Pfizer Inc.: Reasons Not To Buy Now

| About: Pfizer Inc. (PFE)

Summary

Pfizer Inc. has just made a deal with Allergan and is going to focus on diversifying its cash flows.

I like the good dividend yield and the significant buyback program performed by the company during the last five years.

However, it is time for the company to make serious investments because most important patents expire in a 3-5 year period.

The comparative analysis shows that the company is slightly undervalued. However, the DCF and the zero-growth analyses change the overall picture.

I issue a HOLD recommendation on this stock and set a target price range at $28 - $34 per share.

pfizer Pfizer Inc. (NYSE:PFE) was a widely discussed company during the last month of 2015. The good dividend yield of 3.5% with a potential for increase due to strong free cash flows was the main point. On the other hand, the potential for revenue decrease because of Lipitor, Norvasc, Viagra, and Xalatan patents' approaching expiration dates and the concerns about the Allergan's integration make the investment look quite risky. A focus on mass biological origin products is another risky decision the company makes in order to be independent from the blockbusters. The future is uncertain but we can weigh the facts now to make it clear if the stock is worth buying or not.

The main reason why investors look at this company is its good dividend yield. During the last five years, the dividend per share growth rate has been 8% per annum. Some of the growth is explained by stock repurchases. As you can see from Diagram 1, the company has always spent more than 100% of its net income on dividends and buybacks. Moreover, data show that the company has historically spent more than 50% of its free cash flow on dividends and stock repurchases. In 2013, the company spent nearly 200% of it on shareholder compensation (see Diagram 2).

Stock buybacks always lead to EPS accretion, if the earnings power (E/P - the opposite of P/E) is higher than the after-tax cost of debt. Pfizer's after-tax cost of debt is 1.6%, while the E/P ratio is approximately 4.2% (so the P/E ratio is 23.8x). Hence, the company's management does its best to increase forward EPS for the shareholder. Increasing EPS means that DPS will also grow, ceteris paribus. Hence, the dividend payments will also increase, if the free cash flows remain strong.

Diagram 1

Source: data - Morningstar.com, infographics by author

Diagram 2

Source: data - Morningstar.com, infographics by author

However, the point about free cash flows is rather uncertain. The fact is that the company spends most part of its free cash flow on dividends and buybacks and not on additional investments. If you look at operational cash flow dynamics (presented in Diagram 3), you will see that it is slowly decreasing. Moreover, most of the free cash flow is generated by depreciation & amortization savings arisen from former acquisitions and capital expenditures. The D&A is not a good source of free cash flow because it is a non-cash account that represents past transactions but not the future performance.

Diagram 3

Source: data - Morningstar.com, infographics by author

Diagram 4 shows Pfizer's growth and operating metrics. Although the growth is negative, it is not the point I want to emphasize. I want readers to pay attention to operating metrics such as the operating and net income margins, which are significantly lower than their respective industry averages. Consequently, the ROA and ROE figures are also in the red zone. It says a lot about the company's efficiency.

Diagram 4

Source: Morningstar.com

Finally, look at Diagram 5. It shows the dates when the company's patents will expire (or have already expired). The red lines represent the drugs, which patents have already expired or will expire in the nearest two years. Although most patents' expiration dates are after 2020, patents on Enbrel, Celebrex, Zyvox, and Lyrica are expiring soon and they represent a significant portion of the company's current revenue stream (~7.8%, ~5.4%, ~2,7%, and ~10.4% respectively, totaling to ~26.3%). According to this information, it is clear that the company's dividend-paying potential is under pressure because the revenues will likely squeeze, while the marketing and R&D costs along with CapEx will increase.

Diagram 5

Source: company's latest annual report, infographics by author

The company has shown a decent price appreciation and return on its stock during the last five years. A market capitalization of ~$200B makes it one of the largest pharma companies in the world (see Diagram 6). Nevertheless, I see it clearly that the company's stock does not look good for buying right now. Hence, I would like to use my traditional set of the DCF, zero-growth, and comparative analyses to calculate fair price range the company's equity.

Diagram 6

Source: data - Morningstar.com

DCF analysis

My DCF model is presented in Diagram 7. In Diagram 8, you can see how different metrics of Pfizer Inc. are expected to change during this period. I have made several assumptions, which can be easily seen in the "Assumptions" tab of my Excel file. My model shows that, after subtracting the market value of debt, minority interest and adding back cash and investments, the market value of equity is around $194.4B in the Base scenario. Consequently, the fair value per share is approximately $31 per share. It is slightly lower than the current price ($30.37 per share).

Diagram 7.

Source: data - Morningstar.com, DCF model by author

Diagram 8.

Source: data - Morningstar.com, infographics by author

Sensitivity Analysis

The sensitivity analysis is presented in Diagram 9. According to the Base scenario and the assumptions for the EV/EBITDA multiple and WACC, the price range is estimated to be between $28 - $34 per share. This price range represents a (-11%)-8% upside opportunity for the stock.

Diagram 9.

Source: data - Morningstar.com, model by author

Zero-growth Analysis

The Zero-growth analysis has been described in one of my articles. You can read more about it here.

According to this analysis, the current stock price shows no margin of safety. The valuation gives a fair market value of equity of $215B, which transforms into a fair price of $34.14 per share. This price level is 12% higher than the current price level. If we only used net income in the calculations, the result would give us a fair value per share of only $21.3. It is 30% lower than the current price. So, we can definitely say that the stock has no margin of safety at current price level.

Comparative Analysis

My comparative analysis is based on three key ratios: P/E, P/S, and P/BV (see Diagram 10). The results are quite mixed. Most results say that the stock is fairly valued at the current level. The P/BV ratio shows that it is even undervalued. However, the company has a diversified capital structure, so the EV/EBITDA multiple should also be included in analysis. The company's current EV/EBITDA multiple is 12.7x, while the Drugs (Pharmaceutical) industry's average is 13.6x. According to it, the company looks undervalued.

Diagram 10.

Source: data - Morningstar.com, infographics by author

Opinion

Despite the good results of the comparative analysis, I am concerned about Pfizer's free cash flow generating abilities in the mid-term. The company needs to invest more money in CapEx and R&D because patent revenues, which represent more than 25% of total sales, are going to decline rapidly in the future. Below- average operating and net income margins do not support the thesis of quality EPS growth, despite the significant buybacks made recently. The acquisition of Allergan also puts the future cash flow generating abilities of the united company in question.

The DCF and zero-growth analyses show that the stock is overvalued. However, I would not short the company right now because the dividend yield is still high at the moment and the company may show natural growth in the future. Hence, I issue a HOLD recommendation on this stock and set a target price range of $28 - $34 per share. This price range represents a (-11%)-8% upside opportunity for the stock for the next twelve months.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.