Why Merck's Spin-Off Is No Cure


On the surface, Merck's announcement on Jan. 29 that it would spin off Merck-Medco, its pharmacy-benefits management company with $26 billion a year in revenue, looks like a bold move. Merck, which bought Medco back in 1993, says both companies may enjoy better valuations on Wall Street as pure plays. And the deal, which will be done in two pieces, including an initial public offering, could bring Merck $3 billion in cash this year by some estimates. The plan, says Merck Chairman and CEO Raymond V. Gilmartin, "will create better value for shareholders."

So why is Wall Street yawning? Merck's stock moved up less than 1%, to $57.52 a share, on the news. The reason: Shedding Merck-Medco does nothing to address Merck's fundamental problem -- a weak drug pipeline. The company is seeing patents expire on a number of big-selling products, including the hypertension drugs Vasotec and Prinivil.

That will trigger cheap generic knockoffs of those drugs that quickly erode Merck's sales. But the company's new drug lineup hasn't been robust enough to offset the losses from those products. And growth of its recent blockbuster, the arthritis drug Vioxx, has stalled after concerns were raised about possible cardiovascular side effects.

MARRIAGE-SHY. Add it all up, and Merck's earnings this year will likely be flat. "This deal doesn't change the underlying issues in their drug business," says Dr. John R. Borzilleri, portfolio manager at State Street Research & Management. That pressure has led many investors to question Merck's decision to forgo a major merger. Pfizer, after all, is generating strong growth these days, thanks in part to its acquisition of Warner-Lambert in 2000. Many analysts say it would make sense for Merck to buy Schering-Plough.

Schering and Merck have already partnered on a new cholesterol-lowering drug. And analysts say manufacturing problems have beaten down Schering's stock. Acquiring Schering would offer Merck big cost-cutting opportunities, which could help boost earnings' growth.

Merck's Gilmartin, however, maintains that the company isn't interested in a megamerger. He argues that Merck is better off focusing on its internal research efforts, an operation he says will launch 11 new medicines over the next five years. And he says Merck will supplement its internal R&D efforts with smaller acquisitions and licensing deals to strengthen its product lineup.

COUNTDOWN TO EXPIRY. But those deals aren't risk-free. Consider Bristol-Myers Squibb's $2 billion deal last fall to gain co-marketing rights to the cancer drug being developed by ImClone Systems. ImClone's application has been delayed at the Food & Drug Administration, and regulators are looking into whether its management has properly disclosed to investors the full extent of those regulatory problems. Now it's unclear when that drug will get approval.

At the same time, Merck's stock price is depressed, now trading at a price-to-earnings ratio of about 18 times this year's expected earnings, according to SG Cowen Securities. The Big Pharma average is closer to 23 times. That means Merck may have less flexibility to do stock-financed deals. "It puts them at a disadvantage," says Norman M. Fidel, health-care portfolio manager at Alliance Capital Management.

And while the company will be launching new products in coming years, patent pressures are far from over. In 2006, Merck's patent will expire on its biggest-selling drug, the $6.6 billion cholesterol-lowering drug Zocor. Another reason Wall Street is far from convinced that a sale of Merck-Medco is enough to remedy what's ailing Merck. By Amy Barrett in Philadelphia


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