Introduction and Shareholder Analysis
Pfizer (NYSE: PFE) is involved in the development, manufacturing and marketing of pharmaceutical products. The industry is intensely competitive. There are a few unique characteristics. Pharmaceutical products have long and expensive development periods — upwards of ten years and $100 million depending on the nature of the drug and the scope of the clinical trials process. In order to encourage companies to engage in innovation, companies are given lengthy patent protection for their drugs upon receiving regulatory approval. This allows them to charge monopoly rents so that they may recover the development cost. A product brought to market is often highly lucrative, so success in the industry depends largely on the firm’s ability to bring product to market and capitalize on the monopoly rents.
According to MSN Moneycentral (2009), Pfizer’s share price closed on November 19, 2009 at $18.11. Over the past two years, Pfizer shares have generally declined. The stock ended November 2007 at $27.49, meaning that it has fallen 34% over the past two years. In that same span, the S&P 500 has declined around 21%. In order to compare the performance of Pfizer to the performance of the market, these figures need to be adjusted for risk. Pfizer’s beta is 0.76. Therefore, if the market declined 21%, Pfizer should have declined (0.76)(21) = 16%. That Pfizer has dropped 34% indicates that the stock has underperformed dramatically for the past two years. Shareholders are not getting the returns they would have expected from Pfizer stock.
Liquidity and Solvency
Pfizer’s liquidity situation has deteriorated in recent years. Five years ago, the company’s current ratio was 1.5. This improved to 2.2 in 2006 but has since fallen back to 1.6. This indicates that in the past year, Pfizer has seen its working capital reduced. This can indicate a slowdown in business, particular if couple with a decline in other liquidity metrics.
Pfizer’s quick ratio has showed the same trend as the current ratio. The quick ratio measures only those elements of the current ratio that can be converted to cash quickly, such as short-term investments and accounts receivable. It is valuable for two reasons. The first is as a basic liquidity measure. Pfizer’s quick ratio of 1.4 is generally considered healthy. It has been better in the past — 1.9 for the last two years — but 1.4 is within its five-year range. The other use of the quick ratio is that it removes inventories from the current ratio. In economic downturns, the current ratio can be abnormally large if the firm has excessive inventory supply. For Pfizer, however, the quick ratio supports the trend identified in the current ratio, that the company has seen its solvency reduced in the past year. The level, however, is healthy for both of the key liquidity ratios.
Another means to identify liquidity and solvency issues is to examine the firm’s turnover ratios. The accounts receivable ratio measures the speed at which the receivables are being converted to cash. Pfizer’s receivables turnover improved last year from 4.9 times to 5.4 times. The average collection period declined from 72.5 days to 71 days; the end of year collection period dropped from 74.2 days to 67.7 days. This indicates that Pfizer has tightened its collection period. Given how high these collection periods are, a move to tighten the receivables turnover would not be considered unusual.
Inventory turnover indicates the degree to which the firm’s inventory is converted to cash. Unsold inventory represents business risk and inefficiency. Days inventory has increased from 185.3 to 217.8. Average inventory turn declined from 2.0 to 1.7 and ending inventory turn declined from 2.1 to 1.9. This indicates that Pfizer’s inventory supplies are building — they are not selling their inventory as quickly as they have in the past.
Put together, Pfizer has seen a deterioration in its liquidity over the past year. The company’s current and quick ratios have declined, although they are still healthy. The company has tightened receivables, but this is an attempt to improve cash flow in light of rapidly building inventories. Pfizer’s inventory levels, it should be noted, are only high compared with 2007 numbers; they are far below inventory levels of four or five years ago.
Pfizer’s debt ratio has increased from its historic level of 40% to 50% in the past year. This further supports the idea that Pfizer has seen a constriction of its cash flow, and it has been forced to borrow to maintain a necessary level of working capital. A related figure, the liabilities to shareholder’s equity ratio, has held steady at 0.1.
The ratio of fixed assets to long-term liabilities was 1.67 in 2008 ($13,287 / $7,963), compared with 2.15 in 2007 ($15,734 / $7,314). This indicates that the fixed asset base has declined over the past year. While the long-term liabilities have decreased as well, they have not decreased enough.
Pfizer’s current debt to total debt ratio is 50.4%, up from 43.4%. However, over the context of five years this metric has fluctuated significantly. In 2005 it was at 55.5%, so the current level is not cause for alarm. Pfizer’s gearing ratio is 12.2%, up from 10.1% and well above its usual level. Also of concern is the times interest earned, which is 16.9, compared with historic levels over 20.
The implications of these figures are that Pfizer’s debt management position is weaker than it was a year ago, and weaker than its historic levels. The company is by no means in a difficult position with its debt, however. The economic downturn has clearly impacted Pfizer, based on increasing debt, decreased liquidity and increased liquidities. That the firm has taken steps to improve its receivable turn also indicates a deteriorating financial position.
The pharmaceutical industry is characterized by high margins, as products are granted monopolies to help offset the high cost of developing drugs. As such, Pfizer enjoys strong gross margins on its products. Those gross margins were 83.2% in 2008, up from 76.8% in 2007. This level is lower than the historical average for Pfizer.
More telling for the pharmaceutical industry is the net margin. Development costs for new drugs are expensed, so the EBITDA will reflect those costs. Net margin reflects the ability of the firm to generate enough marketable products to offset the development costs being incurred today for future products. Pfizer’s net margin (pre-tax) was 20.1%, compared with 19.2% a year ago. It is historically higher. The after-tax net margin is a trickier measure, because the tax structure of pharmaceuticals reflects a number of incentives paid to the industry — for example tax credits for the development of so-called orphan drugs. Managing the after-tax net margin, therefore is a major part of the pharmaceutical company’s business. For Pfizer, the after-tax net margin in 2008 was 16.8%, the same as it was in 2007. Aside from an abnormally high figure in 2006, Pfizer’s after-tax net margin is in line with its historic levels.
Pfizer has not enjoyed any revenue growth in the past five years. Sales levels in 2008 were $48.296 billion, compared with $48,988 billion in 2004. This lack of revenue improvement is an indicator of a mature business, and that Pfizer is only developing successful new products at a rate to replace patent expiries.
Pfizer’s earnings per share in 2008 were $2.04 (MSN Moneycentral, 2009). This compares with 1.48 in 2007. Prior to 2008, the company’s EPS had fluctuated in a range for years, between 1.45 and 1.75. Thus, 2008 represented an improvement in the company’s bottom line and returns to shareholders.
Pfizer’s price/earnings ratio at the end of 2008 was 14.7. At the end of 2007 it was 19.3. Five years ago it was 17.8. The P/E ratio reflects the markets optimism, or lack thereof, with respect to the company’s growth prospects. The decline in Pfizer’s P/E over the past two years reflects that the company’s stock dropped in 2008 while its earnings per share increased. Over the long-run, such a decline in Pfizer’s P/E is not unreasonable. The company has failed to grow revenues over the past five years and in 2008 saw its liquidity situation deteriorate and its debt levels increase.
Pfizer has increased its dividend steadily over the past five years. The dividend in 2008 was $1.28 per share, up from $1.16 in 2007. In 2004 the dividend was $0.68. With the increase in dividend and the decrease in the company’s share price, it is clear that Pfizer has increased its payout ratio over the past few years. This is consistent with a company that has a profitable business that is not growing. They are entering a more mature phase of their life cycle, and are therefore spending less on new product development and more on dividends to shareholders.
Pfizer’s return ratios are a mixed bag. The return on equity last year was 14.1%, compared with 12.5% in 2007. This ratio has fluctuated over the past five years, however, with last year’s performance being in the middle. The return on assets was 7.3% last year, up slightly from 7.1% the year before. Again, the metric has fluctuated and 7.3% is in the middle.
These figures indicate that Pfizer’s returns are about average. Aside from an unusually good year in 2007 with respect to their returns, the company is rangebound in terms of its managerial efficiency. Recapturing the 2007 successes would be more encouraging but at present there is little to indicate a long-term trend of improved returns on either equity or assets.
Pfizer’s performance in the past five years has been uninspiring. The firm has been relatively stationery, especially with respect to revenues. Their business seems to be maturing as well, supported by the fact that the company has steadily increased its dividend. Indeed, without top line growth to attract investors, Pfizer has little choice but to increase the dividend in order to stem the sale of the firm’s stock.
Pfizer stock has suffered more than would be expected given the firm’s beta. There are two industry factors that make this especially alarming. The first is that pharmaceuticals are demand inelastic, both in terms of price and in terms of the economy. These drugs are a quality of life issue for many, so demand should not fall in light of a financial crisis. Indeed, Pfizer’s revenues have remained constant through the crisis. Therefore, the damage to the firm’ stock is not related to the market overall.
Rather, it is likely related to concern in the industry with respect to the impact of possible health care reform, and with respect to the skyrocketing cost of drug trials resulting from stricter FDA guidelines. Pfizer also carries some firm-specific issues that have damaged its stock. The company has not been able to increase its revenue over the past five years. Operating income has declined in that period, as has the firm’s asset base and the book value of its equity. At best, Pfizer is holding steady; at worst it is shrinking.
This has taken all growth components out of the firm’s stock. Management has tried to compensate investors for the lack of growth by increasing its dividend 88% over the past five years. This increases the return to investors but has not done so enough to compensate for the removal of growth from Pfizer’s economic model.
In the past year, Pfizer has seen some difficulties. Although the bottom line number is better, the company has been subject to a decline in many key metrics. Its current and quick ratios are down. Inventory levels are up and inventory turn is down. While receivables turn is down, it is not unusual for a firm facing difficult financial times to squeeze its customers for quicker payment, especially in light of the fact that collection for Pfizer was in the 2 1/2-month range in 2007.
Pfizer has also increased its debt level recently. After maintaining a stable capital structure for years, the company has finally taken on more debt in order to meet its cash flow needs. This will increase the firm’s risk at a point when its business is maturing, which is not a cause of optimism. However, in light of the broader business cycle it is important to remember that rough times do happen and Pfizer’s leverage is neither unusual nor dangerous.
Given what has been gleaned from this analysis, I would not purchase Pfizer stock. Nor would I have a few years ago. The stock’s performance has been below expectations, and there are major structural reasons for that. The company has stagnated, and increases to dividend yields have not offset the lost growth potential.
There are fundamental issues holding back Pfizer as well. The company’s industry is beset with uncertainty and a rising cost structure. The monopoly rents still make being in the pharmaceutical business worthwhile, and Pfizer’s healthy margins reflect that. However, the company has certainly not excelled in the difficult circumstances. The returns on Pfizer in recent years have been dismal, and there is no evidence to suggest that top line revenues are going to improve. The bottom line improvements in 2008 may not be sustainable over the long-term either, leaving Pfizer with reduced performance and an increased debt load. I would not, therefore, purchase Pfizer stock.
Some financials from MSN Moneycentral. (2009). Retrieved November 20, 2009 from http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=PFE&lstStatement=Income&stmtView=Ann
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