The investment thesis
The thesis here is really simple. Pfizer (NYSE: PFE) is currently trading at a discount of around 10% to its fair value. Yet at the same time:
- It enjoys a wide moat thanks to its technological lead, scale, intellectual property and strong pipeline.
- It generates a very competitive return on capital employed (“ROCE”) at a fundamental level. It boasts expanding margin, strong execution and superb financial strength. Its profitability is expected to further accelerate based on the DuPont framework.
- Moreover, in the short term, the investment is also supported by a few catalysts. Notably, COVID-19 related sales from Comirnaty and potentially Paxlovid could provide growth catalysts.
- Based on contracts Pfizer already has in place, the company is targeting $29 billion in Comirnaty sales in 2022. In early November, it announced positive trial results for its new COVID-19 pill Paxlovid. And Paxlovid has been approved for emergency use in the Philippines, Reuters reported citing the Asian country’s drug regulator in March 2022.
Note that this article will focus more on the process-level discussion of PFE’s operations, not its specific drug development projects. For discussions of its pipeline, interested readers can check out my previous post on PFE here.
The superb profitability of PFE
The following graph shows the profitability of PFE measured by the most fundamental measures: the return on capital employed (“ROCE”). Note that ROCE is different from return on equity (and more fundamental and important in my opinion). ROCE considers the return on capital ACTUALLY employed. It therefore provides essential insight into growth, as it shows the amount of additional capital a business needs to invest to earn a given additional income. For companies like PFE, I consider the following elements of capital actually employed: 1) Working capital, including payables, receivables, inventory; 2) Gross property, plant and equipment; and 3) R&D expenses are also capitalized.
Based on the above considerations, the ROCE of PFE over the past decade is shown below. As we can see, PFE has been able to maintain a remarkably high and stable ROCE over the long term: on average 44% over the last decade. To put things in perspective, the ROCE of the outperforming FAAMG group, calculated using the same method above, is “only” around 50% to 60% on average in recent years. Take Google (GOOG) (GOOGL) and Meta Platforms (FB) as two examples. Their ROCE in recent years has averaged around 55%.
Going forward, we expect all three fundamental drivers of profitability to continue to improve, especially post-breakup. These drivers are profit margin (“PM”), asset turnover ratio (“ATR”) and leverage. As detailed in my previous writings:
Through simple calculations, we can show that the ROCE is only the product of these three factors (the so-called DuPont equation), i.e.
ROCE = PM x ATR x leverage.
Where PM is defined here as operating income divided by total income, ATR is defined as total income divided by total assets, and leverage is defined as total assets divided by total capital employed . Note that I made the following changes so that DuPont’s equation can apply to modern businesses. I defined leverage as the ratio of total assets divided by total capital employed, instead of total assets divided by equity.
The reason for this is that many modern corporations have zero or negative equity, hence the traditional definition of leverage is not meaningful. Yet, regardless of the social capital in the accounting sense, a company always needs capital to make a profit. The new definition could be understood as effective leverage. It is a leverage effect on the company’s working capital (debts, receivables and inventories), on gross tangible fixed assets, etc. If these things represent equity in the accounting sense, then effective leverage will be the same as the traditional definition. Otherwise, effective leverage makes more sense.
With the above background, next we will look at these three drivers one by one.
PFE’s profitability levers
Based on the discussions above, the following three charts show the three buttons of PFE over the past decade. As the first graph shows, the profit margin has increased for PFE in recent years in terms of operating cash. It hovered around the ~32% level at the start of the decade and has extended to exceed 40% now. To better ground the discussion, consider that, on average, the profit margin for the entire economy fluctuates around 8% and rarely exceeds 10%. Of course, this is an average across all business sectors. Nevertheless, as a general rule, 10% is a very healthy profit margin and 20% is a very high profit margin. Thus, nearly 40% of the PFE is at the very high end of the economy as a whole.
The second graphic shows the ATR pilot. ATR measures how effectively a company uses its assets to generate revenue. The higher the ATR, the better the company’s performance, as higher ratios imply that the company generates more revenue per dollar of assets. As seen, PFE’s ATR has been remarkably consistent around an average of 0.29. And its current ATR is above the historical average by a good margin, demonstrating the solid execution of management.
In addition, the ATR is a button that the management can constantly modify according to its operations. And as mentioned above, I am optimistic that PFE’s many new initiatives can further improve its operational efficiency.
This third and final chart shows the effective leverage. As can be seen, the effective leverage of the PFE has also been fairly stable around an average of 4.6 over the past decade. Leverage fluctuated in a relatively narrow range between 4 and 6 most of the time, demonstrating its well-managed balance sheet and superb financial strength.
Projected profitability and projected returns
Now, with the above understanding of fundamental profit drivers, we make projections about future profitability and long-term returns. I’m optimistic that its current high level of ROCE will sustain for the long term as it is achieved by turning the right buttons (expanding margin and stable execution), not the wrong button (leverage). In fact, its current leverage has been lower than the historical average by a good margin.
For the next 3 to 5 years, an annual growth rate higher than single digits is also expected (close to 7.5%) given its strong ROCE. At 44% ROCE, a modest investment rate of 10% would be able to sustain an organic growth rate of 4.4%. Given PFE’s long-term pricing power, adding a conservative inflation index of 3% would achieve a growth rate of 7.5%. And the total return over the next 3-5 years is expected to be in the range of 21% (the low-end projection) to around 50% (the high-end projection), which translates to a very high annual total return. attractive up to the double digit figure.
Such a return is even more attractive when adjusted for risk. The company enjoys super financial strength (A++) and solid revenue consistency (“A”).
Investing in EFP also involves risks.
- In addition, current macroeconomic and geopolitical uncertainties may have an unpredictable impact on its operations. Many pharmaceutical companies (including PFE) will still supply drugs to Russia, but there are some negative impacts. For example, PFE CEO Albert Bourla said the company was stopping any further investment in Russia.
- Specific to PFE operations and drug development. In particular, its COVID-19 pill Paxlovid is still facing uncertainties and delays. Paxlovid is intended for home use. However, it is unlikely to be available to many people around the world for about a year due to regulatory and production issues.
Conclusion and final reflection
PFE uses different accounts for several good reasons:
- For long-term value investors, it generates a very competitive long-term return on capital employed (“ROCE”) and fundamental analysis from DuPont shows its potential to further extend ROCE. I’m optimistic that its current high level of ROCE will sustain for the long term as it is achieved by turning the right buttons (expanding margin and stable execution), not the wrong button (leverage).