FOOL ON THE HILL
Pfizer's Flat Four Years

At $36, Pfizer's stock is flat with prices reached four years ago, but all the while, earnings have grown annually. So, is the stock a good value now? At 26 times projected 2002 free cash flow, it doesn't look inexpensive, but for a company expected to grow 20% this year, it's a much better deal than most S&P 500 companies.

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By Jeff Fischer (TMF Jeff)
June 21, 2002

Pfizer (NYSE: PFE) trades at $36 today. It traded at $36 in 1998. Even accounting for the company's $115 billion acquisition of Warner-Lambert two years ago, and the subsequently higher market cap, the stock hasn't moved up in four years. Even while earnings have grown. And grown.

Pfizer soared from 1994 to 1998, rising about eight-fold. The stock was due for a rest. But the stock hit the afterburners and rose even higher in early '99 on the heels of Viagra. Then it was really due for a rest. And it has.

Earnings have grown by double digits annually since 1998, but the stock has declined. The 70 P/E that Pfizer touched four years ago has taken a long time to deflate. But it has.

Now the stock's P/E is 27 -- as low as it's been in five years. The stock trades at 22.7 times this year's earnings estimate, and 19.8 times 2003 estimates. And, unlike most technology companies, those estimates aren't wild stabs in the dark. They'll likely prove accurate. Management projects at least 20% growth this year and 15% annual growth the next two years.

So, at this price, is Pfizer finally a good value?

Valuation is about Free Cash Flow 
Free Cash Flow (FCF) is income from operations minus capital expenditures (found on the cash flow statement). Free cash flow is the lifeblood of a company. Pfizer had $7.03 billion in free cash flow last year. The company has an Enterprise Value (EV) of $220 billion. That gives Pfizer an EV/FCF ratio of 31.4. This is more meaningful than the 27 P/E.

Johnson & Johnson (NYSE: JNJ) had $7.1 billion in 2001 free cash flow. At $55 per share, it has an enterprise value of $160 billion. J&J trades at 22.6 times its FCF. It's expected to grow 16% this year, compared to more than 20% growth at Pfizer. Still, Pfizer, at 31.4 times FCF, looks much more expensive.

Let's run a discounted cash flow model on Pfizer assuming an 11% discount rate, which means that we hope to earn at least 11% annually on our investment. We know Pfizer's expected growth rate the next three years. After that, we'll aim to be moderate -- not aggressive and not overly conservative. (Please see past columns to learn about running Discounted Cash Flow (DCF) models.)

Year    FCF Est.    Est. Growth    Discounted Value
      in billions   year-o-year       at 11% rate
1 ('02) $8.40B         20%               $7.56B
2        9.66          15%                7.84 
3       11.10          15%                8.16
4       12.43          12%                8.18
5       13.79          11%                8.18
6       15.30          11%                8.18
7       16.98          11%                8.18
8       18.67          10%                8.10
9       20.35           9%                7.95
10      22.18           9%                7.81

First stage value.......................$80.14 billion

Were Pfizer to stop operating in 10 years, after achieving the growth outlined above, it would create current value of $80.14 billion at our 11% discount rate. But Pfizer won't disappear in 2012, so we need to add a continuing valuation factor. If we assume Pfizer can grow 9% in year 11, we get another $24.17 billion in year 11 value.

To find the company's continuing value, we assume nine years more growth (at 9%) and then discount that to present value. We reach $109.89 billion in continuing value. We add this continuing value to our 10-year first-stage value. So, $80.14 billion plus $109.89 billion = $190.03 billion. Divide that by Pfizer's 6.24 billion diluted shares outstanding and we arrive at $30.45 per share.

Thus, according to the model, we would want to pay around $30 to $31 per share if we hope to earn at least 11% annualized "indefinitely." (With a similar conclusion in 1999, we called Pfizer a decent value when it was at $32.)

Obviously, these models have many flaws. One large flaw is that they assume a very certain growth rate when the future is anything but certain. Therefore, DCF models are best used as a general guideline -- as just one of many general tools to consider in your buy and sell decisions.

With Pfizer at $36, I'm not selling. I own shares in a Drip, and I will in fact consider buying more when I have money to invest for five years or more. Meanwhile, I'll be watching the company's future potential very closely, via its drug pipeline.

The pipeline is the only promise
Pfizer needs to get several new blockbuster drugs to market by 2006. It must do so in order to maintain a strong growth rate, especially as old blockbusters come off patent. Merck (NYSE: MRK) saw patents expire on a handful of drugs starting in 2000, and investors began to worry about that three years beforehand, in 1997. Pfizer has some very large sellers coming off patent in the next two to four years:

  • Diflucan, with $1.0 billion in annual sales, comes off patent in 2004
  • Zithromax, with $1.5 billion in yearly sales, off patent in 2005
  • Norvasc, with $3.5 billion in yearly sales, off patent in 2006
  • Zoloft, $2.4 billion in yearly sales, also 2006

Those four drugs accounted for 30% of Pfizer's 2001 sales. Coming off patent doesn't mean an end to sales, but, in the past, up to 50% of annual sales can be grabbed by generic drug makers within a few years.

To compensate, Pfizer says it's on track to file 15 new drug applications by the end of 2006. In this regard, Pfizer is much-better prepared for patent expiry than Merck was; and, given considerable luck, Pfizer may be able to largely fill these coming gaps.

That won't come easy. Pfizer spends more on research and development than any peer, with a planned $5.3 billion R&D spend this year. In comparison, J&J will likely spend about $3 billion on pharmaceutical R&D this year, and Merck will invest a few hundred million dollars less than that.

Candy, anyone?
After a two-year lockout period, Pfizer is now free (as of two days ago) to sell the candy and razor blade operations that it acquired with Warner-Lambert. Since these divisions don't mesh with its drug business, sales are expected by many analysts. These divisions would likely sell for more than $5 billion. That cash could be used to repurchase shares, for acquisitions, to retire debt, toward even more R&D -- you name it.

Conclusion
In this economy, Pfizer is a very strong company expected to grow this year's earnings by more than 20%. Pfizer's stock trades at a price actually below the average S&P 500 P/E ratio of 28, and the average S&P 500 FCF ratio of 34. But even with a 27 P/E and at 31 times FCF, Pfizer doesn't look inexpensive. Committed long-term investors might consider buying more shares incrementally here in the mid-$30s, following the recent decline from the $40s. I will be. Less-assured investors might want to wait and hope for an even better price. Patent expiration worries could eventually bring it about. Or not. Which reminds us: Investing is about your own personal tolerance for risk, and everyone is different. I'll only add money to Pfizer gradually.

What is your opinion on Pfizer? Share it on the Pfizer discussion board, where other Fools are currently researching and analyzing the company. Enjoy the weekend!

"Mind the gap!" is a fun announcement to hear on the London Tube. "Something, something Grazie" is fun to hear over loudspeakers in Italian train stations. Jeff Fischer owns shares of Pfizer and J&J in dividend reinvestment plans. The Fool has a disclosure policy.