Is This Rx Too Costly For Merck?

Less than a year ago--back when the drug business seemed relatively upbeat--Chief Executive P. Roy Vagelos of Merck & Co. was turning up his nose at Medco Containment Services Inc. Medco demanded discounts from its pharmaceutical suppliers. Vagelos wouldn't give in, refusing to sell to the mail-order distributor. Instead, he bet that his own big sales force would keep industry leader Merck's sales soaring.

But drugmakers have been dragged into a radically new era, and Vagelos is talking a very different game now. The pell-mell growth of managed care, he says, will continue, requiring vertical integration up and down the pharmaceutical food chain. Hence, Merck's July 28 announcement that it plans to pay $6 billion in stock and cash for Medco.

This probably is not a merger that Merck investors will digest easily. Merck shares sank 1 3/8 on the news, to 30 3/4, a 52-week low. Medco's stock gained 4 3/8 but closed at 34 1/8 on July 28--well below the $39 a share value implied by Merck's offer. "This is not a done deal," says Neil B. Sweig, a drug analyst with Capital Institutional Services.

DATA LODE. Beaming happily in New York's Waldorf-Astoria Hotel, Vagelos and Medco Chairman Martin J. Wygod shrugged off the early skepticism. "I think Merck needs Medco and Medco needs Merck because together, the combination is an offensive giant," Vagelos told BUSINESS WEEK. By acquiring the $2.2 billion-a-year distributor, arguably the nation's most tightfisted buyer of medicines, Vagelos expects to boost distribution of Merck's products significantly, even as he cuts sales reps. More important, he's hoping the deal will yield crucial market intelligence about Medco's 33 million U.S.customers.

But this bet has the makings of a costly long shot. For one, the deal could face a stiff antitrust review: Medco counts virtually every major drugmaker among its suppliers, and several are likely to object to Merck's influence. Even if Merck clears that hurdle, some of its competitors privately say they may well drop or cut back their dealings with Medco if Merck controls it. Says one rival executive: "Everybody is assessing their relationship with Medco as of today." Competing drugmakers may well seek out alternative distributors or develop their own. Wygod admits that "some manufacturers are going to look at this as a strong competitive move, and they will perhaps tie up with other pharmacy management companies."

If Medco risks losing customers, it's not clear to some observers just what Merck gains. For instance, Vagelos argues that the detailed information Merck would gain from Medco's enormous customer base could help aid efforts to research and market new products. "Merck needs to have closer links to health-care providers, patients, and to bill payers," he says. Yet some rivals insist that data services such as Walsh America/PMSI already provide similarly useful information. "There's a lot of data available, and you don't have to spend $6 billion to get it," says a high-ranking executive at one competitor.

SAFETY NET? Merck officials concede the deal would be costly. Merck plans to borrow up to $2.4 billion and issue some 112 million shares of stock to pay for Medco, offering shareholders $39 or 1.2 Merck shares for each Medco share. At about 5%, Medco's tight net margins will drag down the combined company's. According to Merck Chief Financial Officer Judy C. Lewent, the dilution of Merck's stock could last three years. Lewent argues: "We are comfortable making investments today that will allow the company to grow in the future."

Is this truly how Merck will grow? "Theoretically, in the long run, it's probably not a bad deal," says Mariola B. Haggar, a pharmaceutical analyst with Salomon Brothers Inc. "But that may not be apparent for a while." More than anything, Medco may represent insurance--a solid business to support profits at a time when there are few big prospects in Merck's development pipeline. To remain at the top of the drug industry, Merck still needs to produce new drugs that will pick up where its stars of the last decade are leaving off.

      THE DEAL
      Merck acquires Medco Containment Services.
      About $6 billion, 40% in cash and 60% in Merck shares. Merck will issue new 
      stock and sell commercial paper and medium-term debt.
      a $2.2 billion pharmaceutical distributor, with a huge mail-order operation and 
      access to 90% of U.S. pharmacies.
      access to products from the world's largest pharmaceutical manufacturer, plus 
      substantial market clout.
      Medco will keep its name and operate as a Merck subsidiary. Chairman Martin 
      Wygod will join Merck's board and buy $32 million of Merck shares.
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