Large pharmaceutical companies generate healthy cash flows, part of which they usually return to shareholders in the form of dividends and share buybacks. But these businesses also have plenty of other options for capital allocation in order to produce growth, including pouring money into research and development to create new drugs and acquiring other companies that have technology and portfolios of drug candidates that will boost future profits.
The skill a management team uses in allocating capital between shareholder returns and the need for growth is usually what makes the difference between a great stock investment and a mediocre one. Pfizer (NYSE:PFE) and Eli Lilly (NYSE:LLY) are two of the biggest drug companies in the world. Which of these is making the decisions that make it the best choice for your stock portfolio?
Valuation and stock performance
2018 was a good year for investors in both companies, as the stocks posted strong gains compared to a decline of 6.2% in the S&P 500, and were two of the best performers in big pharma. Pfizer stock gained 24.8% last year, although it has given back 2% so far in 2019. Eli Lilly did even better, soaring 40.5% in 2018, and has tacked on another 6.4% since the beginning of this year.
Both stocks got a boost midyear when investors were seeking stocks that wouldn't be affected by a trade war. But these "defensive" stocks also held up well toward the end of the year when the broader market tumbled, thanks to steady and predictable growth. Pfizer grew revenue in 2018 by 2.1% and earnings per share, adjusted for currency effects and one-time events, by 13.2%. Lilly generated 7.4% revenue growth last year and EPS jumped 29.7%.
The price-to-earnings multiples of both stocks expanded last year, but investors continue to give a higher valuation to Lilly, expecting the higher growth rate of that company to continue into the future. Pfizer sells for 14.8 times management's guidance for earnings in 2019, and Lilly is priced at 21.9 times. The S&P 500 is now selling for 16 times forward earnings and the pharmaceutical industry is selling at 14.9 times of forward earnings, so Pfizer is right in line with its peers while Lilly shares sell for a premium.
Both stocks pay a dividend, but Pfizer has Lilly beat for yield. Pfizer will pay $1.44 per share in dividends this year for a healthy yield of 3.4%. Lilly's dividend in 2019 is $2.58, which works out to a yield of 2.1%, the lowest in its peer group. Both companies recently raised their dividends and generate plenty of cash flow to keep raising them for the foreseeable future, but Lilly is growing its dividend faster. Pfizer recently raised its dividend 6%, but Lilly's stronger growth allowed it to boost its 2019 payout 15% after an 8% dividend raise the year before.
Eli Lilly's growth prospects
There is a reason why investors are paying up for Lilly and being content with a lower yield: growth. Most big drug companies are dealing with headwinds created by losing exclusivity for older, money-making drugs. Lilly went through a period of patent expirations from 2011 to 2014, and the impact of generic competition kept the stock in limbo from 2015 through early last year. But the worst of that is behind it now, and top-line growth is being powered by volume growth of newer drugs.
In the most recent quarter, Lilly's newer products contributed 13.7 percentage points to the company's volume growth while drugs that have lost exclusivity were only a 4.5-point drag on volume. For the full year, Lilly's strong position in diabetes, cancer, and immunology produced 9% volume growth in its drug portfolio, and the trends indicate this performance should continue.
Looking forward, Lilly's investments should pave the way for even more gains. Its recently closed acquisition of precision medicine company Loxo Oncology, a specialist in treatments for genomically defined cancers, adds an already-approved drug and candidates that could launch in 2020 and 2022. Lilly is also entering the pain field with migraine drug Emgality, which launched last quarter. Last year's successful spinoff of slower-growing Elanco Animal Health will also be a boost to Lilly's growth rate.
Pfizer's growth prospects
Pfizer is today about where Lilly was a few years ago. In recent years, sales declines in the company's established products like Viagra and Lipitor have been a stiff headwind that canceled out much of the progress from newly launched drugs in high-growth segments like oncology and biosimilars. For the full year of 2018, Pfizer's innovative health segment, where the company groups together most of its forward-looking portfolio, had 6% operational growth, but essential health, which includes the company's legacy products, reported an operational decline of 4%.
The near future doesn't look much better. Pfizer's guidance for 2019 revenue is for a decline of 1.2% at the midpoint, the result of a $2.6 billion headwind from exclusivity losses. Pfizer is anticipating the impact of the June 2019 loss of exclusivity for Lyrica, its $4.6 billion anticonvulsive drug. Pfizer expects the effect of Lyrica losses to impact its results for the next two years, saying in the most recent conference call that, "[W]e still view 2020 as a challenging year."
But the picture will eventually change for Pfizer, as it did with Lilly. After the Lyrica patent expiration, it doesn't have any significant exclusivity losses for other drugs until 2025. The company believes that 2021 will be an inflection point, with sales growth returning to mid-single digits and improving margins resulting in even faster profit growth.
Income or growth?
Of the two companies, Pfizer has a cheaper valuation, a higher and sustainable dividend yield, and the strong possibility of a growth spurt a couple years from now, a bit outside the market's typical time horizon. Eli Lilly has strong growth now that should continue for years, but also has more expensive shares that go with the higher expectations and a much lower yield. Which stock is the better buy?
The answer depends on an investor's objectives. I think dividend investors who have patience won't regret buying Pfizer. The stock's healthy 3.4% payout is relatively safe and near-term expectations for growth are low. Eventually, the market will start looking forward to a return to growth in 2021, and dividend investors who hung in there during this flat growth period will be rewarded with some capital appreciation to go with the current income.
Growth investors should choose Lilly, though. Expectations are higher for the company, as the higher earnings multiple and lower yield show, but the company is set up to deliver on those expectations, and I think the valuation will hold up for years. Eli Lilly expects to spend 23% of 2019 revenue on research and development, as compared with only 15% for Pfizer. Lilly is making those R&D dollars count and making savvy acquisitions and divestitures as well. Now is not the unusual opportunity that Lilly stock presented last year at this time, but in the long haul, shares should still outperform the market.