Schering-Plough's Trap

On Monday, I began a close look at pharmaceutical company Schering-Plough (NYSE: SGP  ) . The stock has plummeted from $60 to around $16, and it still may not be a value. But the company still has a lot going for it and it's worth keeping an eye on. Here's a look at its business prospects and valuation.

Ongoing business prospects
Much has been written about how losing the Claritin patent has hurt Schering-Plough, but many investors don't realize that other areas of the business are suffering as well. Its hepatitis C franchise, for one, is losing market share. Analysts estimate that in 2004 the company will have revenues of around $8 billion, down from $10 billion in 2002.

Schering-Plough is not a razor/razorblade business like Gillette (NYSE: G  ) , where sales may slump in the short term but will eventually pick up. As a complex pharmaceutical company, Schering-Plough has some serious business issues. This is not the case of a company screwing up for a quarter or being hurt by a slow economy. In the current political, climate all pharmaceutical companies are being forced to lower prices, which hurts margins and free cash flow. In addition, generic drugs are invading all markets, truly calling into question if the historical operating margins and performance of pharmaceutical companies can be replicated going forward.

Faced with these uncertainties, I approached valuing Schering-Plough's future business prospects with caution. I chose to make conservative assumptions, not hope for best-case scenarios. Taking such an approach, I assumed the following:

  • Schering-Plough will discover new drugs in the future, and some will even be blockbusters like Claritin.

  • Schering-Plough will also lose patent protection on additional drugs in the future.

  • Schering-Plough's historical financial results are probably a good indication of the strength of the business when things are good. That means there is not much upside to historical results.

  • And finally, margins for pharmaceutical companies will continue to be under pressure and will contract a bit. They'll still great businesses, but not quite as lucrative as in the past.

Based on these assumptions, I concluded that Schering-Plough was going to have a tough time going forward, and that the stock was nowhere near a value in my view. This doesn't mean the stock cannot go up; it just means using my disciplined approach it does not currently represent a compelling value.

Though new to Fool.com, I have written about the company before on other financial sites and I predicted the dividend would need to be cut and that the stock would continue to trade lower. I made these forecasts by looking at the numbers and listening to management. Though Schering-Plough never released free cash flow (FCF) generated from Claritin, it does release sales numbers. Making a few minor assumptions, I believe one can determine approximately how much FCF Claritin produced and thus what effect its loss would have on the company's valuation. Frankly, this analysis took me all of one hour to complete.

Historical Claritin sales were as follows: 1995, $790 million; 1996, $1.2 billion; 1997, $1.7 billion; 1998, $2.3 billion; 1999, $2.7 billion; 2000, $3 billion; 2001, $3.16 billion; and 2002, $1.8 billion.

To calculate FCF from Claritin, I simply used the overall FCF margin (a percentage of sales) and multiplied it by Claritin sales. I know that my calculations may have been too conservative, meaning I may actually have underestimated FCF from Claritin, but if I did that, the results for Schering-Plough would only be worse. I just wanted to get a baseline valuation without Claritin FCF, just something to see if the current price was a value. According to my calculations, Claritin accounted for a low of $170 million FCF in 1995 and a high of $567 million FCF in 2001.

In 2001, Schering-Plough generated total FCF of $1.75 billion. It is not hard to see that by subtracting most of Claritin's FCF, going forward Schering-Plough would generate normalized FCF of roughly $1.2 billion. All of this is assuming I did not undercalculate Claritin's FCF generation and that all of Schering-Plough's other businesses are doing well -- not slam-dunk assumptions.

Prior to Aug. 21, 2003, Schering-Plough was paying a total dividend of roughly $1 billion per year. Faced with estimated FCF of less than $1.2 billion in 2004 (much less actually), I predicted there was no way the company could have maintained the dividend. Management knew this also and they should have cut the dividend during the second-quarter earnings release. Yet it held out, I believe, to release the news when much of the Street was on vacation, to lessen the blow. Regardless of the timing of the announcement, if you were holding Schering-Plough for the dividend, you now have no reason to own it.

Business for Schering-Plough will likely get better; it just may take some time. The point of all of this is that valuation matters when buying a turnaround play like Schering-Plough, and at its current price it does not appear cheap in my view.

A little cash flow analysis
So you want to know what I think Schering-Plough is worth? By looking at its historical cash flows, I see that the company generated all-time high FCF of $1.75 billion in 2001. As you know, achieving such cash flow means the company will need a new blockbuster drug, something I believe will eventually happen.

The problem is that, these days, there are incredible political and market forces on pharmaceutical companies to lower the price of drugs. In the future, these pressures will likely lower margins for the companies. Thus, I have adjusted Schering-Plough's historical results downward, and I believe that on a normalized basis the company can produce FCF results of roughly $1.5 billion.

However, the timing of when Schering-Plough will be able to normalize FCF is uncertain and will not likely happen soon. Remember, management is saying that 2004 results will be worse than 2003. Investors will probably be faced with another 12 months of negative news flow, before things get better.

All of these negative factors mean investors should demand a wider margin of safety. To me, $1.5 billion in FCF makes the company worth $25 billion to $30 billion. At roughly $16.50 per share, Schering-Plough has a current market cap of $24.5 billion. I am not saying the stock won't go up, but I believe if you have a disciplined investing approach, you really cannot justify owning the company at these levels.

Schering-Plough can certainly return to form, and at some point it indeed may be an interesting value play. But that time is not now. I'd wait for more breathing room before purchasing shares.

Paul Jaber, C.F.A, is a guest columnist for The Motley Fool. He appreciates your feedback at pjaber@perpetualvalue.com. The Motley Fool is investors writing for investors.


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