The case for Pfizer
Courtesy of Vitaliy Katsenelson, at Contrarian Edge
I understand why investors don’t want to own Pfizer (PFE); there is little excitement in the stock:
- It is down significantly from the Viagra-high it reached in 1998. Yes, Pfizer is the maker of Viagra, the drug that spawned a slew of commercials that made TV unwatchable (especially if you have little kids who ask you if they or you need this medicine that makes people on TV hug each other, or ask you “What is reptile dysfunction?”).
- Pfizer’s earnings have not gone anywhere for years.
- As with almost anything medical-related, Pfizer is exposed to the political risks of Washington DC.
- Finally, it is facing patent expirations of its major blockbuster drugs like Lipitor ($12 billion of sales) and a few others that will hinder PFE’s future growth for years.
There is not much one can do about TV commercials except cancel cable or watch less TV (I did both). Nor there is not much one can do about the stock-price decline over the last ten years – maybe the only thing to do is learn not to buy hype; after all, Pfizer was trading at over 50 times earnings in the late ’90s.
I don’t want to dismiss the political risk, but it seems that due to extensive lobbying efforts by pharmaceutical companies, political risk has turned into only a slight inconvenience. Pharma companies have agreed to $80 billion of price concessions over the next ten years, but at the same time they’ll benefit from a larger customer base, as more people will have access to health insurance.
Instead of being mesmerized by huge drug expirations, we can do the value-investor kind of thing – estimate the impact of drug expirations on PFE’s cash flows and value the stock using discounted cash-flow analysis based on these assumptions.
So let’s value Pfizer:
No New Drugs Scenario: At the end of 2009 Pfizer acquired Wyeth (WYE), a large pharmaceutical company. I’ll address this very important acquisition in a bit, but first, let’s look at Pfizer on a pre-Wyeth basis. The fewer optimistic assumptions we use, the less likely the future will disappoint us. Applying this logic, let’s assume that soon after a drug-patent expiration, as the generic version hits the market, revenue from that compound declines 90% and stays at that level indefinitely. So, for instance, Lipitor’s revenues would drop off from around $12 billion to $1.2 billion after its patents expire in 2011.
Let’s also assume that the $8 billion Pfizer spends on R&D is completely wasted, and that over the next 5 years Pfizer will not come up with a single new drug. We estimated and discounted Pfizer’s cash flows over next five years. Based on these assumptions , it is worth about $15-18 a share. The difference in this range is accounted for mostly by assuming various inflation rates (price increases) on existing drugs.
Wyeth Acquisition Was a Stroke of Genius: Pfizer took advantage of the financial market meltdown when it offered to buy Wyeth in the spring of 2009. PFE paid $60 billion for a company with earnings of about $4.5 billion, or about 13 times earnings. This is a very attractive price, considering that historically acquisitions in this industry have been done at much, much higher valuations (i.e., P/Es in the high teens and low twenties).
There are plenty of redundancies between the two companies in manufacturing, sales force, etc., so Pfizer is expected to save $4 billion on cost redundancies in three years, but even if costs savings are half what Pfizer expects, earnings power of the combined entity has increased by $6.5 billion ($4.5 billion from WYE’s earnings and $2 billion from cost savings). In other words, Pfizer’s actual acquisition valuation of Wyeth was less than 10 times earnings – incredibly cheap!
It Gets Better: Pfizer bought an asset (Wyeth with added cost savings) that had an earnings yield (the inverse of the P/E of 10) of 10% and financed a third of it with stock, a third with debt issuance, and the rest with its own cash. Though PFE’s stock was undoubtedly cheap (not an ideal currency for acquisition), billions of dollars of cash on its balance sheet were earning the company almost nothing; also, it was able to issue debt with an after-tax cost close to 4%. This combination of Wyeth’s bargain-basement purchase price and advantageous financing has created about $4 a share of value for Pfizer’s shareholders.
I have to admit, at first I was skeptical of the Wyeth acquisition – $60 billion is a lot of money, even for Pfizer; and historically, huge acquisitions have rarely solved companies’ problems or created shareholder value, in large part because companies overpaid for their targets, but that is not the case here.
The Bottom Line Is This: If Pfizer (including Wyeth) doesn’t come up with a single new drug, after spending $11 billion on R&D (Wyeth spent $3 billion a year), Pfizer’s stock is worth between $19-22 a share, based on discounted cash-flow analysis.
New Drugs Are Free: Drug discovery is not a linear process – serendipity, perseverance, and financial might are the essential ingredients required for success in this costly endeavor. Pfizer has the latter two; the first one is an act of God kind of thing. But we are not buying this stock and praying: Pfizer has 100 drugs under development, 25 of which are in late-stage (phase 3) trials. Wyeth has an additional few dozen drugs in the pipeline, as well as 7 drugs in late-stage trials.
I have no idea what drugs will be successful, but I don’t have to because, first of all, we are not paying for them, since today’s stock price discounts no new drugs. Second, though it is human nature to believe that "Everything that can be invented has been invented," as (a fictional) patent office official believed when he submitted his resignation in the late 1800s, that is unlikely to be the case.
Here Is How We Look at Pfizer: Pfizer also fits the profile of a stock that should do well in our steroidally challenged economy, as its revenues are unaffected by economic cyclicality. In case of inflation it has significant pricing power to pass cost increases to consumers (yes, and even the government). In case of deflation it should be able to maintain prices, and its ample cash flows will allow Pfizer to pay off its debt in a few years, if it chooses to. It is priced like a very safe bond with an embedded nonexpiring, free call option, yielding 4%. If Pfizer doesn’t come up with a single new drug its price will not change much; it will be where it is today. Any new drugs are just an added bonus.
Disclosure: own Pfizer
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.
Vitaliy Katsenelson, CFA
Investment Management Associates, Inc.
