Let's take 'em in that order.
What's up with Pfizer?
The big pharma stocks have been in a slump for nearly six months. During that time, both of our pharmaceutical Rule Makers -- Pfizer and Schering-Plough -- have suffered along with the rest of the industry. So what's going on? Well, the pundits blame rising interest rates and the possibility of forthcoming negative healthcare legislation. While those factors certainly have a negative impact on the sector, I think Pfizer is also suffering from some problems of its own.
The damage jumped out at me as I was looking at the company's most recent cash flow statement. Year-to-date, Pfizer's operating cash flow of $614 million is less than half its reported net income of $1,544 million. As I mentioned a few weeks ago in The Most Important Financial Statement, cash flow is the reality that is of real consequence to investors; net income is nothing more than a sometimes-useful fiction. Over the past two quarters, Pfizer has presented sparkling income statements showing solid top- and bottom-line growth. But underneath the income statement's disguise, the cash reality has been quite a different story. Pfizer's operating cash flow is down 50% from the year-ago level.
The cash flow statement shows the extent of the damage, but Pfizer's root problem starts on the balance sheet. As Phil wrote yesterday, savvy investors use the balance sheet as a sanity check for the income statement. That's where the flow ratio proves especially useful. (Do you understand the flow ratio? If not, take a few moments and detour this way.) Since the beginning of the year, Pfizer's flow ratio has catapulted from 1.34 to 1.71. That's a 28% move in the wrong direction. The reason we place so much emphasis on the flowie is because a rising flow ratio works like a cash vacuum.
Pfizer's year-to-date "profit" of $1,544 million was eroded into only $614 million of operating cash flow. How?! According to the cash flow statement, $1,198 million was eaten up by "changes in assets and liabilities." That line item could just as easily read "changes in the flow ratio." When the flow increases, cash gets sucked from operations. That's what has happened to Pfizer during 1999.
But let's not stop there. Digging deeper in our understanding of Pfizer's business, part of Pfizer's ailing flowie comes from its "alliance revenues." These monies include Pfizer's revenue-sharing deals with G.D. Searle (for the arthritis drug Celebrex) and Warner-Lambert (for the cholesterol fighter Lipitor). In these deals, Pfizer utilizes its industry-leading sales force to co-market the other drug companies' products. Heretofore, investors have hailed these deals as a sign of Pfizer's marketing strength, but there's just one problem: Apparently, these alliances allow Pfizer's partners to hold off payment well into the future, and in the meantime, Pfizer's receivables are ballooning.
Using the second quarter financial statements, here's the year-over-year comparison of net sales (in-house drugs) and alliance revenues:
($ millions) Q2 '99 Q2 '98 Growth Net Sales 3,298 3,114 5.9% Alliance Revenues 481 198 142.9%As you can see, demand for Pfizer's in-house drugs has been somewhat stagnant. The company has been keeping up with Wall Street's demand for double-digit growth by pursuing these alliance revenues. And that would be fine, except for the fact that these deals have enormous working capital costs. That is, the alliance revenues require a higher level of receivables, and higher receivables mean a higher flow ratio, and a higher flowie means -- vroom, vroom! -- the cash vacuum.
The following table compares Pfizer's growth in revenues versus growth in accounts receivables:
($ millions) Q2 '99 Q2 '98 Growth Total Revenues 3,779 3,312 14.1% Accts. Rec. 3,396 2,885 17.7%Going forward, I'll be paying extra close attention to the composition of Pfizer's revenues. The smart money knows that Pfizer's alliance revenues are not as valuable as its in-house drug sales, or "net sales." When Pfizer reports earnings next week, let's pay close attention to the revenue breakdown. (Unfortunately, Pfizer only includes its income statement when it reports earnings. We'll have to wait for the next 10-Q before getting a glimpse of the Q3 balance sheet and cash flow statement.)
Pfizer's business may not be firing on all cylinders, but it's still a fantastic company. I still consider it the undisputed Rule Maker of the pharmaceutical industry. This year, the company will invest $3 billion in research and development -- tops in the industry -- to find the next generation of cures and life-enhancing medicines. When the company's in-house drug portfolio resumes growth, then operating cash flow should improve, and so should the stock.
Free Trades at American Express!
In about a month, American Express -- already the world's #1 financial services brand -- will be opening a new online brokerage format, with a unique pricing twist: free trading... at least for certain account minimums. With a minimum of $25K, clients get free stock buys. With $100K, both buys and sells are free. This is fantastic news for AmEx and bad news for rest of the brokerage players. AmEx is moving boldly to gain market share in online investing so that it can eventually cross-sell its other products such as online banking, credit cards, charge cards, personal loans, and more. Given the strength of AmEx's brand and its stellar customer service, I think they will succeed.
The benefit of AmEx's announcement to our portfolio is twofold. First, AmEx's stock has moved higher on the news, which of course helps our portfolio's performance. But more importantly, as soon as AmEx's new brokerage is available, the Rule Maker Portfolio will be switching brokerage accounts pronto! Currently, we use Suretrade because of its rock-bottom $7.95 commissions. But with our level of assets, the MakerPort will qualify for free stock buys, which means no more commissions for our monthly $500 purchases. That amounts to $95.40 of commission savings each year. Compounded at 11% one year of commission savings will be worth $271 in ten years. When you consider the power of compounded growth, the commission savings of AmEx's new brokerage pricing is nothing less than a boon for the Rule Maker Portfolio.
Microsoft's Online Annual Report
You may want to check out Microsoft's newly available 1999 online annual report. Here's an excerpt from Bill Gates' letter:
"In the years ahead, we will see accelerating change in the software industry, as the computing needs of our customers start to move beyond the PC into a 'PC-Plus' world. The PC will undoubtedly remain at the heart of computing at home, work, and school, but it will be joined by numerous new intelligent devices and appliances, from handheld computers and auto PCs to Internet-enabled cellular phones. More software will be delivered over the Internet, and the boundary between online services and software products will blur."
Take a look at Microsoft's 1999 cash flows, with its $10 billion in operating cash flow and $9.5 billion in free cash flow. Microsoft is now selling at ~50 times its free cash flow, versus 30 times for the S&P 500. But Microsoft is growing two to three times faster. You be the judge of which is the better value.