• It is down significantly from the Viagra-high it reached in 1998.  Yes, Pfizer is the maker of Viagra, the drug that spawned a slew of commercials that made TV unwatchable (especially if you have little kids who ask you if they or you need this medicine that makes people on TV hug each other, or ask you “What is reptile dysfunction?”).
• Pfizer’s earnings have not gone anywhere for years.
• As with almost anything medical-related, Pfizer is exposed to the political risks of Washington DC.
• Finally, it is facing patent expirations of its major blockbuster drugs like Lipitor ($12 billion of sales) and a few others that will hinder PFE’s future growth for years.

There is not much one can do about TV commercials except cancel cable or watch less TV (I did both).  Nor there is not much one can do about the stock-price decline over the last ten years – maybe the only thing to do is learn not to buy hype; after all, Pfizer was trading at over 50 times earnings in the late ’90s.

I don’t want to dismiss the political risk, but it seems that due to extensive lobbying efforts by pharmaceutical companies, political risk has turned into only a slight inconvenience.  Pharma companies have agreed to $80 billion of price concessions over the next ten years, but at the same time they’ll benefit from a larger customer base, as more people will have access to health insurance.

Instead of being mesmerized by huge drug expirations, we can do the value-investor kind of thing – estimate the impact of drug expirations on PFE’s cash flows and value the stock using discounted cash-flow analysis based on these assumptions.

So let’s value Pfizer:

No New Drugs Scenario:  At the end of 2009 Pfizer acquired Wyeth (WYE), a large pharmaceutical company.  I’ll address this very important acquisition in a bit, but first, let’s look at Pfizer on a pre-Wyeth basis.  The fewer optimistic assumptions we use, the less likely the future will disappoint us.  Applying this logic, 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.  The difference in this range is accounted for mostly by assuming various inflation rates (price increases) on existing drugs.
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.

Disclosure: own Pfizer

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.

Today I’ve caught up on my last three BusinessWeek podcasts, called “Story Behind the Story.” John Burns, BW’s editor, interviews the reporter who wrote this week’s cover story. These podcasts are fantastic, because you often get a good overview of the lengthy article, but also some interesting new insights.

One talked about the Chinese shopping spree. China has found that it is hard to diversify away from the US dollar without shooting itself in the foot by driving the dollar down (thus devaluing its dollar reserves), and so it’s going on a buying spree of foreign businesses – smart! Unlike the Japanese, who in the late ’80s were buying up the world and paying market or above-market prices, the Chinese are buying things on sale – things tend to be cheaper during a recession.

Another podcast talked about Microsoft, a stock I own and have written about. Microsoft has been doing a lot more things right than wrong lately. But introducing free online Office (supported by advertising) will be a very tricky endeavor, because it has to make sure that it doesn’t cannibalize its core Office business. The upside here is that Microsoft may be able to capture a new customer – the one that used but never paid for Office (like most people I know who use Office at home) or the ones who are not using Office, or using Google’s apps.

The last podcast discussed retirement. Here is what I took out of it: stocks for the long-run, no more. The promised average 7% real (after inflation) rate of return from stocks, also called Siegel’s constant (after Jeremy Siegel, Wharton professor who wrote Stocks for the Long Run), only exists if your long run consists of decades. Here is the chart from my book that shows how the “real” rate of return came about. Range-bound markets took the above-average real (after inflation) returns of bull markets, splashed them with their below-average real rates of return, and voila, you got yourself stocks for the long-run rate.

I read this week that McGraw-Hill is putting BusinessWeek up for sale. The magazine got a lot thinner over the years – fewer pages means fewer advertisements; I am sure it’s bleeding money. I hope McGraw-Hill finds a buyer; BusinessWeek is a terrific magazine and the best contrarian indicator, period.

Here are some excerpts from the article:

1. Blockbuster success is a double-edged sword. In this litigious society a discovery of side-effects brings an army of tort lawyers to the doorsteps of pharmaceutical companies. 
2. The demographic trends of ageing baby boomers will push demand for the pharmaceuticals into the stratosphere for a long time. However, investors should add another dimension to their analysis – product diversification.  Companies that have a high concentration of sales in just a few blockbuster drugs should either be avoided or have a much smaller place in the portfolio. Also, investors should temper valuation premium expectations for the overall sector as it is unlikely to return to its old levels.
3. Medical device/instrument companies are likely to take over the leadership from pharmaceutical companies and inherit the premium valuation.  [Zimmer (ZMH), Biomet (BMET) come to mind here].  They will reap the rewards from the baby boomers’ desire for longer and healthier lives. With few exceptions, medical device/instruments companies have a much more diversified product line.
4. Companies that provide services to the pharmaceutical industry are a good sidedoor to participate in the industry’s future prosperity without subjecting investors to the all risks. IMS Health (RX), a provider of market intelligence to the pharmaceutical industry, comes to mind as a good side position. It has all the qualities of a pharmaceutical company: strong competitive advantage, terrific return on capital, monopoly-like profit margins, great cash flows, very reasonable valuation and good consistent growth prospects ahead, without all the aforementioned risks. [I no longer own RX, but it maybe a good time revisit the stock.]

Position in ZMH