Ploughing Ahead

by Matt Richey (TMF Verve)

ALEXANDRIA, VA (May 25, 1999) -- Yesterday, we began our week-long focus on pharmaceutical companies, many of which are well-suited to a Rule-Making investor's portfolio. The drug companies enjoy high gross and net margins, plenty of cash, and a required repeat-purchase business model. Further, the industry is reasonably sheltered from competition thanks to the steep up-front costs of developing new drug compounds and the government-guaranteed protection of patents. And if that's not enough, the outlook for pharmaceutical companies has never been better with the convergence of aging demographics and booming science.

Today, let's take a look at MakerPort holding Schering-Plough (NYSE: SGP). Since we purchased our shares last August, the stock is down about 7%. Did something go wrong? Did the company miss Wall Street's estimates? Has business slowed? Nope, in fact, quite the opposite has occurred. Despite the stock's near-term underperformance, the business has prospered. For 1998, Schering grew sales by 19% and achieved its 13th consecutive year of double-digit growth in earnings per share. Ever since this portfolio's inception, we've noted our willingness to accept flat or even negative returns over the short-term in exchange for the much more substantial rewards of long-term ownership in some of America's finest companies. And, in Schering-Plough's financial results, I see one heckuva fine company.

Although I don't have any specialized knowledge of the pharmaceutical industry, I like what I see in Schering-Plough's financial statements and 1998 annual report. Let's start off with the income statement. In the first quarter of this year (see press release), business was strong with sales, net income, and gross and net margins all higher. Fifteen percent top-line sales growth carried through into even higher 20% net profit growth thanks to expanding net margins, which now stand at nearly 25%. The diluted sharecount expanded slightly by 0.4%, which is within the range of acceptability, although we'd like to see share buybacks bring that number down.

On the balance sheet, there's good news and bad news. The good news is that cash is outgrowing debt, with net cash (cash minus debt) of $664 million, up five-fold from one year ago. The bad news is that the Flow ratio jumped 13% to 1.22. Although this number is still under our standard of 1.25, the direction is somewhat worrisome. The culprit was higher accounts receivable, which grew by 37% -- much faster than sales growth. According to the footnotes of the 10-Q, the escalation in accounts receivable was caused by the timing of trade purchases within the quarter. For now, the uptick in the Flowie appears harmless, but we'll keep our eye on this metric in the quarters ahead.

All in all, Schering's first quarter looked good, and especially so when compared to the average first quarter results of three competitors: Pfizer, Merck, and Warner-Lambert. Schering wins in all of the following categories:

                Schering- Competitors'
                Plough    Average     
Gross Margins   80.2%     68.9%
Net Margins     24.7%     17.1%
Cash-to-Debt    1.80      0.83
Net Cash        $664M     ($561.7M)
Fool Flow Ratio 1.22      1.39

Schering's strong brand, excellent financial results, and competition-whooping performance give the company a strong second tier Rule Maker ranking of 46 (see analysis). A better showing on the Flowie would have given the company a solid first tier score. Shoulda, woulda, coulda -- it's all for naught, if Schering doesn't have a direction that's sweeter than it's current location. Let's look at the most important areas of the business and see what lies ahead.

During the first quarter, Schering exhibited strong momentum in the allergy/respiratory and anti-infective/anti-cancer therapeutic categories, which accounted for more than half of the company's overall sales:

        $ millions
                        Q1    Q1
                Growth  1999  1998
& Respiratory   15%     $866  $753
& Anticancer    36%      422   311
  Combined      21%    1,288 1,064

The allergy/respiratory category is led by continued growth of the world's number one antihistamine -- Claritin, a once-daily non-sedating allergy medicine. For continued growth in this category, the company is utilizing direct-to-consumer advertising to target the almost 50% of allergy sufferers who use over-the-counter medications and the nearly 20% who take no medication at all. Claritin's patent is set to expire in 2002, but the company is battling on Capitol Hill for a three-year extension. According to this Associated Press story, Schering has a strong case for deserving the additional three years.

The anticancer/anti-infective category is led by Intron A and Rebetron Combination Therapy (Rebetol capsules and Intron A injection). On its own, Intron A is used to treat malignant melanoma and in conjunction with chemotherapy for the treatment of non-Hodgkin's lymphoma. When Intron A is combined with Rebetol capsules, Rebetron Combination Therapy is the leading treatment against hepatitis C. Affecting 10 million people worldwide and 4 million in the U.S. alone, hepatitis C is a deadly disease that attacks the liver. With 150,000 newly infected people each year, hepatitis C contributes to the deaths of 8,000 to 10,000 Americans each year, with the number of deaths expected to triple by 2010. With the recent European Union (EU) approval of Rebetron Combination Therapy, sales in this category should continue to grow swiftly.

On January 1 of this year, Schering-Plough reorganized its internal structure to emphasize its focus on pharmaceutical research and development (R&D). During the first quarter, Schering bolstered its future by investing 12% of sales in R&D, up from 11.7% a year ago. Although this investment is far less than industry research leader Pfizer's 16.7% of sales, Schering's pipeline appears to have a number of promising agents:

Drug           Medical Condition          FDA Phase
Temodal        brain tumors               early
Caelyx         breast and ovarian cancer  III
Melacine       melanoma                   III
FPT Inhibitor  various solid tumors       II
p53 tumor
  suppressor   various solid tumors       early and II
PEG-Intron     hepatitis C                III
Tenovil        Crohn's disease            III
Tenovil        rheumatoid arthritis       II
Remicade       rheumatoid arthritis       III
Integrilin     cardiovascular diseases    II

One of the more interesting areas of development is the p53 tumor suppressor, which is a form of gene therapy that may have potential application in at least 50% of human tumors. Schering's future may well lie in the exciting arena of biotechnology, genomics, and gene therapy

As long as Schering-Plough keeps investing smartly in future research, I expect this Rule Maker's stock price to one day catch up with its solid business performance.


05/25/99 Close

Stock Change    Bid
AXP   -2 5/16   114.50
CHV   -  7/8     91.00
CSCO  -5        104.38
EK    -1         70.50
GM    +1 7/16    84.63
GPS   -2 1/16    60.06
INTC  -3 1/16    52.88
KO    +  9/16    67.25
MSFT  -1         76.25
PFE   -4        102.25
SGP   -1 5/16    44.56
TROW  -1 1/8     35.88
XON   +  9/16    80.19
YHOO  -10 15/16 126.94

                  Day     Month  Year    History
        R-MAKER  -2.75%  -9.58%   1.34%  28.23%
        S&P:     -1.70%  -3.80%   4.81%  29.69%
        NASDAQ:  -2.97%  -6.37%   8.58%  44.04%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     76.25    94.84%
   6/23/98   34 Cisco Syst    58.41    104.38    78.69%
    5/1/98   55 Gap Inc.      34.37     60.06    74.75%
   2/13/98   44 Intel         42.34     52.88    24.89%
    2/3/98   22 Pfizer        82.30    102.25    24.24%
   5/26/98   18 AmExpress    104.07    114.50    10.03%
    2/6/98   56 T. Rowe Pr    33.67     35.88     6.54%
   2/17/99   16 Yahoo Inc.   126.31    126.94     0.50%
   2/27/98   27 Coca-Cola     69.11     67.25    -2.69%
   8/21/98   44 Schering-P    47.99     44.56    -7.15%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     80.19    24.64%
   3/12/98   17 General Mo    72.41     84.63    16.88%
   3/12/98   20 Eastman Ko    63.15     70.50    11.64%
   3/12/98   15 Chevron       83.34     91.00     9.19%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   3660.00  $1781.55
   6/23/98   34 Cisco Syst  1985.95   3548.75  $1562.80
    5/1/98   55 Gap Inc.    1890.33   3303.44  $1413.11
   2/13/98   44 Intel       1862.83   2326.50   $463.67
    2/3/98   22 Pfizer      1810.58   2249.50   $438.92
   5/26/98   18 AmExpress   1873.20   2061.00   $187.80
    2/6/98   56 T. Rowe Pr  1885.70   2009.00   $123.30
   2/17/99   16 Yahoo Inc.  2020.95   2031.00    $10.05
   2/27/98   27 Coca-Cola   1865.89   1815.75   -$50.14
   8/21/98   44 Schering-P   2111.7   1960.75  -$150.95

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1603.75   $317.05
   3/12/98   17 General Mo  1230.89   1438.63   $207.74
   3/12/98   20 Eastman Ko  1262.95   1410.00   $147.05
   3/12/98   15 Chevron     1250.14   1365.00   $114.86

                              CASH     $70.09
                             TOTAL  $30853.15

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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