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German Pharma Powerhouse Potential

Germany's flagging pharmaceutical industry may be getting a second wind. On Mar. 13, German drug and chemicals maker Merck KGaA launched an unsolicited $17.4 billion bid for domestic rival Schering (SHR). At a press conference at Merck's Darmstadt headquarters, Chief Executive Michael Romer hailed the proposed tie-up as "the ideal combination" and one that offered both companies an opportunity "to take a quantum leap" to become more competitive.

The move would mark the first major all-German pharma union in nearly a decade. If consummated, it would transform two midsize players into the country's second-largest drugmaker behind Bayer (BAY), with combined annual sales of $13.4 billion.

Schering, though, is playing hard to get. CEO Hubertus Erlen says Merck's offer "significantly undervalues" the company. Schering's supervisory board is expected to formally recommend that shareholders reject the bid when it meets on Mar. 14. But Schering's shareholders seem to think it's a good match.

GOOD FOR GERMANY. Schering's stock price soared by 26% on the news, the biggest gain in a decade. One of Schering's large shareholders, Union Investment, voiced its support for "Merck's approach," but reckoned the offer will need to be sweetened to succeed, German newspaper Handlesblatt reported. Another key investor, German insurer Allianz (AZ), which has an 11.8% stake, declined to comment on the offer. But Allianz has repeatedly stated its policy is to sell its stakes in "nonstrategic" holdings when the price is right. On Mar. 14, Merck KGaA published an open letter in Berlin newspapers to Schering's employees lauding the offer as "a once-in-a-lifetime opportunity."

Germany more or less invented the modern pharmaceutical industry more than a century ago. Yet, after sitting on the sidelines during the last decade of mega-mergers, German drugmakers are finding it increasingly tough to go it alone. The Merck family, which owns a controlling 73% stake in the company, is selling the acquisition as a potential boost for Germany.

The family is contributing $1.2 billion to help finance the deal. "We are pleased that we are able to make such an investment in Germany and thus strengthen the competitiveness of the German pharmaceuticals business," said Jon Baumhauer, chairman of the Merck Family Council, at the press conference.

HEFTY PROPOSAL. The proposed merger highlights the quandary faced by Europe's second-tier drugmakers. The cost of developing new drugs has soared in recent years. Without the marketing muscle needed to compete against global giants such as Pfizer (PFE) and Britain's GlaxoSmithKline (GSK), midsize firms are increasingly turning to mergers and acquisitions to gain critical mass.

Last November, Swiss biotech Serono (SRA) effectively put itself on the block. And Germany's Altana (AAA) is actively seeking a partner or a buyer for its drug business. For these companies, there are just two choices: Scale up or scale back.

Merck is determined to do the former. It says a merger with Schering would yield nearly $600 million in annual cost synergies by 2009. Moreover, it claims the union will give both companies much-needed heft. Their combined research and development budget would total $1.6 billion, triple the amount Merck currently spends.

PURE-PLAY PHARMA. The deal would create a much stronger player in oncology. Merck's colorectal-cancer drug Erbitux was recently approved to treat head and neck cancer. Schering brings its blood-cancer drugs Leukine and Campath to the table.

Merck would also gain access to new markets. Schering is the world's biggest maker of birth-control drugs, including best-selling Yasmin. It's a leader in multiple-sclerosis treatments as well. In addition to its top-selling drug, Betaferon, Schering is hoping to get Campath approved for use in multiple sclerosis.

The benefits to Schering, however, aren't as obvious. Schering divested its own chemicals business a decade ago to become a pure-play pharma company. A union with Merck would dilute that focus.

A LONG COURTSHIP? Both companies logged an operating profit of $1.1 billion last year. But prescription drugs accounted for just 30% of Merck's $7 billion in sales in 2005, and operating margins for the pharma business were below 10%. In contrast, Schering's hit 17.5% in 2005, on the back of a major restructuring program launched two years ago; the drugmaker posted sales of $6.3 billion last year.

Nonetheless, Merck is unlikely to take no for an answer. Although there has been speculation that a white knight for Schering might emerge in the form of Switzerland's Novartis (NVS) or Britain's Astrazeneca (AZN), many analysts think such a scenario is unlikely. Instead, many expect Merck to raise its bid. Looks like this courtship could be a long one.

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