Merck-Medco Spinning Off From Parent Amid Revenue Recognition Controversy; Future Uncertain

Drug Cost Management Report, July, 2002

Merck & Co. is preparing to spin off its PBM subsidiary in an initial public offering worth approximately $1 billion. The IPO was scheduled for the last week in June but was delayed as DCMR went to press due to low demand. The PBM--to be known as Medco Health Solutions, Inc., (NYSE: MHS) joins a limited playing field of publicly traded PBMs (figure 7).

Figure 7. Selected Financials for Existing Publicly Traded PBMs

                                           Quarter
PBM                   Stock Symbol          Ending          Revenues

AdvancePCS             NASDAQ:ADVP      12/31/2001    $3,365,895,000
Caremark Rx               NYSE:CMX      03/31/2002    $1,614,117,000
Express Scripts        NASDAQ:ESRX      03/31/2002    $2,749,069,000
HealthExtras           NASDAQ:HLEX      03/31/2002       $54,652,255
NMHCRx                NASDAQ: NMHC      03/31/2002      $145,683,304
ScripSolutions/        NASDAQ:MIMS      03/31/2002      $151,651,000
 MIM Corporation

                           Cost of
PBM                       Revenues    Gross Profit

AdvancePCS          $3,251,819,000    $114,076,000
Caremark Rx         $1,490,850,000    $123,267,000
Express Scripts     $2,574,412,000    $174,657,000
HealthExtras           $44,658,086      $9,994,169
NMHCRx                $136,251,197      $9,432,107
ScripSolutions/       $135,623,000     $16,028,000
 MIM Corporation

                         Operating
PBM                         Income      Net Income

AdvancePCS             $65,824,000     $27,350,000
Caremark Rx            $79,733,000     $62,495,000
Express Scripts        $78,270,000     $43,969,000
HealthExtras              $572,568        $583,708
NMHCRx                 $2,1 37,306      $1,103,245
ScripSolutions/         $6,694,000      $5,207,000
 MIM Corporation

The PBM manages $29 billion in drug spend for approximately 1,700 clients, and serves 65 million members. The spin-off includes the Systemed PBM subsidiary as well as Provantage Health Services, a PBM acquired by the company in 2000.

Merck says that the delay is due to the general stock market climate, and not to a recent Wall Street Journal article which exposed a controversial accounting procedure employed by the PBM. Merck-Medco's practice has been to count member copayments in its gross revenue, and then subtract the copayments from its cost-of-revenue portion of the balance sheet. Member copayments are paid directly to pharmacies and are never held by the PBM. Therefore, some accounting experts believe that including copayments on the PBMs statement is misleading, because it inflates the gross revenue figures for both the PBM subsidiary and it's parent company.

The PBM says it has been using this revenue recognition method since before it was acquired by Merck & Co., and maintains that the practice is within generally accepted accounting procedures (GAAP). A company spokesman explains that the method has no impact on reporting of net income or earnings per share, and has never been cited as a cause for concern before.

Caremark Rx, Inc., another publicly traded PBM, also uses this method of revenue recognition and defends it as GAAP. The other largest publicly traded PBMs, Advance PCS and Express Scripts, do not include copayments in the revenue tally. While some investors may be spooked by any critique of PBM accounting practices in the post-Enron era, many analysts are advising that the revenue recognition issue has no bearing on the stock value for either Merck & Co. or Medco Health Solutions.

Figure 8. Merck-Medco Gross Margins[*],
1999-2001

                       1999     2000     2001

Millions of dollars    $925   $1,112   $1,284
% on net revenues      5.5%     5.0%     4.4%

[*] defined as net revenues minus cost of revenues.

However, filings with the Securities and Exchange Commission have revealed that Medco Health Solutions' gross operating profits are in fact very slim--3.2% in the first quarter--and are highly dependent on rebate revenue from drug manufacturers, including parent company Merck. The PBM has received $115.6 million in rebates from Merck in the first quarter of 2002; rebates from Merck equaled 14% of the PBM's total rebates in 2001. A spokesman says operating profits may continue to shrink because PBM clients are demanding a larger portion of the rebate revenue for themselves.

Merck & Co. will retain 80.1% of Medco Health Solutions after the IPO is completed, which it will eventually distribute to Merck & Co. stockholders. In addition, Medco Health Solutions has agreed to continue promoting Merck's products--such as Zocor--on its formularies for the next five years in return for rebates. In fact, under the terms of the agreement between the PBM and Merck, Medco Health Solutions will be liable for damages to Merck if it does not maintain the agreed-upon market share for Merck's products. These factors essentially assure that the PBM's profits will continue to be tied to Merck's for the foreseeable future.

Figure 9. Merck-Medco Rebates
Received From Merck & Co.

Year     (Millions)

1999      $266.70
2000      $350.50
2001      $439.40

SOURCE: AIS

Note: Table made from a bar graph.