R&D is a primary growth driver for pharmaceutical companies. Pfizer (NYSE:PFE) CEO Ian Read, newly appointed at the time, announced draconian cuts to this sensitive expense area on 1/31/2011, and followed through, cutting it from $9.4 billion in 2010 to $6.7 in 2013. Here’s his rationale, from the 4Q 2010 earnings press release:
We continue to closely evaluate our global research and development function and will accelerate our current strategies to improve innovation and overall productivity. Key steps in this process include greater focus in disease areas of greatest scientific, medical and commercial opportunity, a realigned global R&D footprint to increase our presence in key biomedical innovation hubs, and an increased level of outsourcing for services that do not drive competitive advantage for Pfizer. Furthermore, we plan to enhance internal programs that are designed to strengthen pipeline delivery and differentiated innovation. As a result of these actions, we expect to reduce adjusted R&D expenses(1) to between approximately $6.5 to $7.0 billion in 2012 compared with our previous target of $8.0 to $8.5 billion.
With R&D there is always the issue, how to differentiate ivory tower work from commercially valuable intellectual property, and how to ensure that promising ideas make it through to production.
Pfizer has addressed the issues at the corporate level by 1) focusing on five key areas and 2) by setting proof-of-concept as the cutoff between corporate and operating segment R&D expenses.
By the end of 2011, the focus was restricted to five high-priority areas that have a mix of small and large molecules-immunology and inflammation; oncology; cardiovascular, metabolic and endocrine diseases; neuroscience and pain; and vaccines. The company also stated in the 10-K that R&D spending may include upfront and milestone payments for intellectual property rights.
Pfizer provides R&D expense by segment on a quarterly basis. As of 9 months, for 2014 R&D increased year over year, with most of it going to GIP (global innovative products). I interpret the increases in segment R&D as an indication that the current structure works: the operating units are investing to bring viable concepts to fruition in a timely manner. Certainly the management structure and accounting provide motivation for entrepreneurial thinking about where to invest.
A Sour Note
At the Credit Suisse Healthcare Conference (transcript), Vamil Divan raised the following question:
What is it about the PD-1/PD-L1 and maybe first wave here that you guys are behind and then didn’t kind of catch that one? Maybe that’s more of a question more appropriate for someone else, but just as you think about it is there any way you have to kind of make sure the next wave that’s coming up that you don’t miss that one and the sort of internal learning that you think about it in terms of future advancements next year?
Albert Bourla, recently appointed Group President of VOC, acknowledges an error of judgment in his reply:
This is the nature of the research business that you have to make bets when very little data are available, some they get it right, some they get it wrong, usually people are belonging to the same categories because some that they get right, some that they get wrong. I mean years ago, we didn’t think that we should invest in that and we didn’t.
Looking back at the expense reductions, it’s possible to infer that Pfizer missed an opportunity due to excessive cost-cutting, and that CEO Ian Read would have been the proper person to answer the question.
Buying Into the Game
Days later, Pfizer announced a global strategic alliance with Merck KGaA (OTCPK:MKGAY), to jointly develop and commercialize Anti-PD-L1 to accelerate presence in Immuno-Oncology. The agreement included an upfront payment of $850 million and potential milestones of up to $2 billion.
Guidance for the 4th quarter was reduced by 10 cents, to reflect the payment.
So… years ago Pfizer didn’t invest, and now they’re buying back into the game. We all have 50/50 hindsight. My take: the cost-effectiveness of internal R&D, the opportunity costs of missing the wave, and the benefits of collaboration and strategic alliances as substitutes will continue to receive management attention at Pfizer.
When announcing the fourth-quarter dividend, Pfizer also announced an $11 billion share repurchase program. In effect, the board is saying that the company has (or expects to generate) that amount of excess capital, which will be returned to shareholders over time.
To my way of thinking, some of this excess capital may be money that was not spent on R&D in a timely and opportunistic manner. Certainly the board should be questioning Read on the issue of capital allocation.
Forming an Opinion on Management
I searched the internet for interviews with Ian Read, and came across an article in the Telegraph that provides some insight. Read provides a “signature coin” to each employee, which basically empowers and shields the individual when it becomes necessary to tell management things they don’t want to hear.
I also checked at GlassDoor, where Read enjoys a 76% approval rating from employees, in spite of the fact, mentioned by many of them, that restructuring is ongoing.
My overall impression is favorable.
Since reducing the quarterly dividend in 2009, Pfizer has increased it by 2 cents each year. Given the substantial amount of excess capital, and the company’s past dividend history, I anticipate that it will be increased by 2 cents for 2015, continuing the trend.
My preferred method is PE5 (Price/5 year average EPS). I picked up the idea from Ben Graham, and modified it by working with 4 years of historical earnings plus an estimate for the current year. It’s somewhat difficult to apply here as the company has divested operations on a regular basis, with ongoing restructuring, and historical information may not be the best basis for valuing the company.
Under the circumstances, I used Net Income from Continuing Operations. Here’s how I did the math, arriving at an estimated FMV of $33:
The 22X multiple is my current estimate of the long term average PE5 for well-known and profitable large cap dividend paying companies.
Working with an on-line DCF (Discounted Cash Flow) calculator, using TTM FCF per share of $2.40, and assuming 1% growth for 10 years and 3% thereafter, I apply a WACC of 7.8% and arrive at an intrinsic value of $44 per share.
Avenues to Liberate Value
Pfizer pursued a tax-inversion deal to acquire AstraZeneca (NYSE:AZN), but was unsuccessful on that front. For 2014, the company has reorganized its segments into GEP (Global Established Products), GIP (Global Innovative Products) and VOC (Vaccines, Oncology and Consumer). This enables the production of audited financial statements to separate GEP from the more rapidly growing R&D driven part of the company. A spinoff becomes possible in 2017.
From a long-term point of view, management is demonstrably interested in liberating value, and most likely they will make something happen.
I’m investing in ways that will be profitable if the company increases its dividend as discussed above and the share price makes its way up to $44 over the next several years.
While capital allocation is questionable here, I believe that buybacks will enhance shareholder value, and I also believe management is sufficiently flexible to continue their review of R&D and take any corrective action that may be required going forward.
According to TipRanks.com, which measures analysts’ and bloggers’ success rate based on how their calls perform, blogger Tom Armistead has a total average return of 14% and a 69% success rate. Tom Armistead is ranked #573 out of 7391 total experts