Description

The purchase of WPE.AD (Pfizer 2008 $20 calls) provides an inexpensive and leveraged way to capture the upside of PFE (Pfizer), a very cheap stock. Credit is due to bill67 who proposed a similar concept in December 2004; I believe the timing and price are particularly attractive now to follow this strategy.


WHY PFIZER:

I have no proprietary information on Pfizer; a good description of the company, its products and risks are available in its 10-K, analyst reports and bill67’s write-up last year.

With the consistently poor incremental news emerging from Pfizer (and the large U.S. pharmaceutical manufacturers) over the last year, the stock has been driven incrementally lower to levels that I believe make no sense if you step back and look at the whole picture:


1) At its current market capitalization, PFE is extremely cheap on fundamentals (B = billions):

Market Value = $158B (7.37B shares in July 2005, prior to probable recent buybacks)

Cash + investments = $18.3B (July 3, 2005)
Total Debt = $12.8B (July 3, 2005)

Net Cash = $5.5B (July 3, 2005)

EV = $153B (using July 3, 2005 balance sheet)


Two weeks ago, PFE withdrew guidance for 2006. After this withdrawal of guidance, analysts estimate:


$B 2004 1H05 2H05 2006 2007

Net Income (before
extraordinary items) $16.1 $7.4 $7.0 $14.2 $14.8
Depreciation & Amortization 5.1 2.5 2.6 5.2 5.4
Capital Expenditures -2.6 -1.2 -1.4 -2.9 -3.0

Free Cash Flow (simplified
definition) $18.6 $8.7 $8.2 $16.5 $17.2


EV (projected at year-end 2007) = $153B - $(8.2 + 16.5 + 17.2)B = $111 B

FCF yield = $17.2/$108 = 16%

If PFE trades up to a free cash flow yield of 8-10% in January 2008, this results in an EV of $172 - 215 B, implying a share price of $30-35, and a total return of 40-60%.

Note that this analysis conservatively ignores potential share repurchases at current low prices, which PFE has the financial wherewithal and inclination (PFE repurchased 126 million shares for $3.4B in 2005) to do.

Also, please note that I want to avoid debates related to false precision ... I believe the numbers to be a roughly accurate representation of historical numbers and analyst estimates.


2) If there are negative revenue surprises between now and 2008, Pfizer has several levers to pull in order to meet cash flow targets, including cuts to its huge SG&A ($16 billion per year) and R&D ($8 billion per year) expenditures. Analysts have recently complained about the unproductive R&D expenditures at PFE, which may imply that the company will either cut costs or generate revenues from products in the R&D pipeline not currently expected by analysts.


3) The market has an asymmetrical view of the company’s product pipeline …. as CEO Hank McKinnell recently said, analysts know the specifics of the downside of the product portfolio (scheduled patent expirations, etc), but only the company knows the upside (new products in the R&D pipeline). It seems an intelligent bet to invest in a R&D-intensive company at that point in the product cycle where much bad news is out and very little good news is expected.


WHY PFIZER LEAPS?


1) In general, LEAPS are at multi-year lows in terms of price, due to the combination of the low volatility in the market (as measured by the VIX) and low interest rates.


2) WPE.AD (Pfizer 2008 $20 calls) offer a leveraged way to invest in Pfizer; after adjusting the PFE 2008 price target for the total of approximately $1.70 in interim dividends (9 x $0.19 per quarter) not received by LEAP holders, PFE would trade for $28.30 - $33.30 per share in January 2008. WPE.AD should trade at $8.30 - $13.30 per contract, implying a total return of 85-195%.


3) In the case of an unforeseen disaster with PFE (litigation, etc), where the stock drops substantially below the $20 strike price in the near term, the LEAPS should still retain some time value, creating a potential $3 down, $8-13 up situation.


WHY NOW?


1) Pfizer is currently detested by the analyst community. Pfizer withdrew 2006 earnings guidance at its analyst meeting on October 20; analysts were shocked and felt betrayed …. you can listen to the outrage that permeated the meeting on the archived webcast at http://events.reflectsystems.com/clients/pfizer/2005q3/launch.htm


2) As stated earlier, the best time to invest in a R&D-intensive company is at that point in the product cycle where much bad news is out and very little good news is expected from the R&D pipeline; I believe that time is now.


3) The stock hit a new multi-year low, falling to $21.50 currently from $25 in early October, $29 in June and $50 in 2000. Since Pfizer hit a multi-year low in late October, there may have been tax loss selling by mutual funds (which have October 31 tax year-ends) in the last few weeks, creating short-term artificial pressure on the stock.


PLEASE NOTE THAT I MAY HAVE A CURRENT POSITION IN PFE OR WPE.AD, WHICH COULD CHANGE AT ANY TIME


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Catalyst

1) More clarity from guidance to be provided by PFE in early 2006

2) End of mutual fund tax loss selling on October 31

3) Any positive product news from PFE over the next two years

4) Historically, drug company stocks have outperformed in a slowing economy, which the U.S. may face in 2006, with rising energy prices and rising interest rates