Pfizer: The Market's Undervalued Ugly Duckling

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 |  About: Pfizer Inc. (PFE)
by: Analytical Chemist

Once upon a time, Pfizer (NYSE:PFE) was the beautiful princess of the investment world. In 1999, it led the world in prescription drug sales, reached a high of over $48 a share on earnings of 82 cents per share, and had seven billion-dollar drugs. Lipitor, launched in 1997, topped two billion dollars in sales in 1999. Viagra had launched the year before and had great growth prospects. Pfizer still reigns as the world’s largest pharmaceutical company. Lipitor is now the best selling drug of all time, with over $10 billion in sales last year.

In 2010, Pfizer earned $2.23 in adjusted earnings per share and currently sells for just under $19. Investors are worried about Pfizer’s growth prospects after the clock strikes midnight on the company’s Lipitor patent this November. However, the market is missing the enchanted forest for the trees and drastically overestimating the effect that patent loss will have on Pfizer’s earnings. A discounted cash flow analysis depicts Pfizer as undervalued and a great stock to buy now. That’s right; it’s an ugly duckling.

Simply put, the discounted cash flow model says that a company is worth the total of all future cash flows. These cash flows must be discounted because dollars received from an investment today are worth more than dollars received from an investment in the future. The amount of this discount should be what investors could receive from an alternative investment. When comparing the relative value of stocks, the alternate investment is the market as a whole, so we want to use the market’s long-term return as a discount rate. Since it’s impossible to know the future return, history is a suitable guide. Let’s use a historical value of 10-11% depending on the aggressiveness of the projection.

So to value Pfizer, let’s look at three scenarios: one conservative, one aggressive, and one middle-of-the-road (the Goldilocks scenario). We’ll use a range of earnings projections from analysts, historical growth rates, and Pfizer’s earnings guidance. Pfizer has projected 2011 adjusted earnings at $2.16-$2.26. It projects 2012 earnings at $2.25-$2.35. Analysts have a range of 2011 earnings projections of $2.18-$2.34, and 2012 earnings of $2.15-$2.38.

In a conservative case, let’s assume the sky is falling. The loss of Lipitor affects Pfizer more than anyone expects, and Pfizer’s branded drugs lose more and more ground to generic drugs. European governments demand lower prices for their national medical systems. And (bear with me here), health care reform in the United States forces Pfizer to pay higher taxes and fees, and also reduces the price at which Pfizer can sell its drugs. Pfizer’s 2011 earnings come in well below anyone’s expectations at $2.00 a share, and after that, things just keep getting worse. Imagine that adds up to earnings falling 15 cents a share each year for the following 4 years (that’s an 8.5% annualized decline) and then remains constant. Using a discount rate of 11%, that gives a fair value of $14.00 a share. In this reasonable “worst case” scenario for Pfizer, the porridge is toooo cold.

In an aggressive projection, Pfizer achieves the high end of 2011 projected earnings of $2.34 and does the same in 2012 at $2.38 a share—a 6% earnings growth for the following 3 years, then 4% annual earnings growth after that. These increased earnings are derived from new branded drugs, increasing generics sales (Pfizer’s generics subsidiary Greenstone already has over $10 billion in annual sales), improved operating efficiencies, and synergies from the Wyeth acquisition in 2010.

The long-term growth in the pharmaceutical industry is projected to be around 4% so, in the long term, Pfizer maintains its market share. At a discount rate of 10%, that gives a fair value of just under $39 a share. Some will consider this projection too optimistic for a yummy bowl of sustaining porridge; it is toooo hot.

The most reasonable projection takes the midpoint of Pfizer’s earnings guidance for 2011 and 2012. After that, earnings per share increase 4% from 2011 to 2012 and continue that 4% growth in perpetuity. If Pfizer can increase earnings 4% the year after losing patent protection on the world’s best selling drug, Pfizer can continue this growth and track the industry growth rate. Then, with the more conservative 11% discount rate, Pfizer’s fair value would be $33 per share. Not too optimistic, not too pessimistic. But in fact, just right.

At the current price of under $19 per share, then, Pfizer is the undervalued ugly duckling of the market. A conservative approach using a discounted cash flow model shows the fair value of Pfizer at $33 per share, more than 70% higher than its current value. If the next few years go well, an upside of the aggressive projection gives us $39 a share. Our worst case, cold porridge scenario shows the downside, but even the most pessimistic analysts out there don’t expect Pfizer’s earnings to decrease nearly 40%, never again to increase.

Yet even under the cold scenario, we find that Pfizer’s fair value would be $14 a share, a (baby) bear-able 26% drop from these levels. The upside to downside ratio of these projections is a $20 per share gain over a $5 per share loss. This 4:1 ratio affords a nice level of protection if our projections turn out to be rosier than Pfizer’s future. At these levels, Pfizer is a strong buy, so ladle yourself up a nice big bowl of Pfizer Pforridge. Serve warm.

Disclosure: I am long PFE.