Pfizer (PFE) is a widely held mega-cap drug company that recently announced plans to merge its generic drug business, Upjohn, with Mylan (MYL). This move is partially being forced upon Pfizer due to the significant potential liabilities generic drug companies have to opioid-based litigation. While this spin-off should leave Pfizer with a compelling portfolio of patented drugs and a respectable pipeline, this move is a possible harbinger of a dividend reduction.
Spin-off at the low or perhaps before the fall
Upjohn is Pfizer's generic or off-patent division, which manufactures various generic drugs and some well-known Pfizer medications that are now off-patent, such as Celebrex, Lipitor, and Viagra. Pfizer is essentially selling Upjohn for $12 billion, which the new Upjohn-Mylan company will take on as debt. Also, Pfizer shareholders will receive 57% of the new company in the form of 0.12 shares of it for each Pfizer share they own.
The remaining Pfizer will be focused on the success of recent drugs and its pipeline, with the hopes that manufacturing patented drugs will be more profitable or at least higher margin. An example of this higher risk/reward strategy would include Pfizer's recent acquisition Array BioPharma (ARRY).
Pfizer announced that $11.4 deal billion deal for Array in June, where it expanded its oncological pipeline to include colorectal therapies and also expanded its research facilities within the growing industry of targeted cancer treatments. Pfizer completed the deal on July 29 or at basically the same time it announced the spin-off of Upjohn.
The new Pfizer will have a significant pipeline, including a sizable oncology department and should also have a higher profit margin. The business and its profit margin will also be more sensitive to the performance of the pipeline. Moreover, it is likely that the market would bestow upon the new Pfizer, with greater relative potential, a higher earnings multiple.
Life after Upjohn
This plan is not without its risks, including that pipelines can fail and drug pricing could be regulated and mandated lower, but Pfizer must move forward with the hopes it will continue to find helpful drugs and that doing so will be a highly profitable venture for those who succeed.
Pfizer estimates it will have $40 billion in 2020 sales and operating cash flow of $11-12 billion. Pfizer's expenses may go up because the generic business does not have substantial expenses, while the existing Pfizer pipeline and the recently added Array drugs are costly to develop.
(Source: Pfizer's Upjohn spin-off presentation)
In case you cannot read that footnote to that seemingly important blue box about the dividend down there, let me quote that for you (and let us wonder why this logical and crucial fact is buried rather than blue boxed):
In the event the distribution is structured as a spin-off and based on combined dividend resulting from combination of continued Pfizer ownership and 57% equity ownership of NewCo.
So, I guess that means that if the deal is structured as expected, which includes initiating a dividend in the first quarter after closing the transaction, that the remaining Pfizer's dividend will reduce my roughly 57% of that NewCo's payout.
Further, it should be expected that a company that is more focused on R&D may be less likely to have a substantial dividend than one that houses mature businesses. The NewCo has the potential and likelihood to receive new indications and will have a small pipeline of its own too, and it has the profile of a dividend-paying company.
As it is the case that some of the former Pfizer business lines that are most suited to distribute cash will be housed in the NewCo, the remaining Pfizer is slightly less suited to have a growing dividend policy. Also, if Pfizer intends to acquire pipelines and pay for their R&D while simultaneously removing cash flow, the company has to prioritize acquisitions and their development over cash distribution.
Pfizer also indicated that it expects the combined dividend to be the same to shareholders, but that also means that to the extent the NewCo will pay a dividend or is expected to do so that Pfizer shall immediately reduce its own dividend.
Therefore, it is likely that the remaining Pfizer will pay a slightly reduced dividend going forward and that the dividend should be slightly less likely to consistently grow on an annualized basis. The company will become more speculative on its R&D and that should go along with a slightly lower payout profile.
The search for a higher multiple and only one target on your back
There really is no safe place to hide in drug production. The generic manufacturers are under intense pricing pressure and competition as well as opiate-related liability. Simultaneously, patented drugs face pressure from a changing marketplace that is becoming less tolerant of expensive drugs and more interested in government mandates that might limit profitability.
Pfizer is getting rid of some well-known lines of business within Upjohn and some stable moneymakers. Several had declining revenues due to pricing pressure and reduced market share, but they are still profitable and many are not costly to run. They clearly have value and are likely to support a growing dividend payout, as should be expected from mature business lines.
Pfizer hopes that its future is brighter and that it does not need to live off the corpse of its past. If successful, the remaining company is likely to grow faster and have the potential for a considerably higher profit margin. In short, Pfizer hopes to be more directly valued for the potential growth of its patented portfolio, with the expectation that this potential will be rewarded with a higher market multiple.
Pfizer's dividend will likely reduce by about 5-15% on account of the spin-off of Upjohn into a NewCo with Mylan. That NewCo will likely provide a dividend that is in line with that reduction. Pfizer will get $12 billion from this transaction, but a significant amount should be earmarked for debt reduction and CapEx, and not support an increased dividend.
It does not appear clear that Pfizer's shareholder base wholly understands this transaction or this probable pro-rated payout shift between the two companies. Confusion about this is weighting on present PFE validations, and this is likely to continue until either Pfizer or the NewCo establishes actual post transaction payouts.
Uncertainty over these dividend policies and market fluctuations, including those caused by political rhetoric, are likely to keep pressure on share prices. As a result, Pfizer appears susceptible to near-term valuations in the mid to low $30s, which is likely to represent a strong long-term opportunity.
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.