Wide Moat Surrounds Pfizer's Solid Foundation

Pfizer's size establishes one of the largest economies 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, the company is now launching several potential blockbusters in cancer, heart disease, and immunology.

Pfizer's vast financial resources support a leading salesforce. Pfizer'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 eventual 2019-20 U.S. patent losses on Lyrica will slow long-term growth.

However, we believe Pfizer's operations can withstand upcoming generic competition, and the 2009 acquisition of Wyeth helps insulate the company from any one particular patent loss. Following the merger, Pfizer has a much stronger position in the vaccine industry with pneumococcal vaccine Prevnar 13. Vaccines tend to be more resistant to generic competition because of the manufacturing complexity and relatively lower prices.

Patent Protection Provides Pricing Power 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 company 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. Additionally, while Pfizer holds a diversified product portfolio, there is some product concentration, with its largest product, Prevnar, representing just over 10% of total sales. However, we don't expect typical generic competition for the vaccine because of its complex manufacturing and relatively low prices. Further, we expect new products will mitigate the eventual generic competition of other key drugs.

Also, Pfizer’s operating structure allows for cost-cutting following patent losses to reduce the margin pressure from lost high-margin drug sales. Overall, 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, a powerful distribution network sets up the company as a strong partner for smaller drug firms 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 manufacturing cost advantages in the vaccines division. Pfizer is considering selling its consumer healthcare group, but the potential divestment shouldn't have a material impact on the company's moat.

Fair Value Uncertainty Is Low Pfizer faces generic competition, an increasingly stringent Food and Drug Administration, and stronger managed-care and pharmacy benefit manager negotiating power. New drug development has become challenging in several disease areas with a more risk-conscious FDA. Additionally, managed-care companies and pharmacy benefit managers have grown during the past two decades into powerful entities 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 and put downward pricing pressure on the drugs if the clinical data lacks positive differentiation. On the branded competition front, Merck is working to develop a next-generation pneumococcal vaccine that covers 15 valents, which could threaten Pfizer's Prevnar 13, which covers two fewer valents. However, overall we view Pfizer's fair value uncertainty as low, given the low volatility of cash flows from a diverse product portfolio with inelastic demand.

Pfizer holds a very strong financial position with a large degree of flexibility. With the majority of its cash flow derived from a diverse portfolio of products, we don’t expect a high degree of volatility with future earnings. While Pfizer is likely to continue to make acquisitions, we believe it can relatively easily take on debt to fund larger deals.

The announcement that COO Albert Bourla will move to the top spot in 2019 signals a likely continuation of Pfizer's strategic focus on moving toward areas of unmet medical need in drug development, divesting assets in areas lacking scale, and making synergistic midsize acquisitions, all of which should guide the company to continued steady growth. Bourla's background as chief operating officer as well as leadership in the innovative drug business gives him strong credentials for running the overall organization. We believe his gaining the COO spot in January largely set him up for an eventual CEO appointment. This thoughtful and telegraphed passage of leadership is a welcome pathway and in contrast to the past CEO change at Pfizer, where Ian Read abruptly took over following increasing concerns about the previous CEO. While Bourla will probably want to leave his mark on Pfizer's legacy, we expect a calm hand at the helm similar to Read's, with decisions made in a calculated way in the best interest of shareholders and patients.