Big pharmaceutical giant Pfizer (NYSE: PFE) isn't often thought of as a substantial growth driver of income investors' portfolios, but over the trailing five-year period, inclusive of dividends, Pfizer has returned 143%. That's incredible, and a big boon for shareholders who may have been hit hard during the Great Recession.
On the surface, Pfizer offers what every income investor would be looking for in a long-term investment. Over the trailing 12-months it's generated $16.9 billion in operating cash flow, it's paying out a premium dividend yield relative to the overall market of 3.3%, and it presumably has a vast and diverse product portfolio capable of sustaining its payout for years to come.
A head-scratcher for Pfizer's shareholders
But, a comparison of Pfizer's top-line over the past five years relative to its stock performance could leave you scratching your head.
Pfizer has been one of the hardest hit pharmaceuticals when it comes to patent loss expirations. Within the past five years cholesterol-fighting drug Lipitor, still the best-selling drug of all-time, was exposed to generic competition, as well as Celebrex, Detrol, and Spiriva in select countries. Since peaking in 2010, Pfizer's total revenue has dropped in four straight years from $67.8 billion to $49.6 billion, and based on its 2015 fiscal guidance, which calls for $44.5 billion-$46.5 billion in total revenue, a fifth consecutive year of declines is likely.
Clearly, this divergence between Pfizer's rising share price and falling revenue cannot persist over the long run. I believe if Pfizer has any hope of maintaining or adding to its current valuation it's going to have to make three specific moves for its shareholders.
No. 1: Spin off or sell its established pharmaceutical segment
Based on commentary from Pfizer's management following the release of its fourth-quarter results, it looks as if they're still giving serious credence as to whether or not they will split up the company into two separate components, or perhaps looks to sell a particular operating segment.
Beginning last year Pfizer began reporting its results in three separate operating segments: a global established pharmaceutical, or GEP, segment, a global innovative pharmaceutical segment, or GIP, and vaccines, or V. As the names imply, Pfizer's GEP segment can generate significant cash flow at minimal cost and deliver healthy dividends, but it's also poised to continue to be hit by generic competition. On the contrary, Pfizer's GIP is made up of high-growth newer drugs and pipeline products. The dividends may not be as nice, but the long-tail growth potential likely is.
Most investors would probably favor pharmaceutical growth as opposed to a static or slowly dying product portfolio, therefore making it logical in my view that Pfizer would prefer not to sell its GIP segment. But simply spinning off its GEP or at least separating the two major business segments should make it easier for investors to choose whether they'd prefer to own an income play or a growth play with the potential for income down the road. Not to mention, splitting the segments makes it easier for investors to understand how Pfizer makes its money. If Pfizer were to split its operations, its vaccine segment would likely be accounted with its GIP product portfolio.
Selling a segment could also make sense, but the difficulty could be in finding a buyer for its established product portfolio when generic competition seems poised to eventually eat away at its top- and bottom-line. A private-equity firm could show interest, but I think financing a deal this large could be out of most buyers' range unless they were one of Pfizer's peers.
No. 2: Seek additional "bolt-on" acquisitions
Second, and to steal a term from Pfizer's rival Merck (NYSE: MRK), Pfizer should forgo trying to land the elephant in the room when it comes to acquisitions and instead look for potential "bolt-on" acquisitions that can fortify its product and drug development portfolios.
For instance, in June, Merck announced that it would be purchasing clinical-stage hepatitis C drug developer Idenix Pharmaceuticals for $3.85 billion. This represented a more than 235% premium over Idenix's prior closing price the day before the deal was announced. The move was made by Merck to help bolster its own HCV product portfolio, which is comprised of a combo hopeful grazoprevir and elbasvir. The thinking here is Idenix's nucleotide inhibitors could be successful on their own or in some combination with existing products in Merck's pipeline. With the World Health Organization estimating that 180 million people worldwide have hepatitis C, there's plenty of room for Merck to enter the playing field and still be wildly successful.
I believe Pfizer's needs to follow Merck's lead, and rather than seeking out a potential "home run merger," it should instead aim to bolster its product portfolio or pipeline with a bolt-on acquisition.
Keep in mind this is pure speculation on my part, but Jazz Pharmaceuticals (NASDAQ: JAZZ) is a biopharmaceutical stock that I believe would make an intriguing fit for Pfizer. Jazz's therapeutic focus on neurologic and oncologic diseases and disorders lines up nicely with Pfizer's therapeutic areas of focus. Xyrem, Jazz's fast-growing lead drug targets narcolepsy and excessive daytime sleepiness, while ultra-rare drug Erwinaze target a specific type of acute lymphoblastic leukemia. Adding Jazz should be instantly profitable for Pfizer, with Jazz bringing in north of $400 million in operating cash flow over the trailing 12-month period, while Pfizer's size should help boost Jazz's margins even higher since it could likely reduce its manufacturing costs.
As I said, Jazz may not be the exact company per se, but a bolt-on acquisition of this type could be perfect to reignite Pfizer's growth.
No. 3: De-emphasize share buybacks in favor of its dividend
Lastly, I don't want to completely knock Pfizer's management team for its efforts to return cash to shareholders, but I'd like to see the company back off its excessive share repurchase program and be more proactive about returning cash as a dividend.
On one hand I totally understand why Pfizer has aggressively repurchased its shares. By lowering its shares outstanding it can help inflate its EPS as its top-line revenue figure falls. This lessens the impact of patent expirations and keeps nervous traders from selling Pfizer's stock in a frenzy. In fact, according to Pfizer it's returned nearly $65 billion in share buybacks and dividends combined to shareholders over the last four years.
However, share buybacks are only a short-term support for Pfizer's share price in lieu of its falling revenue. Instead of trying to prop up its EPS, Pfizer should really reward investors by immediately putting money in their pockets via a dividend.
Based on Pfizer's projected dividend payout of $1.12 per share, it's in line to return nearly $6.9 billion to shareholders this year. Yet, if Pfizer holds true to its forecast of returning approximately $13 billion in 2015, it has another $6 billion in cash to work with. This means Pfizer could have the luxury of foregoing its buyback and giving shareholders an extra $0.95 per share. At a hypothetical $2.07 in full-year payouts, Pfizer would be yielding about 6% and could be one of the most sought-after dividend stocks.
Obviously Pfizer doesn't have to get rid of share buybacks completely, but it'd clearly be nice to see the company shift its focus even more toward dividend payments in the coming quarters.
What this investor thinks
Ultimately I believe Pfizer is a work in progress at its current level. Management has done everything it can to cut costs and boost share buybacks in order to support its EPS in a falling revenue environment. However, investors are eventually going to realize they're dealing with a company that's backpedaling. Until such time as we see Pfizer actually growing its top-line again, or at least making strides to reignite its growth via a bolt-on acquisition or a split, I'd suggest investors watch patiently from the sidelines.
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Sean Williams has no position in any stocks mentioned.