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When German conglomerate Bayer announced late last year that it is seeking a majority partner for its drug business, speculation swirled that a rival pharmaceutical giant would snap it up. Bayer seemed attractive not for its illustrious past (the company launched the modern pharmaceutical industry with its 1897 invention of aspirin) or high-volume present (it has annual pharma revenues of j4.8 billion), but for its future: the company has a sexual-potency drug, Levitra, ready to come on the market this year, which is touted as the next Viagra. The prize is almost certainly worth billions in sales.

But with a potential payday like that, why is Bayer getting out — and why have no suitors jumped in yet? That's the paradox across the drug industry: pharmaceutical companies are among the most profitable legal businesses in the world, and employ some 520,000 people in Europe. And yet the sector has been behaving lately as if it were in a sharp downturn. The battle for control of Bayer is just the latest in a series of corporate partnerships, mergers and hostile takeovers that have shaken up the drug industry in recent years.

Why such an urge to merge? One reason is that developing drugs has become both harder and more expensive than ever. It takes on average 15 years to bring a drug to market from inception. The cost of developing a drug averaged $168 million in 1991, $365 million in 1997 and is now $650-$800 million. One result is that new drugs in the pipeline have fallen off dramatically, even though companies are getting bigger. In 1987 the U.S. Food and Drug Administration had 60 new drug applications; in 2000 it had just 30. "The bottom line is that it's really hard to do," says Ross Williamson, an analyst at Cap Gemini Ernst & Young. "The FDA [has] very onerous demands for trials."

So does Europe. Last month, the European Parliament summoned Thomas Lönngren, executive director of the European Agency for Evaluation of Medical Products (emea), to ask why so few new drugs were being produced. The emea had just 31 new drug applications last year, compared with 58 in 2001. "There's been an enormous amount of restructuring," Lönngren told the Parliament. "Never has so much money been spent on R and D with so little outcome." (R and D costs as a percentage of drug-company sales were 12% in 1970, 15% in 1990 and 20% today.) He said research projects were being driven not by health questions but by financial considerations — a demand for blockbuster drugs to help pay for the 60% of drugs that don't return a profit. One result: an upsurge in marketing costs. In 2000 Merck spent $161 million promoting the arthritis remedy Vioxx, more than Pepsi spent advertising its soft drink.

The big American drug giants in recent years have been outpacing European pharmaceutical companies, once the world's most successful. In 1990 Europe had the largest market share for drug sales, while today America has 47% of the market, nearly double the European share. There's also a brain drain headed west — Swiss drugmaker Novartis recently moved its R and D headquarters from Basel to Boston because U.S. investments are now producing bigger returns.

The current round of buying began last summer, when U.S. giant Pfizer offered $60 billion to purchase rival Pharmacia in a deal that will create the world's biggest drug firm, with annual sales of $48 billion. (European regulators have delayed the deal, pushing it into the first quarter of this year.) Rivals like Bayer think this means they need to grow to compete. "I think there's going to be a lot of pressure on drug companies," says David Blumberg, managing partner of Accenture's health-care group. "It's not just to make deals happen, it's to make results including revenue growth happen. It's hard to be a niche player in this industry."

Media speculation has focused on British-based GlaxoSmithKline — itself the product of a 2000 merger — as a potential buyer or strategic partner for Bayer's pharmaceutical business. Glaxo already has a co-marketing agreement with Bayer to sell Levitra. Some argue that since Levitra is a potential billion dollar drug, Glaxo may be so concerned about preserving its marketing partnership with Bayer — and keeping it out of the hands of a rival — that it will be willing to step in and buy the company.

But analysts aren't so convinced. "I think it is highly unlikely," says James Culverwell, a pharmaceutical industry analyst at Merrill Lynch in London. "It doesn't bring them a pipeline of new drugs, it brings them a lot of German infrastructure that is hard to reduce. Why would they want that sort of headache?"

Bayer started thinking about merging its drug business in 2002 after its best- selling cholesterol-reducing drug, Lipobay, was taken off the market after it was implicated in more than 50 deaths. Lipobay had been expected to add $1 billion in sales last year. So far, 5,700 users of the drug have filed lawsuits against Bayer in the U.S. Bayer also said that it has set aside $257.2 million to settle a civil and criminal investigation into allegations that it underpaid rebates for pharmaceutical products under Medicaid, the U.S. health plan for the poor.

A further Bayer headache is the imminent expiration in the U.S. of the patent on another Bayer best seller, the antibiotic Cipro, the drug of choice during the panic over anthrax, which boosted sales to j1.9 billion. The company hopes a new once-a-day Cipro version will help maintain sales against generic competition from companies like Ratiopharm in Germany.

Bayer had long insisted that it needed a drug unit to help offset market cycles in its chemical and pesticide units. When Werner Wenning took over as CEO last year, he suggested the company would be willing to merge its drug business as long as it maintained control of the new entity. In November, he dropped that demand. "We can no longer realistically expect Bayer to have a majority interest," Wenning said.

The most likely fate for Bayer's drug business would be to merge with one of Europe's middle-sized drug companies, such as Germany's Schering. A mid-sized suitor would be attracted to Bayer's existing U.S. sales and Bayer management could receive 30-40% of the shares in such a combination. "There is nothing in it for big companies like Glaxo," says Colin Isaac, an analyst with J.P. Morgan. "Bayer is No. 18 in terms of sales but in terms of profitability they are 43."

Small size is not an issue in the marriage of Pfizer and Pharmacia. The main driver for their merger is that Pfizer lacks blockbusters in its pipeline. By buying another giant, Pfizer gets the benefit of Pharmacia's R and D infrastructure while trimming costs by eliminating back-office duplication. "You get commercial intensity because you end up with a larger sales force and more strength in a particular category," says Accenture's Blumberg. "From a research perspective, with smaller companies, it's relatively hit or miss that the next drug is going to fit in with their commercial strength. With a large company, you're much more likely to have good coverage."

Some doubt that merger mania is genuinely benefiting the companies involved. Robert Gray, a mergers and acquisitions expert at Cap Gemini Ernst & Young, says industry mergers have not done as well as expected. "Between 60-80% failed to enhance shareholder returns," he says, adding that integration can take two to four years, and most companies run out of energy to see the merger through to a profitable end.

That should be a cautionary tale to executives now contemplating more consolidation. With the dangers of failure so high, drug companies should be more careful in making billion-dollar bets on megamergers. Instead, Gray argues, companies should be thinking about acquiring small competitors. But as Bayer's managers have shown, the appeal of the big deal may be just too hard to pass up.

• CHARLES P. WALLACE/Berlin
• The German drugmaker needs a buyer to cure its headaches