Last fall, I wrote a series of articles about Pfizer (NYSE: PFE) in which I raised some concerns about the way it runs its business and the numbers found in its financial statements. (You can find links to all of those articles at the bottom of tonight's report.) I have been trying for some time to speak with Pfizer in more detail about these issues. One night last week, Matt and I finally got a chance to talk with the following three representatives of Pfizer: James Gardner, VP of Investor Relations; Ron Aldridge, Director of Investor Relations; and Rick Hoddeson, VP of Operations Planning & Analysis.
In tonight's report, I'll go over some of the issues we discussed related to Pfizer's management of its working capital (current assets and current liabilities), as well as its revenue growth. In subsequent reports, I'll also share with you the other things discussed during our conversations.
The first two issues we spoke about were the significant impact that alliance revenues have had on Pfizer's overall growth rate and Pfizer's working capital management. In 1999, Pfizer grew its overall revenues by 20%, which is quite an impressive rate. Pfizer has been investing heavily in the discovery of new products, so if you take this number at face value, it looks like these efforts have been very rewarding. However, if you dig a little deeper, you'll see that revenues from alliance products -- such as Monsanto's Celebrex and Warner-Lambert's Lipitor -- heavily influence Pfizer's revenue growth. In 1999, alliance revenues grew by 139%. The revenue from products developed in-house by Pfizer grew by only 9%.
Of course, we've invested in Pfizer for the long haul, and thus the normal reaction is that something which happens over the period of a year is often no great shakes. But, what we do need to investigate is whether the alliance revenue situation is part of a long-term trend or merely a short-term event.
During the call, we discussed whether the slow growth of in-house products should be a concern, as well as some of the reasons for it. Pfizer argues that the number of blockbuster products it has (i.e., those with sales over $1 billion) is the highest in the industry. In addition, five of Pfizer's seven blockbuster products are growing at a rate in excess of 10%. What was not answered was my question about what it is that's keeping the overall rate of revenue growth for Pfizer-developed products to less than 10%. A look at the numbers for 1999 indicates that it appears to be caused by slower growth related to consumer healthcare products, animal healthcare products, and Procardia XL, a drug for hypertension that has seen declining sales largely due to Pfizer's release of Norvasc. It should be noted that on a combined basis, sales of Norvasc and Procardia XL grew by about 11% last year.
Pfizer says that its alliance revenues are an example of the company drawing upon and leveraging products that it did not develop itself. The cash outlay for these products in terms of research and development (R&D) is not as significant as it is for internally developed products. It also does not record cost of sales for these products, which means they have very high gross margins. The company did state, however, that the time it takes to collect these revenues is a negative.
The other thing that Pfizer stressed during this part of our conversation was that growth to both its top line (revenues) and its profitability (earnings) is what matters. The company's view is that the income statement is the most important financial statement. They said that's what its investors look at first. The investors that Pfizer is referring to in this context are the Wise and institutions.
I don't agree. I'm a Pfizer shareholder, and I have a different way of looking at things. I believe in emphasizing the long-term over the short-term. I'd be willing to suffer some short-term pain for long-term gain.
You see, when I took my first accounting course, one of the things I learned was that the essential purpose of a company is to increase shareholder value. Unfortunately, I don't think Pfizer is maximizing long-term shareholder value with its primary focus on managing top- and bottom-line growth. Managing a business so that all it does is produce bottom-line earnings is not the be-all and end-all. There's much more to the story than that.
While Pfizer admitted that there is merit in the cash flow approach to looking at the business (and that they see its importance increasing in the future), they are much less interested in emphasizing cash flow because it's not the measure that the Wise are concerned about. The sad part of this is that while there may be some short-term gain, over the long haul, better working capital management will most likely lead to higher earnings anyway.
What's clear to me from our conversation is that the way Pfizer runs its business is geared toward what it thinks the "market" wants: growth in earnings. Working capital management is not as important as the company's main objective: growing earnings. Pfizer's goal is to maintain its industry-leading bottom line growth by making sufficient investment to sustain that growth. I think that as Foolish shareholders, one of our goals should be to work with Pfizer to change its attitude so that the company will choose to run its business in a way that adds the most long-term value.
Pfizer also said that the balance sheet imposes limitations on the measurement of working capital and cash flow. The problem is that a balance sheet is merely a snapshot of how the company looks at a point in time. One of the things that can happen is that alliance revenues and the related receivables may be booked at the end of the quarter and then the collection takes place the next month.
Pfizer also said that it could easily make its balance sheet look better if it decided to have its goods toll manufactured (this means that another firm makes the goods for Pfizer), but it would realize less profit from this arrangement, lowering its gross margin. Pfizer also suggested a different way to evaluate its asset management. Here's the formula:
Net Income + Depreciation + Amortization
Accts. Rec.+Prop., Plant & Equip.+Intang. Assets
Out of curiosity I calculated this ratio for both Pfizer and Schering-Plough (NYSE: SGP), our other pharmaceutical holding, and found the two companies to be pretty similar in this regard for both 1999 and 1998. Since I'm not familiar with this formula yet, I can't say much else about it. But, I'll look into it some more.
We ended this part of our conversation with Pfizer saying that they are conscious of the working capital management issues I've raised. They expect there will be a greater emphasis on these numbers in the future as the financial reporting rules are expected to place a greater emphasis on cash earnings. In addition, as the merger with Warner-Lambert (NYSE: WLA) draws closer to closing, the two parties will work together to put in place a "best practices" model.
As a Rule Maker investor, I hold out hope that these best practices will focus on the policies of Warner-Lambert. I received a copy of the merger proposal along with my Pfizer annual report. Since the merger proposal included some pro forma consolidated financial statements, I calculated the Rule Maker metrics for Pfizer with and without Warner-Lambert. Here are the results from the balance sheet:
Pfizer/Warner
Pfizer Pro Forma
Rule Maker Criteria Only Results
9) Cash-to-Debt Ratio 0.80 0.72
10) Flow Ratio 1.61 1.42
The reason for the decline in the cash-to-debt ratio is that the pro forma financials include $1.8 billion of debt that resulted from the payment that Warner had to make to American Home Products (NYSE: AHP) after backing out of their merger. As you can see, the Flow Ratio improves nicely under the combined entity.
That's all that we have time for tonight. Although it may be interrupted by the earnings releases of some of our stocks, I'll share the rest of our discussion with Pfizer in future columns.
Phil Weiss (TMFGrape on the boards)
