As with everything that I will post to the investing section of this blog, the following should not be construed as investment advice. It is simply meant to be the ramblings of a now-retired individual with some time on his hands. I am not affiliated with any organization and have no interest in publishing other than for the intellectual exercise. While I make an effort to be accurate with my facts, I do not assert that any of the following information is 100% reliable. If I own a stock upon which I comment, I will always say so. In this case, I do own Pfizer in a personal account.
Barron’s this week decided to write up Pfizer and put the company on its cover page. Since it’s a company I find interesting, I decided to dig a little deeper and provide some thoughts in something other than financial-rag-speak. In a summary-up-front, I’d argue Pfizer makes a pretty interesting investment at current levels, albeit with a reliance on what the market will pay for an earnings re-acceleration story that begins sometime in 2020. Pfizer isn’t yet a loved company, for good reason, but its market cap is too significant to be ignored by institutional investors. Thus, I think the investing picture is skewed positively (just look at what’s happened with Bristol-Myers Squibb and AbbVie). I think the idea of hedging out the Viatris (i.e. Upjohn-Mylan) exposure is intriguing if minor in its import.
For a number of years now, Pfizer has been playing footsie with various ways to unlock value for shareholders, from merging with AstraZeneca to spinning out businesses (most notably its animal health business, Zoetis), to entering into joint ventures like the HIV endeavor, ViiV. Under the leadership of new CEO Albert Bourla, who will become Chairman and CEO January 1, 2020, it seems that Pfizer will undergo a series of more decisive changes. Ian Read, who had served as CEO since 2010, will step down.
Let’s talk a little about Pfizer
Amongst institutional investors, I don’t think Pfizer is taken very seriously. While Ian Read has put up a respectable strategy and operational legacy, it’s far from stellar. Under his leadership, the company has acquired companies like Hospira for $15bn and Anacor for $5bn, as well as licensed products like Merck KGaA’s avelumab. I think the Street would argue these haven’t been value-creating endeavors. When it comes to R&D productivity – the life blood of any biopharmaceutical company – Pfizer has a checkered past that’s improved marginally of late. In order to inform this statement, I arbitrarily peeked back at the company’s pipeline in 2016, just to remind myself of where we were. As of February 2nd, of that year, Pfizer boasted 8 novel agents in Phase 3 development (i.e those that weren’t line extensions, new indications for marketed products or biosimilars). Here’s the update on those:
I think it’s fair to note that the approved drugs were approved only recently. Thus, one wouldn’t expect sales to be too substantial as of late 2019. That said, for drugs where there’s multi-blockbuster potential (i.e. >$2bn in peak sales), companies often disclose early figures to satisfy analysts. From this list, the only candidate I’d characterize as an obvious success is Trumenba.
Today, Pfizer has a few more interesting candidates in late development, as well as the fruits of some inorganic stratagems (e.g. the $11bn acquisition of Array Biopharma). Still, I can’t say at this juncture anything’s really changed. The organization is still led scientifically by Chief Scientific Officer, Mikael Dolsten, whose tenure closely matches that of former CEO, Ian Read.
So, why are things interesting now?
Let’s start with the inorganic stuff
On August 1, 2019, Pfizer announced that GSK and Pfizer had closed a joint-venture agreement under which Pfizer and GSK would contribute their consumer health businesses and obtain respective ownership stakes of 32% and 68% in the combined entity. GSK is taking charge operationally, while Pfizer will step back and simply report its passive financial interest from here. I won’t spend a lot of time on details other than to say 1) for once, it looks like Pfizer received reasonable value for the business it sold, 2) this is the kind of business where synergies ought to be real and obtainable (e.g. improved negotiations with the trade over shelf space, the elimination of redundancies, better purchasing of fairly standard supply chain items, maybe even some cross selling opportunities, etc.), and 3) GSK ought to improve on Pfizer’s performance (Pfizer Consumer Health Care had been posting flattish results, where GSK has been growing low-to-mid single digits).
On July 29, 2019, Pfizer and Mylan announced they were merging Pfizer’s aging/legacy brand business, Upjohn, with Mylan to create a new company which will be called Viatris. The market promptly threw up all over this idea, with Pfizer’s shares dropping nearly six and a half percent. I think I understand why folks were disappointed. While Pfizer shareholders stand to receive 57% of Viatris, it will be run by Mylan executives/appointees. This includes Chairman Robert Coury, whose reputation is controversial to put things gently, President Rajiv Malik and eight members of an eleven-member board. Beyond this, Pfizer shareholders will still have to worry about the performance of a generic pharma company with much different growth opportunities and capital demands than Pfizer’s remainco – the innovative biopharma company; I’m sure some felt that a split-out or sale would have been much cleaner. Pfizer and Mylan executives expect the deal to close in mid-2020.
For better or worse, these two managerial exits will accomplish a couple of objectives. First, it will make valuing Pfizer’s shares a bit easier. There will be a public market for Viatris, and Pfizer shareholders will be able to monitor it in real time. Consumer health, while subsumed in the GSK figures, is a steady business with very reliable metrics on a comparables or transactional basis. It too should be easy to value. With perhaps 85% of the value of Pfizer accruing to the remaining biopharma business, investors should also be able to focus their efforts. Second, Pfizer personnel will be able to focus exclusively on the creation, development and launch of novel medicines addressing high unmet needs. Perhaps this will have a positive effect on R&D productivity.
What about the organic stuff?
I’ll state what is obvious to most. A biopharma company is really just a series of products launched into an existing infrastructure. In Pfizer’s case, there are a number of growth drivers, a couple of key products, one major product going off patent, and a number of late stage pipeline candidates that will probably set the tone for investors over the coming few years. As of Q3, Pfizer’s Biopharma business (the innovative stub) boasted an annualized sales rate of roughly $40bn. Lyrica, the one big product currently being genericized, has already been moved to Upjohn, so its worth is embedded in the inferential value Pfizer shareholders get in the proposed merger with Mylan. Ibrance, a terrific drug for hormone positive breast cancer, accounts for about 13% of Biopharma sales and grew 27% operationally in the quarter. Ibrance really faces no obvious competitive threats. Prevnar, the leading vaccine used to prevent pneumococcal disease, accounts for about 16% of Biopharma sales and declined about 3% operationally. Biopharma, overall, grew 9% operationally in the quarter.
Pfizer’s pipeline is “O.K.” (hey — they don’t give two and a half stars to just anybody). For better or worse, a lot of the dross has already fallen out. Hence, the late stage pipeline is a bit thin, numerically, but of relatively high quality. I highlight below four Phase 3 programs that matter, and I am optimistic about three.
Pfizer has two growth drivers I believe are worthy of added comment. The first is Xtandi, which I believe will win the war amongst next generation anti-androgens used to treat prostate cancer. Xtandi looks cleaner than J&J’s Erleada and more flush with data than Bayer’s Nubeqa. Alliance revenues for this product increased 25% operationally in the quarter (to $225mm) and should benefit from earlier and more extensive use pursuant to anticipated regulatory approvals. The second is Vyndaqel, a novel treatment for an uncommon heart condition. This product is off to a very strong start and boasts above average margins. With time, it has multi-block buster potential.
In my opinion, many of the theoretical risks Pfizer faces are mitigated.
Merck & Co., is working on a pneumococcal vaccine that will compete with Prevnar. It does cover a couple of serotypes that are clinically important and which Prevnar doesn’t cover. However, Pfizer is in advanced testing with a 20 valent vaccine that covers these and 5 additional serotypes.
Earlier this year, Pfizer’s Xeljanz, an oral medication for arthritis, received added warnings for clotting and related deaths on its prescribing label. So far, this development hasn’t had a significant impact on sales, and it’s encouraging to see that Pfizer’s pipeline candidates of the same or a related class appear cleaner on side effects.
If there’s a more existential threat, it’s that of health care reform. A big chunk of Pfizer’s sales and earnings come from oral anti-cancer medications. These are used disproportionately in the elderly, and are therefore often reimbursed under Medicare Part D. While access to anti-cancer medicines is a sensitive topic, there is a lot of dissatisfaction amongst beneficiaries and a lot of government dollars at stake. If one plans to own Pfizer long-term, the subject bears watching.
Some numbers and some investing thoughts
In sum, it would appear that Pfizer’s stated target of achieving a 6% CAGR for Biopharma over at least the coming five years appears reasonable. However, I was surprised to see how little attention was given to the company’s earnings progression on its most recent quarterly call, given the impact of Lyrica and the various moving parts associated with GSK and Mylan.
Through 9 months of 2019, Pfizer earned $2.39/share on an adjusted basis. Management has provided guidance of $2.94-3.00/share on an adjusted basis, which means that Q4 guidance is $0.55-0.61/sh. That’s a pretty big step-down from $0.75/sh. In Q3 and a run rate of roughly $0.80/sh. before the loss of Lyrica. If there’s a silver lining, it’s that there’s only $200mm/Q of Lyrica left to go in the U.S.
For Q4, Pfizer has pointed to a few cents in dilution from a full quarter of the Array acquisition, as well as a further deterioration in exchange rates. Pfizer had also indicated it will move from contemporaneous reporting for its consumer health business to a one quarter lag under the new GSK J.V., and that this would lead to 2019 earnings dilution of roughly $0.03/sh. Despite all this, I expect there’s also a bit of expectations management built into guidance. According to Pfizer’s 10Q, Upjohn earned $2.3bn, $2.0bn, and $1.4bn before overhead in Q1, Q2 and Q3, respectively. Sales declined from $3.1bn to $2.2bn over that stretch. U.S. Lyrica sales declined from roughly $900mm to $200mm. Thus, in round numbers, Upjohn’s earnings power probably troughs at $1.2bn before overhead and taxes. On the flip side, Biopharma earnings have grown from $5.9bn in Q1 to $6.1bn and $6.5bn in Q2 and Q3, respectively. In Q4, earnings should increase again, if for no other reason than growth in the high margin product, Vyndaqel. Say Q4 Biopharma is $6.7bn, Upjohn is $1.2bn, and combined Other Business Activities and Corporate is $3.2bn in expense (i.e. on trend). That would put Q4 earnings in the ballpark of $0.70/sh. at a 16% tax rate. Add the Array and consumer health care dilution, and Pfizer maybe ends up at $0.65/sh.
In 2020, consumer health care will normalize and should start to grow. Biopharm should too. Thus, I think the current consensus of $2.74/sh. is achievable. However, this probably isn’t hugely important to the thesis, but rather a bulwark against which value investors can start to gauge their level of optimism for a renaissance at Pfizer Biopharma.
So, let’s think about that.
Pfizer includes a table of segment performance in its press release. From it, you can deduce a few things:
- Biopharma and Upjohn both boast attractive gross margins. In the case of Biopharma, gross margins hit 91.5% in Q3, which CFO Frank D’Amelio attributed to productivity and a contribution from Vyndaqel. I think it’s reasonable, given a lack of significant patent expiries from here forward, to expect 2020 gross margins for Biopharma to hover in the low 90’s%.
- R&D runs nearly $2bn per quarter, and you can be assured that nearly all of that accrues to Biopharma. The other businesses simply aren’t R&D intensive. Based on Array’s S.E.C. filings, it appears we should add about a quarter of a billion dollar R&D load to Pfizer Biopharma for that organization, bringing the total to perhaps $8.25bn on an annualized basis.
- If points 1 and 2 are in the right ballpark, the key to deriving the base from which to get excited or not for Biopharma depends on the allocation of SI&A. Here, too, I think it’s safe to assume that most of the bodies and overhead will accrue to biopharma. I base this on logic (e.g. you don’t run DTC campaigns for generics, biosimilars or soon-to-be extinguished products; you don’t detail aggressively with sales reps and you aren’t willing to pay for market data from iQvia). What’s more, the numbers make sense. If we tie 90-95% of unallocated SI&A to Biopharma, we arrive at a figure of roughly $2.7bn, or 27% of net sales. This is actually on the low side of the average for a pure-play peer set.
If those are the right numbers, Biopharma has earnings power in the range of over $19bn before interest and taxes in 2020.
The last elephant in the room is the balance sheet
As of Q3, Pfizer’s cash, cash equivalents and short-term investments amounted to $9bn. Long-term investments amounted to $2.7bn. On the other side of the ledger, interest bearing liabilities totaled $53bn. On these figures, Pfizer puts up about $60mm in interest income and $400mm n interest expense. Just prior to the close of the Mylan combination, management contemplates that the new Viatris will make a one-time $12bn payment to Pfizer, and that Pfizer will use this to retire debt. Thus, subject to variances in cash sources and uses for the coming half year, Pfizer ought to have a proforma debt balance of just over $40bn.
If we take these figures through the income statement and apply a 16% tax rate, new Biopharma should have base earnings of over $0.65/sh. per quarter coming out of the Mylan transaction, and earnings ought to be growing double digits.
Pfizer shareholders own 32% of a consumer health business with a greater-than $13bn top line. Consumer health businesses, if run properly, boast 20% operating margins and low-to-mid single digit top line growth. Typically, they are worth 3-6x sales, depending on moats and the appetite of investors. If we go with 3.5x forward sales, peg the run rate at $13.5bn, and give Pfizer 32%, the value to Pfizer is $15bn.
Mylan currently trades at around $18/sh. and has just over 500mm shares outstanding. It doesn’t appear that there’s a big deal-related discount built into the shares, given that the stock traded at $19/sh. before Pfizer and Mylan made their announcement. Thus, if Mylan’s 43% stake in Viatris is worth $9bn, Pfizer’s is worth $12bn.
Finally, there’s the payment. Viatris is going to hit the ground with a ton of debt, but some decent early capacity to generate free cash (Mylan’s presentation says the goal is to get to 2.5x D/EBITDA or less by the end of 2021, while initiating a dividend). On proforma 2020 sales of $19-20bn in 2020, Viatris will begin with $24.5bn in debt and EBITDA margins in the range of 40% (including synergies). This $24.5bn includes the debt Upjohn will incur in order to make the one-time $12bn payment to Pfizer.
If Pfizer has 5.6bn shares outstanding, consumer health is worth $2.7 per share, and Viatris and the payment are each worth $2.1.
So, what’s Biopharma worth?
Well, I guess that’s up to the markets. However, I think 15x isn’t unreasonable, given the pipeline and the lack of patent expiries until 2026. If the company can put up $0.65/sh. beginning in Q3 2020, I think $2.70-2.90/sh. in 2021 is a good figure (just for Biopharma). 15x that would be $42/sh. at the mid-point, on top of which you could add the $7/sh. described above. While that sounds like quite attractive a target for a lumbering, unloved biopharmaceutical company, I think it might be realistic to set one’s sights a little lower. It’s almost never in management’s interest to give away the store all at once. What’s more, I believe it takes time for companies to go from unloved to, well, something better than unloved. Finally, it’s an election year, and health care reform is going to be on the agenda. Thus, Pfizer may not see the upper forties right away. Nevertheless, the bones of the idea feel right, and Pfizer does offer investors a 3.8% dividend while the broth clears. One final thought relates to Mylan. I, for one, am attracted to the Pfizer Biopharma and consumer health businesses to a much greater degree than I am Viatris. If I were an institutional investor with the ability to hedge, I might short enough Mylan stock to hedge out my exposure to this fledgling entity. That’s not to make a stock call one way or the other, but simply to focus my energies on the business about which I care.