NEW YORK – Drugmaker Merck & Co. said Tuesday it plans to spin off Merck-Medco, the pharmacy benefits management unit it acquired in 1993, in order to focus on its more-profitable drug development business.
Industry analysts said Merck would eventually boost its earnings by spinning off the low-margin operation into a separate publicly traded company. A spinoff of Medco could also help Merck sidestep potential conflict-of-interest issues and make it easier for investors to track Merck's performance.
Merck warned last month that earnings growth would grind to a halt in 2002 due to competition from cheaper generic drugs and slowing sales of its cholesterol fighter Vioxx. The firm's shares are off 13 percent since the bombshell warning.
Firms like Medco are hired by insurers to make sure only drugs on the insurer's list of approved medications are dispensed by pharmacies -- a role meant to help keep drug expenses affordable.
But Merck has been accused of using Medco as a vehicle to promote its own expensive medicines, rather than cheaper rival treatments.
Because Medco is a key channel for Merck drugs, Prudential Securities analyst Tim Anderson said shedding the unit could worsen the already slow sales growth of Merck's products.
"While it's good that Merck is cleaning up their business, the unfortunate reality is they need Medco at this point to help sell products they currently have," Anderson said.
Merck, based in Whitehouse Station, New Jersey, plans an initial public offering of a portion of the Medco shares by mid-2002, with the remaining stake to be divested over the following 12 months. But the move will not change Merck's forecast of no earnings growth this year.
The world's No. 3 drugmaker said it still expects its core pharmaceutical business to deliver double-digit earnings growth in 2003, driven by accelerating revenue growth.
Merck did not put a value on Medco, for which it paid $6.6 billion in 1993, but the unit's revenues have risen ten-fold since then to $26 billion in 2001. Some analysts on Tuesday estimated the unit was worth about $6 billion.
"This is a very good event for Merck because Medco has been depressing Merck's margins and it has been raising concerns about conflicts of interest, and whether Medco is doing what is right for the patient or what is right for Merck," said analyst Mike Krensavage of Raymond James and Associates.
Merck-Medco, which manages more than a half billion prescriptions annually, handles transactions for 65 million Americans, about a fourth of the population.
Although Medco's revenues represent over half of Merck's $47 billion in 2001 revenue, they account for just 10 percent of Merck's earnings per share because of the unit's razor-thin margins compared with fat margins for prescription drugs.
"Divestiture of Merck-Medco will be slightly positive for Merck, as it will bring in some cash ... and will remove any Medco-related distractions from Merck's senior management," independent drug analyst Hemant Shah said.
Shares of Merck rose 52 cents, or about 1 percent, to close at $57.52 on the New York Stock Exchange Tuesday.
Pharmacy benefit managers (PBMs) are supposed to save insurers money by encouraging patients to take the best-priced effective drugs, including copycat generics that sell for a fraction of the cost of original branded medicines.
But Merck and rival PBMs have been accused of taking rebates from a variety of drugmakers to push more-expensive branded products, instead of encouraging cheaper generics.
Medco has steadfastly claimed, however, it has ensured the best interests of its clients in its dealings.
"I think if there is not a conflict of interest, there is definitely an appearance of one," said Krensavage.
Consumers and private employers have sued Medco and its rivals Express Scripts Inc. and AdvancePCS , alleging double-dealing. Suits claim they included expensive drugs on their lists of preferred medicines for their own benefit rather than the benefit of their clients.
Medco has also been accused of promoting use of Merck's own drugs, including expensive cholesterol fighter Zocor, rather than less-expensive drugs -- a potential conflict of interest that analysts have cautioned could trigger antitrust concerns.
Salomon Smith Barney analyst Mark Striker on Tuesday called the spinoff of Medco an "excellent strategic move," adding it would allow Merck to remove itself from a business that could pose conflicts of interests.
"It is difficult if not illegal for a pharma company to extract synergies from PBM ownership," Striker said.
PRELUDE TO M&A ACTIVITY
Merck denied the spinoff was related to its weak earnings, saying only that the decision follows a four-month strategic review. Analysts said the spinoff could give Merck cash to buy other firms, or make itself an attractive merger partner.
Merck Chief Executive Raymond Gilmartin tried to shoot down such speculation in a conference call with analysts, repeating his position that Merck is more interested in licensing drugs from other firms rather doing major merger deals.
Medco has been the most consistently profitable PBM. Rival firms have seen pieces of their business change hands frequently as companies bet on the direction of the drug distribution business.
PCS Health was sold for decreasing prices through the 1990s, starting with McKesson's Corp's $4 billion sale to Indianapolis drugmaker Eli Lilly and Co. in 1994, a $1.5 billion sale to drug store chain Rite Aid in 1998 and a $1 billion sale to Advance Paradigm in 2000 to form AdvancePCS.
SmithKline Beecham sold Diversified Pharmaceutical Services for $700 million to Express Scripts after it had paid $2.3 billion to UnitedHealth Group Inc. for it.