Merck banks big on Schering savings
Cost cutting takes precedence over risks in the $44 billion dollar pharma deal.
(breakingviews.com) -- Merck has never believed in big pharma M&A. So why is it bidding $44 billion for rival Schering-Plough - which might lose the right to sell an important drug because of the deal?
Well, the two should fit nicely. But the big motivation is up to $25 billion-worth of potential cost cuts.
Delivering such massive synergies may be even more important than usual. On top of the usual risks - regulatory approvals, integration and so on - Merck might be buying damaged goods.
Schering has the right to sell Johnson & Johnson's (JNJ, Fortune 500) anti-arthritis drug Remicade overseas. It loses the licence if there is a change of control at the company. So Merck's bid could cause $2.1 billion, or 12%, of Schering's sales to disappear.
Somewhat counterintuitively, Merck (MRK, Fortune 500) thinks that won't happen - even though its shareholders will own 68% of the combined company. That's partly because of two bits of cleverness from the deal wizards.
First, the acquisition is structured as a reverse merger, with the old Schering (SGP, Fortune 500) as the surviving company - renamed Merck. Despite being in charge, Merck argues there is no actual change in control of Schering because the corporate entity will survive.
Second, the change of control provision kicks in if Schering directors stop making up a majority of the board. Merck thinks it can get around this too, because the Schering corporate entity isn't, technically, going away, and that entity's shareholders appoint all its directors. If those shareholders elect directors who were previously on Merck's board, that's their prerogative.
Just in case this turns out not to wash in legal terms, Merck's executives say their guidance for the combined company's earnings growth doesn't depend on Remicade. This implies they think the deal makes sense with or without the drug.
They may be right. Putting the estimated $3.5 billion of annual savings - achievable in full by 2011, according to Merck - on a multiple of 10 after 30% tax gives a value to shareholders of up to $25 billion today. That's more than double the premium Merck is paying for control of Schering - and the two firms know each other well and their headquarters are nearby.
Still, if they can afford to risk the loss of billions in profitable revenue that underlines just how urgently the drugs industry as a whole needs to shrink. 
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