<THE RULE MAKER PORTFOLIO>
Pfizer's Investing for the Future?
By Phil Weiss (TMF Grape)
TOWACO, NJ (July 21, 1999) -- As I'm sure you must know by now, Pfizer (NYSE: PFE) finally released earnings Monday morning of $0.18 per diluted share, up 20% from a year ago and a penny ahead of estimates. I say "finally" because no one really seemed to know when Pfizer would be releasing its quarterly numbers. Just about every day last week it seemed as if there were rumors that "today is the day for Pfizer earnings."
Pfizer is one of the few companies generally not too forthcoming when it comes to providing analysts the information that they want to hear. As discussed in this excellent CFO Magazine article on Pfizer, our company's executive vice president and CFO, David Shedlarz, has a reputation for being pretty "closemouthed."
Pfizer is also a rarity in that it doesn't have conference calls after releasing earnings. Instead, it issues the most comprehensive earnings press release you're likely to find. There's plenty of detailed income statement information in the regular press release, as well as additional information in a Q&A format discussing Pfizer's quarterly performance in a bit more detail.
In the CFO Magazine article, it's interesting to read how many of the analysts are upset with Pfizer because they believe the company may be managing its earnings down rather than up. At least a portion of this sentiment is related to the fact that when it comes to pharmaceutical companies, the general rule is that earnings should be fairly smooth and predictable. In essence, the analysts seem to think that Pfizer is spending unnecessarily on research and development (R&D) as a means of keeping its earnings down. Pfizer counters that this spending is an investment in its future.
As an investor in Rule-Making stocks, I'm more than willing to sacrifice some current earnings in exchange for greater earnings in the future. One thing that's inherent in the pharmaceutical industry is that companies often have products that are significant revenue generators for a period of eight to ten years. If a company isn't investing in its future during the years that it has blockbuster products available for sale, then it's possible it will run into trouble as the patents on those products expire. This is a concern that's been expressed about companies like Merck, which I covered in more detail back in May.
Okay. Let's take a look at Pfizer's income statement and see what the second quarter looked like.
Sales Growth looked pretty solid on the surface, with overall revenues up 14%. Growth in Pfizer-developed pharmaceuticals was paced by a 17% increase in the blockbuster anti-hypertensive Norvasc, and a 16% increase in Zoloft, the blockbuster drug for depression. In addition, potential future blockbusters such as the antibiotic Zithromax (up 27%), the antihistamine Zyrtec (up 38%) and the alpha blocker Cardura (up 18%) all had strong results for the quarter. The one downer was Viagra, as sales fell by 25% from the same quarter of last year. (But this was an improvement from the first quarter.)
Overall revenues were up 14% for the quarter. That seems like a pretty solid figure for a mature pharmaceutical company like Pfizer, doesn't it? Well, not exactly. Overall sales growth was boosted by the growth in "alliance revenues." These are the revenues that Pfizer receives as a result of its marketing agreements for the anti-cholesterol drug Lipitor (with Warner-Lambert), the Alzheimer's drug Aricept (with Esai) and the COX-2 inhibitor Celebrex (with Monsanto). Pfizer's alliance revenues were up 143% for the quarter. This means that the growth attributable to products developed by Pfizer was only 6%. That's not a very impressive figure. We'll come back to it a little later in the report.
Gross Margins were up two percentage points year-over-year, from 85% to 87%. The dollar amount of cost of sales actually fell for the quarter, even though dollar sales increased. Part of this can be attributed to the alliance revenues, as Pfizer does not incur any costs to manufacture these products. According to question #19 of the Q&A, improvements in business and product mix as well as manufacturing efficiencies are among the positive factors that contributed to this improvement. This is quite an impressive feat -- particularly for a company with gross margins of this magnitude.
Net Margins for the quarter increased from 18% to 19% when compared to the second quarter of 1998. This is also a positive development.
The last thing I'd like to discuss is the 21% increase in R&D expense for the quarter (and 28% year-to-date). Typically, pharmaceutical companies invest around 10% to 12% of their sales in R&D. By breaking the 20% mark, Pfizer is in some ways behaving more like a biotech company than a mature pharmaceutical enterprise. As a point of comparison, in the first quarter of 1999, premier biotech firm Amgen's (Nasdaq: AMGN) ratio of R&D to sales was 25%.
I did a little more digging, as I wanted to see if the growth in this ratio is an aberration or part of a trend. I pulled out my copy of Pfizer's 1998 annual report and looked at the data found on page 62. Here's what I found:
1998 1997 1996 1995 1994 1993
Revenues 13,544 11,055 9,864 8,684 6,825 6,080
R&D 2,279 1,805 1,567 1,340 1,036 880
Ratio 16.8% 16.3% 15.9% 15.4% 15.2% 14.5%
1992 1991 1990 1989 1988
Revenues 5,816 5,352 4,757 4,220 3,960
R&D 776 654 545 449 401
Ratio 13.3% 12.2% 11.5% 10.6% 10.1%
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What this table shows us is that Pfizer really is reinvesting its profits back into its business. The increase in R&D costs appears to be a trend and not an aberration. Some of these profits are directed toward the process efficiencies that resulted in the increased gross margins mentioned above. The bulk of the dollars, though, are being reinvested in developing new drugs and marketing efforts. For example, Pfizer created a specialty sales force dedicated to rheumatology.
The key question for an investor is, "What kind of return are these investments yielding for Pfizer?" At the moment, the results are mixed. The marketing-driven alliance revenues have borne the most fruit. But the current returns from Pfizer's R&D are a little less robust than what they have been in the past. If the R&D dollars are not being spent effectively, then that's not a good thing. I suspect that they are, but would like to see more evidence to support that belief, especially in light of some of the rumors that were circulating a while ago saying that Pfizer's pipeline is not quite as strong as we have been led to believe.
Despite the concerns, reading through the Q&A leaves me confident that R&D investments will bear more fruit in the future. Pfizer expects to receive approval for two new drugs this year: Tikosyn, a heart medication; and Relpax, a migraine medication. In addition, it is working on a number of other projects. One of the most interesting to me is a joint effort with Warner-Lambert to combine Norvasc and Lipitor. According to the Q&A, more than 100 million patients in the U.S. have the symptoms that these drugs treat, but only about 15% are being treated for both conditions.
Pfizer hasn't shared its balance sheet with us yet, so I'll be very interested to see what that looks like when it's released in the August 10-Q. I'm hoping that we'll see some improvements in our company's Flow Ratio, as well as its ratio of cash-to-debt. All in all, Pfizer's quarterly results as reflected in the income statement were acceptable, although I'd like to see sales start to show more rapid growth so that I can feel more comfortable that its R&D and marketing investments are yielding good results.
If you have any questions about tonight's report or want to continue this discussion, please ask them on either our Rule Maker Companies Board or the Pfizer board. Also, if you think a friend or relative might enjoy reading this report, click on the small "E-mail this to a friend" link in the upper-right-hand corner of the page.
Phil Weiss, Fool
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07/21/99
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Rule Maker Stocks
Rec'd # Security In At Now Change
2/3/98 48 Microsoft 39.13 94.69 141.95%
6/23/98 68 Cisco Syst 29.21 63.06 115.93%
5/1/98 82.5 Gap Inc. 22.91 47.88 108.94%
2/13/98 44 Intel 42.34 65.56 54.86%
2/3/98 66 Pfizer 27.43 35.75 30.32%
5/26/98 18 AmExpress 104.07 134.00 28.76%
2/17/99 16 Yahoo Inc. 126.31 151.88 20.24%
8/21/98 44 Schering-P 47.99 52.75 9.91%
2/6/98 56 T. Rowe Pr 33.67 36.69 8.95%
2/27/98 27 Coca-Cola 69.11 62.63 -9.38%
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Rec'd # Security In At Value Change
3/12/98 20 Exxon 64.34 78.13 21.43%
3/12/98 20 Eastman Ko 63.15 73.06 15.70%
3/12/98 15 Chevron 83.34 94.25 13.09%
3/12/98 17 General Mo 72.41 66.50 -8.16%
Rule Maker Stocks
Rec'd # Security In At Value Change
2/3/98 48 Microsoft 1878.45 4545.00 $2666.55
6/23/98 68 Cisco Syst 1985.95 4288.25 $2302.30
5/1/98 82.5 Gap Inc. 1890.33 3949.69 $2059.36
2/13/98 44 Intel 1862.83 2884.75 $1021.92
2/3/98 66 Pfizer 1810.58 2359.50 $548.92
5/26/98 18 AmExpress 1873.20 2412.00 $538.80
2/17/99 16 Yahoo Inc. 2020.95 2430.00 $409.05
8/21/98 44 Schering-P 2111.7 2321.00 $209.30
2/6/98 56 T. Rowe Pr 1885.70 2054.50 $168.80
2/27/98 27 Coca-Cola 1865.89 1690.88 -$175.02
Foolish Four Stocks
Rec'd # Security In At Value Change
3/12/98 20 Exxon 1286.70 1562.50 $275.80
3/12/98 20 Eastman Ko 1262.95 1461.25 $198.30
3/12/98 15 Chevron 1250.14 1413.75 $163.61
3/12/98 17 General Mo 1230.89 1130.50 -$100.39
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