Here's a c&p from Motley Fool e mail message last night. This might explain the downgrade. I am long PFE in my IRA and will maintain but will not be a buyer anytime soon.
Pfizer's Approach to Its Business -- Part 1 of 2
A Talk with Investor Relations
By Phil Weiss
TOWACO, NJ (October 26, 1999) -- FRUSTRATED! That one word sums
up the feeling that I had after Matt and I spoke to Pfizer's
(NYSE: PFE) Investor Relations department (IR) Monday evening.
The call was a follow-up to last week's column in which I wrote
about the company's recent earnings report.
fool.com
Before I discuss the source of my frustration, though, there are
some points that I'd like to clear up first. One of the topics
that we discussed in our call was the change in wholesaler
inventory stocking patterns of Zoloft, Norvasc, and Cardura. The
actual story from IR is that wholesaler inventory levels fell
during the quarter. It seems that prescription growth for the
quarter was 15%. However, sales increased at a slower pace of
13.7%. The third quarter was actually strong for these products.
The de-stocking of inventory at the wholesaler level led to
Pfizer recording a lower level of sales for the quarter than if
inventory levels had remained constant. IR and I both agreed
that the press release could have done a better job of
describing this situation.
We also discussed the decline in Selling, Informational and
Administrative expenses for the quarter. According to IR, this
decline was the start of a trend and not a one-time occurrence.
The decline in these expenses is part of management's intention
to restrain spending. Although the company expects revenue
growth to remain strong, it is expected that its growth rate may
decline from current levels.
In addition, Pfizer added a large number of sales people to help
with the marketing of Lipitor, Celebrex, and Viagra. It is not
expected that any of the products it releases in the near future
will generate the kind of sales that these three products did.
As a result, the existing sales force can be used to sell and
market its new products. This is all part of the company's
efforts to protect its bottom line. Let me repeat those last
words again for emphasis -- "protect the bottom line." Read on
and you'll see them over and over again.
We also discussed Pfizer's "alliance revenues." You'll remember
that these monies include Pfizer's revenue-sharing deals with
G.D. Searle (for the arthritis drug Celebrex) and Warner-Lambert
(for the cholesterol fighter Lipitor). In these deals, Pfizer
utilizes its industry-leading sales force to co-market the other
drug companies' products. While the company will not release
specific figures related to its terms for any of these
agreements, IR did share some additional information on these
relationships. First of all, collection terms for alliance
revenues (at least in the case of Lipitor, which was the only
product that was specifically named) are several months longer
than for Pfizer's other accounts receivable balances.
As an example, Pfizer might sell its in-house products to
wholesalers and require payment within 30 days. But in the case
of alliance revenues, based upon what I was told by IR, it seems
reasonable to assume that Warner-Lambert doesn't have to pay
Pfizer its share of Lipitor revenues for a period of 120 days or
more. This was part of the price that Pfizer paid for getting a
share of the profits from products with exciting sales potential
like Lipitor, Celebrex, and Aricept. Pfizer currently takes
about a 40% share of the revenues from these products, so it
does have a significant impact on its bottom line. Notice that I
used those words again.
It should also be noted that Pfizer's alliance revenues do not
come without cost to the company. These co-marketing agreements
require Pfizer to incur a portion of ongoing research and
development (R&D) related to the alliance products. Pfizer also
incurs related sales and marketing expenses.
The last financially related topic that we discussed during the
call was Pfizer's use of debt to fund its share repurchase
program. IR was not concerned about Pfizer incurring additional
debt because the company's debt is highly rated by such services
as Standard & Poor's and Moody's. The company has almost
unlimited borrowing power. In addition, it believes that
investors want them to buy back shares as it expresses
confidence in the long-term performance of the company. Oh yeah,
and let me add that a smaller number of shares also helps them
increase the bottom line (earnings per share increases when you
reduce the "S" in EPS). Boy, that phrase is starting to sound
awfully familiar, isn't it?
Pfizer views itself as one of the top five or ten companies in
terms of financial strength. While I might not rank them at that
lofty level, I can't deny that Pfizer is a top tier company
financially. But, I have a problem when a company that is
currently generating negative free cash flow (FCF) is borrowing
money in order to finance its share repurchase program.
Such juicy details you won't find in Pfizer's glowing press
releases. For that, we need to dig into Pfizer's second quarter
10-Qand look at its cash flow statement. For those uninitiated
with the concepts of "operating cash flow" and "free cash flow,"
Matt has put together the following condensed and labeled
version of Pfizer's cash flow statement through the first six
months of this year:
Pfizer Statement of Cash Flows Six Months Ended
(millions of dollars) July 4, June 28,
1999 1998
Operating Activities
Income from continuing operations $1,544 $1,129
Adjustments:
Depreciation and amortization 244 235
Other 24 --
Changes in assets and liabilities (1,198) (150)
1) Net cash provided by oper. activities 614 1,214
Investing Activities
2) Purchases of Property, Plant, & Equip. (687) (461)
3) Free Cash Flow (FCF) = (1) - (2) (73) 753
Just to make sure we all have our terms straight, let's review
the three important numbers to take away from this important
financial statement:
1) "Net cash provided by operating activities" is what we
commonly refer to as "operating cash flow" (OCF). Think of this
as cash profits.
2) "Purchases of property, plant, and equipment" is what we
commonly call "capital expenditures" or simply "cap ex." These
are monies paid for computers, networking equipment, office
buildings, land, and other similar long-lived assets.
3) "Free cash flow" (FCF) is the cash left over after all
business reinvestment has been taken care of. This is the cash
that the company could theoretically pay out to shareholders as
a dividend.
Now let's put it all together. You'll find that for the first
six months of this year, Pfizer generated operating cash flow of
$614 million and had net purchases of property, plant and
equipment (PP&E) of $687 million. That leaves it with negative
FCF of -$73 million. Over the same period, Pfizer's income
statement reported a much more favorable "income from continuing
operations" of $1,544 million.
The important truth to understand is that profits on the income
statement are only beneficial if they translate into free cash
on the cash flow statement.
In Pfizer's situation of negative free cash flow, I don't want
to see the company compounding its problems by borrowing money
in order to fund its share repurchase program. More debt only
works to reduce Pfizer's already low ratio of cash-to-debt.
So how does all of this impact the bottom line? It doesn't -- at
least not yet. But Pfizer's balance sheet and cash flow
statement are showing troubling signs. After our discussion with
Pfizer's IR, both Matt and I agree that Pfizer's management is
far too focused on managing the income statement and pleasing
Wall Street, instead of managing the overall business for
maximization of long-term shareholder value.
Tomorrow, I'll go into greater depth on explaining my concerns
with Pfizer's alliance revenues and its related business
practices.
If you want to continue this discussion, we've been discussing
this topic on the Pfizer message board for the last few days in
this message thread:
Discussion of Rule Maker Article on Pfizer
boards.fool.com
And if you have questions on any of today's financial concepts,
such as free cash flow, please ask a question on the Rule Maker
Beginners board.
Have a Foolish night and good luck to the Yankees as they
continue their march towards the title of best team of the
decade and, of course, the century -- now that's a real Rule
Maker. Just think of how many times the team has successfully
reinvented itself while maintaining such a consistently high
level of performance.
Phil |
