- Pfizer's robust free cash flow can comfortably support 8%-plus annual dividend growth.
- The current valuation trades at a solid discount to peers and overall market despite the higher dividend yield and healthy dividend prospects.
- Price floor should be at $26.
- Given the current state, maximum downside would be 9% from the current level after factoring in the dividend income.
The share price for Pfizer (NYSE:PFE) has dropped by 7% over the past 3 years, underperforming a gain of 2% for the S&P 500 Index over the same period. In my view, the recent price weakness has presented an invaluable buying opportunity, as I see limited downside risk from here.
The price pullback was largely due to Pfizer's disappointing Q1 performance whereby the company's top line came in below consensus estimates due to underperformance from many products. However, I believe the market reaction presents a buying opportunity for long-term value investors, as Pfizer has been working diligently to create long-term shareholder value by focusing on strategic actions including a major acquisition (i.e. the AstraZeneca (NYSE:AZN) deal) and divestitures (i.e. potential sale of business units in few years). Even if the AstraZeneca deal does not go through, I believe management will pursue smaller M&A opportunities and return a large amount of capital to shareholders. Of course, the company will have sufficient resources for those capital plans (discussed later).
Thanks to the price weakness, Pfizer now trades at 13.1x forward 2015 EPS, which is at a 22% discount to the average P/E multiple of its North American peers (see comps table below). The stock's forward P/E multiple also trades at a 12% discount to the same multiple of the S&P 500 Index despite the fact that Pfizer's 3.5% dividend yield is much higher than the S&P 500's average at just 1.9%. On a trailing basis, Pfizer's P/E traded below that of the S&P 500 for the first time in the past 3 years. The discount is now at 4%, compared to an average premium of 19% in the past 3 years (see chart below).
Pfizer's valuation also looks cheap on an absolute basis. Based on the current annualized dividend of $1.04 per share and a 10% cost of equity, the Gordon growth dividend discount model suggests that the current share price of ~$29 implies a dividend growth rate in a range of 6.0%-6.5%, which is much lower than the company's historical dividend CAGR at 10% since 2010 (see chart below).
Looking forward, I expect Pfizer can continue to hold the dividend growth at about 8%-9% per annum, which is consistent with the most recent 8% hike. On a standalone basis (i.e. excluding impact from the potential AstraZeneca transaction), consensus estimates predict Pfizer's free cash flow to be around $15B per annum over the coming 3 fiscal years. At 8.5% annual dividend growth, I estimate the total annual dividend payment would reach $8B by 2016, which is slightly more than 50% of the forecasted free cash flow, meaning that the company would not only be able to maintain healthy dividend growth, but would also have ample cash capacity to pursue M&A opportunities and return capital through buying back shares. As such, the current implied 6.0%-6.5% dividend growth assumption appears to be low.
From a dividend yield perspective, Pfizer is now trading near my estimated floor level. Looking at the 3-year historical trend, the yield rarely traded above 4.3% and the 3-year average yield is about 3.6% (see chart below).
Given the average yield of Pfizer's peers is only 3.1% (see comps chart), I believe the stock would draw significant demand when its yield exceeds 4.0% (given the condition that there is no significant deterioration on the company's growth prospects), and hence a 4.0%-plus yield would not last long, as buying pressure would push up the share price and thus weigh on the yield. As such, assuming the dividend will grow by just 6.0% (vs. my estimate of 8%-9%) in the next cycle and lower share price results in a higher dividend yield at 4.3% (i.e. likely a yield ceiling), this scenario would imply a share price of $26, which represents a downside of only 9% if the 3.5% dividend income is factored in (see sensitivity table below).
In conclusion, given my view that Pfizer would provide long-term value and continue to raise the dividend at a healthy pace with ample cash capacity, I consider a buying zone to be at below $30 given the conservative assumption embedded in the valuation and solid margin of safety.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.