Pfizer Inc. (PFE) is the world’s largest pharmaceutical firm and has 9 different drugs classified as “blockbusters” by their more than $1 billion in sales per year. However, they will lose patent protection on the world’s best selling drug, Lipitor, in late 2011 which will greatly diminish sales of the cholesterol treatment. With Lipitor accounting for more than one-fifth of the company’s revenue in the last year, investors are reasonably concerned about their ability to replace such a huge portion of sales.
The company is pouring money into its research and development department in order to replace this key revenue stream, and Bloomberg television interviewed Martin Mackay, president of pharmaceutical research for Pfizer, about the firm’s pipeline. As you might expect, Mackay was extremely optimistic about their pipeline with more than 500 ongoing projects and 26 drugs in phase III trials, and he went as far as to say, “We’re in the golden age of drug discovery.” However, he also alluded to the company’s strategy will diversify away from such a heavy reliance on drug development,
“The strategy at Pfizer is to be a very solid growing company, albeit with single-digit growth, and be a diversified company which not only has pharmaceuticals and new pharmaceuticals coming out of R&D, but nutritionals, consumer products, animal-health products, and the like,” Mackay said. — Bloomberg.com 4/7/2010
Since selling its consumer healthcare business to Johnson & Johnson (JNJ) in 2006, Pfizer has seen an ever higher dependence on its pharmaceuticals division, which accounted for 91% of sales in 2009. The acquisition of Wyeth last year not only strengthened Pfizer’s pharmaceutical pipeline, but also gave them strong over the counter products like Advil and Robitussin as well as ChapStick. Building their non-prescription drug businesses seems to be a goal of Pfizer’s, but at this point none of these products would come close to filling the $11.4 billion hole left by Lipitor. Even after completing the acquisition of Wyeth, drug sales are the undeniable engine of revenue growth. PFE investors, above all else, must have faith in their pipeline of upcoming drugs. It will likely require at least two if not more of these drugs to be approved and achieve strong, blockbuster-type sales in order to maintain revenue at current levels.
We believe the market’s uncertainty about PFE’s revenue and earnings expectations post-Lipitor have kept the valuation a little bit depressed. However, remember that Lipitor does not go off patent for about 18 months, and sales are expected to grow in this fiscal year to $68.1B. And with a little over 8 billion shares outstanding, revenue per share of $8.44 gives the company a price-to-sales valuation of 2.02x, which compares favorably to PFE’s historically normal range of 3.4x to 5.0x. Similarly, price-to-cash earnings have historically ranged between 12.1x to 17.8x, but the current level of price-to-cash earnings is only 10.3x. With Pfizer selling well below its historically normal valuation ranges, we would expect a price of $20 to $25 to be much more befitting of the current fundamentals. All of this is to say that accordingly to our methodology, Pfizer is Undervalued.
Are their risks in investing in Pfizer? Of course, the loss of patent protection for Lipitor is one issue, and no one knows how well their pipeline drugs will be able to pick up the slack. However, this problem is nothing new to Pfizer’s management and they have worked to diversify their business and they expect to discover other drugs with growth potential. Other risks include the unknown effects that healthcare reform will have on drug companies. Will the government assume more control on pricing of drugs and constrict profits? Or will the greater number of insured prove a benefit to drug companies. There are still many details up in the air regarding the new healthcare system, and Pfizer and other drug companies may be affected on way or another.
There is no doubt that this stock has been woefully disappointing to investors over the last decade down 60% in that time; all the while the company has continued to consistently grow fundamentals. This is precisely the kind of company that we like to find at Ockham, as it is unloved by the market despite strong growth. We think the downside of Lipitor has already been at least somewhat recognized in the price, and thus the downside is limited. Pfizer offers an attractive valuation, and long term investors will receive one of the industry’s most attractive dividends as they wait for the market to realize the underlying value.