Why Pfizer Could Beat This Sector Peer

Jul.16.14 | About: Pfizer Inc. (PFE)

Summary

We pitch two companies from the pharmaceuticals sector, Pfizer and Novartis, against one another in the latest instalment of our Head-To-Head series.

The article focuses on the relative strengths and weaknesses of Pfizer and Novartis based on business performance and sustainability/dividends/forecasts.

It ends with a discussion of the current valuations of the two companies, and details whether Pfizer represents good relative value at current price levels.

Pfizer Background

Pfizer (NYSE:PFE) was founded in 1849 and is headquartered in New York. The company's Primary Care segment offers prescription pharmaceutical products primarily prescribed by primary-care physicians for various therapeutic and disease areas comprising, among others, Alzheimer's disease and cardiovascular conditions. Its Specialty Care and Oncology segment provides prescription pharmaceutical products for anti-infectives, endocrine disorders, haemophilia and vaccines. The company's Established Products and Emerging Markets segment offers prescription pharmaceutical products that had lost patent protection or marketing exclusivity in certain countries and/or regions, as well as sold in emerging markets. Its Consumer Healthcare segment provides non-prescription products in a range of therapeutic categories, such as dietary supplements, pain management, respiratory, and personal care.

Team Money Research Rating

Our investment philosophy is to focus on company fundamentals and identify stocks that are displaying strong business performance, that operate sustainably and that pay a decent, well-covered dividend.

We score each company relative to the other on the following criteria within each of our two main buckets:

Business Performance

  1. Return on equity
  2. Return on assets
  3. Operating margins
  4. Quarterly revenue growth
  5. Quarterly earnings growth

Sustainability/Dividends/Forecasts

  1. Debt to equity ratio
  2. Interest cover
  3. Dividend payout ratio
  4. Forward yield
  5. Annual EPS growth forecast

Once we have scores for the two buckets, we can then assess whether a company represents good value based on the current prices of the two stocks. We use the following criteria to assess valuations on a relative basis.

Valuation

  1. Forward price to earnings ratio
  2. Price to book value ratio
  3. Enterprise value to EBITDA
  4. Price to 3-year average free cash flow ratio
  5. 5-year price to earnings growth ratio

So, for example, a company that scores well compared to its rival on the first two buckets (business performance and sustainability/dividends/forecasts) and that is undervalued relative to its peer (based on the third bucket: valuation) could outperform its competitor going forward.

The table below highlights the data that we will use to score Pfizer and Novartis (NYSE:NVS) for the first two buckets.

Stock

Pfizer

Novartis

Business Performance

Return on equity

13.75%

14.31%

Return on assets

5.75%

5.83%

Operating margins

32.68%

19.51%

Quarterly rev. growth

-8.50%

0.20%

Quarterly EPS growth

-15.30%

22.60%

Sustainability/Dividends/Forecast

Debt to equity ratio

47.59%

30.16%

Interest cover

12.73

16.72

Dividend payout ratio

31.00%

69.00%

Forward dividend yield

3.50%

3.00%

Annual EPS growth forecast

0.89%

9.42%

Click to enlarge

We then score each company relative to its peer based on the above data, with points being awarded as follows:

1st place: 10 points

2nd place: 0 points

Below are the scores for Pfizer and Novartis:

Stock

Pfizer

Novartis

Business Performance

Return on equity

0

10

Return on assets

0

10

Operating margins

10

0

Quarterly rev. growth

0

10

Quarterly EPS growth

0

10

Sustainability/Dividends/Forecast

Debt to equity ratio

0

10

Interest cover

0

10

Dividend payout ratio

10

0

Dividend yield

10

0

Annual EPS growth forecast

0

10

Total Score

30

70

Click to enlarge

As you can see, Pfizer is beaten by 70 points to 30 in the first two buckets. However, we feel that this score is not reflective of the quality of Pfizer because in the criteria in which it scored zero, it posted respectable numbers. For example, in terms of profitability Pfizer appears to be performing well. Its return on equity is a very healthy 13.75%, while return on assets of 5.75% is encouraging given the challenging features of the pharmaceutical industry right now, such as patent expiry and the threat of generic competition. Furthermore, Pfizer's margins remain strong at 32.68%, which highlight just how profitable the company still is.

In addition, Pfizer, despite losing out to Novartis in terms of sustainability, does not carry a large amount of balance sheet risk. Its debt to equity ratio of 47.59% is only moderate, while interest cover seems comfortable at 12.73. Indeed, Pfizer's balance sheet is not overly leveraged and this gives it the scope to make acquisitions going forward in an attempt to stimulate top and bottom-line growth.

Of course, growth is key to Pfizer's future, since its quarterly growth numbers (and its earnings forecasts for next year) were disappointing and were well behind those of Novartis. Meanwhile, a dividend yield of 3.50% is attractive and beats Novartis' yield of 3.00%. What we're impressed with, though, is the potential for Pfizer to increase dividends per share, with the payout ratio currently standing at just 31.00%. This bodes well for income-seeking investors going forward.

So, while Novartis has undoubtedly performed well in the first two buckets, we don't feel that its performance is quite as dominant as the overall scores suggest. Therefore, we remain upbeat about Pfizer's performance, provided it can stimulate its top and bottom lines in future.

Valuation

Despite this, we acknowledge that Pfizer was second best in the first two buckets and, as such, should trade at a discount to its peer, Novartis. Let's see if it does.

Stock

Pfizer

Novartis

Valuation

Forward price to earnings ratio

13.61

15.86

Price to book ratio

2.50

3.14

EV/EBITDA

8.82

14.39

PEG

4.53

2.19

Price to free cash flow ratio

11.64

19.63

Click to enlarge

We're surprised at the size of the valuation discount between Pfizer and Novartis. Sure, we expected a discount, but Pfizer offers better value in four of the five valuation criteria and, in addition, the gap between the two stocks is fairly large. For instance, Pfizer trades at a discount of 14.19% to Novartis based on the forward P/E ratio, despite Pfizer having a far lower expected growth rate than its peer. In addition, Pfizer's EV/EBITDA ratio is 38.71% lower than that of Novartis, while its price to free cash flow ratio is 40.70% lower. Although less of a discount, Pfizer's price to book ratio is 20.38% lower than that of Novartis, while its PEG ratio is higher due to the aforementioned lower growth rates.

Overall, we feel that Pfizer's current valuation is too low in relation to that of Novartis. Sure, it was second best in the first two buckets, but we feel its price could appreciate versus Novartis so as to narrow the excessively wide valuation gap that currently exists between the two companies.

Conclusion

Pfizer is a high quality company that we believe offers good value at current levels. Although it was beaten into second place by Novartis on the Team Money Research rating system, it appears to be relatively undervalued at current levels. That's because we feel that its performance in the first two buckets was deserving of a discount, but not one as wide as that encountered in the third bucket, valuation. As such, we feel that Pfizer could outperform its sector peer, Novartis, going forward.

Feedback Request: Which stocks do you want to see go head-to-head against Pfizer in future articles? Please comment below!

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.