In tonight's report, I'd like to share the financial statement and working capital issues we discussed. Our questions are in italics, followed by a synopsis of Pfizer's response and some Foolish commentary.
Why isn't a balance sheet issued when earnings are released?
In Pfizer's view, the balance sheet is secondary for a company that's part of a growth, research-based business. In addition, its investment client base (i.e., analysts and institutional investors) doesn't demand it.
It should be noted that Pfizer is not required to publish a balance sheet until its 10-Q or 10-K is released. That said, the balance sheet is critical to our analysis of a company's quarterly progress, and most of our other Rule Makers -- Microsoft, Intel, Cisco, Yahoo!, Gap, and more -- do include a balance sheet as part of the earnings press release. Also, as shareholders with a long-term outlook on investing, we should be more important to Pfizer's management than its "clients."
Will research and development (R&D) expenditures continue to grow in line or above the rate of revenues? How about selling, general and administrative expenses (SG&A)?
Pfizer expects there will be a "tempering in its spending rates." On a stand-alone basis, Pfizer is projecting 16% revenue growth for each of the next three years. R&D is expected to grow 15.3% for 2000. After the merger with Warner-Lambert (NYSE: WLA) has been finalized, it is expected that revenues will grow by 13% annually and that R&D growth will be in the mid-teens. There will continue to be relatively heavy spending on R&D, but this will be tempered somewhat by some expected top-line (revenue) synergies. Pfizer also expects that the merger will result in savings of $200 million in 2000, $600 million in 2001, and $800 million in 2002.
Is the law of large numbers beginning to hurt Pfizer's growth?
Pfizer said the following: "Yes, this is an issue. But, scale is very key in this industry. We're not choking yet." Pfizer believes that it is in a class of ONE in the pharmaceutical industry. It views significant growth for a company of its size as both an issue and a challenge. Pfizer believes that such factors as its R&D investment, partnerships with genomics companies, and its efforts to bring all necessary tools in-house will be important elements enabling it to continue to grow.
What's the return realized on short-term investments versus the amount paid on short-term (S/T) and long-term (L/T) borrowings (S/T 4.3%, L/T 6.1% per the 1999 Annual Report)?
The primary reason for asking this one is that I was trying to get some insight into why Pfizer's balance sheet included $4,442 million of cash and short-term investments at the end of 1999 as well as $5,001 million of S/T debt and $525 million of L/T debt. While I realize that there may be reasons a company wants to include both stock and debt in its capital structure, I don't see the merits of carrying large cash balances and carrying corresponding amounts of debt as well.
Pfizer said that historically its capital structure maintains a 1:1 relationship between financial assets and financial liabilities and that its interest income does exceed its interest expense.
When I dug a little deeper, I also learned that a significant portion of Pfizer's cash is held by subsidiaries that are based outside the U.S. Due to the intricacies and, dare I say, injustices of U.S. tax law, Pfizer would most likely be at least partially double-taxed on distributions of cash from its foreign subsidiaries to the U.S. Pfizer has actually taken a position under the accounting rules treating its foreign earnings as being permanently reinvested outside the U.S. This keeps it from accruing this tax cost on its financial statements.
To a certain extent, what Pfizer has said here makes sense. However, I can also make an argument that the U.S. tax rules actually favor borrowing outside the U.S. This would mean that to a certain extent Pfizer could use some of its cash balance to lower its debt levels. This strategy could even make it a little cheaper for Pfizer to repatriate some of its foreign earnings to the U.S.
Reviewing the 1999 Annual Report, I noted that there were significant investments in property, plant, and equipment (PP&E). What was the focus of this investment -- for example, new R&D facilities, new plants?
Pfizer said that it is currently involved in a far-reaching modernization of its manufacturing and distribution facilities. This process actually began about a decade ago when it sold its specialty chemicals business. It has been optimizing its R&D operations in Connecticut, the United Kingdom, and Japan, and has added and/or upgraded laboratory space. Warner-Lambert also has an R&D facility in Michigan. Pfizer does not expect to incur significant new plant costs in the near future.
The annual report says that the increase in S/T borrowings was primarily to fund $2.5 billion of stock repurchases. Please explain the rationale.
Pfizer said that this decision is not motivated by EPS management because the interest gained on cash sitting on the balance sheet exceeds the benefit from reducing the share count. It also said that this investment decision had also served the company well in the past.
One thing that I found interesting is that Pfizer's answer did not address capital structure issues. Recently, I spoke at an NAIC Investor's Fair in Iowa. During one of the company presentations, I asked one speaker why his company had chosen to use S/T debt to fund stock repurchases. First, he simply said that this debt would be converted to L/T debt. When pressed further, he indicated that it was because the company felt that its capital structure (i.e., debt and equity) could support more debt. While my Rule Maker approach leaves me questioning that choice at least a little bit, I was more satisfied with that answer than Pfizer's.
How much is Pfizer willing to sacrifice to grow earnings over cash flow? In other words, does cash flow or working capital management have any bearing in the decision making and management process?
Pfizer views cash as a mechanism to help achieve earnings growth. The company now has more opportunities for expansion than its cash flow can support. Thus, in order to avoid being forced to forego opportunities, cash flow will be a bigger driver in Pfizer's future. I know that we'll be keeping an eye on Pfizer's Flow Ratio as that's one way we'll be able to tell if Pfizer is improving its performance in this area.
Why is Pfizer's cash conversion cycle so long?
Pfizer said that the timing of the accrual and the related payment of its alliance revenue does not coincide well with balance sheet publication. It also said that the days sales outstanding (DSO) for alliance revenues is about the same as for in-house products. Its large international presence makes it difficult to collect sales quickly, as in many foreign countries the government is the one that pays for Pfizer's products.
My reaction here is that even if these things are true, that doesn't make up for the fact that Pfizer's DSO is consistently higher than that of its competitors. I believe that the company should make a more concerted effort to revamp its accounts receivable collection policies in order to cut down on its interest-free loans and bring this money in-house more quickly.
As for the days of sales in inventory (DSI), according to Pfizer's overall business model, it's a sin for a company with 85% gross margins to go on back order, thus inventory is kept at levels where that would never happen. While that may be true, I can't help but think of a great quote by Michael Dell that fellow portfolio manager Zeke Ashton cited in his Foolish research report on Dell Computer (Nasdaq: DELL):
"There is an inverse correlation between the quality of the information you have and the amount of inventory (or assets) you need. Most businesses tie up a tremendous amount of assets anticipating things that may not actually happen. If you have perfect information about what the customers want to buy, you need very little in the way of physical assets to be able to supply them. If you have no information, you need a tremendous amount of inventory to prepare for the possible outcomes."
It seems to me that Pfizer should give consideration to improving the quality of its information so that it doesn't have to tie up capital in the production of inventory that could quite conceivably end up sitting on its shelves.
After this part of the discussion I was left with the feeling that Pfizer does pay some attention to the issues that are of the most concern to Rule Maker investors, but that it has a ways to go until its performance matches those of some of the other businesses we own in this portfolio. Hopefully, both the combination with Warner-Lambert and the need to generate sufficient cash to fund its future growth opportunities will lead to some improvements.
That's all that we have time for tonight. I expect that I'll finish this series when we get a break from earnings season some time in May. Around that time, I'll also cover Pfizer's earnings, which were reported today, after the company issues its 10-Q. Tomorrow night, I'll be back to discuss Intel's (Nasdaq: INTC) first-quarter earnings report.
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