I Hate Pharma
(Guest Commentary - December 7, 2006)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks and evaluating companies, I have again invited our regular guest commentator Mr. Bill Rempel for a quick mid-week discussion of an individual stock that he likes. As subscribers should know, Bill has been writing a regular guest commentary for us since June 2005. His first commentary was on “The Art of Value Investing” and was very well-received (that is why we brought him back on a regular basis!). Bill is a prolific writing on the stock market and individual stocks and is the author of a very active market blog at: http://www.billakanodoodahs.com/
In this commentary, Bill is going to discuss Pfizer (a pharmaceutical company which needs no introduction) and its recent troubles with two drugs in the Phase III trial. While Bill does not like how businesses are conducted at the pharmaceutical companies, he nonetheless recognizes the current value in buying PFE shares – along with a company that has historically done well and has raised dividends. Without further ado, following is biography of Bill:
Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see “Getting on the Entercom” for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.
Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
I hate pharma. Their lobbyists are constantly trying to misuse the power of "government" in order to protect their fiefdom over individual health, through customer-friendly actions like increased regulations of vitamins and bans on bio-identical hormones. Of course, the fact that you can't patent a chemical that occurs naturally in the human body isn't an issue – they're doing this for your safety. Similarly, our insane "intellectual property" laws encourage exactly the wrong kind of R&D, since the incentive is to change the shape of the molecule slightly, call it an "improvement," and patent it. Oh, and let's not forget the incentive to find hitherto unknown diseases and syndromes, scare the public about them, and suggest that there's a pill that can help. And don't even start me on direct-to-consumer advertising! It seems that you're only allowed to explain what the drug is for if it relates to the organ just forward of the epididymis. Otherwise, no explanation, just "ask your doctor" about it. ARRGHH!
Pfizer (PFE) currently has several drugs in their CVMED area, related to cardiovascular, metabolic, and endocrine diseases. Eight are in line, including Lipitor, Chantix, Caduet, Genotropin, Exubera, Inspra, Revatio, and Norvasc. Eleven are in pre-clinical trials, ten are in phase one, seven are in phase two, and it used to be that two were in phase three – until this weekend. Torcetrapib/atorvastatin was withdrawn from trials, and the stock tanked as a result.
PFE was down 15% at the open and down 10% at the close, but most of the action was scared lemmings selling at market, meaning that an alert and aggressive day-trader could have made a 5.9% gain in 30 minutes. Unfortunately I didn't have internet access Monday morning, but I do today, and no one can convince me that torcetrapib/atorvastatin's failure is worth a 10% discount on future earnings through perpetuity. Can you say "fallen angel?" I could, if I thought any big pharma stock was worthy of the term "angel."
Regardless, I tend to salivate when I see huge gaps and huge volume, and my theory is to follow the day's direction and not the gap's direction for a quick hitting trade. The volume of 289 million shares approximates 7 times the average daily volume, and a full 4% of the float changed hands in one day. The average daily volume was exceeded in the first 30 minutes of trading, and that's where most of the movement came. This was a "heathen enema" – all of the non-believers in the stock were washed out. The day ended very strongly, near the highs, which is a bullish sign. Combine that with the above, and I would make a bull case for PFE here.
Looking at this from a broad business point of view, the atherosclerosis segment has a potential worldwide market of maybe $34 billion, with obesity, diabetes, bone and muscle health, and thrombosis making up another $70.7 billion of potential worldwide market. A sizeable portion of drugs fail to pass phase three trials, and this is one failure, for one drug, in one segment. Going one step further, the entire CVMED area accounted for 41% of the company's revenues through three quarters of 2006, and under 44% of the Pharma sector's revenues (the consumer health business was sold this year to JNJ). It is true that Lipitor accounts for 26.7% of revenues, but Lipitor is experiencing several positive trends, including a May 2006 approval in the E.U., an application for secondary prevention of cardiovascular events in the U.S., positive impact from the Medicare act, and a trend towards higher dosages. The plan was for torcetrapib to be combined with Lipitor (torcetrapib/atorvastatin) with a presentation to the American College of Cardiology in March 2007 and a filing with the Feral Dea-, er, FDA later in the year.
It seems very likely that the massive share-dumping shown below was an overreaction.
After the fallout, we have a large-cap company with a trailing P/E of 14.4, selling for 3.4 times sales and 2.6 times book. PFE's return on assets is close to 10%, and their return on equity is close to 20%. The current ratio is over 2, and the Debt/Equity is under 0.2. Pfizer was already trading at a discount, in both P/E and Price/Book, to Johnson and Johnson, Glaxosmithkline, Novartis, Merck, AstraZeneca, Abbott, Wyett, Eli Lilly, Bristol-Meyers, and Schering-Plough. It was one of only two large-cap majors to trade under a 17 multiple, and the industry average is an 18. They also had the highest net margin in the most recent quarter of any of the majors.
The dividend on the stock is $0.96 annually, or just under 4%, at a time when bonds are yielding under 4.5%. Given a 5% annual growth rate and an 11.5% discount rate, a P/E of 16 would be "fair." With a more aggressive 15% discount, a P/E of around 10 is "fair." However, one must take into account the sizeable dividend when looking at the returns. Did I say "sizeable dividend?" I meant to say "sizeable growing dividend" – which sends a signal to the market. The dividend has more than doubled since 2001! I might have found the stock arguable at full price, but given the "10% off sale" that we're being treated to, I found it hard to resist, and took a long position on Tuesday morning at the open.
I view the technical sell point as a violation of the lower range from Monday's trade, although another technique I'm fond of is a volatility-based trailing stop, which would suggest giving the stock a little more room. The "fallen angel" is a stalwart of the value investor, and even if you're inclined to hold regardless of movement below Monday's range, "Mr. Market" has given us a discount, much similar to the ones it has given in the last year or so for large cap stocks like Merck, Wal-Mart, and Berkshire-Hathaway. What you choose to do with that discounted price is up to you.