Merck - Schering Plough Under the Microscope: Why a Reverse Merger?

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 |  Includes: MRK, SGP
by: Clifford Mintz

Some of you may have been wondering why the $41.1 billion Merck - Schering Plough merger announced Monday was designed as a reverse merger. For those of you who are not familiar with the reverse merger strategy, this is how it works. Generally speaking, a failing or failed publicly traded company that is listed on one stock exchange or another merges with a privately held company. The privately held company takes over the public stock listing and manages the day-to-day operations of the new business. Private companies that engage in reverse mergers are usually looking for cash infusions for product development or a stock listing (without going through an initial public offering) which offers it shareholders immediate cash value. Investors who previously held stock in the public company are either compensated for their shares in cash or given shares (at a negotiated price) in the new entity. Any cash (or assets) left in the public company can be used to develop the formerly private company’s product(s) and if successful, shareholders in the old public company can eventually benefit.

If reverse mergers are designed to bolster the prospects of private companies in need of cash, why was the Merck (NYSE:MRK) - Schering Plough (SGP) deal structured as a reverse merger? As I mentioned in a post Monday, Schering-Plough markets Remicade outside of the US under an agreement with Johnson & Johnson which sells the drug in America. A termination clause in the original marketing agreement stipulates that the ex-US rights to Remicade (and another drug being developed) would revert to Johnson & Johnson (NYSE:JNJ) if control or ownership of Schering Plough changes. Remicade, a treatment for rheumatoid arthritis, developed by Johnson & Johnson’s subsidiary Centocor, represented $2.1 billion in sales for Schering in 2008.

Further, about 70% of Schering Plough’s revenue comes from outside the US. That said, the success or failure of the deal really hinges on whether or not Johnson & Johnson will challenge the change-in-control clause for Remicade. To obviate that possibility, Merck devised an unusual reverse merger strategy in which ownership of Schering Plough will not change hands—at least on paper anyway. Instead, even though Merck is putting up the money to purchase Schering, and Richard Clark, Merck’s Chairman and CEO, will run the newly combined company, Merck would technically become a subsidiary of Schering Plough and consequently there would be no change in Schering Plough management! Recall that Fred Hassan, Schering Plough’s CEO will remain with the newly formed entity during the transition. After the deal closes, Fred would step down as CEO, Merck’s current CEO—Richard Clark—would assume leadership and quietly change the name of the company from Schering Plough to Merck.

Of course, Johnson & Johnson could challenge the deal anyway, and if Merck was to lose in arbitration, it could possibly jeopardize the entire financial upside of the deal. Merck contends that even if it loses the rights to Remicade, the deal still makes sense. Not so, said one Wall St analyst, “I think that is a lot of malarkey. You don’t take out 20 percent of a company’s revenue and their core international growth driver and say it is not worth anything,” he said. Other analysts think that the uncertainty over Remicade puts Schering Plough shareholders at a disadvantage and one response may be for Johnson & Johnson to make a higher bid for the company. Still others believe that, while sale of Schering Plough makes sense, the $41.4 billion price offered by Merck is too low. Johnson & Johnson didn’t comment on the deal.

Schering Plough employees who I talked with Monday after the deal was announced are not pleased with it either. They feel that Johnson & Johnson would be a more suitable partner and that Fred Hassan, who was under enormous shareholder pressure, had no choice but to sell the company as quickly as possible. It is not surprising that many Schering Plough employees would rather have the company sold to Johnson & Johnson rather than Merck.

Unlike most pharmaceutical companies, Johnson & Johnson tends to leave the companies it purchases alone and runs them as wholly-owned after it purchases them. Another reason why a merger with Johnson & Johnson makes more sense than one with Merck is that Johnson & Johnson has a very profitable consumer products division. This would be a better fit for Schering which has several highly visible and profitable consumer products like Coppertone and Dr. Scholl’s. In contrast, Merck sold its consumer products division years ago and will almost certainly divest itself of Schering’s consumer products division after the deal closes.

Now that Schering Plough is no longer in play, all eyes are on Bristol-Myers Squibb (NYSE:BMY). BMY is about the same size as Schering Plough, has plenty of cash on hand and is thought to have a robust biotechnology pipeline. And, like Schering Plough, it has been rumored to be a takeover target for the past 20 years!

Until next time...

Disclosure: no positions

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