This month’s report focuses on two superb quality companies, Pfizer and Coca Cola. Both have been disappointing performers for the past several years. Before we start on Pfizer, let’s talk about healthcare costs and pharmaceuticals.
Pharmaceutical companies get the majority of the blame for rising healthcare costs. Problems cannot be solved without an accurate focus on their sources. Fact is, pharmaceuticals comprise only 11% of the national healthcare bill. Cutting or flattening the growth of that small a percentage of anything cannot mathematically make much of a difference. Even if drugs happened to be free last year, healthcare costs would have risen! It is also important to be cognizant that the economic return on pharmaceuticals is estimated at 7 to 10 times their cost, driven by the savings from keeping patients out of the hospital and getting them back to contributing to GDP by working, spending, and paying taxes. Comparing pharmaceuticals to taxation explains our fixation on this one component of healthcare. It is a highly visible cost that one pays persistently, so it gets tiring after a while. Still, people who need to take medicines to treat a chronic health condition like diabetes, high blood pressure, cancer, or high cholesterol would certainly not want to be without them. For these people, and our healthcare system, drugs are a real bargain.
Pfizer (PFE 27) is the world’s leading pharmaceutical company, with 33 major medicines covering all ten distinct therapeutic areas. The stock has been a disappointing performer for the last five years, as growth stalled in 2005, concluding a five-year period in which revenues doubled. The high 20’s historical P/E has eroded to 13.5. There is a litany of factors contributing to the dramatic decline from highly valued to bargain priced. 1) It is difficult to grow a large base like Pfizer’s at a sufficient rate to earn a strong stock price. 2) Patent protection is expiring on a number of Pfizer’s important drugs between now and 2007. 3) 2005 earnings per share are expected to decline modestly to $1.95 from last year’s $2.12. 4) The political environment for pharmaceutical companies is contentious, severely pressuring pharmaceutical prices as we try to figure out how we will pay for the healthcare of a rapidly aging population. 5) The FDA is addressing public criticism by adding safety warnings to many drug labels, 6) The legal environment is negative, with mischievous legal challenges to patent rights by generic drug companies and potentially expensive liability for drug side effects, even if a very low percentage of patients are hurt while a high percentage are helped by a drug. This makes pharmaceutical company managements less inclined to take the risk of spending twelve years and as much as $1 billion to commercialize one drug.
However, the depressing period of Pfizer ownership will end late this year if management’s projection of a return to double-digit growth in 2006 and 2007 is accurate. Management’s optimistic guidance is based on 1) the low base created by disappointing 2005 earnings, 2) expense reductions and productivity initiatives tied to the assimilation of the Pharmacia acquisition, and 3) a notably efficacious research and development program. Pfizer has the world’s largest privately funded biomedical research organization. Funding of $7.7 billion of R&D in 2004, increasing to over $8 billion in 2006 has provided Pfizer with the strongest new product pipeline in the pharmaceutical industry. Thirteen major new drug applications have been completed towards a goal of twenty filings in the five years ending in 2006. Newly approved drugs are expected to replace lost revenues from patent expirations in 2006 and 2007. Productivity improvements are projected to drive double-digit earnings growth in 2006, followed by new product revenues driving double-digit earnings growth in 2007. For 2008 and beyond, a total of 145 compounds in full-scale development as new medicines will drive growth. Standouts in Pfizer’s early clinical pipeline include some truly amazing drugs, two of which actually cause cancerous tumor regression and one that reduces plaque accumulation in blood vessels associated with artherosclerosis.
The FDA has concluded that cardiovascular risk is a “class effect” for all NSAIDs (non-steroidal anti-inflammatory drugs.) Accordingly, it has required that all prescription NSAIDs, including Celebrex, shall carry a label warning of the risk of cardiovascular and gastrointestinal bleeding side effects. This is actually an advantage for Celebrex, in that all prescription NSAIDs will have the same warning, while doctors widely believe that Celebrex has lower risk of gastrointestinal bleeding. 16,500 deaths occurred last year due to gastrointestinal bleeding, many linked to regular usage of NSAIDs, more deaths than were caused by the cardiovascular side effects of NSAIDs. Nevertheless, Pfizer’s Bextra, a very strong NSAID, will be withdrawn from the market due to negative short-term data on high dosage patients with a history of cardiovascular problems. Adequate long-term cardiovascular data is not yet available. Like virtually all blockbuster prescription drugs, Pfizer’s Lipitor is the subject of a legal challenge to the validity of its patent. A generic company is seeking to break into the market for the drug that arguably has contributed the most to the improvement in the heart disease death rate. This hangs over the stock, because stock market investors do not trust their ability to predict court decisions. Although Pfizer feels the challenge will fail, it is protecting itself by developing a Torcetrapib/Lipitor combination drug, which would outperform Lipitor alone and extend patent protection for many years. Torcetrapib raises HDL (“good cholesterol”) and Lipitor lowers LDL (“bad cholesterol.”)
Pfizer generated free cash flow of approximately $15 billion in 2004, paid $5.5 billion in dividends and spent $6.7 billion on stock repurchases. The 200 million shares repurchased were 2.7% of the total stock outstanding. Since Pfizer does not go overboard with employee stock option grants, this is an effective way to reduce the share count and increase earnings per share. Pfizer will repatriate $28 billion in foreign cash in 2005, equivalent to $4 per share. Consensus earnings per share estimates for the next five years are $1.95, $2.20, $2.40, $2.61, and $2.85, respectively. The stock is very inexpensive compared to an intrinsic value estimate in the mid 30’s.
Coca Cola (KO 42) possesses formidable assets: arguably the world’s best known brand name, the financial strength of $6 billion of cash flow from operations, unrivaled global distribution, expansive marketing power, and dedicated employees. However, the company’s volume and revenue growth has been poor over the past 5 years, due to a failure to capitalize on the growth of non-carbonated beverages, particularly water. The parallels to Gillette before James Kilts took over as CEO are remarkable. The question for the Coke investor is whether new Chairman and CEO E. Neville Isdell can revitalize Coke the way James M. Kilts revitalized Gillette, resulting in a doubling of Gillette’s stock price.
Isdell cites numerous measures to accelerate growth:
· Bridge gaps in execution by capitalizing on the company’s fundamental capabilities and strengths
· Focus on diet and light products
· Expand into other segments of the nonalcoholic beverage industry
· Expand presence in immediate-consumption channels
· Re-energize marketing and innovation
· Drive increased efficiency and effectiveness
· Support already healthy growth in less developed markets such as China and Russia.
These measures became tangible late last year with the commitment of a $400 million increase in marketing spending on diet brands. The first sign of improvement was seen in the March quarter, with worldwide volume growth of 3%, led by 15% volume growth in Dasani, Coke’s bottled water product. Essentially, Coke must seek to become the king of non-carbonated drinks, just as it dominates the carbonated market. The non-carbonated market is larger than the carbonated market, running at an annual rate of $230 billion, and growing. Coke only has 4% of this market, compared to 60% of the carbonated market. Coke can attack this market with little incremental cost by giving its bottlers, spread out over 200 countries, non-carbonated products to sell. Of a total of 50 billion beverages served per day worldwide, Coke only accounts for 1.3 billion of them. The opportunity is obvious.
Coke is an exceptionally solvent and wealthy company. Capital returned to shareholders in 2004 included cash dividends of $2.4 billion and stock repurchases of 38 million shares, 1.5% of stock outstanding, for $1.75 billion. Earnings per share for 2005 are projected at $2.07. Intrinsic value depends on how well management executes over coming years. A stagnant Coke is intrinsically worth $40, but a revived Coke is worth $50.
Steven L. Ré, CFA April 22, 2005
The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets sometimes go down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.