Posted on October 15, 2007 by David Laidlaw
After the health risks associated with Vioxx surfaced a few years ago, we liquidated all of our holdings in the pharmaceutical sector. The legal liabilities were the spark that caused us to re-evaluate our investment thesis and sell these stocks. However, this legal liability was not the most important rationale. We believed that the bigger threats to the industry were intellectual property challenges, the lack of new blockbuster drugs on the horizon and the likelihood of price controls due to governmental purchasing power. Our net thinking has not changed, but we re-entered the sector and purchased Pfizer across client accounts over the summer.
Pfizer became an attractive investment as its share price has steadily declined over the years. Our cash flow models value the company at roughly $24 per share (it trades at $24.65 as of 9/30/07) even if its revenues and income do not grow over the next 10 years. Even though Pfizer faces a number of challenges including Lipitor – its $12 billion revenue producer – going off patent in three years, we think that it will be able to grow its bottom line during the coming decade.
Pfizer is undergoing a significant business restructuring after the serial acquisitions of Warner Lambert and Pharmacia. In an effort to save $1.5 to $2 billion, the company has streamlined its manufacturing operations, closed operating plants and begun to reduce its sales force. These measures will increase net income.
The pharmaceutical industry has also bifurcated between those organizations that have full marketing departments that can sell drugs in numerous markets and those other companies that are primarily research oriented and do not have large sales forces. Due to its heft alone, Pfizer is an attractive partner for any company that needs to bring a drug to market, but doesn’t have the sales capability.
Pfizer’s next blockbuster drug, Lyrica, which treats epilepsy and muscle/nerve pain, appears poised to continue expanding rapidly. Though the company’s late stage pipeline is weak, Pfizer has 47 agents in Phase II studies and 11 in Phase III. Many of these will fail as is typical with drug development, however, the law of averages suggests that some will sell and a handful may even garner multiple billions in sales.
Finally, Pfizer pays a 4.8% dividend. This yield is very attractive in an environment where the 10-year Treasury yields 4.6%. The yield and low price point relative to cash flows provide a margin of error which is what we’re looking for in our investments.