Description
We believe Schering-Plough (Ticker: SGP) is conservatively worth $40 per share (vs $20 currently), thereby offering a massive margin of safety for a diversified company with strong intellectual property protection, a good management team, substantial growth potential, and sizeable ex-US exposure. We know many value investors tend to follow Warren Buffett and cast pharmaceutical companies into the “too hard pile,” but we feel SGP’s value is so compelling – and further downside risks so minimal – that it is well worth any investor’s time in examining. The ultimate effects of a recent trial setback have been wildly exaggerated by the market, presenting investors a tremendous opportunity in SGP’s shares.
In our opinion, the strength, diversity, and growth potential of SGP’s business is not adequately valued by the market at its current price of $20 per share (market cap of $32 billion). SGP trades at an industry-low EV/Trailing Revenue multiple of roughly 2x ($20B in sales including the recently acquired Organon business) versus the industry median of approximately 3x, while it trades at an industry-low normalized P/E of 8x versus the industry median of 13x (which is also substantially below its long-term average absolute P/E and S&P 500 relative P/E).
SGP is a diversified global health care company which produces pharmaceutical, biotech, animal health, and consumer health products. SGP’s largest pharmaceutical product is the cholesterol drug Zetia/Vytorin (13% of total revenues at roughly $2.5B; US patent expiry in 2015; joint venture with Merck & Co. except in Japan) and its largest biologic product is Remicade (8% of total revenues at roughly $1.5B, growing at double-digits; only ex-US revenues due to joint venture with Johnson & Johnson). The drug Nasonex (allergies) is another $1B product growing at double-digit rates. Meanwhile, SGP’s historical strong-suit allergy (Claritin/Clarinex) and hepatitis businesses are stable to slowly declining but still generate over $1B each in annual sales. The animal health business generates $1 billion in annual sales, while the consumer business generates another $1 billion in sales as well. The market tends to peg SGP as a one-product (Vytorin) company and clearly underappreciates the breadth of SGP’s business.
Although SGP is covered by over 20 sell-side analysts, most of them have done a very poor job in evaluating SGP’s long-term earnings potential (as evidenced by how dramatically EPS estimates have moved upward over the past 18 months; we expect this to continue despite the recent headlines regarding Vytorin, which we’ll discuss in depth below). Since a basic description of SGP’s business and its major products can easily be garnered from its SEC filings and sell-side reports, we will focus our analysis on the most important aspects of SGP’s business and its fair value. (NOTE: As mentioned above, Zetia and Vytorin are sold through a joint venture with Merck. As such, SGP’s profits from the drugs are carried in the “Equity Income” line on the income statement, so the sales are NOT shown in total revenues. In doing our analysis, we add half the revenues of the SGP/MRK off-balance sheet JV, and further consolidate all the revenues and costs of the recently acquired Organon health care business to SGP’s GAAP financials.) This minor but important disconnect in the accounting has obscured the situation enough that the majority of the sell side community seems to be blissfully ignoring the potential profit improvement in the base (i.e. ex-JV) portion of the business.
Through a five year turnaround instituted by CEO Fred Hassan and his team (Carrie Cox, in particular), SGP now finds itself in an enviable position among its peers:
- SGP has the lowest patent exposure in the entire pharmaceutical industry between now and 2016 at less than 8% of revenues (mainly Temodar in 2009 and Clarinex in 2011).
- SGP has generated the fastest revenue growth (>10%) in the industry over the past 2 years. We believe SGP will continue to generate above average revenue growth for the next eight years – largely unaffected by a US recession and potential US policy changes.
- In our opinion, SGP has the second best late-stage pipeline in the industry when adjusted for its revenue base (first place goes to Merck & Co.). We believe SGP will launch the following new products by 2011 – SCH 530348 ($2 billion+ in peak sales potential; anti-clotting), Golimumab ($1+ billion; Remicade follow-on for arthritis), Sugammadex ($1 billion; anesthesia drug that’s been called one of the biggest advances in the field in decades), Boceprevir ($1 billion; hepatitis C), Asmanex/Foradil combo pill ($1 billion; asthma/COPD), Zetia/Lipitor combo pill ($1 billion; cholesterol), Asenapine ($500 million; antipsychotic), Zetia in Japan ($500 million; just launched), Claritin/Singulair combo pill ($250 million; asthma), Vicriviroc ($250 million; HIV). Sanford Bernstein analyst Tim Anderson’s initiation report on SGP in November of 2007 discusses the pipeline in more detail.
- NOTE on the pipeline: While we understand that the typical generalist value investor can easily grow frustrated with the variance and unpredictability of pipeline projections and toss this idea aside, the point of listing these is to illustrate that SGP has MANY shots on goal, so we believe you should view this broad array of future products as a considerable margin of safety. Many of these forecasts for peak sales could be rather far off – and some of the products could certainly flame out completely – yet STILL we see the company as remarkably undervalued.
- Approximately 2/3 of SGP’s revenues are from markets outside the U.S. (highest % in the entire industry), thereby benefiting from a weakening USD and limiting exposure to a US recession and/or US health care policy changes in 2009+.
- In an industry whose icon (Pfizer) has engaged in value-destructive acquisitions left and right while scrambling to fortify its rapidly eroding prospects, SGP managed last year to acquire an extremely attractive business in Organon Biosciences, which it purchased from Akzo Nobel. The $15B deal, expected to be immediately accretive for SGP based on conservative forecasts, boosts SGP’s sales base by over $5B and further adds several intriguing pipeline products to its portfolio. All in all, management dramatically lowered the risk profile of the company by broadening its product offering, giving us all the more comfort in its valuation.
- SGP has over $1.3 billion in US NOL carry forwards ($0.80 per share).
If SGP has such strong patent protection, a robust late stage pipeline, and a good management team, then why is it so cheap and why is there so much confusion about how much it is worth?
- Management began an eight year turnaround plan in 2003. Impressively, the management team has successfully completed the most difficult half of its turnaround plan by resolving legacy issues (including a costly FDA consent decree), returning to profitability, and dramatically increasing research and development spending. Most sell-side analysts incorrectly view this half-way point as the finished product; there is significant room for consent decree costs to be extracted from here.
- Management gives no EPS guidance, causing most sell-side analysts to look in the rearview mirror and focus their future EPS estimates on incremental improvements rather than obvious (in our opinion) earnings potential.
- Furthermore, only two analysts we have seen have adequately adjusted GAAP financials for economic reality by adding half of the SGP/MRK joint ventures revenues and COGS as well as including the revenue and cost items from the recently closed Organon transaction.
- Lastly, the recently released ENHANCE trial has been completely misinterpreted by the media, Congressmen, and other non-scientists (this certainly wouldn’t be a first!). We will discuss this in depth below.
The end result is that SGP trades at the cheapest multiples we have seen in over a decade in the pharmaceutical/biotech industries (with the exception of Merck & Co.’s shares in 2005, battered by staggering Vioxx liability forecasts which have since been quashed), while SGP’s future is one of the brightest. Using conservative revenue estimates and the industry’s average net profit and EBITDA margins (we see no reason that the company cannot achieve this by 2010), we conclude SGP’s 2008 normalized EPS is $2.50 and the company could earn over $3 per share in 2010. Using a conservative 17x trailing multiple, discounting three years at 10%, and adding the NOLs, we achieve our $40 current fair value estimate.
ENHANCE – What exactly does it mean to the value of Zetia/Vytorin and SGP? Not much, in our opinion
(Warning: We are going to proceed with a bit of scientific discussion here, but nothing that should be over the average investor’s head. As this event is what has caused the massive dislocation in the stock price, it’s supremely important for prospective investors to understand just how wildly overblown the headlines are in order to really comprehend the allure of this investment.)
The widely maligned ENHANCE trial was designed and started before the current management team took control of SGP in 2003. As opposed to the long-term outcomes study SGP is currently conducting with 10,000 patients, this trial enrolled only 700 patients with a rare genetic trait that causes very high bad cholesterol (LDL) and used an imaging technique – a method the FDA has yet to condone in approvals – to investigate whether Vytorin (a combination of Zetia with Zocor) helped reduce the buildup of plaque better than Zocor alone (now available as a generic).
Before the recent data release, unfounded conspiracy theories about ENHANCE had percolated over the past six months after MRK/SGP announced that they intended to change the primary endpoint, then announced they would stick with the original primary endpoint, and finally announced on January 14 that the study missed its primary endpoint. The crescendo of this bad press was a malicious mischaracterization of Zetia/Vytorin by a certain high-profile activist cardiologist with a large ego (Steve Nissen), to the detriment of public health (FDA’s opinion). So far, we count 5 inaccurate cover stories, 4 subpoenas, 3 class actions, 2 congressional probes, and a partridge in a pear tree (we are actually not keeping track of all of these, but our sarcasm in regard to the media coverage should be clear). In the midst of all these headlines, not one that we have seen has pointed out that Dr. Nissen has been paid to conduct research by two of Vytorin’s biggest competitors, Pfizer (Lipitor) and AstraZeneca (Crestor). Moreover, in the aftermath of the data release, the American College of Cardiology, the American Heart Association, AND the Cleveland Clinic (Dr. Nissen’s employer!) have come out in defense of Vytorin.
Given the fact that SGP’s stock has nearly been cut in half from $34 over the past 6 months, the misinformed Mr. Market has evidently concluded that SGP was a one-hit-wonder whose main product is going to be pulled from the market. This conclusion is patently absurd.
Here are the important takeaways from the study: ENHANCE failed to prove that 80mg Vytorin is superior to 80 mg Zocor at preventing plaque buildup, not that it was inferior at doing so. Furthermore, it proved (once again) that Vytorin lowers bad cholesterol SUBSTANTIALLY more than any other currently marketed drug while maintaining a clean safety profile. Lastly, the trial casts doubt on whether reducing plaque buildup is even correlated with lower risk of heart attack and stroke since the patients receiving Zocor (a drug PROVEN to reduce the risk of heart attack and stroke) also had plaque buildup over the course of the trial! (On the other hand, several decades of scientific study indicate that the lower the LDL, the lower the risk of heart attack and stroke – barring safety issues like those that derailed Pfizer’s Torcetrapib.)
This is why the FDA has approved drugs and will continue to approve drugs based on their ability to lower LDL as the best proven proxy for lowering the risk of heart attack and stroke. The FDA held a very telling conference call Friday, January 25, in which it discussed all of this and suggested it was unlikely to change Zetia/Vytorin’s label (since the label already states that Zetia/Vytorin have not been proven to reduce the risk of heart attack and stroke – just like Crestor’s label – a blow to trial lawyers).
Further, ask yourself this much: you may have seen the headlines about this study and the havoc it’s wreaked on SGP and MRK’s share prices, but may not have paid attention to the gory details. Did you realize that not a single death was linked to these drugs in a statistically significant manner? This isn’t Vioxx, folks, so it is folly to project any sort of wild product liability numbers onto these companies. The sensationalist headlines could certainly lead one to believe otherwise.
Thus, with no label change, no major formulary changes (i.e. the drugs have not been made more expensive for patients), no grounds for any lawsuits, and no vast conspiracy behind a large stock sale by executive Carrie Cox, the franchise has only been slightly damaged in the long-term. In fact, another leading statin (Crestor) provides us with an example of how a franchise can bounce back from a negative publicity-driven setback: after FDA whistleblower David Graham claimed Crestor should be pulled from the market because it was an unsafe/unproven drug, Crestor’s market share took a similar hit as Zetia/Vytorin (i.e. US total prescriptions declined about 15%). Nine months later, Crestor had regained its former market share and more. SGP CEO Fred Hassan obviously believes this will be the case with Zetia/Vytorin because he has announced he will be buying $2 million worth of SGP’s stock on the open market after the 4Q07 earnings release.
So, why did ENHANCE fail to meet its primary endpoint? Take your pick: 1) it was underpowered to show statistically significant efficacy (i.e. p value of 0.05 or less) at 700 patients; 2) even after being treated, the patients were not even close to the national cholesterol guidelines of LDL below 70 mg/dL; 3) the plaque buildup in the patients at the beginning of the trial was the thinnest of any major imaging study, indicating these patients were already heavily treated; 4) biologically implausible changes in plaque from quality control problems of reading the arterial images made the data erroneous; 5) plaque thickness is not necessary correlated with lower risk of heart attack or stroke.
In our opinion, the Zetia/Vytorin franchise will continue to grow after this temporary setback. However, it is our opinion that SGP is still worth more than $20 per share even if Zetia/Vytorin were completely pulled from the market (almost no chance).
Valuation: Now that the company will be putting the FDA consent decree behind it, we see no reason that SGP cannot eventually achieve merely average industry net margins which, by our calculations after making some adjustments for equity income accounting, are around 19%. This is not a permanently disadvantaged business, and it is being run by one of the most highly-regarded operators in the pharmaceutical sector.
Year end financials including the consolidated Organon businesses and cap structure changes to finance the deal are not available yet, but using one sell side model, we gather it should show roughly $9B in long term debt plus $500mm of short term debt and $2.5B in preferred stock, net of about $2.5B in cash and equivalents. All this added to a roughly $32B market cap results in an enterprise value of $42B.
We view the current trailing sales base as $20 billion based on: $12.5B GAAP sales + $2.5B for SGP’s share of Zetia/Vytorin revenues + $5B for the acquired Organon businesses. Allowing for 5% growth this year (for a company that has been growing overall well in excess of that over the past three years under Hassan, and this number allows for a 20% hit to sales for Zetia/Vytorin), we see 2008 revenues of $21 billion as conservative. Using the 19% normalized net profit margin and dividing by 1.6 billion shares outstanding gets us to roughly $2.50 in normalized EPS this year, hence the roughly 8X normalized P/E we specified earlier.
Please note that consensus EPS forecast is $1.54 for 2008, $1.70 for 2009, and $2.00 for 2010 (down this month from $2.30). While SGP’s shares languished in the $20 area for most of 2005 and 2006, those same estimates were generally $1.20 (’08), $1.40 (’09), and $1.60 (’10). We are getting to pay the same price for a company that’s achieved significantly more than was expected of it, such that even with this dramatic setback in expectations, estimates are still 20-30% ahead of where they were two years ago. We are NOT implying that the company reaches normal margins overnight, just letting you know what we think is achievable. With that in mind, here is the company’s net margin regression (due to Claritin patent expiry) then progression over the past several years (based on a sales base that adds back half the Zetia/Vytorin revenues):
2002: 20.5% (Claritin family $2.4B sales)
2003: 5.5% (Claritin family $1.0B sales)
2004: 0.1%
2005: 4.9%
2006: 9.9%
2007: 13.7%
The overall sales base for the company in 2002 was a mere $10B. So ask yourself: why couldn’t SGP achieve remotely equivalent margins on a scale that’s now twice that sales amount? Obviously the characteristics of the business are different now than they were in 2002, but we fail to see why the company cannot return to its prior operating levels eventually. There is no drastic difference in profitability between Claritin and any other large pharmaceutical franchise. The acquired Organon business will lower margins in the near term, but it is vitally important to note that the seller Akzo is a chemicals company which had very little competency in managing the business (very underpenetrated in the United States). There is every reason to assume that Fred Hassan and his team at SGP will be able to turbocharge the top line for that franchise. Meanwhile, on the cost side of the deal, management’s stated synergy forecasts of $500mm are a mere 9% of estimated 2007 Organon sales; typical achieved cost synergies in such large-scale pharma M&A deals has been closer to the mid-teens.
Given 2008 ought to be a sub-normal growth year, assume they reach $25B in sales by 2010 (implying a little less than 10% annualized growth in 2009 and 2010). On a 19% net margin, this delivers roughly $4.8B in net income, or nearly $3 per share.
If one prefers to view the company on the basis of free cash flow (CFO minus capex), SGP generated $1.7B in 2006, and likely about $2.1B in 2007. We think it is reasonable to expect roughly $2B in FCF for 2008 (6% yield) and, given the minimal patent expiries over the next eight years, expect it to grow at a mid-teens rate from 2009 into the foreseeable future. 6% may not seem earth-shattering but again, we don’t think the status quo is even close to potential SGP efficiency.
Clearly one can quibble with our characterization of normalized margins and the timeframe it will take for SGP to achieve them. We confess we really are not sure how long it will take for SGP to normalize its base business, or for the Zetia/Vytorin script trends to recover (though there is some super early evidence that those have at least stabilized a bit). The consent decree is behind the company, so they’re immediately on the road to recovery of the base business. They’ve got a previously underperforming asset that they stole for less than 3x sales which they can use as an additional lever to boost overall profitability. So we hope that within the next three years they can make substantial headway on that net margin front. But that’s not entirely the point here: what we’ve got is a double whammy of supranormal costs combined with a massively misinterpreted trial result on a flagship product giving us a huge opportunity to buy the shares at rock-bottom sentiment. Fear is driving Mr. Market’s view of Schering Plough. Clearly a draconian scenario is currently being priced into the shares, and even if Zetia/Vytorin were completely pulled from the market, we are left with a business which generated $18 billion in trailing twelve month sales, growing at a double-digit clip, all trading for an enterprise value of roughly $40 billion. Every way we look at it, we see the downside risks from here as minimal.
Primary risks to our thesis:
- Permanent impairment of Zetia/Vytorin franchise
- Unsuccessful assimilation of Organon acquisition and unsuccessful execution of cost cutting
- Lipitor patent expiry in 2011 (will be a powerful generic)
- Increasing competition to Nasonex
- Clinical failures for most of SGP’s late stage pipeline
Disclaimer: The fund we manage owns shares of SGP. Securities may decline in value, so please conduct your own research as well. We may buy or sell shares without notification on this board.
Catalyst
1. Script trend stabilization or recovery for Zetia/Vytorin
2. Margin improvement as company removes shackles of FDA Consent Decree
3. Margin improvement on acquired Organon business (previously managed by a chemicals company without SGP's pharma competence)
4. Pipeline approvals along the way