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Undervalued Pfizer Remains Poised for Growth

Strong cash flows support drug development and a dividend that yields above 4%.

Although Pfizer PFE reported a failed study that reduced our sales forecast for cancer drug Ibrance, as well as our fair value estimate, the company continues to hold an entrenched, robust portfolio of drugs and a strong pipeline, supporting our wide economic moat rating.

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.

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, Pfizer 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 2019 U.S. patent loss on neuroscience drug Lyrica is weighing on near-term growth. However, Pfizer’s recent decision to divest itself of its off-patent division to create a new company in combination with Mylan should drive accelerating growth at the remaining innovative business at Pfizer.

Further, we believe Pfizer’s operations can withstand the additional generic competition, and a diverse portfolio of drugs helps insulate the company from any one particular patent loss. Following the merger with Wyeth several years ago, 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.

Patents, Scale, and Distribution Network Dig a 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. While Pfizer holds a diversified product portfolio, there is some product concentration, with the company's largest product Prevnar representing just over 10% of total sales. However, we don't expect typical generic competition for the vaccine due to complex manufacturing and relatively low prices for the product. We also expect new products will mitigate the eventual generic competition of other key drugs. 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, the company’s 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 manufacturing cost advantages in the vaccine division. Pfizer recently created a consumer healthcare joint venture with GlaxoSmithKline that could lead to an eventual divestment of the unit, but the potential divestment shouldn’t have a material impact on the company’s moat.

We believe Pfizer has a stable moat trend. Over the next five years, the company’s major patent losses represent just over 10% of total sales. However, the strong pipeline, combined with stable currently marketed drugs, should lead to modest growth of 2% annually over the same period excluding acquisitions. Also, some of the patent exposure facing Pfizer is on biologics, which shouldn’t decline as fast as small molecules when patents expire. Offsetting the patent losses on the pipeline side, we expect well over $1 billion in peak annual sales from three new drugs, including recently launched cancer drug Xtandi and Vyndaqel for a rare cardiovascular disease.

Turning to the macroeconomic environment, Pfizer has several headwinds but is making solid strategic moves to address the challenges. On the negative side, the risk-sensitive U.S. Food and Drug Administration is generally only approving very safe drugs or drugs in high-need areas such as cancer. Also, managed-care organizations and pharmacy benefit managers have consolidated over the past decade and are now using their growing size to demand lower drug prices and reduced coverage for less innovative drugs, forcing drug companies to push for true innovation and reducing the power of Pfizer’s distribution networks. Further, the U.S. government is evaluating comparative effectiveness programs and more aggressive price negotiations, raising the bar for future innovation. While Pfizer faces several headwinds, its pipeline is focused on more innovative treatments in areas of unmet medical areas such as cancer where payer coverage and pricing power remain strong. Outside the pipeline, strong entrenchment in vaccines and consumer healthcare gives the company some relief from the pressures in the drug division.

Some Risks, but Low Uncertainty Pfizer faces generic competition, potential drug pricing policy changes by governments, an increasingly stringent FDA, 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 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 uncertainty as low based on 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. As of the end of 2019, debt/capital stood at 45% and debt/EBITDA was 2.1, which suggests that Pfizer remains on solid financial footing. 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.

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