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Merck Craves Some Powerful Medicine

Merck & Co. (MRK) has proven its mastery of pharmaceutical marketing with blockbuster drugs like Zocor and Vioxx. When it comes to pitching an initial public offering, however, the drugmaker still appears to be on a learning curve.

Case in point: The company's effort to sell a 19.9% stake in its Merck-Medco Managed Care pharmacy-benefits operation. The reception to this IPO has been cool. As executives from the pharmacy arm, to be renamed Medco Health Solutions, made the rounds with money managers in late June, they've been grilled on everything from aggressive revenue recognition policies to contractual strings between Medco and Merck that may hamper the the pharmacy operation's competitiveness.

"TOO MANY RED FLAGS." Merck's handling of the Medco offering is adding to growing disenchantment on Wall Street with the drugmaker's chairman and CEO, Raymond V. Gilmartin. The IPO had been expected to close on Thursday, June 27. But that has been pushed off until at least Monday, July 1. And while Merck had originally hoped the Medco IPO would get done in the $22-$24 price range, industry sources say the price has now been pared to $20-$22.

That means Medco will be valued at around $5 billion -- much less than most Wall Street observers originally expected. Medco's value "is less than billed, as has been typical with Merck," says Dr. John R. Borzilleri, portfolio manager at State Street Research & Management, which holds a small Merck stake. "There are too many red flags to interest me."

In fact, the Street's confidence in Gilmartin's leadership has been on the wane for more than a year. While he had vowed that Merck's growth rate would remain competitive with that of the rest of the industry, Merck's earnings will be flat this year as generic competition eats into sales of some drugs and the new-product pipeline remains alarmingly empty.

PROMISE AND PERFORMANCE. Gilmartin is promising to deliver double-digit earnings growth next year, but Wall Street doesn't seem to be buying it. Cowen Securities analyst Stephen M. Scala expects Merck's sales, excluding Medco, to grow just 5% in 2003, to $23 billion, while net income will rise 6%, to $7.3 billion.

The result: Merck's stock is down 22% over the past year, to around $49 a share. "Gilmartin's credibility has been strained," says John Schroer, president at Itros Capital Management, which hasn't held Merck shares since the money management firm was founded in May, 2001.

For his part, Gilmartin says it's impossible to gauge how the Medco offering is being received until the deal closes. But when it comes to Merck's performance, he acknowledges he has some work to do. "When you set out a goal...and you don't [hit that goal], certainly there is some issue on credibilty," he says. "The way to address that is to deliver. And that's what we're doing." Lawrence A. Bossidy, retiring chairman of Honeywell and a Merck board member, says directors continue to support Gilmartin.

Gilmartin's immediate challenge is to make the Medco IPO successful. But questions about Medco's accounting aren't helping its prospects. The company books as revenue co-payments that consumers pay pharmacies -- even though the company never gets its hands on that money. The practice, which is also used by rival Caremark Rx, has made Medco's revenue growth look more robust than it would be under a more conservative approach, although analysts say the accounting tactic had no impact on earnings. A Merck spokesman says its accounting is in accordance with generally accepted accounting principles.

THE HARD SELL? More importantly, Merck's desire to continue to benefit from its relationship with Medco has hampered its efforts to sell the deal. Under the terms of the IPO, if Medco doesn't sell enough Merck products through the benefits plans it manages, it will have to pay the drugmaker damages. That deal will cause some clients to drop Medco for fear that it may be more concerned with selling Merck drugs than promoting the best products, says Richard T. Evans, an analyst with Sanford C. Bernstein & Co. Merck's Gilmartin points out that the arrangement hasn't scared off big customers, including General Motors, which recently renewed its Medco contract.

Even if the deal goes through as planned, it will do little to address Merck's fundamental problems of patent expirations and a weak pipeline. Generic competition has eroded sales of some major drugs, such as the hypertension treatment Vasotec.

At the same time, the growth of Merck's painkiller Vioxx has slowed in the wake of competition from a new drug, Bextra, from Pharmacia, as well as lingering concerns about possible cardiovascular risks associated with Vioxx. And the drugmaker announced in March that its next-generation painkiller, an expected blockbuster called Arcoxia, has been delayed. Now, more data is being collected, including information on cardiovascular safety.

WHICH PRESCRIPTION? As if that weren't enough, Merck's biggest seller, the $7 billion plus cholesterol-lowering drug Zocor, could face generic competition in 2006. "We see the Zocor patent expiration being a train wreck," says John P. Waterman, chief investment officer at Rittenhouse Financial, which sold its Merck shares earlier this year.

What can Gilmartin do? Some on Wall Street think Merck should consider a merger with another large pharmaceutical player. Cost savings from such a deal could boost earnings for a few years until the new drug lineup improves, notes Michael Yellen, manager of the Aim Global Health Care Fund. But Gilmartin has said that large mergers are often disruptive. Instead, he believes Merck should focus on its internal research and development efforts. Others have argued that the company should aggressively hunt for products to license and acquire from smaller biotech companies.

With so many drugmakers facing pipeline woes, the competition for such deals is already fierce. All of which means there are no easy answers to Merck's current ailments. By Amy Barrett in Philadelphia

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