BITS > JUNE 2002

A Study of Pfizer on the Stock Selection Guide

Editor's note: As part of our salute to CompuFest 2002, BITS is pleased to present an educational feature that should catch the interest of many readers: a stock study by one of NAIC's leading SSG instructors. The company Mr. McManus uses in this illustration, Pfizer Inc., was the third most popular stock in this year's Top 100 Survey, and the company is featured as the Stock to Study in the June issue of Better Investing.

Comments and judgments that follow are those of Mr. McManus and not of NAIC or its publications staff. The article is presented for its educational value in illustrating NAIC stock study tools and techniques in action, with no investment recommendation intended. Readers are advised to do their own research and analysis of any company of interest before making an investment decision.

In the past few years, Pfizer Inc. has sprinted past others in the industry to become the leading pharmaceutical company. The current darling of Wall Street, Pfizer continues to produce spectacular revenue and earnings growth, making it an inviting possibility for NAIC investors. Recently, however, the company's P/E ratio has started to sag -- part of a trend within the pharmaceutical industry. While still valued more than its peers, is there something fundamental happening within this industry that we as long-term investors should be noting?

Pfizer is part of the pharmaceutical industry. While drugs and drug products compose only 9 percent of total healthcare spending in the United States, many of these products are truly lifesavers that lower cholesterol, stabilize the effects of diabetes and put the killer HIV virus on full retreat. The average American becomes a "customer" of the pharmaceutical industry at around age 42. Products address the aches and pains associated with aging. Most of the spending happens in the last few years of life, as products ease the transition into eternity.

The pharmaceutical industry has received a lot of recent attention. A number of events have occurred -- the human genome (the code for life) has been deciphered, for example, though it's not yet understood. Companies may now advertise directly to consumers, helping to accelerate the sale of their products. Blockbuster drugs such as Viagra, Vioxx and Lipitor have made important differences in people's lives. One important trend goes unpublicized, however: The R&D engine of the pharmaceutical industry is stalling, and stalling badly.

The number of new drugs -- not modifications or reformulations -- is stalling. In fact, while the spending on R&D has increased fourfold over the past 10 years, the annual number of new drugs (new chemical entities) has remained flat and is starting to decline. Perhaps the industry is headed for further consolidation. Unless the smaller players can create new blockbuster drugs (annual sales in excess of $1 billion), it's hard to see how they can sustain the $600 million to $800 million needed to bring a new drug to market.

The human genome experiment is really a triumph of modern science; however, it's unlikely to have a major impact on the pharmaceutical world for a few years. While the genome has been mapped, the real work will be in figuring out what it all means. Ultimately, drug companies will want "targets." A target is something that a company can use to screen drug candidates. For example, let's say there's a crazy protein produced in the body that starts a series of chemical reactions that ultimately trigger a cancer. The "target" is this protein.

Drug companies have hundreds of targets. When fully realized, the Human Genome Experiment is likely to present thousands more targets. Drug companies have libraries with many hundreds of thousands of potential drugs.

They also have highly automated systems for screening these libraries against new targets. Both the libraries and targets are growing all the time. Companies have an increasing challenge to ensure that effective drug candidates are brought forward into the very expensive drug development process. This process is complicated by the fact that as many as 10 percent of the molecules in a drug library might show some activity against a target. If a library has 1 million compounds, having 100,000 candidates is untenable. Drug companies are forced to come up with clever schemes to reduce this number substantially. Ultimately, only one "hit" can be a marketable drug.

This process often seems more an art than a science. Pfizer is a company that appears to be doing something right. With eight drugs having sales in excess of $1 billion per year, the company seems able to sort out which candidates are truly drugs. Pfizer also seems to possess an excellent sales and marketing team, which helps sell not only its in-house offerings, but also drugs licensed or comarketed with partners. It's not surprising that an increasing number of NAIC members have Pfizer in their portfolios.

The information used in this analysis was obtained from the Online Premium Service available through NAIC. This truly excellent service makes preparing an SSG very easy -- at least the drudgery of number crunching is simplified. But the challenge of judgment can remain as daunting as ever.

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Figure 1. Front side (Section 1) of Hugh McManus' SSG study of Pfizer Inc.

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Figure 2. Back side (Sections 2-5) of Hugh McManus' SSG study of Pfizer Inc. Download PDF for full-size SSG.

Studying Pfizer on the Stock Selection Guide

(See Figures 1-2)

Sales: Pfizer has maintained remarkably consistent growth in sales over a 10-year period. The merger with Warner-Lambert explains a discontinuity in 1999 to 2000. The compound annual growth rate from 1992 to 1998 is around 18 percent -- a very respectable number. If the results for 2000-2001 are excluded, the growth rate becomes 12.6 percent. In fact, the growth rate slows from 2000 to 2001 becoming 8.5 percent. The recent quarterly figures also support a slight decline in growth; the percentage change is 11.4 percent. This figure is lower, but it's still quite respectable.

The overall growth rate in the pharmaceutical market is 6 percent to 10 percent. A growth rate of 18 percent going forward may be difficult to sustain. The average annual percentage change in quarterly growth is around 9 percent. Revenues grew at 8.5 percent from 2000 to 2001. While these figures are lower than the 10-year average growth, a conservative choice for future growth would be 9 percent to 10 percent. I selected a projected annual sales growth rate of 10 percent. (Figure 1)

Earnings per share (EPS): The growth in earnings has been stellar. With a minor drop in 1993, Pfizer has a compounded annual growth rate of around 20 percent in its bottom line -- truly a remarkable number. The preferred procedure -- which projects future earnings from sales -- is often a better way to determine expected earnings, and that's what I used in this study. At a growth rate of 10 percent, the projected value of sales in five years is $51.7 billion. The other estimates required to use the preferred procedure follow.

The 10-year average pre-tax profit margin is 22.5 percent. If outliers -- the highest and lowest PTP numbers -- are excluded, the average of the remaining eight is 22.7 percent -- not that different. If this process is taken one step further, with the highest and lowest pair of PTP margins excluded, then the average of the remaining six years is 22.5 percent. All in all, while the profit margin has bounced around, the overall trend appears to be relatively stable. Going forward I used a margin of 22.5 percent.

Projecting tax rates is a complicated business. In fact, corporate tax planning and accounting are extremely complex subjects. Over the past 10 years, Pfizer has had an annual tax rate of 28.5 percent. The tax rate has fluctuated, rising after the merger, falling when earnings drop. Using the method outlined above, an indication of the overall stability can be determined. Excluding outliers, the middle eight years have an average of 28.4 percent; the middle six years show the same result. Going forward I used a projected tax-rate of 28.5 percent.

Pfizer does not pay preferred dividends, so the next figure to determine is the number of shares that are likely to be outstanding in five years. Following the merger with Warner-Lambert, the shares outstanding jumped dramatically. A better way to determine the policy regarding issuance of shares is to examine what happened between 1992 and 1999. The number of shares outstanding does not fluctuate greatly. Nor is there any strong trend in the data. Going forward the projected number of shares should not be significantly different from the current number outstanding. For this reason, I used a figure of 6 billion for future shares outstanding.

With these figures, the preferred procedure results in projected EPS in five years of $1.39. The annual growth rate implied in this figure is a paltry 1.1 percent. (see Figure 1) This figure might appear low, but let's continue the analysis to see what the market thinks.

Part 2 of the SSG (see Figure 2) can be quite revealing. Both the pre-tax profit margin and the return on equity (ROE) have trended up in recent years. The ROE showed a stellar 45 percent for 2001. This number is way outside the industry norm and is unlikely to be sustained going forward.

The overall 10-year average is around 30 percent; this figure doesn't change much if outliers are excluded. Both the ROE and pre-tax margin are well-behaved. Management is doing something right, which buoys confidence for the future.

While Parts 1 and 2 in the SSG study the fundamentals of a company, Part 3 provides insight into the thoughts of investors. The P/E ratio is simply the price the market is willing to pay per dollar of earnings. Parts 3D and 3E in the SSG show that there is wide variation in this opinion over the course of a year. The challenge faced in this section is to select a value for the P/E that can be used to predict the future price of a stock.

Like many companies, Pfizer experienced P/E inflation during the late 1990s. A quick examination of the PMG chart (Portfolio Management Guide, not shown) for Pfizer shows that the P/E has in fact been falling over the past few years.

As an aside, the PMG can be a great reassurance that things happen in cycles -- P/Es certainly do. The P/E for Pfizer was really high in the late 1990s. It has now settled down. The PMG chart bears a caution that high P/E levels do not continue forever. Whenever one gets impatient about a high-flying company, take a look at the PMG chart. It really makes the old adage "patience is genius in disguise," worthy of elevation as the fifth NAIC principle.

The high P/E was almost 70 in 1998; the figure has settled down to a more reasonable 36 in 2001. The low P/E shows a range from the mid-20s in 1997 and 2001 to over 38 in 1998. The average high and low P/Es are 52 and 31, respectively. While 50 seems high -- and perhaps not sustainable in the long term -- 30 also looks like a large number for a low P/E.

Projecting P/Es is really an effort to determine how other people will value a stock and whether you, the analyst, are comfortable with that projection. Keep in mind that investors do wild things. We saw that up close during the Internet craze; we're currently seeing perfectly good companies getting hammered. When it comes to the market, extremists rule and moderates profit.

Pharmaceutical companies are all about news, good and bad. Pfizer will see good times ahead; analysts will be happy and there will be buyers of the stock. The P/E will adjust up accordingly. Conversely, when news is bad, the P/E will sag. Since the five-year average high and low are above normal, in this analysis the high will be reduced by 20 percent. When rounded, the result is a high P/E of 40 and a low of 25. The levels reflect the valuation the market often affords these highly profitable companies, while throttling back on the levels seen in the past few years.

Using these projected high and low values for the P/E, the resulting price range becomes $33 to $56. The current price of around $37 falls in the lower part of this range.

The rest of the SSG falls into place quite nicely. The analysis puts Pfizer in the buy zone. Frankly, when Part 1 of the SSG was completed, this result was unexpected. Such an anemic growth in earnings over five years seldom yields an attractive opportunity. Pfizer appears to be an exception. It's great when good companies go on sale; it's even better when the analysis carried out is conservative.

The upside/downside ratio is a comfortable 5-to-1. We're basically saying that the price is likely to fall somewhere in the $33 to $55 range during the next five years. If the stock were purchased at the current price of $36.50, there is five times as much upside potential as downside risk. Anything better than 3-to-1 is good -- as long as it doesn't get too high, like more than 10-to-1. Then figures should be checked, especially the low price estimate.

Both the current and projected relative values are around 66 percent. Here, we're conducting a comparison of the current with the average P/E ratio that was calculated in Part 3. Keep in mind that this average includes the heady days of the late 1990s when P/E ratios were very high. The historical average P/E ratio might be inflated slightly, which in turn reduces the relative value. Nevertheless, this figure is probably a good one.

Generally speaking, if the relative value gets below 90 percent, certainly lower than 80 percent, a good investor should start to ask questions. Clearly 67 percent is low; however, one can become comfortable with this figure because Pfizer is good company with a solid balance sheet and a pipeline and current portfolio of drugs and drug products that should sustain its growth.

Finally, Part 5 of the SSG -- the part that often, sadly, gets overlooked -- throws a monkey wrench into the analysis. Part 5 gives the bottom line --will this investment double in value over five years? The calculation includes both capital appreciation based on the projected stock high price and projected dividend payments. Part 5 shows that the annual rate of return is a shade over 10 percent; we're really looking for a company that returns around 15 percent per annum. Pfizer doesn't quite fit the bill.

So, this is where you get to do some homework. Clearly, Pfizer is a very interesting company right now. Its current stock price makes it an inviting candidate for purchase. This analysis took an extremely conservative position, however, when it came to predicting projected earnings. The rationale was spelled out in detail.

Do you agree with the method and the result? For those attending CompuFest in New Orleans, let me suggest that we have an informal get together at an appropriate waterhole -- maybe on Friday evening -- and discuss Pfizer. I will encourage a few people like Mark Robertson to come along, too. It should be quite an educational session.