Description

This is the end of the year, and some of the best risk/reward opportunities are generally available in the (relatively few) stocks which are trading at their 52 week lows. Pfizer (PFE) is one such opportunity, especially if you play it via the very cheap LEAPS.

PFE is the world’s biggest pharmaceutical company ($52 billion in revenues) and one of the biggest publicly traded companies in the world (roughly $200 billion market cap), and can be acquired for a surprisingly modest price of 12 times next year’s earnings. PFE is down almost 30% from its 2004 high point, and is basically trading at a 5 year low. PFE hasn’t traded at this low of a P/E multiple since the early 1990’s when the Clintons were threatening to privatize health care. The balance sheet is clean with cash of $19 billion versus about $19 billion of debt. PFE is generally acknowledged to have one of the best product pipelines in the drug industry. While PFE with $52 billion in revenues is not going to grow at a fast clip, even the more pessimistic sell side analysts are projecting PFE to grow EPS at roughly 5% annually going forward for the next 5 years, which is a period during which PFE is going to be facing a headwind of patent expirations on some important products. These patent expirations are what cause analysts to be relatively pessimistic on the stock. But we feel that a very successful company that’s still expecting to grow slightly during its most difficult patent expiration period, priced at 12 times 2005 earnings and with a massively liquid stock, is just too cheap. Importantly, this 5% growth rate might be understated due to two factors that analysts don’t give them much credit for: 1) After doing giant acquisitions of Warner-Lambert (roughly $90 billion) and Pharmacia (roughly $60 billion), PFE should still have substantial “financial flexibility”, or the ability to cut costs to continue achieving EPS growth (SG&A is about $17 billion annually and R&D is approaching $8 billion), and 2) PFE generates enormous amounts of cash ($20 billion of operating profit this year, which is net of spending over $7 billion on R&D) which can be used to buy back shares, make acquisitions and do JV deals with smaller innovative firms.

While we like the stock, we think that certain long term call options on PFE are particularly cheap and the preferred way to play this opportunity. The one we like best is the Jan 07 $30 call at $2.75, which we will discuss further below.

PFE is at $27.20, and the company will do $2.12 of EPS in 2004, and is expected to do $2.31 in 2005, with roughly 5% growth thereafter. Thus the stock is currently at 12.8 times 2004 EPS and 11.8 times 2005 EPS. Compare this to the following: Eli Lilly is trading at 17 times 2005 EPS, Wyeth is trading at 15 times 2005 EPS, Bristol-Myers is trading at 17 times 2005 EPS, and Merck (which is troubled by the removal of Vioxx from the market and the potentially huge liability from Vioxx) is trading at 12 times 2005 EPS. Excluding PFE, Merck (due to Vioxx), and Schering-Plough (which has an extraordinarily high P/E multiple since it hardly has any earnings), the others are trading at an average 2005 P/E of about 16. If PFE were to trade at 16 times 2005 EPS of $2.31, the stock would be at $37, up 35% from the current price, and we think that when investors get more interested in PFE the price is likely to reach or surpass that level.

PFE is followed by 30 sell side analysts who can each describe the company and its products better that we can, so we aren’t going to go into a lot of detail. Obviously it’s virtually impossible to have an information edge on PFE, plus given the huge scale of PFE, most specific news or “insights” on it are really just distractions from the big picture. Analysts have to have something to write about each day, and they do. But the investment thesis here is simply that this is a huge and profitable company, with a truly outstanding long term track record of value creation, which is trading at a valuation which you rarely see for this scale of a company. With some marginal improvements in sentiment or a rotation into defensive and less economically sensitive stocks like drugs, PFE should do quite well from these prices.

While the bullish cash on PFE is fairly straightforward (cheap very big cap drug stock at 12 times earnings with earnings that should still be growing), there are multiple negative issues that have conspired to push PFE to this low valuation. We’re not saying these issues are immaterial; but we think they are so well known that they are priced into the stock. These issues are discussed briefly below, although more detail is available on any of these issues from the sell side analysts:

Patent Expirations: From 2005 through 2007, PFE will have patent expirations that impact about $14 billion of revenues, which is about 27% of PFE’s 2004 revenue base of $52 billion. Of course PFE has known about this problem for years, and several years ago it set a goal to file new drug applications for 20 new drugs in the five year period from 2001 through 2006, which the company is on-track to do. Additionally the current PFE drugs that are not facing patent expiration will continue to grow. Thus while PFE will lose revenues due to patent expirations, it is expected that those losses will be more than offset by growth in other existing drugs plus new drugs, resulting in annual net revenue growth in the 3-5% range. Thus while the next three years will be “growth challenged” for PFE, it’s not like they are going to be $14 billion smaller in a few years. Of course the “perception problem” is that these patents are expiring with a 100% probability, while each of the drugs that are being counted on for growth (both existing and new drugs) have some probability of not meeting expectations or just failing, although they also have some probability of doing better than expected. And, of course, totally new sources of revenue from acquisitions or JV’s are not factored in. Most of the sell side analysts have detailed analysis and projections of the growth of each existing and new drug from now to 2009, so there is a lot of detail available from which to make your own estimates of the future.

Cox-2 Controversy: Merck’s Cox-2 inhibitor Vioxx was pulled from the market at the end of September due to cardiovascular issues. Since that time, PFE’s stock has fallen about 10%, largely due to concerns regarding the fallout on PFE’s Cox-2 inhibitor drugs Celebrex and Bextra. Celebrex will be about 6.4% of total PFE revenues in 2004 and Bextra will be about 2.5%. While there are a few noisy academics theorizing that Vioxx is really a class effect which impacts all of these Cox-2 drugs, the facts are that all data to date has shown Celebrex to have an extremely clean safety profile. In fact PFE is going to initiate some additional long term trials to see if Celebrex is actually beneficial to the heart. Most of the Bextra data has shown it to be safe, with the exception of two trials that used an injectible form of Bextra in open heart surgery (which Bextra isn’t even approved for). Bextra’s label was recently revised to include a warning that patients who have recently had heart surgery shouldn’t take it, as well as a warning about a very rare but potentially fatal skin reaction. Overall, Celebrex and Bextra appear to have gained business due to the elimination of Vioxx from the market, so the whole Vioxx controversy will likely be a net positive for PFE, despite the current negative headlines. To put this whole issue into perspective, if Bextra, the higher risk of the two drugs, were to be totally eliminated from PFE (there has been no suggestion of this and we don’t expect this to happen), that would likely reduce PFE’s EPS by about $0.08 in 2005 (less than 4% negative impact).

Lipitor Patent Challenge: PFE’s biggest drug is the statin drug Lipitor, which is currently doing about $10 billion annually – Lipitor is the largest selling drug in the world, and it’s still growing (Lipitor revenues in 2004 will be up about 14% from 2003). PFE has patents on Lipitor that run through 2010 and 2011, but an Indian generic company called Ranbaxy is trying to break these patents in order to launch a generic version sooner. The patent infringement trial just started November 30th, and should be complete soon, although it will take the judge probably 9-12 months to issue a decision, which will likely be appealed regardless of who wins. About 2/3 of the Lipitor sales are in the US and would be impacted by the loss of these patents, so that would be about 13% of PFE’s total sales at risk. Analysts have been saying PFE has an 80%-90% chance of prevailing. “Composition of matter” patents are notoriously difficult to get invalidated through this type of legal process, plus Ranbaxy has to get two patents invalidated. Our view is that Ranbaxy is basically taking a flyer on this -- if they win, it would be huge for Ranbaxy, but if they lose, it doesn’t cost them that much, so on an expected value basis even if Ranbaxy has a small chance of success it’s a worthwhile risk. The odds appear to be vastly against Ranbaxy. Of course in litigation anything can happen, and its possible PFE will lose this decision – which would be a big blow to PFE given that Lipitor’s US sales are about 13% of PFE’s sales (a loss would actually be a big blow to the entire branded drug industry, since a major composition of matter patent has never been invalidated).

In any event, note that PFE is working on a follow-on drug to Lipitor, which is a combination of Lipitor and an entirely new drug, which if successful would be launched in 2008 or so, and which could allow PFE to hold on to its huge Lipitor franchise even after its Lipitor patents run out in 2010 and 2011.) This drug has the potential to be PFE’s largest selling drug ever if it’s successful. (While Lipitor reduces the “bad” LDL cholesterol, this follow-on drug both reduces the “bad” LDL and raise the “good” HDL. As such, assuming the new combination drug is approved, a large percentage of statin users could likely switch to this new drug.)

Accounting: The EPS numbers referred to above ($2.12 for 2004 and $2.31 for 2005) are operating or “cash EPS” numbers that exclude purchase accounting intangibles amortization. Thus GAAP EPS numbers are different from these operating EPS numbers which the market focuses on. Also PFE did several huge acquisitions over the recent past, and has taken multiple restructuring charges to integrate these acquisitions and generate synergies and cost savings, which have been excluded from “operating EPS.” With the acquisition of Pharmacia, a huge amount of the purchase price was allocated to intangibles consisting of trade names and patents, which continue to amortize under GAAP – this leads to about $2.3 billion annually of intangibles amortization which is ignored in the “operating EPS” numbers. While there is an argument that the acquired branded pharmaceutical drugs do have finite lives, and thus economically these intangibles should be amortized over time, PFE is spending almost $8 billion on R&D annually to replace these and its other drugs, all of which is being expensed. In any event, this “operating EPS” concept seems to be pretty widely accepted by analysts.

While we think the stock is interesting at these price levels, we find the long term call options more attractive. We don’t base that observation on some fancy mathematical model, but instead on common sense. Now, bear in mind that we are not trying to make an unassailable argument here; instead we are just explaining how we think about it – anyone can beg to differ if they wish. Anyway, when thinking about whether to own a call option or a stock outright, we compare the expected return from owning each under a range of stock price outcomes. But in computing the expected return from owning the call, we also include some “opportunity cost” rate of return on the un-deployed cash (that is, the excess of the stock price over the call price). We don’t use leverage (and thus don’t borrow money at low interest rates), so we use our “expected” minimum rate of return on our overall portfolio as the “opportunity cost” rate of return.

For example, if your choice is between buying the PFE stock at $27.20 or buying the Jan $30 2007 call at $2.75, if you buy the call you have $24.45 of un-deployed cash available to invest in other opportunities over the 2+ year period. If you assume an “opportunity cost” rate of return of 15%, then through the expiration date you will generate an additional $8.36 in profit from this capital. So if your target price for PFE in two years is $37, this is how we evaluate whether we want to own the stock or the call: If you buy the stock at $27.20 and sell at $37 in two years, and get say $1.43 in dividends, then your total dollar profit is $11.23. On the other hand, if you buy the call for $2.75, and in two years the stock is at $37, the intrinsic value of the call is then $7, and you have made $4.25 in profit on the call plus the additional $8.36 on the un-deployed cash, to total $12.61. So we view the call as “superior” in an upside scenario. Of course, looking at the scenario where things don’t turn out well – say PFE stock is at $15 in 2 years, we don’t have to go through the math here – obviously the call should be dramatically superior. In addition, the call is superior if prior to expiration the stock declines dramatically due to negative news, since the call won’t go to zero (and will have a suddenly higher volatility built into its price), while the stock of course suffers the full value of such decline. Obviously you can build a relatively simple spreadsheet and look at the outcomes under various price scenarios and use various assumptions for the return on the un-deployed cash.

Another way to look at it is this: If you buy the call instead of the stock, it’s as if you bought the stock at $32.75, but you only had to make a downpayment of 8% of the purchase price ($2.75), and somebody made you a nonrecourse, non-interest bearing loan for 92% of the purchase price ($30). We think a nonrecourse, non-interest bearing loan for 92% of the purchase price should be discounting heavily in determining its present value. So, say you use a 15% discount rate, that makes the loan have a present value of $22.36 – suggesting that your overall purchase price is $25.11 (which compares favorably to an outright purchase of the stock at $27.20).

I guess we’re just saying that for guys who don’t use leverage, and for guys who value downside protection and cling tightly to their capital, overall the calls seem just too cheap to us. Let the PhD’s sell them to us.

In terms of catalysts, it’s tough to say that there’s any specific catalyst out there. The concept simply is that, all things considered, PFE is just too cheap for such a huge cap stock. At some point, sentiment will change and the big guys will probably bid it up to a more fair price. A rough target of ours as of the end of 2006 (shortly before our calls expire), is 15-16x estimated 2007 earnings. That would put the stock close to $40. (In reality, we hope and expect that sentiment will turn in 2005 and the stock will trade into the $36-$38 range, at which point we would probably exit the position since the risk/reward will have changed dramatically, especially for the calls which will still have time premium built into them.)

Catalyst

Just too cheap at 12 times next year's EPS.
Shift in sentiment and/or rotation into more defensive names.