Dueling Fools A Duel Over Pfizer
Bull Argument

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Dueling Fools
By Mike Trigg (TMF Tonto)
July 18, 2001

Pfizer (NYSE: PFE) has spent the past 150 years researching and developing ways to cure illnesses, but many don't know its efforts go way beyond that. With the introduction of Viagra in 1998, the company began "raising the dead" from a long, dark winter, but its most noble contribution -- in my mind -- deals with former heavyweight boxing champion Mike Tyson. 

"I'm on the Zoloft to keep me from killing y'all," Tyson told reporters in a news conference last year to promote a fight versus Polish boxer Andrew Golota. "It has really messed me up, and I don't want to be taking it, but they are concerned about the fact that I am a violent person, almost an animal," he continued. "And they only want me to be an animal in the ring."

Tyson's comments were great free advertising for Pfizer's leading anti-depressant drug, which had $2.1 billion in sales last year, but there's more to the world's largest pharmaceutical company than boxing and impotence. The characteristics of the pharmaceutical industry are very attractive. While upfront costs for researching and developing drugs are high, manufacturing and selling costs are quite low, resulting in extremely high profit margins.

Pharmaceuticals are also a repeat-purchase business, which means predictable and recurring revenue. In almost all cases, illnesses don't go away with one or two pills. Patients are placed on medication for several weeks at least, and oftentimes for years or even the rest of their lives.

The industry should also benefit from favorable demographic trends. The percentage of people over 65 is expected to exceed 20% of the U.S. population by 2010, with similar trends repeating around the world. This is significant because people over 65 use three to four times more prescription drugs than people in their 30s, and purchases made by the former account for 34% of healthcare expenditures.

I could go on about the pharmaceutical industry, but as Rick would point out, this duel's about Pfizer. Johnson & Johnson (NYSE: JNJ), Merck (NYSE: MRK), Eli Lilly (NYSE: LLY), Schering-Plough (NYSE: SGP), and others also benefit from these characteristics. What's different about Pfizer, however, is that it has a more diversified revenue base than its peers.

In fact, Pfizer had eight different drugs with more than $1 billion in revenues last year. The largest sales force in the world and an R&D budget that dwarfs the competition accompany that industry-leading portfolio. Last year, Pfizer spent $4.4 billion on R&D, compared to Johnson & Johnson, Merck, and Eli Lilly, which spent $3.1 billion, $2.3 billion, and $2 billion, respectively. 

The company's potently profitable drugs have little patent exposure as well, something much of Pfizer's competition can't claim. Five of Merck's best-selling drugs are expected to lose their patents this year, for example. True, any drug can be outdone by a new product, but this low exposure to generics leaves it well positioned. Drugs with long patent lives include Zithromax (2005), Zoloft (2005), Norvasc (2007), Lipitor (2010), Viagra (2011), and Celebrex (2013).

Still, pharmaceutical companies are only as good as their upcoming drugs. With its R&D spending expected to exceed $5 billion this year, it's easy to understand why Pfizer's pipeline is locked and loaded. Phase III (60% chance of approval) and registered drugs with the potential to benefit its results significantly include Exubera (inhaled insulin), Valdecoxib (pain, arthritis), ONYX-015 (liver cancer), and Remune (HIV vaccine).

Truthfully, the Duel's space constraints don't permit a complete review of Pfizer's pipeline, but I think Rick would agree there's little weakness in this area. Instead, he'll probably form his argument around the company's valuation, which is well above the rest of the industry. Pfizer currently trades at 42 times this year's earnings, in line with its five-year average of 41 times. 

Pfizer closed last week at $38.43 per share, leaving it with a market cap of $242.6 billion. Looking at the numbers, I'm not sure the stock can double in five years. Instead, given its history of strong fundamentals, we might be best served to treat the company like a bond that posts 10% annual returns, putting Pfizer's market cap at $390.7 billion in five years.

For the analysis, let's assume Pfizer will have a net margin of 26% in five years. Currently, its net margin is 20%, but some Wall Street analysts expect the figure to reach 28% by 2004. The company has been cutting costs since its merger with Warner-Lambert. It delivered $400 million in savings last year, and in 2001-2002, the company originally forecasted savings of $1 billion and $1.2 billion, respectively, but has since revised those figures to $1.2 billion and $1.6 billion.

With these assumptions, let's take a look at what level of sales growth will be necessary for Pfizer to achieve 10% annual returns at various future P/E multiples:

Projected P/E          40       35     30 
Year 5 Earnings ($B)   9.76   11.16   13.02 
Year 5 Revenue ($B)   37.56   42.93   50.09 
Growth Rate for 10%    4.5%    7.4%   10.7% 

To appreciate 10% annually the next five years, Pfizer needs $9.76 billion in earnings in year five, growing its top line 5% annually. That seems very achievable, given the company's current drugs have little patent exposures and its pipeline is loaded. Then again, we've assumed a P/E of 40, which is in line with its five-year average. With a P/E of 35, it would need to grow its top line 7%, which still seems achievable, given the company's strong portfolio of current and potential drugs.

At the current price, it's clear the rewards for investing in Pfizer outweigh the risks. The company appears fairly priced for 10% annual returns, it has leading drugs with little exposure to generics, and its pipeline leaves it well positioned for future growth. If that's not enough, you now also know the company is responsible for keeping convicted felon, crazed boxers at rest.

Mike Trigg owns shares of Pfizer, but hates taking medicine. His other stock holdings can be viewed online, as can The Motley Fool's disclosure policy.

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