The Wrong Rx For Roche?

Critics say the drugmaker's purchase of Corange won't do enough to offset its recent setbacks

Crawling along the back streets of North London in a chauffeur-driven Mercedes, Franz B. Humer has just a few minutes to reach a private airfield before his flight to Basel is scheduled to take off. But the 52-year-old chief executive of Switzerland's Roche Holding Ltd. isn't worried. He's known for his cool style. Indeed, that's the pose he has struck as merger mania has broken out in the world's pharmaceutical industry. With the majority of Roche controlled by Hoffmann family shareholders, "we don't have to look over our shoulders," he says. Indeed, Humer is about to complete an $11 billion purchase of his own.

Yet Humer's unflappable demeanor belies the pressure that is beginning to bear down on his $12.8 billion company. Ironically, some industry analysts are convinced that Roche's acquisition of Corange Ltd.--the holding company for German diagnostics group Boehringer Mannheim and U.S. orthopedics company Dupuy Inc.--is the wrong deal. The Corange acquisition will transform Roche into the world's No.1 diagnostics company. It may also give Roche a headstart in the emerging field of "disease management."

But Corange's drug holdings are considered second-rate--not big or innovative enough to overcome recent setbacks in Roche's core pharmaceuticals business. Drugs account for 64% of Roche's sales and an estimated 69% of its operating earnings. Yet even after the Corange deal, Roche will rank only No.7 in the world. And the diagnostics business produces lower margins than pharmaceuticals. Roche's shares currently trade at 38 times earnings, in line with other drug industry shares. But Corange's overall operating margins are 13.3%, compared to Roche's 21%. "Why should we pay pharmaceutical multiples for a commodity business?" demands Stewart Adkins, a drug analyst at Lehman Bros. in London.

To make matters worse, the Basel-based giant has suffered a series of problems with promising drugs. Roche was forced to withdraw its potential blockbuster anti-obesity drug, Xenical, from the U.S. last fall to investigate its possible link with breast cancer. Roche has resubmitted data and is now awaiting a decision by the U.S. Food & Drug Administration. Likewise, analysts have lowered sales estimates for Posicor, the first of the new calcium antagonist heart drugs that won U.S. approval last July, after drug interaction problems.

The drug unit's margins have also been hit by Roche's costly preparation for the global rollout of six new drugs, including the Parkinson's medication Tasmar. In the U.S. alone, Roche has recruited over 1,000 new salespeople. Meanwhile, Roche has been shutting down factories and trimming its inventory. Some analysts expect Roche to take a sizable restructuring charge when it reports yearend results on Apr. 7.

Given these troubles, some analysts argue that Roche needs its own mega-deal in pharmaceuticals: A merger, for example, between Roche and a company such as SmithKline Beecham, Schering-Plough, or Zeneca PLC. But Humer--a lawyer, MBA, and opera buff who became Roche chief executive on Jan. 1--shrugs off such suggestions. He says Roche will stay alert for strategic buys and partnerships. But he doesn't want to play the mega-merger game. "We have the strength to grow our business organically," he notes. Besides rolling out new drugs, a top priority now is to integrate Corange's operating units into Roche--rather than to hunt for more acquisitions.

FAMILY BIZ. There's a further obstacle to another big merger. After spending much of its war chest on Corange, the only way Roche could do a major deal would be through a friendly stock swap. But that's impossible given the company's current capital structure. Although the Hoffmann family owns less than a sixth of Roche's outstanding shares, it controls the voting stock. Few expect the family to give up control. But the Hoffmanns may approve converting more shares to voting status to allow a possible merger partner some control, analysts say. On Feb. 12, Roche's biggest institutional investor, BZ Group, sold a 5% stake of Roche voting shares to a mystery buyer. Some analysts believe the family itself bought the stock, as a possible precursor to a capital restructuring.

Humer acknowledges that Roche would be hamstrung if it wanted to pursue a big merger. But he insists that Roche can keep pumping out innovative new products through biotech alliances and its own labs. On Feb. 2, it announced a $200 million deal with Iceland's deCODE Genetics Inc. in genetic research. DeCODE was courted by several drugmakers before it chose Roche because of its research unit. Humer, who spent 13 years at Glaxo Wellcome before joining Roche, recruited the company's new research chief, Dr. Jonathan Knowles, from Glaxo. Says deCODE CEO Dr. Kari Stefansson: "Roche has recently gone through a rejuvenation."

The question is whether Roche can afford to continue cherry-picking smaller deals. The rising cost of research, coupled with pressure from drug purchasers to lower drug prices, is forcing the industry to consolidate rapidly. Unless it can keep up the pace, Roche risks slipping into the industry's second tier. That's why Humer may eventually decide to give up his calm, deliberate approach--and jump into the merger frenzy.

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