Rule Maker Portfolio
Questionable Results at Pfizer?

By Phil Weiss (TMF Grape)

TOWACO, NJ (Oct. 21, 1999) -- In tonight's report we'll check in on the third-quarter earnings of Pfizer (NYSE: PFE) and Schering-Plough (NYSE: SGP), our two pharmaceutical companies. First to report was Pfizer, which was up nearly 8% Tuesday as the market reacted positively to its earnings release. As you'll see a little later in this report, I have some questions about whether the market's reaction was appropriate.

Unfortunately, the vast majority of the companies in this industry present only their income statements when they release earnings. The balance sheet and cash flow statements aren't published until the 10-Q is released (about 45 days after the quarter ends). One positive about Pfizer, though, is that it does provide a lot of additional information in the form of a Q&A that supplements the income statement information.

Let's take a look at Pfizer's income statement and see how it does under some our Rule Maker criteria.

Sales Growth of at Least 10%: On the surface, revenue growth looked quite strong. Total revenues for the quarter were up 20%. But, we need to look at the numbers more closely. Pfizer's revenue has two components. The first is net sales. Generally, this figure represents sales of products that are developed, manufactured, marketed, and sold by Pfizer. These sales were up only 10% over the year-ago figure.

The other sales component is alliance revenue. This figure represents Pfizer's revenue generated by its co-marketing agreements with Warner-Lambert (NYSE: WLA) for Lipitor; Monsanto (NYSE: MTC) for Celebrex; and Eisai for Aricept. The bulk of the overall 20% sales growth came from these alliance revenues, which were up by 159% over the same quarter a year ago. The problem with alliance revenues is that evidence suggests that Pfizer doesn't receive actual cash payment for these revenues until well after the sales are booked.

There was also something in the supplemental information portion of Pfizer's earnings press release that troubled me. Three different times I read the following words: "Sales growth in the U.S. was impacted by changes in wholesaler stocking patterns." This wording was found in Pfizer's discussion of the factors that contributed to the sales growth of Norvasc, Cardura, and Zoloft. While I can't be sure, my interpretation is that Pfizer boosted sales for the quarter by pushing more inventory to its wholesalers. An example of the sequence of events would be as follows:

Pfizer offers favorable sales terms ("Buy now and no interest for six months!") to wholesalers to encourage them to buy more product than they normally would. The wholesalers jump at the offer, and Pfizer records sales income, with a concurrent reduction in inventory and increase in accounts receivable. The bottom-line result is that reported income for the quarter is higher. It's also possible that sales could have been overstated since some of what's been sent to the wholesalers could later be returned to the company.

If that interpretation is accurate, then it's just another example of what concerns me the most about Pfizer -- its lack of concern for the balance sheet. The company's flow ratio has consistently been above our 1.25 standard, and in my opinion, Pfizer's management of its working capital (current assets and liabilities) leaves something to be desired. The company takes as long or longer to collect its outstanding accounts receivable than the other major companies in its industry. The activity related to "wholesaler stocking patterns" also leads me to believe that we'll see a further increase in the company's flow ratio when the 10-Q arrives.

Gross Margins of at Least 50%: Depending on your view of things, Pfizer's gross margin for the quarter either improved from 86% a year ago to 88% or declined from 86% to 80%. This is because cost of sales included a charge of $310 million related to Trovan, a product whose future is in jeopardy as a result of recent regulatory actions severely scaling back the market for this drug. Pfizer excluded this charge in arriving at the $0.23 that was reported as income from continuing operations.

Since Pfizer has not discontinued sales of Trovan altogether (it will still be selling it in limited quantity in the future), I'm less inclined to treat this item as a one-time charge outside of continuing operations. Pfizer is a pharmaceutical company. It had a problem with one of its drugs for which it has recorded sales income in the past and present. My opinion is that unless Pfizer treats the revenues from this product the same as it treats the costs of production, the write-down of this inventory should not be excluded from operating income. As a result, I'm inclined to include the $0.05 Trovan charge in determining both gross margins and net income.

Net Margins Above 7%: Pfizer easily passes this hurdle. Depending on how you treat the Trovan charge, Pfizer's net margin for the quarter was either 18% or 23%. Again, I have to express a concern. During the quarter, Pfizer's selling, informational, and administrative expenses rose 11% from the year-ago figure and actually fell 6% from the second quarter. As a general rule, I like to see a tighter reign on expenses. However, the quarter-to-quarter and year-to-year change in this line item seems to be out of whack when compared to past results. Once again, I can't help but wonder whether Pfizer is attempting to manage its earnings -- at least a little bit. This is definitely something that I'll keep an eye on so that I can tell if this is a one-quarter aberration or the start of a trend. I'd be more comfortable learning that it was the start of a trend.

I'd also like to talk a little bit about one of the more subjective Rule Maker criteria: expanding possibilities. One of the characteristics that leads people to believe that Pfizer has an outstanding future is its pipeline of new products. Pfizer also is reinvesting more of its revenues in research and development (R&D) than any other traditional pharmaceutical company (over 17% for both the quarter and the year-to-date). However, Pfizer seems to keep running across problems with the products in its pipeline. As noted above, there have been problems related to Trovan. There has also been some controversy related to Viagra. The approval of anti-psychotic Zeldox has taken longer than expected. According to question #25 of the Q&A supplement, clinical studies for the drug ezlopitant, a drug for the treatment of emesis and nausea associated with cancer chemotherapy, have been discontinued due to poor efficacy.

In light of the comparatively low increase in Pfizer's net sales revenues, I would like to see Pfizer soon realize more of a return on its significant R&D efforts. The company needs to have a new drug approved that boosts its top-line growth in the near future. Right now, the ones that look the most promising are Relpax (a migraine medication that will be co-marketed by Warner-Lambert), the recently approved anti-arrhythmic drug Tikosyn, and the aforementioned Zeldox.

I'll be quite interested to see what Pfizer's balance sheet and cash flow statements look like when they're released in November. I'm hoping that we'll see some improvements in our company's flow ratio as well as its ratio of cash-to-debt. In this Fool's view, Pfizer's quarterly results as reflected in its income statement raised some questions. I'm eager to learn whether there are any improvements in the balance sheet that mitigate some of what I see in the income statement. I've also e-mailed a copy of the Pfizer section of this report to our company's investor relations department. I'll share with you whatever response I get.

Let's turn now to our other pharmaceutical Rule Maker, Schering-Plough, which yesterday reported its third-quarter results. Earnings per share of $0.35 met Street estimates. Unfortunately, Schering-Plough's earnings release does not include nearly as much information as that of Pfizer. We can take a quick look at the Rule Maker income statement numbers for the quarter.

Third-quarter sales grew by 13% over the same quarter a year ago. Per the usual, sales growth was led by anti-allergy Claritin and anti-viral/anti-cancer Intron-A. Those two drugs accounted for more than half of Schering's $1.9 billion of worldwide pharmaceutical sales.

Gross margins came in at 80% for the quarter. This was essentially flat when compared to the year-ago figure as well as that for the second quarter. As is the case with all successful pharmaceutical companies, the cost of manufacturing drugs (cost of sales) is relatively low -- and hence, the high gross margins. A high gross margin business model allows a company to pour its resources into sales, marketing, and research. Schering-Plough's biggest expense item -- selling, general, and administrative (SG&A) costs -- are typically about twice as large as its cost of sales. Research and development expense grew 19% during the quarter and now stands at 12.6% of year-to-date sales.

Down on the bottom line, net margins for the quarter improved to 23%, up from 22% a year ago. The high net profit margins that you find in companies like Schering-Plough are what help the company to be successful year after year.

If you have any questions about tonight's report or want to continue this discussion, please visit the RM Companies board, Pfizer board, or Schering-Plough board. And for that question you're afraid might be "too dumb" to ask, fire away on our always-friendly RM Beginners board.

Have a Foolish night and good luck to the Yankees as they take on the Braves for the title of best team of the decade.



Rule Maker Portfolio

10/21/99 Closing Numbers
Ticker Company Dly Pr Chg Price
EKEASTMAN KODAK-1 15/16$67.94
GPSGAP INC5/8$35.31
KOCOCA-COLA CO9/16$54.31
XONEXXON CORP-7/16$76.06
YHOOYAHOO INC13/16$181.94

  Day Week Month Year
To Date
Rule Maker .82% 5.61% 3.98% 12.52% 40.63% 21.97%
S&P 500 -.45% 2.90% .07% 4.42% 30.94% 17.01%
S&P 500(DA) -.45% 2.90% .07% 5.00% 32.71% 17.92%
S&P 500(DCA) n/a n/a n/a n/a 17.95% 10.10%
NASDAQ .50% 2.57% 2.03% 27.79% 73.03% 37.63%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg

Trade Date # Shares Ticker Cost Value LT $ Val Ch
  Cash: $181.37  
  Total: $36,564.69  

The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.