TMFDeej (99.46)

Big Pharma is Cheap

April 27, 2010 – Comments (6) | RELATED TICKERS: PFE

Uncertainty in a sector often creates great opportunities to invest in solid companies at cheap prices.  One sector that I have been focusing my research on lately is healthcare.  As a result of all of the debate about healthcare and the government's recently passed reforms many stocks in this sector have been significant laggards during the recent massive rally in the markets.  

I already talked about my recent investment in CVS last week (link).  Today I am going to talk about a different section of the healthcare industry, Big Pharma.  One can make a strong case that a number of the biggest players in pharmaceuticals would make excellent long-term investments today.  The specific company that I placed my bet on is Pfizer (PFE).

I'm not going to lie and say that I came up with the investment thesis for PFE all on my own, like I did with the power companies that I talked about yesterday.  The great part about investing is that unlike back in school when copying another person's paper was discouraged, in investing you're allowed to copy off of your neighbor.  In fact, it makes sense to take a look at where Super Investors are putting their money.  I never, ever blindly invest in companies just because so and so bought shares of it, but I do use the list of stocks that other investors who I respect have purchased as a starting point.

I became interested in Pfizer after noticing that Whitney Tilson of the hedge fund T2 Partners, David Einhorn of Greenlight Capital, and Vitaliy Katsenelson all had major positions in the stock.  In fact, according to a March report published by Goldman Sucks Pfizer is the second most popular stock amongst major hedge funds, with 45 of the ones that the company tracks owning it (it's second to Apple).

So why invest in PFE?  It excels in two of the three qualities that I look for in stocks, it's cheap and it pays a solid dividend.  It currently trades at 13.6 times earnings and pays a 4.3% dividend.

The question with PFE is how much is the company worth once the company loses its patent protection on a number of its blockbuster drugs?  Here's what one of the aforementioned people, Vitaliy Katsenelson, has to say about the stock, The case for Pfizer:

"So let’s value Pfizer:

No New Drugs Scenario:  ...Let’s assume that soon after a drug-patent expiration, as the generic version hits the market, revenue from that compound declines 90% and stays at that level indefinitely.  So, for instance, Lipitor’s revenues would drop off from around $12 billion to $1.2 billion after its patents expire in 2011. 

Let’s also assume that the $8 billion Pfizer spends on R&D is completely wasted, and that over the next 5 years Pfizer will not come up with a single new drug.  We estimated and discounted  Pfizer’s cash flows over next five years. Based on these assumptions , it is worth about $15-18 a share....

Wyeth Acquisition Was a Stroke of Genius:  Pfizer took advantage of the financial market meltdown when it offered to buy Wyeth in the spring of 2009.  PFE paid $60 billion for a company with earnings of about $4.5 billion, or about 13 times earnings.  This is a very attractive price, considering that historically acquisitions in this industry have been done at much, much higher valuations (i.e., P/Es in the high teens and low twenties). 

There are plenty of redundancies between the two companies in manufacturing, sales force, etc., so Pfizer is expected to save $4 billion on cost redundancies in three years, but even if costs savings are half what Pfizer expects, earnings power of the combined entity has increased by $6.5 billion ($4.5 billion from WYE’s earnings and $2 billion from cost savings).  In other words, Pfizer’s actual acquisition valuation of Wyeth was less than 10 times earnings – incredibly cheap!

It Gets Better: Pfizer bought an asset (Wyeth with added cost savings) that had an earnings yield (the inverse of the P/E of 10) of 10% and financed a third of it with stock, a third with debt issuance, and the rest with its own cash.  Though PFE’s stock was undoubtedly cheap (not an ideal currency for acquisition), billions of dollars of cash on its balance sheet were earning the company almost nothing; also, it was able to issue debt with an after-tax cost close to 4%.  This combination of Wyeth’s bargain-basement purchase price and advantageous financing has created about $4 a share of value for Pfizer’s shareholders.

I have to admit, at first I was skeptical of the Wyeth acquisition – $60 billion is a lot of money, even for Pfizer; and historically, huge acquisitions have rarely solved companies’ problems or created shareholder value, in large part because companies overpaid for their targets, but that is not the case here.  

The Bottom Line Is This: If Pfizer (including Wyeth) doesn’t come up with a single new drug, after spending $11 billion on R&D (Wyeth spent $3 billion a year), Pfizer’s stock is worth between $19-22 a share, based on discounted cash-flow analysis. 

New Drugs Are Free:  Drug discovery is not a linear process – serendipity, perseverance, and financial might are the essential ingredients required for success in this costly endeavor.  Pfizer has the latter two; the first one is an act of God kind of thing.  But we are not buying this stock and praying: Pfizer has 100 drugs under development, 25 of which are in late-stage (phase 3) trials.  Wyeth has an additional few dozen drugs in the pipeline, as well as 7 drugs in late-stage trials.

I have no idea what drugs will be successful, but I don’t have to because, first of all, we are not paying for them, since today’s stock price discounts no new drugs.  Second, though it is human nature to believe that “Everything that can be invented has been invented,” as (a fictional) patent office official believed when he submitted his resignation in the late 1800s, that is unlikely to be the case. 

Here Is How We Look at Pfizer: Pfizer also fits the profile of a stock that should do well in our steroidally challenged economy, as its revenues are unaffected by economic cyclicality.  In case of inflation it has significant pricing power to pass cost increases to consumers (yes, and even the government).  In case of deflation it should be able to maintain prices, and its ample cash flows will allow Pfizer to pay off its debt in a few years, if it chooses to.  It is priced like a very safe bond with an embedded nonexpiring, free call option, yielding 4%.  If Pfizer doesn’t come up with a single new drug its price will not change much; it will be where it is today.  Any new drugs are just an added bonus."

Great analysis. 

Deej