Pfizer: Why A Major Acquisition Or Break-Up Is Needed

May.30.14 | About: Pfizer Inc. (PFE)

Summary

Annual dividend per share growth of 8%-10% is no longer sustainable given Pfizer's current state.

Free cash flow and earnings dividend payout ratios would increase notably in order to support 8%-10% dividend per share growth.

Pfizer would need to make cash flow-accretive acquisitions or break up in order to maintain healthy dividend growth over a long run.

The current valuation appropriately reflects this risk.

The dividend of Pfizer (NYSE:PFE) has grown by 10.2% CAGR since 2009, but the annual rate has decelerated from 11.1% in 2010 to 8.3% in 2014. In this article, I will illustrate my cash flow analysis to provide readers some perspectives on Pfizer's future cash flows and dividends.

My free cash flow projections (see chart below) started with consensus revenue estimates from 2014 to 2016, which predict the top line to decline from $51.6B in 2013 to $48.7B in 2016, by -1.9% CAGR. I noted that Pfizer's operating cash flow ("OCF") margin trended up slightly from 33.2% in 2011 to 34.4% in 2013. To be fair, I assumed a flat OCF margin of 32.7% through 2016, which is consistent with its 3-year historical average and in line with the market's consensus view on a flat EBITDA margin through 2016. For capex, I assumed the figure to reach $1.4B in 2014 and stay unchanged by 2016. Based on these assumptions, free cash flow was projected to trend from $16.6B in 2013 to $14.6B in 2016. Given that Pfizer's annualized dividend will be $1.04 per share for 2014, I estimated total dividend spending to be $7.0B in 2014 (details are discussed later), implying that free cash flow payout ratio will be approximately 47% in 2014, which is notably above the actual levels in the past 3 years. Assuming no growth in dividend spending in 2015 and 2016, the free cash flow payout ratio will stay at 47%-48% in those years. In this case, after paying out dividend, Pfizer would have about $7.6B-$7.8B excess free cash flow per annum over the forecast period.

Assuming 85% of the excess free cash flow is spent on share buyback (the other 15% is to account for dilution impact from equity issuance and minor cash acquisitions, given that Pfizer has no major acquisition plan in near term), I estimated that total share count will reduce to 6.3B by 2016, with repurchase price growing at an assumed rate of 7.5% per annum from the current price of ~$30. As such, based on my projected flat dividend spending, I forecasted that dividend per share will rise by 2.8 CAGR, from $1.04 in 2014 to $1.10 in 2016. Given the consensus EPS estimates from 2014 to 2016, my dividend per share forecasts would result in a flattish earnings dividend payout ratio at 47% over the forecast period. Essentially, this analysis means that Pfizer's per share dividend growth rate in the past few years (10.2% CAGR since 2009) is no longer sustainable given the company's current state. Annual growth in dividend per share higher than 2%-3% over the next few years will further drive up free cash flow and earnings payout ratios, which is a negative sign.

For example (see chart below), based on the same model, in order to maintain the pace of dividend per share growth at ~8%, I estimated that total dividend spending will need to increase by 5.5% per annum in 2015 and 2016. Under this scenario, free cash flow and earnings dividend payout ratios will rise to 53% and 51%, respectively, by 2016.

Hence, with a goal of maintaining a healthy dividend per share growth over a long run, Pfizer would need to make structural changes, such as acquiring businesses or break-up of existing businesses with accretive cash flow impact. Given Pfizer's healthy balance sheet with $33.9B cash balance, a net debt-to-EBITDA multiple of only 1.0x, and robust free cash flows over the next few years, I believe the company would have ample resources to pursue these opportunities.

Based on current annualized dividend of $1.04 per share and a 10% cost of equity (the CAPM model would result in 7.4% cost of equity, based on 3% risk-free rate, 6% equity risk premium, and Pfizer's 5-year beta of 0.74), the Gordon Growth Dividend Discount Model suggests that the current share price of ~$30 implies a dividend growth rate of 6.0%-6.5% (see chart below). Given my views on the cash flow and dividend prospects, as well as the company's ability to make changes, I believe the current stock valuation to be fair, as it has factored in the risk of maintaining the recent dividend per share growth rate (8.3%). As such, I would still recommend accumulating the shares at this level.

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.

Disclosure: I am long PFE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.