Merck Needs Schering-Plough

Based on our earnings model, we expect Merck & Co., Inc. (MRK - Analyst Report) to post flat EPS growth from 2008 - 2013 due to the combination of patent expirations of key drugs, recent pipeline failures and softening sales of Gardasil and Singulair.

The proposed merger with Schering-Plough (SGP) is clearly an attempt to address Merck’s slowing sales and EPS growth. Schering-Plough 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 joint venture 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 merger is expected to be slightly accretive to non-GAAP EPS in the first full year, and significantly accretive afterwards. Merck believes that the merger will result in non-GAAP EPS annual growth in the high-single digits from 2009 - 2013 (using Merck’s stand-alone non-GAAP EPS as the 2009 base). This is premised on producing $3.5 billion in annual cost savings but apparently not dependent, according to Merck, on retaining rights to Remicade and golimumab.

Given that we model combined sales of both drugs to be over $3.5 billion in 2013, we are skeptical that their guidance is reasonable if they lose the ex-U.S. rights to both compounds.

The merger is expected to close in the fourth quarter.  We believe it’s in Merck’s best interests to get the deal done, notwithstanding potentially material concessions to Johnson & Johnson (JNJ - Analyst Report) relative to rights to Remicade and golimumab.

On a stand-alone basis, we model EPS of $3.22 in 2009, down 6% from 2008. We maintain our Hold recommendation. Our target price is $27, or 8.4x our $3.22 EPS estimate.