The Merck deal is driven by politics - and fear
It seems like every time we get a Democratic president, Merck (MRK) decides it needs to make a big merger. Last time Merck made a big deal it was 1993 just after Bill Clinton entered the White House. Merck was afraid of politically-driven change in the health care industry -- as well as the possibility that its competitor Bristol Myers Squibb (BMY) would buy Medco Containment Services, then a mail-order drug shipper that was pushing Bristol's drugs over Merck's into Pharmacy Benefit Managers (PBMs), which were dominating corporate drug purchases. So in 1993 Merck bought Medco for $6.6 billion. The deal flopped and Merck ended up spinning off Medco Health Solutions (MHS) in 2003 roughly a year after Merck discovered that $14 billion of Medco's revenue was an accounting fraud.
Now Merck wants to try again -- this time it's buying another drug company, Schering Plough (SGP) in a $41.1 billion cash and stock deal. Schering-Plough shareholders would get 0.5767 shares of Merck and $10.50 in cash for each share. This price is a 34 percent premium to where it closed last Friday and the deal will leave Merck shareholders with 68 percent of the combined company. Forty-four percent of the price will be paid in cash, with $9.8 billion coming from existing cash balances and $8.5 billion from debt. The companies expect to cut $3.5 billion in costs beyond 2011. And Schering-Plough is expected to "modestly" add to Merck's earnings. So does this deal make any more sense than Merck's Medco disaster?
With Merck stock down 4.4 perecnt in pre-market investors are lukewarm. The 34% premium seems high and the cost savings and modest earnings boost strike me as insufficient. But at least in this case, as opposed to the Medco deal, Merck will probably have an easier time integrating Schering Plough since they are both in similar businesses. Back in 1993, Merck thought its ownership of Medco would help it win more drug business with PBMs and stop Bristol Myers from getting an advantage.
While that deal flopped, of Merck's objectives for the Schering deal -- to cut costs and boost the drug development pipeline -- only the first is likely to be achieved. Both companies are having trouble coming up with new drugs to offset the ones that are going off patent. And whatever changes President Obama may have in store for the health care industry -- potentially boosting the fortunes of generic drug makers like Mylan Laboratories (MYL) -- it is unlikely that Merck will be able to adapt to changes in the industry when it is consumed with integrating Schering Plough.
And the industry has undergone some big changes already to which Merck has not adapted. Motivated by cost cutting, Health maintenance organizations (HMOs), increasingly make drug purchase decisions, taking power from doctors who used to buy them. So thousands of drug company sales people taking doctors to exotic locations no longer help boost drug sales. Instead, having the lowest prices matters most and that's where generic manufacturers, who make off-patent drugs at a much lower cost, win.
And then there's the rising cost and lack of success at coming up with new patented drugs. Both Merck and Schering are having trouble with that; big pharmaceuticals companies tend to have dry drug development pipelines while spending billions. And I am not sure that this merger helps much with putting more life into the combined company's new drug incubator.
So I am not overly optimistic about what this deal does for Merck. But I have no doubt that every other publicly-traded drug company will now start to see itself as either predator or prey. And this will help merger arbitrageurs and M&A advisors -- both of which could use the business.
History has shown that merging based on fear of what a Democratic president will do to health care is not a profitable strategy. But that does nothing to stop executives from fear-driven deals.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.