Picking up where I left off yesterday, here's what we know:
- Pfizer is focused on "protecting the bottom-line" of the income statement in order to meet/beat Wall Street's quarterly expectations.
- This income statement focus comes at the expense of managing the overall business from the perspective of the balance sheet and cash flow statement.
- And it shows. Through the first half of 1999, Pfizer is generating negative free cash flow (FCF).
- Even so, the company is repurchasing its own shares by taking on debt.
- A major cause for Pfizer's deteriorating cash from operations is due to the longer collection terms for alliance revenue products such as Lipitor and Celebrex.
Pfizer books the revenue from its alliance deals, but it doesn't get cash payment until 120 or more days later. Until Pfizer receives cash payment, those revenues sit on the balance sheet as accounts receivables. We don't want accounts receivable; we want CASH! Pfizer is booking these alliance revenues and counting them as net income, but the cash won't roll in until perhaps months later. Until that cash is actually received by Pfizer, the alliance-related net income cannot be counted as part of operating cash flow. Thus, the longer collection period related to the alliance revenues causes operating cash flow to decline.
It helps to think of this situation in terms of Pfizer's customers versus its vendors. Essentially, an accounts receivable balance is nothing more than an interest-free loan to a customer. And in Pfizer's case, it's been handing out an increasing amount of these interest-free loans to its alliance customers. On the other hand, Pfizer's vendors have not lengthened their payment terms for accounts payable. Pfizer's vendors have no sympathy for the fact that it is taking longer for Pfizer to collect some of its revenues! As mentioned yesterday, Pfizer incurs additional expenses related to the co-marketing alliance agreements. Payment of these expenses is due before Pfizer collects the related revenue. So, while Pfizer is giving its partners interest-free loans in the form of accounts receivable, it needs to raise more cash to pay off its current debts.
The end result is that it has to borrow additional funds in order to meet its working capital needs.
Okay, now let's talk about a much simpler way of evaluating this complex situation. One of my favorite metrics in terms of Rule Maker analysis is the flow ratio. This handy little tool allows us to connect a company's balance sheet and income statement while also looking at the operating portion of the cash flow statement.
In discussing Pfizer earlier this month, Matt explained:
"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" (thru 6/99) 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."
It's becoming increasingly clear that the long collection terms associated with Pfizer's alliance revenues is causing Pfizer's operating cash flow to suffer. We can see it on the cash flow statement (see the table in yesterday's report). We can see it in the rising flow ratio.
In a way this is kind of funny. Companies like Amazon.com (Nasdaq: AMZN) are criticized for not making any money. Yet, here is Pfizer, a well-respected "profitable" company, that has much worse cash flow dynamics than Amazon. Amazon generally receives money from its customers before paying its suppliers. Pfizer is often guilty of the opposite.
Pfizer's alliance revenue situation provides us with a real-life example of the time value of money concept. Which would you rather have: a dollar today or the same dollar three months or more from today? If interest rates are low, then three months may not seem like all that much. However, Pfizer has generated $1.5 billion of alliance revenues so far this year. At that magnitude the impact of delayed cash inflow is much more significant.
Finally, in last week's article I mentioned there were signs in Pfizer's Q3 earnings release that the company may be managing its earnings or at least managing its business in a way that generates earnings at a specified level. After Monday's discussion with IR, I was left feeling that this is an undeniable fact. In case you don't believe me, all you have to do is notice how many times I used the phrase "bottom line" yesterday. IR told us that Matt and I are the only ones that have expressed concerns about the collection of alliance revenues, the configuration of the balance sheet, and the company's free cash flow position.
The Wise focus on Pfizer's quarter-to-quarter earnings per share and not its cash flow. Pfizer says that even if it wanted to (and IR indicated it does), it can't change this earnings-obsessed environment. Pfizer's concern is that missing earnings and strengthening cash flow would cause the stock to go down. IR mentioned a specific example of this from a few years ago when Pfizer missed earnings by two pennies, and the stock price fell 15%.
My reaction to that is, "So what?" As long as the long-term outlook of the company is on-track, then an irrational dip in the stock price is just a buying opportunity for Foolish investors! My opinion is that Pfizer's focus on earnings over cash flow may ultimately detract from the long-term outlook -- and thus the long-term value -- of the company. Meeting or beating earnings expectations may provide a short-term benefit, but over the long haul, generating strong cash flow will yield the best results.
Here in the Rule Maker portfolio we rarely talk about value. As a matter of fact, our seventh step actually states that business quality is 100 times more important than valuation. But, if one is to try and value a company, in my opinion the only method that can give meaningful results is based upon discounted cash flow analysis. If Pfizer is running its business to produce higher current earnings instead of to generate FCF, then in the long run, I think it will be worth less as a company. This is because of the fact that the two key drivers behind discounted cash flow analysis are the company's growth rate and its ability to generate free cash flow.
As a shareholder, I'd like to see Pfizer take significant strides in improving its balance sheet. In my opinion, days sales outstanding is too high, the cash conversion cycle is too long, debt levels are higher than I'd like, and working capital management should be improved. The bottom line is that Pfizer needs to manage its business from the perspective of how much FCF it can generate instead of managing the income that flows to its bottom-line.
Does this mean that I'm recommending that we sell our shares of Pfizer?
No!
Am I planning to sell the shares that I hold in my personal portfolio?
No!
But, I will be watching the company more carefully in the future. If the business environment changes for the worse, Pfizer could as well. One thing that I won't be doing though is suggesting that this month's $500 investment be used to buy more shares of Pfizer. Instead, I think we should make this month's investment in one of the Dow Jones Industrial Average's newest members, Intel (Nasdaq: INTC).
More on that tomorrow.
Phil
