Moving on, the columns that I've written over the last two weeks (linked at bottom) about Pfizer (NYSE: PFE) have probably generated more discussion on the Fool message boards than any others that I've written since we launched this portfolio early in 1998.
I think that all this discussion has been great. It's one of the biggest advantages of our message boards. No one of us is an absolute authority on investing or on any one company. I appreciate that people have questioned my analysis and offered additional insights (whether they have agreed or disagreed with me doesn't matter). When I write, I do my analysis and reach my own conclusions. It's good to see that so many other Fools have done their own research and reached their own conclusions as well.
For me, the bottom line on Pfizer is that I still think that it's a top tier pharmaceutical company. I don't believe that we should sell our Pfizer out of the Rule Maker portfolio; I also won't be selling my personal stake in the company. I do believe, however, that the company bears closer watching in the future than it has in the past. Pfizer has an excellent track record of developing successful new products. I expect that it will continue to do just that in the future as well.
If you look at top management of the major pharmaceutical companies, I'm pretty sure that you'll find Pfizer is the only one that's headed by a former marketing and sales person (CEO William Steere) rather than a financial or a technical person. One thing that I've seen in my own business experience is that people with a background like Steere's often are less fiscally responsible than those with financial or technical backgrounds.
In the past I've suggested that while the alliance revenues that Pfizer earns are certainly valuable in terms of adding to the income reported on Pfizer's bottom-line, they are not as valuable as the revenue generated by Pfizer's in-house pharmaceutical products because of the significantly longer amount of time that it takes to collect them. I thought that it would be worthwhile at this point to review another way in which you can look at Pfizer's fiscal policies. I also decided to do the same analysis for Warner-Lambert (NYSE: WLA), the company that developed Lipitor, one of the drugs that Pfizer co-markets.
Before we get to that, I thought it would be worthwhile to take a look at Lipitor, and the partnership between the two companies. Launched in 1997, Lipitor was the first drug to make it to $1 billion of sales in its first year on the market. It is the most frequently prescribed cholesterol medication for U.S. patients. According to Warner-Lambert's annual report, "In 1996, we looked at the global sales potential of Lipitor based on internal resources and said, 'That's not good enough.' So we crafted a winning alliance with Pfizer and established world-class manufacturing facilities in Ireland, enabling Lipitor to set a record for first-year sales for a new drug."
Obviously, this partnership has benefited both parties. During the second quarter of this year, the partnership was expanded with the announcement of the signing of a letter of intent to continue and expand this highly successful marketing alliance. Under the extended arrangement, the companies will continue to co-promote Lipitor for a total of ten years, that is until 2007. Further, the companies plan to explore Lipitor line extensions and product combinations. For example, currently, they are working on a drug that is a combination of Lipitor and Pfizer's heart medication Norvasc. As part of the expanded collaboration, Warner-Lambert and Pfizer also plan to co-promote Pfizer's migraine drug Relpax for ten years.
But, who's benefited more? I decided that one way to tell would be to look at the cash conversion cycle for both companies. Before you go over the rest of this analysis, you might want to take a break, drink a glass of Minute Maid Lemonade (hey, we own Coke in this portfolio, don't we?) and get out your calculators, as we're going to go through some numbers.
The cash conversion cycle (CCC) represents the number of days it takes a company to purchase a raw material, convert it into a finished good, sell the finished good to a customer and receive payment from that customer for that product. The CCC has three components: Days Sales Outstanding (DSO), Days Inventory Outstanding (DIO) and Days Payables Outstanding (DPO). The CCC is a companion to the three most important parts of the flow ratio -- accounts receivable, inventory and accounts payable. The lower a company's CCC, the better.
Let's take the parts one by one.
Days Sales Outstanding (DSO)
On a quarterly basis, DSO is calculated using the following formula: Accounts receivable / (Sales / 90). If you want to calculate it for the year, you can substitute 360 for 90 in that equation. I like to see this figure as low as possible. A low figure means that the company collects its outstanding receivables quickly, which means that it's not giving out interest free loans to its customers for long periods of time.
Let's calculate this number for the second quarter of this year for both Pfizer and Warner-Lambert:
Accounts Receivable 3,396 1,949
Sales 3,779 3,151
For Pfizer we take 3,779 and divide it by 90, getting 41.99. We then take that figure and divide it into 3,396. The result is that it takes Pfizer 81 days to collect its outstanding accounts receivable, which is higher than any other pharmaceutical company I've studied. If you do this same calculation for Warner-Lambert, you'll get a result of 56 days. Looking at those numbers, I'd much rather owe money to Pfizer than Warner-Lambert, as Pfizer would give me 25 extra days to pay.
Days Inventory Outstanding (DIO)
On a quarterly basis we calculate DIO using a similar formula to the one above. The differences are that we use inventory instead of accounts receivable and cost of sales instead of sales. That makes the formula: Inventory / (Cost of sales / 90). Once again we like to see this number as low as possible. There are two reasons for this. One is that as Rule Maker investors, we don't like to see a lot of cash tied up in inventory held on our shelves. The other is that if inventory is held for too long, it can become spoiled or obsolete.
Once again, we'll calculate this number for both companies:
Inventory 1,805 1,027
Cost of Sales 476 723
For Warner-Lambert we take 723 and divide it by 90, getting 8.03. We then divide 8.03 into 1,027 and get 128. This means that Warner-Lambert turns its inventory over almost 3 times a year as 128 * 3 is 384 days, which is a little longer than a year. If you do the same calculation for Pfizer, you'll see that it took 341 days to turn over its inventory. OUCH! I can't believe that! If Pfizer repeated its second quarter performance all year long, it would turn its inventory over just more than once a year. That's horrible.
Days Payables Outstanding (DPO)
You can calculate DPO each quarter using a similar formula: Accounts payable / (Cost of sales / 90). This is a number that we like to see as high as it can be. We like it when a company is able to get interest-free loans from its suppliers, and that's really what payables are, as long as they're paid under stated terms.
Here are the numbers for the two companies:
Accounts Payable 770 1,700
Cost of Sales 476 723
This time, we'll calculate the number for Pfizer. We can take 476 and divide it by 90. That gives us 5.29. Then we can divide 5.29 into 770. Pfizer's payables are outstanding for an average of 146 days. On the other hand, Warner-Lambert's are outstanding for 212 days. The interesting thing about this is that in 1996, the last year before the launch of Lipitor, Warner-Lambert's payables were only outstanding for 94 days. While I can't totally attribute that increase to the Lipitor alliance revenues it owes to Pfizer, I do believe that those revenues have had a big impact on DPO. This leads me to believe that Warner-Lambert is taking a lot longer to pay Pfizer than the 120 days that I suggested last week.
Putting It All Together -- The Cash Conversion Cycle (CCC)
If we add DIO and DSO and then subtract DPO, we're left with the company's cash conversion cycle -- how long it takes to purchase a raw material, convert the raw material into a finished good, sell the finished good and get paid for it.
Here are the second quarter numbers for Pfizer and Warner-Lambert:
Days Sales Outstanding (DSO) 81 56
Days Inventory Outstanding (DIO) 341 128
Days Payables Outstanding (DPO) (146) (212)
= Cash Conversion Cycle (CCC) 276 (28)
Remember, we want cash to be converted quickly, so the lower this number, the better. Warner-Lambert's negative CCC is outstanding. It certainly seems to me that when it comes to managing the balance sheet, Warner-Lambert is the Rule Maker of this comparison. I do believe that Pfizer is costing itself in the long run with what seems to be a lack of solid fiscal responsibility. I think this quote from Warner-Lambert's annual report sums up exactly what I've found by going through its numbers:
"While we may not be among the biggest spenders, we're clearly among the most productive. We like to say it's not only what you put in, but also what you get out!"
I ran these numbers quarterly and annually for Pfizer, Warner-Lambert and our other pharmaceutical holding, Schering-Plough, going back a few years. If you're interested in seeing how the results have changed as Lipitor sales have grown, you can check this post.
What do you think?
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