Schering-Plough: Value or Trap?

I run a hedge fund that maintains a highly concentrated -- some would say non-diversified -- portfolio of quality companies. The core tenet of my investment discipline is to buy companies that trade below my calculation of intrinsic value. As an intrinsic value investor, I am very price sensitive and as prices decrease I believe values become more compelling. The ultimate situation for me is to have a great company trading at a very distressed level for some reason.

Quantitatively, I measure greatness using the following common investment analysis constructs: return on invested capital (ROIC), above-average profit margins, and a low debt-to-capital ratio. Qualitatively, I look for companies that have little competition and that have a quality management team. Buying quality companies is especially important to me because I hold only five to 10 positions in my portfolio. I have little room for error.

Finally, to complete my stock picking process, I use free cash flow to value the company and then I try to buy shares at as large a discount to intrinsic value as possible, a built in margin of safety. Pharmaceutical giant Schering-Plough looks like it may fit my criteria, so I decided to take a closer look.

The Holy Grail in investing, to me at least, is to find a quality company (as defined above) where the stock price is at a multi year low. Unfortunately many people mistake a low stock price for an undervalued stock. Just because a stock is down drastically does not mean that it is a good value. It may have been priced incorrectly during the previous years. A successful stock-picking strategy is not just blindingly buying beaten-down stocks. Many investors who take such an approach often get caught in "value traps" -- stocks that seem like values but really are not.

Value traps can be exposed by looking at the balance sheet and statement of cash flows, and really examining the nature of the business going forward. Most of the time value traps are over leveraged companies that never really generated enough free cash flow to support their past sky-high valuations. Many value traps are dying businesses, meaning they are not just in a slump -- something has fundamentally changed that will affect their future business prospects.

Schering-Plough (NYSE: SGP  ) is currently a stock that has investors scratching their heads. Is it a compelling value at these levels or just another value trap? The stock is down from its high of nearly $60 a few years ago to roughly $16.50 today -- a painful drop. I think at current $15-$16 level the company does not represent a compelling value. I would wait for lower prices and a wider margin of safety before building a position. But many value investors have recently flocked to the stock in the hopes of catching the big turnaround.

Historically, the stock exhibits all the characteristics of a quality company I outlined. It had ROIC in the range from 40% to 20% -- fantastic numbers. It has little debt and a blue chip balance sheet. Its profit and cash flow margins were in the low 20% to high teen range -- truly impressive. So why don't I like the company at these levels? It is all about price, value, and a realistic business outlook.

How Schering-Plough got here
In 2002, Schering-Plough was named one of the fastest-growing top 30 pharmaceutical companies worldwide, hoping to rival heavyweights like Pfizer (NYSE: PFE  ) , Bristol-Myers Squibb (NYSE: BMY  ) , Abbott Laboratories (NYSE: ABT  ) , and Johnson & Johnson (NYSE: JNJ  ) . During the past five years it was a leader in the allergy field and produced substantial free cash flow (FCF) from its Claritin drug. But disaster came last year when Claritin was no longer eligible for patent protection -- meaning other companies could make generic copies. Schering-Plough began offering Claritin over-the-counter (OTC) and profits plummeted. It's simply much more lucrative to sell a prescription drug versus an OTC drug.

Investors were slow to realize the true value of Claritin to the company, and the stock began to slowly drift lower (instead of a fast, decisive drop). I would argue that currently investors still have not fully realized the gravity of the situation.

In mid-2002, Schering-Plough had manufacturing and compliance problems with the Food and Drug Administration (FDA), which led to a $500 million fine and a promise to bring its operations up to FDA standards. Further, in the fall of 2002, the company encountered some issues with the Securities and Exchange Commission (SEC) involving regulation FD (fair disclosure). It seems former management may have alerted some larger investors of the seriousness of its problem before telling the general public.

On Sept. 9, 2003, Schering-Plough settled with the SEC for violating regulation FD. The company, which did not admit or deny any wrongdoing in the settlement, agreed to a cease- and-desist order and to a $1 million civil fine. While getting the SEC and FDA issues behind it should be a positive for the company, one still has to question the validity of Schering-Plough's historical performance if some part of it was based on cutting corners.

Claritin sales and FCF peaked in 2001, and the stock began its long decline. With no way to stem the loss of Claritin FCF, the company was forced to lower its future profit outlook. Then, by late 2002, Schering-Plough had decided to replace its chairman and CEO.

For most of 2002 and 2003, the company continued to pay a huge dividend that carried an attractive yield of over 5% at times. Many flocked to the stock, using the dividend as a safety net. It was the type of situation where investors could have used the advice of Motley Fool Income Investor, for any cursory analysis of the financial statements would have alerted them that the dividend was unsustainable.

Throughout 2003, new management has been evaluating the situation and telling investors that things do not look good. In its first-quarter 10-Q filing, the company even stated that cash flow from operations may not be enough to support operating expenses, working capital, and the dividend. At that time the stock traded in the mid $18 range. Surely such a straightforward statement from management would have been an eye opener for investors? Nope -- they still believed in the dividend and that the company was cheap because its price had declined so much.

Finally, the crushing news flow started to arrive. First, on July 7, 2003, management lowered its sales and earnings forecasts for Q2 '03. The stock was still in the $18 range. Then, on Aug. 21, 2003, the company slashed its dividend by 68% to $0.22 from $0.68 per year, thus eliminating a major reason for holding the stock for a number of shareholders.

The stock fell 9% that day, but I believe the timing of the announcement was suspect. In fact, when Schering-Plough reported its earnings in July (when everyone was paying attention), it did not take that opportunity to cut the dividend. Further, during the conference call following the announcement, CEO Fred Hassan was not present. I find this incredulous; the company claimed he had a prior commitment. Would you trust a CEO who could not deliver the worst news to date to shareholders in person? In my view, new management has not gotten off on the right foot in the honesty department with the way it handled the dividend cut. The stock seems to have settled into the $15-$16 range.

What's to like about Schering-Plough?
Obviously, there's a lot wrong with the company. So, why should we bother following it? Well, there are still a lot of positives to consider:

The balance sheet remains solid with $4 billion in cash and little debt. This is essentially why I started watching the company in the first place.

The company brought in a new management team, which while untested at Schering-Plough, is likely better than the former team that caused the company to get FDA and SEC fines. Even with the mishandling of the dividend issue, I believe current management at least understands the seriousness of the problems. They know that if they cannot right the ship, the stock price won't move.

In three years the stock has gone from $60 to $15. While this alone should never be a reason to buy a stock, in certain circumstances it can alert investors to an irrational market. Sometimes when turnarounds don't happen as fast as investors anticipate, panic selling can lead to a very cheap stock. This is yet to be seen with Schering-Plough.

The company's ROIC has historically been fantastic, ranging between 22% and 45%. If things start to go right, and SGP can again achieve those margins, the stock will be higher.

In addition, its FCF margins (as a percentage of sales) have also been incredible, ranging between 16% and 22%. Again if results return to historical form, this is the type of company investors should love to own.

All this information tells me that when a pharmaceutical company discovers a blockbuster drug, it can produce great results. To put things into perspective, an average company's ROIC is about 10% and its FCF margins are around 7%. Historically Schering-Plough has been a good company, but to move forward I need to review the company's ongoing business prospects as well as its current valuation.

Click here for Part 2 of this article.

Paul Jaber, C.F.A., is a guest columnist for The Motley Fool. He holds no position in Schering-Plough and appreciates your feedback at pjaber@perpetualvalue.com. The Motley Fool is investors writing for investors.


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