Big Pharma has enjoyed an exceptional stretch of performance lately, reversing what had been a relatively rare period of underperformance brought on by overdone fears over this sector's ability to continue to grow. While the recovery in Pfizer's (NYSE:PFE) valuation was valid, the question now is whether the shares have significant room left to move. Given a relatively weak growth profile, investors shouldn't expect these strong returns to continue on all that much longer.

SEE: Healthcare Sector – Play or Stay Away?

Earnings Show Some Of The Risks
While Pfizer is still very early in the life-cycle of new drugs like Xeljanz and Eliquis, the reality for Pfizer is that new blockbusters largely just help fill the gaps created by the patent expirations of yesterday's blockbusters. That makes great top-line growth challenging.

Revenue fell 9% this quarter, a miss of more than 3% relative to the average sell-side estimate. Results were going to unimpressive due to large declines in Lipitor and slow growth in the mature big-name drugs, but it seems as though the movement of the Japanese yen played a big role in the miss (with sales to Japan over 10% of sales). Among the major drugs, Lyrica (the company's largest drug) was up 12%, while Enbrel was down 2% and Prevnar 13 was down 10%.

Margins were mixed once again. Gross margin was a little weak; down a point and a half from last year and about a quarter-point below expectations. Operating income fell 12% and missed expectations by about 2%, as Pfizer used better operating expense leverage to partially compensate for soft reported sales.

SEE: Analyzing Operating Margins

Is Pfizer Vulnerable To The Next Big Thing?
Given Pfizer's large size, there aren't many disease states or drug categories where the company does not compete. Still, there's a big difference between leadership and “we'll get their eventually”, and that's becoming more apparent in areas like oncology and virology.

Pfizer is not very involved in the gold rush toward new hepatitis C therapies. More significantly, the company seems to be lagging in the emerging field of immuno-oncology. Not only is this a market with multi-billion dollar potential (perhaps $10 billion or more), it could threaten Pfizer's existing position in markets like renal cell carcinoma. Companies like Bristol-Myers (NYSE:BMY), Merck (NYSE:MRK), and Roche (OTC:RHHBY) do seem to be further along, and that could leave Pfizer in a position where it has to acquire/in-license compounds or accept a less competitive position within oncology.

It's also worth noting that Pfizer's pipeline doesn't quite pop with huge potential blockbusters. Drugs like Eliquis and Xeljanz are still young enough in their lives to get “honorary pipeline” status for purposes of this discussion, but aside from cancer drugs palbociclib and dacomitinib there aren't a lot of drugs with huge revenue potential. Then again, this is not necessarily a terrible thing – many drug companies have been hurt by losing huge revenue contributors (like Lipitor), and there has been a deliberate shift away from the “Snow Whites” and towards the Seven Dwarves.

SEE: Pharmaceutical Sector – Does The FDA Help or Harm?

The Bottom Line
Pfizer generates strong margins and has very deep pockets when it comes to both internal R&D and external licensing and M&A. To that end, I see no reason to believe that Pfizer won't continue to be a solid income-generating stock. Where Pfizer is likely to be more challenged, though, is in generating meaningful long-term revenue growth or significantly better free cash flow (FCF) margins.

I am looking for Pfizer to grow it's top-line around 1% across the long term, with free cash flow just slightly above that. Investors should definitely note that management is contemplating splitting the business (between “Innovative Core” and the value-oriented side of the business), but that won't come for a few years. In the meantime, the growth I expect from Pfizer points to a fair value in the very high $20s, or roughly in line with today's price.

At the time of writing, Stephen D. Simpson owned shares of Roche.

Related Articles
  1. Economics

    Pharmaceutical Sector: Does The FDA Help Or Harm?

    We look at how the FDA affects the pharmaceutical industry, and how investors can avoid the pitfalls.
  2. Fundamental Analysis

    Evaluating Pharmaceutical Companies

    Learn how to find a healthy pharmaceutical investment in a market full of weak drugs.
  3. Fundamental Analysis

    Pharma Patent Trolls: Cheap Drugs At A Steep Price

    Though patent trolls can help patients achieve cheaper medication in the short-term, everyone pays for it in the long term.
  4. Insurance

    Pharmaceutical Phenoms: America's Best-Selling Medicines

    These three drugs were the winners of their day. Find out what winning pharmaceuticals have in common.
  5. Stock Analysis

    Will J.C. Penney Come Back in 2016? (JCP)

    J.C. Penney is without a doubt turning itself around, but that doesn't guarantee the stock will respond immediately.
  6. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  7. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  8. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  9. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  10. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center