MERCK EXPECTS MEDCO’s 33 MIL. COVERED LIVES TO PROVIDE "SIGNIFICANT" ADDED VOLUME FOR MERCK BRAND AND GENERIC DRUGS: ACCESS TO PATIENT INFORMATION IS KEY

The 33 mil. covered lives and 95 mil. annual prescriptions generated by Medco Containment Services drug benefit plans are the clearest short-term attractions underlying Merck's $6 bil. acquisition offer for the prescription drug management firm. The 60% stock/40% cash offer was unveiled by Merck and Medco on July 28 following board approvals by the two companies on the previous day. The large patient/prescription base will immediately give Merck an unprecedented close-up view of actual drug dispensing and use patterns for a large segment of the prescription drug market. Through its PAID subsidiary, Medco processes over 61 mil. prescriptions annually. The firm directly dispenses another 34 mil.-plus prescriptions through its mail-service pharmacy business. Together, the PAID retail prescriptions and the mail-service prescriptions account for almost $4 bil. in annual drug expenditures. As another benchmark on the size of Medco's current operations, the firm claims to provide management services for 22% of the funded pharmaceutical market. The $6 bil. price tag can be calculated from two perspectives. From traditional calculations, it is designed to offer Medco shareholders more than a $9 per share gain (or a 31% premium over current Medco NASDAQ trading) and about 2.3 times estimated revenues and 45 times estimated earnings in Medco's just-completed June 30 fiscal year. The purchase price for the vertical Merck-Medco integration is half of the valuation placed on the Bristol-Myers Squibb horizontal merger announced four years and two days earlier, on July 27, 1989. That stock-swap transaction was priced at $12 bil. From a less traditional perspective, it can be calculated as a cost per life -- a cost for the opportunity to make each Medco covered life a more solid customer for Merck drug products. By that measure, Merck will be paying about $181 per patient for each of the roughly 33 mil. covered lives currently under Medco drug benefit programs. Merck expects that covered life figure to be a point of departure for further growth and for the number of Medco lives to "rise markedly" in the future. Merck Chairman Roy Vagelos stressed the added prescription volume potential from better drug compliance at a merger press conference, noting that a large number of patients/customers slip away from treatment. Pointing out that 29% of people over the age of 45 stop taking medications before they should, Vagelos maintained that "approximately 50% of patients on chronic therapy, such as drugs to reduce high blood pressure or high blood cholesterol, stop within a year." Medco's full patient profile records and prescribing information could permit Merck-Medco to devise systems for reminding patients to continue medications -- or carried further, it could also lead to efforts to define patients on the database at risk of other diseases. Those patients could be advised to seek medical check-ups. Merck and Medco explain that "we will bring to patients new programs to encourage them to help manage their own pharmaceutical care." Merck has prided itself on being a research-intensive firm. If it merges with Medco, it will still be research-intensive, just with a broader definition of research: focusing on marketing/drug use information as well as new drug development. While access to data and information is one of the first gains for Merck, the company also has the potential in the short-term to increase its drug volume to a large subset of the Medco covered lives. For about one-third of its covered lives, Medco has a direct impact on drug selection through managed care pharmacy (i.e., formulary) plans. The broad Merck line of branded and recently added generic products from West Point Pharma could quickly form the foundation for those formularies. As of May 1 of this year, Medco had 10 mil. lives covered under formularies: 8 mil. in integrated retail and mail-order plans and 2 mil. under mail- order-only managed care programs. Merck and Medco maintain that they will continue to work "with all pharmaceutical companies to meet customer needs." The companies stress that the acquisition has no impact on existing Medco contracts. Medco's selection process for covered drugs will continue to be an independent process within an independent Medco, the companies say. Basic business logic, however, indicates that with a $6 bil. investment at risk, Merck will quickly attempt to substitute as many of its products as possible for the current Medco formulary products. Medco VP Strategic Marketing and Planning Per Lofberg told a July 28 press conference: "We will continue to provide high-quality single source and multisource products from all manufacturers which will result in the most cost-effective plans to the payors." Merck products will have a most-favored status, Lofberg acknowledged. Medco "will obviously" include Merck products "in these programs," the Medco exec said, "and, where cost effective, we will use our established prescriber intervention methods to make use of Merck products." Merck Chief Financial Officer Judy Lewent reminded securities analysts July 28 that Medco Chairman Martin Wygod had been quoted as saying that Merck products have been "under-represented" in Medco sales, although Merck has been a supplier of Medco since the spring and Merck claims its products accounted for over 12.6% of the mail-order business in 1992. Lewent pointed out that after the Medco deal, Merck will obviously benefit by better representation. She said Merck expects "significant" added volume. Merck Chairman Vagelos indirectly commented on the opportunity for shifting Medco customers to Merck products. He noted the increased trend towards therapeutic substitution within drug classes. Therapeutic substitution "is growing," Vagelos maintained, "because medical scientists out there recognize that in some classes drugs are similar and can be substituted. There are some buyers, some payors who would like substitution to begin." Medco's Prescriber's Choice counterdetailing program designed to shift prescriptions to a select group of Medco-chosen products encompassed 6-7 mil. lives as of the beginning of May. The Merck chairman also expressed interest in the ability of Merck to begin providing generic substitutes for major products soon coming off patent. He noted a number of major drug products are losing patent protection and Merck-Medco plan to take advantage of that opportunity, presumably through West Point Pharma. Interest in a deal with Medco may explain why Merck decided to start up West Point Pharma as an in-house entity instead of using the DuPont-Merck joint venture to participate in the generic business. There were strong indications just prior to the establishment of West Point Pharma that Merck intended to use the DuPont-Merck joint venture as a way to enter the generic business. That approach, however, would not have allowed Merck as much control over the production cost or internal pricing of specific drugs. At the July 28 session with analysts, Lewent cited manufacturing efficiencies as one advantage of the deal. She noted for example, that there is a duplication of effort for packaging Merck products for Medco that can be quickly eliminated. She did not specifically mention potential changes in the distribution of Merck products to retail outlets and the downstream customer, but she stressed that the potential for synergies was the reason that Merck decided to approach the Medco deal as a full purchase instead of the joint-venture approach used with Astra, J&J and DuPont. Merck's manufacturing strength and broad line may also be one of the incentives for Medco to merge at this point. The drug benefits firm recently has been explaining to analysts that the managed care programs have a lower profit margin because of the way the revenues and costs are reported. The company reports the full value of a prescription filled as a sale but is obligated to report the costs of filling the product as a cost-of-goods. If the cost of goods could be controlled more rigorously in-house, that might help address margin erosion for Medco. Similarly, Merck can see a long-term reduction in sales costs if it can use Medco's sales approach to big plans to create large one-shot sales opportunities for its products. Merck says it does not anticipate a sudden drop in the size of its sales force after the merger but will continue to let attrition reduce the size of its costly selling operation. In the longer term, Merck is positioning itself for an accelerated consolidation in pharmaceutical purchasing as a result of the percolating health care reform proposals. If, for example, the market for pharmaceuticals were quickly aggregated under the health alliance approach to purchasing coverage, Merck would have in-house an experienced pharmaceutical benefit plan managment group for bid for large chuncks of that market. At the merger press conference, Vagelos noted: "We want to go to governments, starting in the U.S., and convince them the way we are doing it may be a model and we can facilitate any changes health care reform might come up with." The Merck-Medco vertical integration was described by Medco Chairman Wygod as permitting the two companies to "complete the cycle from discovering drugs, to diagnosing and prescribing, to educating patients, to dispensing medicines and monitoring utilization, through measuring outcomes and initiating new research." Medco calls itself the "nation's largest provider of managed prescription care," based on sales of $2.2 bil. in calendar 1992. In terms of covered lives, however, McKesson's PCS subsidiary may recently have caught up to and surpassed Medco. At McKesson's July 28 annual meeting, the company reported that PCS "has received commitments from clients that will add more than 7 mil. members to its managed pharmacy care programs, increasing the total lives covered to 42 mil." McKesson said that figure has more than doubled in one year. The announcement of the Merck-Medco agreement came just over a year after Medco disclosed that it was exploring the possibility of a horizontal merger in the provider/benefit management sector. Medco was in discussions regarding a possible business combination with United Healthcare, but those talks resulted only in a short- lived marketing agreement with United Healthcare's Diversified Pharmaceutical Services ("The Pink Sheet" July 13, 1992, T&G-1). That marketing agreement ended in May.