Tuesday, June 09, 1998

Cash-King Portfolio Report
by Phil Weiss

Towaco, NJ (June 9, 1998) – Good evening, fellow Fools. Tonight we're going to begin a 3-day series on reading financial statements. Then on Friday, we'll release our list of five finalists for the 8th C-K position of this portfolio. Then on Monday, those five horses will be paraded out for your vote in our online poll next week. The winner enters the C-K portfolio.

Okay, tonight we'll start with the income statement. We'll be using Pfizer's (NYSE: PFE) income statement from fiscal 1997, which is available from the company's website by clicking here: Pfizer's Income Statement. If you have a copy of our Pfilly's annual report in tow, the income statement appears on page 41. I encourage you to have this statement opened in front of you during this column.

Now many of us probably think that income statements are pretty easy to read, and they can be. But one thing to keep in mind is that there is more to what's in an income statement than what you see on page 41 of Pfizer's annual report. More detailed information on the income statement can be found in the Financial Review section of Pfizer's annual report found on pages 29-39. In addition, there are the Notes to the Financial Statements, which appear on pages 45-58 of Pfizer's annual report. They're also available on the website. These often-overlooked notes are really full of lots of good information for investors.

Ok, let's get to the numbers. Disclaimer up-front: This sort of cataloguing of items on financial statements can be a bit slow-going. But it's important to know what the various entries represent, in addition to learning more about the relationships between items. We'll do our best to keep it punchy, though!

The income statement starts with revenues. For most companies this is pretty simple. However, Pfizer has thrown us a bit of curveball. They have a separate line item labeled "Alliance Revenue." If you don't know what that is, all you have to do is flip over to Note 4 “Business Alliances." It turns out that alliance revenues are from the sales of their cholesterol-drug Lipitor (in partnership with Warner-Lambert) and their Alzheimer's drug Aricept (in partnership with Eisai). Of Pfizer's $12.5 billion in annual sales, $316 million (or 2.5%) comes from alliance revenues.

The next section of the income statement is called Costs and Expenses. First up, cost of sales. This represents the costs that Pfizer incurs to manufacture its inventory. Included in cost of sales are such amounts as the cost of the materials that are converted from raw materials into finished goods, the salaries of those employees tied directly to the manufacturing of finished goods, and the depreciation on assets used in the manufacturing process. If we take the cost of sales, divide it by total revenues, and subtract the result from one, we see that Pfizer has gross margins of nearly 82%. That's $2.27 billion in costs divided by $12.5 billion in revenues and subtracted from one. It equals 81.8, or 82%. Very high gross margins -- a very low cost to running the manufacturing side of their business. We like that.

Now we come to selling, general and administrative expenses (SG&A). A quick glance at Note 1G tells us that in 1997 Pfizer spent $948 million on advertising (about 20% of total SG&A expenses). Other amounts included on this line are costs such as salaries of the company's management team, administrative personnel and sales force, depreciation expenses related to assets other than those used in the manufacturing process, amortization expense related to intangible assets and professional fees (e.g., amounts paid to Pfizer's outside accountants and attorneys).

I think I need to backtrack for a second here. I've mentioned this thing called depreciation a couple of times, but I haven't described what it is. When a company purchases an asset that they expect to use over a period of time, (e.g., a building, machinery, office furniture, office equipment), accounting rules allow them to write-off the cost of that asset over what is estimated to be its useful life.

For instance, if Pfizer buys a piece of heavy equipment to mass produce Viagra pills, the company will on their financial statements reflect the costs of that investment over the estimated full life of the piece of equipment (say, 15 years). Pfizer's long-lived assets are described in Note 1D. If you want to know how much combined depreciation and amortization expense Pfizer had in 1997, you can check its Consolidated Statement of Cash Flows.

The next line on the income statement is "Research and Development (R&D)" expenses. Here we confirm that Pfizer has been making significant investments in R&D over the last few years, ringing up over $1.9 billion in R&D spending last year. Another way to measure the growth in research spending is to divide R&D by total sales. This shows you how much of the business of today Pfizer is investing in finding the products of tomorrow. To date, R&D as a percentage of sales has increased from 14.4% in 1995 to 15.4% in 1997. As the company has taken sales from $10 billion to $12.5 billion, they've actually driven higher their amount of R&D spending in aggregate and percentage terms. Sweet.

The next line item is "other deductions net." This amount is detailed in Note 7. A quick glance at Note 7 tells us that Pfizer's interest income and interest expense net to just about zero. This note also tells us the breakdown between depreciation and amortization expense that we found in the Statement of Cash Flows.

The next line is titled "Income from Continuing Operations." Continuing operations are just what the term implies. When a company decides to sell, stop or otherwise dispose of one of its lines of business, then the performance of that business is no longer part of the company's year-to-year operations. It gets reported on a separate line called Discontinued Operations (which you'll see on the statement reads zero for both 1996 and 1997, but $19 million in 1995). If you check Note 17, you'll see that Pfizer sold its food science business and this amount was reported as a discontinued operation in 1995.

The next line is called provision for taxes on income. Pfizer's income tax liabilities are discussed in more detail in Note 8. Absent any special tax planning, most companies pay tax at a rate of about 40%. Yep, 40% -- ouch. That figure consists of 35% for federal taxes and a composite state tax rate of about 5%. That said, most pharmaceutical companies pay taxes at a lower rate than 40%. Why?

Because of things like manufacturing in low-tax jurisdictions (Ireland and Puerto Rico are among the most common), doing business in countries other than the US (some of which have lower tax rates), research and development tax credits, and other miscellaneous items. If we divide Pfizer's provision for taxes on income of $865 million into its pre-tax earnings of $3,088 (tap tap, tap tap), we find that its effective rate of tax is only 28%. That's pretty good.

The next line on the income statement is called "minority interests." Minority interests represent the ownership interests of minority shareholders of subsidiaries included in the consolidated group. For example, if Pfizer owns 99% of one of its subsidiaries, then the remaining 1% is reported as a minority interest. Accounting rules require that companies deduct the value of these minority interests from their net income. In Pfizer's case, we're talking about a $10 million reduction off over $3 billion in earnings. Truly minor.

Finally, we get a look at Pfizer's "bottom line," with earnings of $2.2 billion in 1997. Divide that by sales of $12.5 billion, and you get those net profit margins of 17.6%. Healthy, indeed... and a full ten percentage points above our requirement here in the C-K Portfolio.

At the bottom of the statement, we get a look at Pfizer's earnings per share for the year. These figures are now being represented in basic and fully diluted terms. Basic is just the total net income divided by the total number of ownership shares outstanding. Fully diluted, the better measure, factors in the dilution of all issued but unexercised stock options. Regulatory standards in the U.S. now demand that all issued options be counted as shares in the earnings-per-share calculation. Smart.

Well, that's about it for definitions. I'd like to close with a restatement of Pfizer's income statement entries matched up against our Cash-King criteria. Here they are:

Sales above $1 billion?
Yep, $12.5 billion.

Market Capitalization above $5 billion?
Yep, $141 billion.

Gross Margins above 50%?
Yep, 82%.

Ascending Margins?
Yep, gross margins up from 78% in 1995 (to 82% today), net margins up from 16% in 1995 (to 18% today).

I'll be back tomorrow night to discuss items found on the balance sheet. In the meantime, if you have any questions, please do post them in our Cash-King Strategies Folder. The link is provided below and the C-K message boards are always linked in the top right of this page.

Fool on,

Phil Weiss


Stock  Change    Bid 
 AXP   -1 5/8   107.38 
 CHV   -1       80.00 
 KO    +  9/16  81.63 
 GPS   +  13/16 60.44 
 EK    +1 5/16  71.63 
 XON   -1 1/4   69.94 
 GM    -  13/16 73.19 
 INTC  +  7/8   70.19 
 MSFT  +1 3/8   87.06 
 PFE   +4 1/16  112.50 
 TROW  +1 3/4   35.69 
                  Day   Month    Year  History 
         C-K      +1.06%   3.03%   8.97%   8.97% 
         S&P:     +0.24%   2.53%  11.70%  11.70% 
         NASDAQ:  +0.73%   1.23%   8.95%   8.95% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   22 Pfizer        82.30    112.50    36.70% 
     5/1/98   37 Gap Inc.      51.09     60.44    18.30% 
    2/27/98   27 Coca-Cola     69.11     81.63    18.11% 
     2/3/98   24 Microsoft     78.27     87.06    11.24% 
     2/6/98   56 T. Rowe Pr    33.67     35.69     5.98% 
    5/26/98   18 American E   104.07    107.38     3.18% 
    2/13/98   22 Intel         84.67     70.19   -17.11% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko    63.15     71.63    13.42% 
    3/12/98   20 Exxon         64.34     69.94     8.71% 
    3/12/98   17 General Mo    72.41     73.19     1.08% 
    3/12/98   15 Chevron       83.34     80.00    -4.01% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   22 Pfizer      1810.58   2475.00   $664.42 
     5/1/98   37 Gap Inc.    1890.33   2236.19   $345.86 
    2/27/98   27 Coca-Cola   1865.89   2203.88   $337.99 
     2/3/98   24 Microsoft   1878.45   2089.50   $211.05 
     2/6/98   56 T. Rowe Pr  1885.70   1998.50   $112.80 
    5/26/98   18 American E  1873.20   1932.75    $59.55 
    2/13/98   22 Intel       1862.83   1544.13  -$318.71 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko  1262.95   1432.50   $169.55 
    3/12/98   20 Exxon       1286.70   1398.75   $112.05 
    3/12/98   17 General Mo  1230.89   1244.19    $13.30 
    3/12/98   15 Chevron     1250.14   1200.00   -$50.14 
                               CASH   $2037.63 
                              TOTAL  $21793.01 
 *The year for the S&P and Nasdaq will be as of 02/03/98