Pfizer's Pipeline Productivity Is Improving

We are holding firm to our $38 fair value estimate following

In the quarter, growth from vaccine Prevnar 13 and recently launched drugs helped offset generic competition, leading to 5% year-over-year operational growth (excluding the Hospira acquisition). While the organic growth rate is likely to slow in 2016 as Prevnar sales annualize the U.S. bolus of adult patients recently approved for treatment, several other recently launched drugs are poised for rapid growth. In particular, breast cancer drug Ibrance is well positioned to generate peak annual sales of more than $6 billion, and while competition is emerging from Eli Lilly LLY and Novartis NVS in this drug class, we believe Pfizer's first-mover advantage and lack of differentiation in the class will lead Ibrance to the majority of market share. Several other key pipeline assets are also poised for growth, including diabetes drug ertugliflozin, which should launch next year in a one-tablet fixed combination with Merck's Januvia.

Pfizer's foundation remains solid, based on strong cash flows generated from a basket of diverse drugs. The company's large size confers significant competitive advantages in developing new drugs. This unmatched heft, combined with a broad portfolio of patent-protected drugs, has helped Pfizer build a wide economic moat around its business.

Potential Blockbusters on Deck Pfizer's size establishes one of the largest economy of scale in the pharmaceutical industry. In a business where drug development needs a lot of shots on goal to be successful, Pfizer has the financial resources and the established research power to support the development of more new drugs. Also, after many years of struggling to bring out important new drugs, Pfizer is now launching several potential blockbusters in cancer, heart disease, and immunology.

Pfizer's vast financial resources support a leading salesforce. The firm's commitment to postapproval studies provides its salespeople with an armamentarium of data for their marketing campaigns. Further, Pfizer's leading salesforces in emerging countries position the company to benefit from the dramatically increasing wealth in nations such as Brazil, Russia, India, China, and Turkey.

While entrenched as an industry leader, Pfizer faces challenges in the near term. The loss of patent protection on several drugs will weigh on future growth. In particular, the 2017 patent loss on Viagra and the 2019 U.S. patent loss on Lyrica will slow long-term growth.

However, we believe the firm's operations can withstand the blitz of new generic competition, and the 2009 acquisition of Wyeth helps insulate Pfizer from any one particular patent loss. Following the merger, Pfizer has a much stronger position in the biologic industry with meningitis vaccine Prevnar and rheumatoid arthritis drug Enbrel. Biologics tend to be more resistant to generic competition as a result of the complexity in the structure of the drugs.

Large Size and Drug Portfolio Dig a Wide Moat Patents, economies of scale, and a powerful distribution network support Pfizer's wide moat. Pfizer's patent-protected drugs carry strong pricing power that enables the firm to generate returns on invested capital in excess of its cost of capital. Further, the patents give the company time to develop the next generation of drugs before generic competition arises. While Pfizer holds a diversified product portfolio, there is some product concentration with its largest drug Lyrica representing 6% of total sales; however, we expect new products will mitigate the eventual generic competition. Pfizer's operating structure allows for cost-cutting following patent losses to reduce the margin pressure from lost high-margin drug sales. Pfizer's established product line creates the enormous cash flows needed to fund the average $800 million in development costs per new drug. In addition, its powerful distribution network sets up the company as a strong partner for smaller drug companies that lack Pfizer's resources. Pfizer's entrenched consumer and vaccine franchises create an added layer of competitive advantage, stemming from brand power in consumer healthcare and cost advantages in the vaccine division.

Drug Development More Challenging Pfizer faces generic competition, an increasingly stringent Food and Drug Administration, and stronger managed-care negotiating power. New drug development has become challenging with a more risk-conscious FDA. Additionally, managed care has grown during the past two decades into a powerful entity that can negotiate lower drug prices. Although more remote, litigation risks remain, as evidenced by Merck's MRK high settlement costs involving Vioxx. Also, several of Pfizer's pipeline drugs are reaching markets behind competitors, which may increase the risk of commercialization failure.

Pfizer maintains a highly flexible financial position, and we do not expect that to change after the Allergan merger, especially since the deal will be funded primarily with stock. At the end of September, Pfizer's cash and investments of $37 billion nearly offset its $39 billion debt position, despite the recent acquisition of Hospira. While acquiring Allergan will bring more debt onto Pfizer's balance sheet since Allergan owed $43 billion in debt at the end of September, we think cash inflows from Allergan's divestiture of generic assets to Teva TEVA for $40.5 billion will help keep net leverage easily manageable. We think Pfizer debtholders will still face some event risk, though. Once the firm repurchases the $5 billion remaining on its authorized share-repurchase program, it may increase that program significantly. Also, the firm may eventually split into two organizations (branded pharmaceuticals and established pharmaceuticals), which could alter our view of its credit profile in the long run. Additionally, Pfizer remains committed to its dividend and aims to maintain a payout ratio around 50%, which could constrain its credit profile as well.