- Pfizer has been beaten up these past two days. It was cheap before, now it is cheaper. The stock may be of interest to value investors.
- The company offers a dividend yield of 3.2% and the dividend can grow at a long-term rate of 5% to 6%. This might be of interest to income investors.
- The patent cliff is behind. What matters is what lies ahead. The pipeline of 7 drugs in registration and 20 in Phase III suggests that the game is not over.
I'm taking a look at Pfizer (NYSE:PFE) today, because the stock has been beaten down over the past few days.
Recent news flow: it never rains, it pours!
Firstly, a retrospective study which suggests that Viagra might raise the risk to melanoma. Viagra's patent has expired, so the impact on revenue is minimal. And it is too early to consider liability aspects, for that in my view the study needs to be prospective and a cause and effect relationship needs to be better established. In addition, in a recent article on Forbes, they observe that "The investigators did not explore whether other PDE5A inhibitors, including tadalafil (Cialis) and vardenafil (Levitra), were associated with melanoma, since these drugs were not available at the start of the study. But in their discussion they point out that because these drugs are longer-acting they may potentially result in an even greater increase in risk for melanoma." It is interesting that we saw a severe price response in Pfizer, with little to no impact on Bayer (OTCPK:BAYRY) and GlaxoSmithKline (NYSE:GSK) who manufacture and market Levitra, or Eli Lilly (NYSE:LLY), which owns the Cialis brand.
Secondly, a threat to Zyvox from competition arose as a result of an FDA advisory committee which smiled at potential competitors. Zyvox accounts for 2.2% of Pfizer's revenue, but surely competition is something everyone must expect.
Finally, we have Celebrex, where in March 2014 the Court had invalidated a re-issue patent. That cuts eighteen months and as much as $3 billion off revenue ($1 billion in 2014, and $2 billion in 2015). Pfizer is appealing the decision, but with the patent expiring on 30 May, people will get nervous.
It never rains, it pours. And when it pours, people with no umbrella often run indoors. Where is the umbrella?
The worst of the patent cliff is behind us. What matters now is what lies ahead. And the pipeline at Pfizer holds promise. There are seven discovery projects in registration, twenty in Phase III, twenty-three in Phase II, and thirty-two in Phase I. I have no doubt that Pfizer is no longer the darling of the market - is unlikely to be viewed as a growth stock, or return to its glory days of the 1990's. Yet, it remains a solid value stock, providing investors with very reasonable dividend income. Lyrica and Prevnar are the bedrock of Pfizer's revenue today - and growth in these brands is adequate to provide top line stability. Prevnar provides a particular exciting growth opportunity: in February, Pfizer announced that Prevnar 13 was licensed by the FDA under an accelerated approval process to address an unmet medical need in older adults. Progress has been positive and it a phase three study on safety and immunology of Prevnar 13 on adults with HIV is positive. More recently, Bivalent rLP2086 received Breakthrough Therapy Designation for Potential Prevention of Meningococcal B Disease. Pfizer's oncology segment has been growing rapidly. And within that segment, palbociclib, Inlyta, Sutent and Xalkori are well worth watching: all of these drugs have product enhancements in Phase III trials, and could provide an opportunity for meaningful revenue growth. In addition, the new molecules in phase three development palbociclib, dacomitinib, and inotuzumab ozogamicin also are well worth watching.
Pfizer deserves investor consideration because the markets are expensive, while Pfizer is not
The market is expensive. If we work with a risk free rate expectation of 4.50%, a long-term equity risk premium of 5.75%, we are setting our long-term return expectations at 10.25%. This we expect from a market where long-term nominal growth can be expected at 6.25%, with shareholder value returned via a mix of dividends and buybacks of 53% of earnings. You can read more about where I get my estimates for long-term market returns, long-term nominal growth, and the equity risk premium here.
With as reported earnings for 2014 estimated at $106, if we use a very long-term growth expectation of 6.99%, the S&P 500 is worth 1,845.00. S&P 500 Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.99% * $106 * 53% / (10.25%-6.99%) = $1,845. At this price, it is likely that an investor with a return expectation of 10.25% will be satisfied. My estimate of long-term nominal earnings growth for the S&P 500 is 6.25%, based on a mix of long-term nominal U.S. growth and long-term nominal global growth. Alpha is the difference between actual returns and the risk adjusted return expectation. And if I am correct, the market is overvalued and pricing seventy-four basis points of negative alpha. If we use S&P 500 operating earnings estimates of $116 for 2014, we get forty-four basis points of negative alpha.
As of now, negative alpha of forty-four to seventy-four basis points suggests that markets are expensive, but not terrifyingly so. It is time for lower risk appetite or rising risk aversion levels, and for rotation out of expensive pockets of the market, to cheaper areas. Churn, not exit is what is evident. The S&P 500 is attractively valued at 1,492, if you rely on as reported earnings and at 1,633 if you rely on operating earnings. This does not necessarily suggest that a bear market is imminent: the implied over-valuation of 11% to 19% is very much in-line with the customary level of over-valuation during periods outside of recessions.
In my view, selling a market simply because it is expensive is not a good idea. Markets can go from being expensive to very expensive, and from being cheap to very cheap. And no one knows which it will be. But negative alpha is an important market timing tool for asset allocators - it hints that it might be time to return to allocation, by selling some of the expensive asset class, and buying another asset class.
During times when alpha expectations turn negative, it pays to listen closely to the voice of the market, for that is where we can see changing levels of risk aversion. In U.S. we have seen small and midcap stocks outperform large capitalization stocks for a long while. We have also seen growth stocks outperform value stocks for an extended duration. This signals low levels of risk aversion amongst market participation. But in recent times this has changed. There are clear signs of a shift in bias back to value from growth and from small and midcap stocks to large cap stocks. This suggests that risk aversion levels are rising. And so the more active asset allocator might also use an expectation of negative alpha to adopt a more defensive equity portfolio.
How do different market participants view Pfizer?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stocks sector and the stock's industry of operation.
Pfizer scores high on value, in comparison to the market as a whole, and in comparison with stocks in its sector and industry of operations. It scores high on quality across the board too. The score for growth is mediocre in comparison to its sector and industry of operation, and poor in comparison to whole market growth expectations. Momentum is weak in comparison to the market as a whole, and in comparison with stocks in its sector and industry of operations. Momentum in comparison to its industry of operation is abysmal.
Source: Alpha Omega Mathematica
AOM Model Recommendation
Pfizer is attractive to value investors. It is also attractive to balanced and growth investors who allocate capital at sector level. All other stock selection and capital allocation style combination view the stock as neutral.
Source: Alpha Omega Mathematica
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 58% and an AOM Hold Recommendation for Pfizer.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, nor does it replace the due diligence we must do as investors. It is a tool which uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Pfizer:
Why look at Pfizer now?
Firstly, Pfizer is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, Pfizer pays a dividend of $0.26 per share which provides a dividend yield of 3.2%, which is a significant premium to the broad market dividend yield. This too provides defensive characteristics to the stock. Thirdly, Pfizer enhances its defensive character by returning a generous amount of capital to owners via buybacks.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 0.85 for Pfizer. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock relative to weekly closing prices of the S&P 500 at 0.68, and I adjust it to 0.90 on account of the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock.
The coefficient of determination for Pfizer is 31.80%. This suggests that only 31.80% of the price movement in Pfizer is explained by movements in the market: the residual price movement is based on company specific factors. This low coefficient of determination suggests that the market related risks are low. And because company specific risks can be diversified, Pfizer is a great pick for most portfolios at the present time.
Pfizer also has an alpha intercept of 0.14%, which means that if the S&P 500 returns 0%, the stock can be expected to return 0.14%. But because of the low coefficient of determination, the raw beta and alpha are less meaningful.
Cyclicality and Pfizer
In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late cycle, stocks in the healthcare sector continue to outperform. If I am right, this is positive for Pfizer investors.
You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance today I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how U.S. sectors will behave. For example, if Europe, other developed markets, or emerging markets shift into early or mid-cycle condition, U.S. companies from defensive sectors may well underperform as money-flows shift overseas, or to sectors which are more sensitive to the economy.
Analyst price expectations
Recently Pfizer traded at $30.87. From Yahoo Finance we know that seventeen analysts expect an average price target of $34.27 (median $35.00), with a high target of $41 and a low target of $29. This is a wide dispersion in expectations, which suggests risks are high. It is early in the year. So far, it appears that the bears have the upper hand.
We might believe that Pfizer is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Pfizer is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a stand-alone basis and regardless of broad market valuations.
Mathematically, the worth of Pfizer is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 0.90, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Pfizer, we should be targeting a long-term return of 9.675%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. From the quarterly presentations available on Pfizer's website, we know that adjusted diluted earnings per share at Pfizer were as follows: 2008: $2.42, 2009: $2.02, 2010: $2.23, 2011: $2.31, 2012: $2.10 and 2013: $2.22. For 2014, Pfizer guides at $2.20 to $2.30. I am comfortable with Pfizer's guidance mid-point $2.25 as a fair representation of sustainable earnings.
Twenty analysts included on Reuters data estimate average earnings of $2.35 (High: $2.31, Low: $2.15) during the year ended December 14, while nineteen analysts estimate that it will rise to an average of $2.33 (High: $2.50, Low: $2.12) for the year ending December 15. Four analysts assess long-term growth rates at 2.1% on average, with a high estimate of 4% and a low estimate of 2%. On growth, in my view, four analysts cannot be said to reflect a reasonable growth view for the stock. I am looking for 5.4% nominal long-term growth, and arrive at this estimate by applying a 13.5% return on equity to 40% of profit which I expect will be retained to re-invest in growth.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Pfizer will pay out approximately 60% of earnings via dividends and buybacks (approximately 45% via dividends and another 15% via buybacks) over the long term. An adjusted payout ratio of 60%, assuming nominal earnings growth of 5.40%, implies a return on incremental equity of 13.50%: the 40% of earnings retained, invested at a 13.5% return on equity, delivers the required 5.4% (40% * 13.5%) growth. This return on incremental equity is not unreasonable to expect, considering that the recent return on equity was 14.45%, and it has averaged 11.03% over the past five difficult patent cliff years. The industry and sector averages were 20.34% and 19.71% respectively, while the five-year averages ran at 20% and 19.23% respectively.
If we use a very long-term growth expectation of 5.08%, Pfizer is worth $30.87. Pfizer Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 105.08% * $2.25 * 60% / (9.675%-5.08%) = $30.87. At this price, it is likely that an investor with a return expectation of 9.675% will be satisfied.
The growth estimate implied by the current market price of 5.08% is low. Alpha is the difference between actual returns and the risk adjusted return expectation. If Pfizer grows at a long-term rate of 5.4%, we have growth alpha of thirty-two basis points. And an investor buying at present levels can expect a long-term return of 9.995%.
An investor with a shorter time horizon might do quite well too. A price target of $41 implies confidence in long-term earnings growth rising to 6.18% from 5.08% at present. And this level of expectation is optimistic, but within the realm of possible outcomes. A rise in return on incremental equity to 15.5%, a significant discount to long-term industry averages, would take growth to 6.2%, if 40% of profits are re-invested in growth. Pfizer Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.18% * $2.25 * 60% / (9.675%-6.18%) = $41.
To cut a long story short, Pfizer is priced at a level which offers between thirty-two of alpha, compared with the S&P 500, which prices between forty-four to seventy-four basis points of negative alpha. This indicates that Pfizer creates alpha relative to the S&P 500 of between 0.76% and 1.06%. This might seem small, but with the magic of compounding it grows to be a substantial amount. And it represents 7% to 10% over the total long-term market return expectation of 10.25%.
The post is done - this is an explanatory note
The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.
If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta and stock return expectations.
There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas, which I hope will help.
1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is long-term return expectation minus long-term growth rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very long term, the growth risk premium has tended toward 4.5% for the market.
2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings.
3. When you look at long-term growth rates, remember it is not the next year's growth or the next five years' growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rates for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in line with market growth expectations for the following 45 years. What this signals is that I'm willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].
4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.