RULE MAKER PORTFOLIO

Rule Maker To Buy SGP
August 20, 1998


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Rule Maker Portfolio Buy Report
Announcement: Purchase up to $2,094 of Schering-Plough.

Schering-Plough (NYSE:SGP)
One Giralda Farms
Madison, NJ 07940
(973)822-7000
http://www.schering-plough.com

An Overview of the Company

Schering-Plough Corp. is engaged in the discovery, development, manufacturing, and marketing of pharmaceutical and health care products worldwide. The company is divided into three segments: pharmaceuticals, animal health, and consumer products. The company's major pharmaceutical therapeutic areas include respiratory, anti-infectives, anti-cancer, dermatologicals, and cardiovascular.

Schering-Plough's major pharmaceutical products fight respiratory ailments (which include Schering-Plough's Claritin brand of nonsedating antihistamines), and anticancer products (including the company's alpha interferon anticancer/anti-infective, Intron-A).

In 1997, the company's sales by product type broke out as follows:


 Product        Percentage of
 Type             Total Sales 
 Respiratory              40
 Anticancers/
 anti-infectives          17
 Consumer products        10
 Other drugs              10
 Cardiovascular            9
 Dermatological            8
 Animal health             6

About 39% of Schering-Plough's 1997 sales were in international markets. These sales accounted for approximately 27% of the company's profits.

The Basic Financials

Over the last five years, Schering-Plough has demonstrated consistent sales and earnings growth, widening margins, and highly positive cash flows. Throughout, the company has kept its investments in Research and Development very high as a percentage of sales (above 12%). The company has also had a history of buying back shares while increasing dividends. That all adds up to a very Foolishly-run business.

Let's start with a glance at some of the income statement numbers (and, of course, the complete 10-K is available for your perusal via Fool Data).


                                           5-year
                                           Annual
                         1992       1997   Growth
Revenue              $4.1 bil.  $6.6 bil.   10.8%
Gross Profit Margin     77.8%      80.7%     0.7%
R&D                  $511 mil.  $847 mil.   10.6%
R&D / Sales             12.6%      12.5%    -0.2%
Net Profit           $720 mil.  $1.4 bil.   14.9%
Net Profit Margin       17.8%      21.3%     3.7%
EPS                     $0.90      $1.97    17.0%
Shares Outstanding    798 mil.   733 mil.   -1.7%

One of the key things we note from the trend in both gross and net profit margin is that as the business grows it is being operated more efficiently over time. Additionally, according to Market Guide, the company's gross and net profit margins over the last 5 years are 80.3% and 20.6% -- considerably higher than the pharmaceutical industry averages of 69.7% and 16.0%, respectively.

The company's effective tax rate is also significantly lower than the industry average -- 3.4% lower over the last 12 months and 6% lower over the last 5 years. Schering-Plough does everything in its power to hold down its tax rate, and these savings go right to the company's bottom line. The company's 21% net profit margins are a testimony to that.

One of the benefits of those high margins is that they allow for a consistent high level of investment in research and development -- holding steady above 12% -- which has resulted in the increase in sales across all product lines. The growth, however, has primarily come from pharmaceutical products, which have the highest margin of the group for Schering-Plough.

Additionally, although the company has actually increased its dividend in each of the last 12 years, the year-by-year decrease in shares outstanding indicates that Schering-Plough has also provided additional returns to shareholders by increasing its share price through stock buybacks.

Basic Financials
(as of August 19, 1998)

Price........................................................$97 1/8
Trailing earnings...........................................$2.17
Calendar 1998 est. earnings..........................$2.33
Calendar 1999 est. earnings..........................$2.72
P/E on trailing earnings..................................43.7
P/E on 1998 estimate....................................40.7
P/E on 1999 estimate....................................34.8

Basic Rule Maker Criteria (*)

Market capitalization...........................$71.3 billion
Gross profit margin......................................80.1%
Net profit margin..........................................21.4%
Cash on books...................................$707 million
Long-term debt.....................................$46 million
Cash as a multiple of long-term debt..............15.4x
Leveraged Flow Ratio.....................................0.93
Unleveraged Flow Ratio..................................1.05

(*) Data based on 10-Q for quarter-ended 6/30/98

Additional Data (*)
Consensus 5-year est. growth rate................15.3%
Debt as % of equity.....................................10.6%
Debt as % of revenues...................................4.8%
Dividend yield..............................................0.93%
Return on Equity..........................................47.1%
Return on Invested Capital.............................41.7%

(*) Data based on 10-Q for quarter-ended 6/30/98

Concentrated Look at the Business

The Company traces its history to 1864 when Ernst Schering, a Berlin chemist, founded the company. Schering-Plough's former German parent corporation, Schering AG, lost the company when it was seized by the U.S. government at the onset of World War II. It was later sold to Merrill Lynch (NYSE: MER), which took it public in 1970. The company then merged with Plough Inc. in 1971. Subsidiaries of the company are located throughout the world and are engaged in the discovery, development, manufacturing, and marketing of pharmaceutical and healthcare products around the globe.

Okay, get ready for a long listing of products, which we'll be reviewing together in the weeks ahead.

Let's start with the most important category, respiratory and allergy drugs, which make up Schering-Plough's biggest product category. They accounted for approximately 40% of 1997 sales. The Claritin antihistamine and the Claritin D decongestant have over 40% of the US market for such products. Together the two products represent the world's largest selling antihistamine. They accounted for over $1.7 billion of the company's sales in 1997. Other allergy/respiratory drugs include Nasonex, Vancenase allergy nasal products, Vanceril asthma inhaler, and Proventil, Theo-Dur and Uni-Dur for asthma.

Anti-infectives and anti-cancer products accounted for 17% of Schering-Plough's 1997 sales. Intron-A, a leading alpha interferon marketed for several anti-cancer and anti-viral indications is the leading product in this group. Other products include Eulexin, a treatment for prostatic cancer, antibiotics Cedax and Netromycin, Leucomax, and Ethyol, a cytoprotective agent.

So, 57% of the company's business is linked to antihistamines and anti-cancer medications. Beyond this, read on.

Dermatological products represented 8% of the company's 1997 sales. Lotrisone, a topical antifungal and anti-inflammatory cream, and Elocon, a topical steroid cream and ointment, are the leading products in this line, which also includes such high-potency steroids as Diprolene and Diprosone.

Cardiovascular products accounted for 9% of 1997 sales and were led by Imdur, an oral nitrate, and K-Dur, a potassium supplement. Other drugs accounted for 10% of 1997 sales. The biggest sellers in this group are Losec, an anti-ulcer drug, and the line of Fibre Trim diet aid products.

Schering-Plough's consumer products division includes such well-known over-the-counter (OTC) medicines as Afrin nasal spray, Chlor-Trimeton allergy tablets, Coricidin and Drixoral cold medications, and Gyne-Lotromin for vaginal yeast infections. Schering-Plough sells foot care items under Dr. Scholl's and other names; it sells Coppertone and other sun care products. The company also makes Paas Easter egg decorating kits. This segment accounted for approximately 10% of the company's sales in 1997.

Further, the company is a leading maker of animal health care products, which accounted for 6% of 1997 sales. Growth of this division has been enhanced by the purchase of Mallinckrodt's animal health business on June 30, 1997. Nuflor, a broad-spectrum, multi-species antibiotic is the driver of the company's sales growth in this business line.

In the pharmaceuticals business, a drug with sales of over $1 billion annually is generally viewed as a blockbuster product. In 1997, Claritin qualified as a blockbuster. It's expected that Claritin-D will join it in the near future. At this point, these products dominate Schering-Plough's business.

The company's management certainly has a top-notch reputation; they are respected as the finest financial managers in the industry. This is something that this Fool saw first hand during my days in Public Accounting when I audited the international component of the company's tax provision. With the exception of the former CEO and current Chairman of the Board, Robert Luciano, all of the company's key managers are in their 40s and 50s.

A Look at Historical Stock Performance

Since 1986, after adjusting for stock splits in 1987, 1990, 1995, and 1997, Schering-Plough's stock price has increased from a low of $3.90 to its current level of $97.13. That's total growth of 2391% over the ten years, or 38% growth per annum -- far outpacing the S&P 500's average growth. Over that time, earnings per share have grown by over 19% annually. Schering-Plough has also increased its annual dividend for 12 consecutive years. During that period, they've generally maintained a dividend payout ratio of 35% or less while still maintaining a highly positive cash flow.

Concerns Going Forward

Schering-Plough faces significant competition in its primary markets and is also subject to substantial government regulation. These factors place significant pricing pressures on the company. In the United States, many of the company's pharmaceutical products are subject to increasingly competitive pricing as managed care groups, institutions, government agencies, and other buying groups seek price discounts. In most international markets, the company operates in an environment of government-mandated cost containment programs. Since the company is unable to predict the final form and timing of any future domestic and international governmental or other health care initiatives, the effect of these factors on operations and cash flows cannot be reasonably estimated.

In addition, Schering-Plough and its competitors are constantly searching for technological innovation. To the extent that new products are introduced into the marketplace, Schering-Plough's existing products -- like Claritin -- can either see a decline in market share or become obsolete. There are concerns about the expiration of patents on Claritin.

That can lead to generic competition, which can add significant pricing pressure. Since patent protection offers some form of price protection, Schering-Plough is under constant pressure to continue developing new, innovative products. If it is unable to come up with new products, however, trouble looms. Fortunately, Schering-Plough has a pipeline full of great products on the way. Want to read more about them, Fool? Just read the next section of this report.

Prospects Going Forward

One of the principal reasons that we decided to add another pharmaceutical company to the Rule Maker portfolio was our belief that this is an important industry for Fools to have represented in their portfolios. No matter whether the economy is booming or in recession, people will always need drugs to help keep them healthy. People all over the world are also living longer due to the many advances that these companies have brought about.

Schering-Plough has a long history of product innovation. The company is smaller than many of the other name players in the industry. However, its management has exhibited the ability to keep coming up with successful new products and grow its business. We actually view the smaller relative size of this company as a potential advantage; it means that new drugs can have a more significant impact on the company's bottom line. The company consistently reinvests over 12% of its sales revenues into its R&D efforts. This investment should enable the company to continue to meet its growth targets

The most important drugs currently marketed by Schering-Plough are those in its Claritin line and Intron-A cancer drugs. Fortunately, these products have a few years to go before the patents on them expire. It is also quite possible that the company could come up with new dosings, new indications, or drug delivery methods for these products that would extend the patents even more.

Other promising products in the pipeline include the following: Avakine, a treatment for Crohn's disease that has been licensed from Centocor (Nasdaq: CNTO) for marketing outside the US and was just recommended by an FDA advisory panel; Vasomax, a possible competitor for Pfizer's (NYSE: PFE) Viagra, for which a new drug application has been filed with the FDA; Melacine, a therapeutic vaccine in Phase III trials licensed from Ribi ImmunoChem Research (Nasdaq: RIBI); and Caelyx, a drug to help patients battle breast and ovarian cancer licensed from Sequus Pharmaceuticals (Nasdaq: SEQU), which is also in Phase III trials.

You can see that our company does a lot of licensing. Managed correctly, that can be a great asset. SGP shares the costs of development, while benefiting from its powerful marketing presence in the sale of new drugs.

Currently, the 26 analysts that follow Schering-Plough's stock have forecast a mean 5-year EPS growth rate of 15.3%. The company has demonstrated an ability to grow at these levels (or higher) in the past, and we have no reason -- given their financial standing and past performance -- to believe that it should not continue to deliver this level of growth in the future.

Of note, the company trades at a premium to its 5-year growth rate. This premium is based upon both the company's long standing history of consistent, solid expansion and its increasing margins earned on its sales. The market rewards companies that deliver consistently by discounting that growth on a forward basis. An investor calculating a simple YPEG (5-year growth rate times projected year-ahead earnings) for this company will find that growth is being discounted forward at least 2 years. This valuation tool tells us that Schering-Plough may trade sideways for awhile, but we're buying our piece of the business with a view towards retirement. Two years of patience for the potential of year after year (decade upon decade?) of market-beating growth is a trade we're more than happy to make.

Is Schering-Plough Corporation a Rule Maker Stock?

From a Rule Maker perspective, there really isn't much that concerns us about Schering-Plough. It easily passes all the numerical-based Rule Maker criteria. We were, however, disappointed to see the company's Flow Ratio increase year-over-year, as accounts receivable got away from SGP a bit. We'll be watching this and inquiring more about it from the company directly.

Schering-Plough passes all of the other Rule Maker tests with flying colors. Great debt management. Large cash reserves. High margins all around. A commitment to R&D. Historical excellence. And even a smattering of consumer brand names. Drug industry namebrands are a bit different than mass-market brands -- a bit weaker as well -- but we think Schering-Plough's products have a great reputation in the medical world.

As a result, this stock will be added to the Rule Maker portfolio over the next five business days (reliant upon Tom's mad flipping of coins). We're excited to be a partner-owner in a business that has driven so much meaningful research in decades past and that has methodically grown a business that has rewarded customers, shareholders, and employees alike. Welcome into the market-beating world of Rule Makers, Schering-Plough. We look forward to learning more about you in the years ahead.

-- Phil Weiss (pweiss@homemail.com)

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