Merck Buys Schering-Plough -- and Time

Merck's acquisition of Schering-Plough is all about buying breathing room, relief from what looks to be a 4-year, 50% earnings decline as key products go generic. Moreover, the relief comes relatively inexpensively (unless J&J steps in with a counteroffer), a fact that reflects Schering's lack of strategic options. In this interview, Merck's R&D boss Peter Kim and chief strategist, Mervyn Turner, explain the key pipeline and marketing complementarities and cost-cutting possibilities which prompted the deal -- and how they plan to integrate the two businesses.

Schering’s strategic challenges offered Merck the breathing space it needed. But the deal’s not a long-term answer to the growth problem.

By Roger Longman

It’s difficult to avoid drawing comparisons between the first two Big Pharma acquisitions of 2009. Both Pfizer Inc.’s acquisition of Wyeth [See Deal] and Merck & Co. Inc.’s bid for Schering-Plough Corp. provide enough cost reductions to keep earnings growing for a few years as important products go generic. [See Deal] And both deals diversify the buyers--with biologics, animal health, and consumer businesses.

But strategically the deals are pretty different, as Peter Kim, president of Merck Research Laboratories, and Mervyn Turner, PhD, the company’s chief strategy officer, explain in the following interview. Pfizer’s deal--beyond the $4 billion in cost cuts that allowed it in the first place--is all about the acquisition of capabilities the company figures it will need when average gross margins across the industry are significantly lower than they are today. In effect, that deal creates a commercial organization that can cheaply add and sell a wide range of new products, with a range of margins--small and large molecules, vaccines, and OTC products. (See "Pfizer/Wyeth: Industrializing Pharma?," IN VIVO, February 2009 (Also see "Pfizer/Wyeth: Industrializing Pharma?" - In Vivo, 1 Feb, 2009.).)

Merck’s deal is less ambitious, less potentially transformative. Merck isn’t turning itself into something different--an industrial company. It will be largely the same Merck (driven mostly by innovative primary-care products), streamlined. With Schering-Plough, it is buying breathing room, relief from what looks to be a four-year, $4 billion top-line decline (translating to a 50% decline in operating income over the same period) as alendronate (Fosamax), losartan (Cozaar/Hyzaar), and montelukast (Singulair) all lose patent protection. (See Exhibit 1.)

Thanks to what Merck believes will be $3.5 billion in cost cuts, a combined Merck/Schering should see its operating income grow about 50% by 2013. To put that in perspective: Pfizer aims to cut $4 billion from the combined Wyeth/Pfizer, or roughly 14% of projected combined pro forma 2013 earnings. Merck’s $3.5 million in synergies represents about 40% of sales. Merck is getting the extra leverage because, unlike Pfizer, Merck isn’t buying new capabilities--in biologicals and nutritionals, for example--as much as it’s buying marketed drugs and pipeline. (Merck is buying new infrastructure with Schering’s OTC business, but that operation is relatively small--3% of the pro forma combination. It’s also possible that the consumer business could be sold or perhaps transferred to Johnson & Johnson as part of a broader deal to appease its larger rival over Merck’s reverse-merger maneuver to side-step a change-in-control provision that would otherwise forfeit Schering-Plough’s ex-US rights to two key products, the anti-TNF antibodies infliximab (Remicade) and golimumab.

By 2013, Merck will also theoretically start to benefit from Schering’s late-stage pipeline, significantly richer than its own: including a thrombin receptor antagonist (TRA) and boceprevir for hepatitis C, both of which could reach the market in 2012, and golimumab, which could be on the market this year. And while the growth of its marketed products has been comparatively unexciting, the Schering drugs at least have the advantage of relatively long-term patent protection.

Moreover, all of this is coming for a relatively reasonable price (unless J&J steps in with a counter-offer). Schering’s board accepted a price of about $24 per share--about 60%-plus in stock. Wyeth shareholders, in contrast, will get their payments entirely in cash; Roche is likewise paying all-cash for the 44% of Genentech Inc. it doesn’t already own in a deal worth $46.8 billion. [See Deal]

The price on the deal is just a few dollars below Schering’s 2008 high in January, just before sales of the Merck-Schering joint-venture cardiovascular products ezetimibe (Zetia) and the ezetimibe/simvastatin combination (Vytorin) began to plummet on data suggesting the drug didn’t help with atherosclerosis, but way below the low 30s it reached in 2007, when Vytorin was growing quickly. Relative to CEO Fred Hassan’s tenure: the price is about 40% above its level when Hassan joined the company in April 2003.

Indeed, Schering’s stock performance reflected its lack of strategic options--despite its healthy pipeline--and the new dangers of primary care. In the first place, Schering had put itself on the hook for a $700 million, 30,000-patient Phase III program for TRA. That’s money that won’t go into other programs. In effect, Schering was limiting its options to make a single, big, primary-care bet.

The company had explored other options for TRA, spending much of 2007 talking with potential partners about a co-promotion of the drug. But Hassan eventually pulled out of the talks. Had Schering signed a deal, the company would have been worth much less to an acquirer--and already the number of Schering’s potential buyers was limited to two: Merck and J&J. Those two companies owned half of Schering’s most important drugs. If Schering was taken over by an outsider, Merck would have activated its change-of-control options on Schering’s half of the Vytorin joint venture; J&J would have done the same with Remicade and golimumab (and still may). Anyone other than Merck or J&J would have been left with a much diminished Schering-Plough.

It’s possible, perhaps, that another buyer might have figured out a way around these change-of-control provisions. After all, Merck believes it’s escaped J&J’s change-of-control rights to Remicade and golimumab through its reverse-merger structure. But it’s not likely a buyer could have gotten around both the Merck and the J&J contracts.

In short, Schering, tied to a primary-care strategy it probably couldn’t afford to execute on its own, played its cards as well as it could.

In an odd way, Merck has the same problem Schering does. It, too, is largely dedicated to primary care--and like Schering, it can no longer afford the risks on its own. Since 2003, its late-stage primary-care pipeline has produced little good news. Its substance P anti-depressant, two dual-PPAR anti-diabetic treatments, the niacin/anti-flushing agent lipid drug Cordaptive, and the anti-obesity taranabant have all failed or suffered significant setbacks. Sitagliptin (Januvia) and the cervical cancer vaccine Gardasil are the only regulatory bright spots. But of those two only Januvia has been an unalloyed commercial success: Gardasil sales have begun to decline. Even with sales of $23 billion, Merck couldn’t afford the diversity "to absorb the kinds of hits you take on the pipeline" if you’re committed to primary care, notes Turner.

Schering was almost uniquely able to provide that diversity, and to do so affordably. As Kim and Turner argue, Schering’s marketed products fit almost perfectly into Merck’s current marketing organization, which will theoretically allow Merck to increase the profitability of the individual sales call (one rep with the ability to detail multiple products to the same specialist) while simultaneously shrinking the relative size of the commercial organization--60% of the deal’s cost cuts will come from sales and marketing.

Same thing for R&D. Schering’s therapeutic focus matches closely with Merck’s, with very little overlap among the compounds in terms of mechanism of action. (See "Schering Helps Merck Where It’s Needed Most: The Pipeline," The Pink Sheet DAILY, March 16, 2009 (Also see "Schering Helps Merck Where It’s Needed Most: The Pipeline" - Pink Sheet, 16 Mar, 2009.).) That means that Merck adds significant diversity to its pipeline--but it can also, claims Kim, manage that diversity effectively because the new programs fit so well with Merck’s therapeutic expertise. Moreover, because of Merck’s function-and-franchise matrix, which Kim explains below, R&D can shrink as a percentage of overall sales. It doesn’t have to add large amounts of new therapeutic expertise; it doesn’t need any more foundational infrastructure. We’d expect significant cuts from the overlapping functions.

Indeed, in contrast with both Pfizer/Wyeth and Roche’s acquisition of Genentech, Merck’s R&D plans don’t appear to contradict at all its development and commercial notions. As Merck believes in the importance of scale commercially, it also believes in the importance of scale throughout R&D. Not for Merck are the biotech-like R&D structures being implemented by GlaxoSmithKline PLC, Pfizer, and Roche--the latter two doing so just as they are also adding significantly to the total research program through their acquisitions.

So far, the market has taken positively to the Merck deal, up about 25% in the two weeks since the announcement. And yet the market still hasn’t absorbed one fundamental message of the deal: Merck isn’t going to become again a growth company in the sense investors had been trained to expect by industry’s track record of double-digit sales increases in the 1980s and 1990s. It’s simply too large.

Like Pfizer, Merck will have to figure out how to grow its bottom line faster than its top line. It’s a good bet Merck will be able to do that for the next few years, thanks to cost cuts from the merger. But it’s a lot less clear whether a cheaper sales and marketing model and a more efficient R&D organization will be enough to continue to drive above-average earnings growth, particularly in a primary-care market undergoing massive change.

Merck, for example, is making a major bet on primary-care lipid drugs--its CETP inhibitor, for example, and Cordaptive, which Merck is still trying to get approved following the FDA’s May 2008 not-approvable letter. But generics are winning the statin war among cholesterol agents and likely will gain ground against brands when atorvastatin (Lipitor) goes generic in 2011. More than a year after Vytorin sales crumbled in the wake of the ENHANCE trial, the product continues to lose market share--with the loss beginning to accelerate, according to analysts, as managed-care buyers flex their muscles, emboldened by the downturn in the economy. The primary-care market may still be large, but it will certainly be smaller--in terms of patients put on a new pill--than it has been.

Merck’s bet on primary care, however, is at least hedged with the acquisition of Schering-Plough. As Merv Turner argues: "We know that sometime in the next decade we’re going to be operating in a different milieu with a very different set of players. Our long-term strategy has to evolve and take account of that. I can’t tell you today what that future is going to look like. But we will need the time to grow and settle and see how that landscape shakes out. The Schering deal provides that time."

Q: What’s different about this deal than the other mergers we’ve seen?

Kim: That it’s driven, in very large part, by the quality of the Schering pipeline and the resulting combined pipeline. The two companies have focused on very similar therapeutic areas, but what’s remarkable is that there are very few overlaps in mechanism of action.

There are only two that I’d point to. One is the IGF1r monoclonal antibody for oncology, which is an area that a number of companies are active in. Both companies have a molecule, but neither candidate is in late-stage development.

The second is HCV protease inhibitors. We’ll continue with [Schering’s Phase III] boceprevir but we also fully intend to continue with our own [Phase II] molecule, MK-7009, which is quite far behind boceprevir but which we think is an excellent compound. The overlap--in therapeutic area, not mechanism--ends up expanding not only the number of candidates in our pipeline—very strikingly in Phase II and III—but also the diversity of the pipeline. In cardiovascular, for example, we add atherothrombosis, with the thrombin receptor antagonist.

In respiratory, we announced last year that we were going into inhaled therapies because we felt that local delivery would be advantageous in targeting drug to the lungs in treating asthma and COPD. Last year, in fact, we licensed what we consider to be the best-in-class inhalation device. And we also announced last year that we were going to make our first inhalation product, a combination of montelukast with an inhaled corticosteroid--Schering’s mometasone (Nasonex). Here we are trying to build a presence in respiratory disease through inhalation therapy, which we don’t have experience with, and now we bring on board Schering with their experience in respiratory and inhalation therapy--as well as their inhalation device.

In infectious disease, we said we were interested in HIV and HCV. Schering is interested in both.

And this deal dramatically accelerates our progress to get into oncology and neuroscience. Schering gives us marketed oncology products, including a billion-dollar drug for brain tumors, temozolomide (Temodar). And in neuroscience they give us an antipsychotic, asenapine, which is under review, as well as a novel anesthesia reversal agent that has been approved in Europe and Australia, sugammadex.

In short, this deal gives us an excellent combined pipeline--the best in the industry by far.

Q: Question:You’ve got three late-stage programs that most people would say are very attractive: TRA, boceprevir, and golimumab. You haven’t mentioned that one, which gets you into the anti-TNF business.

Kim: Absolutely. This deal accelerates our move into inflammation. Golimumab is an important drug--the once-monthly subcutaneous dosing we see as very important. Earlier in the pipeline I’d point to the IL-23 program in Phase I.

Q: Sugammadex and asenapine are the two drugs I’d be most skeptical about. Sugammadex has certainly got a challenge in trying to get enough patients to allay the regulators’ concerns about hypotonia.

Turner: We think that there’s a path forward with sugammadex that we discussed with Schering. And we’re familiar with the FDA correspondence. We think the plan moving forward in the US is well thought out.

Q: And with asenapine, you think you can come up with a significant differentiator in weight gain to cut through the competitive noise? There are a lot of antipsychotics out in the world.

Kim: Yes, there are more than several antipsychotics, but patients and physicians switch until they find which drug is the best for them. As you know, weight gain with current antipsychotics is a significant issue.

Q: I’d still put sugammadex and asenapine as smaller opportunities than TRA, boceprevir, and golimumab. Would you disagree?

Kim: Asenapine and sugammadex are very important from a strategic point of view. Asenapine was resubmitted to the FDA in February; it could be approved this year. Sugammadex has been approved in the EU and Australia already. They accelerate our position in neuroscience, getting us out into the market, interfacing with the scientific thought leaders, while we continue to build a pipeline.

Q: How important was Schering’s biologics capability?

Turner: It wasn’t a driver, but it sure was a help to us as we thought about broadening our biologics capabilities to complement the Merck BioVentures concept [Merck’s move into innovative biologics and biosimilars], which we’re still going to pursue very aggressively--nothing’s changed there. But we’re trying to get further into the innovative space.

Q: Does it provide you with additional bio-processing capability, which we assume you’ll need for the Merck BioVentures?

Turner: It helps a little on the manufacturing side. Not a great deal because a lot of Schering’s capacity is spoken for. But it gives us a group of people who know the business, both on the preclinical development and manufacturing sides. Couple that with the acquisition we made of Insmed’s biologics assets [See Deal], where we got two pipeline candidates, a manufacturing facility, and 70 employees with a lot of experience among them in the biologics arena.

Q: Would you put pipeline as the number one driver for this deal?

Turner: From the MRL [Merck Research Labs] perspective, yes. But equally importantly, it brings us a stable of products that complement our existing portfolio. The areas in which Schering now works line up very nicely on the commercial side. For example, to Peter’s point about the respiratory franchise, now instead of just being able to talk to the physician about Singulair, we can also talk about Nasonex and Clarinex [desloratadine] upon closure of the deal. Instead of making a call to the obstetrician just to talk about Gardasil, we can talk about other women’s health products.

Q: In short, the complementarity of marketed products makes your detail calls more profitable.

Turner: Yes. We’re implementing a new commercial model. But even within that new model, having a range of products to target at a particular physician segment is going to be very important. And Schering’s product line has a relatively long-lived IP position.

But the third major element, along with the commercial products and the pipeline, is the synergies. There are substantial opportunities to rationalize the efforts of the two companies.

Q: Do you expect the combined commercial organization to be relatively smaller than what you’ve got now?

Turner: We’ve said that 60% of the overall synergies will come on the sales and marketing and administrative side.

Q: How will you manage a much larger R&D organization?

Kim: Unlike any of the other large pharma mergers of the past--to the best of my knowledge--this is a unique situation. The structure of our function-and-franchise matrix organization is scalable. When I joined Merck, I inherited an organization that had very strong functions: outstanding organizations for drug metabolism, biostatistics, medicinal chemistry, etc. But everything was aligned in functions, including clinical trials. The theory was that really smart people should be able to handle all the different therapeutic areas. I felt that wasn’t correct: we needed to overlay subject-matter expertise. Over time, working hard to fill out the positions, we set up six franchises--cardiovascular, diabetes and obesity, neuroscience, oncology, infectious diseases, which includes vaccines, and BRIE (bone, respiratory, immunology, and endocrine). Each of those six franchises is now headed up by a franchise head who runs a franchise coordinating committee.

The job of the franchise head and coordinating committee is to look across all the available targets and compounds and set the priorities and the strategy.

So when I say it’s scalable: the fact that we have the franchises in place will allow us to look across the combined pipeline to set the priorities. I don’t think that’s ever been done before in one of these pharma mergers.

Q: But will you need to have as large an R&D group, relative to your now-combined revenues, as you do today?

Turner: There will clearly be overlap in a number of areas of research, preclinical, and clinical development that should allow us to try for synergies.

Kim: A key driver to the deal was the quality of Schering’s pipeline. Therefore one knows there are outstanding people behind it. Our organizations have a common culture of scientific excellence. The long-time former head of Schering-Plough R&D--Cecil Pickett [retiring head of R&D at Biogen Idec]--actually came out of Merck. The Organon organization has shown by its compounds real scientific excellence as well. So it’s very important to retain the talented Schering employees as we move forward. Exactly what that means in terms of the size of the final organization, gaining the efficiencies in using the franchise-function matrix organization we have, we have yet to flesh out.

Turner: We want from this a culture that reinforces a spirit of innovation, a culture where people can prioritize and make tough decisions. An organization that benefits from scope and yet is lean and flexible with a focus on customer value. I believe we can bring these attributes into the new organization.

Q: Merck hasn’t done that as well as Schering?

Turner: As an industry I believe we find it very hard to let go of an idea. We all know that three-quarters of the costs of our business are in the cost of failure. We need to identify failures faster and eliminate them. That should be a real driver for bringing down the cost of the overall R&D enterprise. The costs we’re carrying just can’t be sustained. We have to get to that culture where we’re able to make tough decisions and live with them.

Q: How do you bring that into the company if the top people at Schering--Fred Hassan, Carrie Cox, Tom Koestler--aren’t going to be around?

Turner: That’s a challenge for us on the integration side. But it’s a need we recognize; Peter is building the requisite capability within the organization.

Q: Companies like GSK, Pfizer, and Roche are splitting R&D into very small groups. Is this something you want to do as well or will the franchise structure obviate that need?

Kim: The whole purpose of the franchise-function matrix was to be able to take advantage of scale while still allowing the appropriate decision makers to make the decisions. So no--we actually think there are advantages to scale if you can deal with the fact that there are different sets of decisions to be made in terms of the what and the how. The what would be the activities around assessing the medical need, and interfacing with the scientific thought leaders in a given therapeutic area, being able to prioritize compounds and targets across the portfolio, assessing the competitive landscape within a therapeutic area. The what is done by world class experts in, for example, cardiovascular disease, from basic science through the late clinical stages. And they should not be the group that’s doing the same things for the oncology portfolio.

But then when it comes to the how, the executing--doing the high-throughput screening, the medicinal chemistry, running the worldwide clinical trials involving thousands of patients--you want people who know how to do it, where you can take advantage of scale to execute efficiently and cost-effectively.

For what we do, in primary care, we think scale is important. Take TRA. It’s an example of the sort of large-scale program that is needed in order to address the cardiovascular arena, to which we’re committed. This merger brings to bear the scale and diversity needed to work in these sorts of areas. We have what we think is the best in class CETP inhibitor, which we’re doing a major study with; we’re completing the large amount of work remaining on Cordaptive; and now we’re adding TRA--another major investment. When you’re dealing with these high-risk/high-reward areas, you want to be able to place multiple bets and move them forward with the resources they need behind them. That’s one of the really exciting aspects of this combination.

Q: When did the idea of an acquisition of this size gel at Merck?

Turner: There’s been a large team of us working on an acquisition strategy for a long time. We looked at every combination, large and small, more than 400 companies. But we could not find the mix of marketed products and pipeline that would synergize in a way that made for a really attractive combination. But it wasn’t really until Dick [Clark, Merck’s CEO] was able to get into a conversation in December [2008] with Fred Hassan that we were able to see that this was something that made a lot of sense.

Q: Still, it wasn’t all that long ago that most of the top executives at Merck--you included, Merv--didn’t believe that big mergers were a good idea. What’s changed?

Turner: We have to recognize that we’re in an era where the business is getting more difficult and scale matters now for a company that plans to be in the primary care business. We have to be large to absorb the kinds of hits you take on the pipeline and to have a diverse enough portfolio. Although I’m a huge fan of biotech, I just don’t think it’s possible to source a portfolio of the required diversity solely from the outside. We have to have a large and strong internal research and development organization to build the kind of depth we’re really going to need to smooth out some of the lumps in the portfolio.

Q: So why not just get smaller? Let Singulair’s patent expire and grow from a smaller base.

Turner: There are two problems with that strategy. One is that the smaller you are the more vulnerable you are to pipeline failures because you can’t spread your bets wide enough. Second, if you get smaller, you’re going to get gobbled up.

Q: And there’s a necessary problem with that? If you’re successful and get bought at a good premium, is that a terrible thing?

Turner: That’s a fair point. But we’d rather be successful and do the gobbling if we can.

Q: On the other hand, if you’re larger and want to be able to absorb the pipeline hits, it also means you’re not going to be growing as fast. No one drug will do much for you. So aren’t you in a kind of catch-22: no drug failure will hurt you much but no drug success will help you much, either.

Turner: I don’t think we can go back to the mid-1990s when we had 25 consecutive quarters of double-digit growth. That growth is very difficult to sustain in this environment, large or small. I don’t know anyone who’s doing that anymore. Growth is sustainable--but you have to be very smart in thinking how you build a portfolio, diversify risk across it, the kinds of bets you make within it.

Q: Getting more than mid-single-digit growth at your new size--$40 billion--is going to be difficult, particularly on a sustainable basis.

Turner: That’s true. One of the things we’re trying to do with this merger is to give ourselves the opportunity over the next six or seven years, by taking advantage of Schering’s pipeline, its products, and the deal’s synergies, to understand how the health care business is going to shake out, what kind of new business models are going to evolve, who will be our new competitors--how we’re going to compete in a different landscape. We know that sometime in the next decade we’re going to be operating in a different milieu with a very different set of players. Our long-term strategy has to evolve and take account of that. I can’t tell you today what that future is going to look like. But we will need the time to grow and settle and see how that landscape shakes out. The Schering deal provides that time.