A couple of years ago, when Michael Krensavage was an analyst at Raymond James & Associates, he asked a high-level executive at Merck & Co. whether the company would copy the rest of the pharmaceuticals industry and find a merger partner — perhaps its New Jersey–based neighbor Schering-Plough Corp., which was co-marketing two cholesterol drugs with Merck? As Krensavage recalls, the executive scoffed, “Why would we want to buy Schering-Plough?”

Separately, Krensavage posed a similar question to Fred Hassan, then Schering’s CEO, this time during an analyst meeting. “Hassan had no direct reply,” Krensavage recalls, but “his body language suggested a conflict between Merck and Schering-Plough.” (Krensavage speculates that it was owing to differences over pricing strategy for the cholesterol drugs.)

Apparently, Hassan and his counterpart at Merck, Richard Clark, found some mutual attraction after all. In March 2009, Merck announced that it was acquiring Schering-Plough for $41.1 billion in cash and stock.

Krensavage, who now runs an eponymous hedge fund firm in New York specializing in pharmaceuticals, and other longtime merger advocates are scratching their heads trying to understand why Merck finally changed its mind and why Schering, with a stronger product line, agreed to the deal.

But maybe Merck was right to wait. There are significant signs that this marriage — which creates the second-largest drug company in the world, by most rankings, with some $42 billion in annual sales — may just buck the odds and lead to a happy ending.

“They’re keenly aware of how many of these mergers have failed in the past, and they’re very determined to show this as a counterexample,” says Kris Jenner, manager of T. Rowe Price’s $2 billion Health Sciences Fund. Before the announcement of the merger, which closed in November, Jenner’s fund owned about $40 million each of Merck and Schering-Plough, its second- and third-biggest pharmaceuticals holdings.

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For more than a decade — buffeted by faltering research, expiring patents, competition from biotech firms, public pressure over prices, tougher government scrutiny and the looming uncertainty of health care reform — most drug companies have seen their salvation in mergers. Sanofi-Synthélabo bought Aventis. GlaxoWellcome teamed up with SmithKline Beecham. Sandoz and Ciba-Geigy became Novartis. Pharmacia & Upjohn joined with Monsanto. Pfizer gobbled up everything in sight. Although the combinations have usually cut costs, their success in bringing new drugs to market has typically been spotty.

The management of Merck, meanwhile, refused to join the game. Other than small acquisitions, the company hadn’t done a major deal since the Eisenhower presidency. That might be seen as a principled belief in independence, except that independence wasn’t working.

Merck’s stock price languished for much of the past decade, tumbling from a high of about $90 at the start of 2001 to the low 20s by early last year. The company’s annual revenue was stuck between $22 billion and $24 billion from 2003 through 2008, as two of Merck’s biggest sellers lost their patent protection, opening the door to cheaper, generic competition. Of the products that were expected to replace them, about a dozen didn’t sell as well as predicted, had safety issues or never made it to market. Even a groundbreaking vaccine for cervical cancer couldn’t jump-start the bottom line. Moreover, Merck’s product line was seen as too narrow, relying heavily on vaccines and cardiovascular treatments. Under Raymond Gilmartin, the chief executive from 1994 to 2005, morale slumped and key executives fled.

The worst blow was the collapse of painkiller Vioxx, which at its peak brought in $2.5 billion a year. In September 2004, after a three-year study showed that taking Vioxx for more than 18 months doubled a patient’s risk of stroke and heart attacks, Merck pulled it from the market, prompting thousands of lawsuits against the drugmaker, which had been pitching Vioxx in hundreds of millions of dollars’ worth of television and print ads.

That arguably turned Merck — dubbed the “most admired” company in America by Fortune magazine every year from 1987 through 1993 — into the least-admired drug company, as Vioxx became the poster child for the entire industry’s hypermarketing and insufficient testing of potentially dangerous drugs.

It also spelled the end for Gilmartin. Seven months after Merck pulled Vioxx, he was pushed out and replaced by Clark, then the head of manufacturing. A three-decade Merck lifer, Clark was largely dismissed as a nicer but no stronger CEO. Morale improved, but the company’s disdain for mergers didn’t change.

So why did Clark and other top Merck executives suddenly decide to entertain the idea that analysts and investors had been tossing around for years? And why does that bet look good now?

A turning point was Schering’s $14.4 billion 2007 acquisition of Netherlands-based Organon BioSciences, a biotech company with successful products for hepatitis C, infertility and contraception. “What we started to see in the Schering-Plough organization became very, very attractive,” Peter Kellogg, Merck’s CFO, tells Institutional Investor.

Merck and Schering also have the benefit of familiarity. The two companies have jointly marketed cholesterol drugs Vytorin and Zetia since 2004. “That experience together built a lot of confidence,” notes Kellogg.

During the merger process, Merck seems to have been especially sensitive to the morale and ego problems that can arise in melding staffs and laboratories. “We are spending a great deal of time on culture, because we truly believe that you need to get the culture right in the new company in order to make sure that your strategy and your objectives are executed the right way,” Clark, who declined to be interviewed for this story, told investors at a JPMorgan health care conference in January.

Timing, too, may help the merger succeed. “Acquisitions done when markets are down tend to do much better than acquisitions done when markets are up,” points out Peter Tollman, a senior partner at the Boston Consulting Group. “Often they’re more strategic, and you get better pricing.”

Most important, Schering brought a rich dowry of drugs in development, including products for blood clots and skin cancer and a new anesthetic. With Organon, Schering gained blockbuster therapeutic protein PegIntron for hepatitis C, as well as another promising treatment for the same disease. In addition, some of Schering’s biggest sellers have many years remaining on their patents — most notably, Saphris for schizophrenia and bipolar disorder, just approved by the U.S. Food and Drug Administration. Schering also co-markets rheumatoid arthritis blockbuster Remicade and a new successor, Simponi (although the merger with Merck may jeopardize those rights).To top off this treasure trove, Schering adds geographic diversification, because it has a much stronger presence than Merck overseas: According to Kellogg, Merck got 44 percent of its sales premerger from outside the U.S., but that rises to 53 percent in the new combined Merck — putting it more in line with other global pharmaceuticals companies, which typically get about 55 percent of their revenue from non-U.S. markets.

“Merck’s decision to purchase Schering-Plough is an absolute about-face,” says Krensavage, who wouldn’t disclose his hedge fund’s total assets but says its Merck holdings are significant. “The answer comes down to research.”

In the past, Merck and other members of Big Pharma would have had replacements ready to roll out of the labs as their old drugs reached the end of their patents. But in the pharmaceuticals world, it has become almost cliché to note that research and development has slowed. Traditionally, drugs are developed by screening hundreds of thousands of chemical combinations until one finally hits a particular disease target. Not surprisingly, the easy matches have long since been discovered. The mapping of the human genome at the start of the new millennium was supposed to move research smoothly along to the next stage, leading to the creation of biologically based “designer” drugs aimed at specific genes. However, that’s turned out to be a slower, more complex process than expected — and in any case, it’s a field that’s been dominated by biotechs, not Big Pharma. Moreover, when companies finally do find drugs that seem to work, they face recently tightened FDA standards for approval.

As a result of both weaker R&D and tougher FDA oversight, regulators approved only 26 new molecular entities — that is, unique new drugs — last year, versus 34 in 1999.

Fewer new approvals inevitably depress sales. In October, IMS Health, a Norwalk, Connecticut–based pharmaceuticals industry forecasting firm, predicted that worldwide drug sales would grow at what it called “historically low levels” through 2013 — a 4 to 7 percent compounded annual rate — although it did cite “stronger-than-expected demand in the U.S.” By contrast, IMS Health reported sales growth averaging 11.8 percent annually from 1999 to 2003.

With fewer products to sell, virtually every big drug company has slashed costs. The industry has shed more than 100,000 jobs since 2004 — including nearly 18,000 at Merck, which shrank its premerged workforce to 52,700.

As if that weren’t enough pressure, now the industry will have to figure out what health care reform might mean. Big Pharma recognized early on the potential benefit of gaining 30 million new customers in the U.S.; its trade organization last June reached an agreement with the White House to support the basic concept of reform in return for a pledge to limit any hit to the industry — mainly via rebates and discounts in government programs — to $80 billion over ten years. Through the ups and downs of the reform debate, even as the House of Representatives raised the potential hit to $140 billion, the drug companies stayed loyal to their deal. In late January, however, the road to health care reform took a new twist, when Massachusetts elected Republican Scott Brown to fill the senatorial seat formerly held by Ted Kennedy, breaking the Democrats’ supermajority in the Senate. Regardless of what any final legislation looks like, the newly merged Merck — thanks largely to its Schering dowry — is better positioned than many other drugmakers to profit in a post-health-care-reform world.

The postmerger optimism at Merck is a stark contrast to the negative sentiment swirling around the company just a few years ago. In fact, in many ways, Merck has faced a tougher climb out of trouble than its competitors. That’s partly because it started from such a high plane and fell so far.

During its “most admired” years of groundbreaking research, Merck was led by a brilliant, charismatic and arrogant scientist named P. Roy Vagelos. The son of Greek immigrants, Vagelos grew up in the shadow of Merck’s great laboratories in Rahway, New Jersey, and then headed those labs for nine years. Famously, he used to waylay scientists in the hallways to discuss their projects and would eat lunch with staff in the company cafeteria.

Two changes in the early 1990s eroded that culture: Vagelos was forced to retire at 65, under company rules, and the top brass moved to new corporate offices in Whitehouse Station, about 20 miles west of Rahway. Gilmartin — who had run medical device maker Becton, Dickinson and Co. before joining Merck in June 1994 as CEO — was viewed as a nice guy yet was widely disliked by employees. Critics say he relied too much on consultants and squelched research creativity by adding layers of bureaucracy, and Wall Street stopped trusting his optimistic pronouncements. What hurt Gilmartin most was that he was an outsider. As many employees and other critics saw it, he didn’t understand Merck or the pharma industry.

Adding to the company’s woes, Vagelos, in his most ill-conceived decision, had paid $6.6 billion in 1993 for pharmacy benefits manager Medco Containment Services — a middleman that administers corporate prescription drug benefits — as a defensive move against the Clinton-era prospect of health care reform. But Medco’s penny-pinching ways never fit in with Merck’s pour-on-the-R&D-dollars culture and dragged down profit margins. Gilmartin — in one of his most heralded moves — spun off Medco in 2002.

Then the patents on the Vagelos-era blockbusters began to expire. In 2006, Merck’s previously biggest-selling drug, Zocor, went off patent. Sales of the cholesterol-lowering drug, which at one point amounted to more than $5 billion annually, plummeted to $877 million in 2007. The patent on Fosamax expired in 2008. The osteoporosis drug, which averaged $3.1 billion a year in sales from 2005 through 2007, generated just $1.1 billion in revenue for 2009, according to estimates from Mehta Partners, a New York–based research boutique.

Nor is the patent expiration issue going away. Hypertension medications Cozaar and Hyzaar go off patent this year, putting more than $3.5 billion in sales at risk, and the $4.6 billion asthma and allergy drug Singulair will follow in 2012 (see table, page 60). With a host of smaller drugs set to tumble next, Vishal Manchanda, a senior global pharmaceuticals analyst at Mehta Partners, predicts that Merck will lose 25 percent of its premerger revenue by 2014.

The intended replacements — one of which was to be Vioxx — have not lived up to expectations. Zetia and Vytorin were supposed to extend Merck’s dominance of the cholesterol drug franchise by adding a new method of fighting “bad” low-density lipoproteins. However, in a four-year trial of some 720 patients, the drugs didn’t slow, and possibly speeded up, the growth of fatty plaques in arteries, which can lead to heart attacks and strokes.

In 2006, Merck introduced Gardasil, a vaccine for the most common types of the virus that causes cervical cancer, to glowing headlines. Although it was the first vaccine proven to prevent cancer, the drug always flirted with controversy because the cervical cancer virus is spread mainly through sexual contact and Merck is marketing the vaccine to the parents of teenage and preteen girls. The company has negotiated that minefield carefully with religious-right groups, but it has aroused the ire of consumer advocates with heavy-handed lobbying.

When Clark took over as CEO, he worked hard to shore up morale, meeting regularly with managers and sales representatives around the U.S., giving staff his e-mail address and reviving Vagelos’s vaunted cafeteria chats. In the ultimate symbolic gesture, he invited Vagelos for a talk — something Gilmartin had refused to do — and, yes, the two ate lunch in the cafeteria. Industry watchers say Clark overall has been a pleasant surprise and a stronger chief than expected.

Clark also set out to improve drug development by bringing together the researchers, marketers and manufacturing people who had been kept in separate fiefdoms. Merck has historically attracted brilliant scientists to head its R&D — Vagelos, then Edward Scolnick and now Peter Kim, lured from the Massachusetts Institute of Technology in 2001. Although Kim, a research biologist, had little administrative experience, he learned quickly on the job. Most notably, he opened up the labs’ doors, encouraging researchers to look for new compounds in outside scientific literature and to use their contacts to seek acquisitions.

Yet all the effort and brilliance haven’t produced big results. In the past year and a half, Merck has halted mid- and late-stage research on what seemed like promising treatments for heart failure, migraines and obesity and has delayed filing an application for a more advanced migraine product, all because of serious side effects seen in human trials. In addition, in April 2008 the FDA rejected a combination of allergy drugs Claritin and Singulair that, ironically, would have been developed in a joint venture with Schering. Days later — to the shock of virtually the entire industry — regulators nixed what was supposed to be a shoo-in, a cholesterol-­fighting drug that melded the well-known vitamin niacin with a compound to prevent the common side effect of flushing. And last fall, in an extraordinary move, the FDA wouldn’t accept an application to combine Zetia with another cholesterol pill, Pfizer’s Lipitor, demanding to see more data first.

Of course, Merck isn’t the only company that has had to deal with a tougher FDA. “The FDA has asked in some cases for more data than perhaps they had asked for in the past,” Kellogg says.

Merck has enjoyed good news on the legal front. In November 2007 the company settled the vast majority of the roughly 50,000 Vioxx claims for the relatively low sum of $4.85 billion. Analysts credit Kenneth Frazier, then Merck’s general counsel, who insisted on fighting every case rather than settling early. He has since been promoted to head of global human health, the No. 2 job at the company, overseeing the drug business that accounts for almost all of Merck’s revenue.

For a while, Merck faced the risk of hundreds more potential suits claiming that osteoporosis drug Fosamax destroys jawbone tissue. But investors relaxed when the first case ended in a mistrial last year. “I do not believe there are enough plaintiffs to make it a significant threat,” contends Ira Loss, a senior health care analyst at investment research firm Washington Analysis.

Dick Clark would make a good poker player. At a Goldman, Sachs & Co. health care conference in January 2009, a few weeks after Clark had approached Schering CEO Hassan about a potential merger, the Merck chief executive was asked during his presentation what his company would look like in five years. “From a research standpoint, both from an internal and external standpoint, you will see an acceleration of a pipeline and the franchises that are important to us,” Clark told the audience. What he did not say was that that acceleration would be fueled by the acquisition of Schering, which had a dozen strong drugs in late-stage trials and no looming patent expirations.

“It all comes down to the pipeline, and Schering-Plough is obviously driving the long-term growth of the newly formed group,” explains Joshua Owide, a senior health care analyst at London-based research and consulting firm Datamonitor.

Schering initially played hard to get. CEO Hassan is a pro at negotiating mergers and reinvigorating failing companies. After melding Pharmacia & Upjohn with Monsanto in 2000, then nursing the new and improved Pharmacia through FDA rejections and a stock slide, he sold it to Pfizer in 2003 for $56 billion and proceeded to revive Schering-Plough, which had been beset by safety, fraud and securities investigations. It was Hassan who engineered the Organon deal.

During the Merck negotiations, Schering even contacted another potential merger partner. Although Schering has never publicly identified the mystery company, at various times observers have speculated on a hook-up with Bristol-Myers Squibb or Johnson & Johnson, which has a joint marketing deal with Schering for Remicade. Still, the negotiations seem to have been amiable, and when talks with the unnamed suitor broke down early last February, it was only a matter of Merck’s boosting its initial offer of about $22 a share in cash and stock to seal the deal. The final price: $23.61, about a 34 percent premium over Schering’s closing price the day before the merger was announced.

By virtually all accounts, Schering, with its rich cache of drugs and research, didn’t need the deal. Datamonitor predicted that the company, without merging, would have had the fastest growth rate through 2013 of any U.S. Big Pharma player. Indeed, the merger hurt Schering in one way: by jeopardizing its share of Remicade, which brings in $2 billion-­plus in annual sales, and Remicade’s newly approved successor, Simponi. That’s because the co-marketing deal with J&J apparently gives J&J full rights to the two drugs if ownership of Schering changes.

Thus the big question puzzling Wall Street: Why did Schering agree?

In a conference call with analysts when the merger was announced, Hassan cited “stunning and accelerating changes in our own industry’s environment” and the size of the Merck offer, especially “the more than threefold increase that our shareowners will realize in the dividends.” The Schering CEO, who declined to comment for this story, added, “This was the right transaction at the right time.”

To get around the Remicade restriction, the deal was structured as a reverse merger that makes Merck a subsidiary of Schering — even though the new entity is named Merck and run by Clark. For now the issue is in arbitration; industry observers expect the three parties ultimately to work out an agreement. One possibility: In return for the Remicade rights, Schering could give J&J its consumer health division, which includes such stalwarts as Coppertone sunscreen, an area with traditionally low margins.

If the merger follows historical patterns, it will succeed in at least one goal — saving money through economies of scale and combining administrative, marketing and research functions. In announcing the deal last March, Clark predicted $3.5 billion in annual savings starting next year and a reduction in the combined 106,000-person workforce of up to 15 percent, mainly in non-U.S. positions.

But that’s the easy part.

The real goal is creating drugs, and there the precedents are not promising. Drug industry mergers have rarely spurred the bursts of creativity that were promised beforehand. Industry experts often point to the overhyped expectations of the 2000 GlaxoSmithKline hookup, which suffered an R&D brain drain and barely managed to dribble out three new drugs in its first three years.

By cutting costs “mergers buy time for research to improve,” notes Krensavage. “They don’t fix the problem of R&D productivity.” If anything, mergers can make matters worse by shaking up morale and thus dampening productivity. “There’s the disruption that takes place in the pipeline — closing down sites, this person being selected for the job over that person, which compounds move forward and which compounds do not, and general administrative bureaucracy,” explains T. Rowe Price’s Jenner.

Still, if any merger can succeed, experts say, Merck–Schering may be the best bet.

For one thing, Washington Analysis’ Loss points out, “they worked together for a while, and they know each other.” He says it’s also probably easier to meld two New Jersey neighbors than companies from different states or even different countries with distinct national cultures and regulations, as with Astra of Sweden and the U.K.’s Zeneca Group, which combined in 1999 to create AstraZeneca, or Rhône-Poulenc of France and Hoechst of Germany, which formed Aventis that same year. By contrast, Schering staff won’t have to sell their houses and uproot their families to work at Merck headquarters, less than 35 miles away.

Many observers are impressed with how the two companies have handled the logistics so far. Not surprisingly, Merck people — including Frazier in human health, Kim in R&D, Kellogg in finance and Willie Deese in manufacturing — continue to run many key areas, but erstwhile Schering executives are in charge of animal health and regulatory compliance. Altogether, Merck claims, about two fifths of Schering-Plough’s senior management will stay on in executive roles.

“They’re out there trying to get in front, to get a clear message to the Street,” avers Ian Wilcox, head of life sciences for Philadelphia-­based consulting firm Hay Group. “They’re saying, We want to make sure we understand how Schering works and how to leverage it.”

Indeed, many analysts see a lot of potential marketing leverage, particularly in allergies, infectious diseases and women’s health: For instance, Singulair and Schering’s Asmanex and Nasonex treat slightly different aspects of allergies and asthma but are prescribed by the same specialists, so sales reps could pitch all three simultaneously — and then, after the first two go off patent in 2012, focus on Nasonex. Similar synergies are possible with Merck’s HIV and antibiotics products and Schering’s hepatitis C offerings.

“The franchises fit together very nicely,” Kellogg says. “There’s not one product in our portfolio that’s more than 10 percent of sales.”

Of course, the most important leverage will take place in the labs. Merck seems to be off to good start. Clark told analysts in October that he had visited all of Schering’s research sites and many of Merck’s to gain an understanding of the people and programs and see firsthand “where the overlaps and redundancies are” and where the two companies might complement each other. To avoid heavy-handedness, he added that cost-cutting and closures will be done in a “staged” process. “We will do it in terms of research franchise, not site by site,” he explained.

Ironically, now that Clark has turned out to be a more effective CEO than most observers had expected, he will soon have to leave — by March 2011, under the mandatory age-65 retirement policy. Some of the presumed heirs apparent — including Peter Loescher, Frazier’s predecessor as president of global human health; Bradley Sheares, who ran U.S. drug sales; and Margaret McGlynn, chief of vaccines — have gone, leaving Frazier as the most obvious candidate and R&D head Kim as a dark horse. With that day little more than a year away, Kellogg would say only that “Dick is working with the board” on finding a successor.

Regardless of whom the board selects to replace Clark, his legacy will rest on the merger with Schering-Plough and its efficacy in delivering blockbuster drugs to market.