Merck and Schering-Plough Merger: When Form Overrides Substance
If it walks like a duck and quacks like a duck, is it really a duck? That is a question Johnson & Johnson might ask about a 2009
transaction involving pharmaceutical companies Merck and Schering-Plough. On August 7, 2009, shareholders of Merck and Company
(“Merck”) and Schering-Plough Corp. (Schering-Plough) voted overwhelmingly to approve a $41.1 billion merger of the two firms. With
annual revenues of $42.4 billion, the new Merck will be second in size only to global pharmaceutical powerhouse Pfizer Inc.
The motivation for the merger reflects the potential for $3.5 billion in pretax annual cost savings, with Merck reducing its workforce
by about 15 percent through facility consolidations, a highly complementary product offering, and the substantial number of new drugs
under development at Schering-Plough. Furthermore, the deal increases Merck’s international presence, since 70 percent of Schering–
Plough’s revenues come from abroad. The combined firms both focus on biologics (i.e., drugs derived from living organisms). The new
firm has a product offering that is much more diversified than either firm had separately.
The deal structure involved a reverse merger, which allowed for a tax-free exchange of shares and for Schering-Plough to argue that it
was the acquirer in this transaction. The importance of the latter point is explained in the following section.
Former shareholders of Schering-Plough and Merck become shareholders in the new Merck. The “New Merck” is simply Schering–
Plough renamed Merck. This structure allows Schering-Plough to argue that no change in control occurred and that a termination clause
in a partnership agreement with Johnson & Johnson should not be triggered. Under the agreement, J&J has the exclusive right to sell a
rheumatoid arthritis drug it had developed called Remicade, and Schering-Plough has the exclusive right to sell the drug outside the
United States, reflecting its stronger international distribution channel. If the change of control clause were triggered, rights to distribute
the drug outside the United States would revert back to J&J. Remicade represented $2.1 billion or about 20 percent of Schering-Plough’s
2008 revenues and about 70 percent of the firm’s international revenues. Consequently, retaining these revenues following the merger was
important to both Merck and Schering-Plough.
The multi-step process for implementing this transaction is illustrated in the following diagrams. From a legal perspective, all these
actions occur concurrently.
Step 1: Schering-Plough renamed Merck (denoted in the diagrams as “New Merck”)
a. Schering-Plough creates two wholly-owned merger subs
b. Schering-Plough transfers cash provided by Merck and newly issued “New Merck” stock
into Merger Sub 1 and only “New Merck” stock into Merger Sub 2.
“New Merck”
(Schering Plough)
Step 2: Schering-Plough Merger:
a. Merger Sub 1 merges into Schering-Plough in a reverse merger with Schering-Plough
surviving
b. To compensate shareholders, Schering-Plough shareholders exchange their
shares for cash and stock in “New Merck”
c. Former Schering-Plough shareholders now hold stock in “New Merck”
Step 3: Merck Merger:
a. Merger Sub 2 merges into Merck with Merck surviving
b. To compensate shareholders, Merck shareholders exchange their shares for
shares in “New Merck”
Combined Company Resulting from Steps 1-3
Schering-Plough
Shareholders
“New Merck”
(Schering-Plough)
1 Share of Schering-Plough
Common
Merck Shareholders
Merck
Merger Sub 2
“New Merck”
(Schering-Plough)
1 Share of “New Merck” common
1 Share of Merck Common
Merger
Former Merck Shareholders
Former Schering-Plough
Shareholders
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Concluding Comments
In reality, Merck was the acquirer. Merck provided the money to purchase Schering-Plough, and Richard Clark, Merck’s chairman and
CEO, will run the newly combined firm when Fred Hassan, Schering-Plough’s CEO, steps down. The new firm has been renamed Merck
to reflect its broader brand recognition. Three-fourths of the new firm’s board consists of former Merck directors, with the remainder
coming from Schering-Plough’s board. These factors would give Merck effective control of the combined Merck and Schering-Plough
operations. Finally, former Merck shareholders own almost 70 percent of the outstanding shares of the combined companies.
J&J initiated legal action in August 2009, arguing that the transaction was a conventional merger and, as such, triggered the change of
Discussion Questions:
1. Do you agree with the argument that the courts should focus on the form or structure of an agreement and not try to interpret
the actual intent of the parties to the transaction? Explain your answer.
2. How might allowing the form of a transaction to override the actual spirit or intent of the deal impact the cost of doing business
for the parties involved in the distribution agreement? Be specific.
Answer: When form trumps the actual intent of the parties to an agreement, the risks associated with doing deals increase. For
agreements to work well, they must ultimately require that the parties to an agreement trust each other. The purpose of such
3. How did the use of a reverse merger facilitate the transaction?
Answer: The use of a reverse merger enabled the transaction to be considered tax free in that both the continuity of ownership
Merck
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In the first instance, Merger Sub 1 was merged into its parent Schering-Plough, with Schering-Plough surviving. The creation
of Merger Sub 1, which contained “New Merck” stock (created by Schering-Plough) and cash (provided by Merck), provided
Cablevision Uses Tax Benefits to Help Justify the Price Paid for Bresnan Communications
In mid-2010, Cablevision Systems announced that it had reached an agreement to buy privately owned Bresnan Communications for
$1.37 billion in a cash for stock deal. CVS’ motivation for the deal reflected the board’s belief that the firm’s shares were undervalued
and their desire to expand coverage into the western United States.
CVS is the most profitable cable operator in the industry in terms of operating profit margins, due primarily to the firm’s heavily
concentrated customer base in the New York City area. Critics immediately expressed concern that the acquisition would provide few
immediate cost savings and relied almost totally on increasing the amount of revenue generated by Bresnan’s existing customers.
In order to gain shareholder support, CVS announced a $500 million share repurchase to placate shareholders seeking a return of cash.
The deal was financed by a $1 billion nonrecourse loan and $370 in cash from Cablevision. CVS points out that the firm’s direct
investment in BC will be more than offset by tax benefits resulting from the structure of the deal in which both Cablevision and Bresnan
agreed to treat the purchase of Bresnan’s stock as an asset purchase for tax reporting purposes (i.e., a 338 election). Consequently, CVS
will be able to write up the net acquired Bresnan assets to their fair market value and use the resulting additional depreciation to generate
significant future tax savings. Such future tax savings are estimated by CVS to have a net present value of approximately $400 million
Discussion Question:
1. How is the 338 election likely to impact Cablevision System’s earnings per share immediately following closing? Why?
2. As an analyst, how would you determine the impact of the anticipated tax benefits on the value of the firm?
3. What is the primary risk to realizing the full value of the anticipated tax benefits?
Teva Pharmaceuticals Buys Ivax Corporation
Teva Pharmaceutical Industries’, a manufacturer and distributor of generic drugs, takeover of Ivax Corp for $7.4 billion created the
world’s largest manufacturer of generic drugs. For Teva, based in Israel, and Ivax, headquartered in Miami, the merger eliminated a large
competitor and created a distribution chain that spans 50 countries.
To broaden the appeal of the proposed merger, Teva offered Ivax shareholders the option to receive for each of their shares either
0.8471 of American depository receipts (ADRs) representing Teva shares or $26 in cash. ADRs represent the receipt given to U.S.
Case Study. JDS Uniphase–SDL Merger Results in Huge Write-Off
What started out as the biggest technology merger in history up to that point saw its value plummet in line with the declining stock
market, a weakening economy, and concerns about the cash-flow impact of actions the acquirer would have to take to gain regulatory
approval. The $41 billion mega-merger, proposed on July 10, 2000, consisted of JDS Uniphase (JDSU) offering 3.8 shares of its stock for
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each share of SDL’s outstanding stock. This constituted an approximate 43% premium over the price of SDL’s stock on the
announcement date. The challenge facing JDSU was to get Department of Justice (DoJ) approval of a merger that some feared would
result in a supplier (i.e., JDS Uniphase–SDL) that could exercise enormous pricing power over the entire range of products from raw
components to packaged products purchased by equipment manufacturers. The resulting regulatory review lengthened the period between
the signing of the merger agreement between the two companies and the actual closing to more than 7 months. The risk to SDL
shareholders of the lengthening of the time between the determination of value and the actual receipt of the JDSU shares at closing was
that the JDSU shares could decline in price during this period.
As of July 10, 2000, JDSU had a market value of $74 billion with 958 million shares outstanding. Annual 2000 revenues amounted to
$1.43 billion. The firm had $800 million in cash and virtually no long-term debt. Including one-time merger-related charges, the firm
recorded a loss of $905 million. With its price-to-earnings (excluding merger-related charges) ratio at a meteoric 440, the firm sought to
use stock to acquire SDL, a strategy that it had used successfully in eleven previous acquisitions. JDSU believed that a merger with SDL
would provide two major benefits. First, it would add a line of lasers to the JDSU product offering that strengthened signals beamed
across fiber-optic networks. Second, it would bolster JDSU’s capacity to package multiple components into a single product line.
On July 9, 2000, the boards of both JDSU and SDL unanimously approved an agreement to merge SDL with a newly formed, wholly
owned subsidiary of JDS Uniphase, K2 Acquisition, Inc. K2 Acquisition, Inc. was created by JDSU as the acquisition vehicle to complete
the merger. In a reverse triangular merger, K2 Acquisition Inc. was merged into SDL, with SDL as the surviving entity. The post-closing
organization consisted of SDL as a wholly owned subsidiary of JDS Uniphase. The form of payment consisted of exchanging JDSU
common stock for SDL common shares. The share exchange ratio was 3.8 shares of JDSU stock for each SDL common share
outstanding. Instead of a fraction of a share, each SDL stockholder received cash, without interest, equal to dollar value of the fractional
share at the average of the closing prices for a share of JDSU common stock for the 5 trading days before the completion of the merger.
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the public. The consummation of the merger was to be subject to approval by the shareholders of both companies, the approval of the
regulatory authorities as specified under the HSR, and any other foreign antitrust law that applied. For both parties, representations and
warranties (statements believed to be factual) must have been found to be accurate and both parties must have complied with all of the
agreements and covenants (promises) in all material ways.
The following are just a few examples of the 18 closing conditions found in the merger agreement. The merger is structured so that
JDSU and SDL’s shareholders will not recognize a gain or loss for U.S. federal income tax purposes in the merger, except for taxes
payable because of cash received by SDL shareholders for fractional shares. Both JDSU and SDL must receive opinions of tax counsel
Case Study Discussion Questions
1. What is goodwill? How is it estimated? Why did JDS Uniphase write down the value of its goodwill in 2001? Why does this
reflect a series of poor management decisions with respect to mergers completed between 1999 and early 2001?
Answer: In theory, goodwill represents the value of the acquired firm’s intangible value including brand, intellectual property,
good customer relations, and high employee morale. Goodwill is calculated as the excess of the purchase price over the target’s
net book assets (i.e., the sum of the book value of equity of the acquired company plus revalued assets less revalued liabilities.
The $38.7 billion write-down of the firm’s goodwill reflected the declining market value of the assets acquired through a series
2. How might the use of stock, as an acquisition “currency,” have contributed to the sustained decline in JDS Uniphase’s stock
through mid-2001? In your judgment what is the likely impact of the glut of JDS Uniphase shares in the market on the future
appreciation of the firm’s share price? Explain your answer.
Answer: The lofty JDSU share price in 1999 and early 2000 made it a very attractive acquisition “currency.” Management
presumed that projected synergies would result in a more than proportional increase in future earnings sufficient to offset the
3. What are the primary differences between a forward and a reverse triangular merger? Why might JDS Uniphase have chosen to
merge its K2 Acquisition Inc. subsidiary with SDL in a reverse triangular merger? Explain your answer.
Answer: Both forward and reverse triangular mergers are used to effect tax-free transactions. Forward and reverse mergers are
similar in that they both require purchase of at least 80% of the FMV of the target’s net assets, allow acquirer to retain the
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4. Discuss various methodologies you might use to value assets acquired from SDL such as existing technologies, “core”
technologies, trademarks and trade names, assembled workforce, and deferred compensation?
Answer: The value of intellectual property may be estimated by looking at recent comparable sales, by estimating the cost of
replacing such assets, by computing the present value of royalties generated if such assets were licensed, or by treating the asset
5. Why do boards of directors of both acquiring and target companies often obtain so-called “fairness opinions” from outside
investment advisors or accounting firms? What valuation methodologies might be employed in constructing these opinions?
Should stockholders have confidence in such opinions? Why/why not?
Answer: Fairness opinions are often obtained to minimize potential liability from shareholder lawsuits which might ensue if it is
later determined that the acquirer “overpaid” for the target firm or that the target firm’s shareholders received less than fair
Consolidation in the Wireless Communications Industry:
Vodafone Acquires AirTouch
.
Deregulation of the telecommunications industry has resulted in increased consolidation. In Europe, rising competition is the catalyst
driving mergers. In the United States, the break up of AT&T in the mid-1980s and the subsequent deregulation of the industry has led to
key alliances, JVs, and mergers, which have created cellular powerhouses capable of providing nationwide coverage. Such coverage is
being achieved by roaming agreements between carriers and acquisitions by other carriers. Although competition has been heightened as
a result of deregulation, the telecommunications industry continues to be characterized by substantial barriers to entry. These include the
requirement to obtain licenses and the need for an extensive network infrastructure. Wireless communications continue to grow largely at
the expense of traditional landline services as cellular service pricing continues to decrease. Although the market is likely to continue to
grow rapidly, success is expected to go to those with the financial muscle to satisfy increasingly sophisticated customer demands. What
follows is a brief discussion of the motivations for the merger between Vodafone and AirTouch Communications. This discussion
includes a description of the key elements of the deal structure that made the Vodafone offer more attractive than a competing offer from
Bell Atlantic.
Vodafone
Company History
Vodafone is a wireless communications company based in the United Kingdom. The company is located in 13 countries in Europe,
Africa, and Australia/New Zealand. Vodafone reaches more than 9.5 million subscribers. It has been the market leader in the United
Kingdom since 1986 and as of 1998 had more than 5 million subscribers in the United Kingdom alone. The company has been very
successful at marketing and selling prepaid services in Europe. Vodafone also is involved in a venture called Globalstar, LP, a limited
partnership with Loral Space and Communications and Qualcomm, a phone manufacturer. “Globalstar will construct and operate a
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worldwide, satellite-based communications system offering global mobile voice, fax, and data communications in over 115 countries,
covering over 85% of the world’s population”.
Strategic Intent
Vodafone’s focus is on global expansion. They are expanding through partnerships and by purchasing licenses. Notably, Vodafone lacked
a significant presence in the United States, the largest mobile phone market in the world. For Vodafone to be considered a truly global
Company Structure
The company is very decentralized. The responsibilities of the corporate headquarters in the United Kingdom lie in developing corporate
strategic direction, compiling financial information, reporting and developing relationships with the various stock markets, and evaluating
AirTouch
Company History
AirTouch Communications launched it first cellular service network in 1984 in Los Angeles during the opening ceremonies at the 1984
Olympics. The original company was run under the name PacTel Cellular, a subsidiary of Pacific Telesis. In 1994, PacTel Cellular spun
off from Pacific Telesis and became AirTouch Communications, under the direction of Chair and Chief Executive Officer Sam Ginn.
Strategic Intent
AirTouch has chosen to differentiate itself in its domestic regions based on the concept of “Superior Service Delivery.” The company’s
focus is on being available to its customers 24 hours a day, 7 days a week and on delivering pricing options that meet the customer’s
Company Structure
AirTouch is decentralized. Regions have been developed in the U.S. market and are run autonomously with respect to pricing decisions,
marketing campaigns, and customer care operations. Each region is run as a profit center. Its European operations also are run
Merger Highlights
Vodafone began exploratory talks with AirTouch as early as 1996 on a variety of options ranging from partnerships to a merger. Merger
talks continued informally until late 1998 when they were formally broken off. Bell Atlantic, interested in expanding its own mobile
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Motivation for the Merger
Shared Vision
The merger would create a more competitive, global wireless telecommunications company than either company could achieve
separately. Moreover, both firms shared the same vision of the telecommunications industry. Mobile telecommunications is believed to be
Complementary Assets
Scale, operating strength, and complementary assets were given as compelling reasons for the merger. The combination of AirTouch and
Vodafone would create the largest mobile telecommunication company at the time, with significant presence in the United Kingdom,
United States, continental Europe, and Asian Pacific region. The scale and scope of the operations is expected to make the combined
Synergy
Anticipated synergies include after-tax cost savings of $340 million annually by the fiscal year ending March 31, 2002. The estimated net
present value of these synergies is $3.6 billion discounted at 9%. The cost savings arise from global purchasing and operating efficiencies,
AirTouch’s Board Analyzes Options
Morgan Stanley, AirTouch’s investment banker, provided analyses of the current prices of the Vodafone and Bell Atlantic stocks, their
historical trading ranges, and the anticipated trading prices of both companies’ stock on completion of the merger and on redistribution of
the stock to the general public. Both offers were structured so as to constitute essentially tax-free reorganizations. The Vodafone proposal
Table 1. Comparison of Form of Payment/Total Consideration
Vodafone
Bell Atlantic
5 shares of Vodafone common plus $9 for each
share of AirTouch common
1.54 shares of Bell Atlantic for each share of AirTouch common
subject to the transaction being treated as a pooling of interest under
U.S. GAAP.
Share exchange ratio adjusted upward 9 months out to reflect the
payment of dividends on the Bell Atlantic stock.
A share exchange ratio collar would be used to ensure that AirTouch
shareholders would receive shares valued at $80.08. If the average
Morgan Stanley’s primary conclusions were as follows:
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1. Bell Atlantic had a current market value of $83 per share of AirTouch stock based on the $53.81 closing price of Bell Atlantic common
2. The Vodafone proposal had a current market value of $97 per share of AirTouch stock based on Vodafone’s ordinary shares (i.e.,
common) on January 17, 1999.
3. Following the merger, the market value of the Vodafone American Depository Shares (ADSs) to be received by AirTouch shareholders
under the Vodafone proposal could decrease.
4. Following the merger, the market value of Bell Atlantic’s stock also could decrease, particularly in light of the expectation that the
proposed transaction would dilute Bell Atlantic’s EPS by more than 10% through 2002.
In addition to Vodafone’s higher value, the board tended to favor the Vodafone offer because it involved less regulatory uncertainty.
As U.S. corporations, a merger between AirTouch and Bell Atlantic was likely to receive substantial scrutiny from the U.S. Justice
Department, the Federal Trade Commission, and the FCC. Moreover, although both proposals could be completed tax-free, except for the
Acquisition Vehicle and Post Closing Organization
In the merger, AirTouch became a wholly owned subsidiary of Vodafone. Vodafone issued common shares valued at $52.4 billion based
on the closing Vodafone ADS on April 20, 1999. In addition, Vodafone paid AirTouch shareholders $5.5 billion in cash. On completion
of the merger, Vodafone changed its name to Vodafone AirTouch Public Limited Company. Vodafone created a wholly owned
subsidiary, Appollo Merger Incorporated, as the acquisition vehicle. Using a reverse triangular merger, Appollo was merged into
Discussion Questions:
1. Did the AirTouch board make the right decision? Why or why not?
2. How valid are the reasons for the proposed merger?
Answer: Vodafone was intent on becoming a global carrier. To achieve this goal, it was necessary for the firm to achieve
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3. What are the potential risk factors related to the merger?
Answer: The risks include the potential for having overpaid and for not being able to earn Vodafone’s cost of capital on the
4. Is this merger likely to be tax free, partially tax free, or taxable? Explain your answer.
5. What are some of the challenges the two companies are likely to face while integrating the businesses?
Answer: While no integration is ever easy, the two companies are compatible in many ways. They are managed on a
decentralized basis, have a shared vision of how to grow the cellular business, and have relatively young workforces.
Determining Deal Structuring Components
BigCo has decided to acquire Upstart Corporation, a leading supplier of a new technology believed to be crucial to the successful
implementation of BigCo’s business strategy. Upstart is a relatively recent start-up firm, consisting of about 200 employees averaging
about 24 years of age. HiTech has a reputation for developing highly practical solutions to complex technical problems and getting the
resulting products to market very rapidly. HiTech employees are accustomed to a very informal work environment with highly flexible
hours and compensation schemes. Decision-making tends to be fast and casual, without the rigorous review process often found in larger
firms. This culture is quite different from BigCo’s more highly structured and disciplined environment. Moreover, BigCo’s decision
making tends to be highly centralized.
New Horizons issued stock through an initial public offering. While the co-founders are interested in exchanging their stock for New
Horizon’s shares, the remaining Upstart shareholders are leery about the long-term growth potential of New Horizons and demand cash in
exchange for their shares. Consequently, New Horizons agreed to exchange its stock for the co-founders’ shares and to purchase the
remaining shares for cash. Once the tender offer was completed, New Horizons owned 100 percent of Upstart’s outstanding shares.
Discussion Questions:
1. What is the acquisition vehicle used to acquire the target company, Upstart Corporation? Why was this legal structure used?
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Answer: The acquisition vehicle is a joint venture corporation. This legal structure was used to mitigate risk by spreading the
2. How would you characterize the post-closing organization? Why was this organizational structure used?
Answer: The post closing organization is a holding company framework. This post closing structure was chosen to preserve
3. What is the form of payment? Why was it used?
Answer: The form of payment is a combination of cash and stock for the Upstart’s outstanding stock. This form of payment was
4. What was the form of acquisition? How does this form of acquisition protect the acquiring company’s rights to HiTech’s
proprietary technology?
Answer: The form of acquisition was a purchase of stock. This is preferable in this instance because of the importance of
5. How would the use of purchase accounting affect the balance sheets of the combined companies?
Answer: Assuming the acquirer adopted a Section 338 election, Upstart’s assets would have been revalued with a portion of
6. Was the transaction non-taxable, partially taxable, or wholly taxable to HiTech shareholders? Why?
Answer: The transaction would have been partially taxable. It would have been tax-free for those receiving stock and taxable to