SGP/Merck Merger Makes Sense

Highlights include Schering-Plough Corp. (SGP), Merck & Co. (MRK - Analyst Report) and Johnson & Johnson (JNJ - Analyst Report).

Schering-Plough/Merck & Co. Merger Makes Sense

On a stand-alone basis, we expect Schering-Plough's (SGP) sales to increase only 2% in 2009 as increased competition to prescription Claritin/Clarinex comes online and consumers shift discretionary spending away from Animal Health and Consumer products. We expect EPS to fall 5.2% in 2009 to $1.68 as gross margins contract from 2008 levels as a result of a reduced benefit from foreign exchange. SG&A expenses should remain in check as additional benefits are reaped from the PTI program.

The proposed merger with Merck & Co. (MRK - Analyst Report) is currently expected to close in the fourth quarter. However, we believe Johnson & Johnson (JNJ - Analyst Report) will raise some form of challenge relative to rights to Remicade and golimumab, which could potentially delay consummation of the deal.

While a counterbid for Schering is not out of the question, we believe J&J is more likely to seek full or additional rights to Remicade and golimumab or possibly other financial concessions.

We believe it's in Merck's best interests to get the deal done given their significant near-term patent cliffs and softening sales of Singulair and Gardasil. Schering has relatively little exposure to patent cliffs through 2013, and possesses one of the strongest late-stage pipelines in Big Pharma. The deal will add immediate synergies relative to the Vytorin/Zetia JV, and should offer little overlap in currently marketed products and pipeline compounds.

Given the minimal product overlap and relative ease in combining the cholesterol business, we would expect the combination to provide significant synergistic opportunities with combining sales, marketing, research and other back-office functions. The deal should also help geographically diversify revenue sources as Schering currently has about 70% of revenues coming from overseas, versus only 44% for Merck. For all of these reasons, a merger with Schering makes a lot of sense in our opinion; we expect the deal to eventually get done.

Based on the terms of the merger agreement, Schering-Plough shareholders will receive 0.5767 Merck shares and $10.50 for each Schering-Plough common share. Based on Merck's current share price ($27.00) this values Schering-Plough at $26/share. SGP currently trades at $23.65, the discount likely reflecting the risk of some sort of interference (in the form of seeking additional rights to Remicade/golimumab or financial concessions) from J&J and volatility in Merck's share price. We recommend that investors hold at the current price.