Hold SGP Until the Acquisition

On a stand-alone basis we expect Schering-Plough’s (SGP) sales to fall 2% in 2009 due to a significant foreign exchange headwind. Increased competition to prescription Claritin/Clarinex and consumers shifting discretionary spending away from Animal Health and Consumer products will also impact sales growth.

We expect EPS to fall 1% in 2009, a more moderate drop than revenues as operating margins benefit from foreign exchange. Gross margins and SG&A and R&D expenses showed a significant benefit from foreign exchange in the first quarter, helping push up EPS 5% on a revenue decline of 6%.

While we do not expect the same degree of benefit in the remainder of the year, we believe foreign exchange will help widen operating margins by about 250 basis points in 2009 versus 2008 levels. Operating margins will also benefit from cost-containment from the PTI program.

The proposed merger with Merck & Co., Inc. (MRK - Analyst Report) is currently 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.

We believe Merck needs Schering-Plough to help offset their significant difficulty in growing revenues due to near-term patent cliffs and softening sales of Singulair and Gardasil. 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 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-Plough currently has about 70% of revenues coming from overseas, versus only 44% for Merck. For all of these reasons, the merger makes a lot of sense in our opinion, and we expect the deal to close in the fourth quarter.

Based on the terms of the merger agreement Schering-Plough shareholders will receive 0.5767 Merck shares and $10.50 for each common share. Based on Merck’s current share price ($25.79) this values Schering-Plough at $25.37/share. SGP currently trades at $23.74, the discount likely reflecting the risk of concessions to Johnson & Johnson relative to rights to Remicade/golimumab and volatility in Merck’s share price.

We recommend that investors hold at the current price. Our price/share target for Schering-Plough is $26, based on our $27 per share price target for Merck.

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