MRK

Business Context and Reporting Period

This summary covers the Form 10-Q filed by Schering-Plough Corporation for the quarterly period ended September 30, 2004. The company is a research-based pharmaceutical firm facing significant financial strain due to a confluence of negative events over the past three years, including the loss of marketing exclusivity for its leading product (CLARITIN), aggressive competition in the hepatitis C market (PEG-INTRON/REBETOL), and substantial costs related to FDA consent decrees and litigation settlements. The company is heavily reliant on the commercial success of VYTORIN (a joint venture with Merck) to restore profitability.

Key Financial Metrics

Margins: Cost of sales as a percentage of net sales increased to 35.9% in Q3 2004 (from 32.6% in Q3 2003) due to lower production volumes and increased spending related to the FDA consent decree. Selling, general, and administrative (SG&A) expenses rose to 45.1% of sales in Q3 2004.

Material Changes vs. Prior Period

• Revenue Decline: Consolidated net sales decreased 1% in Q3 2004 and 5% for the nine-month period compared to 2003. U.S. sales dropped 4% in Q3 and 17% year-to-date, driven by the OTC switch of CLARITIN and generic competition for REBETOL.
• Profitability Volatility: The company reported a net income of $26 million in Q3 2004, a significant improvement from the $265 million loss in Q3 2003. However, the nine-month period ended with a net loss of $112 million, compared to $90 million income in the prior year. The 2003 loss was heavily impacted by a $350 million litigation reserve charge, while the 2004 loss included $138 million in special charges and an $80 million R&D charge for a product license.
• Special Charges: Special charges for the nine months ended September 30, 2004, totaled $138 million ($111 million for employee termination and $27 million for asset impairment). This is a reduction from the $370 million in special charges recorded in the same period in 2003 (primarily litigation reserves).
• Equity Income: Equity income from the cholesterol joint venture with Merck increased significantly to $95 million in Q3 2004 (from $24 million in Q3 2003) and $249 million for the nine months (from $21 million), driven by the launch of VYTORIN.

Guidance, Outlook, Risks, and Unusual Items

Management Commentary and Outlook

Management states that the current business model is not sustainable without a significant increase in cash flow from operations. The company's ability to generate profits is dependent on the successful commercialization of VYTORIN. If VYTORIN does not provide material cash flow, the company may need to examine strategic alternatives. Management expects U.S. operations to continue generating tax losses in 2004 and potentially beyond, requiring the company to access funds held by foreign subsidiaries to fund U.S. cash needs, which may trigger U.S. income tax payments.

Strategic Developments

• Bayer Agreement: In September 2004, Schering-Plough entered a strategic agreement with Bayer to market Bayer's primary care products (Avelox, Cipro) and assume U.S. commercialization of Levitra. This is expected to be mildly dilutive to earnings in 2004.
• Toyama License: The company incurred an $80 million charge for the exclusive worldwide rights to garenoxacin, an antibacterial agent.

Risks and Contingencies

• Legal Settlements: The company settled an investigation with the U.S. Attorney's Office for the Eastern District of Pennsylvania for $345.5 million ($291.9 million net). $177.5 million was paid in Q3 2004, with the remainder due by March 2005. Investigations in Massachusetts regarding sales and marketing practices remain ongoing.
• FDA Consent Decree: The company is subject to a consent decree regarding Good Manufacturing Practices (cGMP) at facilities in New Jersey and Puerto Rico. Failure to meet deadlines could result in additional payments (capped at $175 million for missed steps, but uncapped for uncertified products) and production halts.
• Credit Ratings: Credit rating agencies (Moody's, S&P, Fitch) have downgraded the company's debt ratings to "Baa1" or "A-" with negative outlooks. This has triggered an increase in interest rates on long-term debt and poses risks to commercial paper availability.
• Liquidity: While consolidated cash exceeds debt by $2.3 billion, the majority of cash is held by foreign subsidiaries, while debt is held by the U.S. parent. Repatriating funds to the U.S. may incur significant tax liabilities.

Investor Verification Checklist

• VYTORIN Performance: Verify the sales trajectory and market share of VYTORIN, as it is the primary driver for future cash flow recovery.
• Liquidity Structure: Confirm the company's ability to access foreign cash reserves to fund U.S. operations and dividends without incurring prohibitive tax costs, especially under the "American Jobs Creation Act of 2004."
• Legal Exposure: Monitor the status of the ongoing Massachusetts investigation and the potential for additional fines or penalties beyond the settled Pennsylvania case.
• Consent Decree Compliance: Track the company's progress on FDA cGMP revalidation deadlines to assess the risk of production stoppages or uncapped financial penalties.
• Debt Covenants: Review the impact of credit rating downgrades on interest expense and the availability of the $1.5 billion in revolving credit facilities.