This content is from: Home

Merck takes its medicine

The family-controlled German drug giant has its first nonfamily chairman.

The family-controlled German drug giant has its first nonfamily chairman.

By David Lanchner
March 2001
Institutional Investor Magazine

And for public shareholders, Bernhard Scheuble may be the right potion.

For 300 years German drug company Merck kept it in the family , ownership, management, capital-raising. After establishing the business in 1668 as a pharmacy in the small city of Darmstadt, south of Frankfurt, members of the Merck family held the top executive titles and collected every penny of the profits. They also personally financed expansion as Merck grew into a diversified pharmaceuticals and chemicals company with E6.7 billion ($6.2 billion) in annual sales.

That got expensive. In 1995, needing cash for acquisitions, the family floated 26 percent of the company, attracting public shareholders by touting Merck's hot products , mainly diabetes drugs and specialty chemicals. At $1.2 billion, Merck represented Germany's biggest-ever initial public offering. The Mercks got the money, but shareholders got burned. Four years later the stock had still not moved more than 7 percent above its Dm54 ($25) issue price; during the same period the best European drug stocks had tripled in value. Merck's new shareholder base grew disenchanted with the company's habit of playing its cards close to the vest and managing for wealth preservation rather than profits. Even insiders, bound by a shareholder pact to keep 76 percent of voting control within the family by trading only among themselves, became restive.

So chairman Hans Joachim Langmann, a Merck by marriage, played an ace. In 1999 he appointed an outsider to succeed him when he retired at 74 in mid-2000 , the first nonfamily member ever to run the company. The new chairman, 47-year-old Bernhard Scheuble, has galvanized Merck by introducing stock options, improving financial reporting and generally proving himself a far more investor-friendly CEO than his predecessors. Sure enough, the market approves. In January Merck's stock hit an all-time high of E50, up 45 percent since Scheuble took over last July.

But Scheuble is serving two masters. Langmann and other family owners like Merck's tradition of steady if unspectacular gains. They approve of the conservative strategy that has kept the company diversified in an era when most of its rivals are spinning off noncore businesses. After taking the helm in 1970, Langmann had provided a growing stream of dividends for the 120 founding-family members. The idea of managing for short-term profits doesn,t exactly thrill these insiders. But outside shareholders and dissident family members want to see their stock go up. Even near their record high, Merck's shares are trading about 30 percent lower than the average for European drugmakers. (Langmann, who rarely speaks to the press, refused to comment for this article.)

Being the first professional manager at a family-controlled corporate icon is no picnic, and Scheuble has been careful to play up his role as the compromise candidate. "We must always try to optimize quarterly results, but we must also pay attention to the midterm and the long term," he says. The jury is still out on whether he can pull off this feat.

Merck's modern history began in 1827, when Emanuel Merck, a great-great-grandnephew of the founder, moved operations out of the family store and began manufacturing raw materials for pharmaceuticals. By 1900 the company was making 10,000 different drug and chemical compounds and had expanded sales and production to London, Moscow and New York. After World War I the family's international operations were confiscated; these included the New York subsidiary, U.S. market darling Merck & Co.

During World War II the German company faced near-extinction when Allied bombers destroyed 80 percent of its manufacturing capacity. The postwar economic boom brought recovery and expansion. But while its U.S. cousin focused on pharmaceuticals and grew into the world's biggest drugmaker, German Merck remained a midsize, diversified family holding, with rather plodding growth of 10 percent to 12 percent a year.

By 1999 some family members were grumbling. Angry about their underperforming stock, the dissidents threatened not to vote to renew the shareholder pact. Meanwhile, fee-hungry investment bankers were urging Langmann to take the company private again, as an alternative to giving up family control. The pressure drove Langmann to do the once unthinkable and appoint Scheuble.

Head of Merck's pharmaceuticals division since 1997, Scheuble had already shown more interest in providing shareholder value than any of his predecessors had. For years no other Merck senior executive met regularly with investors; Scheuble traveled to Frankfurt, London, New York and San Francisco. The only division chief to use return-on-sales targets, he also made major efforts to give Merck's pharmaceuticals business more focus. He pushed Langmann to sell off the low-margin dermatology operations in 1997 and to turn the biomaterials and ascorbic acid units into joint ventures with other companies the following year.

"We were always impressed by Scheuble and his collaborators, but we only really started buying Merck once he,d taken the company over," says Michael Sieghart, a fund manager at Frankfurt-based DWS Group, Germany's largest mutual fund manager and a subsidiary of Deutsche Bank. "It's the Scheuble accession which convinced us major change was on the way." Since last August Sieghart has accumulated almost 2 percent of Merck's E1.9 billion in shares outstanding and intends to buy more for his E1 billion Biotech Aktien Typ O fund.

Institutional investors who had shunned Merck,s stock are betting that, as chairman, Scheuble will keep his eye on the bottom line and bring the company,s management style into the 21st century. That will take gumption. In Europe private owners and public shareholders frequently butt heads. Outside investors rarely win.

Even some of Germany's largest companies are family-controlled , Munich-based carmaker Bayerische Motoren Werke, for example. Like Merck,s, BMW's shares have often underperformed sector indexes, because the controlling Quandt family has been relatively indifferent to short-term earnings performance. Indeed, BMW clung to its money-losing Rover division for six years, bowing to investors, demands and dumping the business only in 2000 , after it had dragged BMW,s entire car group into the red.

Elsewhere in Europe disputes between private owners and outside investors have flared up at Italian telecommunications operator Olivetti and Belgian drug company Solvay. Some fund managers, especially in the U.S. and U.K., won,t buy into listed companies that remain privately controlled unless they have to match a country or an industry index. "As a general rule, we avoid them," says Stuart Gilmartin, a European fund manager at SG Asset Management in London. "Even when such companies adopt shareholder-friendly change, it invariably comes slowly."

Merck has four operating divisions: pharmaceuticals, specialty chemicals, laboratory products and laboratory distribution. But although the company has a leading position in some areas , in pharmaceuticals, it,s diabetes drugs; in specialty chemicals, it's liquid crystals for electronic displays and pigments for the auto and cosmetics industries , none of its four divisions is an industry leader in terms of overall sales.

Langmann, a courtly man with a Ph.D. in nuclear physics, reluctantly listed the company when he realized that he could no longer finance acquisitions out of cash flow. Although he had won praise for improving Merck's drug pipeline by buying Napa, California,based Dey, which focuses on respiratory drugs, and Lexigen Pharmaceuticals Corp., a Boston-based biotechnology company, acquisitions in the slow-growth lab distribution business have come in for sharp criticism. And industry analysts say Merck remains far too diversified at a time when competitors such as AstraZeneca, Aventis and BASF have spun off noncore chemical businesses.

But Langmann didn,t change his strategy or his style of communicating it when new shareholders came on board. Outside investors who visited Darmstadt were fobbed off on junior executives, and Langmann, who never made road trips, would face analysts and stockholders only when announcing semiannual results. If his audience pressed him to hint whether earnings for the next half would be up or down, he would irritably reply that it did not matter.

"He would tell us that what counted was long-term, balanced growth," says Gerd Schubert, a buy-side analyst at Frankfurt-based Deka Group, one of Germany,s biggest fund managers. "As he saw it, the company was an investment fund for his family, designed to minimize risk to their capital." Deka initially added Merck to its funds, portfolios after the 1995 listing but quickly sold out and has not bought back in.

Investors were pleasantly surprised when Langmann tapped Scheuble. It was a shrewd move. Scheuble's flair for investor relations has begun to win favor among formerly skeptical institutions. At the same time, Langmann has kept the family traditionalists happy. Scheuble is a company star: He joined Merck in 1982 and in the early 1990s built its two most profitable niche businesses, liquid crystals and specialty pigments.

Langmann and other conservative stakeholders believe that Scheuble proved his commitment to Merck,s long-term goals by investing heavily in these niches, which initially bled red ink. The specialty chemicals business, where liquid crystals and specialty pigments accounted for roughly 75 percent of E216 million in operating profit for 2000, now logs a 20 percent return on sales , the highest of any of Merck,s operations.

Scheuble also rejuvenated the pharmaceuticals division after he took it over in 1997 by refocusing it on promising diabetes drugs and, more recently, on cancer treatments. He did this not only through research and development spending , amounting to some 16 percent of the division's sales of E2.9 billion , but also through about 30 small acquisitions. In addition, Scheuble engineered clever distribution and licensing deals with global drug companies such as New York,based Bristol-Myers Squibb Co. Last year pharmaceuticals accounted for 43 percent of Merck,s sales but 61 percent of its profits; its return on sales, at 15.5 percent, is the company,s second-highest, after specialty chemicals.

Scheuble has a track record of pushing Merck toward greater accountability and disclosure. When he took over the pharmaceuticals division, he began reporting return on sales even though other division heads refused to do so. (Now, all four divisions must report this ratio.) In 1998 he convinced Langmann to name a new investor relations chief: Christian Raabe, who as financial controller was helping Scheuble promote Merck's drug pipeline to investors. Raabe's most notable achievement had been ending the practice of giving information to German analysts ahead of their U.K. and U.S. counterparts, a Merck tradition that cost the company credibility in the world's two most liquid capital markets. (The former investor relations boss was sent to Argentina as country manager.)

Then, in October 1999, when he knew he would be taking over as chairman, Scheuble urged Langmann to appoint a new chief financial officer, Michael Becker. As chief accountant and financial controller at Merck since 1998, and at BASF before that, Becker had done his best in the name of transparency, trying to keep unexplained exceptional items to a minimum.

Chairman-designate Scheuble's most investor-pleasing contribution was influencing Langmann to sell Merck,s poorly performing, 70-year-old contrast-media division in December 1999 for E870 million. Langmann had clung to the business, citing strong past profits from the division's X-ray machines and scanners.

"It was a watershed event," says Thomas Shrager, one of five senior money managers at New York,based Tweedy, Browne Co., Merck's largest outside shareholder, with 7.4 percent of the free float. "It was a clear sign that Scheuble was being given real management control of the company." Shrager had begun building a significant stake in Merck soon after the July 1999 announcement that Scheuble would replace Langmann, and he accelerated his buying after the contrast-media sale.

Once in his new job, Scheuble hit the ground running. In October he bought Biovation, a privately owned Scottish biotech company that is helping Merck develop cancer-fighting antibodies; in December he acquired Florence-based Molteni Pharma, a private company working on several diabetes drugs. And Scheuble is the first Merck chairman to state clearly that his development priority is pharmaceuticals.

Now, he says he would like to spin off at least part of the U.S.-based lab materials and equipment business during the next two years to help fund further pharmaceuticals acquisitions , particularly in the U.S., the world's most lucrative drug market. "To see steady earnings growth and get our share price in line with our competitors, we need to do more than just optimize our income , we need to acquire," says Scheuble, a self-assured former academic who studied nuclear physics, like Langmann, before earning a Ph.D. in display technology.

He may eventually sell Merck's poorly performing vitamins and nutrition business. But although Scheuble seems determined to give the company greater focus, he is not about to turn it into a pure pharmaceuticals business. That's a relief to Langmann, who as head of E. Merck, the family partnership that controls the company, meets with Scheuble about once a week for a debriefing. "At least for the moment, both of them seem to believe that a diversification strategy is best in the long term, in order to weather downturns in particular sectors and to cross-fund operations," says a senior company executive.

Despite the specialty chemicals unit's high profitability, many outsiders believe that spinning it off would eliminate the roughly 30 percent discount to breakup value that dogs Merck's shares. "Investors like pure plays," says DWS Group's Sieghart. Analysts say such a sale would fund many years, worth of drug R&D. But Scheuble says he has no intention of selling off the division. "It would be completely foolish to sell liquid crystals or pigments," he insists. "I don,t see this rationale that you have to be in one business segment or the other."

Scheuble's stubbornness notwithstanding, investors consider him shareholder-friendly. Although he has never lived in the U.S., he calls himself an "Americanophile," saying that he admires the philosophy of limited government intervention and lots of private sector accountability. "I like the discipline imposed on corporate behavior by analysts and investors," he says.

As chairman, he has benchmarked financial goals for Merck's divisions against its best-performing rivals and set a return-on-capital-employed target of 15 percent for the whole group. Scheuble has started reporting results quarterly and initiated "research and development days" on which analysts are invited to hear presentations by Merck executives and outside experts on products in development. And he has launched a new compensation program; from now on, Merck's top 200 managers will have stock options to exercise if the shares rise more than 30 percent in a calendar year.

New CFO Becker, meanwhile, has clarified Merck,s opaque accounting. "It used to be very hard to tell where our profits and losses were coming from," he says. "In 1999, for example, we had roughly 60 unexplained exceptional items as part of income and expenses, amounting to one third of our net profit of E220 million. That was unacceptable for investors. For 2000 and beyond we,ve converted all but about ten of these exceptionals into clearly explained and recurring operating income and expense items. We are also reporting our annual results in February, three months ahead of the old date." Many analysts feel it's about time , Merck's fiscal year ends with the calendar year.

And Scheuble is delivering performance. In 2000 Merck's overall sales rose 26 percent, to E6.7 billion, and aftertax earnings jumped 19 percent, after a 33 percent drop in 1999. Profits were dragged down that year by Merck's $535 million buyout of the 50.1 percent of West Chester, Pennsylvania,based lab materials business VWR Scientific Products that it did not own; the turnaround is largely thanks to diabetes drugs, liquid crystals and specialty pigments. As for Merck,s shares, currently at about E45, they are trading at 17 times estimated 2001 earnings , 32 percent lower than the average peer group multiple.

Enthusiasts think they,re cheap. Christine Bryan, manager of the $76.4 million Schroder Medical Discovery Fund, owns slightly more than 1 percent of Merck's free float and says the stock is among her top five European holdings. She bought into Merck last August, after hearing Scheuble speak at the Goldman Sachs Healthcare Conference in La Jolla, California, in June. "We bought Merck because we were seeing, with the appointment of the new CEO, improved disclosure and a clear aligning of investor interests with management's , especially as a result of the stock options," she says. "Merck was also at an attractive valuation compared with other drug companies."

Scheuble's appointment has placated the family owners. All but one voted to renew the shareholder pact, keeping majority control in the family for the next 20 years. At the same time, Scheuble,s institutional fans are betting that despite his conservatism, he will hold nothing sacred. Some even believe that asset sales the chairman now dismisses could lie in Merck's future. "I would encourage Scheuble to get rid of specialty chemicals," says Tweedy Browne's Shrager. "Not giving away value is something that interests both management and the family, so that kind of spin-off could eventually happen."

Shrager predicts that, given Merck's need to expand in the U.S., family owners may eventually be willing to sell their stakes or dilute them below 50 percent. "Meanwhile, if there is volatility in the share price, I am very happy, since that means I can buy more shares at cheap multiples," he says.

You would never have heard that kind of optimism about Merck's stock in the old days.