Merck & Co. Spin-off Quick Summary – February 13, 2020
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On February 5th, in conjunction with Merck’s 4Q and FY19 earnings release, Merck announced that it would be spinning off a portfolio of products from its Women’s Health, Legacy Brands, and Biosimilars businesses into a new independent, publicly traded company that they are currently calling Newco. The transaction is expected to occur in the first half of 2021 and is expected to be tax-free for current Merck shareholders. Additionally, Merck is expected to receive an $8-9BN special dividend from NewCo (most likely funded through debt) upon the consummation of the transaction.
Why the Spin-off?
As management talked about extensively during the presentation to investors and analysts, there are a number of compelling financial and strategic reasons for the transaction. From a financial perspective, management is expecting up to 100bps of revenue growth acceleration from 2021 to 2024 after shedding their lower growth segments. Additionally, management is projecting $1.5BN in pre-tax operating efficiencies by 2024, implying an operating margin over 40% by 2024. It isn’t clear to us why a spin-off would drive operating efficiencies, but perhaps management is taking the spin-off as an opportunity to reevaluate its cost base. From a strategic perspective, management harped on a few key points that drove the decision to do this transaction.
The spin-off (“NewCo”) contains a portfolio of drugs that are considered to be much lower growth than the rest of Merck’s business. This is a global pharmaceutical business within the Women’s Health sub-segment in addition to some legacy brands and biosimilar products. Some select brands within this space include Nexplanon, Renflexis, Ontruzant, Zetia, Puregon Pen, Brenzys, Singulair, and Arcoxia.
Unfortunately, Merck did not provide specific financial information on this segment other than informing investors that NewCo is 15% of MRK revenue, 25% of their manufacturing sites, 50% of their products, and 60% of the parent company’s SKUs.
Additionally, per the Philadelphia Business Journal, management expects top line growth for NewCo to be minimal over the next four years, although they do expect more acceleration from the business on its own versus as a part of Merck. Management has called out the decline in revenues expected in 2021 versus 2020, essentially blaming the issues on a loss of exclusivities on Zetia in Japan and Nuvaring in the United States.
Consumer expenditures in the global pharmaceutical market are expected to grow modestly over the next few years, driven by an aging population and an increase in drug innovation. However, there are significant headwinds in the space as well, driven by cost cutting and price controls around both generic and patent-protected drugs. Growth will then have to come from volume, as price increases will be increasingly difficult to come by for these firms.
Globally, the pharmaceutical industry is rather fragmented, leading to intense competition across all three segments for NewCo. They’ll compete on the segment level, especially in the defined niche of biosimilars and women’s health. Most of the competition here will revolve around the maintenance of patents on current drugs, significant R&D breakthroughs, and pricing power contingent on a lack of government regulation of price.
The NewCo will create, design, and manufacture pharmaceutical drugs, primarily distributing these drugs via wholesalers, then selling said drugs to pharmacies and hospitals, where they will be prescribed to patients. Patients and their health insurers end up bearing the final cost of the drugs. With that being said, Merck hasn’t broken out customers of the spin-off versus customers of their overall business, so investors cannot pinpoint their exact exposure.
Quality of Business
The newly formed business is relatively high margin with a low capital intensity. As such, it will generate high returns on invested capital. However, the business will be slow/no growth. As such, I do not expect it to trade at a high valuation.
Although management has not yet announced what the specific capital structure will look like, investors can safely assume that this spin-off will carry debt as NewCo will pay out $8-9bn to Merck in conjunction with the spin-off.
Top management for NewCo has been announced, with two veterans assuming the Chief Executive and Chairman of the Board positions. The Chief Executive Officer will be Kevin Ali, currently a Senior Vice President at Merck leading their enterprise portfolio strategy including responsibility for the strategic review of Merck’s Human Health portfolio. He has three decades of pharmaceutical and commercial experience, and he was an expected choice to take the role.
Carrie Cox will be the Chairman of the Board of Directors for the NewCo after the spin-off. Cox is the former chairman and CEO of Humacyte, a leading biomedical engineering company from 2010 through 2018. Additionally, she served as the EVP and President of Global Pharmaceuticals at Schering-Plough until its merger with Merck in 2009.
Potential for Indiscriminate Selling
There definitely could be indiscriminate selling as the spin-off will be viewed as a less attractive company than Remainco. Further, the spin-off will be significantly smaller (although still a large cap) than Remainco. There could also be indiscriminate selling if the spin-off isn’t included in the S&P 500 index, where Merck is currently a constituent.
Merck currently trades at 11.4x forward EBITDA. We would expect the current spin-off to trade at a significant discount to Merck.
Our best guess is that Mylan’s current multiple of 7x EBITDA would be appropriate. Similar to Mylan, Merck’s spin-off will have significant exposure to generics with declining revenue.
Assuming a 7x EV/EBITDA multiple, the spin-off should trade at a $16.8BN to $20.5BN enterprise value range.