After a mating dance that lasted several stanzas, involved multiple suitors and contained enough intrigue and plot twists for an episode or two of Zorro, Rule Maker company Pfizer (NYSE: PFE) and fellow pharmaceutical Warner-Lambert (NYSE: WLA) came to terms for Warner-Lambert to be acquired by Pfizer, a deal currently valued at $84 billion.
The all-stock deal works out, at current Pfizer share prices, to about $98 per share of Warner-Lambert. This is about a 40% premium to Warner Lambert's share price at the point that they decided to merge with American Home Products, back in November 1999. Pfizer will have significant goodwill amortization offsets for the next several years as a result. But we knew this going in, right?
In the end, Pfizer's shareholders will come away holding 61% of the combined company, which will be called Pfizer, Inc.
By consummating this merger, Pfizer adds an unparalleled sixth drug with annual sales above $1 billion: Norvasc (hypertension), Zoloft (depression), Viagra (erectile dysfunction), Zithromax (antibiotic), diflucan (antifungal) and now, Lipitor (cholesterol inhibitor).
Pfizer also adds Warner-Lambert's substantial research and development (R&D) efforts, which include it's Parke-Davis Labs. When combined with Pfizer's R&D, the new company will invest $4.7 billion into its drug research efforts for fiscal 2000 -- far and away the largest research budget within the pharmaceutical industry.
Finally, Pfizer will gain control over such home products as Listerine and Trident gum, though given Pfizer's recent sale of its own over-the-counter product lines, it would not surprise many if they quickly sold off these brands as well.
What Pfizer does not get out of this acquisition is any cash, even though Warner-Lambert has nearly $2 billion of it on hand. This is due to the "breakup fee" that Warner-Lambert negotiated with American Home Products (NYSE: AHP) when they first decided to merge. Warner's going elsewhere, and thus must pay a $1.8 billion fee in cash to AHP.
The details and the soap opera of the merger dance have been detailed quite well in the press, with the Warner-Lambert CEO, Lodewijk de Vink approaching one company after another to try to have someone rescue his organization from Pfizer's grasp. This list included Procter & Gamble (NYSE: PG), which was scared off last month when leaks to the press caused its share price to tank and Warner-Lambert's to spike. So in the end, it's Warner-Lambert being swallowed by Pfizer, the one deal that really makes the most sense.
The prize in this whole ordeal, at least for Pfizer, is Lipitor, which reached $3 billion in sales last year, and was sold under a co-marketing agreement between it and Warner-Lambert. Pfizer has left no question about the fact that this revenue stream is the one it wishes to protect and bring in-house. This marketing alliance was quite beneficial to both companies, but it should be more so now that Pfizer won't have to share it with anybody.
"Should" is the operative word here. We at the Rule Maker have taken Pfizer to task for its poor cash management policies, particularly in regard to the lengthy payment cycles the company has allowed its alliance partners. For example, in the Lipitor co-marketing agreement, Pfizer routinely gave Warner-Lambert 120+ day payment terms. This helped push Pfizer's receivables out to an excruciating 81 days to collect on delivered goods -- much longer than any other pharma company. This function, called Days Sales Outstanding (DSO), is calculated using the formula: Accounts Receivable / (Sales / 90). Contrast Pfizer's DSO to Warner Lambert's and you'll find that on average Pfizer gave its customers an additional 25 days to pay, interest-free. Such laxness in Pfizer's collection policies has had a nasty effect on its balance sheet and cash flow.
This is exactly why we pound the table on the Foolish Flow Ratio. A company cannot invest a receivable; it cannot spend a receivable. The only current asset we really like is cold hard cash. So although the amount of uncollectable receivables that pharmaceutical companies have to write down each year is quite small, there is still a definite cost for poor cash management. And that cost is paid by shareholders in the form of a lower market value for their shares.
On a wider scale, Warner-Lambert's cash conversion cycle, helped in part by its sweet payment schedule from Pfizer, was negative 28 days. This means that the company on average collected cash on its product sales 28 days BEFORE they were produced. Pfizer, on the other hand, collected cash nearly nine months (276 days) AFTER its goods were produced. In evaluating a company's cash conversion cycle, a lower number is better, as we hope to see our companies collect cash quickly and pay it out slowly. It goes without saying (even though we have in the past and will in the future) that Pfizer's cash conversion cycle is alarmingly high, and places an unnecessary threat on the company's financial standing.
Even if Wall Street doesn't pay attention to this sort of thing, efficient working capital management is still highly important to the long-term profitability of the company. When Warner-Lambert is absorbed, the combined balance sheet will immediately look much better for Pfizer. First, for the simple reason that Warner will be ahead on its cash cycles. And second, since the former alliance between the two companies -- one which was among the most offensive of Pfizer's cash management tendencies -- will be internalized, thus netting out those terms.
In the end, the same people who controlled pre-merger Pfizer will be in charge of the combined entity. This company, particularly with the matching of strength on strength in the merger, is a definitive Rule Maker. It remains to be seen, however, whether or not the company showers so much attention on the income statement's bottom line that its cash management on the balance sheet again deteriorates.
Finally tonight, Cisco Systems (Nasdaq: CSCO) reported its fiscal Q2 2000 earnings after the bell. Our networking Rule Maker turned in EPS of $0.25 which beat the $0.24 predicted by the Wise. And although it does not affect the value of the company, a two-for-one stock split was also announced. Here's a link to the earnings release. Tomorrow, Phil Weiss will give his perspective on Cisco's profit picture and outlook.
