Pfizer (PFE): Safe and Steady Dividends

Pfizer (PFE) is a blue-chip dividend stock that has paid a consistent dividend for multiple decades.

 

Furthermore, over the last 20 years the total dividends paid per share has increased at a nearly 10% compound annual growth rate (CAGR).

 

In recent years, however, Pfizer’s total dividend growth rate has slowed and the payout ratio is now over 90%.

 

Should investors be concerned that this global pharmaceutical giant’s best days are behind it or, worse, that another dividend cut could be forthcoming?

 

Let’s start with a look at the business.

 

Business Analysis

Pfizer was incorporated in 1942 and today is a global biopharmaceutical company with operations all across the globe. Their portfolio of products includes mainly medicines and vaccines.

 

The company has engaged in significant merger and acquisition activity over the years and has even increased its appetite more recently.

 

In November 2015, Pfizer announced a merger with Allergan, another global pharmaceutical company. However, the deal was scrapped after the U.S Treasury unveiled new rules to curb tax inversion deals.

 

One recent mega deal Pfizer did execute was its acquisition of Hospira for $15.7 billion, which closed in the summer of 2015. Hospira is one of the leading providers of sterile injectable drugs and infusion technologies.

 

Overall, Pfizer is one of the largest pharmaceutical companies in the world, generating revenues of nearly $49 billion and spending $7.7 billion on research and development in 2015.

 

They operate the business through three reporting segments: the Global Innovative Pharmaceutical segment (GIP); Global Vaccines, Oncology and Consumer Healthcare (VOC); and the Global Established Pharmaceutical segment (GEP).

 

The GIP business (29% of revenue) focuses on developing and commercializing medicines that improve patients’ lives. Key therapeutic areas include inflammation/immunology, cardiovascular/metabolic, neuroscience/pain and rare diseases.

 

The VOC business (26% of revenue) focuses on the development and commercialization of vaccines and products for oncology and consumer healthcare.

 

The GEP business (44% of revenue) includes legacy brands that have lost or will soon lose market exclusivity in both developed and emerging markets, branded generics, generic sterile injectable products, biosimilars and infusion systems.

 

Overall, Pfizer had 8 therapeutics or family of therapeutics that contributed over a billion dollars to 2015 revenues, while their top ten accounted for around 47% of total revenue. Their top therapeutics are some that consumers might recognize, such as Lyrica and Viagra, but also include relatively new therapeutics as well.

 

Pfizer’s largest therapeutics in 2015 were Lyrica (Epilepsy), Enbrel (arthritis), Viagra (Erectile dysfunction), the Prevnar family of therapeutics (pneumococcal vaccines), Sutent (various carcinomas), Lipitor (cholesterol), and the Premarin family (menopause).

 

Pfizer had significant revenue concentration in these products in 2015, including 13% of revenue in the Prevnar family, 10% in Lyrical, 7% in Enbrel, 3.8% in Lipitor, 3.5% in Viagra, 2.3% in Sutent, and 2% in the Premarin family.

 

There are many positive characteristics in investing in a pharmaceutical company, including recession resistant products, but investors really need to be aware of patent expirations on any of the therapeutics in the portfolio.

 

Some more recent exclusivity losses on major products include Lyrica in July 2014 in major European markets, Enbrel in the summer of 2015 in Japanese and European markets and with US exclusivity ending in December 2016, and Zyvox in 2015 in the US and January of 2016 in major European markets.

 

Pfizer’s strategy for building the pipeline of new therapeutics is through M&A and internal R&D investment. This is critical for the company’s future growth.

 

As of February 2016, they had a number of projects in different R&D stages. They had 34 discovery projects in Phase 1, 18 in Phase 2, 30 in Phase 3, and 8 in Registration.

 

Furthermore, Pfizer has executed a couple of very large transactions recently to rebuild the pipeline. In addition to the 2015 Hospira deal, so far in 2016 they have executed two large deals to obtain potentially blockbuster therapeutics.

 

In May of 2016, Pfizer announced that they will acquire Anacor Pharmaceuticals for a total transaction value of $5.2 billion, assuming conversion of outstanding convertible notes.

 

Anacor’s main commercial product is Kerydin, a toenail-fungus ointment, but Pfizer seems to be more excited about eczema treatment crisaborole. Pfizer estimates that crisaborole could reach peak sales of $2 billion.

 

In addition to the Anacor deal, Pfizer is set to acquire Medivation for $14 billion. Medivation is a biotech company whose only product is prostate cancer medication Xtandi. Xtandi’s growth potential was the main rational behind the deal as it is growing rapidly and even being tested for other applications including breast cancer.

 

Furthermore, Medivation has a few later stage pipeline therapeutics, talazoparib and pidilizumab, that could turn into blockbusters as well.

 

Talazoparib is a phase 3 breast cancer drug and pidilizumab is being tested to treat lymphoma.

 

All in all, Pfizer appears to be recovering well from the patent cliff a few years back by investing significant capital in R&D and acquisitions to rebuild the pipeline.

 

As long as management has allocated capital well by conducting in-depth market research and due diligence, the business should begin to return to organic growth after years of struggling.

 

 

Dividend Safety Analysis: Pfizer

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Exxon’s dividend and fundamental data charts can all be seen by clicking here.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Pfizer’s Dividend Safety Score is 67, which indicates that the dividend is secure and much safer than the average dividend paying stock in the market. The key drivers of the company’s solid Dividend Safety Score include a conservative FCF payout ratio, a recession-resistant business model, and a healthy balance sheet.

 

While the earnings per share (EPS) payout ratio is very high and could be interpreted as signaling danger, the free cash flow payout ratio, which is a better indicator of Pfizer’s ability to pay dividends given the non-cash expenses it recorded in 2015, is healthy and more consistent with historical levels.

 

 

Currently, analysts expect Pfizer to generate EPS of $2.46 for 2016, and we expect Pfizer to pay out about $1.20 in dividends. This implies a payout ratio of about 49%, which is more in line with the historical free cash flow payout ratio.

 

Furthermore, Pfizer’s free cash flow payout ratio of 55% over the last 12 months is more or less right in line with other global pharmaceutical peers including Merck (46%) and Lilly (normalized in 40% range).

 

Another key business characteristic that leads to Pfizer’s safe dividend is its recession resistant business model. While it can be very expensive to internally research, develop, run clinical trials, and ultimately commercialize a new drug, they can enjoy years of monopoly status with a product that should have extremely stable to growing demand.

 

This dynamic leads to a very stable margin structure and predictable cash flow to fund the dividend.

 

 

The last key component driving a better than average Dividend Safety Score is Pfizer’s solid balance sheet. As of July 3rd, Pfizer had cash and short-term investments of nearly $21 billion on the balance sheet.

 

To illustrate how large this is relative to the dividend, they could continue to fund the dividend at the 2016 run rate of roughly $7.35 billion for nearly three years with this cash.

 

Offsetting the cash is gross debt of around $44 billion dollars. This implies they had net debt of about $23 billion dollars and a very safe net debt/EBIT (earnings before interest and taxes) ratio of 0.8x.

 

However, the Medivation acquisition occurred after the end of the second quarter, so the balance sheet doesn’t reflect its impact. Management plans to finance the $14 billion transaction through cash on hand. This lowers Pfizer’s cash from roughly $21 billion to around $7 billion.

 

Even when making the adjustments for the acquisition, Pfizer’s balance sheet is still very strong and should not be a source of risk for a dividend cut. The company also maintains solid investment-grade credit ratings on its debt.

 

Overall, dividend investors should sleep well at night knowing that Pfizer has relatively modest payout ratios, a very stable business model serving non-cyclical end markets, and a healthy balance sheet.

 

Nevertheless, it is conceivable (albeit very unlikely) that a repeat of the 2009 dividend cut could happen again where the quarterly dividend payout was reduced substantially.

 

 

In early 2009, Pfizer announced that it was acquiring its U.S. rival Wyeth for roughly $68 billion dollars. The strategic rationale for the deal was to help Pfizer offset the expected revenue decline from the upcoming patent cliff in 2011, which included the blockbuster drug Lipitor.

 

Dividend cuts like this are difficult to predict because it has to do with management’s capital allocation decisions rather than the underlying payout ratios, business fundamentals, and balance sheet.

 

With that said, astute investors could have anticipated management’s decision by understanding that the company would need to make a large acquisition to insulate itself from the patent cliff.

 

Today’s situation isn’t as dire as it was back in 2009, and it looks like Pfizer has already made their large acquisitions to rebuild the pipeline and drive incremental growth.

 

Furthermore, Pfizer recently decided to not breakup into multiple companies and will continue to operate as one company.

 

While the future is unknowable and difficult to forecast, we would be surprised if management made a large capital allocation decision that would force a dividend cut.

 

Dividend Growth Analysis

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Pfizer’s Dividend Growth Score is 52, which indicates that Pfizer has about average dividend growth potential.

 

While not a dividend aristocrat, long-term investors have been handsomely rewarded from holding Pfizer stock even despite the 2009 cut.

 

The dividend has increased at nearly a 10% CAGR over the last 20 years and a 4% CAGR over the last 10 years, which still easily outpaces inflation.

 

 

Unlike some other global pharmaceutical executives such as Eli Lilly (see our analysis of Lilly here), Pfizer’s management team doesn’t talk about their expectations for dividend increases. However, they still do have a focus on making sure they have an appropriate capital return strategy that includes dividends.

 

Ian Read, Pfizer’s Chairman and CEO, discussed his view on the second quarter earnings call on managing the company’s cash flows in the event they chose to split up the company (which they elected not to do):

“And clearly if you’re in two distinct divisions, you don’t have the same opportunities of deployment of cash, if you’re in two companies as you do if you’re one. You have less choices as to in which areas you put it. When you’re one company, you can take those cash flows, return them to shareholders, continue to invest in the area of business, pay your dividend, or do business development in the essential business.”

Source: Seeking Alpha

So while the management team doesn’t openly discuss their expectations for dividend increases, the dividend is top of mind when thinking about allocating the company’s cash flow.

 

Given the variety of factors impacting the business, it is very difficult to forecast an accurate dividend growth rate on a go forward basis. With that said, we can look at a few areas to give us a better idea of what a ballpark growth rate could look like.

 

If the recent past is any indicator, then investors can expect the dividend to grow in the high single digits, similar to the past three years of growth.

 

Furthermore, current consensus EPS forecasts project annual earnings growth of 7-8% over the next couple of years (not including the Medivation acquisition). If Pfizer maintains the current payout ratio in line with the peers, then it seems reasonable to expect the dividend to grow in proportion to the EPS growth.

 

Considering all of these factors, over the next few year investors should expect the dividend to outpace inflation at a minimum with additional upside if key therapeutics in the pipeline prove to be successful.

 

Valuation

Pfizer currently trades at around 13.4x 2016 earnings estimates and offers a 3.6% dividend yield, which is slightly higher than the stock’s five-year average dividend yield of 3.4%.

 

The business is very stable given the recession-resistant nature of Pfizer’s end markets. However, the business has two main risks associated with it.

 

The first risk is that they can’t internally develop enough new drugs to offset the recent and upcoming patent expirations in their current portfolio.

 

Secondly, they have made a number of acquisitions at large premiums to try to replenish the pipeline. If the drugs they acquire in these acquisitions are not a success, then they will have impaired a significant amount of capital while not doing anything to improve the business. We think this is a low probability event and, in all likelihood, the business should be able to perform well.

 

Given the reasonable P/E ratio and anticipated growth, Pfizer investors could be poised to generate a high-single digit to low-double digit annual total return.

 

Conclusion

Pfizer is one of the largest global pharmaceutical companies in the world with numerous blockbuster therapeutics rounding out their diversified portfolio.

 

However, the company does face real challenges with generic competition to some of their blockbuster drugs. To combat these challenges, Pfizer is restocking the pipeline through internal investment and a couple recent major acquisitions.

 

Overall, Pfizer seems like a good company to consider for investors living off dividends in retirement. The company has a good balance sheet, enjoys a business model that performs well in all economic environments, generates plenty of free cash flow to cover the dividend, and offers a 3.6% dividend yield, which is nearly twice as high as the overall market’s yield.