Last week Pfizer (NYSE: PFE) released its first 10-Q since the close of its merger with Warner-Lambert in June. One thing I've wondered about is whether the merger would improve Pfizer's balance sheet, since Warner-Lambert is such an efficient company. So far, things are looking good. Pfizer collected its receivables quicker and generated better cash from operations in the second quarter.
This acquisition was accounted for as a pooling of interests, which means that prior financial statements are restated, and the two entities are treated as if they had always been part of the same company. Pfizer hasn't yet restated its 1999 financial statements to include Warner-Lambert's results (the 10-Q indicated that restated financials would be filed by September 2000). In most cases, that would mean that there wouldn't be much value in comparing Pfizer's results for the second quarter of this year to its results from a year ago, as the company is so different for the two periods.
However, in this case I think the comparison is relevant, since it gives us our first chance to look at Pfizer's balance sheet with and without Warner-Lambert. These financials also give us a starting point for the combined entity -- one that we'd like to see start on a steady path toward higher efficiency in terms of minimizing debt and maximizing working capital efficiency.
One of the primary complaints I've had about Pfizer is its focus on managing earnings over keeping its balance sheet in order. Historically, Pfizer has carried its outstanding accounts receivable balance longer than other major pharmaceutical companies. Pfizer's view has essentially been that a dollar of revenue is valuable no matter when it's collected. While this is true, it's also true that a dollar of revenue collected today is more valuable than one collected in the future. In the second quarter of 1999, Pfizer's days sales outstanding (DSO) -- accounts receivable / (sales / 90) -- was 81 days.
This means that Pfizer gave its average customer an interest-free loan for close to three months. I don't know about you, but I'd love to find a bank that would loan me money interest-free for three months. I'm pretty sure I won't find one, because a bank run that way would ultimately go out of business.
I realize I've been harping on this issue for a while in various reports. I'm happy to say that I now have some real numbers to put behind the cost associated with poor working capital management. In this press release the director of financial planning for Litton Electron Devices, a division of Litton Industries (NYSE: LIT) discusses some of the benefits the company would realize by cutting receivables from 60 days to 40 days or less:
- Funds would be freed up to focus on core business development.
- Improved cash flow from receivables in excess of $2 million -- within just the first six months of implementation.
- Savings of $150,000 in interest charges alone. (This figure was upped to at least $250,000 in another article discussing the impact of shortening the cash conversion cycle by 20 days.)
Let's compare Pfizer's DSO of 81 days in the second quarter of last year to results for the first quarter, after the merger with Warner-Lambert. Here are the figures we need to perform this calculation:
Accounts receivable: $5,341 Sales: $7,041If we use the formula detailed above, we find that Pfizer's DSO was 68 days, a definite improvement. Warner-Lambert's DSO last year was 56 days, so this quarter's result sits in between the two figures. Over time, we want to see it migrate more and more toward Warner-Lambert's performance. One small sign that it could was found in the 10-Q, which said that net cash provided by operating activities was positively impacted by the timing of collections of accounts receivable.
Pfizer's days sales inventory (DSI) -- inventory / (cost of sales / 90) -- showed similar improvement. Pfizer's DSI was an astounding 341 days in the second quarter of 1999. It was 202 days in the second quarter of this year. Warner-Lambert's DSI in the earlier period was 128 days. A logical question is what impact this had on Pfizer's Flow Ratio and cash-to-debt ratio. Not surprisingly, Pfizer's Flow Ratio fell to 1.47 this year from 1.71 a year ago. Its ratio of cash-to-debt improved to 0.88 from 0.83.
Truthfully, however, we don't yet know if the improvements in DSO and DSI were by default, as a result of the merger, or are real, positive, sustainable signs of future results. We'll keep a close eye on how things develop.
I found a couple of cautionary points on this subject in the 10-Q, however. First, on April 27, Pfizer's board of directors voted to continue the current share repurchase program originally started in April 1998. The plan still allows for the repurchase of up to 140 million shares at a cost of $1.9 billion. This plan was first approved in September 1998 and was to last two years. In my opinion this program should be suspended until some more debt is cleared from the balance sheet.
Second, Pfizer wrote, "When necessary, Pfizer utilizes short-term borrowings for various corporate purposes." I'd rather Pfizer use its money to purchase and implement a financial system like the one acquired by Litton Electron Devices. This could scale back its needs for short-term borrowings and improve its working capital management.
Which do you think is more important to Pfizer's long-term success -- delivering earnings that meet the expectations of the Wise or cleaning up its balance sheet and improving its working capital management? Let us know your thoughts on our Rule Maker Companies discussion board.
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