Seeking Alpha
Long only, dividend growth investing, dividend investing, value
Profile| Send Message|
( followers)  

Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.

Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheets of Pfizer (NYSE:PFE) and Merck (NYSE:MRK) in order to get some clues as to how well these companies are doing.

I will go through the balance sheets of these two companies, reviewing the most important items, and seeing if there are any major differences between the two that make one a better investment than the other. Information that I used on Pfizer can be found here, and information on Merck can be found at this link. Note that this article is not a comprehensive review as to whether either of these two stocks should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

This article might be a bit too basic for some, and too long-winded for others, but I hope that some of you can derive benefit from it.

Background

Pfizer is a major pharmaceutical company whose business is split into five segments. Their Primary Care segment researches, develops, and produces prescription drugs that are prescribed by primary care doctors. These drugs are used to treat numerous disorders, including Alzheimer's Disease, cardiovascular issues, erectile dysfunction, depression, and respiratory illnesses. Pfizer even produces a drug that is designed to help people quit smoking. Some of the many drugs that fall within this segment of Pfizer's business include Chantix, Celebrex, Lyrica, Viagra, and Pristiq. This segment accounts for 26% of the company's sales. Their Specialty Care and Oncology segment produces prescription drugs that are prescribed by specialists.

These drugs include anti-infective drugs, as well as drugs that treat endocrine disorders, hemophilia, and oncology-related issues. Some of these drugs include Enbrel, Geotropin, Tygacil, and Xyvox. This segment accounts for 26% of Pfizer's sales. Their Established Products and Emerging Markets segment is responsible for prescription drugs that have lost patent protection or marketing exclusivity, as well as for all prescription drugs that are sold in the emerging markets. Some of these drugs include Lipitor, Effexor, Protonix, and Medrol.

This segment accounts for 34% of the company's sales. The Animal Health segment offers products and services for treating and preventing diseases in livestock and pets. Some of the products that this segment offers include anti-invective drugs, vaccines, parasiticides, and medicinal feed additives. And, last but not least, their Consumer Healthcare segment produces non-prescription drugs and other items that include dietary supplements, personal care and pain management items, and respiratory care medicines. Some of their brand-name products in this area include Advil, Caltrate, Centrum, Chap Stick, Preparation H, and Robitussin. Together, Pfizer's Animal Health and Consumer Healthcare segments combine for 14% of the company's sales.

Pfizer recorded $59B in sales over 2012, and has a market capitalization of $208B. 61% of the company's sales come from outside the United States.

Merck is another pharmaceutical powerhouse. Their business is divided into three segments. Their Pharmaceutical segment produces therapeutic and preventive prescription drugs, as well as vaccines. Their prescription drugs include Zetia for cardiovascular issues, Januvia for diabetes, Singulair for respiratory issues, and Isentress, which is used for treating HIV. Their vaccines include Gardasil, which is used to prevent certain types of human papillomavirus. This segment is responsible for 86% of Merck's sales. Their Animal Health segment produces drugs and vaccines for animals, while their Consumer Care segment produces over-the-counter items such as foot care and sun care products, under the brand names of Dr. Scholl's and Coppertone. Together, those two segments combine for 14% of the company's sales.

In 2012, Merck recorded over $47B in sales, and has a market capitalization of $131B. 57% of the company's sales come from outside the United States.

Cash and Cash Equivalents

The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.

At the end of 2012, Pfizer reported cash and short-term investments of $32.7B. That's a lot of cash for a company that has a market capitalization of $208B. That means that the company's stock is trading for just over 6 times its cash position, which may make it attractive to value-oriented investors. The company paid out $6.53B in dividends and spent $8.23B on stock buybacks in 2012. In 2012, the company generated $15.8B in free cash flow. Going forward, Pfizer has the authorization to repurchase up to $11.8B in stock over the next several years.

Merck reported $16.2B in cash and short-term investments at the end of 2012, a lot of cash for a company with a market capitalization of $131B, meaning that the company's stock is trading at just over 8 times its cash position. During 2012, the company paid out $5.12B in dividends, and spent $2.59B on buybacks. It generated free cash flow of $8.05B.

The table below illustrates all of this information pretty clearly. Pfizer trades at a more attractive multiple relative to its cash position, although Merck isn't so bad in this area either. The dividend payouts and share repurchases by both companies over 2012 were covered by their free cash flows.

Symbol

Market Cap.

Cash Position

Dividend Payouts (NYSE:TTM)

Buyback Amount

Free Cash Flow

PFE

$208B

$32.7B

$6.53B

$8.23B

$15.8B

MRK

$131B

$16.2B

$5.12B

$2.59B

$8.05B

Table 1: Cash Positions and What Pfizer and Merck Do With Their Cash

Net Receivables

Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.

Pfizer had $12.4B in receivables on its balance sheet, equal to 21.0% of its 2012 sales. This percentage was slightly up from the 20.1% of sales that it recorded in 2011, and lower than the 22.4% of sales that it recorded at the end of 2010.

Merck reported $7.67B in receivables, equal to 16.2% of its revenue for 2012. This was inline with percentages of 17.2% and 16.0% for 2011 and 2010, respectively.

Given the consistency of these percentages over the last couple of years for each company, I don't see anything to worry about here for either of these two companies.

Current Ratio

Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.

If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.

The current ratio of Pfizer is 2.15, while Merck sports a current ratio of 1.91, both of which are outstanding. This means that both companies have more than enough current assets on hand to meet their short-term financial obligations, even in the event of a disruption of their operations.

Property, Plant and Equipment

Every industry requires a certain amount of capital expenditures. Land has to be bought. Factories have to be built. Machinery has to be purchased, and so on. While much of this is necessary, a company that has to constantly spend money here in order to keep up with its competition may be in a fiercely competitive industry, where it is difficult for anyone to obtain a sustainable competitive advantage. However, it could also work as an advantage in that large investments in this area could present a large barrier to entry to would-be competitors. Whether investments here are a good thing or a bad thing has to be examined on a case by case basis.

Right now, Pfizer has $14.5B in property, plant, and equipment on its balance sheet. This figure is down from the $15.9B that they reported a year ago, and the $18.6B that they reported the year before that. This decline is due to divestitures of the company's Nutrition business to Nestle in 2012, the sale of its Capsugel business in 2011, and depreciation. 41% of the company's assets here are in buildings, while 39% are in machinery and equipment.

Merck reported $16.0B in property, plant, and equipment at the end of 2012. This is inline with the $16.3B that the company reported one year before, and the $17.1B that they reported at the end of 2010. 51% of these assets are in machinery, equipment, and office furnishings, while 40% are in buildings.

Given that we don't see any huge increases in the capital expenditures of either company in this area, I don't see much to worry about here.

Goodwill

Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case-by-case basis, as good companies are rarely purchased at or below book value.

Pfizer has $44.7B worth of goodwill on its balance sheet. This represents 24% of the company's total assets. This amount of goodwill is consistent with the $44.6B that they reported at the end of 2011, and the $43.9B that the company reported at the end of 2010. Of the amount of goodwill that the company currently has on the books, nearly half of it is from the company's 2009 acquisition of Wyeth. Since then, the company has not made any major splashes on the acquisition front.

Merck has $12.1B worth of goodwill on its balance sheet, which is consistent with the $12.2B that they reported at the end of 2011, and the $12.4B that the company reported at the end of 2010. This figure accounts for just over 11% of Merck's assets.

For the reason discussed at the beginning of this section, I generally don't like to see goodwill account for more than 20% of a company's total assets. While this is not a problem for Merck, I'm a little bit concerned about Pfizer as they are just over this threshold.

Intangible Assets

Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights, and trademarks that have been purchased from someone else. They are listed on the balance sheet at their fair market values. Internally-developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto their assets. Many intangible assets like patents have finite lives, over which their values are amortized.

This amortization goes as annual subtractions from assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.

Pfizer reported $46.0B of intangible assets on its balance sheet, accounting for nearly 25% of total assets. 81% of these assets have finite lives, with an average useful life of 11 years. The other 19% are from trade names that have indefinite lives and can't be lost to amortization. Of this $46.0B total, $36.0B come from developed technology rights, which include the right to develop, use, market, and sell products, compounds, and intellectual property. Virtually all of this $36.0B in this area came from Pfizer's acquisitions of Wyeth in 2009 and Pharmacia in 2003. The company's $46B total in intangible assets is down from the $51.2B that they reported at the end of 2011, and the $57.6B that they reported at the end of 2010. Of this decline, $2.65B was due to the divestiture in 2012 of the company's Nutrition business, while most of the rest was due to amortization.

Merck reported $29.1B of intangible assets on its most recent balance sheet, which equates to 27% of the company's total assets. 87% of these intangible assets are from products and product rights that are related to some of the drugs that the company produces. Some of these drugs include Zetia, Vytorin, Nasonex, Claritin, and Nuva Ring. These assets have finite lives, which will eventually be lost to amortization. The company's intangible assets total has fallen from the $34.3B that they reported at the end of 2011 and the $39.5B that they reported at the end of 2010. This decline is due to amortization. Over the past two years, their gross amount of intangible assets has remained roughly the same. This means that the company hasn't acquired any new intangibles from third parties over the past two years.

Both of these companies reported large totals of intangible assets that represent relatively high percentages of their asset totals. Most of these assets will be lost from the balance sheet, as they will be amortized away over time. This will represent a reduction in each company's net worth, unless they have new assets with which to replace these items. This reduction in net worth may be accompanied by a reduction in the company's share price. So, this will be an important thing to monitor for each company in the years to come.

Return on Assets

The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:

Return on Assets = (Net Income) / (Total Assets).

For Pfizer, the return on assets would be $16.5B in core earnings, divided by $186B in total assets. This gives a return on assets for 2012 of 8.87%. This is slightly lower than the 9.52% that was reported for 2011, as well as the 9.23% that was reported for 2010. The drop from 2011 to 2012 was due in part to the company losing exclusivity for its Lipitor drug.

For Merck, the return on assets for 2012 was 11.2%, which is the same as what it reported at the end of 2011, and above the 10.2% that the company reported at the end of 2010.

In the table below, you can see how the returns on assets of both companies have changed over the last couple of years. These figures are fairly consistent for both companies, although I give a slight edge to Merck, because their returns on assets are a little bit higher. It should also be mentioned that both of these companies have asset totals that are well above $100B. This can represent a huge barrier to entry to would-be competitors.

Symbol

2012

2011

2010

PFE

8.87%

9.52%

9.23%

MRK

11.2%

11.2%

10.2%

Table 2: Returns On Assets From Pfizer And Merck

Short-Term Debt Versus Long-Term Debt

In general, you don't want to invest in a company that has a large amount of short-term debt when compared with the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.

Pfizer is carrying $6.42B worth of short-term debt, with $2.45B being original long-term debt that is maturing with the year. I'm not too concerned with this item, as it is dwarfed by the company's huge cash position.

Merck is carrying $4.32B worth of short-term debt. This figure is dwarfed by Merck's cash position, so I don't see much to worry about here.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.

Right now, Pfizer is carrying $31.0B of long-term debt, compared with the $34.9B reported at the end of 2011, and $38.4B that was reported at the end of 2010. Of the $31.0B in long-term debt, approximately $13.3B is due within the next five years, with the rest of it not due for another six years or more. Interest rates on this debt range from 2.5% to 7.2%, with maturities ranging from 2014 to 2039.

Merck currently has $16.3B worth of long-term debt, versus $15.5B from one year ago, and $15.5B from the year before that. Of the $16.3B in long-term debt, $6.1B is due within the next five years, with rates between 1.1% and 6.5%. During 2012, the company issued $2.5B of long-term debt for general corporate purposes, including the repayment of commercial paper and the funding of the company's pension obligations. This new debt was issued in three tranches, with one of them being for $1B at 1.1% due in 2018. One tranche is for $1B at 2.4% due in 2022, while the other is for $500M at 3.6% due in 2042. These are really good rates.

The table below illustrates the long-term debt figures for both companies and how they have changed over the last couple of years.

Symbol

2012

2011

2010

PFE

$31.0B

$34.9B

$38.4B

MRK

$16.3B

$15.5B

$15.5B

Table 3: Long-Term Debt At Pfizer And Merck

It is clear that Pfizer has a lot more long-term debt than Merck, but at least it shows that the company is working to bring this item down.

In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of each company's core earnings over the last 3 years. The average earnings of Pfizer over this period is $17.5B. The 3-year average for Merck is $11.5B. When you divide the long-term debt by the average earnings of each company, here is what we find.

Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings

For Pfizer, here is how it looks: $31.0B / $17.5B = 1.77 years

For Merck, it looks like this: $16.3B / $11.5B = 1.42 years

From looking at this, it appears to me that the long-term debt positions of both companies are manageable, when compared to the earnings power and cash positions of each company. I see nothing to be alarmed about here at this time.

Treasury Stock

In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will usually exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio in the case of historically-strong companies, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre, or even severely distressed, when doing the debt-to-equity calculation, when in reality, it might be a very strong company.

Pfizer has $40.1B worth of treasury stock on its balance sheet, while Merck has $24.7B.

Debt-To-Equity Ratio

The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Pfizer and Merck stack up here.

Debt To Equity Ratio = Total Liabilities / Shareholder Equity

For Pfizer, it looks like this: $104B / $81.3B = 1.28

For Merck, it looks like this: $53.0B / $53.0B = 1.00

The table below shows these figures for both companies over the last couple of years.

Symbol

2012

2011

2010

PFE

1.28

1.28

1.22

MRK

1.00

0.93

0.94

Table 4: Debt-To-Equity Ratios At Pfizer And Merck

From this, you can see that Merck has a consistently lower debt-to-equity ratio than Pfizer. However, this calculation did not strip out the negative effects of either company's huge treasury stock position.

A variation of this ratio that I like to use takes into account the presence of treasury stock on the balance sheets of very strong companies. When there is a large amount of treasury stock on the balance sheet, the regular debt-to-equity ratio can make a very strong company appear as a mediocre, or even a severely distressed company. Here, I add the treasury stock back into the equity, as treasury stock can be re-issued at a later date if the need arises (although you hope that never happens). I call this ratio the adjusted debt-to-equity ratio. It's calculated like this.

Adjusted Debt To Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)

For Pfizer, it looks like this: $104B / $121B = 0.86

For Merck, it looks like this: $53.0B / $77.7B = 0.68

In the table below, you can see how this figure has changed over the last couple of years.

Symbol

2012

2011

2010

PFE

0.86

0.92

0.96

MRK

0.68

0.64

0.67

Table 5: Adjusted Debt-To-Equity Ratios Of Pfizer And Merck

From this table here, Merck's debt-to-equity ratios are pretty good and consistently below those of Pfizer. However, Pfizer doesn't look so bad here either. I give the edge to Merck.

Return On Equity

Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.

Return On Equity = Net Income / Shareholder Equity

Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. For this reason, I also strip out the effect of treasury stock here, when I calculate the adjusted return on equity.

For now, let's just calculate the normal return on equity.

So, the return on equity for Pfizer is as follows:

$16.5B / $81.3B = 20.3%

The return on equity for Merck is:

$11.9B / $53.0B = 22.5%

In the table below, you can see how the return on equity has fared over the past couple of years for both companies.

Symbol

2012

2011

2010

PFE

20.3%

21.8%

20.5%

MRK

22.5%

21.7%

19.9%

Table 6: Returns On Equity From Pfizer And Merck

To strip out the negative effects of treasury stock, I calculate what I call the adjusted return on equity.

Adjusted Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)

For Pfizer, it comes out as: $16.5B / $121B = 13.6%

For Merck, it looks like this: $11.9B / $77.7B = 15.3%

In the table below, you can see how this figure has changed over time for both companies.

Symbol

2012

2011

2010

PFE

13.6%

15.7%

16.2%

MRK

15.3%

15.1%

14.1%

Table 7: Adjusted Returns On Equity At Pfizer And Merck

From looking at tables 6 and 7, it's almost a tie here. This is especially so if you look at the 3-year averages of these numbers for both companies. However, Merck's adjusted return on equity is creeping in the right direction, while that of Pfizer is falling.

Retained Earnings

Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:

Retained Earnings = Net Income - Dividend Payments - Stock Buybacks

On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.

Pfizer reported a $54.2B in retained earnings at the end of 2012. This figure compares with the $40.4B that the company reported in 2009. Retained earnings at Pfizer grew at a cumulative rate of 34.2% since 2009.

Merck reported $40.0B in retained earnings at the end of 2012. This compares with the $41.4B that it reported at the end of 2009. So, retained earnings at Merck fell by 3.4% since the end of 2009. This drop was due largely to a $12B decline in reported earnings for 2010.

The table below shows how the retained earnings at both companies have changed over the last few years.

Symbol

2012

2011

2010

2009

PFE

$54.2B

$46.2B

$42.7B

$40.4B

MRK

$40.0B

$39.0B

$37.5B

$41.4B

Table 8: Retained Earnings At Pfizer And Merck

The clear winner in the retained earnings department is Pfizer, as they have been able to grow their retained earnings at a pretty decent rate.

Conclusion

After reviewing the balance sheets of both Pfizer and Merck, it can be seen that both companies have a few things in common. They both have large cash positions relative to their market capitalizations. They have very strong current ratios, which suggest that both companies will be able to continue meeting their short-term financial obligations in the event of an unlikely disruption of their operations. They both have very manageable long-term debt positions as well, in light of each company's earnings power and cash position.

They also have goodwill and intangible assets that when combined, represent more than 30% of each company's total assets, almost 50% in the case of Pfizer. Over time, most of these assets will disappear from the balance sheet due to amortization, which will represent a reduction in each company's net worth, unless new assets are introduced to replace the ones that are lost. This could ultimately lead to a decline in the stock prices of the two companies. Special attention should be paid to this item for both companies.

While this is a close comparison, I'm going to give the slight edge to Merck. This is because Merck has a consistently lower debt-to-equity ratio, slightly better returns on assets, and a smaller total asset percentage of goodwill and intangible assets.

Now, keep in mind, that this doesn't necessarily mean that Merck is a better overall investment than Pfizer. There are other things that you need to consider, such as whether each company has enough products in its pipeline in order to replace the ones that are lost due to expiring patents. This, right here, is one of the biggest risks that comes with investing in stocks of pharmaceutical companies. Analyzing the balance sheet is just one of the many things that need to be done before making a final investment decision.

To find out more about how I analyze financial statements, please visit my website by following this link. It's a new site that I created for fun, as well as for the purpose of helping others make sound investment decisions.

Thanks for reading and I look forward to your comments!

Source: The Battle Of Big Pharma: Who Has The Better Balance Sheet, Pfizer Or Merck?