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TheStreet Open House

5 Short Sighted Stock Spinoffs

4. Merck's 2003 Medco Spin

In 1993, Merck (MRK), then the world's largest pharmaceuticals company, cut a rare vertical merger buying a controlling stake Medco Containment Services for $6 billion, allowing it to make and distribute prescription drugs directly to consumers.

As a result of the deal, Merck was able to market its drugs to Medco's then 33 million strong customer base, managing over 95 million annual prescriptions for government employees, corporations and unions. "This is an aggressive but carefully considered strategic move to keep Merck close to patients and customers in a rapidly changing and highly competitive health-care market," said Merck Chief Executive P. Roy Vagelos of the deal.

The deal faced intense immediate resistance because of the possibility that the tie-up would increase prescription prices. When the merger was cut the Philadelphia Inquirer quoted an aide for Sen. David Pryor (D., Ark.), a key advocate for low drug-prices as saying "this is a step backward for health-care reform. The whole foundation of health-care reform is competition; this takes a competitor out of the market." Nevertheless, the merger closed.

Less than decade later, Merck relented to conflict over the deal, spinning a now rebranded Medco Health Solutions (MHS) for little gain in a 2003 tax-free dividend to shareholders. "Medco's ownership by Merck has been a lightning rod for criticism, although there's been nothing inappropriate," said Medco's Chairman David Snow to USA Today at the time of the spin.

During the tie-up Medco's sales grew astronomically, but Merck saw comparatively minor gains and had its drugs lead surpassed by Pfizer (PFE) and GlaxoSmithKline (GSK). Merck's revenue more than doubled to $22.4 billion by the end of the merger, while Medco grew revenue to $34.2 billion, a more than tenfold increase. It meant that by the time of the spin, 63% of overall revenue came from Medco. However, low Medco profit margins dragged on Merck's overall share pricess, leading to a radical shift in strategy.

After the spin, which gave shareholders one Medco share for every eight Merck shares, both companies stock prices and earnings abilities diverged. Medco's shares have gained over 500% since its Aug. 2003 initial public offering, while Merck's shares have fallen by nearly a quarter. As a result, even with Medco's subsequent stock gain, Merck shareholders have seen losses since the spin, when excluding dividend payments.

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Since the spin, Medco's sales are expected to have nearly doubled to $68.5 billion, while profits are expected to triple to $1.5 billion according to 2011 earnings estimates compiled by Bloomberg. Meanwhile, Merck sales have grown at the same rate and profits have doubled, on the heels of big merger activity.

With the looming threat of its drugs like Vasotec and Prinivil for hypertension, Mevacor for high cholesterol and Prilosec for ulcers going generic, the company relied on osteoporosis treatment drug Fosamax and asthma treatment Singulair. As that drug headed the way of going generic in 2009, Merck pulled the trigger on one of the 10 biggest mergers in Monday history buying Schering-Plough for $41.3 billion in May 2009.

The merger gave it Schering products with longer patent lives like allergy spray Nasonex as well as a popular suntan lotion brand in Coppertone, an insole-maker in Dr. Scholl's and a stronger international presence. However, with it came legal battles. In 2009, Merck and Schering-Plough settled a suit for cholesterol treatment Vytorin after allegations of withholding key clinical trial results. Merck also pleaded guilty to a criminal charge with the U.S. Department of Justice for its marketing of painkiller Vioxx before it was pulled in 2004.

In July 2011, Express Scripts (ESRX) announced a deal to buy Medco Health Solutions (MHS) for $29 billion in a deal to combine two of the largest pharmacy benefits managers in the U.S. However, the deal is facing antitrust scrutiny, which jeopardizes its outcome.

Currently, Medco's stock is more than 10% below the $71.36 a share purchase price, signaling investor uncertainty over the deal, or an easy stock return if it's completed.

For more on pharmaceutical mergers, see 8 big acquirers of 2011. See TheStreet's 3 healthcare buys for 2012 for more on the sector.

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