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Tickers in this Article: BAY, PFE, MRK, SGP, JNJ, BMY
Which large pharmaceutical stock has performed best over the past five years: Pfizer (NYSE: PFE), Merck (NYSE: MRK), Schering Plough (NYSE: SGP), Bristol-Myers Squibb (NYSE: BMY), Johnson & Johnson (NYSE: JNJ)? Not even close. The big performer in big pharma has been Bayer AG (NYSE: BAY), the Germany-based manufacturer of the eponymous pain reliever and much more.

Headquartered in Leverkusen, North Rhine-Westphalia, Bayer is the holding company of the Bayer Group, which encompasses over 280 businesses, including pharmaceuticals, diagnostics, agricultural products and polymers. The largest segment, healthcare, accounts for 45% of revenue and consists of pharmaceuticals (27% of total revenue) and consumer health products (18%).

Front and Center
The segment's prominence will surely grow in coming years after Bayer's purchase of Schering AG (no relation to Schering-Plough) for 16.5 billion euros in 2006. (Note: all figures in this article are for euros unless otherwise stated)

The Schering purchase fits Bayer's master plan to become a stronger competitor to rivals GlaxoSmithKline and Novartis and lessen dependence on its more cyclical chemicals divisions.

The new Schering-enhanced pharmaceutical business will sport the moniker Bayer Schering Pharma AG and is expected to produce $12 billion in sales this year, with eventual synergies expecting to strip $700 million from annual costs by 2009.

The Schering purchase is already paying dividends. Bayer reported a solid first quarter 2007, with revenue rising 23% to $8.3 billion and net income soaring to $2.8 billion from $600 million from the year-ago period. As expected, the healthcare segment posted the strongest growth, producing revenue of $3.6 billion, boosted by a $1.4 billion contribution from Schering. Net operating cash flow increased to $1.65 billion, or 47.31%, when compared to the same 2005 quarter.

Expanding Margins

Despite the whirlwind of activity, Bayer continues to improve margins. On that front, the company believes margins for healthcare will increase to 24% in 2007, up from 22.3% in 2006. Overall margins should be helped further by a restructuring in the crop science segment that is expected to produce annual savings of $300 million by 2009.

For 2007, revenue is projected to grow to $33.7 billion, including a full-year contribution of the mid-2006 acquisition of Schering and ongoing sales growth of 5%. Earnings before interest and taxes (EBIT) are expected to increase to $3.35 billion, up from $2.76 billion in 2006.

Powered by strong earnings growth, Bayer's stock has surged ahead another 57% over the past 12 month, easily outperforming both the S&P 500 and AMEX Pharmaceutical indexes.

More of the Same
Any stock can fall, especially after such a strong advance; however, in almost any business environment (excluding a depression, of course), Bayer should continue to thrive.

The Schering acquisition will continue to strengthen Bayer's healthcare business, while divestitures of several non-core businesses will allow management to focus on more profitable segments (pharmaceuticals and consumer health products). Sales of these businesses are expected to generate after-tax proceeds of $5 billion, which will be used to repay debt.

Bayer has demonstrated an enviable pattern of earnings-per-ADR growth over the past two years, which I believe should continue into the relevant future. During the past fiscal year, Bayer increased its earnings-per-ADR to US$2.67 from 2005's US$2.22. This year, earnings-per-ADR is expected to nearly double to US$4.52.

Based on Bayer's expected earnings-per-ADR growth, I think the ADRs remain a 'buy'. Based on the forward estimate of US$4.52 coupled with an average P/E multiple of 17.5, a 12-month price target of US$80 seems entirely reasonable.

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