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As Merck & Co (NYSE:MRK) starts a new chapter Wednesday following its $41 billion acquisition, sorry, reverse merger, of Schering-Plough (SGP), the elephant in the room remains the ongoing arbitration with Johnson & Johnson (NYSE:JNJ) over two of Schering’s most valuable products: the anti-rheumatic antibodies Remicade and Simponi (J&J ups the ante in battle for Remicade and Simponi, May 28, 2009).

The arbitration was never going to stop the Merck-Schering deal from completing, but the fact that a settlement has not yet been reached suggests the legal process will now have to run its course, with a verdict not expected until the first quarter of next year. While the distraction and uncertainty caused by the arbitration is far from ideal for Merck as it sets about integrating the two businesses, the high stakes at risk make the battle inevitable and worth fighting tooth and nail for.

Fine print

Merck’s move on Schering back in March of this year was constructed as an elaborate reverse-merger, technically allowing Schering to remain the surviving entity under accounting practice, thereby attempting to avoid triggering a change of control clause in the deal with J&J over the two products.

However, as J&J is claiming, the practical reality of the situation is that Merck has acquired Schering, and therefore Remicade and Simponi have new owners. The newly merged company is still called Merck, Merck’s original shareholders now control 68% of the enlarged group and the new board is made up of all 14 members of Merck’s board and just 3 directors from Schering.

Conversely, Merck claims that the fine print of the deal, originally signed with Centocor in 1998 (J&J then acquired Centocor in 1999), only refers to Schering being the surviving entity from any merger and that the issues of shareholder ownership and board structure were not included, and therefore not relevant.

As such it seems both J&J and Merck have compelling arguments to make in the arbitration court and picking a winner at this stage is fiendishly difficult.

While J&J will probably win on any logical or reasonable grounds, it seems that Merck could ultimately prevail on a technical basis. Given that the deal was originally struck between a big pharma player, Schering, and a decent sized but smaller biotech, Centocor, the terms of the deal are likely to favour the bigger partner. In addition, it would be quite amazing if Merck embarked on this complicated reverse-merger strategy without being completely convinced of winning any legal battles for control of Remicade and Simponi.

High stakes

Remicade and Simponi currently have a combined NPV of $6.9bn, according to EvaluatePharma. Removing these products from the $41 billion acquisition price would reduce the value of Schering to Merck by around 17%.

As such, the loss of these products is unlikely to go down too well with Merck’s shareholders, who may then justifiably claim that the group ended up paying too much for Schering.

Meanwhile, for J&J the two products are the most valuable in its portfolio, with a combined NPV a staggering $23.3 billion. Gaining Schering’s international rights to Remicade and Simponi would therefore enhance the value of this franchise, generating yet more profits to swell a cash pile of around $12 billion that has been used to make a number of significant acquisitions and strategic investments so far this year.

For J&J the arbitration is definitely a gamble worth taking. Even if it loses, the already lucrative terms of the deal will remain intact, whereas it has a chance of either gaining full control over the products or at least some improved economic terms if a settlement is reached.

For Merck the stakes are quite a bit higher. Losing the products to J&J would not only be damaging in economic terms, but the company could end up losing face amongst its peers and shareholders.

Source: Johnson & Johnson: The Elephant in the Merck-Schering Living Room