This is the first new piece of Rule Maker content since the attacks last Tuesday. As expected, stocks were very volatile yesterday. With the exception of Nokia (NYSE: NOK) all Rule Maker stocks are trading at lower values. We aren't surprised by this. Stocks are volatile, especially so in times of such uncertainty.

Where does the Rule Maker stand? The terrorist attacks haven't changed our opinion of the strength of many of the companies in our portfolio, though the short-term outlook, which we can't predict, looks rough. If fewer people travel and the economy worsens, for example, American Express (NYSE: AXP) will struggle. We hope this isn't news for any American Express shareholder.

Our confidence in the portfolio, however, doesn't mean there aren't issues we must address. Two months ago we started reviewing each of our holdings. So far, we've looked at Nokia, American Express, Intel (Nasdaq: INTC), and Microsoft. You can follow any of the preceding links to find out where we stand on each of these companies. In today's story, Mike Trigg will continue the review with a look at Pfizer (NYSE: PFE).

We don't pretend there aren't problems with some of our holdings. Remember, the portfolio is meant as a teaching tool -- both for our readers and ourselves -- and we've learned hard lessons. In the coming weeks we'll take a fresh look at Yahoo! (Nasdaq: YHOO), Cisco (Nasdaq: CSCO), Coca-Cola (NYSE: KO), and Schering-Plough (NYSE: SGP), companies about which we have real concerns, not in light of last week's tragedy, but for reasons related to valuation, basic business model, and understandability. 

One final housekeeping issue: On September 5, we announced plans to buy additional shares of American Express with our $500 monthly investment. The attacks on the Pentagon and World Trade Center prevented us from buying the shares within five business days, our established procedure. Yesterday the markets reopened and we bought 16 shares of Amex at $30 apiece. For those interested, our archived reports provide returns for all the stocks in our portfolio. You can also see daily updates for the portfolio as a whole on our Investing Strategies page.

We hope that this day finds you well and safe. For those who were lost, or who lost someone, our prayers are with you.


Pfizer (NYSE: PFE) is the Rule Maker Portfolio's best performing stock, returning more than 40% since we bought the company in February 1998. Today, we continue our review of each holding, discussing the pharmaceutical giant. Admittedly, I keep getting the easy assignments: reviewing holdings that remain obvious Rule Maker stocks. The tough columns are yet to come, as we start deciding what to do with Yahoo! (Nasdaq: YHOO) and Schering-Plough (NYSE: SGP). In the meantime, we welcome your thoughts on the Rule Maker message board.

It's no secret the pharmaceutical industry lends itself to Rule Maker investing.  The upfront costs for R&D are high, but manufacturing and selling expenses are low, resulting in extremely high margins. Pharmaceuticals are also a repeat-purchase business because illnesses don't go away with one or two pills. And the industry should benefit from favorable demographic trends: The percentage of people over 65 -- who use three to four times more prescription drugs than people half their age -- is expected to exceed 20% of the U.S. population by 2010. 

The favorable characteristics of this industry have led the Portfolio to make two additional pharmaceutical purchases, most recently Johnson & Johnson (NYSE: JNJ). Also, we just finished a review of Merck (NYSE: MRK), another pharma that remains on our watch list. That said, we continue to view Pfizer as the New York Yankees of the pharmaceutical industry. The company has the largest sales force in the world, an R&D budget that dwarfs the competition, and eight blockbuster drugs that had more than $1 billion in revenues last year.

Pfizer's top-selling drugs have little patent exposure as well, something much of its competition can't claim. (Five of Merck's best-selling drugs will go off patent this year, for example.) Pfizer's most significant drug to lose protection is Neurotin, an epilepsy treatment with sales of $1.3 billion in 2000, which will lose its patent in 2002. Diflucan, a fungal infection drug with $1 billion in sales last year, will also lose protection in 2004. But beyond those, drugs with long patent lives include Zithromax (2005), Zoloft (2005), Norvasc (2007), Lipitor (2010), Viagra (2011), and Celebrex (2013).

With Pfizer's R&D budget surpassing $5 billion this year, no one should be surprised its pipeline is locked and loaded. Truthfully, today's column does not permit a complete review of its pipeline, but by all accounts there's little worry in this area. Phase III and registered drugs with the potential to significantly impact sales include Exubera (inhaled insulin), Valdecoxib (pain, arthritis), ONYX-015 (liver cancer), and Remune (HIV vaccine). (We recently wrote on how to assess the strength of a company's pipeline, using Pfizer as the example.)

The Warner-Lambert merger, which we've discussed in previous columns, has also proven to be a success. Since Pfizer stole Warner-Lambert away from American Home Products (NYSE: AHP), despite paying a $1.8 billion penalty, cost cutting has been the name of the game. Pfizer originally forecasted savings of $200 million in 2000, but then actually turned in $400 million. In 2001 and 2002, initial guidance called for savings of $1 billion and $1.6 billion, respectively, but the estimate has since been changed to $1.2 billion and $1.6 billion or more.

Even though there's a lot to like about Pfizer's future, we do have some concerns. While the company's eight blockbuster drugs have very little patent expiration exposure, it will become increasingly difficult for those products to maintain their dominance. Viagra, an impotence drug with $1.3 billion in sales last year, will face increased competition from Eli Lilly's (NYSE: LLY) Cialis, for example. Zoloft, an anti-depressant with $2.1 billion in sales last year, also continues to have its growth stymied by Forest Laboratories' (NYSE: FRX) Celexa.

Indeed, slowing market share of blockbuster marketed drugs is a problem every major pharmaceutical company must face, but in Pfizer's case the situation puts increased significance on its ability to ensure new drugs are launched with no mistakes and that there are very few, if any, missteps in developing new products. Pfizer recently launched Geodon, for example, a schizophrenia drug with the potential for $1 billion in sales. But Geodon took two years to get final approval and is a good example of the hiccups Pfizer could face. 

Growth is also a concern. In the past three years, revenue growth has fallen from 22% to 18% to 8%. True, 2000 revenue growth was hurt because of weak foreign currencies, but it's very difficult for any company, even one with a solid research franchise and portfolio of blockbuster drugs like Pfizer, to maintain sufficient top-line growth on revenue base of roughly $30 billion in trailing-twelve-months sales. Put another way, the company is almost forced to develop only large blockbuster drugs, which are becoming fewer in number as time goes by.

This issue of growth begs the question: At the current price, does the stock have a good possibility to appreciate two times over the next five years?  Pfizer closed as of this writing at $38.17 per share, leaving it with a market capitalization of $241 billion. With more than $7 billion in trailing twelve months free cash flow, Pfizer currently trades at a multiple of 34 times free cash flow, compared to the S&P 500, which currently trades 23 times. Below are estimated P/FCF ratios and the growth rates required for stock to post 2x5y returns:

Projected P/FCF             35      30       25
FCF Growth Rate for 2x/5y   14%     18%      22%

Assuming a price-to-free cash flow ratio of 30 times, Pfizer needs to grow free cash flow 18% annually over the next five years to more than $18.9 billion for 2x5y returns. We think it's reasonable to assume the market will still be willing to pay that type of a multiple for a leading pharmaceutical company like Pfizer with a solid research franchise and a portfolio of blockbuster drugs. But even at a 35 times free cash flow, it's far from a foregone conclusion that the company would be able to post the returns required for the stock to double.

Having said that, we do look forward to staying Pfizer shareholders for many years. The characteristics of the pharmaceutical industry make the stock a classic Rule Maker, and it boasts clear advantages, such as the largest sales force in the world and an R&D budget that looms over that of its competition. The company's pipeline also appears robust, although we do have some concerns over its growth potential ten years out, given its size. The possibility of Pfizer with a market cap of $480 billion (twice its current size) in five years doesn't seem very likely, which makes it doubtful we'll add to our position until there's some weakness in the stock price.

Mike Trigg owns shares of Pfizer and was amazed when the Fool's Rick Aristotle Munarriz informed him that the company made Bubblicious chewing gum, Mike's favorite. Mike's stock holdings can be viewed online, as can The Motley Fool's disclosure policy.