Before I discuss the source of my frustration, though, there are some points that I'd like to clear up first. One of the topics that we discussed in our call was the change in wholesaler inventory stocking patterns of Zoloft, Norvasc, and Cardura. The actual story from IR is that wholesaler inventory levels fell during the quarter. It seems that prescription growth for the quarter was 15%. However, sales increased at a slower pace of 13.7%. The third quarter was actually strong for these products. The de-stocking of inventory at the wholesaler level led to Pfizer recording a lower level of sales for the quarter than if inventory levels had remained constant. IR and I both agreed that the press release could have done a better job of describing this situation.
We also discussed the decline in Selling, Informational and Administrative expenses for the quarter. According to IR, this decline was the start of a trend and not a one-time occurrence. The decline in these expenses is part of management's intention to restrain spending. Although the company expects revenue growth to remain strong, it is expected that its growth rate may decline from current levels.
In addition, Pfizer added a large number of sales people to help with the marketing of Lipitor, Celebrex, and Viagra. It is not expected that any of the products it releases in the near future will generate the kind of sales that these three products did. As a result, the existing sales force can be used to sell and market its new products. This is all part of the company's efforts to protect its bottom line. Let me repeat those last words again for emphasis -- "protect the bottom line." Read on and you'll see them over and over again.
We also discussed Pfizer's "alliance revenues." You'll remember that these monies include Pfizer's revenue-sharing deals with G.D. Searle (for the arthritis drug Celebrex) and Warner-Lambert (for the cholesterol fighter Lipitor). In these deals, Pfizer utilizes its industry-leading sales force to co-market the other drug companies' products. While the company will not release specific figures related to its terms for any of these agreements, IR did share some additional information on these relationships. First of all, collection terms for alliance revenues (at least in the case of Lipitor, which was the only product that was specifically named) are several months longer than for Pfizer's other accounts receivable balances.
As an example, Pfizer might sell its in-house products to wholesalers and require payment within 30 days. But in the case of alliance revenues, based upon what I was told by IR, it seems reasonable to assume that Warner-Lambert doesn't have to pay Pfizer its share of Lipitor revenues for a period of 120 days or more. This was part of the price that Pfizer paid for getting a share of the profits from products with exciting sales potential like Lipitor, Celebrex, and Aricept. Pfizer currently takes about a 40% share of the revenues from these products, so it does have a significant impact on its bottom line. Notice that I used those words again.
It should also be noted that Pfizer's alliance revenues do not come without cost to the company. These co-marketing agreements require Pfizer to incur a portion of ongoing research and development (R&D) related to the alliance products. Pfizer also incurs related sales and marketing expenses.
The last financially related topic that we discussed during the call was Pfizer's use of debt to fund its share repurchase program. IR was not concerned about Pfizer incurring additional debt because the company's debt is highly rated by such services as Standard & Poor's and Moody's. The company has almost unlimited borrowing power. In addition, it believes that investors want them to buy back shares as it expresses confidence in the long-term performance of the company. Oh yeah, and let me add that a smaller number of shares also helps them increase the bottom line (earnings per share increases when you reduce the "S" in EPS). Boy, that phrase is starting to sound awfully familiar, isn't it?
Pfizer views itself as one of the top five or ten companies in terms of financial strength. While I might not rank them at that lofty level, I can't deny that Pfizer is a top tier company financially. But, I have a problem when a company that is currently generating negative free cash flow (FCF) is borrowing money in order to finance its share repurchase program.
Such juicy details you won't find in Pfizer's glowing press releases. For that, we need to dig into Pfizer's second quarter 10-Q and look at its cash flow statement. For those uninitiated with the concepts of "operating cash flow" and "free cash flow," Matt has put together the following condensed and labeled version of Pfizer's cash flow statement through the first six months of this year:
Pfizer Statement of Cash Flows Six Months Ended
(millions of dollars) July 4, June 28,
1999 1998
Operating Activities
Income from continuing operations $1,544 $1,129
Adjustments:
Depreciation and amortization 244 235
Other 24 --
Changes in assets and liabilities (1,198) (150)
1) Net cash provided by oper. activities 614 1,214
Investing Activities
2) Purchases of Property, Plant, & Equip. (687) (461)
3) Free Cash Flow (FCF) = (1) - (2) (73) 753
Just to make sure we all have our terms straight, let's review the three important numbers to take away from this important financial statement: 1) "Net cash provided by operating activities" is what we commonly refer to as "operating cash flow" (OCF). Think of this as cash profits.
2) "Purchases of property, plant, and equipment" is what we commonly call "capital expenditures" or simply "cap ex." These are monies paid for computers, networking equipment, office buildings, land, and other similar long-lived assets.
3) "Free cash flow" (FCF) is the cash left over after all business reinvestment has been taken care of. This is the cash that the company could theoretically pay out to shareholders as a dividend.
Now let's put it all together. You'll find that for the first six months of this year, Pfizer generated operating cash flow of $614 million and had net purchases of property, plant and equipment (PP&E) of $687 million. That leaves it with negative FCF of -$73 million. Over the same period, Pfizer's income statement reported a much more favorable "income from continuing operations" of $1,544 million.
The important truth to understand is that profits on the income statement are only beneficial if they translate into free cash on the cash flow statement.
In Pfizer's situation of negative free cash flow, I don't want to see the company compounding its problems by borrowing money in order to fund its share repurchase program. More debt only works to reduce Pfizer's already low ratio of cash-to-debt.
So how does all of this impact the bottom line? It doesn't -- at least not yet. But Pfizer's balance sheet and cash flow statement are showing troubling signs. After our discussion with Pfizer's IR, both Matt and I agree that Pfizer's management is far too focused on managing the income statement and pleasing Wall Street, instead of managing the overall business for maximization of long-term shareholder value.
Tomorrow, I'll go into greater depth on explaining my concerns with Pfizer's alliance revenues and its related business practices.
If you want to continue this discussion, we've been discussing this topic on the Pfizer message board for the last few days in this message thread:
Discussion of Rule Maker Article on Pfizer
And if you have questions on any of today's financial concepts, such as free cash flow, please ask a question on the Rule Maker Beginners board.
Have a Foolish night and good luck to the Yankees as they continue their march towards the title of best team of the decade and, of course, the century -- now that's a real Rule Maker. Just think of how many times the team has successfully reinvented itself while maintaining such a consistently high level of performance.
Phil
