfolio as the legacy drugs have patents that expire.

And so I thought we can kind of run through as it relates to this episode, what I'll call Big Pharma 101 and thinking through how you go from phase one through commercialization of these drugs and ultimately the patent expiry that a lot of them then face. I think that's a great description of what these big multinational pharmaceutical companies do. Things that I would add is I think of this business as a hits-driven business. So it's very R&D intense. Like you said, you're constantly having to do R&D to develop new drugs.

The product development cycle is very structured due to the FDA regulations. And it's also IP dependent, unlike other businesses where they may have some IP component to it. Here, IP is all you really have to defend the economic returns for your product. And once that IP expires, and it tends to do so in a very discreet way, the revenue and the profits from your drugs diminish very, very quickly.

And so therefore, you have to have a constant pipeline of drugs that you're developing to fill up the portfolio of drugs that you have on the market as some leave. It's maybe worth a double click on the actual product development cycle. We keep saying this word, develop drugs, develop drugs, but how you actually do that, it's worth a little bit of an introduction to that. So first of all, it's worth talking about what are you actually developing? And there's really like two big types of products in the industry. There are small molecule products, and then there's biologics products.

So small molecule products are the original type of product that was made by the pharma industry, beginning all the way back in the 1950s, like I talked about. These are like very small molecules. And the way I think about them is you can literally draw them on a piece of paper in front of you. And they're made via traditional synthetic chemical methods in big tanks. And those drugs are, I would say, it used to be close to 70. Now it's probably close to 50% of revenue of the entire industry. The second type of product is a biologic.

And typically, the type of biologic that has become very popular is something called a monoclonal antibody. This is a very complicated product that are produced in bioreactors from living human cells. They really became a large part of the industry in the late 1980s. And so if you've heard of firms like Amgen, Genentech, Regeneron, or any biotech, quote unquote,

firms, this was the product that they were inventing in the 1990s. But now the lines have blurred and both the big multinational large cap companies like Merck, as well as companies like Genentech, they all sort of make both types of products. The reason it's worth knowing that there are two different types of products

is they have very different economics, particularly on the IP expiration side. And that's starting to become really, really important. And then the other thing that's probably worth talking about is just that there's a very structured product development cycle. So just because you come up with a molecule that you think is useful in the lab doesn't mean that that's a drug and you can just start giving it to people. You have to go through a very structured set of

processes to prove to the FDA, which is the regulatory body that governs the whole pharmaceutical industry, that your drug is safe and effective in humans. And so you take it through a set of clinical trials. People may have heard phase one, phase two, phase three clinical trials. This is just a sequence of human trials where you either prove that the drug works or you learn that the drug fails. And phase three in particular is the run where you're

you're actually confirming whether this drug works. They're very big. They're very expensive. You can spend up to $100 million on a single trial. And that whole structured product development cycle takes about seven and a half years. On the high end, it can go up to like 15 years. And on the low end, it can be like four years. It's a long time. So you have to plan your R&D efforts considerably ahead of time because developing a product doesn't just take six months. It

It takes seven and a half years, basically. That's sort of the industry. We develop products. We try to develop a portfolio of products that have very high revenues and very high profits that can offset the inevitable loss of some of those drugs in the portfolio. And so I think that means from an analyst perspective, I think you can sort of break up evaluating a pharma business and do a couple of key levers. The first lever is just how good is the pipeline?

How many new drugs do they have in phase three, phase two, phase one? And do you think that those things are going to be approved or not? The second is once those drugs get to market, how big are they? How many people use them? What price can you charge for them? And how much margin dollar is dropping down to the bottom line? And then the third is the sort of outflow of that, where how is their IP situation on all of the drugs that they have in the portfolio?

Do they have three drugs that are about to lose IP protection? Okay, well, that's something that you have to keep in mind as an analyst. So those are sort of the three buckets that I sort of think about when I'm looking at any pharma company, Merck included.

And so if I kind of look at the financial profile of Merck today, obviously it jumps off the page that they have a handful or perhaps one drug that contributes a disproportionate amount of the revenue. But what is the basic layout of the P&L of this business and the geography and business mix? Effectively, it seems like it's a cancer business to me, but perhaps that's misinformed. How would you describe it?

No, I think that that is a good way of describing Merck. Merck right now is a cancer business. Merck right now has a market cap of about $285 billion and revenue of about $60 billion. Around $53 billion of that is pharmaceuticals. They actually do have a second segment of the business that we won't talk about too much, which is the animal health business that accounts for about $5.5 to $6 billion of revenue. And that's like a legacy business that they've had in since the 1950s.

They used to have other segments. They sold off their women's health products and their biosimilars business. They spun it off into a company called Organin in 2021. But of that $60 billion, $25 billion of that is just one drug, which is Keytruda. And Keytruda is a cancer drug. So it's very accurate to say that this company is a cancer company. That's about 40% of its sales. And that's pretty heavy. Most pharmaceutical firms don't have one drug that is responsible for 40% of their sales.

So that's pretty unusual. The way that I might say it is Merck is sort of a cancer and vaccines company. So a lot of the other part of the revenue comes from their portfolio of vaccines, which is another legacy business. They've been making vaccines since 1950s. The big one is Gardasil, which is a vaccine that prevents cervical cancer and does so very well, by the way. It's almost eliminated HPV-oriented cancer. So I would encourage anyone to get HPV vaccinations. It's a pretty amazing drug. But that did about $8.8 billion in sales in 2023. And then

And then they've got three other vaccines for a host of other viral diseases. And together, those do about 4 billion. And then there's a couple of smaller products here and there. They've got a diabetes drug. They've got a drug for COVID-19 that people used to think of as very promising has become less so as the pandemic has abated.

And together that gets you to about the $60 billion top line. Speaking a little bit more generically, pharma is a high gross margin business. And the reason that it's a high gross margin business is these drugs do not cost a lot of money to manufacture.

Now, small molecules cost almost nothing to manufacture. So these are pills that you might take in a bottle and get from your pharmacy. Those cost very little, on the order of $5 per pack, regardless of what the price that you're selling that drug for is. Biologics, which are the antibodies of which Keytruda is one, are a little bit more expensive, probably around $150 a gram of that is where Morgan Stanley Benchmark did a couple of years ago. But it's still only 5% to 10% of the price.

And so once you throw in some of the other stuff that goes in the gross margin line item, things like royalty costs and things like that, you're typically looking at a gross margin for these pharma companies of above 70%. The really good ones can get up to 75% and Merck's about 73%. So this is a high gross margin business. Some of the other big P&L items, advertising and marketing spend is another huge line item that typically runs you around 15% to 18% of sales for the industry. For Merck, I think it's about 16%.

It's actually really important. Some of this is fixed costs. You can think of the advertisements that you see on television for drugs during the Super Bowl. But sometimes it's also more variable where they'll have sales reps or science liaisons who go to visit physicians and who go to conferences and try to educate physicians on the clinical data surrounding a drug. So that's another big line item there that you've got to keep in mind. And then the last one, of course, is the R&D bucket. This is the most R&D intensive industry in the world.

It's more R&D intensive than the semiconductor industry, than the software industry, than any other industry that I think you'll have covered on the show so far. It typically runs you about 20% of sales. We got to be careful with Merck's 2023 data because they have one huge acquisition that they did, which skews the numbers. But in 2022, they did about $13.5 billion of R&D, which is around 20% of their sales.

All of that, you add it up, you get to about an operating margin of around 30%, which again, is the highest of any industry in the world. So I think the key lesson you got to be aware of as an analyst is that the operating margins of this industry does not necessarily mean return. Sometimes you can use...

operating margins as a nice proxy for returns on capital. But you have to be careful about that here because R&D is not capitalized. You just put it on the P&L. You don't actually put it on the balance sheet. And once you capitalize your R&D expenditure as an intangible asset, like a brand,

your return on capital only is actually slightly higher than the average industry once you do that. But what's different about pharma is there's really high variance in your return on invested capital. So when a company is doing well, it does really, really well. Whereas when a company is doing poorly, it's pretty bad. And so I think that actually gives you a lot of opportunity as an investor to find opportunities where you feel very strongly about a company and can make a lot of money investing in it.

So when you consider R&D

There's the general thought that you can do organic or inorganic R&D. Organic meaning you reinvest within your business. Inorganic meaning you make acquisitions. It seems like the company has become increasingly acquisitive, presumably that has much to do with the ensuing patent cliff of Keytruda. But I guess I'd be curious how the dynamics with that blockbuster junk interlope with how the business thinks about its R&D spend.

Yeah, so I'll sort of divide this into the two components of the question. The one is the patent scenario surrounding K Truda. And then the second is the acquisition and the R and D strategy.

So on the sort of IP side of things, the reason I brought up small molecules versus biologics earlier is there are differences in this dynamic. So for small molecules, the decline in your sales and your profits as your drug goes generic, which is what we call it in the industry when your IP expires, is really, really rapid. There's a great example of a drug which was called Seroquil, which was an antipsychotic drug, and it lost its patent protection in 2012.

in less than three months lost 80% of its sales. So it's huge. It goes really, really quickly. Now, that's a small molecule. So that's a molecule that you can draw on a piece of paper. And small molecule drugs tend to go generic a lot easier than these biologic drugs do. Keytruda is a biologic drug. It's an antibody. It's produced by cells in a big bioreactor, and you cannot draw it down on a piece of paper.

And the reason that's important is it makes it really hard to know whether you've exactly copied that drug correctly or not. So with a small molecule, I can take my drug, I can do some very cheap tests on it, and I can prove that the drug that I have tried to copy is exactly the same thing as the original drug. That's a lot harder to do for a biologic.

So the generic versions of these biologic drugs, which are called biosimilars, they do not cause the same degree of revenue erosion and certainly not as quickly. The core example of this might be the insulin drugs. So the insulin drugs are not monoclonal antibodies, but they're biologics. Their core patents actually expired a long time ago, but the companies were able to still make money off of those drugs for a considerable amount of time afterwards.

And the reason for that is because it's a lot harder to copy those drugs. So you might think that that's actually a bull case for the business. This drug, even if it loses its IP protection in 2028, which is when it's scheduled to do so, it's not going to have this 80% loss of revenue in less than a year. But it's also worth being aware of some caveats to that that might make it more of a bear case. The two things are that one, the FDA has opened up a new regulatory pathway,

That's called the interchangeable biosimilar pathway. And that allows a firm to certify that their copy of Keytruda is literally one-to-one substitutable for Keytruda. It used to be that no company was allowed to claim that for a biosimilar.

And so that will make physicians more likely to substitute away from Keytruda and Tobio similar. So that's an important thing to keep in mind. And then the other thing, political scrutiny is very important. People don't like it when people make money off of drugs after their patents have expired.

It's seen as a breach of the social contract that pharmaceutical companies engage in. And as an investor, you have to recognize that these businesses interface with government more than your average business. Because of the insulin problem and also because of Humira, which was another biologics drugs that made a lot of money after its core patents expired, there's a lot of political scrutiny that is going to be placed on drugs, which continue to make a lot of sales after their patent expiration. So that's the IP side of things and how I think about the IP side.

That does interface with your second question, which was the question about the R&D strategy. It's just an unquestionable truth that demand for acquisitions, which means how likely it is that Merck or Pfizer engages in external R&D via acquisitions, increases the closer you get to the IP cliff for any given drug. So if you consider Merck, for example,

Since 2019, they've done over 12 different individual transactions, which have ranged in size from as low as 250 million to as high as 10 billion with their most recent acquisition of a company called Prometheus. And each of these acquisitions you can think of as being a form of R&D that is a complement

to their internal R&D efforts. Now, it's worth noting that the industry as a whole has become way more acquisitive over the last 20 years. There's this great statistic that if you go back to 1995, which was the Merck era that I was talking about at the beginning of the podcast, they made around 70% of their revenue from drugs that were internally sourced. So drugs that came out of the Merck R&D labs. Now, for the whole industry,

it's completely flipped. It's actually closer to like 50 or 60% of revenue coming from externally sourced drugs. So these are drugs that have been bought from other companies. And even Keytruda was not a drug that Merck invented. Keytruda was a drug that they happened to get because they bought a company. And so...

I would say that if you look at the R&D pipeline that they have right now, that they're trying to line up to replace the Keytruda revenue, it's, I would say, close to 70% to 80%, I would say, of drugs that they have acquired from other companies.

Just to kind of speak through how patents work more generically to make sure the audience has a better understanding, is there kind of approximate back of the envelope that the industry uses for going from that phase one through phase three drug submission approval to having that patent protection? And what else can you do to extend those patents and

What will they do then to try to extend the IP here? It's worth noting that you get your original patent IP before you start the clinical trial process. So that's actually huge because it means that the longer your clinical trial process goes on, the more of your life cycle that you have under patent is eaten up.

which is why people try to get through clinical trials as quickly as possible. Any extra year in the clinical trial process is one less year on patent protection. There are a bunch of ways, though, outside of the core IP that you can supplement your patent protection. So, for example, there are regulatory exclusivities.

If you are applying for an indication that has very few existing therapies, the FDA will actually, to incentivize people to develop drugs for these conditions,

They will give you a regulatory exclusivity, which says nobody else can market a drug with the same mechanism of action for that specific indication. Now, again, those are really narrow and the actual amount of time that you get is pretty short. So a patent term typically is around 15 years on the market. You do get patents for longer, but like I said, they're eaten up by the clinical trial time.

So typically, the back of the envelope rule for the industry is you get about 15 years on the market with your primary IP. Your FDA regulatory extensions to that can sometimes add up to two to three years here and there. So it's important. It's particularly important for a drug like Keytruda, where it's approved for like 40 indications. It's less important for drugs like older drugs, like, for example, the cholesterol drugs, which were blockbusters back in the late 90s and the early 2000s.

Those were really only approved for like three to four indications. And so the regulatory exclusivity is less important there. That's one thing you can do. The other thing to keep in mind, though, is there isn't just one patent that covers these drugs. These drugs have families of patents that are all assigned to that single drug. And particularly for biologics,

Those patents can cover anything from the actual sequence of the antibody that is the drug, but it also includes things like formulation patents. It includes things like process production patents and things like that. And so particularly for biologics, there are ways that biologics

the entire IP portfolio is not going to expire at one time. Now, for small molecules, like I said, there is a considerably higher risk of that. And the reason is that the patent portfolios are smaller. There's less scope for doing these formulation and process patents that extend the lifetime.

And so for small molecules, the 80% in less than eight months sort of rule actually holds pretty steadily. For biologics like Keytruda, there's a lot of things Merck can do to extend the revenue longer than just the expiration of the primary IP. I completely appreciate it. I mean, I think that the time horizon obviously is one that is imperative and then the ability to kind of extend those patents through combination therapies, obviously being topical. I guess the other question that goes hand in hand with that one

How do you dictate pricing in that you may have spent hundreds of millions or billions of dollars in R&D and you have this drug that's been approved? How does pricing work? Huge issue, as you can imagine, from a public policy perspective. A couple of things to remember just in terms of how prices are set in the industry. Patients don't pay prices for drugs. Insurance pays for the drugs.

Although the value from the drug is dictated by how valuable the physician thinks it is to the patient and that relationship that they have together, price is fundamentally dictated by negotiations that the pharmaceutical companies engage in with the insurance companies, and particularly a subset of the insurance companies called pharmacy benefit managers, or PBMs. And so basically the way you can think about this is like a negotiation, where a PBM says, I have 100 million people who I cover in my insurance company.

We're going to bargain to see what price that I will pay you for your drug.

Now, the thing that it's important to keep in mind here is that every pharmaceutical product which comes to market has some degree of pricing power. And the reason for that is it's patent protected. Nobody can come in and copy while that patent is in effect. So there is always some pricing power. I want to be very clear about that. The question, though, is you've spent all this fixed capital to develop these drugs and a lot of capital on drugs that didn't work. And

And so you need to maximize the amount of profit dollars that are flowing down to the bottom line. So from a pricing perspective, how do we do that? Well, one is to not have a lot of close substitutes. And what I mean by that is pharmaceutical patents are very narrow. So for example, let's pick a drug like statins. So statins were a very popular class of drug. There were six different statins that were approved. One

One came from Merck, one came from Pfizer, one came from Bristol-Myers Squibb, et cetera, et cetera. Even though you can't copy Merck's statin or Pfizer's statin, that doesn't stop another company from coming up with their own statin. And so within these classes of drugs, so statins, ACE inhibitors,

whatever the class of drug is, if you have more close substitutes, then you have less pricing power because the PBM is going to be like, hey, I'm not going to pay you what you want for this drug. I'm going to make all my insurance beneficiaries take Pfizer's statin because it's basically the same thing as your statin. So even though you have patent protection, the pricing power you get just from that patent is pretty narrow.

So how can you think about pricing higher? Well, one thing that you can do is to have a lot of different indications that you have data for. And you can perhaps tell where I'm going with this, but Keytruda is a drug that is approved for 40 different indications. So there are other PD-1 antibodies. Regeneron has one. Very classically, Bristol-Myers Squibb has one. But the reason Merck can command premium pricing for Keytruda

is because Keytruda has this breadth of clinical data that the other drugs cannot match. And so the PBM cannot say, hey, I'm going to force all my beneficiaries to use Bristol-Myers Squibb's nivolumab drug because nivolumab hasn't been proven to work in non-small cell lung cancer and hasn't been proven to work in all of these other indications. And so the breadth of indications that you can put together is one way that you can command premium pricing in your negotiations with PBMs. To put some numbers on this,

The way we think about this is every pharma company announces a list price for its drug. And then what happens is the negotiations negotiate for a discount to that list price. In pharma, we always want to use fancy words. And so we call that discount a rebate, but it's the same thing. It's a discount. And so you can think about the degree of price competition in

in a particular segment or a particular class of drugs in terms of the rebate that you're getting from the list price. So Keytruda's list price is $191,000, which is pretty expensive for a drug that probably only cost them about $19,000 to make on variable costs. So that's a lot of gross profit dollars. But the key thing is, is that the net price for Keytruda is probably not that much lower than the list price. Now,

Now, that data is pretty secret. The companies do not like to disclose it. You can use data to estimate it, which I just don't have in front of me. But most people agree that the price for Keytruda, because it's such a unique drug with a huge breadth of clinical data, is probably pretty close to $191,000.

Fascinating. And I think maybe just to marry the conversation that we had around pricing and IP and Keytruda, how exactly did they fall into this blockbuster? What was it that was the unique insight that led them to such an economically positive outcome? It's an interesting story. There are some documentaries out there on immuno-oncology that I would recommend. There's one called Breakthrough. If someone has an hour and a half to kill, I would recommend watching. But

The story starts in the 1990s. We had had these anecdotal reports scientifically for a very long time that the immune system, your immune system that typically fights infections, could actually recognize and kill tumors too, cancer as well. But actually trying to make a drug that forced the immune system to recognize and destroy cancer

had failed over and over and over again. There was this big cancer vaccine craze in the 1990s that all went bust and lots of companies lost tons and tons of money on it. And so by the 2000s, people were pretty not very excited about the idea of trying to make the immune system fight cancer. But there were these two researchers, one guy whose name was Jim Allison, who I had the lucky chance to work a little bit with in my career, as

as well as a guy named Tasuku Hanzo in Japan. And they discovered these types of molecules called checkpoints. And these are molecules that tamp the immune system down. They're called bricks. It's kind of how we analogize them, like brakes on a car. They sort of negatively regulate the immune system. And so they found these molecules in the 1990s. And if you blocked those molecules, the type of immune cell called CD8 T cell, which is responsible for fighting viruses,

would go crazy if you block these molecules. And if you deleted the molecules, you get like an autoimmune disease, meaning that your immune system would attack your own body. And so we knew that this had something to do with the immune system here. And so people were like, maybe this will work in cancer. And the first company that actually worked on it was Bristol-Myers Squibb, actually. Bristol-Myers Squibb acquired a company called Medirex in 2002. And that was the company that was first working

on developing an antibody to PD-1, which was the molecule that Susuku Hanzhou discovered in the 1990s. So they were going along, putting this drug through clinical trials,

And then in 2010, they announced data for the first time in phase two trials. And Merck was actually in the room at the time where that data was announced. And so Merck was like, oh, crap, we have this thing. It looks really exciting. What do we do about it? And it turns out that a couple of years earlier, they had bought a company which had bought a second company, which was also developing a PD-1 antibody. And

And that's a stroke of luck. It's a stroke of luck. They didn't develop the drug rationally, but kudos to the Merck clinical development team. Once they saw that data in 2010, which showed that this approach could be very useful, they put their foot to the floor and they have run, I think, what many people agree is the largest and best executed clinical trial campaign maybe ever in

And so, Keytruda was put through clinical trials way faster. They thought they were about four years behind Bristol-Myers Squibb when they started in 2010. But by 2016, Keytruda was ahead in terms of its sales and in terms of the number of indications that it had been approved for. And the tipping point was in 2016 when they ran a big trial in metastatic non-small cell lung cancer. So, this is a huge indication. It's about the biggest cancer indication in terms of medical therapy.

It's easily the largest one out there, followed by breast cancer. It was the big jewel in the crown. And Bristol-Myers Squibb's drug failed and Keytruda worked. And so that set off the tipping point where Keytruda overtook Opdivo and became the most dominant drug in terms of its revenue in the pharmaceutical industry today. So now that we have an appreciation for the story of Keytruda, I am curious, you don't go from...

zero to $40 billion in sales overnight, what is it that's enabled them to get to the revenue numbers that they have? It's a great question. I think the thing that makes Keytruda really unique amongst drugs is just the number of conditions that it is approved for. And I'll use the word indication, which is like the biopharma fancy word for a condition in which a drug works. And so Keytruda was first approved way back in 2014 when they were just starting this for melanoma.

Melanoma was really the first cancer that immunotherapy showed a lot of promise in. And so that was approved in 2014. We already sort of talked about the 2016. That was the big tipping point. And that was the approval and metastatic non-small cell lung cancer. And that was the one where Keytruda worked and Bristol-Myers Squibb's Opdivo didn't. And that was a huge boost for its sales. And then over time, what's happened is they've just continued testing it in more and more cancers.

I think one thing that sometimes people who are not analysts of the industry sometimes can get confused with is that cancer is not really one disease. In fact, even breast cancer or lung cancer is not really one disease. There are subtypes upon subtypes upon subtypes. And so what Keytruda has just done and what has made it so incredible is that it's just gone from indication to indication and it's worked in a lot of them. So in addition to the two that I've mentioned, it is approved for 40 different cancer indications.

Things like triple negative breast cancer, head and neck cancer, lymphoma, cervical cancer, esophageal cancer. That is unprecedented. Cancer drugs typically don't work in every single cancer. They typically are designed and researched around a specific type of cancer and a specific mechanism that only applies to one cancer. And so it's been incredible to see one drug work in so many different tumors. And I

And I think that's what's driven Keytruda's revenue growth because each of these indications are more patients. And so what's really driven Keytruda's revenue growth is volume, just the number of patients who are taking the drug. They've taken some pricing. I mentioned earlier that the list price is $191,000.

It started at around like 140,000. So that's not nothing. They have taken some pricing, but mostly the growth is all through volume and by adding more and more indications. The other thing that they've done is they've moved in what we call different lines of therapy. So in cancer treatment, there are typically four different lines of therapy. There's neoadjuvant therapy, which is I give you a medicine before I do surgery.

And that's because you have a cancer that's in one place, but it's really, really big and it's really hard to operate on. So I try to shrink the tumor so that I can operate on it more quickly. Then there's adjuvant therapy, which is, okay, I've taken out the tumor, but I don't want the tumor to come back. So I'm going to give you some medicine to destroy all the little bits of tumor that are in the body that my surgeon can't get to. And then there's first-line metastatic treatment. And this is cancer that's metastatic, unfortunately. So it means it's in so many different parts of the body that you can't really operate on it.

And so we give you medicine to try to control the growth of that cancer. And first line just means it's the first treatment you get. So you come to me, I'm the oncologist, and you say, Doc, I've got metastatic cancer. I say, OK, this is the first drug I'm going to give you. And then, of course, there's second line, third line, even up to fourth, fifth line treatment, where every line is after the first treatment stopped working, we give you another treatment. Those are sort of the big lines of therapy in cancer.

This is less true in other indications. But for cancer, which is pretty much the only thing that Keytruda has approved for, it's important to kind of know about. And in addition to sort of expanding the different types of indications that Keytruda has been approved for, so the different breast cancers, esophageal cancers, whatever, whatever, they've also started in the second line metastatic setting and then moved upwards. So for

Firstly approved for second line, then first line metastatic, then adjuvant, then neoadjuvant. And as you can also probably guess, the number of patients who come in with metastatic cancer is a lot lower than the number of patients who come in with a local cancer that needs adjuvant treatment.

And so as you move up those lines of therapy, again, the addressable patient market starts to expand. That's another driver of volume for Keytruda. And so as a result of both of these things, both indication growth as well as line of therapy growth, it's really called a pipeline in a drug. It's a whole pipeline for a pharma company, but it's just in one drug.

And so that's driven volumes up. And that's what's really accounted for the majority of Keytruda's growth from a standing start of zero to $25 billion in sales today.

And so if you kind of look out on the competitive pressures that KTRA will face, obviously one being if you lose your patent protection, generic producers come in. That's one. I guess the other would be alternatives that have objectively a better drug. I know there are some rumors and some data out there that would be indicative of such, but help us to understand what it looks like out there.

The thing about immuno-oncology is when it started working in that sort of 2010 to 2014 period, everyone thought this is the wave of the future. We're going to have 15 new immuno-oncology drugs which are going to revolutionize the standard of care. And in reality, it's really just been Keytruda. Keytruda has been dominant. It's been consistently the best drug, the one that has worked the best. Recently, particularly, there's a drug was created by a company called Summit Therapeutics.

It has a very long, weird, complicated name, ivonisizumab. I cannot pronounce it myself. I'm going to be totally honest with you. The drug names, it's a whole other conversation. But it's an antibody too, and it targets PD-1 just like Keytruda does, but also targets another molecule called VEGF, vascular endothelial growth factor. And their theory is that by combining those two targets in one molecule, they might be able to generate higher responses in lung cancer.

And so they ran a China trial, so a trial that happened only in China, in lung cancer, which is, like I mentioned, the biggest indication. It's the biggest market if you take all the cancer drugs.

It's about 35% of Keytruda's sales. And so the high-level results from that trial showed that the progression-free survival, which is the amount of time that cancer patients get before their cancer starts growing again, was 11 months for Summit's new drug and only five months for Keytruda's individual approach. And so people were sort of arguing that this was going to be

the first time that Keytruda had been definitively surpassed in clinical trials.

However, there are some things we need to keep in mind about this from an analyst perspective. The first thing is this data is not approvable data. And the reason for that is that it is China-only data. The FDA right now does not allow companies to submit China-only data to support a U.S. approval. So it may be approved in China, but it will not be approved in the United States. They're going to have to run a whole separate trial, and they are running it, to prove the same result replicates in the United States.

That's going to take about two years to run. So that's the first reason to keep in mind. The second reason is, and this is going to get into the weeds here, so I apologize. The trials are not one-to-one comparable. They did not use chemotherapy in their regimen with Keytruda. But in the United States, the standard of care is that you combine Keytruda with chemotherapy for a subset of these lung cancer patients. And so it wasn't really a fair one-to-one comparison. And

And so, again, when they come to the United States, they're going to have to run the trial with that fair one-to-one comparison. And then the last thing to keep in mind is what this drug does is it combines two mechanisms of actions into one molecule. It says, I'm going to go after this PD-1 molecule, which is what Keytruda does, and I'm also going to go after this VEGF molecule, which...

all on the same drug. But you can also do a thing where you say, I'm going to do that separately. I'm going to give you two drugs, one that does PD-1 and one that does VEGF. And that was already tried in America. And its results were maybe slightly better than Keytruda, but not so definitively better that it was statistically significant and clinically significant, more importantly. And so we've already have some data to suggest that this approach may be

is not as effective as maybe that trial is making it seem. So when you combine all those different things, personally, my view on the matter is that I don't think it poses that much threat to Keytruda. I think that the bigger threat to Keytruda is the expiration of IP in 2028. I think by the time we get close to this data showing out, we're already going to be so close to the IP expiration that the biggest driver of

of revenue for the company is going to be how long and how quickly Keytruda's revenue declines post-expiration. And so it begs the question, in some ways, at this point, we're coming to the end of 2024. General consensus is that the patents will expire in 2028. What did the next five years look like for Merck? And what are the paths that we can see from here?

We already talked a little bit about the patent expiration, but I think that that's one of the two key questions that Merck has to answer in the next four years and is very important for investors. Question one, how fast will Keytruda's revenue erode post-patent expiration in 2028? Is it going to be closer to that small molecule like 80%?

in eight months gone? Or is it going to be more like Humira, where they managed to not just stem the loss of revenue, but actually grow revenue post patent expiration? And so that's a really important question. And we talked already a little bit about some of the dynamics there. But the second question is, assuming maybe not the worst case scenario, but closer to the worst case scenario for Keytruda's revenue loss in 2028,

Can Merck not just make up that revenue loss, but also continue to grow its free cash flow over time? And so that points us to the question of what's in the pipeline coming forward. And as we already also mentioned, Merck has moved aggressively. They have known Tetruda's revenue cliff is coming. And so they have made a lot of aggressive expectations.

R&D bets to try to fill its pipeline. The way I'm going to try to summarize it is I'm going to try to break down what I think are the three big growth drivers that I think can possibly make up the gap. So the first one is the acquisition that they made of a

of a company called Acceleron Pharmaceuticals back in 2021. They spent around $11 billion to acquire a drug called Socatercept, which is now approved for pulmonary arterial hypertension. Now, pulmonary arterial hypertension has nothing to do with cancer. It's a completely different medication. But it has some similarities in the sense that it is what we call in medicine a high unmet need condition. And that's just a condition where we don't really have very good drugs

to treat the disease right now. Even though there are not that many people who get pulmonary arterial hypertension, because what the last 20 years of this industry have proved and Keytruda proves is that you can charge very high prices when you make a meaningful change in the standard of care for these conditions that we don't have very good drugs for.

Depending on who you ask, the consensus forecast sales for this drug range from, on the low end, $2 to $3 billion, and on the high end, around $8 to $9 billion. And Merck obviously thinks it's on the higher end of that. They think that's going to take a big chunk out of the Keytruda revenue loss just in that one drug.

I think that's a bit overoptimistic. And the reason for that is that forecasting is notoriously fickle in this industry, hence the large range of forecasts that are being given. But it's definitely true that this drug is already approved. Its clinical trial results looked really good. Will it be a blockbuster? Almost surely. The question, though, again, is you've got $25 billion to make up. How much of a chunk is that going to get?

So that's the first leg of the R&D stool. The second leg is their other big acquisition, which they made in 2023 of a company called Prometheus. They're advancing a drug in not pulmonary arterial hypertension, a completely separate set of indications, specifically ulcerative colitis and Crohn's disease. These are autoimmune diseases that affect the gut. And they've been very, very effective.

huge markets for the last 20 years. I've mentioned the drug Humira before a couple of times on the podcast already, and that was a drug that redefined treating those conditions. The problem is, is that unlike pulmonary arterial hypertension, Crohn's disease and ulcerative colitis, and a lot of the autoimmune diseases actually, now 20 years later have really good treatments for them. Humira is one, but there's also a second generation of drugs,

targeting other molecules that have already come to market and make for a very crowded therapeutic environment. So the question for the drug that they acquired from Prometheus is going to be whether they can drive some sort of durably differentiated clinical profile. If they can, then it's a great market. It's a huge market. There's been appetite for people to get new drugs and use new drugs.

But the fundamental question is going to be whether you have some sort of clinically differentiated profile over the crowded number of drugs that already exist.

And then the third leg of the stool that I would focus on comes back to cancer. They've made some aggressive pushes outside of cancer, but they are continuing their cancer line of therapies. Specifically, they focused on a new modality of drug called an antibody drug conjugate. So we talked a little bit already about two main modalities, small molecules and monoclonal antibodies. This type of drug...

and antibody drug conjugate is a new type of modality that combines the best of both worlds. And basically, the goal is to try to get all the benefits of giving chemotherapy to patients, cancer patients, with fewer of the side effects. Giving chemotherapy is a nasty business. It causes a lot of side effects, fatigue, nausea, vomiting, diarrhea, risk for infections. It

It's no fun to have to go through chemo, but chemo is very good. It is still the mainstay of a lot of our cancer regimens. And even with new modalities like immunotherapy, like Keytruda, they've often been combined with chemotherapy and not supplanted chemotherapy. And so...

there's been this push to try to figure out ways to get chemotherapy's efficacy without its side effects. And antibody drug conjugates try to do that by taking an antibody that is specifically targeted to a specific tumor and then attaching the chemotherapy to that molecule in a specific way that the chemotherapy drug is not active in the rest of your body, but it's only active right where the tumor is. And this sort of modality of therapy

blew up in breast cancer over the last two years. There's a company called Daiichi Senkyo, which is partnered with AstraZeneca, which is another one of the mainline pharmaceutical companies. And the drug is called TDXD. And that drug created really, really great outcomes for previously very difficult to treat subtypes of breast cancer.

That created this frenzy over antibody drug conjugates that Merck has made two big bets in. The first is they acquired a company called Veloz Bio for about $3 billion back in 2019. And then secondly, they spent $4 billion to partner with that same company, Daiichi, on three other types of antibody drug conjugates that they're advancing.

Those are a little bit earlier in the pipeline than the pulmonary arterial hypertension drug. They're mostly in phase two. But if those work out, those will be large additions to the overall portfolio of drugs. That's the three-legged stool that Merck is betting on to replace Keytruda Revenue. My overall conclusion is that they've moved very aggressively. And I give the team credit for understanding the depth of

revenue loss that they are going to have to replace and moving aggressively to fill up their pipeline. I also give them a lot of credit for diversifying. I think they've recognized a key truth, which is that sometimes it's very difficult to follow up things that you've done before. And so rather than only betting that they will continue their dominance in coming up with new cancer medicines, they have instead diversified into other indications. So overall, I think they've done a very good job.

But I do think we have to end with a caveat, which is just that thinking in terms of base rates, which is a concept that Michael Malbison loves. Every time a big pharmaceutical company has come up to one of these patent cliffs, they have struggled. We talked about Merck in the past. Pfizer also struggled when Lipitor went off patent in around 2009. So the base rate is that this is a very difficult period to handle. And so as good of a job that I think Merck has done, I think if you're an investor and

You need to be clear-eyed about the challenges that come from replacing a large drug like Keytruda. I know it's tough to kind of paint broad strokes on a business that's so specialized, but a lot of this conversation has been focused on capital allocation, your ability to reinvest at high rates of return either through reinvestment or M&A.

I wonder how you think about the special sauce of these businesses. Is it science? Is it finance in that you're identifying undervalued assets and just maximizing your shots on goal as you kind of assess the industry broadly, how you think about large cap pharma in that vein? I think there's a little bit of both of the elements that you've mentioned. I think you've got to be really good at science. I mean, there's just no question about it. You have to have really good scientists.

But I do think that as the industry has moved towards more external R&D, which, like I mentioned, has been happening over the last 20 years, being able to identify undervalued assets has become a larger and larger part of the business. You have a lot of these small biotech companies, hundreds and hundreds of hundreds of them that are

that are developing drugs. And I think what's made the really successful companies successful is their ability to look at all those hundreds of companies and find the diamonds in the rough. It's almost like being an investor. They're internal investors too, just like you're investing in companies.

They're trying to find the right assets amongst all of these smaller companies that are going to work really, really well in clinical trials and that they can push forward and be aggressive with clinical development with. So I think that you need science for that. If you're bad at science, if you don't have the right people to analyze the drug, you're going to make bad decisions in that allocation process.

But I do think it is also very important to have other specialties on board, have other people who can say, we think that this is a high area of unmet need. We think that we can charge this price. And even though we haven't charged it in the past or have some other differentiated insight on the commercial side of things to really go and buy the right drug. And so I do think great science matters. But ultimately, I do think that your second point is what I would say is more important for these large cap pharmas now, which is

being able to do smart capital allocation with respect to acquisitions. I really do think that's important. The other thing I would mention, though, is execution is important. If there's one thing to take away from the Merck story is that they executed their clinical development, getting through the clinical trial phases quickly and effectively. And

And that is something that if I was an analyst, I'd be very concerned about with my company. Because Bristol-Myers Squibb had the inside line on developing PD-1 drugs. They were first. They were four years ahead of Merck.

But Merck saw the data, made a clear bet, and then executed very, very effectively. And that is a core competency of these large cap pharmaceutical firms. As they've started to buy a lot of their earlier stage, so phase one R&D, preclinical R&D from some of these external companies, these smaller biotechs, their core competency has been running clinical trials and doing that effectively and doing that well.

And so in addition to having great scientists, as well as being able to analyze the landscape of drugs that they can possibly go out and buy, I would add to the third part of this is just how good are they at executing the ins and outs and the days to day of clinical trial development. And I think that that's really, really important for ultimately driving shareholder value for these companies.

And so with most organizations, leadership and the business structure is kind of centered around the key economic engine of the business. Obviously, in the case of Merck, you're dealing with Keytruda and its economic success. But it seems like once you commercialize and have a base book of business, you're

It comes to a steady state and the patents start to expire. And I wonder if the business makeup and the work structure is different in the way it deploys resources relative to a prototypical business with a dominant economic engine. The big pharma companies are, generally speaking, split into two big organizational branches. You've got the R&D side of the company and the commercial side of the company. And those are largely two completely separate organizations.

Within the R&D arm, you typically also have two subsets. You have a group that is what you think of as the traditional research group. These are the scientists in the lab who are testing molecules on mice and monkeys doing this sort of early research. We call that the preclinical group.

And then there's also a side of the R&D arm that's more oriented to, quote, development. We call them the clinical groups. That group is really responsible for running the clinical trial process and shepherding the drug through its clinical trial pipeline and getting to results.

FDA approval. Then on the commercial side, once a drug is approved, and usually a little bit earlier than that, once it's actually just clear that the drug is going to be approved, groups get formed on the commercial side of the organization. And that group is responsible for actually launching the drug. So that group includes things like most of the marketing teams, the sales teams, regulatory teams that interface with the FDA and get clarity on what types of medical claims they're allowed to make to doctors, etc., etc., etc.

And these two groups do definitely work together. It's not like they exist in complete silos, but they are separate groups of the organization. And typically when, for example, you're considering working at those companies, you're either joining one or the other. So going back to your question, the organization is structured around the dominant economic engine. There's actually two groups.

centers or organizational activity. The way I would think about this is sometimes these economic engines are sequenced. So there's a lot of activity that gets done on the R&D side until the drug is approved, and then the commercial side builds up.

And so there's sort of a handoff where one organization grows during the R&D part of the timeline and then shrinks, and then the commercial side takes over. But with a drug like Keytruda, one thing that's important to remember is that the first approval right back in 2014 was not the first only approval for Keytruda. They have continued to run more and more clinical trials in new indications and new lines of therapy like we talked about. And so unlike I think some drugs which have that handoff structure, in this case, I think there really have been two

organizational centers of the company that have been existing in parallel. And then I guess as an extension of that, it's notable that Merck carries the namesake of its founder, which is

presumably is a testament to the ingenuity of its leadership over time. Interestingly, in recent history, Ken Frazier served as CEO who came from a legal background, which struck me as kind of out of the ordinary for what I would believe is a science-led business. How important is leadership here? And what is the new strategy given that they recently had turnover in the C-suite?

I definitely agree with you that leadership is incredibly important, though I think it's less about one leader. And I'll come to this later. But I think it's mostly about the relationship between two leaders. But just to comment on the science side of things, the business was led for about 20 years, like we talked about, by Roy Vagelos, who is...

the CEO from 1975 to around 1995. He was actually a scientist by training and he started as the chief of R&D and then he was promoted to the CEO job after that. However, having scientists in the role of the CEO is actually very rare. If you look at the top 10 pharma companies by market cap today, I think except for Regeneron, none of them have a scientist as CEO. Ken Frazier was a former CEO of Merck throughout most of the Keytruda era that we've been talking about. He was a lawyer actually.

And he was considered a true statesman for the industry. I mean, it's hard to see a CEO who's gotten more positive reviews than Ken Frazier. He was actually their lead attorney during the Vioxx legal troubles that I mentioned at the very top of the episode. And then what made Ken Frazier, I think, such a great CEO was, and this comes back to my point about leadership, is that he had a great relationship with another key executive, who's the chief of R&D.

That guy's name was Roger Perlmutter. Perlmutter was actually one of Vagelos' R&D deputies at Merck back in the 1990s. But he got passed over for leadership in the 90s, and so he left for Amgen. And then he was brought back by Ken. And that was a truly great decision.

From reading reports of the early Keytruda era, Roger Pomatter played a really key role in recognizing that Keytruda could be a future potential blockbuster. And not just one blockbuster, but an absolutely enormous mega blockbuster that could do more than $10 billion in sales.

And so he was a key part in this bet that they made on Keytruda. Maybe understated how much the bet on Keytruda was truly a huge one. They spent a considerable amount of their R&D budget just dedicated to Keytruda. And it would have been a really bad capital allocation decision if Keytruda had stopped working. And so I think that's a great illustration of how the partnership between the CEO and the chief of R&D is really important for making good capital allocation decisions.

Now, you talked about C-suite turnover. Both Fraser and Perlmutter are now gone. Fraser retired, Perlmutter left to go run a startup. And so that means there's now a new generation of leadership.

Robert Davies is the CEO, and then the chief of R&D is a guy named Dean Lee. And they're both going to have to try to forge their own relationship and find their own recipe for success. So Dean, in particular, he's really new. He's actually only been at Merck since 2017. But I will say, in listening to him talk on calls and some of the interviews that he's given, he has hammered home the need for diversification of that pipeline away from Keytruda. And he's been saying that for many years now. And I think you've...

like we talked about in the section on the pipeline, you've seen his focus on diversification reflected in the R&D decisions that have been made. He spent R&D and M&A dollars not just on cancer, but on autoimmune disease, on pulmonary hypertension. And so I think that that is him recognizing the core truth. It's very hard to double down on your success. And sometimes you might be better off diversifying. But that relationship is going to be really, really critical moving forward.

Which kind of dovetails into our concluding question, where we typically ask lessons that can be learned from studying this business and applied to other investments as well as applied to other drug companies in this case. How would you conclude in that vein? I think for other drug companies, I think it's really important to know where you are in the life cycle. Are

Are you like Merck, where the key question that's going to drive the stock is about the pipeline and the IP expiration? That's one place you can be in the story. The other way is you could be on the complete other side of the product lifecycle where none of your products really have any IP expiration coming up. You've got

15, 20 years until you're going to deal with that problem. But the real core question is, how quickly are the drugs that you're launching going to grow? How large are the peak sales going to be? Those are different scenarios. And so what I think you can, as an analyst, take away is how do you analyze these businesses, know where you are in the product lifecycle.

Because pharma has such a structured product lifecycle, that allows you, I think, to frame where you are in that cycle very, very clearly in a way that's, I think, really hard to do for other industries because they don't have such a defined product lifecycle. And so I think that that's one of the key lessons I would take away for any drug company, really, any large cap pharma company, whether it be Merck or Pfizer or Genentech or whatnot. In terms of other businesses,

The lesson that I would sort of take away is it's a core lesson, but having a really differentiated offering. I think that in pharma, we assume that IP gets you everything. It gets you all the pricing power that you want. But if you look at the Keytruda story, it's really not that at all. Yes, you get a floor on your pricing power from your IP portfolio. But what makes Keytruda a dominant franchise is its breadth of clinical data.

Now, that's a very specific thing for pharma. But if you apply it to other companies, the thing that I'm looking for is, do you truly have a differentiated product, a product that has value to your consumers in customers in a way that nothing else does? And that, I think, drives your ability to price and drives your pricing power and therefore drives a lot of shareholder returns.

I think you've kind of packed into 60 Minutes a wealth of information as it relates to a pretty complicated and complex topic. We appreciate it. This was a fascinating conversation. Absolutely. Happy to be here. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out JoinColossus.com. That's J-O-I-N-C-O-L-O-S-S-U-S dot com.