In 2002 Schering (SGP) was named one of the fastest-growing top 30 pharmaceutical companies worldwide. During the past five years SGP was a leader in the allergy field and produced substantial free cash flow (FCF) with its Claritin drug. Disaster came last year when Claritin was no longer eligible for patent protection – meaning other companies could make copies. SGP began offering Claritin over-the-counter and profits plummeted, it is much more lucrative to sell a prescription drug versus an OTC drug. SGP also has had some regulatory and legal issues with the FDA that remain unresolved.
The balance sheet remains solid with $4 billion in cash and little debt, which is why I started looking at the company in the first place. The management team that caused many of its current problems was replaced in 2003 and the company is trying to turn itself around. In two years the stock has gone from $40 to $15 representing apparent value for some investors. Until August 21, 2003 the stock had a $0.68 annual dividend, which yielded nearly 4.5%, high enough to sucker in less rigorous analysts and investors. In short SGP has turned up on many ‘value’ investors’ watch lists this year.
Source: Perpetual Value Asset Management estimates and company reports.
On August 21, 2003 SGP 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 SGP 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, the CEO Fred Hassan, was not on the call. I find this incredulous; the company claimed he had a prior commitment. Would you trust a CEO that could not deliver the worst news to-date to shareholders in person?
When the stock was trading between $17 and $20 investors were buying, essentially for the dividend yield (dividend payment divided by stock price). A quick glance at the table below (compiled by me before the dividend cut) would have made it apparent to any astute investor that a dividend cut was going to be necessary, yet the buying continued. I have been speculating for months that SGP would have to cut its dividend, and I believed the stock would fall when it was cut. The lesson to learn from this is that when a stock’s dividend yield seems too good to be true, it usually is – you always have to look at the balance sheet and cash flow statement carefully. Ask yourself is the dividend sustainable. Based on 2001, 2002 and expected 2003 and 2004 results it was obvious SGP’s dividend would need to be cut.
Much has been written about how losing the Claritin patent has hurt SGP, but many investors don’t realize that other areas of the business are suffering as well. Its hepatitis C franchise is losing market share, in fact analysts estimate that in 2004 SGP will have revenues of around $8 billion down from $10 billion in 2002.
SGP is not a razor/razorblade business like Gillette, where sales may slump in the short-term but will eventually pick-up. As a complex pharmaceutical company, SGP has some serious business issues.
Finally, the table included highlights the historical free cash flow SGP has generated. In 2001 SGP achieved all time high FCF of $1.75 billion. Yet as you can see Claritin contributed a lot to SGP’s historical FCF and dividend payment. Normalizing the results for the loss of Claritin, and assuming a new product will eventually make up the slack, I believe SGP can produce $1.5 billion of FCF.
To me $1.5 billion in FCF makes the company worth $25 to $30 billion. At roughly $15 per share, SGP has a current market cap of $22.3 billion. With all its problems I would like a wider margin of safety before thinking of purchasing shares.
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