Last week I scoured through the 500 companies that comprise the economically diverse S&P 500 index and listed five that I thought may not have what it takes to stand the test of time. This week I thought I would turn my attention to the Dow Jones Industrial Average
My thesis here is pretty simple: Just because an index is broad-based doesn't mean there aren't bad apples hidden among the bunch. Picking bad seeds from a grouping of 500 wasn't too difficult; picking one potential rotten apple out of a batch of just 30 considerably larger and more diverse businesses -- much tougher.
With that being said, I changed my approach slightly when picking out the weakest link in the Dow from a company that won't stand the test of time, to a company that should underperform the market over the next few years. While it's not impossible that a Dow component could go bankrupt (ahem, General Motors and Eastman Kodak), I find the extremely long-term prospects for the majority of the 30 companies to be good.
Without further ado, here is my choice for the worst company in the Dow Jones Industrial Average:
Pfizer isn't preparing to fall off a patent cliff -- it's diving head-first into the Mariana Trench of all patent cliffs. Over just a three-year period, Pfizer is set to lose patent exclusivity on some of its biggest revenue-producing drugs, including the top-selling drug in the world, Lipitor.
All told, in 2011 Pfizer said goodbye to patent exclusivity on cholesterol medication Lipitor and Xalatan for glaucoma. In 2012, schizophrenia drug Geodon and overactive-bladder drug Detrol will be thrown to the generic wolves. Finally, Pfizer's osteoarthritis drug Celebrex comes off patent in 2014. If you think I'm making a big stink over nothing, just look at how much of Pfizer's sales these five drugs accounted for over the past year.
Source: Pfizer IR press release.
These five drugs contributed $15.2 billion of Pfizer's $67.4 billion in sales in 2011. That's 23%. Generic competition isn't going to steal every last cent of this revenue, but if recent patent losses are any indication, then Pfizer's shareholders could be in for a few years of pain.
Take hypertension drug Norvasc, for example. The drug lost patent protection in 2007 and used to supply Pfizer with $4 billion in revenue. Sales of the drug have fallen in each year since then and contributed just $1.4 billion in 2011. Effexor, used in the treatment of depression, came off patent in 2010, and sales dipped in 2011 by a whopping 61%. Even Lipitor, which just lost patent exclusivity in November, shed 24% of its revenue in the fourth quarter and caused full-year sales to dip by 11%. Ranbaxy International and Watson Pharmaceuticals
For the sake of shareholders, I wish their plights ended there -- but they don't. Pfizer's dividend also looks as though it could find itself at risk if generic competition continues to feast on Pfizer's expiring patents.
Sources: Dividata and Morningstar.
Pfizer's payout ratio -- the amount a company pays out in dividends as a percentage of its profit -- is not very consistent. Unlike most large drugmakers, Pfizer seems quite susceptible to the ebbs and flows of the economy. In two of the past 10 years, Pfizer paid out more in dividends than it earned in profit.
Pfizer's 4.1% yield might be an allure to some, but let me show you the other side of to this payout. In 2009 and 2010, Pfizer paid consecutively lower dividends. Its current yearly payout of $0.88 is 31% lower than what Pfizer paid shareholders in 2008. Although Pfizer recently approved a dividend increase of $0.02 per quarter in 2012, I don't see how any further increases would be prudent, considering the impending revenue shortfall that is quickly approaching.
Where's the innovation?
The biggest detriment to Pfizer's value, without question, is its lack of innovation. For a company so well known for having a diverse pipeline, it has fallen miles behind its competition in hot areas of research.
Take hepatitis C, for example. Despite a huge balance sheet and a long list of collaborative partners, Pfizer's polymerase inhibitor (PF-868554) is only in phase 2 clinical trials. In the meantime Vertex Pharmaceuticals
Unless Pfizer makes a bold move and deploys some of its cash to acquire new drugs, it's going to have a difficult time trying to replace its lost revenue in the coming years. Add to that the prospect of a stagnant or possibly even falling dividend, and you have a recipe for disaster. It's for this reason that I originally made a CAPScall of underperform on Pfizer and why I plan to keep this call active for the foreseeable future.
Disagree with my assessment? Let me know in the comments section below.
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