UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number 1-6571

 

SCHERING-PLOUGH CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(908) 298-4000

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Securities registered pursuant to section 12(g) of the Act:
None.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer þ     Accelerated Filer o     Non-accelerated Filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of June 30, 2006 (the last business day of the registrant’s most recently completed second fiscal quarter): $28,174,450,381

 

Common Shares outstanding as of January 31, 2007: 1,487,743,906

 

 

 

TABLE OF CONTENTS

 

 

OVERVIEW OF THE BUSINESS

 

Schering-Plough refers to Schering-Plough Corporation and its subsidiaries, except as otherwise indicated by the context. Schering Corporation, a predecessor company, was incorporated in New York in 1928 and New Jersey in 1935. The trademarks indicated by CAPITAL LETTERS in this 10-K are the property of, licensed to, promoted or distributed by Schering-Plough Corporation, its subsidiaries or related companies.

 

Schering-Plough is a global science-based health care company with leading prescription, consumer and animal health products. Through internal research and collaborations with business partners, Schering-Plough discovers, develops, manufactures and markets advanced drug therapies to meet important medical needs. Schering-Plough’s vision is to earn the trust of the physicians, patients and customers that it serves around the world, as well as its shareholders who own Schering-Plough. Schering-Plough’s worldwide headquarters is in Kenilworth, New Jersey, and its website is www.schering-plough.com.

 

In April 2003, the Board of Directors named Fred Hassan as the new Chairman of the Board and Chief Executive Officer of Schering-Plough. Under his leadership, a strategic plan was initiated with the goals of stabilizing, repairing and turning around Schering-Plough to produce a long-term value for shareholders. That plan, the six- to eight-year Action Agenda, has been implemented by the new leadership team recruited by Mr. Hassan. In 2006, Schering-Plough announced that it had entered the fourth of the Action Agenda’s five phases slightly ahead of schedule.

 

SEGMENT INFORMATION

 

The new management team reorganized the business from one managed along geographic lines, with the primary segments being U.S. and rest-of-world, to a business organized around its products. Currently, Schering-Plough has three reportable segments: Prescription Pharmaceuticals, Consumer Health Care and Animal Health. The segment sales and profit data that follow are consistent with Schering-Plough’s current management reporting structure.

 

Prescription Pharmaceuticals

 

The Prescription Pharmaceuticals segment discovers, develops, manufactures and markets human pharmaceutical products. Within the Prescription Pharmaceutical segment, there are three areas of focus: Primary Care, Specialty Care and the Cholesterol Franchise. Principal products in this segment include:

 

Primary Care

 

Allergy/Respiratory:  NASONEX, a once-daily, nasal-inhaled steroid for nasal allergy symptoms, including congestion, and for the treatment of nasal polyps in patients 18 years of age and older; CLARINEX, a non-sedating antihistamine for the treatment of allergic rhinitis; FORADIL AEROLIZER, a long-acting beta2-agonist marketed by Schering-Plough in the United States for the maintenance treatment of asthma and chronic obstructive pulmonary disease, and for the acute prevention of exercise-induced bronchospasm; ASMANEX TWISTHALER, an oral dry-powder corticosteroid inhaler for first-line maintenance treatment of asthma; and PROVENTIL (albuterol) Inhaler for the relief of bronchospasm in patients 12 years or older.

 

Antibiotics:  AVELOX, a broad-spectrum fluoroquinolone antibiotic for certain respiratory and skin infections, and CIPRO, a broad-spectrum fluoroquinolone antibiotic for certain respiratory, skin, urinary tract and other infections.

 

Dermatologicals:  ELOCON, a medium-potency topical steroid cream, lotion and ointment.

 

Other Disorders:  LEVITRA, a phosphodiesterase type 5 inhibitor (PDE5) co-marketed by Schering-Plough in the United States for the treatment of male erectile dysfunction.

 

Specialty Care

 

Anti-Inflammatories:  REMICADE, an anti-TNF antibody marketed by Schering-Plough outside of the United States, Japan and certain Asian markets for the treatment of rheumatoid arthritis, Crohn’s disease, ankylosing spondylitis, ulcerative colitis, psoriatic arthritis, psoriasis, and as first-line therapy for the treatment of early rheumatoid arthritis.

 

Anti-virals:  PEG-INTRON Powder for Injection, the only pegylated interferon product for chronic hepatitis C approved for dosing according to patient body weight; INTRON A Injection for chronic hepatitis B and C and other antiviral indications; and REBETOL Capsules for use with PEG-INTRON or INTRON A for chronic hepatitis C.

 

Oncology:  TEMODAR Capsules for certain types of brain tumors, including newly diagnosed glioblastoma multiforme; CAELYX, a long-circulating pegylated liposomal formulation of the cancer drug doxorubicin marketed by Schering-Plough outside the United States for the treatment of certain ovarian cancers, Kaposi’s sarcoma and metastatic breast cancer; and INTRON A Injection, marketed for numerous anticancer indications worldwide, including as adjuvant therapy for malignant melanoma.

 

Antifungals:  NOXAFIL Oral Suspension for prophylaxis (prevention) and treatment (EU only) of invasive fungal infections in high-risk patients and the treatment of oropharyngeal candidiasis (US and EU).

 

Acute Coronary Care:  INTEGRILIN Injection, a platelet receptor GP IIb-IIIa inhibitor for the treatment of patients with acute coronary syndrome and those undergoing percutaneous coronary intervention in the United States, as well as for the prevention of early myocardial infarction in patients with acute coronary syndrome in most countries.

 

Other Disorders:  SUBUTEX, a sublingual tablet formulation of buprenorphine, and SUBOXONE, a sublingual tablet combination of buprenorphine and naloxone, marketed by Schering-Plough in certain countries outside the United States for the treatment of opiate addiction.

 

Cholesterol Franchise

 

ZETIA, a novel cholesterol-absorption inhibitor discovered by Schering-Plough scientists, for use as monotherapy or in combination with either statins or fenofibrate to lower cholesterol.

 

VYTORIN, a cholesterol-lowering tablet combining the dual action of ZETIA and Merck & Co., Inc.’s statin, Zocor.

 

Consumer Health Care

 

The Consumer Health Care segment develops, manufactures and markets OTC, foot care and sun care products. Principal products in this segment include:

 

Over-the-counter (OTC) Products:  CLARITIN non-sedating antihistamines; DRIXORAL cold and allergy, allergy sinus, flu and nasal decongestant tablets; AFRIN nasal decongestant spray; and CORRECTOL laxative tablets.

 

Foot Care:  DR. SCHOLL’S foot care products; LOTRIMIN topical antifungal products; and TINACTIN topical antifungal products; and foot and sneaker odor/wetness products.

 

Sun Care:  COPPERTONE sun care lotions, sprays, dry oils and lip-protection products and sunless tanning products; and SOLARCAINE sunburn relief products.

 

Animal Health

 

The Animal Health segment discovers, develops, manufactures and markets animal health products. Principal products in this segment include:

 

Livestock Products:  NUFLOR bovine and swine antibiotic; BANAMINE bovine and swine anti-inflammatory; and M+PAC swine pneumonia vaccine.

 

Poultry Products:  PARACOX and COCCIVAC coccidiosis vaccines for poultry.

 

Companion Animal Products:  OTOMAX, a steroid for otitis in dogs; EXSPOT topical insecticide for dogs; HOMEAGAIN pet recovery service; and ZUBRIN, an anti-inflammatory/analgesic for dogs.

 

Aquaculture Products:  SLICE parasiticide for sea lice in salmon and AQUAFLOR antibiotic for farm-raised fish.

 

Net sales by segment

 

 

Profit by segment

 

 

Schering-Plough’s net sales do not include sales of VYTORIN and ZETIA that are managed in partnership with Merck, as Schering-Plough accounts for this joint venture under the equity method of accounting (see Note 3, “Equity Income From Cholesterol Joint Venture,” under Item 8, “Financial Statements and Supplementary Data,” for additional information). Equity income from the cholesterol joint venture is included in the Prescription Pharmaceuticals segment profit.

 

“Corporate and other” includes interest income and expense, foreign exchange gains and losses, headquarters expenses, special charges and other miscellaneous items. The accounting policies used for segment reporting are the same as those described in Note 1, “Summary of Significant Accounting Policies,” under Item 8, “Financial Statements and Supplementary Data.”

 

In 2006, “Corporate and other” includes special charges of $102 million primarily related to changes to streamlining Schering-Plough’s manufacturing operations in the U.S. and Puerto Rico announced in June 2006, all of which related to the Prescription Pharmaceuticals segment. Included in 2006 cost of sales were charges of approximately $146 million from the manufacturing streamlining actions which were primarily related to the Prescription Pharmaceuticals segment.

 

In 2005, “Corporate and other” includes special charges of $294 million, including $28 million of employee termination costs, $16 million of asset impairment and other charges, and an increase in litigation reserves by $250 million resulting in a total reserve of approximately $500 million representing Schering-Plough’s then current estimate to resolve the Massachusetts investigation as well as the investigations and the state litigation disclosed under “AWP Litigation and Investigations,” in Note 19, “Legal, Environmental and Regulatory Matters,” in Item 8, “Financial Statements and Supplementary Data.” It is estimated that the charges relate to the reportable

segments as follows: Prescription Pharmaceuticals — $289 million, Consumer Health Care — $2 million, Animal Health — $1 million and Corporate and other — $2 million.

 

In 2004, “Corporate and other” includes special charges of $153 million, including $119 million of employee termination costs, as well as $34 million of asset impairment and other charges. It is estimated the charges relate to the reportable segments as follows: Prescription Pharmaceuticals — $135 million, Consumer Health Care — $3 million, Animal Health — $2 million and Corporate and other — $13 million.

 

See Note 2, “Special Charges and Manufacturing Streamlining,” under Item 8, “Financial Statements and Supplementary Data,” for additional information.

 

STRATEGIC ALLIANCES

 

Schering-Plough markets products that were developed through internal research and products that are licensed from business partners through strategic alliances. In addition to the Merck/Schering-Plough joint ventures and the strategic alliance with Centocor described in more detail below, Schering-Plough is engaged in a number of alliances, including:

 

 

Schering-Plough has also entered into strategic alliances for the development and commercialization of new drug therapies, including the following:

 

 

 

Information About the Merck/Schering-Plough Joint Ventures

 

In May 2000, Schering-Plough and Merck & Co., Inc. (Merck) entered into two separate sets of agreements to jointly develop and market certain products in the U.S., including (1) two cholesterol-lowering drugs and (2) an allergy/asthma drug. In December 2001, the cholesterol agreements were expanded to include all countries of the world except Japan. In general, the companies agreed that the collaborative activities under these agreements would operate in a virtual joint venture to the maximum degree possible by relying on the respective infrastructures of the two companies. The cholesterol agreements do not provide for any jointly owned facilities and, as such, products resulting from the collaboration are manufactured in facilities owned by either Schering-Plough or Merck.

 

The cholesterol agreements provide for Schering-Plough and Merck to jointly develop ezetimibe (marketed as ZETIA in the U.S. and Asia and EZETROL in Europe):

 

i. as a once-daily monotherapy;

 

ii. in co-administration with any statin drug; and

 

iii. as a once-daily fixed-combination tablet of ezetimibe and simvastatin (Zocor), Merck’s cholesterol-modifying medicine. This combination medication (ezetimibe/simvastatin) is marketed as VYTORIN in the U.S. and as INEGY in many international countries.

 

ZETIA/EZETROL (ezetimibe) and VYTORIN/INEGY (the combination of ezetimibe/simvastatin) are approved for use in the U.S. and have been launched in several international markets.

 

Schering-Plough utilizes the equity method of accounting for the cholesterol joint venture. See Note 3, “Equity Income from Cholesterol Joint Venture,” under Item 8, “Financial Statements and Supplemental Data,” for additional information regarding the profits and costs sharing and accounting as provided by the cholesterol agreements.

 

The allergy/asthma agreements provide for the joint development and marketing by the Partners of a once-daily, fixed-combination tablet containing CLARITIN and Singulair. Singulair is Merck’s once-daily leukotriene receptor antagonist for the treatment of asthma and seasonal allergic rhinitis. In January 2002, the Merck/Schering-Plough respiratory joint venture reported on results of Phase III clinical trials of a fixed-combination tablet containing CLARITIN and Singulair. This Phase III study did not demonstrate sufficient added benefits in the treatment of seasonal allergic rhinitis. Although the CLARITIN and Singulair combination tablet does not have approval in any country, Phase III clinical development is ongoing.

 

Information About the Centocor Licenses

 

REMICADE is licensed from and manufactured by Centocor, Inc., a Johnson & Johnson company. Schering-Plough has the exclusive marketing rights to this product outside of the U.S., Japan and certain Asian markets. During 2005, Schering-Plough exercised an option under its contract with Centocor for license rights to develop and commercialize golimumab, a fully human monoclonal antibody, in the same territories as REMICADE. Golimumab is currently in Phase III trials. Schering-Plough and Centocor have been collaborating in resolving the difference in the parties’ opinions as to the expiration date of Schering-Plough’s rights to golimumab. In August 2006, Schering-Plough received a determination through arbitration that its rights to market golimumab will extend to 15 years after the first commercial sales in its territories, but Centocor has appealed this ruling.

 

GLOBAL OPERATIONS

 

Non-U.S. operations generate the majority of Schering-Plough’s profits and cash flow. Non-U.S. activities are carried out primarily through wholly-owned subsidiaries wherever market potential is adequate and circumstances permit. In addition, Schering-Plough is represented in some markets through licensees or other distribution

arrangements. Currently, Schering-Plough has business operations in more than 120 countries and has approximately 19,200 employees outside the U.S.

 

Non-U.S. operations are subject to certain risks that are inherent in conducting business overseas. These risks include possible nationalization, expropriation, importation limitations, pricing and reimbursement restrictions, and other restrictive governmental actions or economic destabilization. Also, fluctuations in foreign currency exchange rates can impact Schering-Plough’s consolidated financial results. For additional information on global operations, see Item 7, “Management’s Discussion and Analysis,” and the segment information described above.

 

Net sales by geographic area

 

 

Schering-Plough has subsidiaries in more than 50 countries outside the U.S. Net sales are presented in the geographic area in which Schering-Plough’s customers are located. The following countries accounted for 5 percent or more of consolidated net sales during any of the past three years:

 

 

Net sales by customer

 

Sales to a single customer that accounted for 10 percent or more of Schering-Plough’s consolidated net sales during any of the past three years were as follows:

 

Supplemental sales information

 

Sales of products comprising 10 percent or more of Schering-Plough’s U.S. or international sales for the year ended December 31, 2006, were as follows:

 

 

Long-lived assets by geographic location

 

 

Long-lived assets shown by geographic location are primarily property.

 

Schering-Plough does not disaggregate assets on a segment basis for internal management reporting and, therefore, such information is not presented.

 

RESEARCH AND DEVELOPMENT

 

Schering-Plough’s research activities are primarily aimed at discovering and developing new prescription products and enhancements to existing prescription products of medical and commercial significance. Company-sponsored research and development expenditures were $2.2 billion, $1.9 billion, and $1.6 billion in 2006, 2005, and 2004, respectively. As a percentage of consolidated net sales, research and development expenditures represented approximately 21 percent, 20 percent and 19 percent in 2006, 2005 and 2004, respectively.

 

Schering-Plough’s research activities are concentrated in the therapeutic areas of respiratory diseases, inflammatory diseases, infectious diseases, oncology, cardiovascular and metabolic diseases and central nervous system disorders. Schering-Plough also has substantial efforts directed toward biotechnology and immunology. Research activities include expenditures for both internal research efforts and research collaborations with various partners.

 

While several pharmaceutical compounds are in varying stages of development, it cannot be predicted when or if these compounds will become available for commercial sale. Schering-Plough’s product pipeline lists significant products in development and is available on Schering-Plough’s website at www.schering-plough.com. Due to the nature of the development and approval process — as well as the fact that human health is involved and the science of human health is constantly evolving — the status of any compounds in development is subject to change. Schering-Plough does not assume any duty to update this information.

 

Four of Schering-Plough’s Phase II projects have been granted fast-track designation by the FDA: a novel thrombin receptor antagonist for acute coronary syndrome and secondary prevention of subsequent cardiovascular events; vicriviroc for HIV; a protease inhibitor compound for hepatitis C; and a new potential treatment for patients with Parkinson’s disease. If any of these products advance to Phase III clinical trials, significant expenditures would be required due to the large number of patients necessary for Phase III trials.

PATENTS, TRADEMARKS AND OTHER INTELLECTUAL PROPERTY RIGHTS

 

Overview

 

Intellectual property protection is critical to Schering-Plough’s ability to successfully commercialize its product innovations. Schering-Plough owns, has applied for, or has licensed rights to, a large number of patents, both in the U.S. and in other countries, relating to molecules, products, product uses, formulations and manufacturing processes. There is no assurance that the patents Schering-Plough is seeking will be granted or that the patents Schering-Plough has been granted would be found valid if challenged. Moreover, patents relating to particular molecules, products, uses, formulations, or processes do not preclude other manufacturers from employing alternative processes or from marketing alternative products or formulations that might successfully compete with Schering-Plough’s patented products.

 

Outside the U.S., the standard of intellectual property protection for pharmaceuticals varies widely. While many countries have reasonably strong patent laws, other countries currently provide little or no effective protection for inventions or other intellectual property rights. Under the Trade-Related Aspects of Intellectual Property Agreement (TRIPs) administered by the World Trade Organization (WTO), more than 140 countries have now agreed to provide non-discriminatory protection for most pharmaceutical inventions and to assure that adequate and effective rights are available to all patent owners. It is possible that changes to this agreement will be made in the future that will diminish or further delay its implementation in developing countries. It is too soon to assess how much, if at all, Schering-Plough will be impacted commercially from these changes.

 

When a product patent expires, the patent holder often loses effective market exclusivity for the product. This can result in a rapid, sharp and material decline in sales of the formerly patented product, particularly in the U.S. However, in some cases the innovator company can obtain additional commercial benefits through manufacturing trade secrets; later-expiring patents on processes, uses, or formulations; trademark use; or exclusivity that may be available under pharmaceutical regulatory laws.

 

Schering-Plough’s Intellectual Property Portfolio

 

Patent protection for certain Schering-Plough molecules, products, processes and uses are important to Schering-Plough’s business and financial results. For many of Schering-Plough’s products, in addition to patents on the compound, Schering-Plough holds other patents on manufacturing processes, formulations, or uses that may extend exclusivity beyond the expiration of the compound patent.

 

Schering-Plough’s subsidiaries own (or have licensed rights under) a number of patents and patent applications, both in the U.S. and abroad. Patents and patent applications relating to Schering-Plough’s significant products, including, without limitation, VYTORIN, ZETIA, REMICADE, NASONEX, INTRON A, PEG-INTRON, TEMODAR and CLARINEX, are of material importance to Schering-Plough.

 

Worldwide, Schering-Plough sells all major products under trademarks that also are material in the aggregate to its business and financial results. Trademark protection varies throughout the world, with protection continuing in some countries as long as the mark is used and in other countries as long as it is registered. Registrations are normally for fixed but renewable terms.

 

Patent Challenges Under the Hatch-Waxman Act

 

The Drug Price Competition and Patent Term Restoration Act of 1984, commonly known as Hatch-Waxman, made a complex set of changes to both patent and new drug approval laws in the U.S. Before Hatch-Waxman, no drug could be approved without providing the U.S. Food and Drug Administration (FDA) complete safety and efficacy studies, known as a complete New Drug Application (NDA). Hatch-Waxman authorizes the FDA to approve generic versions of innovative medicines without such information upon the filing of an Abbreviated New Drug Application (ANDA). In an ANDA, the generic manufacturer must demonstrate only bioequivalence between the generic version and the NDA-approved drug — not safety and efficacy. Hatch-Waxman provides for limited patent term restoration to partially make up for patent term lost during the time an NDA-approved drug is in regulatory review. NDA-approved drugs also receive a limited period of data exclusivity which prevents the approval of ANDA applications for specific time periods after approval of the NDA-approved drug.

 

Absent a successful patent challenge, the FDA cannot approve an ANDA until after the innovator’s patents expire. However, a generic manufacturer may file an ANDA seeking approval after the expiration of the applicable data exclusivity, and alleging that one or more of the patents listed in the innovator’s NDA are invalid or not infringed. This allegation is commonly known as a Paragraph IV certification. The innovator must then file suit against the generic manufacturer to protect its patents. If one or more of the NDA-listed patents are successfully challenged, the first filer of a Paragraph IV certification may be entitled to a 180-day period of market exclusivity over all other generic manufacturers. In recent years, generic manufacturers have used Paragraph IV certifications extensively to challenge patents on a wide array of innovative pharmaceuticals, and it is anticipated that this trend will continue.

 

A number of generic companies have filed ANDAs for CLARINEX tablets, REDITABS, and D-24 and in response, Schering-Plough brought patent infringement actions in 2006. An adverse outcome in this action may result in the introduction of generic desloratadine to prior the expiration of the patent(s) that are the subject of these litigations. In addition, in February 2007, Schering-Plough received a notice from a generic company indicating that it had filed an ANDA for ZETIA and that it is challenging the U.S. patents that are listed for ZETIA. Merck and Schering-Plough are considering the appropriate response.

 

MARKETING ACTIVITIES AND COMPETITION

 

Schering-Plough, through its trained professional sales representatives, introduces and makes known its prescription drugs to physicians, pharmacists, hospitals, managed care organizations and buying groups. Schering-Plough sells prescription drugs to hospitals, certain managed care organizations, wholesale distributors and retail pharmacists. Schering-Plough also introduces and makes known its prescription products through journal advertising, direct mail advertising, the distribution of samples to physicians and through television, radio, Internet, print and other advertising media.

 

Schering-Plough, through its trained professional sales representatives, promotes its animal health products to veterinarians, distributors and animal producers.

 

Schering-Plough sells over-the-counter, foot care and sun care products through wholesale and retail drug, food chain and mass merchandiser outlets. Schering-Plough promotes directly to the consumer through television, radio, Internet, print and other advertising media.

 

The pharmaceutical industry is highly competitive and includes other large companies, some significantly larger than Schering-Plough, with substantial resources for research, product development, advertising, promotion and field selling support. There are numerous domestic and international competitors in this industry. Some of the principal competitive techniques used by Schering-Plough for its products include research and development of new and improved products, varied dosage forms and strengths, and switching prescription products to non-prescription status. In the U.S., many of Schering-Plough’s products are subject to increasingly competitive pricing as managed care groups, institutions, federal and state government entities and agencies, and buying groups seek price discounts and rebates. Governmental and other pressures toward the dispensing of generic products may significantly reduce the sales of certain products when they, or competing products in the same therapeutic category, are no longer protected by patents or exclusivity available under pharmaceutical regulatory laws.

 

Schering-Plough operates primarily in the prescription pharmaceutical marketplace. However, where appropriate, Schering-Plough seeks regulatory approval to switch prescription products to over-the-counter status as a means of extending a product’s life cycle. In this way, the OTC marketplace is another means of maximizing the return on investments in discovery and development.

 

GOVERNMENT REGULATION

 

Each of Schering-Plough’s major business segments is subject to significant regulation in multiple jurisdictions. This section describes the general regulatory framework. Additional information about the cost of regulatory compliance and specific impacts on Schering-Plough’s business and financial condition are described under the heading “Regulatory And Competitive Environment In Which Schering-Plough Operates” in Item 7, “Management’s Discussion and Analysis.” Additional information about other regulatory matters can be found in

Item 3, “Legal Matters”, Note 18, “Consent Decree,” and Note 19, “Legal, Environmental and Regulatory Matters,” under Item 8, “Financial Statements and Supplementary Data.”

 

In the prescription drug segment, regulations apply at all phases of the business, including:

 

 

In the U.S., the national regulation of all phases of the prescription drug business except pricing is centralized at the Food and Drug Administration (FDA). The FDA is responsible for protecting the U.S. public health by assuring the safety, efficacy, and security of human and veterinary drugs, biological products and medical devices. Generally, there is free market pricing in the U.S., although the Centers for Medicare and Medicaid Services (CMS) and Medicare Part B and D include provisions about pricing drugs for the elderly, disabled and indigent who receive federal prescription benefits. Schering-Plough is also committed to complying with voluntary best practices of the Pharmaceutical Research and Manufacturers of America (PhRMA), a trade industry group of which it is a member, regarding marketing and advertising practices.

 

In the European Union (EU), including Schering-Plough’s key markets in the United Kingdom, France, Germany and Italy, there is regulation at the local country level and additional regulation at the EU level, through the European Medicines Agency (EMEA). Pharmaceutical products are regulated at both of these levels through various national, mutual recognition or centralized regulatory procedures. The EMEA coordinates the evaluation and supervision of medicinal products throughout the EU. There is no pan-EU market pricing system; however, individual member states have various systems/agencies that regulate price at a local level.

 

In Japan, there is regulation through the Pharmaceuticals and Medical Device Agency (PMDA). The PMDA regulates pharmaceuticals and medical devices from development through post-marketing use. The Japanese government regulates the pricing/reimbursement of pharmaceutical products in Japan through a complicated pricing process that includes benchmarks with prices in other Western countries such as the U.S., Canada and select EU countries.

 

As all of the major countries have some influence over pricing, even with the CMS in the United States, there is increasing pressure on the pharmaceutical industry to bring products to market that provide differentiation versus existing products. This can lead to more expensive and scientifically challenging clinical trials in order to generate this type of data for new products versus marketed comparators.

 

RAW MATERIALS

 

Raw materials essential to Schering-Plough’s operations are available in adequate quantities from a number of potential suppliers. Energy is expected to be available to Schering-Plough in sufficient quantities to meet its operating requirements.

 

SEASONALITY

 

Certain of Schering-Plough’s products, particularly the respiratory and sun care categories, are seasonal in nature. Seasonal patterns do not have a pronounced effect on the consolidated operations of Schering-Plough.

 

ENVIRONMENT

 

To date, compliance with federal, state and local laws regarding discharge of materials into the environment, or protection of the environment, have not had a material effect on Schering-Plough’s capital expenditures, earnings and competitive position.

 

EMPLOYEES

 

At December 31, 2006, Schering-Plough employed approximately 33,500 people worldwide.

 

AVAILABLE INFORMATION

 

Schering-Plough’s 10-Ks, 10-Qs, 8-Ks and amendments to those reports are filed with or furnished to the SEC and are available free of charge on Schering-Plough’s website as soon as reasonably practicable after such materials are electronically filed with the SEC. Schering-Plough’s address on the World Wide Web is www.schering-plough.com. Since Schering-Plough began this practice in the third quarter of 2002, each such report has been available on Schering-Plough’s website within 24 hours of filing. Reports filed by Schering-Plough with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.

 

Schering-Plough’s future operating results and cash flows may differ materially from the results described in this 10-K due to risks and uncertainties related to Schering-Plough’s business, including those discussed below. In addition, these factors represent risks and uncertainties that could cause actual results to differ materially from those implied by forward-looking statements contained in this report.

 

Key Schering-Plough products generate a significant amount of Schering-Plough’s profits and cash flows, and any events that adversely affect the market for its leading products could have a material and negative impact on results of operations and cash flows.

 

Schering-Plough’s ability to generate profits and operating cash flow is largely dependent upon the continued profitability of Schering-Plough’s cholesterol franchise, consisting of VYTORIN and ZETIA. In addition, products such as PEG-INTRON, REBETOL, REMICADE, TEMODAR, OTC CLARITIN and NASONEX accounted for a material portion of 2006 revenues. As a result of Schering-Plough’s dependence on key products, any events that adversely affect the markets for these products could have a significant impact on results of operations. These events include loss of patent protection, increased costs associated with manufacturing, OTC availability of Schering-Plough’s product or a competitive product, the discovery of previously unknown side effects, increased competition from the introduction of new, more effective treatments and discontinuation or removal from the market of the product for any reason.

 

For example, the profitability of Schering-Plough’s cholesterol franchise may be adversely affected by the introduction of multiple generic forms in December 2006 of two competing cholesterol products that lost patent protection earlier in the year.

 

In recent years, the market for PEG-INTRON and REBETOL has been adversely affected. As a result of the introduction of a competitor’s product for pegylated interferon and the introduction of generic ribavirin, the value of PEG-INTRON (pegylated interferon) and REBETOL (ribavirin) combination therapy for hepatitis has been severely diminished and earnings and cash flow have been materially and negatively impacted.

 

There is a high risk that funds invested in research will not generate financial returns because the development of novel drugs requires significant expenditures with a low probability of success.

 

There is a high rate of failure inherent in the research to develop new drugs to treat diseases. As a result, there is a high risk that funds invested in research programs will not generate financial returns. This risk profile is

compounded by the fact that this research has a long investment cycle. To bring a pharmaceutical compound from the discovery phase to market may take a decade or more and failure can occur at any point in the process, including later in the process after significant funds have been invested.

 

Schering-Plough’s success is dependent on the development and marketing of new products, and uncertainties in the regulatory and approval process may result in the failure of products to reach the market.

 

Products that appear promising in development may fail to reach market for numerous reasons, including the following:

 

 

Intellectual property protection for innovation is an important contributor to Schering-Plough’s profitability. Generic forms of Schering-Plough’s products may be introduced to the market as a result of the expiration of patents covering Schering-Plough’s products, a successful challenge to Schering-Plough’s patent, or the at-risk launch of a generic version of a Schering-Plough product, which may have a material and negative effect on results of operations.

 

Intellectual property protection is critical to Schering-Plough’s ability to successfully commercialize its products. Upon the expiration or the successful challenge of Schering-Plough’s patents covering a product, competitors may introduce lower-priced generic versions of such products, which may include Schering-Plough’s well-established products. In recent years, some generic manufacturers have launched generic versions of products before the ultimate resolution of patent litigation (commonly known as “at-risk” product launches). Such generic competition could result in the loss of a significant portion of sales or downward pressures on the prices at which Schering-Plough offers formerly patented products, particularly in the U.S. Patents and patent applications relating to Schering-Plough’s significant products are of material importance to Schering-Plough.

 

Additionally, certain foreign governments have indicated that compulsory licenses to patents may be granted in the case of national emergencies, which could diminish or eliminate sales and profits from those regions and negatively affect Schering-Plough’s results of operations.

 

Patent disputes can be costly to prosecute and defend and adverse judgments could result in damage awards, increased royalties and other similar payments and decreased sales.

 

Patent positions can be highly uncertain and patent disputes in the pharmaceutical industry are not unusual. An adverse result in a patent dispute involving Schering-Plough’s patents, or the patents of its collaborators, may lead to a loss of market exclusivity and render such patents invalid. An adverse result in a patent dispute involving patents held by a third party may preclude the commercialization of Schering-Plough’s products, force Schering-Plough to obtain licenses in order to continue manufacturing or marketing the affected products, which licenses may not be available on commercially reasonable terms, negatively affect sales of existing products or result in injunctive relief and payment of financial remedies. For example, Schering-Plough’s product, DR. SCHOLL’S FREEZE AWAY wart removal product, is currently the subject of a patent infringement action brought by a third party company, and an adverse outcome in this action may result in Schering-Plough’s inability to continue manufacturing the product.

 

Even if Schering-Plough is ultimately successful in a particular dispute, Schering-Plough may incur substantial costs in defending its patents and other intellectual property rights. For example, a generic manufacturer may file an Abbreviated New Drug Application seeking approval after the expiration of the applicable data exclusivity and alleging that one or more of the patents listed in the innovator’s New Drug

Application are invalid or not infringed. This allegation is commonly known as a Paragraph IV certification. The innovator then has the ability to file suit against the generic manufacturer to enforce its patents. In recent years, generic manufacturers have used Paragraph IV certifications extensively to challenge patents on a wide array of innovative pharmaceuticals, and it is anticipated that this trend will continue. The potential for litigation regarding Schering-Plough’s intellectual property rights always exists and may be initiated by third parties attempting to abridge Schering-Plough’s rights, as well as by Schering-Plough in protecting its rights. See “Patent Challenges Under the Hatch-Waxman Act” in Item 1, “Business”, for a discussion of current Paragraph IV certifications for Schering-Plough products.

 

U.S. and foreign regulations, including those establishing Schering-Plough’s ability to price products, may negatively affect Schering-Plough’s sales and profit margins.

 

Schering-Plough faces increased pricing pressure in the U.S. and abroad from managed care organizations, institutions and government agencies and programs that could negatively affect Schering-Plough’s sales and profit margins. For example, the Medicare Prescription Drug Improvement and Modernization Act of 2003 contains a prescription drug benefit for individuals who are eligible for Medicare. The prescription drug benefit became effective on January 1, 2006, and is resulting in increased use of generics and increased purchasing power of those negotiating on behalf of Medicare recipients.

 

In addition to legislation concerning price controls, other trends that could affect Schering-Plough’s business include legislative or regulatory action relating to pharmaceutical pricing and reimbursement, health care reform initiatives and drug importation legislation, involuntary approval of medicines for OTC use, consolidation among customers and trends toward managed care and health care costs containment.

 

As a result of the U.S. government’s efforts to reduce Medicaid expenses, managed care organizations continue to grow in influence and Schering-Plough faces increased pricing pressure as managed care organizations continue to seek price discounts with respect to Schering-Plough’s products.

 

Outside of the U.S., many governmental agencies strictly control, directly or indirectly, the prices at which pharmaceutical products are sold. In the international markets, cost control methods including restrictions on physician prescription levels and patient reimbursements; emphasis on greater use of generic drugs; and across-the-board price cuts may decrease revenues internationally.

 

There are material pending government investigations against Schering-Plough, which could lead to the commencement of civil and/or criminal proceedings involving the imposition of substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs, and which could give rise to other investigations or litigation by government entities or private parties.

 

Schering-Plough cannot predict with certainty the outcome of the pending investigations to which it is subject, any of which may lead to a judgment or settlement involving a significant monetary award or restrictions on its operations.

 

The pricing, sales and marketing programs and arrangements, and related business practices of Schering-Plough and other participants in the health care industry are under increasing scrutiny from federal and state regulatory, investigative, prosecutorial and administrative entities. These entities include the Department of Justice and its U.S. Attorney’s Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission and various state Attorneys General offices. Many of the health care laws under which certain of these governmental entities operate, including the federal and state anti-kickback statutes and statutory and common law false claims laws, have been construed broadly by the courts and permit the government entities to exercise significant discretion. In the event that any of those governmental entities believes that wrongdoing has occurred, one or more of them could institute civil or criminal proceedings which, if resolved unfavorably, could subject Schering-Plough to substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs. In addition, an adverse outcome to a government investigation could prompt other government entities to commence investigations of Schering-Plough or cause those entities or private parties to bring civil claims against it. Schering-Plough also cannot predict whether

any investigations will affect its marketing practices or sales. Any such result could have a material adverse impact on Schering-Plough’s results of operations, cash flows, financial condition, or its business.

 

Regardless of the merits or outcomes of these investigations, government investigations are costly, divert management’s attention from Schering-Plough’s business and may result in substantial damage to Schering-Plough’s reputation. Please refer to Item 3, “Legal Proceedings” for descriptions of these pending investigations.

 

There are other legal matters in which adverse outcomes could negatively affect Schering-Plough’s business.

 

Unfavorable outcomes in other pending litigation matters, or in future litigation, including litigation concerning product pricing, securities law violations, product liability claims, ERISA matters, patent and intellectual property disputes, and antitrust matters could preclude the commercialization of products, negatively affect the profitability of existing products and could subject Schering-Plough to substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs. Any such result could materially and adversely affect Schering-Plough’s results of operations, cash flows, financial condition, or its business.

 

Please refer to Item 3, “Legal Proceedings” for descriptions of significant pending litigation.

 

Schering-Plough is subject to governmental regulations, and the failure to comply with, as well as the costs of compliance of, these regulations may adversely affect Schering-Plough’s financial position and results of operations.

 

Schering-Plough’s manufacturing facilities and clinical/research practices must meet stringent regulatory standards and are subject to regular inspections. The cost of regulatory compliance, including that associated with compliance failures, can materially affect Schering-Plough’s financial position and results of operations. Failure to comply with regulations, which include pharmacovigilance reporting requirements and standards relating to clinical, laboratory and manufacturing practices, can result in delays in the approval of drugs, seizure or recalls of drugs, suspension or revocation of the authority necessary for the production and sale of drugs, fines and other civil or criminal sanctions.

 

For example, in May 2002, Schering-Plough agreed with the FDA to the entry of a Consent Decree to resolve issues related to compliance with current Good Manufacturing Practices at certain of Schering-Plough’s facilities in New Jersey and Puerto Rico. The Consent Decree work placed significant additional controls on production and release of products from these sites, which increased costs and slowed production and led to a reduction in the number of products produced at the sites. Further, Schering-Plough’s research and development operations were negatively impacted by the Consent Decree because these operations share common facilities with the manufacturing operations.

 

Schering-Plough also is subject to other regulations, including environmental, health and safety, and labor regulations.

 

Developments following regulatory approval may decrease demand for Schering-Plough’s products.

 

Even after a product reaches market, certain developments following regulatory approval, including results in post-marketing Phase IV trials, may decrease demand for Schering-Plough’s products, including the following:

 

 

In the past several years, clinical trials and post-marketing surveillance of certain marketed drugs of competitors within the industry have raised safety concerns that have led to recalls, withdrawals or adverse labeling of marketed products. These situations also have raised concerns among some prescribers and patients relating to the safety and efficacy of pharmaceutical products in general, which have negatively affected the sales of such products.

 

In addition, following the wake of recent product withdrawals of other companies and other significant safety issues, health authorities such as the FDA, the European Medicines Agency and the Pharmaceuticals and Medicines Device Agency have increased their focus on safety when assessing the benefit/risk balance of drugs. Some health authorities appear to have become more cautious when making decisions about approvability of new products or indications and are re-reviewing select products that are already marketed, adding further to the uncertainties in the regulatory processes. There is also greater regulatory scrutiny, especially in the U.S., on advertising and promotion and in particular, direct-to-consumer advertising.

 

If previously unknown side effects are discovered or if there is an increase in the prevalence of negative publicity regarding known side effects of any of Schering-Plough’s products, it could significantly reduce demand for the product or may require Schering-Plough to remove the product from the market. Further, in the current environment in which all pharmaceutical companies operate, Schering-Plough is at risk for product liability claims for its products.

 

New products and technological advances developed by Schering-Plough’s competitors may negatively affect sales.

 

Schering-Plough operates in a highly competitive industry. Schering-Plough competes with a large number of multinational pharmaceutical companies, biotechnology companies and generic pharmaceutical companies. Many of Schering-Plough’s competitors have been conducting research and development in areas both served by Schering-Plough’s current products and by those products Schering-Plough is in the process of developing. Competitive developments that may impact Schering-Plough include technological advances by, patents granted to, and new products developed by competitors or new and existing generic, prescription and/or OTC products that compete with products of Schering-Plough or the Merck/Schering-Plough Cholesterol Partnership. In addition, it is possible that doctors, patients and providers may favor those products offered by competitors due to safety, efficacy, pricing or reimbursement characteristics, and as a result Schering-Plough will be unable to maintain its sales for such products.

 

Competition from third parties may make it difficult for Schering-Plough to acquire or license new products or product candidates (regardless of stage of development) or to enter into such transactions on terms that permit Schering-Plough to generate a positive financial impact.

 

Schering-Plough depends on acquisition and in-licensing arrangements as a source for new products. Opportunities for obtaining or licensing new products are limited, however, and securing rights to them typically requires substantial amounts of funding or substantial resource commitments. Schering-Plough competes for these opportunities against many other companies and third parties that have greater financial resources and greater ability to make other resource commitments. Schering-Plough may not be able to acquire or license new products, which could adversely impact Schering-Plough and its prospects. Schering-Plough may also have difficulty acquiring or licensing new products on acceptable terms. To secure rights to new products, Schering-Plough may have to make substantial financial or other resource commitments that could limit its ability to produce a positive financial impact from such transactions.

 

Schering-Plough relies on third-party relationships for its key products, and the conduct and changing circumstances of such third parties may adversely impact the business.

 

Schering-Plough has several relationships with third parties on which Schering-Plough depends for many of its key products. Very often these third parties compete with Schering-Plough or have interests that are not aligned with the interests of Schering-Plough. Notwithstanding any contracts Schering-Plough has with these third parties,

Schering-Plough may not be able to control or influence the conduct of these parties, or the circumstances that affect them, either of which could adversely impact Schering-Plough.

 

Schering-Plough operates a global business that exposes Schering-Plough to additional risks, and any adverse events could have a material negative impact on results of operations.

 

Schering-Plough operates in more than 120 countries, and non-U.S. operations generate the majority of Schering-Plough’s profit and cash flow. Non-U.S. operations are subject to certain risks, which are inherent in conducting business overseas. These risks include:

 

 

In addition, there may be changes to Schering-Plough’s business and political position if there is instability, disruption or destruction in a significant geographic region, regardless of cause, including war, terrorism, riot, civil insurrection or social unrest; and natural or man-made disasters, including famine, flood, fire, earthquake, storm or disease.

 

Insurance coverage for product liability may become unavailable or cost prohibitive.

 

Schering-Plough maintains insurance coverage with such deductibles and self-insurance to reflect market conditions (including cost and availability) existing at the time it is written, and the relationship of insurance coverage to self-insurance varies accordingly. However, as a result of increased product liability claims in the pharmaceutical industry, the availability of third party insurance may become unavailable or cost prohibitive.

 

Schering-Plough is subject to evolving and complex tax laws, which may result in additional liabilities that may affect results of operations.

 

Schering-Plough is subject to evolving and complex tax laws in the U.S. and in foreign jurisdictions. Significant judgment is required for determining Schering-Plough’s tax liabilities, and Schering-Plough’s tax returns are periodically examined by various tax authorities. Schering-Plough’s U.S. federal income tax returns for the 1997-2002 period are currently under audit by the Internal Revenue Service. Schering-Plough may be challenged by the IRS and other tax authorities on positions it has taken in its income tax returns. Although Schering-Plough believes that its accrual for tax contingencies is adequate for all open years, based on past experience, interpretations of tax law, and judgments about potential actions by tax authorities, due to the complexity of tax contingencies, the ultimate resolution of any tax matters may result in payments greater or less than amounts accrued.

 

In addition, Schering-Plough may be impacted by changes in tax laws including tax rate changes, changes to the laws related to the remittance of foreign earnings, new tax laws and revised tax law interpretations in domestic and foreign jurisdictions.

 

None.

 

Schering-Plough’s corporate headquarters is located in Kenilworth, New Jersey. Principal research facilities are located in Kenilworth, Union and Summit, New Jersey; Palo Alto, California; Cambridge, Massachusetts; and Elkhorn, Nebraska. Principal manufacturing facilities are as follows:

 

 

Schering-Plough owns these properties, with the exception of the Massachusetts research facility. In general, the properties are adequately maintained and suitable for their purposes. As discussed in more detail in Part II of this 10-K, certain of Schering-Plough’s manufacturing sites operate below capacity. During 2006, Schering-Plough took actions to streamline manufacturing operations and continues to work on enhancing long-term competitiveness. See Item 7, “Management Discussion and Analysis,” Note 2, “Special Charges and Manufacturing Streamlining,” and Note 18, “Consent Decree,” under Item 8, “Financial Statements and Supplementary Data,” for additional information.

 

Schering-Plough is currently in the process of building a U.S. pharmaceutical sciences center in New Jersey. Capital expenditures of approximately $38 million were made in 2006 related to this center. Additional capital expenditures of approximately $260 million are expected over the next three years. Schering-Plough is also upgrading processes and systems and strengthening talent in the R&D area.

 

Material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which Schering-Plough Corporation or any of its subsidiaries or to which any of their property is subject, are disclosed below.

 

Additional information on legal proceedings, including important financial information, can be found in the Litigation Charges discussion in Note 2, “Special Charges and Manufacturing Streamlining,” Item 7, “Management’s Discussion and Analysis,” and Note 19, “Legal, Environmental and Regulatory Matters” contained in Item 8, “Financial Statements and Supplementary Data.”

 

Patent Matters

 

As described in “Patents, Trademarks, and Other Intellectual Property Rights” under Item 1, “Business,” intellectual property protection is critical to Schering-Plough’s ability to successfully commercialize its product innovations. The potential for litigation regarding Schering-Plough’s intellectual property rights always exists and may be initiated by third parties attempting to abridge Schering-Plough’s rights, as well as by Schering-Plough in protecting its rights. Patent matters described below have a potential material effect on Schering-Plough.

 

DR. SCHOLL’S FREEZE AWAY Patent.  On July 26, 2004, OraSure Technologies filed an action in the U.S. District Court for the Eastern District of Pennsylvania alleging patent infringement by Schering-Plough HealthCare Products by its sale of DR. SCHOLL’S FREEZE AWAY wart removal product. The complaint seeks a permanent injunction and unspecified damages, including treble damages.

 

Massachusetts Investigation

 

On August 29, 2006, Schering-Plough announced it had reached an agreement with the U.S. Attorney’s Office for the District of Massachusetts to settle an investigation involving Schering-Plough’s sales, marketing and clinical trial practices and programs along with those of Warrick Pharmaceuticals (Warrick), Schering-Plough’s generic subsidiary (the “Massachusetts Investigation”). The investigation was focused on the following alleged practices: providing remuneration to managed care organizations, physicians and others to induce the purchase of Schering pharmaceutical products; off-label marketing of drugs; and submitting false pharmaceutical pricing information to the government for purposes of calculating rebates required to be paid to the Medicaid program.

 

The agreement provided for an aggregate settlement amount of $435 million — a criminal fine of $180 million and $255 million to resolve civil aspects of the investigation. On January 17, 2007, Schering Sales Corporation, a subsidiary of Schering-Plough, pled guilty to one count of conspiracy to make false statements to the government. In connection with the settlement, Schering-Plough signed an addendum to an existing corporate integrity agreement with the Office of Inspector General of the U.S. Department of Health and Human Services. The addendum will not affect Schering-Plough’s ongoing business with any customers, including the federal government.

 

In 2005, Schering-Plough had recorded a liability of $500 million related to the Massachusetts Investigation as well as the investigations and the state litigation described below under “AWP Litigation and Investigations.” The settlement amount of $435 million relates only to the Massachusetts Investigation. The AWP litigation and investigations are ongoing.

 

AWP Litigation and Investigations

 

Schering-Plough continues to respond to existing and new litigation by certain states and private payors and investigations by the Department of Health and Human Services, the Department of Justice and several states into industry and Schering-Plough practices regarding average wholesale price (AWP). Schering-Plough is cooperating with these investigations. These litigations and investigations relate to whether the AWP used by pharmaceutical companies for certain drugs improperly exceeds the average prices paid by providers and, as a consequence, results in unlawful inflation of certain reimbursements for drugs by state programs and private payors that are based on AWP. The complaints allege violations of federal and state law, including fraud, Medicaid fraud and consumer protection violations, among other claims. In the majority of cases, the plaintiffs are seeking class certifications. In some cases, classes have been certified. The outcome of these litigations and investigations could include substantial damages, the imposition of substantial fines, penalties and injunctive or administrative remedies.

 

Securities and Class Action Litigation

 

Federal Securities Litigation

 

Following Schering-Plough’s announcement that the FDA had been conducting inspections of Schering-Plough’s manufacturing facilities in New Jersey and Puerto Rico and had issued reports citing deficiencies concerning compliance with current Good Manufacturing Practices, several lawsuits were filed against Schering-Plough and certain named officers. These lawsuits allege that the defendants violated the federal securities laws by allegedly failing to disclose material information and making material misstatements. Specifically, they allege that Schering-Plough failed to disclose an alleged serious risk that a new drug application for CLARINEX would be delayed as a result of these manufacturing issues, and they allege that Schering-Plough failed to disclose the alleged depth and severity of its manufacturing issues. These complaints were consolidated into one action in the U.S. District Court for the District of New Jersey, and a consolidated amended complaint was filed on October 11, 2001, purporting to represent a class of shareholders who purchased shares of Schering-Plough stock from May 9, 2000 through February 15, 2001. The complaint seeks compensatory damages on behalf of the class. The Court certified the shareholder class on October 10, 2003. Discovery is ongoing.

 

Shareholder Derivative Actions

 

Two lawsuits were filed in the U.S. District Court for the District of New Jersey against Schering-Plough, certain officers, directors and a former director seeking damages on behalf of Schering-Plough, including disgorgement of trading profits made by defendants allegedly obtained on the basis of material non-public information. The complaints allege a failure to disclose material information and breach of fiduciary duty by the directors, relating to the FDA inspections and investigations into Schering-Plough’s pricing practices and sales, marketing and clinical trials practices. These lawsuits are shareholder derivative actions that purport to assert claims on behalf of Schering-Plough. The two shareholder derivative actions pending in the U.S. District Court for the District of New Jersey were consolidated into one action on August 20, 2001.

 

ERISA Litigation

 

On March 31, 2003, Schering-Plough was served with a putative class action complaint filed in the U.S. District Court in New Jersey alleging that Schering-Plough, retired Chairman, CEO and President Richard Jay Kogan, Schering-Plough’s Employee Savings Plan (Plan) administrator, several current and former directors, and certain corporate officers (Messrs. LaRosa and Moore) breached their fiduciary obligations to certain participants in the Plan. The complaint seeks damages in the amount of losses allegedly suffered by the Plan. The complaint was dismissed on June 29, 2004. The plaintiffs appealed. On August 19, 2005, the U.S. Court of Appeals for the Third Circuit reversed the dismissal by the District Court and the matter has been remanded back to the District Court for further proceedings.

 

K-DUR Antitrust litigation

 

Schering-Plough had settled patent litigation with Upsher-Smith, Inc. (Upsher-Smith) and ESI Lederle, Inc. (Lederle), relating to generic versions of K-DUR, Schering-Plough’s long-acting potassium chloride product supplement used by cardiac patients, for which Lederle and Upsher Smith had filed Abbreviated New Drug Applications. Following the commencement of an FTC administrative proceeding alleging anti-competitive effects from those settlements, alleged class action suits were filed in federal and state courts on behalf of direct and indirect purchasers of K-DUR against Schering-Plough, Upsher-Smith and Lederle. These suits claim violations of federal and state antitrust laws, as well as other state statutory and common law causes of action. These suits seek unspecified damages. Discovery is ongoing.

 

Third-Party Payor Actions

 

Several purported class action litigations have been filed following the announcement of the settlement of the Massachusetts Investigation. Plaintiffs in these actions seek damages on behalf of third-party payors resulting from the allegations of off-label promotion and improper payments to physicians that were at issue in the Massachusetts Investigation.

 

Tax Matters

 

In October 2001, IRS auditors asserted that two interest rate swaps that Schering-Plough entered into with an unrelated party should be recharacterized as loans from affiliated companies, resulting in additional tax liability for the 1991 and 1992 tax years. In September 2004, Schering-Plough made payments to the IRS in the amount of $194 million for income tax and $279 million for interest. Schering-Plough filed refund claims for the tax and interest with the IRS in December 2004. Following the IRS’s denial of Schering-Plough’s claims for a refund, Schering-Plough filed suit in May 2005 in the U.S. District Court for the District of New Jersey for refund of the full amount of the tax and interest. This refund litigation is currently in the discovery phase. Schering-Plough’s tax reserves were adequate to cover the above-mentioned payments.

 

Pending Administrative Obligations

 

In connection with the settlement of an investigation with the U.S. Department of Justice and the U.S. Attorney’s Office for the Eastern District of Pennsylvania, Schering-Plough entered into a five-year corporate integrity agreement (CIA). The CIA was amended in August of 2006 in connection with the

settlement of the Massachusetts Investigation, commencing a new five-year term. As disclosed in Note 18, “Consent Decree,” Schering-Plough is subject to obligations under a Consent Decree with the FDA. Failure to comply with the obligations under the CIA or the Consent Decree can result in financial penalties.

 

For a discussion of pending pharmacovigilance matters resulting from pharmacovigilance inspections by officials of the British and French medicines agencies conducted at the request of the European Medicines Agency (EMEA), refer to “Regulatory and Competitive Environment in Which Schering-Plough Operates” in Item 7, “Management’s Discussion and Analysis.”

 

Other Matters

 

NITRO-DUR Investigation

 

In August 2003, Schering-Plough received a civil investigative subpoena issued by the Office of Inspector General of the U.S. Department of Health and Human Services, seeking documents concerning Schering-Plough’s classification of NITRO-DUR for Medicaid rebate purposes, and Schering-Plough’s use of nominal pricing and bundling of product sales. Schering-Plough is cooperating with the investigation. It appears that the subpoena is one of a number addressed to pharmaceutical companies concerning an inquiry into issues relating to the payment of government rebates.

 

Senate Finance Committee Inquiry

 

In January 2006, the United States Senate Committee on Finance followed up on previous requests to Schering-Plough with a request for further information on Schering-Plough’s practices relating to educational and other grants. Schering-Plough understands that the Committee has directed similar follow-up requests to other pharmaceutical companies. Schering-Plough is cooperating with the Committee and has responded to its requests.

 

French Matter

 

Based on a complaint to the French competition authority from a competitor in France and pursuant to a court order, the French competition authority has obtained documents from a French subsidiary of Schering-Plough relating to one of the products that the subsidiary markets and sells. Any resolution of this matter adverse to the French subsidiary could result in the imposition of civil fines and injunctive or administrative remedies.

 

Not applicable.

 

Listed below are the executive officers and corporate officers of Schering-Plough as of February 27, 2007. Unless otherwise indicated, each has held the position indicated for the past five years. Officers serve for one year and until their successors have been duly appointed.

 

 

 

 

 

The principal market for Schering-Plough’s common stock is the New York Stock Exchange. Additional information required by this Item is incorporated by reference from the table captioned “Quarterly Data” (unaudited) under Item 8, “Financial Statements and Supplementary Data.”

 

The following table provides information with respect to purchases by Schering-Plough of its common shares during the fourth quarter of 2006.

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

 

 

Performance Graph

 

Comparison of Cumulative Total Return
For the Five Years Ended December 31, 2006

 

 

 

The graph above assumes a $100 investment on December 31, 2001, and reinvestment of all dividends, in each of Schering-Plough’s Common Shares, the S&P 500 Index, and a composite peer group of the major U.S.-based pharmaceutical companies, which are: Abbott Laboratories, Bristol-Myers Squibb Company, Johnson & Johnson, Eli Lilly and Company, Merck & Co., Inc., Pfizer Inc. and Wyeth. (Warner Lambert Company and Pharmacia Corporation, which are no longer publicly traded after being acquired by Pfizer, Inc., are no longer included in the peer index.)

 

 

 

 

EXECUTIVE SUMMARY

 

Overview of Schering-Plough

 

Schering-Plough discovers, develops, manufactures and markets medical therapies and treatments to enhance human health. Schering-Plough also markets leading consumer brands in the over-the-counter (OTC), foot care and sun care markets and operates a global animal health business.

 

There are two sources of new products: products acquired through acquisition and licensing arrangements, and products in Schering-Plough’s late-stage research pipeline. With respect to acquisitions and licensing, Schering-Plough has recently acquired some new product licenses. However, there are limited opportunities for obtaining or licensing critical late-stage products that will have a positive material financial impact. These limited opportunities typically require substantial amounts of funding. Schering-Plough often competes for these opportunities against companies with greater financial resources.

 

Strategy — Focused on Science

 

Earlier this decade, Schering-Plough experienced a number of business, regulatory, and legal challenges. In April 2003, the Board of Directors named Fred Hassan as the new Chairman of the Board and Chief Executive Officer of Schering-Plough Corporation. With support from the Board, he recruited a new senior executive team and initiated a strategic plan, with the goal of stabilizing, repairing and turning around Schering-Plough in order to build long-term shareholder value. That strategic plan, the Action Agenda, is a six- to eight-year, five-phase plan. In October 2006, Schering-Plough announced that it entered the fourth phase of the Action Agenda — Build the Base. During the Build the Base phase, Schering-Plough continues to focus on its strategy of value creation across a broad front, including:

 

 

As part of this effort, Schering-Plough is enhancing infrastructure, upgrading processes and systems, and strengthening talent—both the recruitment of talented individuals and the development of key employees. While these efforts are companywide, Schering-Plough is focusing especially on research and development.

 

A key component of the Action Agenda is applying science to meet unmet medical needs. Research and development activities focus on mechanisms to treat serious diseases. As a result, a core strategy of Schering-Plough is to invest substantial funds in scientific research with the goal of creating therapies and treatments with important medical and commercial value. Consistent with this core strategy, Schering-Plough has been increasing its investment in research and development. Schering-Plough’s progressing pipeline includes drug candidates across a wide range of therapeutic areas with 21 compounds now approaching or in Phase I development. As Schering-Plough continues to develop the later phase growth-drivers of the pipeline (e.g., thrombin receptor antagonist, golimumab, vicriviroc and HCV protease inhibitor), it anticipates higher spending on clinical trial activities.

 

2006 Results — Highlights of Schering-Plough’s performance in 2006 are as follows:

 

 

 

Strategic Alliances

 

As is typical in the pharmaceutical industry, Schering-Plough licenses manufacturing, marketing and/or distribution rights to certain products to others, and also manufactures, markets and/or distributes products owned by others pursuant to licensing and joint venture arrangements. Any time that third parties are involved, there are additional factors relating to the third party and outside the control of Schering-Plough that may create positive or negative impacts on Schering-Plough. VYTORIN, ZETIA and REMICADE are subject to such arrangements and are key to Schering-Plough’s current business and financial performance.

 

In addition, any potential strategic alternatives may be impacted by the change of control provisions in those arrangements, which could result in VYTORIN and ZETIA being acquired by Merck or REMICADE reverting back to Centocor. The change in control provision relating to VYTORIN and ZETIA is included in the contract with Merck, filed as Exhibit 10(r) to Schering-Plough’s 10-K, and the change of control provision relating to REMICADE is contained in the contract with Centocor, filed as Exhibit 10(v) to Schering-Plough’s 10-K.

 

Cholesterol Franchise

 

Schering-Plough’s cholesterol franchise products, VYTORIN and ZETIA, are managed through a joint venture between Schering-Plough and Merck for the treatment of elevated cholesterol levels. ZETIA is Schering-Plough’s novel cholesterol absorption inhibitor. VYTORIN is the combination of ZETIA and Zocor, Merck’s statin medication. The financial commitment to compete in the cholesterol reduction market is shared with Merck, and profits from the sales of VYTORIN and ZETIA are also shared with Merck. The operating results of the joint venture with Merck are recorded using the equity method of accounting.

 

A material change in the sales or market share of Schering-Plough’s cholesterol franchise would have a significant impact on Schering-Plough’s results of operations and cash flows. In order to maintain and enhance its infrastructure and business, Schering-Plough must continue to increase profits. This increased profitability is largely dependent upon the performance of Schering-Plough’s cholesterol franchise.

 

The cholesterol-reduction market is the single largest pharmaceutical category in the world. VYTORIN and ZETIA are competing in this market and, on a combined basis, these products continued to grow in terms of market share during 2006. As a franchise, the two products together have captured more than 15 percent of total prescriptions for the U.S. cholesterol management market (based on January 2007 IMS data).

 

Japan is not included in the joint venture with Merck. In the Japanese market, Bayer Healthcare will co-market Schering-Plough’s cholesterol-absorption inhibitor, ZETIA, upon approval. Schering-Plough anticipates receiving this approval in Japan in 2007, but due to a backlog of new drug applications in Japan, Schering-Plough cannot precisely predict the timing of the approval.

 

License Arrangements with Centocor

 

REMICADE is prescribed for the treatment of immune-mediated inflammatory disorders such as rheumatoid arthritis, early rheumatoid arthritis, psoriatic arthritis, Crohn’s disease, ankylosing spondylitis, plaque psoriasis and ulcerative colitis. REMICADE is Schering-Plough’s second largest marketed pharmaceutical product line (after the cholesterol franchise). REMICADE is licensed from and manufactured by Centocor, Inc., a Johnson & Johnson company. Schering-Plough has the exclusive marketing rights to this product outside of the U.S., Japan and certain Asian markets. During 2005, Schering-Plough exercised an option under its contract with Centocor for license rights to develop and commercialize golimumab, a new TNF-alpha monoclonal antibody, in the same territories as REMICADE. Golimumab is currently in Phase III trials. Schering-Plough and Centocor have been collaborating in resolving the difference in the parties’ opinions as to the expiration date of Schering-Plough’s rights to golimumab. In August 2006, Schering-Plough received a determination through arbitration that its rights to market golimumab will extend to 15 years after the first commercial sales in its territories, but Centocor has appealed the ruling.

 

Manufacturing, Sales and Marketing

 

Schering-Plough supports commercialized products with manufacturing, sales and marketing efforts. Schering-Plough is also moving forward with additional investments to enhance its infrastructure and business, including capital expenditures for the drug development process (where products are moved from the drug discovery pipeline to markets), information technology systems, and post-marketing studies and monitoring.

 

Schering-Plough continually reviews the business, including manufacturing operations, to identify actions that will enhance long-term competitiveness. However, Schering-Plough’s manufacturing cost base is relatively fixed, and actions to significantly reduce Schering-Plough’s manufacturing infrastructure involve complex issues. As a result, shifting products between manufacturing plants can take many years due to construction and regulatory requirements, including revalidation and registration requirements. During 2006, Schering-Plough closed one manufacturing plant and took other streamlining actions. Schering-Plough continues to review the carrying value of manufacturing assets for indications of impairment. Future events and decisions may lead to additional asset impairments or related costs.

 

Regulatory and Competitive Environment

 

 

 

DISCUSSION OF OPERATING RESULTS

 

Net Sales

 

A significant portion of net sales is made to major pharmaceutical and health care product distributors and major retail chains in the U.S. Consequently, net sales and quarterly growth comparisons may be affected by fluctuations in the buying patterns of major distributors, retail chains and other trade buyers. These fluctuations may result from seasonality, pricing, wholesaler buying decisions or other factors. In addition to these fluctuations, sales of many pharmaceutical products in the U.S. are subject to increased pricing pressure from managed care groups, institutions, government agencies, and other groups seeking discounts. Schering-Plough and other pharmaceutical manufacturers in the U.S. market are also required to provide statutorily defined rebates to various government agencies in order to participate in the Medicaid program, the veterans’ health care program, and other government-funded programs. In most international markets, Schering-Plough operates in an environment where governments may and have mandated cost-containment programs, placed restrictions on physician prescription levels and patient reimbursements, emphasized greater use of generic drugs and enacted across-the-board price cuts as methods to control costs.

 

Consolidated net sales in 2006 were $10.6 billion, an increase of $1.1 billion or 11 percent as compared to 2005. The increase primarily reflected the growth in sale volumes of REMICADE, NASONEX, PEG-INTRON and TEMODAR. This increase also reflected an unfavorable impact of 1 percent from foreign exchange.

 

Consolidated net sales in 2005 totaled $9.5 billion, an increase of $1.2 billion or 15 percent compared to 2004, reflecting higher volumes of REMICADE, NASONEX, PEG-INTRON, TEMODAR and the inclusion of a full year of sales of AVELOX and CIPRO. In addition, foreign exchange had a favorable impact of 1 percent.

 

Net sales for the years ended December 31, 2006, 2005, and 2004 were as follows:

 

 

 

N/M — Not a meaningful percentage.

 

International net sales of REMICADE, a drug for the treatment of immune-mediated inflammatory disorders such as rheumatoid arthritis, early rheumatoid arthritis, psoriatic arthritis, Crohn’s disease, ankylosing spondylitis, plaque psoriasis, and ulcerative colitis, were up 32 percent to $1.2 billion in 2006 as compared to 2005, and 26 percent in 2005 to $942 million as compared to 2004, due to greater demand, expanded indications and continued market growth. During 2006, competitive products for the indications referred to above have been introduced, and additional competitive products are expected to be introduced in 2007.

 

Global net sales of NASONEX Nasal Spray, a once-daily corticosteroid nasal spray for allergies, rose 28 percent to $944 million in 2006 as compared to 2005, and 24 percent to $737 million in 2005 as compared to 2004, as the product captured greater U.S. and international market share in both 2006 and 2005. In 2005, U.S. sales benefited from an increased promotional effort and the introduction of a new scent-free, alcohol-free formulation of NASONEX nasal spray. A generic form of Flonase (fluticasone propionate) was approved early in 2006 and may unfavorably impact the corticosteroid nasal spray market going forward.

 

Global net sales of PEG-INTRON Powder for Injection, a pegylated interferon product for treating hepatitis C, increased 11 percent to $837 million in 2006 as compared to 2005, and 33 percent to $751 million in 2005 as compared to 2004. The sales increase in 2006 reflected higher sales volume in Japan and the U.S. Sales growth in 2005 was due to the December 2004 launch of the PEG-INTRON and REBETOL combination therapy in Japan. In Japan, sales in 2005 benefited from a significant number of patients who were waiting for approval of PEG-INTRON before beginning treatment. PEG-INTRON sales in Japan have begun to decline toward the end of 2006,

and this trend is expected to continue into 2007 as new patient enrollment for hepatitis C treatment moderates and new competition enters the Japanese market.

 

Global net sales of CLARINEX (marketed as AERIUS in many countries outside the U.S.), for the treatment of seasonal outdoor allergies and year-round indoor allergies, increased 12 percent to $722 million as compared to 2005 due to increased demand in Europe and Latin America as well as increased sales in the U.S. despite slightly declining market share. Global net sales of CLARINEX in 2005 decreased 7 percent to $646 million as compared to 2004 primarily due to reduced market share in a declining market in the U.S.

 

Global net sales of TEMODAR Capsules, a treatment for certain types of brain tumors, increased 20 percent to $703 million in 2006 as compared to 2005, and increased 28 percent to $588 million in 2005 as compared to 2004. The increases in 2006 and 2005 sales were due to the increased utilization for new indications. In 2005, TEMODAR was approved by the U.S. FDA for treating newly diagnosed glioblastoma multiforme (GBM), which is the most prevalent form of brain cancer, and by the European Commission for use in combination with radiotherapy for GBM patients in 25 EU-member states as well as in Iceland and Norway. In 2006, TEMODAR was approved in Japan for the treatment of malignant glioma. The growth rates for TEMODAR are expected to moderate, as significant market penetration has already been achieved in the treatment of GBM.

 

International net sales of prescription CLARITIN decreased 4 percent to $356 million in 2006 as compared to 2005. Sales in 2005 increased 16 percent to $371 million as compared to 2004 due to the launch of CLARITIN REDITABS in Japan coupled with an unusually severe Japanese allergy season during 2005.

 

Global net sales of INTEGRILIN Injection, a glycoprotein platelet aggregation inhibitor for the treatment of patients with acute coronary syndrome, which is sold primarily in the U.S. by Schering-Plough, increased 5 percent to $329 million in 2006 as compared to 2005. During 2005, sales decreased 3 percent to $315 million as compared to 2004.

 

Effective September 1, 2005, Schering-Plough restructured its INTEGRILIN co-promotion agreement with Millennium. Under the terms of the restructured agreement, Schering-Plough acquired exclusive U.S. development and commercialization rights to INTEGRILIN in exchange for an upfront payment of $36 million and royalties on INTEGRILIN sales. The restructured agreement calls for minimum royalty payments of $85 million per year to Millennium in 2006 and 2007.

 

Global 2006 net sales of REBETOL Capsules, for use in combination with PEG-INTRON or INTRON A for treating hepatitis C, decreased 6 percent to $311 million as compared to 2005 due to lower sales in Europe and increased competition. Global net sales in 2005 increased 15 percent to $331 million as compared to 2004 due primarily to the launch of the PEG-INTRON and REBETOL combination therapy in Japan in December 2004. In Japan, sales in 2005 benefited from the significant number of patients who were waiting for approval of PEG-INTRON before beginning hepatitis C treatment. Sales are expected to continue to decline as a result of the moderation of hepatitis C patient enrollments in Japan and as new competition enters the Japanese market.

 

Net sales of AVELOX, a fluoroquinolone antibiotic for the treatment of certain respiratory and skin infections, sold primarily in the U.S. by Schering-Plough as a result of its license agreement with Bayer, increased 34 percent to $304 million in 2006 as compared to $228 million in 2005 due to share growth and new indications. Sales of AVELOX in 2004 represented the initial three months of sales under the agreement with Bayer, which was effective October 1, 2004.

 

Global net sales of INTRON A Injection, for chronic hepatitis B and C and other antiviral and anticancer indications, decreased 17 percent to $237 million in 2006 as compared to 2005, and 10 percent in 2005 to $287 million as compared to 2004, due to the conversion to PEG-INTRON for treating hepatitis C in Japan.

 

International net sales of CAELYX, for the treatment of ovarian cancer, metastatic breast cancer and Kaposi’s sarcoma, increased 13 percent to $206 million in 2006 as compared to 2005 primarily due to an expanding market for this product. Sales in 2005 increased 21 percent to $181 million as compared to 2004, reflecting further adoption of the ovarian cancer and metastatic breast cancer indications.

 

International net sales of SUBUTEX Tablets, for the treatment of opiate addiction, increased 3 percent to $203 million in 2006 as compared to 2005 due to increased market share. Sales increased 6 percent to $197 million

in 2005 as compared to 2004 due to increased market penetration. In October 2006, SUBOXONE was approved by the EU, including the 25 member states as well as Iceland and Norway, for the treatment of opioid dependence.

 

Global net sales of ELOCON cream, a medium-potency topical steroid, decreased 2 percent to $141 million in 2006 as compared to 2005, and decreased 14 percent to $144 million in 2005 as compared to 2004, reflecting generic competition that was introduced in the U.S. during the first quarter of 2005. Generic competition is expected to continue to adversely affect sales of this product.

 

Net sales of CIPRO, a fluoroquinolone antibiotic for the treatment of certain respiratory, skin, urinary tract and other infections, sold primarily in the U.S. by Schering-Plough as a result of its license agreement with Bayer, decreased 24 percent to $111 million in 2006 as compared to $146 million in 2005 due to market share erosion from generic competition. Sales of CIPRO in 2004 represented the initial three months of sales under the agreement with Bayer.

 

Other pharmaceutical net sales include a large number of lower sales volume prescription pharmaceutical products. Several of these products are sold in limited markets outside the U.S., and many are multiple source products no longer protected by patents. These products include treatments for respiratory, cardiovascular, dermatological, infectious, oncological and other diseases. Included in other pharmaceutical sales is sales of Schering-Plough’s albuterol products. In 2005, the FDA issued a Final Rule that requires all CFC albuterol products, including Schering-Plough’s PROVENTIL CFC, be removed from the market no later than December 31, 2008. Schering-Plough and other manufacturers of albuterol CFC have to transition to albuterol HFA (PROVENTIL HFA) prior to this 2008 year-end deadline. Schering-Plough has begun the transition to the HFA product. Schering-Plough is uncertain as to the ultimate impact on Schering-Plough’s overall future sales of PROVENTIL products, due to the complexities and multiple external factors influencing this transition, including competing albuterol HFA products.

 

Global net sales of Consumer Health Care products, which include OTC, foot care and sun care products, increased 3 percent or $30 million as compared to 2005 reflecting an increase in sales of sun care products and DR. SCHOLL’S and other foot care products. Sales were $1.1 billion in 2005 and 2004. Sales of OTC CLARITIN decreased 1 percent to $390 million in 2006 as compared to 2005, and 6 percent to $394 million in 2005 as compared to 2004 as a result of the restrictions on the retail sale of OTC products containing pseudoephedrine (PSE). In addition, OTC CLARITIN continues to face competition from private labels and branded loratadine. Net sales of sun care products increased $18 million or 9 percent in 2006 as compared to 2005, and $28 million or 16 percent in 2005 as compared to 2004, primarily due to the success of new COPPERTONE CONTINUOUS SPRAY products launched in 2005. Sales of sun care products in 2005 also reflected a stronger overall suncare season in the U.S. Future sales are difficult to predict because the consumer health care market is highly competitive, with heavy advertising to consumers and frequent competitive product introductions.

 

Global net sales of Animal Health products increased 7 percent to $910 million in 2006 as compared to 2005, and 11 percent in 2005 to $851 million as compared to 2004, reflecting strong growth of core brands across most geographic and species areas led by higher sales of companion animal products in 2006 while the products serving the U.S. cattle market, including NUFLOR, and the vaccine business led sales growth in 2005. The increased net sales were also due in part to better product supply in the U.S. Schering-Plough expects this growth rate to moderate due to increased competition, including the introduction of generic products.

 

Costs, Expenses and Equity Income

 

A summary of costs, expenses and equity income for the years ended December 31, 2006, 2005 and 2004 is as follows:

 

 

 

N/M — Not a meaningful percentage

 

Substantially all the sales of cholesterol products are not included in Schering-Plough’s net sales. The results of these sales are reflected in equity income from cholesterol joint venture. In addition, due to the virtual nature of the joint venture, Schering-Plough incurs substantial selling, general and administrative expenses that are not captured in equity income but are included in Schering-Plough’s Statements of Consolidated Operations. As a result, Schering-Plough’s gross margin, and ratios of SG&A expenses and R&D expenses as a percentage of net sales do not reflect the benefit of the impact of the joint venture’s operating results.

 

Gross margin

 

Despite negative impacts on cost of sales from the costs resulting from Schering-Plough’s actions to streamline its manufacturing operations during 2006, gross margin increased to 65.1 percent in 2006 from 64.8 percent in 2005. This improvement in gross margin is primarily due to increased sales of higher margin products and process improvements within Schering-Plough’s supply chain, including cost savings from the manufacturing streamlining activities completed during 2006. In 2006, cost of sales included charges totaling $146 million associated with Schering-Plough’s actions to streamline its manufacturing operations, offset by savings of approximately $30 million as a result of these actions. See Note 2, “Special Charges and Manufacturing Streamlining,” under Item 8, “Financial Statements and Supplemental Data,” for additional information.

 

Gross margin increased to 64.8 percent in 2005 from 62.9 percent in 2004, primarily due to supply chain process improvements, increased sales of higher-margin products and a favorable impact from foreign exchange, partly offset by higher royalties related to the Bayer products and, beginning September 1, 2005, royalties for INTEGRILIN.

 

Selling, general and administrative

 

Selling, general and administrative expenses (SG&A) increased 8 percent to $4.7 billion in 2006 as compared to 2005, reflecting ongoing investments in emerging markets and field support for product launches as well as higher promotional spending.

 

SG&A expenses increased 15 percent to $4.4 billion in 2005 as compared to $3.8 billion in 2004. This increase was primarily due to the addition in the 2004 fourth quarter of Bayer sales representatives, increased selling expenses in Europe to support the continued launch of VYTORIN and ZETIA, and increased promotional spending, primarily for NASONEX, ASMANEX and the products under the agreement with Bayer.

 

Research and development

 

Research and development (R&D) spending increased 17 percent to $2.2 billion in 2006 as compared to the 2005 period. In 2005, R&D spending increased 16 percent to $1.9 billion as compared to the 2004 period. The 2006 increase was due to higher costs associated with clinical trials as well as building greater breadth and capacity to support Schering-Plough’s progressing pipeline. The 2005 increase is partially due to a $124 million charge in the third quarter of 2005 resulting from Schering-Plough’s exercise of its rights to develop and commercialize golimumab. R&D spending for 2004 included an $80 million charge in conjunction with the license from Toyama

Chemical Company Ltd. for garenoxacin. Generally, changes in R&D spending reflect the timing of Schering-Plough’s funding of both internal research efforts and research collaborations with various partners to discover and develop a steady flow of innovative products.

 

To maximize Schering-Plough’s chances for the successful development of new products, Schering-Plough began a Development Excellence initiative in 2005 to build talent and critical mass, create a uniform level of excellence and deliver on high-priority programs within R&D. In 2006, Schering-Plough began a Global Clinical Harmonization Program to maximize and globalize the quality of clinical trial execution, pharmacovigilance and regulatory processes.

 

Other (income)/expense, net

 

Schering-Plough had other income, net, of $135 million in 2006 as compared to other expense, net, of $5 million and $146 million in 2005 and 2004, respectively, due to higher interest rates on larger overall balances of cash equivalents and short-term investments.

 

Special charges and Manufacturing Streamlining

 

2006 Manufacturing Streamlining

 

During 2006, Schering-Plough implemented changes to its manufacturing operations in Puerto Rico and New Jersey to streamline its global supply chain and further enhance Schering-Plough’s long-term competitiveness. These changes resulted in the phase-out and closure of Schering-Plough’s manufacturing operations in Manati, Puerto Rico, and additional workforce reductions in Las Piedras, Puerto Rico, and New Jersey. In total, these actions have resulted in the elimination of over 1,000 positions. Schering-Plough expects these actions to yield annualized cost savings of approximately $100 million.

 

Special Charges:  Special charges in 2006 related to the changes in Schering-Plough’s manufacturing operations totaled $102 million. These charges consisted of approximately $47 million of severance and $55 million of fixed asset impairments.

 

Cost of Sales:  Included in 2006 cost of sales was approximately $146 million consisting of $93 million of accelerated depreciation, $46 million of inventory write-offs, and $7 million of other charges related to the closure of Schering-Plough’s manufacturing facilities in Manati, Puerto Rico.

 

The following table summarizes activities reflected in the consolidated financial statements related to changes to Schering-Plough’s manufacturing operations which were completed in 2006:

 

 

The accrued liability balance at December 31, 2006, is expected to be paid during the first quarter of 2007. Schering-Plough does not expect to incur any material additional charges related to the manufacturing streamlining actions announced in 2006.

 

2004-2005 Special Charge Activities

 

Special charges incurred in 2005 and 2004 are as follows:

 

 

Litigation charges:  In 2005, litigation reserves were increased by $250 million. This increase resulted in a total reserve of $500 million for the Massachusetts Investigation, as well as the investigations and the state litigation disclosed under “AWP Litigation and Investigations” in Note 19, “Legal, Environmental and Regulatory Matters,” representing Schering-Plough’s then current estimate to resolve this matter. On August 29, 2006, Schering-Plough announced it had reached an agreement with the U.S. Attorney’s Office for the District of Massachusetts and the U.S. Department of Justice to settle the Massachusetts Investigation for an aggregate amount of $435 million plus interest. This settlement amount relates only to the Massachusetts Investigation. The AWP investigations and litigation are ongoing. Subsequent to December 31, 2006, Schering-Plough made payments totaling $388 million related to this settlement including interest of $12 million. Substantially all the remaining payments under this settlement agreement will be paid in the remainder of 2007. See Note 19, “Legal, Environmental and Regulatory Matters,” under Item 8, “Financial Statements and Supplementary Data,” for additional information.

 

Employee termination costs:  In August 2003, Schering-Plough announced a global workforce reduction initiative. The first phase of this initiative was a Voluntary Early Retirement Program (VERP) in the U.S. Under this program, eligible employees in the U.S. had until December 15, 2003, to elect early retirement and receive an enhanced retirement benefit. Approximately 900 employees elected to retire under the program, all of which retired by December 31, 2005. The total cost of this program was approximately $191 million, comprised of increased pension costs of $108 million, increased post-retirement health care costs of $57 million, vacation payments of $4 million and costs related to accelerated vesting of stock grants of $22 million. Amounts recognized in 2005 and 2004 for this program were $7 million and $20 million, respectively. No additional amounts are expected to be recognized under this program.

 

Termination costs not associated with the VERP totaled $21 million and $99 million in 2005 and 2004, respectively.

 

The following summarizes the activity in the accounts related to employee termination costs:

 

Asset impairment and other charges:  For the year ended December 31, 2005, Schering-Plough recognized asset impairment and other charges of $16 million related primarily to the consolidation of Schering-Plough’s U.S. biotechnology organizations.

 

Schering-Plough recorded asset impairment and other charges of $34 million in 2004, related primarily to the shutdown of a small European research and development facility.

 

Equity Income from Cholesterol Joint Venture

 

Global cholesterol franchise sales, which include sales of VYTORIN and ZETIA, made by the cholesterol joint venture with Merck and Schering-Plough totaled $3.9 billion, $2.4 billion, and $1.2 billion in 2006, 2005, and 2004, respectively. The sales growth in 2006 was due to an increase in market share. The 2005 sales comparison benefited from the U.S. launch of VYTORIN in the second half of 2004. As a franchise, the two products combined have captured more than 15 percent of total prescriptions in the U.S. cholesterol management market (based on January 2007 IMS data).

 

Schering-Plough utilizes the equity method of accounting for the joint venture. Sharing of income from operations is based upon percentages that vary by product, sales level and country. Schering-Plough’s allocation of joint venture income is increased by milestones earned. Merck and Schering-Plough (the Partners) bear the costs of their own general sales forces and commercial overhead in marketing joint venture products around the world. In the U.S., Canada and Puerto Rico, the cholesterol agreements provide for a reimbursement to each Partner for physician details that are set on annual basis, and in Italy, a contractual amount is included in the profit sharing calculation that is not reimbursed. These amounts are equal to each Partner’s physician details multiplied by a contractual fixed fee. Schering-Plough reports these amounts as part of equity income from the cholesterol joint venture. These amounts do not represent specific, incremental and identifiable costs for Schering-Plough’s detailing of the cholesterol products in these markets. In addition, these amounts are not reflective of Schering-Plough’s sales effort related to the joint venture, as Schering-Plough’s sales force and related costs associated with the joint venture are generally estimated to be higher.

 

Costs of the joint venture that the Partners contractually share are a portion of manufacturing costs, specifically identified promotion costs (including direct-to-consumer advertising and direct and identifiable out-of-pocket promotion) and other agreed upon costs for specific services such as market support, market research, market expansion, a specialty sales force and physician education programs.

 

Certain specified research and development expenses are generally shared equally by the Partners. Additional information regarding the joint venture with Merck is also included in Note 3, “Equity Income from Cholesterol Joint Venture,” under Item 8, “Financial Statements and Supplementary Data.”

 

Equity income from cholesterol joint venture totaled $1.5 billion, $873 million and $347 million in 2006, 2005 and 2004, respectively. The increase in 2006 equity income as compared to 2005 reflecting continued strong sales of VYTORIN and ZETIA. The 2005 equity income comparison benefited from the U.S. launch of VYTORIN in the second half of 2004.

 

During 2005 and 2004, Schering-Plough recognized milestones from Merck of $20 million and $7 million, respectively. The $20 million milestone in 2005 related to certain European approvals of VYTORIN (ezetimibe/simvastatin) in 2005. The $7 million milestone in 2004 related to the approval of ezetimibe/simvastatin in Mexico in 2004. Under certain other conditions, as specified in the joint venture agreements with Merck, Schering-Plough could earn additional milestones totaling $105 million.

 

It should be noted that Schering-Plough incurs substantial selling, general and administrative and other costs, which are not reflected in equity income from the cholesterol joint venture and instead are included in the overall cost structure of Schering-Plough.

 

Provision for Income Taxes

 

Tax expense was $362 million, $228 million and $779 million in 2006, 2005 and 2004, respectively. The tax provisions in 2006, 2005 and 2004 do not include any benefit related to U.S. operating losses. During 2004, Schering-Plough established a valuation allowance on its net U.S. deferred tax assets, including the benefit of U.S. operating losses, as management concluded that it is not more likely than not that the benefit of the U.S. net deferred tax assets can be realized. At December 31, 2006, Schering-Plough continues to maintain a valuation allowance against its

U.S. deferred tax assets. Schering-Plough expects to report a U.S. Net Operating Loss (NOL) carryforward of $1.54 billion on its tax return for the year ended December 31, 2006. This U.S. NOL carryforward could be materially reduced after examination of Schering-Plough’s income tax returns by the Internal Revenue Service (IRS).

 

In 2006, Schering-Plough generated approximately $600 million in U.S. operating losses; however, due to differences between financial and tax reporting, the expected NOL to be generated on the 2006 U.S. tax return will be less than the U.S. operating loss for the year. Schering-Plough expects to continue to generate U.S. operating losses in 2007; however, the U.S. NOL will be subject to differences between financial and tax reporting.

 

The 2006 and 2005 income tax provision primarily relates to foreign taxes. The 2005 tax provision includes a benefit of $46 million related to an IRS Notice issued in August 2005, which resulted in a reduction of the previously accrued tax liability attributable to repatriations under the American Jobs Creation Act of 2004 (AJCA). The 2004 tax provision includes a $417 million charge related to the intended AJCA repatriation that took place in 2005.

 

The IRS is examining Schering-Plough’s 1997-2002 federal income tax returns and is in the process of completing that examination. Schering-Plough anticipates that the examination will be completed before the end of 2007. The finalization of this IRS audit may result in adjustments to Schering-Plough’s accruals for tax contingencies and the U.S. NOLs as reported on Schering-Plough’s income tax returns. Schering-Plough’s tax reserves reflect its best estimate of the probable tax liability; however, it is reasonably possible that the ultimate resolution of these tax matters may be materially greater or less than the amount accrued.

 

In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” Schering-Plough is required to apply the provisions of this interpretation beginning on January 1, 2007. The provisions of FIN 48 will be applied to all existing uncertain income tax positions on the effective date. Upon the implementation of FIN 48, the cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of Schering-Plough’s retained earnings in 2007. Although Schering-Plough is still evaluating the potential impact of FIN 48, it expects a decrease to opening retained earnings as of January 1, 2007, from $225 million to $300 million with a corresponding increase to the appropriate tax liability accounts upon the adoption of this Interpretation.

 

Net Income/(Loss) Available to Common Shareholders

 

Schering-Plough had net income/(loss) available to common shareholders of $1.1 billion, $183 million and $(981) million for 2006, 2005 and 2004, respectively. Net income available to common shareholders for 2006 and 2005 included the deduction of preferred stock dividends of $86 million, in each period, related to the issuance of the 6 percent Mandatory Convertible Preferred Stock in August 2004. The 2004 net loss available to common shareholders included the deduction of preferred stock dividends of $34 million. Net income/(loss) available to common shareholders for 2006, 2005 and 2004 also included special charges and manufacturing streamlining costs of approximately $248 million, $294 million and $153 million, respectively. See Note 2, “Special Charges and Manufacturing Streamlining,” under Item 8, “Financial Statements and Supplementary Data,” for additional information. In addition, 2006 net income available to common shareholders included an income item of $22 million resulting from the cumulative effect of a change in accounting principle, net of tax, related to the implementation of SFAS 123R, “Share-Based Compensation.”

 

LIQUIDITY AND FINANCIAL RESOURCES

 

Discussion of Cash Flow

 

Operating Activities

 

In 2006, net cash provided by operating activities was $2.2 billion, an increase of $1.3 billion as compared to 2005. The increase primarily resulted from higher net income and the timing of operating cash payments and receipts. As disclosed in Note 19, “Legal, Environment and Regulatory Matters,” Schering-Plough has reached an agreement with the U.S. Attorney’s Office for the District of Massachusetts and the U.S. Department of Justice to settle the Massachusetts Investigation for an aggregate amount of $435 million plus interest. Subsequent to December 31, 2006, Schering-Plough made payments totaling $388 million related to this settlement, including interest of $12 million. Substantially all the remaining payments under this settlement agreement will be paid in the remainder of 2007.

 

In 2005, operating activities generated $882 million of cash, compared with a use of $154 million in 2004. The increase was primarily due to higher net income and timing of payments of special charges related to litigation, partially offset by an increase in accounts receivable due to sales growth; payments of approximately $375 million to tax authorities for tax liabilities related to the repatriation of foreign earnings under the AJCA; and tax payments of $239 million related to the settlement of certain tax contingencies for the tax years 1993 through 1996. Tax charges related to the AJCA were expensed in 2004.

 

In 2004, operating cash flow was favorably impacted by a U.S. tax refund of $404 million as a result of loss carryback. However, cash flow was unfavorably impacted by a $473 million payment to the U.S. government for a tax deficiency related to certain transactions in tax years 1991 to 1992 and the payment of $294 million under the settlement agreement with the U.S. Attorney’s office for the Eastern District of Pennsylvania.

 

Investing Activities

 

Net cash used for investing activities during 2006 was $2.9 billion primarily related to the net purchases of short-term investments of $2.4 billion previously invested in cash equivalents and $458 million of capital expenditures.

 

Net cash used for investing activities during 2005 was $454 million, primarily related to $478 million of capital expenditures and the purchase of intangible assets of $51 million, partially offset by proceeds from sales of property and equipment of $43 million and the net reduction in short-term investments of $33 million.

 

Net cash used for investing activities in 2004 was $621 million and included capital expenditures of $489 million and net purchases of investments of $264 million, partially offset by cash proceeds of $118 million from the transfer of license rights and $7 million from the dispositions of property and equipment.

 

Financing Activities

 

Net cash used for financing activities during 2006 and 2005 was $1.4 billion and $633 million, respectively. Uses of cash for financing activities in 2006 and 2005 include the payment of dividends on common and preferred shares of $412 million and $410 million, respectively; the repayment of $1.0 billion of bank debt and short-term commercial borrowings in 2006, and $1.2 billion of short-term commercial paper borrowings in 2005. Uses of cash for financing activities in 2005 was partially offset by proceeds of $900 million from bank debt incurred by a foreign subsidiary related to funding of a portion of the repatriations under the AJCA during 2005. This bank debt was fully repaid in 2006.

 

The net cash provided by financing activities in 2004 reflected proceeds of $1.4 billion from the preferred stock issuance and $546 million from the increase in short-term borrowings, partially offset by the payment of dividends on common and preferred shares of $354 million.

 

Other Discussion of Cash Flows

 

Schering-Plough is moving forward with additional investments to enhance its infrastructure and business and currently is in the process of building a U.S. pharmaceutical sciences center in New Jersey. Capital expenditures of approximately $38 million were made in 2006 related to this center. Additional capital expenditures of approximately $260 million are expected over the next three years. This center will allow Schering-Plough to streamline and integrate its drug development process, where products are moved from the drug discovery pipeline to market. There will be additional related expenditures to upgrade equipment and staffing for this center.

 

In 2006, U.S. operations generated negative cash flow. U.S. operations have cash needs in excess of cash generated in the U.S. The U.S. operations must fund dividend payments, the majority of research and development costs and U.S. capital expenditures. It is expected that the U.S. operation will also generate negative cash flow in 2007.

 

Total cash, cash equivalents and short-term investments less total debt was approximately $3.3 billion at December 31, 2006. Cash generated from operations and available cash and short-term investments are expected to provide Schering-Plough with the ability to fund cash needs for the intermediate term.

 

  6 Percent Mandatory Convertible Preferred Stock

 

In August 2004, Schering-Plough issued 6 percent mandatory convertible preferred stock and received net proceeds of $1.4 billion after deducting commissions, discounts and other underwriting expenses. The proceeds were used to reduce short-term commercial paper borrowings, pay tax and litigation settlement amounts and litigation costs, and to fund operating expenses and capital expenditures. The preferred stock was issued under Schering-Plough’s $2.0 billion shelf registration, and each preferred share will automatically convert into between 2.2451 and 2.7840 common shares of Schering-Plough depending on the average closing price of Schering-Plough’s common shares over a period immediately preceding the mandatory conversion date of September 14, 2007, as defined in the prospectus. See Note 15, “Shareholders’ Equity,” under Item 8, “Financial Statements and Supplementary Data,” for additional information. The conversion of these preferred shares will not trigger any cash payment by Schering-Plough. At December 31, 2006, $563 million remains registered and un-issued under the shelf registration.

 

Borrowings and Credit Facilities

 

On November 26, 2003, Schering-Plough issued $1.25 billion aggregate principal amount of 5.3 percent senior unsecured notes due 2013 and $1.15 billion aggregate principal amount of 6.5 percent senior unsecured notes due 2033. Proceeds from this offering of $2.4 billion were used for general corporate purposes, including repaying commercial paper outstanding in the U.S. Upon issuance, the notes were rated A3 by Moody’s Investors Service (Moody’s) and A+ (on Credit Watch with negative implications) by Standard & Poor’s (S&P). The interest rates payable on the notes are subject to adjustment. If the rating assigned to the notes by either Moody’s or S&P is downgraded below A3 or A-, respectively, the interest rate payable on that series of notes would increase. See Note 13, “Short-Term Borrowings, Long-Term Debt and Other Commitments,” under Item 8, “Financial Statements and Supplementary Data,” for additional information.

 

On July 14, 2004, Moody’s lowered its rating on the notes to Baa1. Accordingly, the interest payable on each note increased 25 basis points effective December 1, 2004. Therefore, on December 1, 2004, the interest rate payable on the notes due 2013 increased from 5.3 percent to 5.55 percent, and the interest rate payable on the notes due 2033 increased from 6.5 percent to 6.75 percent. This adjustment to the interest rate payable on the notes increased Schering-Plough’s interest expense by approximately $6 million annually. The interest rate payable on a particular series of notes will return to 5.3 percent and 6.5 percent, respectively, and the rate adjustment provisions will permanently cease to apply if, following a downgrade by either Moody’s or S&P below A3 or A-, respectively, the notes are subsequently rated above Baa1 by Moody’s and BBB+ by S&P.

 

Schering-Plough has a $1.5 billion credit facility with a syndicate of banks. This facility matures in May 2009 and requires Schering-Plough to maintain a total debt to total capital ratio of no more than 60 percent, which was met at December 31, 2006. This credit line is available for general corporate purposes and is considered as support to Schering-Plough’s commercial paper borrowings. Borrowings under this credit facility may be drawn by the U.S. parent company or by its wholly-owned international subsidiaries when accompanied by a parent guarantee. This facility does not require compensating balances; however, a nominal commitment fee is paid. As of December 31, 2005, $325 million was drawn under this facility by a wholly-owned international subsidiary for the purposes of funding repatriations under the AJCA. During 2006, this borrowing amount was fully repaid. As of December 31, 2006, no borrowings were outstanding under this facility.

 

In addition to the above credit facility, Schering-Plough entered into a $575 million credit facility during the fourth quarter of 2005 for the purposes of funding repatriations under the AJCA. As of December 31, 2005, the entire amount was drawn by a wholly-owned international subsidiary to fund the repatriations. This facility was paid in full and terminated in 2006.

 

As of December 31, 2006 and 2005, short-term borrowings, including the credit facilities mentioned above, totaled $242 million and $1.3 billion, respectively, including outstanding commercial paper of $149 million and $298 million, respectively. The weighted-average interest rate for short-term borrowings at December 31, 2006 and 2005 was 6.4 percent and 4.7 percent, respectively.

 

Credit Ratings

 

Schering-Plough’s current unsecured senior credit ratings and outlook are as follows:

 

 

The short-term ratings discussed above have not significantly affected Schering-Plough’s ability to issue or roll over its outstanding commercial paper borrowings at this time. However, Schering-Plough believes the ability of commercial paper issuers, such as Schering-Plough, with one or more short-term credit ratings of P-2 from Moody’s, A-2 from S&P and/or F-2 from Fitch to issue or roll over outstanding commercial paper can, at times, be less than that of companies with higher short-term credit ratings. In addition, the total amount of commercial paper capacity available to these issuers is typically less than that of higher-rated companies. Schering-Plough’s sizable lines of credit with commercial banks as well as cash and short-term investments held by U.S. and international subsidiaries serve as alternative sources of liquidity and to support its commercial paper program.

 

Schering-Plough’s credit ratings could decline below their current levels. The impact of such decline could reduce the availability of commercial paper borrowing and would increase the interest rate on Schering-Plough’s short and long-term debt. As discussed above, Schering-Plough believes that existing cash, short-term investments and cash generated from operations will allow Schering-Plough to fund its cash needs for the intermediate term.

 

Contractual Obligations and Off-Balance Sheet Arrangements

 

Schering-Plough has various contractual obligations that are reported as liabilities in the Consolidated Balance Sheets and others that are not required to be recognized as liabilities such as certain purchase commitments and other executory contracts. The following table summarizes payments due by period under Schering-Plough’s known contractual obligations at December 31, 2006.

 

 

 

 

REGULATORY AND COMPETITIVE ENVIRONMENT IN WHICH SCHERING-PLOUGH OPERATES

 

Schering-Plough is subject to the jurisdiction of various national, state and local regulatory agencies. These regulations are described in more detail in Item 1, “Business.” Regulatory compliance is complex, as regulatory standards (including Good Clinical Practices, Good Laboratory Practices and Good Manufacturing Practices) vary by jurisdiction and are constantly evolving. Regulatory compliance is also costly. Regulatory compliance also impacts the timing needed to bring new drugs to market and to market drugs for new indications. Further, failure to comply with regulations can result in delays in the approval of drugs, seizure or recall of drugs, suspension or revocation of the authority necessary for the production and sale of drugs, fines and other civil or criminal sanctions.

 

Regulatory compliance, and the cost of compliance failures, can have a material impact on Schering-Plough’s results of operations, its cash flows or financial condition.

 

Much is still unknown about the science of human health and with every drug there are benefits and risks that may be balanced. Societal and government pressures are constantly shifting between the demand for innovation to meet urgent unmet medical needs and adversity to risk. These pressures impact the regulatory environment and the market for Schering-Plough’s products.

 

Regulatory Compliance and Pharmacovigilance

 

Consent Decree

 

Since 2002, Schering-Plough has been working under a U.S. FDA Consent Decree to resolve issues involving Schering-Plough’s compliance with current Good Manufacturing Practices (cGMP) at certain of its manufacturing sites in New Jersey and Puerto Rico. See details in Note 18, “Consent Decree” under Item 8, “Financial Statements and Supplementary Data.”

 

Under the terms of the Consent Decree, Schering-Plough made payments totaling $500 million. As of the end of 2005, Schering-Plough has completed the revalidation programs for bulk active pharmaceutical ingredients and finished drug products, as well as all 212 Significant Steps of the cGMP Work Plan, in accordance with the schedules required by the Consent Decree. Schering-Plough has obtained third-party expert certification of completion of the cGMP Work Plan as required by the Decree. This certification is in turn subject to acceptance by the FDA. Under the terms of the Decree, provided that the FDA has not notified Schering-Plough of a significant violation of FDA law, regulations, or the Decree in any five-year period since the Decree’s entry in May of 2002, Schering-Plough may petition the court to have the Decree dissolved and the FDA will not oppose Schering-Plough’s petition. There is no assurance about any particular date when the Consent Decree will be lifted.

 

Regulatory Inspections

 

Schering-Plough is subject to pharmacovigilance reporting requirements in many countries and other jurisdictions, including the U.S., the EU, and the EU-member states. The requirements differ from jurisdiction to jurisdiction, but all include requirements for reporting adverse events that occur while a patient is using a particular drug in order to alert the drug’s manufacturer and the governmental agency to potential problems.

 

During 2003, pharmacovigilance inspections by officials of the British and French medicines agencies conducted at the request of the European Medicines Agency (EMEA) cited serious deficiencies in reporting processes. Schering-Plough has continued to work on its long-term action plan to rectify the deficiencies and has provided regular updates to the EMEA.

 

During the fourth quarter 2005, local UK and EMEA regulatory authorities conducted a follow up inspection to assess Schering-Plough’s implementation of its action plan. In the first quarter of 2006, these authorities also inspected the U.S.-based components of Schering-Plough’s pharmacovigilance system. The inspectors acknowledged that progress had been made since 2003, but also continued to note significant concerns with the quality systems supporting Schering-Plough’s pharmacovigilance processes. Similarly, in a follow up inspection of Schering-Plough’s clinical trial practices in the UK, inspectors identified issues with respect to Schering-Plough’s management of clinical trials and related pharmacovigilance practices.

 

Schering-Plough intends to continue upgrading skills, processes and systems in clinical practices and pharmacovigilance. Schering-Plough remains committed to accomplish this work and to invest significant resources in this area. Further, in February 2006, Schering-Plough began the Global Clinical Harmonization Program for building clinical excellence (in trial design, execution and tracking), which will strengthen Schering-Plough’s scientific and compliance rigor on a global basis.

 

Schering-Plough does not know what action, if any, the EMEA or national authorities will take in response to the inspections. Possible actions include further inspections, demands for improvements in reporting systems, criminal sanctions against Schering-Plough and/or responsible individuals and changes in the conditions of marketing authorizations for Schering-Plough’s products.

 

Regulatory Compliance and Post-Marketing Surveillance

 

Schering-Plough engages in clinical trial research in many countries around the world. These clinical trial research activities must comply with stringent regulatory standards and are subject to inspection by U.S., EU, and local country regulatory authorities. Failure to comply with current Good Clinical Practices, other applicable laws or regulations or quality processes can result in delays in approval of clinical trials, suspension of ongoing clinical trials, delays in approval of marketing authorizations, criminal sanctions against Schering-Plough and/or responsible individuals, changes in the conditions of marketing authorizations for Schering-Plough’s products and increased costs.

 

Clinical trials and post-marketing surveillance of certain marketed drugs of competitors within the industry have raised safety concerns that have led to recalls, withdrawals or adverse labeling of marketed products. In addition, these situations have raised concerns among some prescribers and patients relating to the safety and efficacy of pharmaceutical products in general. Schering-Plough’s personnel have regular, open dialogue with the FDA and other regulators and review product labels and other materials on a regular basis and as new information becomes known.

 

Following this wake of recent product withdrawals by other companies and other significant safety issues, health authorities such as the FDA, the EMEA and the PMDA in Japan have continued to increase their focus on safety when assessing the benefit/risk balance of drugs. Some health authorities appear to have become more cautious when making decisions about approvability of new products or indications and are re-reviewing select products that are already marketed, adding further to the uncertainties in the regulatory processes. There is also greater regulatory scrutiny, especially in the U.S., on advertising and promotion and in particular, direct-to-consumer advertising.

 

Similarly, major health authorities, including the FDA, EMEA and PMDA, have also increased collaboration amongst themselves, especially with regard to the evaluation of safety and benefit/risk information. Media attention has also increased. In the current environment, a health authority regulatory action in one market, such as a safety labeling change, may have regulatory, prescribing and marketing implications in other markets to an extent not previously seen.

 

Some health authorities, such as the PMDA, have publicly acknowledged a significant backlog in workload due to resource constraints within their agency. This backlog has caused long regulatory review times for new indications and products, including the initial approval of ZETIA in Japan, and has added to the uncertainty in

predicting approval timelines in these markets. While the PMDA has committed to correcting the backlog and has made some progress over the last year, it is expected to continue for the foreseeable future.

 

These and other uncertainties inherent in government regulatory approval processes, including, among other things, delays in approval of new products, formulations or indications, may also affect Schering-Plough’s operations. The effect of regulatory approval processes on operations cannot be predicted.

 

Schering-Plough has nevertheless achieved a significant number of important regulatory approvals since 2004, including approvals for VYTORIN, CLARINEX D-24, CLARINEX REDITABS, CLARINEX D-12 and new indications for TEMODAR and NASONEX. Other significant approvals since 2004 include ASMANEX DPI (Dry Powder for Inhalation) in the U.S.; NOXAFIL in the U.S., the EU and Australia; PEG-INTRON in Japan; and new indications for REMICADE. Schering-Plough also has a number of significant regulatory submissions filed in major markets awaiting approval.

 

Pricing Pressures

 

As described more specifically in Note 19, “Legal, Environmental and Regulatory Matters,” under Item 8, “Financial Statements and Supplementary Data,” the pricing, sales and marketing programs and arrangements, and related business practices of Schering-Plough and other participants in the health care industry are under increasing scrutiny from federal and state regulatory, investigative, prosecutorial and administrative entities. These entities include the Department of Justice and its U.S. Attorney’s Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission (FTC) and various state Attorneys General offices. Many of the health care laws under which certain of these governmental entities operate, including the federal and state anti-kickback statutes and statutory and common law false claims laws, have been construed broadly by the courts and permit the government entities to exercise significant discretion. In the event that any of those governmental entities believes that wrongdoing has occurred, one or more of them could institute civil or criminal proceedings, which, if instituted and resolved unfavorably, could subject Schering-Plough to substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs. Schering-Plough also cannot predict whether any investigations will affect its marketing practices or sales. Any such result could have a material adverse impact on Schering-Plough’s results of operations, cash flows, financial condition, or its business.

 

In the U.S., many of Schering-Plough’s pharmaceutical products are subject to increasingly competitive pricing as managed care groups, institutions, government agencies and other groups seek price discounts. In the U.S. market, Schering-Plough and other pharmaceutical manufacturers are required to provide statutorily defined rebates to various government agencies in order to participate in Medicaid, the veterans’ health care program and other government-funded programs.

 

In most international markets, Schering-Plough operates in an environment of government mandated cost-containment programs. Several governments have placed restrictions on physician prescription levels and patient reimbursements; emphasized greater use of generic drugs; and enacted across-the-board price cuts as methods to control costs.

 

Since Schering-Plough is unable to predict the final form and timing of any future domestic or international governmental or other health care initiatives, including the passage of laws permitting the importation of pharmaceuticals into the U.S., their effect on operations and cash flows cannot be reasonably estimated. Similarly, the effect on operations and cash flows of decisions of government entities, managed care groups and other groups concerning formularies and pharmaceutical reimbursement policies cannot be reasonably estimated.

 

Medicare

 

Schering-Plough cannot predict what net effect the Medicare prescription drug benefit will have on markets and sales. The new Medicare Drug Benefit (Medicare Part D), which took effect January 1, 2006, offers voluntary prescription drug coverage, subsidized by Medicare, to more than 40 million Medicare beneficiaries through competing private prescription drug plans (PDPs) and Medicare Advantage (MA) plans. Many of Schering-Plough’s leading drugs are already covered under Medicare Part B (e.g., TEMODAR, INTEGRILIN and INTRON

A). Medicare Part B provides payment for physician services that can include prescription drugs administered along with other physician services. The manner in which drugs are reimbursed under Medicare Part B may limit Schering-Plough’s ability to offer larger price concessions or make large price increases on these drugs. Other Schering-Plough drugs have a relatively small portion of their sales to the Medicare population (e.g., CLARINEX, the hepatitis C franchise). Schering-Plough could experience expanded utilization of VYTORIN and ZETIA and new drugs in Schering-Plough’s R&D pipeline. Of greater consequence for Schering-Plough may be the legislation’s impact on pricing, rebates and discounts.

 

Competition

 

The market for pharmaceutical products is competitive. Schering-Plough’s operations may be affected by technological advances of competitors, industry consolidation, patents granted to competitors, competitive combination products, new products of competitors, new information from clinical trials of marketed products or post-marketing surveillance and generic competition as Schering-Plough’s products mature. In addition, patent positions are increasingly being challenged by competitors, and the outcome can be highly uncertain. An adverse result in a patent dispute can preclude commercialization of products or negatively affect sales of existing products. The effect on operations of competitive factors and patent disputes cannot be predicted.

 

2007 OUTLOOK

 

Schering-Plough is on track with the actions to build long-term high performance in the Build the Base phase of the Action Agenda. Schering-Plough will continue to make investments to support its geographical expansion strategy and plans to make sound promotional investments to continue driving the growth of key brands worldwide. Schering-Plough remains focused on controlling its overhead spending and maintaining a right-sized sales force for its current opportunities in the U.S.

 

Schering-Plough currently does not provide numeric guidance. However, the following outlook may be helpful to readers in assessing future prospects:

 

Currently, the U.S. cholesterol lowering market is adjusting to the entry into the market of multiple generic forms of competing cholesterol products. Despite the introduction of new innovative competing treatments and generic versions of competing products, Schering-Plough continues to anticipate that sales from VYTORIN and ZETIA will grow in 2007. The decisions of government entities, managed care groups and other groups concerning formularies and reimbursement policies could negatively impact the dollar size and/or growth of the cholesterol management market, including VYTORIN and ZETIA.

 

As Schering-Plough’s pipeline continues to progress, it expects that the number of patients in Schering-Plough’s clinical trials will increase substantially in 2007. Schering-Plough also will continue to invest in research and development with a focus on enhancing infrastructure and upgrading processes, systems and talent. As a result, Schering-Plough expects R&D expenses, excluding any upfront payments, will grow faster than adjusted net sales in 2007. Adjusted net sales is defined as net sales plus an assumed 50 percent of global cholesterol joint venture net sales. Schering-Plough believes that this growth comparison provides a useful guideline to review our outlook for R&D expenses.

 

As a result of Schering-Plough’s actions to streamline its manufacturing operations, Schering-Plough expects annualized cost savings of approximately $100 million in 2007, and gross margin should improve accordingly.

 

The risks described in Item 1A. “Risk Factors” could cause actual results to differ from the expectations provided in this section.

 

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which is effective for calendar-year companies on January 1, 2008. The Statement defines fair value, establishes a framework for measuring fair value in accordance with Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. The Statement codifies the definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The

standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Schering-Plough is currently assessing the potential impacts of implementing this standard.

 

In September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N (SAB 108), “Financial Statements — Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which is effective for calendar-year companies as of December 31, 2006. SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the financial statements are materially misstated. Under this guidance, companies should take into account both the effect of a misstatement on the current year balance sheet as well as the impact upon the current year income statement in assessing the materiality of a current year misstatement. Once a current year misstatement has been quantified, the guidance in SAB Topic 1M, “Financial Statements — Materiality,” (SAB 99) should be applied to determine whether the misstatement is material. The implementation of SAB 108 did not have any impact on Schering-Plough’s financial statements.

 

In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” Schering-Plough is required to apply the provisions of this interpretation beginning on January 1, 2007. The provisions of FIN 48 will be applied to all existing uncertain income tax positions on the effective date. Upon the implementation of FIN 48, the cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings. Although Schering-Plough is still evaluating the potential impact of FIN 48, upon the adoption of FIN 48, it expects a decrease to opening retained earnings as of January 1, 2007 from $225 million to $300 million with a corresponding increase to other accrued liability accounts upon the adoption of this Interpretation.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The following accounting policies and estimates are considered significant because changes to certain judgments and assumptions inherent in these policies could affect Schering-Plough’s financial statements:

 

 

Revenue Recognition

 

Schering-Plough’s pharmaceutical products are sold to direct purchasers, which include wholesalers, retailers and certain health maintenance organizations. Price discounts and rebates on such sales are paid to federal and state agencies, other indirect purchasers and other market participants such as managed care organizations that indemnify beneficiaries of health plans for their pharmaceutical costs and pharmacy benefit managers.

 

Schering-Plough recognizes revenue when title and risk of loss pass to the purchaser and when reliable estimates of the following can be determined:

 

i. commercial discount and rebate arrangements;

 

ii. rebate obligations under certain federal and state governmental programs; and

 

iii. sales returns in the normal course of business.

 

When recognizing revenue, Schering-Plough estimates and records the applicable commercial and governmental discounts and rebates as well as sales returns that have been or are expected to be granted or made for products sold during the period. These amounts are deducted from sales for that period. If reliable estimates of these items cannot be made, Schering-Plough defers the recognition of revenue. Estimates recorded in prior periods are re-evaluated as part of this process.

 

Revenue recognition for new products is based on specific facts and circumstances including estimated acceptance rates from established products with similar marketing characteristics. Absent the ability to make reliable estimates of rebates, discounts and returns, Schering-Plough would defer revenue recognition.

 

Product discounts granted are based on the terms of arrangements with wholesalers, managed-care organizations and government purchasers, and certain other market conditions. Rebates are estimated based on sales and contract terms, historical experience, trend analysis and projected market conditions in the various markets served. Schering-Plough evaluates market conditions for products or groups of products primarily through the analysis of third-party demand and market research data as well as internally generated information. Data and information provided by purchasers and obtained from third parties are subject to inherent limitations as to their accuracy and validity.

 

Sales returns are estimated and recorded based on historical sales and returns information, analysis of recent wholesale purchase information, consideration of stocking levels at wholesalers and forecasted demand amounts. Products that exhibit unusual sales or return patterns due to dating, competition including expected generic introductions, or other marketing matters are specifically investigated and analyzed as part of the formulation of return reserves.

 

Schering-Plough’s agreements with the major U.S. pharmaceutical wholesalers address a number of commercial issues, such as product returns, timing of payment, processing of chargebacks and the quantity of inventory held by these wholesalers. With respect to the quantity of inventory held by these wholesalers, these agreements provide a financial disincentive for these wholesalers to acquire quantities of product in excess of what is necessary to meet current patient demand. Through the use of these agreements, Schering-Plough expects to avoid situations where Schering-Plough’s shipments of product are not reflective of current demand.

 

Rebates, Discounts and Returns

 

Schering-Plough’s rebate accruals for Federal and State governmental programs, including Medicaid and Medicare Part D, at December 31, 2006 and 2005 were $115 million and $144 million, respectively. Commercial discounts, returns and other rebate accruals in the U.S. at December 31, 2006 and 2005 were $371 million and $378 million, respectively. These accruals are established in the period the related revenue was recognized resulting in a reduction to sales and the establishment of liabilities, which are included in total current liabilities, or in the case of returns and other receivable adjustments, an allowance provided against accounts receivable.

 

In the case of the governmental rebate programs, Schering-Plough’s payments involve interpretations of relevant statutes and regulations. These interpretations are subject to challenges and changes in interpretive guidance by governmental authorities. The result of such a challenge or change could affect whether the estimated governmental rebate amounts are ultimately sufficient to satisfy Schering-Plough’s obligations. Additional information on governmental inquiries focused in part on the calculation of rebates is contained in Note 19, “Legal, Environmental and Regulatory Matters,” under Item 8, “Financial Statements and Supplementary Data.” In addition, it is possible that, as a result of governmental challenges or changes in interpretive guidance, actual rebates could materially exceed amounts accrued.

 

The following summarizes the activity in the accounts related to accrued rebates, sales returns and discounts: