Why Merck's Bayer Deal Makes Sense

Merck got a great price for its consumer health business and continues to push its oncology platform forward.

May 8, 2014 at 6:30PM

Pharma giant Merck (NYSE:MRK) has been a little more active than normal lately, with most of its activities pointing toward better value creation for its shareholders. In addition to strong phase 2 hepatitis C data that vaults the company back into serious competition, Merck was the first to file for approval for its PD-1 drug, putting it in the lead to be first-to-market with this next generation of oncology immunotherapies.

Merck also recently reported earnings, updated investors on its R&D and strategic priorities, and finalized the sale of its consumer health business to Bayer (NASDAQOTH:BAYRY). All of this activated hasn't radically changed the company's earnings prospects, though it does free up significant capital that can be returned to shareholders or invested back into the business.

Bayer pays up for a rare asset
Most sell-side analysts had expected Merck to sell its consumer health business for something on the order of $9 billion to $10 billion. As it turns out, Bayer was willing to pay substantially more than that – agreeing to buy one of the largest consumer health franchises for $14.2 billion in cash. Bayer is paying around 6.5 times sales and 21 times EBITDA, a steep premium to the average of similar large transactions (4.8x / 17.4x).

Bayer was likely willing to pay so much because deals of this size and scale are seldom possible. Bayer badly wants to have the biggest consumer health business, but even after this deal that still won't be the case – assuming that the Glaxo-Novartis combination goes through, that will be the largest consumer health business with about 5.7% share, while this deal will make Bayer second with around 4.5% share. Johnson & Johnson will fall to #3 with just over 4% share.

Bayer gets a business that generates around $2 billion in revenue and boasts strong brands like Claritin and Dr. Scholl's. Importantly, Merck will maintain switch rights for its existing drug portfolio, including Singulair (though an FDA panel recently voted 11-4 against an OTC version of Singulair).

I find it a little interesting that this deal was done for cash. Merck has expressed interest in growing its animal health business and taking Bayer's animal health business back would have accomplished that goal (and likely in a more tax-efficient way). That said, it takes two to deal and Bayer likely didn't want to part with the animal health business, likely forcing it to offer more cash.

An R&D angle as well
This wasn't the only transaction between Bayer and Merck. The two companies also announced that Merck is buying into a collaboration on sGC modulators (a class of cardiology drugs). Merck is paying $1 billion for a 50/50 collaboration on Bayer's sGC drug Adempas for pulmonary aterial hypertension and will market the drug outside of the Americas. The companies will also co-develop vericiguat (BAY102) for heart failure and other potential sGC drugs in the future.

This deal should help improve Merck's cardiology business and gives it potential exposure to under-treated cardiology indications like heart failure.

A mostly positive R&D update
Merck's analyst day had some notable tidbits for investors. The company pushed hard to get its filing for MK-3475 (its PD-1 drug) into the FDA and the company has a PDUFA date of October 28 for the Yervoy-refractory melanoma indication. This isn't a large market, but it gives Merck a good shot at being first-to-market with a PD-1/PD-L1 drug, beating Bristol-Myers to the punch.

Merck also announced that its anti-GITR drug (MK-4166) was entering clinical trials. Anti-GITR drugs stimulate the immune system to attack cancer. All things considered, Merck is still behind Bristol-Myers in immuno-oncology and has had to turn to partnerships for more than Bristol-Myers to augment its early stage pipeline.

Merck also mentioned a "smart insulin" in pre-clinical development. This insulin formulation is apparently inactive at low blood glucose levels, a development which should significantly reduce the risk of hypoglycemia. It's going to be a long road for this product, but it's an interesting idea.

The bottom line
Merck has been quite strong this year, logging a 15% gain thus far and leading rivals like Glaxo, Pfizer, and Bristol-Myers by a pretty significant amount. Optimism regarding the company's hepatitis C and oncology platforms has no doubt helped, as has anticipation of a strong price for the consumer health business. Merck doesn't look tremendously expensive at this level, though I would be a little nervous about sell-side analysts turning more negative on relative value calls in the space. That's admittedly a very short-term concern.

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Stephen D. Simpson, CFA has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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