Merck and Schering-Plough mega-merger will create a company greater than the sum of its parts

Mar 13, 2009 (Datamonitor via COMTEX) -- SGP | Quote | Chart | News | PowerRating -- As a standalone company, Merck & Co. faces a tough future of declining sales. Datamonitor forecasts that the merger with Schering-Plough will succeed in returning Merck to positive sales growth and provide a raft of new pipeline and marketed products. However, before this can be achieved, outstanding issues surrounding Schering-Plough's partnership with Johnson & Johnson must be resolved.

Datamonitor forecasts that Merck & Co.'s prescription pharmaceutical portfolio will see sales decline at a 2008-13 compound annual growth rate (CAGR) of -0.3%. The key factor driving this decline is generic competition against patent expired major products out to 2013, including Singulair, Cozaar/Hyzaar, Fosamax and Zocor. Although Merck's new launch products (including Isentress and Janumet) will boost annual sales by $3.5 billion and core marketed products will generate a further $2.2 billion annual increase, a multitude of expiring products will wipe $6.1 billion from annual sales. Ultimately, Merck's 2013 annual sales would stand $435m below 2008 levels.

In terms of resuscitating its sales growth prospects, Merck has selected an attractive merger target in Schering-Plough. Indeed, boasting a 2008-13 sales CAGR of 4.5%, Schering-Plough is the fastest growing Big Pharma player in the US. The addition of Schering-Plough is expected to lift Merck's 2008-13 compound annual sales growth rate from -0.3% to +1.7%.

The merger also presents the combined unit with an opportunity to achieve further operating cost cuts and accelerate profit growth. Like the majority of their Big Pharma peers, Merck and Schering-Plough already had cost-minimizing plans in place, focused primarily on reducing sales force head count. Taken together, these plans were expected to deliver combined cost savings of nearly $2.5 billion. However, following the announcement of the merger, the companies' management teams have proclaimed that they will achieve annual cost savings of $3.5 billion beyond 2011 through reductions in spend on marketing and administration, manufacturing and R&D.

From a sales and operating profit perspective, then, Merck's merger with Schering-Plough appears highly rational. However, beyond the numbers, the deal also offers an opportunity for Merck to diversify its portfolio across key strategic dimensions, most notably molecule type and therapy area.

Merck is primarily a small molecule company, generating over 80% of 2008 sales from this traditional molecule type. The remainder of Merck's pharmaceutical sales is generated from its vaccine operations. Merging with Schering-Plough will bring a portfolio that includes both monoclonal antibodies (mAbs; Remicade and its follow-on, Simponi) and therapeutic proteins (Puregon, Peg Intron etc).

That said, the degree of molecule type diversification offered by this merger should not be overstated. The new company will remain entrenched in the small molecule market, with this molecule type accounting for 79.7% of combined 2008 sales.

More significantly, perhaps, is Schering-Plough's influence on Merck's traditional therapy area focus. In terms of generated revenues for 2008, Merck's three main areas of focus are cardiovascular, respiratory and infectious diseases. However, of the $12 billion portfolio that will be exposed to generic competition by 2015, 29% comes from cardiovascular, 36% from respiratory, and 7% from infectious diseases. Taking this into account, the need for a drastic deal that will reshape Merck's future and therapeutic focus becomes apparent.

Schering-Plough possesses three franchise focuses which complement Merck's strengths, and the resultant infrastructure overlaps would enhance synergy opportunities. These opportunities, however, are not without their own issues and hindrances.

First and most obviously, the deal would allow Merck to consolidate 100% of the companies' cholesterol joint venture sales. Through working closely together on the development and marketing of Zetia (ezetimibe) and Vytorin (ezetimibe and simvastatin), the two companies would undoubtedly have had a chance to assess their compatibility in terms of practices and corporate cultures. Management claims that 100% ownership of the cholesterol franchise will make for a streamlined decision-making ability and facilitate the creation of future combinations for Zetia.

However, despite the franchise's considerable worth (generating sales of $4.6 billion in 2008), it has recently suffered from major setbacks such as the widespread controversies surrounding the ENHANCE and SEAS studies. With the medical community focusing on intensive statin therapy for the treatment of dyslipidemia, the possibility that prescriptions for Zetia and Vytorin in the US will fall to the equivalent levels noted in Europe looms large.

The second significant synergy created through the deal is the integration of Schering-Plough's respiratory franchise with Merck's business in this category. This would be especially timely given Singulair's 2012 patent expiration, and would add pipeline (Asmanex/Foradil and the QAB/Asmanex collaboration with Novartis) as well as marketed products (Nasonex, Asmanex).

Thirdly, Schering Plough's protease inhibitors for hepatitis C (boceprevir in Phase III and SCH-900518 in Phase II) are in an area where Merck has also been active and will allow the new company to advance the most promising single and combination agents out of the two pipelines. The hepatitis C compounds also complement Merck's strengths in other infectious diseases, such as antibiotics and HIV.

In addition to the synergy opportunities that will arise from the deal, Merck will also have the opportunity to either acquire new portfolios in areas where it has not traditionally been active or bolster failing or vulnerable franchises. For example, Merck stands to benefit significantly by acquiring the substantial women's health and urology portfolio that Schering-Plough built following the purchase of Organon. The most prominent acquisition, however, will be within the immunology & inflammation portfolio, where Remicade (infliximab) is expected to add annual sales in excess of $2 billion.

Indeed, the immunology & inflammation arena is particularly significant to the deal, as the acquisition of Schering-Plough's products will bolster a failing portfolio and signify a sharp change in therapy area focus for Merck. However, Johnson & Johnson's involvement may cause problems for the combined entity going forward.

Schering-Plough has exclusive worldwide marketing rights to anti-TNF Remicade in all markets outside of the US, Japan and portions of the Far East. J&J's subsidiary Centocor brokered this deal in 1998 and, as of a renegotiation in December 2007, the agreement now extends beyond 2014. Schering-Plough reported 2008 Remicade sales of $2,118m, so this is a substantial deal taken on its own. However, the original 1998 deal also included Remicade 'follow-on' molecule Simponi (golimumab). In 2005, Schering-Plough exercised its rights to develop and market Simponi, which is expected to launch during 2009 and to reach blockbuster status, creating a vital future source of revenue for Merck.

However, four change-of-control provisions are built into the licensing deal with (J&J) which could potentially prevent Merck from gaining the overseas rights to both anti-TNF brands. The 'reverse takeover' strategy used in this deal, which essentially means that the smaller Schering-Plough will technically acquire Merck, aims to prevent these clauses from being triggered. Nonetheless, Datamonitor believes that at least one of these clauses will be breached, giving J&J the right to terminate the agreement without compensation.

The prospect of a battle is certainly a dampener on the deal, but the question needs to be asked: why would J&J object? Maintaining Schering-Plough's expertise and experience in marketing an anti-TNF in the EU must be a consideration for J&J. If the company objects to the deal and retains Remicade and Simponi, it will be forced to find new marketing partners in the EU, something that will surely damage the franchise.

There is always the possibility that J&J could move to outbid Merck. This would be out of character for J&J, but the possibility cannot be discounted outright. In the past J&J has avoided entering public bidding wars with its pharmaceutical or biotech peers. However, the healthcare giant currently faces numerous company-specific challenges. As such, it may break from its traditional ways and actively pursue an attractive target among its Big Pharma peers.

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