Hey, Fools! This article is coming at you from Munich, Germany, where I am enjoying a couple of weeks in the land of beer and pretzels. In keeping with the theme, I'll be reviewing the performance of one of our Rule Makers, Schering-Plough (NYSE: SGP). What does our company have to do with Germany, you ask? Well, not a whole lot really, but Schering-Plough at least sounds a whole lot more German than Cisco, Microsoft, or Yahoo!

In any case, Schering-Plough's 1999 annual 10-K came out recently, and I spent some time looking through it between pretzel bites. I don't know about you, but I much prefer reviewing 10-Ks to the quarterly reports. I find that the annual reports give so much more insight into the company's operations, and also provide a reasonably big picture view as opposed to the one-quarter snapshots provided by the 10-Qs.

Of course, we do review each quarterly report for all our holdings, but this is pretty much more for enjoyment than out of necessity. The annual reports are important reading, however, and I definitely recommend that you spend some time reviewing these for every company that you own. With that public safety announcement out of the way, we'll move on to the topic at hand.

As you have probably noticed, Schering-Plough's stock price has been drifting lower and lower in the last year -- falling today to a two-year low -- so it's time to put on the Scherlock hat (sorry, I meant "Sherlock") and see if we can determine the cause of the slide.

Starting with the income statement, we can see that sales in 1999 were $9.176 billion, a nice little chunk of change and an increase of 13.6% over the previous year. This is excellent sales growth for such a large company, and easily surpasses our 10% annual sales growth target.

Cost of goods sold decreased as a percentage of sales, which boosted gross margins for the year to 80.3% from 80.1% in 1998. This is way above and beyond our Rule Maker requirement of 50% gross margin, and I like the direction of this ratio as well, even if it is in only small increments. There are certainly no problems here.

In terms of net income, Schering-Plough reported $2.11 billion in earnings for 1999, up 20.2% from 1998. While we have no net income growth requirement in the Rule Maker, we still like to see these numbers growing, especially when they grow faster than sales. That's because when earnings grow faster than sales, net margins must be getting bigger. That's the case here, as Schering-Plough's net margin has expanded to 22.9% from 21.7% in the last year. So far, so good.

Before we move on to the balance sheet, I'll also note that because Schering is in the business of discovering and selling drugs, R&D is a crucial component of the firm's future success. Schering increased R&D spending in 1999 by 18.2% to a whopping $1.19 billion. This is just under 13% of sales. We like to see our companies invest in their futures, and for a pharmaceutical company, that future is reflected by a strong commitment to research & development.

Our next stop is the balance sheet. Schering-Plough now has almost $1.9 billion in cash, while the company has also increased the short-term debt to $728 million. Still, the cash-to-debt ratio is over 2.5, providing a nice cushion to our desired level of cash at 1.5 times total debt.

At this point, things take a slight turn for the worse. Accounts receivables have increased to $1.022 billion, up from $704 million in 1998. This is a 45.2% increase, which is well above the increase in sales. That's not good. Inventories have also risen faster than sales, up 13.9% to $958 million. Looking down at the "good" liabilities, accounts payables have actually declined, down to $966 million from just over $1 billion in 1998.

In each one of our critical Cash Conversion Cycle components, Schering-Plough is moving in the wrong direction. We can confirm this by calculating the Flow Ratio. Yep, there it is: 1.22, up from last year's 1.09. Schering-Plough still beats our 1.25 limit, but it's getting pretty tight. I'd like to see our company get that Flow back down to under the 1.00 mark, where it has been after some of the company's best quarters. All in all, the balance sheet certainly isn't bad by any stretch of the imagination, but we need to keep an eye on that Flow Ratio in the next several quarters.

Finally, we move to the cash flows statement. One of the reasons that we don't like high inventory and accounts receivables levels is that they represent cash that the company has tied up in assets that aren't helping us. Schering's increasing receivables and inventory and its declining payables have hurt the company's cash profitability. Operating cash for 1999 was $1.89 billion, which is less than net income. After deducting capital expenditures of $504 million, we are left with $1.35 billion in free cash flow for 1999.

While that sounds like a nice figure, when we divide free cash flow by sales, we get a Cash King Margin of only 14.7%, considerably less than our net margin of 22.9%. While Schering-Plough easily beats our 10% Cash King Margin requirement, we can see that the company's net margin overstates true cash profitability by more than a third. In addition, by looking at free cash flow for the last three years, we can see that Schering-Plough's growth in revenues and net income hasn't translated into free cash flow growth: 

Year      FREE CASH FLOW
1997      $1.440 billion
1998      $1.637 billion
1999      $1.350 billion

That's not a particularly reassuring trend, and given the fact that free cash flow is not keeping up with the sales growth, I don't think it is a real mystery why the stock price has been sliding recently.

Lest we be too short-term oriented, we need to consider more than the company's current location, and spend a minute or two pondering the future direction for Schering-Plough. In 1999, $2.7 billion in sales were represented by the company's best selling allergy medicines Claritin and Claritin-D. That's almost 30% of sales. With patent protection for Claritin ending in 2002, Schering-Plough is looking at a real threat to future sales growth.

Because the company didn't provide any detail on the future product pipeline in the most recent 10-K, I don't have a good feel as to whether or not our company is going to be able to make up those lost sales and profits by virtue of new product launches. Because that is going to be a key factor in our assessment of Schering-Plough's attractiveness as an investment, we need to be able to gauge the potential new growth represented by our company's massive R&D spending over the last several years. To this end, I'll start digging around the company website and see what information that I can find. We'll review Schering's research pipeline next week.

Until then, I'll withhold judgment on Schering-Plough. I will say this, though. While I don't anticipate us selling any of our holdings in the near future, I am definitely against adding to our positions in those companies that aren't showing some solid business momentum, regardless of the current price. Sure, Schering-Plough is selling for much lower multiples now than at the time the Rule Maker portfolio initiated our position, but to this point I would have to agree with the market that the company's prospects looked stronger two years ago than they do today.

Before I go, three quick announcements:

First, I'd quickly like to thank our two editors, who conveniently enough are both named Bob. The Bobs are entrusted with the very difficult task of making something coherent of our daily ramblings, and we appreciate their efforts. (Editor's note: That's Mr. Bobs to you, Zeke. And stop sucking up.)

Second, this morning, we purchased four shares of American Express (NYSE: AXP) at $125 11/16 per share, as we said we'd do in yesterday's column. With no commission charge (thanks to AmEx's no-commission buys on accounts with more than $25K in assets), our total purchase amounted to $502.75.

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Until next time, y'all stay Foolish!