I concur with Jim Edwards -- But I Arrive by Another Path

Yesterday, Jim Edwards, over at bnetPharma offered some detailed Schering-Plough expense-line variance analysis -- to suggest that, perhaps, Schering's $1.5 billion, three-year headcount reduction program, dubbed "the PTP" (or Productivity Transformation Program) by CEO Hassan in April 2008, was running out of steam.

While I agree that it is -- I honestly don't follow Mr. Edwards' currency explanation. More on that, below -- but first, our agreement -- captured in his absolutley-dead-on pull-quotes (do go read it all):

. . . .the overall trend is that the company’s productivity is plateauing, not getting better. Obviously, you do not want the results of your productivity program to peak when you’re only half way through. . . .

. . . .Perhaps it’s about time drug company CEOs stopped obsessing over sales rep salaries and started to pay a bit more attention to the cost of chemicals. There might be more money in it. . . .

Quite so.

Now, where we differ: Mr. Edwards suggests that a goodly chunk of the variance he highlights is due to a weaker dollar in 2008. Read this:

. . . .Translation: A lot of the gains you’re seeing in sales productivity are actually the positive effects of the dollar sinking against foreign currencies; when those foreign savings are changed into dollars, Schering gets more cuts. That ain’t productivity — that’s blind luck in the foreign exchange markets. . . .

I agree that it is blind luck -- I just think he's got the directional arrows reversed -- as to the currencies. The dollar was actually strengthening mightily in the fourth quarter of 2008, as compared to the Euro and Japanese Yen.

The stronger dollar is bad news for Schering, because Schering does almost no hedging of its currency exposures (and some 70 percent of all it sales are exposed to currency translation volatility/risk). In the past, it was a tailwind -- now a hurricane-force headwind -- at the sales line.

That is, the non-US-dollar-denominated sales (products sold for euros or Yen), must be brought back to the US in smaller numbers of dollars, as the dollar rises.

Conversely, the expenses (R&D, and SG&A) that Mr. Edwards analyzed are affected inversely -- if we are looking at non-US-dollar-denominated-expenses, they will take a smaller "bite" out of US-repatriated earnings levels.

So, I think the most salient question -- and the one Merrs. Bertolini and Hassan have thus far very-artfully skirted -- is "What are the proportions of US v. non-US expense cuts (primarily headcount reductions, and supply chain rationalization efforts), in the overall PTP program numbers?"

Notice that -- if we assume most PTP expense cuts will be made in the US (for example, US salesforce reductions; and US R&D program cuts) -- there will be little to no expense "pull-trough" to the net income line, from any rising dollar. But there will, on the other hand, be declining sales revenue, repatriated into US currency, from all the European and Japanese sales.

On the other hand, if most of the PTP expense cuts occur in Europe and Japan (in local science and sales forces -- i.e., not terribly-likely, in my estimation), then, but only then, will some of the negative effect of a stronger dollar be blunted -- at the net income line, for Schering.

What is now abundantly clear is that the PTP is far less about Organon facilities-rationalization -- and far more about fixing a cost structure, worldwide, that was premised on endless 20 percent growth of the vastly-profitable cholesterol management franchise. That came to an end on March 31, 2008. The PTP is really about trying to knock the expense base back down, in line with a far-less profitable Vytorin/Zetia franchise -- and soak off some of the vast amount Mr. Hassan "overpaid" for the Organon businesses. That is the reality of it.

And now, that effort is starting to run-aground, because there just isn't much room left to cut away, and still have a business model left (in Europe, especially, inside Organon). So, Jim Edwards and I agree -- we just get there by two differing paths through the foggy-moors of Schering's would-be financial disclosures (and non-disclosures).