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By Ryan Leggio | 07-23-2010 10:41 AM

Even After Patent Cliff, Pfizer Is Undervalued

A new ROIC-focused process for compound development plus the value of Pfizer's other businesses add up to a fair value well in excess of $14, says RS Investments manager Joe Wolf.

Ryan Leggio: Another industry where there has been some headwinds is the health-care industry, one with the law that's been passed. I think, a lot of people are digesting the tax ramifications, and the business ramifications for a lot of these businesses. You own a Pfizer, which investors have been worried about because of the so-called patent cliff that that company faces, but it's a large holding for you. Can you talk a little bit about your investment case for Pfizer and why you're not as worried about this patent cliff that's out there for them?

Joe Wolf: Sure. Again our fixation is around downside protection. And so, if you take a Pfizer, if you take a Merck, if you take an Abbott, if you take a St. Jude: A lot of the investments that we have, you are able to very again draconian assumptions towards what pricing might occur, what demand growth might be, what might happen in pipelines, and you're still arriving at prices that are far higher than our entry prices.

If you take a Pfizer for instance, the world is seeing Pfizer as a small molecule company with a significant patent cliff across the entire board. When you actually deconstruct the business into its pieces, perhaps 20% of this business is actually a small molecule business at this point, and so you're able to essentially put a zero on that entire controversial business, and just value the other pieces and arrive at a price that's far in excess of $14.

The other thing that's going on here is new management has come in. Prior management was compensating their engineers based on how many compounds they produce with very little return on invested capital methodologies.

In fact the more they spent the more they got compensated, and so with the Wyeth acquisition, they've actually decreased R&D by $3 billion or $4 billion on a combined basis. They're taking out a significant amount of cost. Yet we would argue that the return on those dollars, it's going to significantly higher. They've put in a very strict red light, green light milestone-type ROIC process for each of these compounds, and so if you strip out the patent cliff, and all the products associated with it, the core Pfizer business has a nice trajectory upwards in terms of durability, predictability, and return on invested capital with biologics, with diagnostics, with nutritionals, etc.

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