February 6, 2020

Breakingviews: Merck spinoff pits cash now vs. excitement later

by Breakingviews.

Merck is joining the spinoff party. The $217 billion U.S. drugmaker led by Ken Frazier is joining Pfizer and GlaxoSmithKline with plans to separate some stable businesses from fast-growing products. The idea is that the former’s steady and high cash flow will appeal to one set of investors, while the other will have exciting potential, with heavy exposure to Keytruda, the firm’s monster cancer drug. But things don’t always turn out as planned, and stodgier businesses can sometimes be the better bet.

Big pharma companies have been divesting consumer and other non-core operations over the years. The story is simple enough. Discovering drugs requires lots of research and development, which is risky and costly. But success results in fast growth. On the other hand, Merck’s older drugs throw off a lot of cash: The new company will have plenty for business development and to pay a “meaningful” dividend. Moreover, the new firm will take on around $9 billion of debt and distribute nearly as much tax-free to Merck.

Besides potentially attracting new investors to each new entity, the spinoff should result in $1.5 billion of operating efficiencies, Merck estimates. This sounds optimistic: Companies, including Merck, generally say that acquisitions generate savings by centralized procurement and getting rid of extra managers. In contrast, GSK reckons its planned separation into two bits will cost up to 700 million pounds. But smaller firms are often far more productive at drug discovery and development. If Merck’s labs get more medicines to market, the spinoff will create substantial value.

While the idea is sensible, things may not turn out as planned. Keytruda accounted for over a quarter of revenue in the fourth quarter. The separation and Keytruda’s 45% growth rate mean its share of total sales will grow rapidly. That’s a lot of eggs in one basket should Keytruda’s growth disappoint.

Moreover, the new company could have the luxury of low expectations. Its older drugs may prove surprisingly durable as emerging markets usually trust branded ones over no-name generics. The business of making copies of older biologic drugs should grow for years to come. And with other pharma firms spinning off similar divisions, there’s always a chance it eventually gets bought up. That’s the kind of spin investors could easily live with.

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