MRK

Business Context and Reporting Period

This summary covers the Form 10-Q filed by Schering-Plough Corporation for the quarterly period ended June 30, 2003. The company operates in three segments: Global Pharmaceuticals, Consumer Health Care, and Animal Health Care. The reporting period is characterized by a significant decline in prescription sales of the allergy drug CLARITIN following its conversion to over-the-counter (OTC) status and the expiration of U.S. market exclusivity in December 2002. The company is also navigating a consent decree with the FDA regarding manufacturing practices and multiple federal investigations into marketing and pricing practices.

Key Financial Metrics

Margins: Cost of sales as a percentage of sales increased to 33.5% in Q2 2003 from 23.8% in Q2 2002. Income before taxes represented 9.7% of sales in Q2 2003, down from 29.0% in the prior year.

Material Changes vs. Prior Period

• Revenue Decline: Consolidated net sales decreased 17% in Q2 and 18% year-to-date compared to 2002. This was driven by a 24% volume decline, partially offset by favorable foreign exchange rates (6%) and price increases (1%).
• CLARITIN Impact: Global sales of prescription CLARITIN plummeted 86% in Q2 2003 ($112 million) compared to Q2 2002 ($792 million) due to the switch to OTC status and generic competition. U.S. prescription sales dropped from $677 million to $13 million.
• Profitability: Net income fell 71% year-to-date. The effective tax rate decreased to 20.0% from 23.0% due to a shift in the geographic mix of earnings toward lower-tax jurisdictions following the loss of U.S. CLARITIN sales.
• Segment Performance:
  • Global Pharmaceuticals: Sales down 23% (Q2) and 24% (YTD). Allergy & Respiratory sales dropped 46% (Q2) and 50% (YTD). Anti-infective & Anticancer sales were relatively flat (-2%).
  • Consumer Health Care: Sales increased 43% (Q2) and 47% (YTD), driven by the launch of OTC CLARITIN ($88 million in Q2).
  • Animal Health Care: Sales remained flat in Q2 and declined 3% YTD.
• Debt and Liquidity: Short-term borrowings increased to $1,878 million from $1,423 million at year-end 2002. The company funded capital expenditures and dividends through short-term borrowings in Q2 after a $250 million payment under the FDA consent decree offset operating cash flow.

Guidance, Outlook, Risks, and Contingencies

Management Commentary and Outlook:

• Cash Flow: Management states that cash provided by operating activities will likely be insufficient to fund working capital, capital expenditures, and dividends for the remainder of 2003 if current trends persist. The company intends to fund domestic needs through additional borrowings rather than repatriating foreign cash, which would incur U.S. taxes.
• Product Pipeline: ZETIA (ezetimibe) sales were $123 million in Q2. The company expects additional private-label competition for OTC CLARITIN in the second half of 2003. Generic competition for REBETOL is anticipated in the second half of 2003.
• Patent Litigation: A federal court ruled certain claims of the desloratadine compound patent (protecting CLARITIN) invalid. The company has appealed and expects a decision in late 2003 or early 2004.

Material Risks and Contingencies:

• Federal Criminal Investigation: In May 2003, Schering Corporation was named a "target" of a federal criminal investigation by the U.S. Attorney's Office for the District of Massachusetts. The investigation covers four areas: remuneration to induce purchases, off-label promotion, false pricing information for Medicaid rebates, and document destruction/obstruction of justice.
• Consent Decree: The company is subject to an FDA consent decree regarding Good Manufacturing Practices (CGMP). Failure to meet deadlines could result in daily penalties up to $15,000 per day, capped at $175 million total, or a payment of 24.6% of net domestic sales of uncertified products.
• Legal Reserves: In February 2003, the company increased litigation reserves by $150 million related to federal investigations. Management notes that final settlements could materially exceed accrued amounts.
• Credit Ratings: In July 2003, Standard & Poor's lowered the company's long-term credit rating to "A+" and short-term to "A-1" with a negative outlook. Moody's lowered its outlook to "negative" in June 2003.

Investor Verification Checklist

• CLARITIN Transition: Verify the extent of the sales decline in prescription CLARITIN versus the growth in OTC CLARITIN and CLARINEX to assess the sustainability of the Consumer Health Care segment.
• Legal Exposure: Monitor the status of the federal criminal investigation and the potential for fines or penalties exceeding the $150 million reserve increase.
• Liquidity Position: Review the company's ability to service its increased short-term debt ($1.878 billion) and fund operations without relying on foreign cash repatriation.
• Patent Appeals: Track the outcome of the appeal regarding the desloratadine compound patent, which is critical for protecting CLARITIN sales until 2004.
• Consent Decree Compliance: Assess the company's progress on CGMP revalidation programs to avoid daily penalties or production halts.