Tuesday, April 07, 1998

Cash-King Portfolio Report
Phil Weiss

TOWACO, NJ (April 7, 1998) -- I closed yesterday's report with a promise to talk more about Pfizer (NYSE: PFE) over the next couple of days. I decided to do this for two reasons:

1) Pfizer recently released its yearly 10-K report and in the 11 Steps we talk up the idea of reviewing the performance of your Cash-Kings every three months. Doesn't take much. It's painless.

2) One of my favorite things about owning Cash-King stocks is that our extended time horizon invites us to learn more about our companies -- kind of like a slow dance or a long walk on a beach with an old friend

Ok, let's dig in. For starters, all of Pfizer's 1997 financials can be found online. Man, I love technology. Someday the majority of shareholders will communicate directly with their companies and get their financial information via the Internet. After all, it's easier, faster, less expensive, and might help us sustainably grow our forested lands! Here are the links to both of Pfizer's reports:

PFE Annual Report and PFE 10-K Report.

In tonight’s column, I'm going to focus on two of the Cash-King criteria found in our Sixth Step to Investing in Cash-Kings. I'm going to look at Pfizer's days of sales outstanding (DSO), which I'll explain in a moment, and I'm going to look at its Flow Ratio. In fact, I'll be employing a variation of the Flow Ratio, introduced by Dale Wettlaufer in the C-K folder, called the Unleverage Flow Ratio. And I'll explain that, too, in a second.

The last time I devoted a column to Pfizer I relayed what I'd learned in a phone call that I made to Pfizer’s Investor Relations department. It makes so much sense to list out questions you have about your company and then to call them up and ask 'em. That's what they're there for, Fools. You own a part of the business.

When I called last time, the primary concern I had was the company’s relatively high level of days of sales outstanding (DSO). They were selling product, but I didn't think they were collecting payments for those products fast enough. With accounts receivable on the rise (toward historically high levels for the company), our guys and gals at Pfizer didn't have their cash in their pockets earning interest.

This was still fresh in my mind when I learned that Pfizer had just released its 10-K report. I immediately went to its website, clicked open the 10-K report, and scrolled quickly to see if its management of receivables was better or worse than it had been at the end of the third quarter.

For those of you that are unfamiliar with the days of sales outstanding calculation -- which gives you a very good look at receivable levels -- it is calculated by dividing sales over the last four quarters by accounts receivable at the end of the most recent period. Then divide this number by 365 to determine how many days worth of its sales a company has yet to collect on. It may sound like an arduous task, but clacking out this calculation takes all of two minutes. Let's run one for Pfizer.

Pfizer had 1997 sales of $12.5 billion and an accounts receivable balance of $2.5 billion. Let's plug those numbers into our DSO equation:

 Sales        12.5 
 --------   = ------- = 5.00 
 Accounts       2.5 

Ok, so their receivables are running at 20% of sales. Next, we take 5.00 and divide it into 365 days to determine how many days on average it'll take to collect all $2.5 billion in outstanding sales. The answer? 365 / 5 = 73, or 73 days. On average, it will take Pfizer 73 days to collect its uncollected bills. This compares quite unfavorably with three other giants in the pharmaceuticals industry:

Schering Plough: 35 days 
           Merck: 45 days 
          Abbott: 55 days 
          Pfizer: 73 days 

Back when I calculated Pfizer's days of sales outstanding (DSO) at the end of its 3rd quarter of 1997, it was hovering at 69.2 days. Given that it was markedly higher than the competition then, I was even more disappointed to see that it had increased in the 4th quarter. Just as an additional point of reference, this is the highest that Pfizer's days of sales outstanding has been for at least the past 5 years.

I started reading through the 10-K to see if there was any explanation for this increase. I did find a brief mention stating that receivables had increased due to "alliance revenues." Since this didn't satisfy me, I added it to a list of questions for the call I put in to the company.

I spoke with Pfizer's Assistant Director of Investor Relations, Ron Aldridge. The first thing he confirmed is that alliance revenues represent Pfizer’s share of revenues from sales of Lipitor and Aricept -- two drugs that Pfizer sells in alliances with Warner Lambert and Eisai, a Japanese company, respectively.

Aldridge explained that Pfizer’s collection terms for alliance revenues are longer than they are for sales to their regular customers. These collection terms were negotiated between the parties at the time that the related licensing agreements were signed. According to the IR department, the revenue stream from sales of Lipitor and Aricept is more important to Pfizer right now than getting the revenues in hand quickly. They're playing the market share, land-grab game.

The conclusion I drew from this is that since it's expected that sales of these products will increase over time, and since Pfizer has also entered into similar arrangements with other companies, it's quite likely that its days of sales outstanding will actually increase over time. Hmph.

I then asked Mr. Aldridge how high Pfizer would rank its growth in receivables on its list of unattractive balance sheet characteristics (on a scale of 1 to 10). He didn't throw out a number, but he did share that they viewed it as inconsequential. Why? Because the company believes that revenue growth and margin improvement are more important drivers of business results than balance sheet items. Hmph.

The answer, although not that surprising, was disappointing for me. I mean, this is a great company, don't get me wrong. Sales are rising sharply; its products are earning accolades; the company is building the leading brand in the pharmaceuticals industry. And the stock price is making owners happy. Very happy. Over the past three years, Pfizer has risen from $22 to $103 today. Bravo!

But, I consider the climb in uncollectibles to warrant concern. Yes, this longer collection period for alliance revenues is something that I can understand. But what does it indicate? It tells us that our company isn't yet in a truly powerful position relative to its marketing partners.

After all, if Pfizer could illustrate to the world, to its competitors, and to its partners that the drugs it creates and manufactures have the potential to be blockbusters again and again, then Pfizer could demand more timely payment from its distributors. Pfizer either hasn't created enough of the demand or their negotiators haven't used that leverage to shorten the pay periods in contracts.

And by letting customers take their time with payables, Pfizer is giving them free use of Pfizer's money. This isn't the best cash management philosophy, and it doesn't match up well relative to the other companies in the Cash-King portfolio. And with the exception of American Home Products (NYSE: AHP), this collection period is significantly longer than really every major pharmaceutical company that I checked.

We think Pfizer can improve here.

The next thing I wanted to discuss was Pfizer’s $2.3 billion of short-term borrowings. Most of the time when we discuss our beloved Flow Ratio, we take current assets less cash and divide this result by current liabilities (a full explanation is available in Step 7 of our 11 Steps). We do this because we view having our assets tied up in receivables and inventory as a negative, while we consider manageably rising short-term liabilities a positive.

Using the form of the Flow Ratio that we have discussed here in the past, Pfizer’s flow ratio was 1.0 at year-end. However, Pfizer’s short-term loans result in interest cost. In order to look at the impact of the short-term borrowings on the Flow Ratio, we need to look at what Dale Wettlaufer has termed the Unleveraged Flow Ratio.

What's that? It's figured by dividing current assets less cash by current liabilities less short-term borrowings. In doing this, we're pulling out the current portion of long-term debt, which really doesn't reflect anything about our company's ability to hold off payments to suppliers. (If you have questions about this, please drop by our message folder. It's not too tough to grasp.)

For the 4th quarter, unfortunately Pfizer's Unleveraged Flow Ratio increased from 1.4 to 1.7.

But what I learned from Mr. Aldridge about Pfizer’s short-term loans is that the average interest rate that our company is paying on the debt is a low, low, low 2.9%. Since I know that Pfizer’s return on this money is a lot more than 2.9%, the impact of these short-term borrowings on Pfizer is substantially reduced. And so, while its Unleveraged Flow Ratio is up around 1.7, the interest rates on its borrowings brings it considerably lower for us.

Personally, I'm satisfied with Pfizer's explanation on the current portion of long-term debt, but I'm still a bit disappointed about its apparent decision not to tighten down on the length of its collections period. We'll keep watch on this.

Tomorrow, I'm going to jump into what I think will prove a more interesting aspect of Pfizer’s business (though, heck, I hope you enjoyed this report, too). I'll be reviewing the company's current best-selling drugs as well as providing an analysis of the potential blockbusters on the way. Until then...

Fool on!

Phil Weiss


Stock  Change    Bid 
 CHV   +  1/2   80.50 
 KO    -  3/8   79.00 
 EK    -  5/8   63.50 
 XON   -  9/16  67.88 
 GM    -  7/16  66.81 
 INTC  -1 1/4   72.63 
 MSFT  -2 5/8   87.25 
 PFE   -2 15/16 100.56 
 TROW  -  1/4   72.25 
                  Day   Month    Year  History 
         C-K      -0.94%  -0.44%   3.49%   3.49% 
         S&P:     -1.06%   0.71%  10.81%  10.81% 
         NASDAQ:  -1.66%  -2.01%   8.82%   8.82% 
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    22 Pfizer        82.30    100.56    22.19% 
    2/27/98   27 Coca-Cola     69.11     79.00    14.32% 
    2/3/98    24 Microsoft     78.27     87.25    11.47% 
    2/6/98    28 T. Rowe Pr    67.35     72.25     7.28% 
    3/12/98   20 Exxon         64.34     67.88     5.50% 
    3/12/98   20 Eastman Ko    63.15     63.50     0.56% 
    3/12/98   15 Chevron       83.34     80.50    -3.41% 
    3/12/98   17 General Mo    72.41     66.81    -7.72% 
    2/13/98   22 Intel         84.67     72.63   -14.23% 
     Rec'd    #  Security     In At     Value    Change 
    2/3/98    22 Pfizer      1810.58   2212.38   $401.80 
    2/27/98   27 Coca-Cola   1865.89   2133.00   $267.11 
    2/3/98    24 Microsoft   1878.45   2094.00   $215.55 
    2/6/98    28 T. Rowe Pr  1885.70   2023.00   $137.30 
    3/12/98   20 Exxon       1286.70   1357.50    $70.80 
    3/12/98   20 Eastman Ko  1262.95   1270.00     $7.05 
    3/12/98   15 Chevron     1250.14   1207.50   -$42.64 
    3/12/98   17 General Mo  1230.89   1135.81   -$95.08 
    2/13/98   22 Intel       1862.83   1597.75  -$265.08 
                               CASH   $5666.26 
                              TOTAL  $20697.20 
 *The year for the S&P and Nasdaq will be as of 02/03/98