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Executive Summary

Roche's $4.14 bil. unsolicited offer for Sterling is evidence of Roche's desire to re-enter the U.S. consumer products and OTC drug business. In a Jan. 4 open letter from Swiss Chairman Fritz Gerber, Hoffmann-La Roche emphasized its interest in Sterling's OTC operations: "The product lines of Hoffmann-La Roche and Sterling Drug, and in particular our respective strengths in the ethical and over-the-counter markets, are highly complementary and offer significant opportunities in each of these fields." Only five years ago, Roche exited the consumer business in the U.S. with the sale of its Pantene shampoo business to Richardson-Vicks. In conjunction with that sale, Roche also gave up the rights to upcoming Rx-to-OTC switches for some of its products. The company agreed to permit Rich-Vicks to market and develop products from Roche's U.S. research for the domestic OTC market. At the time of that earlier decision to de-emphasize the U.S. consumer business, Roche's two major Swiss pharmaceutical competitors (Ciba-Geigy and Sandoz) were committing themselves to building worldwide OTC operations. The hole in Roche's U.S. marketing capabilities was made evident recently when Glaxo (Roche's comarketing partner on the successful Zantac effort) turned to Sandoz as the comarketing partner for ranitidine for the OTC market. Although Glaxo might have favored a third-party for OTC marketing of ranitidine to assure strong competitive efforts for both products, the fact that Roche did not have an OTC business made them a non-contender for the OTC licensing deal. Sterling's total corporate sales are over $2 bil., of which the U.S. OTC business represents less than 20% of the total. But the OTC business, nevertheless, is very attractive in an industry where internal start-ups are expensive, if not impossible. The hurdle of building a business of substantial size in the U.S. OTC business is well-recognized within the drug industry. Recently, for example, SmithKline-Beckman Chairman Henry Wendt acknowledged that SmithKline's OTC business needed to be twice its current size to remain a long-term, viable operation. Wendt also pointed out that buying OTC size through acquisitions is very tough in the U.S. with only a few properties available and a history of high purchase prices ("The Pink Sheet" Nov. 9, p. 17). The resurgence of Bayer Aspirin under the "wonder drug" promotional campaign has been the catalyst for the growth of Sterling's proprietary business. The branded aspirin showed a sales gain of 25% through nine months in 1987, leading a 10% advance by the company's overall proprietary business. Sterling is also a significant OTC marketer worldwide. The non-U.S. OTC business has been attractive to international drug companies because it offers an alternative to the price controls on Rx products in many state-financed health systems. Roche initiated the tender offer on January 5 without Sterling's consent. Roche said that a call from Hoffmann-La Roche (U.S.) President Irwin Lerner on January 4 to set up a meeting with Sterling Chairman John Pietruski was rebuffed by Sterling, which indicated its intent to stay independent. Roche's open letter portrays the offer as an attempt to merge Sterling into Roche as an autonomous subsidiary. Roche reportedly repeated its request for a meeting of senior executives on Jan. 8. Gerber stated that "consistent with the international range and scope of our operations, Hoffmann-La Roche has historically been committed to decentralized management allowing a high degree of autonomy." In the OTC area, Roche could be expected to give Sterling's current management autonomy. However, with a large existing prescription drug business in the U.S., Roche would be presented with a number of consolidation opportunities. Roche has aggressively been scaling back and trimming its own internal operations in recent years. It is unlikely that Roche would carry either a duplicative Rx business or duplicative functions within the drug business in the U.S. There are some noteworthy areas of overlap in the Roche and Sterling drug businesses in the U.S. One of the prime areas of common interest is the radiopharmaceutical market. Roche's Medi-Physics subsidiary is active in that field, which is also Sterling's current growth market with Omnipaque. Medi-Physics was recently enlarged with the purchase of 10 radiopharmacies from Summa Medical Corporation. The company also will soon be launching a new in vivo diagnostic agent for evaluation of the effects of nonlacunar stroke. The new product, SPECTamine, crosses the blood-brain barrier. It was approved by FDA in late December; marketing will begin in February. Omnipaque, a non-ionic contrast agent for myelography and to enhance CT scans, has grown rapidly. The product did over $50 mil. in sales in 1986 and is expected to do over $100 mil. in 1987. Based on October sales figures, Sterling told analysts last year that the product was annualizing at $120 mil. Sterling licenses Omnipaque from the Norwegian firm Nycomed A/S. The firm signed a long-term development agreement with Nycomed for follow-up compounds in June 1987. Omnipaque, however, faces a threat in the future from compounds that could switch the diagnostic of choice from CT scans to magnetic resonance (MR) procedures. Berlex, for example, has an NDA pending for gadolinium, which is being touted as a key element in switching diagnostic modalities ("The Pink Sheet", Nov. 2, T&G-3). Sterling has a license agreement with a California firm, Salutar, for a magnesium compound that could be used with MR scanning ("The Pink Sheet," Nov. 23, T&G-10). Both companies have strong marketing reputations in the operating room market with tranquilizers (Roche) and anesthetics and pain killers for after surgery (Sterling). One of the most intriguing compounds in Sterling's R&D pipeline is an oral non-opioid, non-ulcerogenic analgesic for mild to moderately severe pain. The compound, designated WIN 48098-6, has been called "very exciting" by Sterling-Winthrop Research Institute President Lawrence Chakrin. It is currently in Phase II trials. Sterling and Roche also would have an interesting overlap in antibiotics. Sterling has a research compound in the quinolone class, and Roche has quietly developed into a significant player in the antibiotic business. While the company is still most famous outside the trade for its tranquilizers, its antibiotics business now has the single largest product. Rocephin reportedly topped Roche's U.S. business in 1987 with sales in the $135 mil. range. The company calls Rocephin the "number 1 third-generation cepahlosporin in the U.S. pharmaceutical industry." Oral Valium generated sales of slightly less than Rocephin in 1987. Combined with Roche's other antibacterial business (Bactrim), Rocephin has created a business of over $150 mil. in the antibacterial class. Roche's experience in that field is likely to expand rapidly in 1988 as it co-markets oral cefuroxime (Ceftin) with Glaxo. In the open letter to Sterling, Roche described its overall U.S. business, drugs, medical devices, clinical labs and vitamins as over $1.5 bil. in 1987. The sales of drugs manufactured by Roche (not including, for example, Zantac) are close to $600 mil. Sterling's U.S. pharmaceutical specialties business is just less than two-thirds of that size. In 1986, it was $304 mil. Through nine months of 1987, that part of the business was up 20%, which would put sales for the full-year 1987 at close to $360 mil. In addition to its drug businesses, Sterling has a number of pieces that do not appear to fit Roche's health orientation -- primarily in the Lehn & Fink household products business. That business includes brands such as Formby's, Lysol and d-Con that could be spun off to reduce the price of the purchase. Lehn & Fink also includes some toiletry lines such as Tussy and Ogilvie hair care. From a financial perspective, Sterling is an appealing takeover target for two reasons. First, the role of operating management in determining the outcome of an outside offer is limited because very little of the stock is held by insiders. The Sterling management group controlled less than one half of one percent of the 57.5 mil. shares of outstanding common stock at the time of last year's annual meeting. Standard and Poor's reports that more than two-thirds of the company's stock is consolidated in the hands of about 430 institutional holders. The consolidated outside holdings, however, worked against Roche in the first week of the offer as arbitrageurs pushed Sterling's price quickly above Roche's initial offering price to the mid-70's level. Drug analysts declared the Roche move the beginning of a new wave of foreign offers for U.S. firms and speculated on prices for Sterling per share as high as $90. Because of the Bayer brandname tie, speculation centered on Bayer AG as a potential bidder against Roche. Bayer's position in the U.S. with Miles, however, does not appear as clean a fit as Roche's. The Alka-Seltzer/Bayer Aspirin overlap in the analgesic market could in itself spell trouble for that deal. A second intriguing aspect of Sterling deal from Roche's point-of-view has to be the relatively high Sterling tax rate. Sterling's corporate tax rate has been declining recently, but the company predicts that it will still be close to 40% (in the high 30's) in 1988. Worldwide, Roche has used tax breaks, including Puerto Rican manufacturing to keep its rates down. Sterling has a 260,000 square foot manufacturing facility in Puerto Rico. In a repeat of the situation at the end of the last decade when Nestle, Bayer, Glaxo and Boots all made entry purchases into the U.S. drug market, the financial community is watching the drug industry closely for new targets and potential offers by well-heeled foreign buyers. Roche's deal is far and away the largest, but it has recently been preceded by several other foreign purchase offers: Sanofi's offer for Robins and, on a smaller scale, Medicopharma's offer for the private-labeler, Pennex. Recent rumors point to Pfizer and Rorer as acquisition candidates. During the previous wave of overseas offers for U.S. companies, Roche was often mentioned as a potential suitor; but the company was never linked publicly to a bid. This time Roche, under a different management, appears committed to take the initiative and be among the first to make a bid for a complementary U.S. purchase before the opportunity passes. The $72 per share cash offer includes a 30% premium to Sterling's 1987 year-end close (55-1/8), but is only 4% above Sterling's top price in 1987 (69-1/4). The effect of the declining dollar and dropping stock prices is clear in a comparison of the price for Sterling at its peak in mid-summer when it was trading at 69-1/4 compared to the Jan. 5 offer. Sterling's total market valuation (without a takeout premium) at the end of July was approximately $4 bil. (or 6.1 bil. Swiss francs at the exchange rate at that time). Roche is offering less than that in Swiss Francs (5.3 bil.) for the purchase now, including a takeout premium. Roche said that its $72 per share offer was not conditioned on any further reviews of Sterling's operations or financing contingencies. In a filing with the Securities & Exchange Commission., Roche reported that $1 bil. of the acquisition funds "is expected to be available [to Roche Switzerland] from Swiss Bank Corporation pursuant to a syndicated credit facility. The Swiss Bank Corporation, Roche added, "has indicated that it is confident that it will be possible to obtain the participation of other banks for up to $3.2 bil. in aggregate additional funds in such syndicated credit facility." In an ironic twist to the Roche attempt at Sterling, ICN maintained its effort at the limited voting stock of the Swiss company. On Jan. 8, ICN released a statement claiming a 7.3% stake in Roche. The company said the Jan. 8 update on its position in Roche was required to clarify "the size of its current position, since some recent news reports have characterized it inaccurately." Chart omitted.

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