Pfizer (PFE 21) is facing a number of substantial uncertainties. On October 20, in conjunction with its third quarter earnings report, Pfizer withdrew its estimates for 2006 and 2007 revenues and earnings. Investors interpret this first as management needing time to assess one particular uncertainty and second as heralding impending reduced guidance. Lipitor, the world’s best selling medication, which generates 23% of Pfizer’s revenues and 30% of earnings, is the target of patent challenges in numerous countries. The cases have been heard, and decisions are at hand. One ruling was just received in the United Kingdom, in which the basic Lipitor patent was upheld. The U.S. cases could be ruled on at any time. Although it is likely that at least one of Pfizer’s patents will be upheld, the gravity of patent protection cannot be underestimated. Were the patents not upheld, Lipitor would essentially be wiped off the Pfizer income statement, a truly depressing prospect. However, much of this potential danger is already in the stock price.
Intellectual property protection is fundamental to the health of a free economy. Without it, companies and individuals have no material incentive to invest in inventions that improve our lives, our businesses, and our economy. Pfizer, in particular, employs 12,000 scientists and invested $7.7 billion in 2004 to discover new medicines and get them through the clinical study and FDA approval process. From discovery to FDA approval is a ten-year gauntlet through which only about 10% of drug candidates survive. In the process, the understanding of disease and therapy is enhanced for all of society. In contrast, generic drug companies invest in finding loopholes in patents that are often already ten years old. While pharmaceutical companies earn their revenues by contributing to our health, longevity, and comfort, generic companies contribute to attorneys and threaten the incentives for innovation that build the prosperity of economies and foster growth in the future.
If the Lipitor patents are upheld, Pfizer will maintain exclusivity of the Lipitor franchise until 2011. And, there are prospects for the extension of exclusivity until 2019, in the form of a new medication that combines Lipitor and Torcetrapib in one pill. Lipitor has proven to be the best drug for reduction of LDL (bad) cholesterol, but it does not raise HDL’s (good cholesterol.) Moreover, a recent study indicates that a competing drug, Zocor, is almost as effective. There was an 11 percent reduction in major coronary events in Lipitor patients compared to Zocor patients, but the difference did not reach statistical significance. However, Lipitor lowered average LDL’s from 122 mg/dL to 81 mg/dL, compared to 104 mg/dL for Zocor. In addition, Lipitor reduced nonfatal heart attacks by 17 percent, major cardiovascular events by 13 percent, and angiograms and bypass surgery by 23 percent, compared to Zocor. Although Lipitor is clinically superior, the mixed study outcome and the fact that Zocor will be available as an inexpensive generic next year frees healthcare insurers and payors to substitute it for expensive Lipitor. They clearly care more about costs than their insured. This will flatten the growth rate of Lipitor revenues in future years, even if the patents are upheld.
Torcetrapib,
a new drug prospect from Pfizer in phase III clinical studies, raises
HDL’s. Combining it with Lipitor
creates a treatment that both lowers LDL’s and raises HDL’s. In the ongoing clinical trial, Torcetrapib
is being administered to patients with serious cholesterol problems. The trial is studying 25,000 patients
worldwide at a cost of $800 million.
After a period on the drug, these patients are scanned, which shows if
plaque build-up has been reduced.
Approval of Torcetrapib, anticipated in 2009, will lead to a combination
therapy unbeatable for human life extension.
Then, if the Lipitor patents have been upheld, this therapy will be a
gigantic revenue and earnings producer for Pfizer.
Pfizer is the world’s leading pharmaceutical company in the battle against atherosclerosis, the leading cause of death in the U.S. Atherosclerosis is the build-up of cholesterol-rich fatty areas, called plaques, in arteries. The break-up and dispersal of these plaques can block blood flow throughout the body, causing strokes and heart attacks. A spectacular candidate for approval in later years, ETC-216, has literally caused arterial plaque regression in people with severe artherosclerosis. Pfizer, which acquired Esperion to get this compound, anxiously awaits the outcome of phase III studies. Both the human health benefits and financial prospects for a drug that reduces plaque are obvious.
Pfizer has some big drugs losing exclusivity, such as Neurontin and Zithromax, but also has 230 projects in development to replace the lost revenues. Drugs commercialized in 2005 include Lyrica for epilepsy and nerve pain, Macugen for macular degeneration, Zmax single dosage antibiotic, Revatio for pulmonary arterial hypertension, and Aromasin for invasive early breast cancer. Next year’s FDA approval candidates include Sutent, a remarkable therapy for stomach and renal cancer, Anidulifungin for fungal diseases, Dalbavancin antibiotic for Gram-positive infections, Exubra inhalable insulin for diabetics, Indiplon for insomnia, and Varenacline, which targets addiction receptors in the brain to reduce craving and withdrawal symptoms for smoking cessation (smokers weaning themselves from tobacco.)
The imminence of Pfizer’s problems, and distance of improvement, has ravaged the stock price. Selling at the lowest P/E in its corporate history, Pfizer is expected to produce minimal earnings growth through 2008. Analyst consensus earnings per share projections for 2005 to 2009 are $1.93, $2.02, $2.14, $2.27, and $2.41, respectively. This earnings stream is large enough in magnitude to produce an intrinsic value estimate in the mid-to-high $20’s. The stock of this high quality company yields 3.5%. The company produces huge amounts of cash, about $13 billion expected in 2005, even after investing over $7 billion in drug development, supporting a large stock repurchase program.
Imagine you owned the whole company. Free cash flow of about $2.00 per share would provide you a yield of 9%. This great company is trading at a pitifully inexpensive price. Hopefully the dreaded Lipitor patent decision will change the company’s fortunes, and help its shareholders make their fortunes back. In any case, the company’s new drug pipeline is likely to put a refreshing new complexion on the company several years from now.
American Express (AXP 51) is the most recognized global financial services brand. This superb quality 155-year-old company has dramatically improved the reliability of its sustained growth by spinning off its broker/dealer division, Ameriprise Financial. The departure of this commodity business allows American Express to concentrate on growing a great brand name while dramatically reducing capital requirements, thus improving return on capital.
American Express’ primary business and growth driver is credit cards. A recent anti-trust victory by the Justice Department outlaws the exclusionary agreement that issuers of MasterCard and Visa credit cards had to sign forbidding them from issuing any competing credit cards. Banks now are lined up to become new partners with American Express in the issuance of American Express credit cards. As a consequence of this, cards in force are currently increasing at a 9% annual rate for American Express. There is a lot of global market share remaining to be captured from MasterCard and Visa. American Express is the leading market share gainer in the credit card business.
“Average spend” per card, the company’s most important growth driver, is growing at 12% this year. The average American Express cardholder charges $11,000 per year, 5 times higher than MasterCard and 4 times higher than Visa. The rewards spread for American Express cards is higher than its competitors, so it attracts larger spenders.
Growth in card issuance and average spend leads to increased billings. Worldwide billings are up 17% so far this year, a 7% lead over the nearest competitor. The success in growing cards and billings has, in turn, led to increased cardmember loans. Lending balances have grown 15% in the first three quarters of 2005, compared to the industry average of 3%. American Express has attracted higher income cardmembers, explaining superior credit quality performance. Write-off rates and 30 day past due rates are well below industry levels. Finally, the number of merchants accepting American Express cards is increasing.
Who gets what in the credit card business? When a merchant accepts a MasterCard for payment of a purchase, he receives about 98.2% of the transaction proceeds. The issuing bank, such as MBNA, keeps a 1.5% “interchange” fee, the merchant’s bank keeps about 0.2% and MasterCard keeps 0.1%. The issuing bank uses its 1.5% to offer awards, miles, cash-back, or other incentives to attract cardholders.
American Express meanwhile only lets the merchant keep about 97.4% of the transaction proceeds. The issuing bank retains about 1.8%, the merchant bank keeps 0.25%, and American Express retains 0.55%. The merchant puts up with the higher cost of accepting American Express, because it has proven to bring in a wealthier customer who spends more. The issuing bank likes the larger interchange fees (1.8% vs. 1.5%), for the reason that it can then offer superior rewards to attract cardholders.
American Express’ long-term growth is based on its core competencies of marketing, payments processing, and credit underwriting. It is not limited to issuing more credit cards. It is related to increased plastic penetration – expanding the use of plastic to new payment streams. Plastic penetration is 40% in the U.S., 20% in international markets, and only low single digits in India and China. New payment types for credit cards include rent, fast food, and business-to-business spending. Adding telecom and healthcare gives huge upside. Trillions of dollars now spent on cash and checks could be transitioned to plastic.
Several new products include networked products with Citicorp, USAA, and UBS. Another lever within the company’s spend-centric model is its “Closed Loop Network,” a management information source to improve the value proposition to both cardmembers and merchants.
A new U.S. bankruptcy law became effective on October 17, 2005. This law makes it more difficult for people to completely discharge their debts through bankruptcy, so many debtors rushed to beat the effective deadline. All lenders, including American Express, expect this to increase bankruptcy related write-offs and delinquency ratios. Total managed write-offs will cause a $200-275 million increase in the company’s usual quarterly bad debt charge, equivalent to about 13 cents per share. American Express says it will take the whole write-off at once, in the December 2005 quarter, rather than amortize it over future quarters.
The company publicly projects a long-term annual growth objective of 12-15%. Analyst estimates reflect that in earnings per share projections from 2005 to 2009 of $2.58, $2.95, $3.33, $3.77 and $4.26, respectively. Intrinsic value estimated in the mid-$40 range will grow in line with earnings. Profit results in coming sequential quarters may include surprises until the Ameriprise spin-off is anniversaried and consumer response to the new bankruptcy law settles out. The resulting stock price volatility may create an opportunity to own this great business.
Steven L. Ré, CFA November 22, 2005
This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein 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 no guarantee of future results. Earnings projections often miss, and markets go up and 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.