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As a dividend growth investor, I'm constantly combing the market for investment opportunities that I believe offer an attractive blend of current dividend yield, dividend safety, and dividend growth over the long term.
One such industry that is capable of offering this unique blend of the above trifecta is the pharma industry.
Image Source: Evaluate Pharma
As anyone who pays attention to global demographics is well aware, the world is growing larger, older, and richer. This bodes well for the pharma industry that provides groundbreaking and valuable treatments to those with disease and illnesses.
As proof of that, global prescription drug sales are expected to compound at an annual growth rate of 6.4% through 2024, which leads me into the pharma stock that has appeared on my watch list recently.
While Pfizer (PFE) isn't the most undervalued pharma stock on the market currently (arguably, AbbVie (ABBV) holds that title), it is another company in the space that is also a compelling investment with market-beating total return potential in the next 5-10 years and beyond.
In this article, I'll delve into more detail on the dividend profile of Pfizer, the growth catalysts of the current drug pipeline for Pfizer, and the risks associated with an investment in Pfizer (or any pharma stock for that matter), and how Pfizer's current stock price compares to my estimated fair value.
We will then estimate the total return potential of Pfizer that supports my underlying thesis of Pfizer being a blue-chip stock with market-beating total return potential over the long term.
Reason #1: Pfizer Offers Both A Safe And Growing Dividend
As I alluded to above, there are three factors that I consider when examining the dividend of a potential investment. We will discuss the dividend safety and dividend growth profile of Pfizer in this specific section, with the valuation component and yield aspect to be discussed in Reason #3 below.
With that said, we'll examine the safety of Pfizer's dividend in the context of the trailing twelve months and the forward EPS payout ratio, and secondly, with the FCF payout ratio.
These two methods of examining a dividend help to form my own opinion on the safety and viability of a dividend, and from that point, I compare my opinion against that of the dividend research firm, Simply Safe Dividends to reach a consensus.
Image Source: Pfizer Q4 2018 Earnings Presentation
We'll start by examining the TTM EPS payout ratio for Pfizer, and comparing that against the dividends paid in 2018.
As illustrated above, Pfizer generated $3.00 of EPS (or $2.92 if gains on equity investments are excluded from the results) in 2018 against $1.36 per share in dividends paid during that same time, for a TTM EPS payout ratio of 46.6%, excluding the gains on equity investments. This payout ratio is right in line with what I'd expect for a pharma stock like Pfizer which needs to continually invest in R&D and strategic acquisitions to maintain a strong drug pipeline for future growth.
Image Source: Pfizer Q4 2018 Earnings Presentation
In terms of Pfizer's 2019 earnings guidance, the company is actually guiding a 4% decline in EPS for 2019 (which we will delve into in further detail in Reason #2), with an EPS midpoint of $2.87 for 2019.
Given the recent dividend 5.9% dividend increase that hiked the annualized dividend per share payout to $1.44, the forward EPS payout ratio will hover around 50% for 2019.
This is again a payout ratio that I'm totally fine with, and it doesn't pose any hardship on Pfizer's R&D requirements in the year ahead.
Having discussed both the TTM and forward EPS payout ratio, we'll now review the trailing twelve months free cash flow of Pfizer against the dividends paid in 2018.
Pfizer earned $15.827 billion in operating cash flow minus $2.042 billion in capex, for a total free cash flow of $13.785 billion in 2018. Meanwhile, Pfizer paid $7.978 billion in dividends during 2018. This equates to a TTM FCF payout ratio of 57.9% during 2018, which is again close to the 50% payout ratio that I generally prefer to see from a pharma company like Pfizer.
Going forward, the dividends paid in 2019 should be about $8.5 billion with that 5.9% dividend increase that we mentioned earlier. FCF is also likely to experience a minor bump in the road, so it should be in the ball park of $13 billion. This would equate to a slightly elevated payout ratio of 65.4%. Although this payout ratio is a bit above what I like to see from a pharma company, I believe the fundamentals will improve beyond 2019, and we'll see that payout ratio strengthen once again in the years ahead.
Image Source: Simply Safe Dividends
My conclusion of Pfizer offering a safe dividend is clearly supported by the fact that Simply Safe Dividends rates Pfizer's dividend at an 82, which is very safe.
However, the safety of a dividend is only one aspect of what I examine. As such, we'll next examine the growth potential of Pfizer's dividend in the coming years.
As a correction to the graphic above, Pfizer actually has a dividend growth streak of 9 years (making it a Dividend Challenger and soon to be Dividend Contender) according to their dividend and split history page. Nonetheless, we can see that Pfizer has a strong history of dividend growth, and it was actually a Dividend Aristocrat before the 50% dividend cut in 2009. It has been a long road for Pfizer's dividend to recover the annualized dividend of $1.28 before that cut 10 years ago, but the fundamentals of Pfizer have improved, and there is less dependence on any one drug as will be discussed in Reason #2 as well.
Pfizer boasts a 7% 5-year dividend growth rate, and with analysts expecting Pfizer to maintain the status quo of 6% earnings growth it delivered in the last 5 years, the dividend is well-positioned to grow at a rate of 6-7% a year over at least the next 5 years.
Having mentioned the analyst consensus of 6% EPS growth over the next 5 years, we'll now delve into the growth catalysts for Pfizer that led to the aforementioned analyst expectations.
Reason #2: A Strong Drug Pipeline To Fuel Future Growth And Fund Dividend Increases
With total revenue of $53.6 billion last fiscal year, Pfizer is one of the world's largest drug makers, with its medications being sold in over 125 countries. As such, Pfizer enjoys a competitive advantage that few companies in the pharma industry do, and that's sheer size and scale. As most investors are aware, the pharma sector is highly complex, capital-intensive, and uncertain. The barriers to entry in this field to emerge as a preeminent player are very high. One doesn't simply start a pharma company in their garage and compete against the likes of Pfizer. With that said, we'll delve into the specifics of Pfizer's business segments next.
Pfizer is divided into three business segments, which include the following:
Pfizer Biopharmaceuticals: This segment contributes to over half of sales (56%), producing patented medications to treat therapeutic areas, including internal medicine, oncology, vaccines, rare diseases, and inflammation and immunology.
The reason this segment drives the majority of Pfizer's sales is because it produces the company's best selling products. Unlike some pharma companies like AbbVie that are highly concentrated and reliant on one drug for the majority of their revenue (i.e. Humira for AbbVie), Pfizer is highly diversified and boasts a drug portfolio with the following drugs:
- The Prevnar therapeutic family of pneumococcal vaccinations (10.6% of 2018 revenue)
- Lyrica to treat neuropathic pain and seizures, to name a few (8.6%)
- Ibrance to treat breast cancer (7.7%)
- Eliquis (blood thinner contributing to 6.4% of 2018 revenue)
- Enbrel to treat arthritis (3.9%)
- Xeljanz to treat arthritis (3.3%)
Upjohn: This business segment markets the legacy medications of Pfizer that have lost exclusivity, such as cholesterol drug Lipitor (which comprises 3.6% of sales), high blood pressure drug Norvasc (1.8% of sales), and arthritis drug Celebrex (1.5% of sales). For a complete listing of the Upjohn brands, interested readers are referred to the Upjohn brand portfolio page. Overall, the business contributes 37% of total sales. Also included in this segment are the sales of some generic drugs as well.
Consumer Healthcare: The smallest business segment of Pfizer's is also the most predictable and reliable in terms of revenue. This is because the Consumer Healthcare segment boasts a powerful group of dietary supplements, pain management, personal care products, and gastrointestinal brands as mentioned below:
- Aqua Ear Solution
As was announced by Pfizer last December, they plan to enter into a joint venture with GlaxoSmithKline (GSK) to create the premier global consumer healthcare company (ranking first globally in the sale of over-the-counter medications), with Pfizer holding 32% equity and GSK holding the remaining 68%. This deal is expected to deliver significant cost synergies to the tune of $650 million in peak cost synergies and to be accretive in each of the first three years following the close of the transaction, which is expected to be around the second half of 2019. On top of those expected cost synergies, the proposed deal is low risk for Pfizer because GSK has agreed to pay a $900 million break fee if the GSK Board of Directors changes or withdraws its recommendation to shareholders for approval, if GSK's shareholders do not approve the proposed transaction, or if the GSK shareholders do not approve the proposed transaction by September 30, 2019.
As some older and more experienced investors may be thinking at this point, "the 2009 dividend cut puts a stain on Pfizer's reputation" and "what's to stop this from happening again?"
While those are pertinent questions and concerns, I firmly believe that the Pfizer of today is considerably different than the Pfizer of 10 years ago, for the better.
Consider this: Pfizer's sales of the blockbuster cholesterol drug Lipitor were $11.4 billion in 2009 (23% of total sales) and following the loss of exclusivity in 2011, sales fell 59% in 2012. Seeing the writing on the wall for Lipitor, this spurred the $68 billion acquisition of Wyeth in 2009 and led to the aforementioned 50% dividend cut.
Fortunately, as we've mentioned before, Pfizer derives no more than 10.6% of its total revenue from any one drug or vaccine family. This is a considerable and positive difference compared to the Pfizer of last decade, which shouldn't lead to any dire situation or necessitate another mega-acquisition, prompting a dividend cut to fund said mega-acquisition.
While the short-term issues (~4% decline in EPS for 2019 projected) of Lyrica's patent expiration in June 2019 loom and weigh on the minds of some investors, the big picture of Pfizer's future is encouraging. Besides the Lyrica loss of exclusivity, the company faces no major LOE events until 2025. In addition, Pfizer has an incredible pipeline that will be introduced by that point in time. How incredible is that pipeline, you ask?
Image Sources: Pfizer Product Pipeline & 2017 Investor Presentation
This pipeline is so impressive that CEO, Albert Bourla stated of Pfizer's pipeline "we think this is the greatest pipeline ever." For context, Pfizer produced 2 and 5 blockbuster drugs in the two previous 5-year periods. Given that half could potentially be approved by 2020 and all could potentially be approved by 2022 and generating sales of at least $1 billion per year, this would move the needle in a major way for Pfizer and certainly supports the analyst consensus of 6% annual earnings growth over the next 5 years.
Risks To Consider:
Image Source: Pfizer Q4 2018 Earnings Presentation
Like all pharma companies, Pfizer's drug business faces the threat of patent expirations having a detrimental impact on the business. In 2019, we're witnessing a minor issue with this in the form of Lyrica's patent expiration in June 2019. Fortunately, for Pfizer, they have one of the more well-diversified drug portfolios in the industry, so even an LOE on a major blockbuster drug like Lyrica won't be that devastating in the long-run. This will cause a short-term dip in EPS for the year, but will soon be offset by the introduction of the 11 other drugs in Pfizer's late-stage registration pipeline.
Another risk that the footnotes above also make a reference to is that, due to the nature of Pfizer's global presence, the strong dollar is expected to unfavorably impact revenues to the tune of $900 million.
Building upon the risks of an investment in a pharma company like Pfizer is the threat of litigation at nearly every corner. Not only do large settlements pose a threat to companies like Pfizer, but the costs of legal representation in these cases are absolutely insane as was the case with Johnson & Johnson (JNJ) and its Q4 2018 legal expenses of $1.1 billion.
As with any pharma company, there are also a plethora of regulatory risks. The recent proposal by the US Department of Health and Human Services which calls for the possible elimination of drug rebates between drug makers and pharmacy benefit managers or PBMs would likely result in declining net drug prices, harming the margins of drug makers.
Unlike other drug makers such as AbbVie, there isn't a serious threat of concentration risk facing Pfizer because of its well-diversified drug portfolio. This takes a bit of pressure off of that spectacular pipeline in the event it doesn't quite materialize as expected, due to the highly complex and uncertain nature of R&D.
The major regulatory risk facing the Pfizer and other industry peers is the possible shift to single payer healthcare. Bernie Sanders popularized the idea during his 2016 presidential campaign, and most Democrats running in 2020 advocate and support "Medicare for All."
While it's unlikely that even a "Blue Wave" in 2020 still wouldn't be able to enact this policy (due to the Senate's 60 vote filibuster), the thought of an eventual shift to single payer would be a game-changer in a negative way for pharma companies.
This is because bulk drug purchases and widespread price controls are rampant in a single payer system as we've seen in other nations. In an industry that is already fraught with uncertainty because of the other risks mentioned above, this would be the knockout blow to the lucrative margins of pharma.
Reason #3: Pfizer Is An Excellent Company Trading At A Fair Valuation
Now that we've examined the safety and growth profile of Pfizer's dividend, as well as its growth catalysts to support the growing dividend thesis and the risks of the company, it's time for us to consider the valuation aspect and the current dividend yield of the company.
I'll examine a variety of methods to reasonably estimate an average fair value of Pfizer stock.
Image Source: izquotes
The first method that I'll use to examine Pfizer's current share price of $40.99 (as of March 9, 2019) is Pfizer's current dividend yield of 3.51% against the 5-year average of 3.54%, according to Simply Safe Dividends. This would indicate that Pfizer is trading at a 0.8% premium to fair value and a fair value of $40.67, indicating 0.8% downside from here. While Pfizer's current dividend yield in comparison to its 5-year average suggests Pfizer is roughly fair valued, even in this case, it is still advisable to purchase an excellent company like Pfizer at fair value. It has served Warren Buffett very well over the years, and there is no reason to believe the merits of that philosophy have changed.
Next, I'll utilize the dividend discount model or DDM to arrive at a fair value figure.
Image Source: Investopedia
Walking through this formula, we can deduce that Pfizer's current annualized dividend per share is $1.44. Simple enough, as that's the one part of this formula that isn't subject to the whims of the one calculating the fair value.
Next, the cost of capital equity, which is otherwise known as the required rate of return, is completely up to the investor and whatever returns they are aiming for in their overall portfolio. In my case, I am shooting for 10% annualized total returns, which is slightly above the historical average of the broader markets.
The final component, in this case, is the long-term dividend growth rate, which I will estimate at 6.5%. This is roughly in line with the 6% earnings growth over the next 5 years that analysts have estimated.
This would give us a fair value of $41.14, implying that Pfizer is 0.4% undervalued and offering 0.4% upside.
The final metric that I often consider is the fair value estimate provided by Morningstar. In this case, the fair value of Pfizer is $46 a share. Morningstar has earned a reputation in the community of being a conservative firm, so the fair value estimate of $46 really speaks to the potential undervaluation of Pfizer in a way that the dividend yield metric did not. The $46 fair value would imply that Pfizer is trading at a 10.9% discount to fair value, offering 12.2% upside.
When we average the above 3 fair value estimates, we arrive at a fair value of $42.60. This would indicate that Pfizer is trading at a 3.8% discount to fair value and offers 3.9% upside.
Again, this is nothing spectacular in terms of discount to fair value, but with a company of Pfizer's quality and profile, any discount to fair value would make it a buy.
Summary: Pfizer Offers A High Probability Of Market-Beating Returns With A Safe Dividend
In terms of the dividend safety and growth profile, Pfizer offers investors a strong blend of the two. A 3.5% dividend yield and 6-7% long-term dividend growth is the formula for success in the equity markets.
Supporting this dividend growth is the underlying earnings growth in the coming years, which is expected to be 6%. In spite of the risks that accompany an investment in a pharma stock like Pfizer, the risk/reward profile slightly leans more toward reward than risk, in my opinion.
Along the lines of the risk/reward profile, the valuation of Pfizer seems to be reasonable and borderline attractive at this point. Any time a company of Pfizer's quality is trading at a discount to fair value, I would rate the company a buy.
The 3.5% dividend yield, the 6-7% earnings growth (and likely dividend growth), and the 0.7% valuation expansion over the next 5 years means that Pfizer is set to deliver 10.2-11.2% annual total returns over the next 5 years.
When we add all of these components together, it becomes quite clear that Pfizer possesses the ability to deliver alpha over the next 5-10 years and beyond.
Disclosure: I am/we are long PFE, ABBV, GSK, JNJ. 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.