What Would a Schering-Plough/BMS Merger Look Like?

SchePloBMS?

As reported yesterday by Global Insight, New Jersey-based newspaper the Star Ledger is claiming that Schering-Plough is taking “serious” steps towards making a bid for fellow U.S. drug-maker Bristol-Myers Squibb (BMS). Speculation is rife in the global pharmaceutical industry over what this may mean for the market, although it is important to stress that BMS and Schering-Plough have neither commented on the Star Ledger report nor offered any general comment on merger negotiations (the newspaper itself notes that Schering-Plough has “yet to approach” BMS with a formal proposal). As a result, Global Insight is taking this opportunity to analyse the overall likelihood of a merger (which we consider small), while taking a look at what the speculation already says about an industry struggling under the weight of red tape and generic assaults.

The rumours stem from the early admittance, following the departure of CEO Peter Dolan, that BMS will consider any and all offers of a merger or takeover. The board is clearly looking to build shareholder value, after the company took a severe beating over its stumbled defence of the patent for blockbuster stroke drug Plavix (clopidogrel). At the opposite end, Schering-Plough has spent most of the last three years getting itself out of a conundrum not entirely dissimilar to that which BMS currently faces. An entirely new management team was put in place in 2003, largely consisting of former Pharmacia & Upjohn/Pharmacia Corporation officials who left after the takeover by Pfizer (U.S.). New CEO Fred Hassan immediately put in place a slow-burning turnaround strategy, centring on building critical mass and portfolio strength, partially at the expense of a promising pipeline.

Two major outcomes of this strategy included the joint ventures (JVs) with Johnson & Johnson (J&J, U.S.), relating to Remicade (infliximab) and Phase III follow-up candidate golimumab, and Merck & Co (U.S.), which involves cholesterol drugs Vytorin (ezetimibe/simvastatin) and Zetia (ezetimibe). It is these two partnerships that form the main impediments to a potential merger with BMS—or at least complicate matters significantly. In order to maintain these JVs without J&J or Merck purchasing Schering-Plough’s stake, Hassan’s company would need to maintain at least 40% control (according to the Merck agreement) or 50% (according to the J&J agreement) of the new company. This would put major pressure on the finances of a company that is considerably smaller than BMS. While Schering-Plough has built a strong cash flow to support such an initiative, it is clear that substantive debt would need to be created to finance a merger; however, it is important to remember the low overall levels of debt in the global pharmaceutical industry, and the risk-averse nature of shareholders who are already looking at the vagaries of pipeline development.

The Star Ledger commented that a complicated stock-for-stock “reverse merger” might be instigated, in order to maintain Schering-Plough's JVs. However, this would mean that BMS was paying a significant premium for Schering-Plough’s share, defying the basic point of a merger for BMS—the creation of shareholder value. Herein lies the major problem that we consider to be the major impediment to the merger. Therapeutically, there aren’t many problems, with Schering-Plough and BMS forming a fairly nice fit; Vytorin and Zetia provide a nice fold for Pravachol (pravastatin) and Plavix (clopidogrel) on the cardiovascular side, while BMS’s new drugs, particularly in the field of oncology, would reduce Schering-Plough’s reliance on the Merck JV and fit nicely with the Temodar (temozolimide) franchise. They also hold complementary focus on HIV/AIDS research. In terms of geographic reach, we do not believe that this would be a top-heavy company in the United States, given Schering-Plough’s relatively small presence there (US$2.4 billion in 2005, or 31% of net sales, compared to US$8.1 billion/70% of net sales at BMS).

Outlook and Implications

The creation of synergies between the two companies would provide significant upside for the immediate prospects of the combined company; such cost reductions and cash creation usually amount to 11-15% in the drug industry. Based on 2005 sales, it would create a company with revenue of US$28.7 billion and an operating income of US$5.4 billion (Schering-Plough’s margins continue to be very poor, although they are improving slowly). Maximising efficiency in the R&D department would clearly play a critical role, with Schering-Plough maintaining a relatively high rate of R&D spending as a share of revenue, at nearly 20%; BMS's rate of 14.3% is more in line with the industry standard (Schering-Plough’s high R&D expenditure and selling, general and administrative (SGA) cost ratio are the main factors behind its depressed margins). The combined R&D budget would stand at US$4.6 billion—one of the largest in the industry—and would oversee a highly competitive pipeline.

The Schering-Plough/BMS speculation tells a story of unrest in the global pharmaceutical industry—both within companies themselves and among shareholders and analysts. For a long time, there has been widespread dissatisfaction with the manner in which some of Big Pharma’s former bright stars are performing. The fact that some of the old guard in pharma management at Pfizer, Merck and BMS have left within the space of a year reflects this dissatisfaction, and the acquisition of Schering-Plough’s management team would clearly form a critical part of BMS’s thinking if merger proceedings go ahead. The ascension of relatively unexpected leaders such as lawyer Jeff Kindler at Pfizer and manufacturing strategist Dick Clark at Merck shows that Big Pharma is looking for new ideas, in new ways.

However, we do not consider that the merger currently makes strategic sense; the leverage that Schering-Plough would need to finance the initiative would lay waste to several years of highly successful turnaround, while a reverse merger simply does not pay dividends for BMS. The uncertainties of Plavix litigation, as well as Schering-Plough’s JVs, provide other downsides. Instead, while companies such as Novartis (Switzerland) have quickly distanced themselves from interest in BMS, we consider such players as AstraZeneca (U.K.) and Sanofi-Aventis (France) to be more attractive propositions, unburdened by some of the risk factors that Schering-Plough carries. Watch this space.