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Big Pharma


Crip1
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Several years ago, Big Pharma was a great way to make some money. This determination on both a macro and a micro perspective. Looking at it macro, the factors included an aging of the US population (my parents and in-laws almost need a separate "pill suitcase" when they travel), further standard of living increases in developing countries (such that these folks can afford more pills than they could previously) and that, in many instances, HMOs were driving their customers to pharma-based treatments rather than procedure-based treatments due to cost-effectiveness. From a micro perspective, the growth rates were significant and P/E's were reasonable....all were throwing of cash and all seemed good with the world. Once the growth rates declined, share prices declined...in some cases significantly.

 

Looking at the situation now, the US population is continuing to age and the standard of living in developing countries is continuing to rise. Growth rates are low as are P/E's, but a lot of smart people have been adding to their Pharma Holdings:

 

Bruce Berkowitz has 18+% of his portfolio in PFE

Warren Buffett has almosst 5% of his portfolio in JNJ

Prem Watsa has over 8% of his portfolio in JNJ

Irving Kahn has close to 11% of his portfolio in SGP

Irving Kahn has 9+% of his portfolio in BMY

 

It would be interesting to note opinions on this sector...

 

-Crip

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I apologize in advance for the long post.

 

I think now is the time to buy into big pharma and lock your shares away for a decade or two.  I like both PFE and SNY, with PFE being my favorite of the two.  In fact, I think Berkowitz's position in PFE will one day be seen as similar to Buffett's purchase of KO in 1988.  I would encourage everyone to listen to the Fairholme Fund conference call with Jeffrey Kindler, CEO of Pfizer, in addition to the other standard research one would do on these companies.

 

Below is why I think that PFE and SNY will be great businesses to own for the long run.  Disclosure: I own both PFE and SNY, as well as FAIRX.

 

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Free cash flow machines:  These companies generate huge amounts of free cash flow and currently have FCF yields of well over 10%.  Granted, it's difficult to determine exactly what is truly FCF (owner earnings) because big pharma must acquire businesses and IP in addition to doing JVs and conducting their own R&D to maintain their current level of earnings.  Still, the standard calculation of FCF (cash from operations minus capex) is a decent approximation of owner earnings, in my opinion.

 

Patent expirations' effects on FCF are both overblown and more than reflected in current prices.  You have to keep in mind that the earnings streams from off patent products will no longer be given away, since big pharma is now going to get into the "branded generics" business (more on branded generics below).  Furthermore, these companies have so much cash on their balance sheets, it's likely that the reduction in FCF that comes with major patent expiration will be made up by their reinvestment efforts fairly soon after expiration.

 

High ROIC/ROE: Big pharma, which is better run today than it used to be, has excellent returns on the capital that is reinvested into the businesses.  These companies are high return on equity businesses with intangible assets making up a large part of their balance sheets.

 

Excellent balance sheets: Big pharma has very solid balance sheets compared to many other industries.  In fact, the combined Pfizer and Wyeth will probably return to AAA status after a few years of paying off debt.

 

Health care reform:  Contrary to what many people seem to believe, health care reform will probably leave big pharma no worse off than they currently are and might actually increase their profits over the long run. 

 

How could pharma benefit from health care reform?  First, any pricing pressure put on pharma by the government will be mitigated by an increased number of people who were formerly uninsured being able to purchase their products.  Second, by collaborating with the government on health care reform, they are likely setting the stage for cooperation with the government to ensure that they get a "fair" price for their products.  From the NY Times on Aug 5: "Pressed by industry lobbyists, White House officials on Wednesday assured drug makers that the administration stood by a behind-the-scenes deal to block any Congressional effort to extract cost savings from them beyond an agreed-upon $80 billion."  Third, by collaborating with the government, they appear to have extracted greater patent protection for biologics versus simple molecule drugs, and most people would agree that biologics are really the wave of the future.

 

If big pharma truly were hurt by health care reform as proposed, they would not be joining with SEIU and other advocacy groups to tout health care reform on TV.

 

"Branded generics":  Big pharma is no longer going to give away the income stream associated with products that go off patent to the major generic manufacturers.  They will go the JNJ route and extract royalties from off patent drug products by selling them as branded/authorized products.  Plenty of people will forgo generic Lipitor, for example, if they can get the real deal for just a few bucks more.  This will especially be the case in emerging markets, where regulatory enforcement of manufacturing standards isn't as rigorous as in the U.S.  If I'm a middle class engineer in India with heart problems, I might feel better knowing that Pfizer has checked up on the authorized Indian generics manufacturer's production standards for Lipitor.

 

SNY is purchasing generics manufacturers in emerging markets.  PFE is partnering with generics manufacturers in emerging markets.  It's very much like the decision for beverage companies to purchase their own bottlers.  Pepsi has decided to buy a major bottler as a low risk way to get a decent return on their free cash.  Coke says no, we'd rather use our money to buy new beverage products.  Coke's approach is riskier, but has a potentially higher return.  Same with SNY and PFE.  PFE thinks it'll earn a better return investing its FCF into finding new drugs, biologics, and vaccines.

 

Expanding markets: As we see the "rise of the rest," more and more people who could never afford drugs will become potential customers.  This is already happening in the BRIC markets and will continue to be the case as emerging markets gets richer over time.  The market for the next Lipitor is much greater today than it was when the original Lipitor first came out.  And PFE will have an even bigger amount of potential customers to sell to when Lipitor v. 10.0 comes out 20 years from now. 

 

Note that big pharma's customer base will expand over time without their having to do anything.  Same amount of R&D for a product but much greater potential for sales.

 

Pharmaceutical/biologics merchant banks:  Berkowitz has mentioned that he believes that Pfizer is very much like Exxon in that it will become a "merchant bank" for the pharmaceutical industry.  What I think he means is that Pfizer will increasingly be partnering with smaller outfits who need cash to come up with new drugs, biologics, and vaccines.  In a way, PFE and SNY will become venture capital funds dedicated to new drug discovery.  They will own equity stakes in a number of small firms but go further than mere VCs in helping these companies with distribution if their drugs succeed.  The distribution of drug products is highly regulated and this creates a barrier to entry that benefits the big dogs like PFE and SNY.

 

Foreign currency earnings: If you are in the U.S. and you are worried about the dollar depreciating relative to other currencies (especially emerging market currencies), you want to be in companies like PFE and SNY that generate earnings abroad.  Over the long run, business done abroad will make up a much greater share of the revenue than business done in the U.S. and U.S. shareholders will benefit from having earnings in a basket of foreign currencies. 

 

Low tax rates:  Effective tax rates for big pharma are much lower than for other big industries because they do a lot of manufacturing outside of the U.S. in low tax localities.  Furthermore, pharma doesn't usually have to repatriate money to the U.S. (except when they are doing major acquisitions) and pay the full U.S. corporate tax rate.

 

Dividend distribution: On top of everything else I've noted above, big pharma is good about returning cash to shareholders.  This will continue to be the case over the long run except when cash is needed for M&A.

 

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So that's why I think PFE and SNY are fat pitch investments at this time.

 

 

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Regarding off-patent products and Pfizer, I've heard more about that topic from Berkowitz than from the Pfizer team. I also got the impression that Fairholme had been caught off guard by the Wyeth deal.

 

Have you heard anything from management to suggest a focus on off-patent branding? The conference call with Berkowitz seemed to focus more upon purchasing late stage products with a reduced emphasis on early stage research.

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Regarding off-patent products and Pfizer, I've heard more about that topic from Berkowitz than from the Pfizer team. I also got the impression that Fairholme had been caught off guard by the Wyeth deal.

 

Have you heard anything from management to suggest a focus on off-patent branding? The conference call with Berkowitz seemed to focus more upon purchasing late stage products with a reduced emphasis on early stage research.

 

Yeah, I found the Wyeth deal to be sort of counter to the vision Berkowitz had for Pfizer. It seemed like he was looking for them to do small nuts and bolts acquisitions rather than a huge deal like Wyeth which may be more difficult to close.

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Regarding off-patent products and Pfizer, I've heard more about that topic from Berkowitz than from the Pfizer team. I also got the impression that Fairholme had been caught off guard by the Wyeth deal.

 

Have you heard anything from management to suggest a focus on off-patent branding? The conference call with Berkowitz seemed to focus more upon purchasing late stage products with a reduced emphasis on early stage research.

 

Yeah, I found the Wyeth deal to be sort of counter to the vision Berkowitz had for Pfizer. It seemed like he was looking for them to do small nuts and bolts acquisitions rather than a huge deal like Wyeth which may be more difficult to close.

 

It's been a while since I've listened to the Fairholme call, and I can't remember if Kindler addressed "branded generics" at any length there.  However, PFE has definitely taken the right steps to increase its presence in the branded generics market.  It has made several announcements about deals intended to increase this business.  PFE also has a newsroom page dedicated to the subject that you can check out if you'd like.

 

See http://www.pfizer.com/news/press_kits/established_products_fact_sheet.jsp ;

http://www.pfizer.com/news/press_releases/pfizer_press_releases.jsp?rssUrl=http://mediaroom.pfizer.com/portal/site/pfizer/index.jsp?ndmViewId=news_view&ndmConfigId=1016273&newsId=20090520005604&newsLang=en )

 

Of course, growth going foward after the Wyeth deal is going to depend on acquisitions and JVs, so that's probably why they've been placing an emphasis on that.

 

You might be right about the Wyeth deal catching Berkowitz off guard.  He definitely indicated before the deal was announced that he thought that Pfizer going at it alone would be a great place to be in going forward.  But I think that's exactly why he brought Kindler onto a special conference call -- to allay his and his shareholders' fears that the Wyeth deal would destroy the thesis on PFE.

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Sorry, but for the small investor, these companies are still overvalued from the standpoint of dividends, which is the bottom line for such investors. They lack other characteristics that would indicate a commitment to shareholders, such as large insider ownership (they are just too big and have a float that is too large).  Worst of all, they have become sales and marketing organizations rather than innovators, having exhausted their longstanding paradigm for developing breakthrough treatments.  They now invent variations of diseases to fit the replacement drugs that they have developed rather than to address longstanding diseases and conditions. Instead they must attempt to purchase innovative companies in order to develop such drugs. Even then the capitalization is so large that highly successful drugs might have minimal effects on the bottom line.

 

For the small investor, a broad based index fund is superior, avoiding the risks of owning equities of individual companies that are too big and whose stocks are too expensive to offer superior performance anyway.

 

Good luck,

Tex

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Sorry, but for the small investor, these companies are still overvalued from the standpoint of dividends, which is the bottom line for such investors.

 

I'm not sure what you mean by being overvalued from the standpoint of dividends.  If you mean that the dividends aren't high enough, I guess that makes a difference for some small investors but certainly not for all small investors.  Regardless, the dividend yield doesn't usually have a bearing on whether a company is overvalued.  It does have an effect on the company's balance sheet, however.  And it seems very prudent in PFE's case to have cut the dividend prior to the merger.

 

Worst of all, they have become sales and marketing organizations rather than innovators, having exhausted their longstanding paradigm for developing breakthrough treatments.  They now invent variations of diseases to fit the replacement drugs that they have developed rather than to address longstanding diseases and conditions. Instead they must attempt to purchase innovative companies in order to develop such drugs. Even then the capitalization is so large that highly successful drugs might have minimal effects on the bottom line.

 

It's true that these companies focus a lot on sales and marketing, definitely too much from society's perspective.  And I sympathize with the notion that they have put a disproportionate emphasis on certain conditions that really aren't a big deal compared to some of the important maladies out there that must be addressed.  But it's not like these companies are completely failing to innovate.  Take a look at Pfizer's pipeline.  They are really focusing a lot on some important diseases.  The number of oncological treatments in the pipeline seems particularly noteworthy. 

 

Additionally, it's almost always the case that when technology-oriented companies become large/megacap companies, they must start forming joint ventures and acquiring other companies to find something to do with the large amounts of cash they generate.  Google and Microsoft, both highly innovative high tech companies, also engage in M&A and venture funding because of their size.  You can't necessarily build everything in-house.  In big pharma's case, it might actually be a good thing for them to focus on providing funds to a number of smaller companies who are potentially onto discovering new, worthwhile drugs rather than giving all that money to their own internal R&D departments. 

 

For the small investor, a broad based index fund is superior, avoiding the risks of owning equities of individual companies that are too big and whose stocks are too expensive to offer superior performance anyway.

 

 

I assume you're talking about an index fund focused on pharmaceutical and biotech companies?  That's not at all a bad approach.  I just think that both PFE and SNY are, in fact, undervalued and are taking the right steps to help distinguish themselves from their big pharma brethren.  I completely disagree with the notion that either PFE and SNY are expensive. 

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Thank you for a very thoughtful and tolerant post. Your point of view is certainly reasonable and very even-handed. You have thought a lot more about this than I have and are more likely to be correct in your expectations.

 

For what it might be worth, let me expand briefly: After a lot of reflection, I realized (or at least believe) that the small shareholder has little to show for his investment unless he receives dividends or trades on some reasonable time scale.  The latter requires some skill and discipline, as well a detailed knowledge of the company's situation in near real time.  However, most very large companies are opaque, even to the professional.  I believe that this is the source of Ben Graham's difficulty with developing an objective valuation measure (like a central value equation).  Mere numbers like earnings, P/E, sales, ROE, free cash flow are useful, but cannot tell us how well the management is using the cash. Further, the small investor has no influence over almost any reasonable sized company, while accepting the full risk associated with bankruptcy, etc. Since the CEOs and boards are also composed of humans, they can make silly mistakes with the cash. I prefer folks like the Leucadia guys, who recognize when they have too much cash to invest efficiently and return it to the shareholders, so that the latter can actually manage the money, as part-owners would.

 

The big pharma sector has represented a value investing dilemma (cf. Graham and others), in that the P/E is almost always very high relative to the rest of the market. One does not achieve value investing nirvana unless the P/E is well below the average S&P P/E of around 14.  So by standard value investing measures (e.g., P/E) one should not be investing in these things.  If Berkowitz is trading from the market low of March, then big pharma is fine, but I cannot see holding these things for a long time.

 

Every time that I heard about a new drug and saw estimates of its future sales, the numbers seemed too small to have much of an effect on the company.  So I could not see the big payoff, even when the pipeline was successful.  Admittedly, I do not enjoy (and lack competence for) reading medical research articles nor assessing for myself the impact of various developments on the pharmaceutical companies and medical patients, so I have stayed away from them. What I have seen over the last ten years tells me that genetic science and related basic biochemical research will likely provide the breakthroughs that society is seeking. In this regard, the most important thing that the new Administration can do is to unleash the forces of research that have been restrained over the last 8 years. What has become painfully clear is that engineering (to develop new technologies) cannot be successful without the underlying knowledge base that research provides. With the required knowledge base, the big pharma companies can then develop new applications from the research results and everyone can prosper. Meanwhile, I expect small incremental steps from the types of drugs that were developed in the past and are still be developed presently.  This of course is just an opinion from a relatively disinterested observer, but lies at the base of my disinterest.

 

Thanks again and best wishes for the future.

Tex

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This OID interview with Berkowitz/Fernandez has a substantial portion devoted to their reasons for liking Pfizer:

 

http://www.fairholmefunds.com/3-17-2009.pdf

 

One point that wasn't brought up much above that I would add is their distribution system. A huge distribution system is non-trivial moat.

 

Also, if you listen to the call Bekowitz set up with Kindler, one of the other things I like is the way they are doing the re-orgs wrt how folks are compensated. You can't put a number on those things but anyone who's worked in an organization where people are compensated on patents filed vs. P&L will know what a huge difference that makes to how work is approached. Like Munger says, incentives are an extremely powerful force -- and it seem like they are lining up the incentive systems correctly.

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This OID interview with Berkowitz/Fernandez has a substantial portion devoted to their reasons for liking Pfizer:

 

http://www.fairholmefunds.com/3-17-2009.pdf

 

 

The OID interview actually addresses one of the questions asked above about a lack of discussion about generics by Pfizer management.  Berkowitz mentions that Kindler knows that PFE gave away a lot of the generics business and that he is being diplomatic in discussing this aspect of their strategy going forward.  I guess that's a partial explanation of why management may not be as vocal about the generics business as they could be.

 

By the way, Charles Fernandez used to be an exec at IVAX, which was bought out by Teva.  So we can safely assume that Berkowitz's assumptions about the generics business are well informed.

 

 

One point that wasn't brought up much above that I would add is their distribution system. A huge distribution system is non-trivial moat.

 

 

Very true.  That's another reason why Berkowitz believes that Pfizer will be an ideal partner for smaller drug companies with good prospects for their molecules.  He also applies the distribution partner thesis to his stake in Forest Laboratories (FRX).

 

 

Also, if you listen to the call Bekowitz set up with Kindler, one of the other things I like is the way they are doing the re-orgs wrt how folks are compensated. You can't put a number on those things but anyone who's worked in an organization where people are compensated on patents filed vs. P&L will know what a huge difference that makes to how work is approached. Like Munger says, incentives are an extremely powerful force -- and it seem like they are lining up the incentive systems correctly.

 

Great point!  Totally forgot about this part of the conference call.

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