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Executive Summary

Marion Merrell Dow, spurred by moves to shore up the stock and speculation about its future as its nears its one-year, post-merger anniversary, bucked the market's downward slide in the third quarter, adding 7-1/4 to close up 28.4% at 32-3/4. "Street" speculation focused on what moves Marion Merrell Dow parent, Dow Chemical, might make to shore up the stock of the recently merged pharmaceutical business given the potential costs of redeeming CVRs issued in the merger deal and pressures during the next several years. Marion Merrell Dow received a setback for OTC Seldane following an FDA advisory committee meeting on cardiovascular effects and the two major products Marion brought to the merger, Carafate and Cardizem, may soon be facing generic competition. In the near term, Marion Merrell Dow's R&D pipeline does not appear to have obvious candidates to make up for lost sales to generics. The "Street's" pessimistic outlook for MMD's future was taking its toll on the stock price. While MMD began 1990 trading at 27, it had slipped to 21-5/8 in March and was hovering in the 23-25 range until July. Drug analysts began to offer several scenarios for Dow Chemical's future handling of the Marion Merrell Dow merger, including: (1) shoring up the stock via financial maneuvers in order to boost MMD's stock price above the $30 per share floor guaranteed in the merger and thereby lowering the costs of redeeming the Contingency Value Rights (CVRs) issued as part of the deal; or (2) the acquisition of another drug company with a stronger pipeline and less generic competition on the horizon. The much ballyhooed joint venture deal between Dow Chemical's competitor DuPont and Merck, announced on July 25, had the effect of calling attention to Dow's position vis a vis MMD and fueled speculation that Dow might either pull MMD into the fold or complete the spinoff. DuPont garnered praise for gaining access to an expanded pipeline and the benefits of consolidation without the high costs associated with mergers or acquisitions. However, Merck lost 10-5/8 in the quarter to close at 76-1/8, representing a 12.2% decline. The slide had more to do with the increasing "Street" concerns that the stock may be overvalued given slowing earnings growth and negative analyst reports on Proscar than to investor dissatisfaction with the long-term potential of the DuPont deal. As part of its offer for Marion Labs last year, Dow paid about $2.2 bil. in cash for its 40% share of Marion and issued CVRs. Those CVRs pose a potentially significant and unknown cost to Dow if MMD stock does not trade at $30 a share by Sept. 30, 1991. At the $30 price, Dow would pay $1.5 bil. given the face value of the CVRs of $15.77. At $30 per share, if Dow elects to redeem the CVRs on Sept. 30, 1992, the firm would pay out $1.9 bil. given the $20.23 face value of the CVRs at that time. The potential hazards related to the CVR redemptions in 1992 include the potential that MMD may take a hit on the market in anticipation of Cardizem's November 1992 loss of exclusivity. Spurred by speculation about moves to benefit MMD stock at the expense of the CVRs, MMD bucked the downslide of the market in August. MMD ended the week of Aug. 3 at 28 and the week of Aug. 10 at 29. On Aug. 13, MMD announced a 33% increase in quarterly cash dividends, its second increase this year, bringing the annual effective rate to $1.70-$1.75 per share. The company said the increase "reflects the Board's confidence in our ability to...achieve the short- and long-term earnings goals we have established." At the same time, MMD announced the repurchase of 3.8 mil. shares as part of a newly established employee stock option plan (ESOP). Following the announcements, MMD closed the week, on Aug. 17, up 1-3/4 at 30-3/4. The stock continued its upward climb in August, ending the month at 33-5/8. EGS fund partner Fred Greenberg told a Bear Sterns pharmaceutical conference Sep. 26: "If you look at Marion, there's no reason in the world fundamentally that the stock should be where it is. They've [Dow] made it very well known that they are out there buying the stock." Actually, Dow announced April 12 that it would be buying an additional 4 mil. shares of MMD. An Aug. 31 13D filing with the Securities and Exchange Commission shows that Dow purchased 1.7 mil.-plus extra shares in June and August for a price of over$47.7 mil. The purchases give Dow control of an additional 1% of equity and beneficial ownership of 68% of MMD. John Curran of Curran Capital Management told the Bear Sterns audience of MMD: "I have no idea what's going to happen. This is mindboggling." Discussing his own portfolio mix of MMD stock and CVRs, he commented: "I would not step up to the plate and do that strategy again. Too risky and not much return for the prices." Responding to Cumberland Associates Oscar Schafer's suggestion that Dow just buy out the rest of Marion, Curran agreed. "Unfortunately," he pointed out to the buy-side audience, "to buy out the rest of Marion, I think [Dow would] have to spend like $4 bil. which would really put debt. It's a dirty situation for them, but they may do it anyway, because that started the deal may want to finish the deal," he speculated. MMD was one of only six pharmaceutical stocks on the "F-D-C" Quarterly Index to close the third quarter ahead, along with K-V, Pfizer, SmithKline Beecham, Novo-Nordisk and Elan. K-V gained 1-3/8 to 9-1/8 (up 17%). Novo-Nordisk added 1-1/2 to close at 51, a 3% increase. The pharmaceutical component slipped 4.9% from June 29 to Sept. 28, while the Index composite (which also included big board diversified, chains and wholesalers) fell 6.7%; living up to their recession-resistant image, however, the Index issues fared better than the broader DJIA and S&P 400 indicators, which dropped 14.9% and 14.3%, respectively. Elan (up 1.3% to 20 on a gain of 1/4) is following a strategy of in-house development that appears to be paying off with investors. The stock, which was in the mid-teens range in the first quarter and the mid- to upper-teens through the half, reached more than 20 a share in the first two weeks of July. Elan slipped some in August, but by close on Sept. 14 had hit a three-year week-ending high of 22-5/8. Elan figured prominently in financial news several times during the third quarter. Elan was the "stock of the week" in Investor's Daily Sept. 14 and has gotten good publicity for the marketing approval of the Verelan controlled release verapamil (being sold by Lederle, Wyeth-Ayerst and Robins) and the pending transdermal nicotine patch to be marketed by Warner-Lambert. Additionally, Elan is apparently in the forefront of a fundraising vogue in the market. Elan is looking to raise $23 mil. to $40 mil. in a recent offering to existing shareholders for an R&D shell corporation, Drug Research Corp. The off-balance-sheet financing technique also recently used by Genzyme for its Neozyme spin-off offering, was the subject of a very positive feature in the Sept. 21 Investor's Daily. Pfizer (up 6-1/2 to 70-5/8) had a 10.1% increase for the quarter. The stock was buoyed by the success of Procardia XL (with Alza's GITS delivery system) and the antifungal Diflucan. Also bolstering the stock was an apparent decline in investor fear about the negative ramifications from the Bjork-Shiley heart valve issue, good first half financial results and the perception that Pfizer's pipeline has sustained promise. The company forecasts a half-dozen approvals through 1992. The extended-release version of the calcium channel blocker Procardia is selling like gangbusters, not only accelerating in terms of sales and new prescriptions but also boosting the entire Procardia franchise. Revenues were $40 mil. in its first three months on the market, and reportedly approached $100 mil. in the first half, partly due to the success of a direct-to-consumer ad campaign promoting potential cost savings from making the switch to the one-a-day product. Revenues have apparently continued to accelerate. An Oct. 2 Alex. Brown report from Richard Stover and Adele Haley calls an estimate of $400 mil. in full-year sales for Procardia XL "conservative." Diflucan's use for AIDS-related fungal infections and its reported superiority to previously standard therapy regimes is pushing that new drug's sales up. The product was approved Jan. 29 and some industry estimates put first year sales above the $200 mil. mark. Prior to its U.S. approval, Diflucan (fluconazole) had 1989 revenues of $44 mil. from several overseas markets where it was launched earlier. While Pfizer rose on Procardia XL, Alza, which developed the drug's delivery system, dropped 17.1%, a loss of 8, to close the quarter at 38-3/4. Alza is just beginning to get a good-sized royalty stream from Procardia XL and has several other products pending at FDA. In August, for example, Janssen's transdermal fentanyl Duragesic was approved and is slated for a January launch. Looking at the weakening of Alza's price, the Stover-Haley team at Alex. Brown gave the stock a "strong buy" recommendation on Sept. 24. They noted that Alza is scheduled to make a number of presentations to the financial community in October and to hold an analysts meeting in New York City on Oct. 22, which could rekindle favorable investor opinion.

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