Merck's Zocor protection program for the spin-off of MedcoHealth Solutions includes an incentive for Medco to keep the cholesterol agent at a market share level tied to its 2001 position.

During the 12 months from July 1, 2002 to June 30, 2003, Merck will reward Medco with extra rebates if the PBM can keep Zocor's share in the plans it administers near the levels that the product achieved in the overall third-party market in 2001.

The added rebates are explained in several paragraphs specific to Zocor in the ¹ S-1 registration statement for the Medco spin-off. Merck filed the IPO April 17 (² Also see "Merck Minus Medco Sets Ambitious Margin Benchmark: 82% On Pure Rx" - Pink Sheet, 22 April, 2002., p. 25).

The special treatment for the $4 bil.-plus U.S. annual sales product appears intended to send a clear message to the financial markets and statin competitors that Merck is retaining control over Medco's drug sales in the statin class despite the spin-off of 20% of Medco's ownership.

The five-year agreement between Merck and Medco beginning on July 1 is openly designed to maintain market share for Zocor and the full line of Merck drugs, and to protect Merck products from restrictions that would favor competitors.

Medco "may" earn added rebates, the S-1 explains, if it can achieve "a market share differential" between Zocor sales in Medco plans and the non-Medco "national third-party market share for Zocor...as of Dec. 31, 2001, less an agreed reduction."

The "agreed reduction" is an implicit acknowledgement by Merck and Medco of the anticipated difficulty of maintaining the status quo against the existing statins led by Lipitor and the expected AstraZeneca entrant Crestor .

Across the full Merck line, Medco has an incentive to keep market share markers from dropping by seven percentage points.

Medco has a target of maintaining a market share ratio (defined as Merck's market share in Medco's programs versus national third-party programs) at a level no lower than seven percentage points below 2001.

"If we fail to maintain the aggregate dollar weighted market share of Merck products at the required level for any quarter," Medco states, the PBM will have to pay Merck liquidated damages and "we will forfeit all" Merck rebates for that quarter.

Medco will also earn specific formulary-access rebate payments from Merck for high utilization of Zocor "in certain plans that Merck determines have high control over utilization" of statins.

Zocor has the highest sales of any Merck product in the Medco plans, and thus "accounts for a higher proportion of rebates" from Merck, Medco notes.

The total "imputed" gross rebates from Merck to Medco during the past three years have been $266.7 mil. (1999), $350.5 mil. (2000) and $439.4 mil. (2001). Medco estimates that the 2002 rebates under the new formulas should remain close to the $439 mil. in 2001.

Merck and Medco are careful in the spin-off prospectus to provide an array of varying, apples-and-oranges facts that give glimpses of Medco's business (and particularly the rebates), but do not permit a clear, full picture.

For example, Medco discloses that Merck's 2001 rebate payments to Medco represented 14% of the total pharmaceutical rebates "that contributed" to Medco's "net profit."

That net profit contribution percentage cannot be directly applied to the imputed gross rebate figures. A direct extrapolation of the full size of Medco's rebate revenues is not possible from the data provided in the S-1 filing.

If it is assumed, however, that Merck's net rebate percentage contribution is representative of Merck's share of gross rebates, then a rough approximation of Medco's total rebate payments from all manufacturers can be calculated at near $3 bil. during 2001.

The $3 bil. in rebates would approximate 10% of total pharmaceutical purchases by Medco.

There are three different figures that define the PBM's drug purchases.

Medco reports a "drug spend" in 2001 of $29.4 bil. (up 27% from 2000). Drug spend is defined as the cost to Medco clients of drugs delivered through mail order or retail. That figure is not a pure representation of Medco's drug purchases because it includes a deduction for fees paid by Medco to clients and an addition for dispensing fees paid to pharmacists.

Medco also reports a "cost of revenues" figure that is $1.5 bil. less than the drug spend in 2001 ($27.8 bil.) and $1.8 bil. less than drug spend in 2000 ($21.2 bil.).

Cost of revenues is the cost of products (for both mail order and retail) with added expenditures for mail order processing and dispensing costs, retail dispensing fees, and the costs of Medco's call centers. Medco subtracts manufacturer rebates from the cost of revenues.

Medco's total revenues ($29.1 bil. in 2001 and $22.3 bil. in 2000) also provide a picture of the cost of products for its clients; that number is reduced by a figure to represent credits to clients for the pass through of rebates.

Medco is bound by the five-year agreement to continue to purchase all Merck drugs directly for use by the mail order part of Medco's business (see chart: " ³ 'Access, Best Efforts and Market Share Obligations' "). AmerisourceBergen is the primary wholesaler supplying the Medco mail order centers.

Merck drugs purchased for mail delivery cost Medco $1.3 bil. in 2001, $1.1 bil. in 2000, and $909 mil. in 1999.

Medco filled a total of 74.7 mil. mail order prescriptions in 2001, an increase of 9.6 mil. (14.7%) over the year before. Thus, the rate of growth of mail order scripts was about half the growth of drug spend dollars (up 27%).

Similarly, Medco's retail script growth lagged behind the increases in drug spend. The PBM handled 462.5 mil. retail scripts in 2001 (up 19.6%).

Medco explains that manufacturer price increases and a larger proportion of higher priced products in its brand mix contributed to the larger dollar increases than script increases.

Medco attributes the slower growth in mail order to the addition of one large client (UnitedHealth) and the acquisition of ProVantage, both of which brought in user groups with less history of mail order use.

Because Medco's mail order scripts tend to serve longer periods of therapy (three months versus one month), some PBM observers adjust the number of mail order scripts upward to make them comparable to retail scripts in number of drug units delivered. Lehman Brothers, for example, interprets the 74.7 mail order scripts to represent three times as many retail scripts, or about 224 mil.

That means that Medco's total scripts in an average one-month supply format equaled about 687 mil. in 2001. The average monthly script dispensed by Medco in 2001 (including pharmacy dispensing fees) cost Medco's clients $42.79.

Another rebate issue addressed by Merck and Medco in their five-year agreement is the effect of payments by Medco to clients on Merck discounts to the Medicaid program.

The contract specifically declares that Merck will not pay Medco "any rebate to the extent that, in Merck's judgment, the payment of that rebate would result in the establishment of a new 'best price' for any Merck product within the meaning of the federal Medicaid rebate statute." Merck will adjust rebates to Medco to assure that they do not affect the rebates due to Medicaid.

Zocor To Get Special Medco Attention: Market Share Protections Set In IPO

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