Pfizer Can Add 5%-10% Value By Streamlining Its R&D Spending

+3.20%
Upside
27.72
Market
28.61
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PFE: Pfizer logo
PFE
Pfizer

Pfizer (NYSE:PFE) is known for its financial discipline, but its adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) plummeted by roughly 17% in 2014 despite only 3.8% decline in revenues. This can be attributed to lower gross margins, higher administrative and marketing expenses, and most importantly, a big jump in research and development spending. This is slightly at odds with what one would expect given the company’s restructuring program to streamline investment. However, some additional spending related to certain drugs in phase 3 trials (which tend to be the most expensive) and the deal with Merck KGaA weighed on the company’s profits. Under the terms of the deal, Pfizer made an upfront payment of $850 million to Merck KGaA, and promised additional payment of up to $2 billion contingent on regulatory and commercial milestones. [1] The key question is, given the recent pressure on profits, was this increase in R&D spending justified? We believe so. Phase 3 drugs have strong probability of getting through to approval, and the deal with Merck focuses on a very promising area of immuno-oncology. Pfizer needs to boost its pipeline considering the large number of its drugs are facing strong competition. The next year will be different as the company intends to reduce its R&D spending. We expect the figure to be around $7.2 billion (19% of gross profits) as compared to $8.4 billion in 2014. This implies that there may not be any big deals such as the one with Merck KGaA, and we expect the company to cut back on some of its R&D staff as it continues its restructuring program. If the company can reduce its R&D expenses to around 16% of gross profits, while not sacrificing on its capability to launch new drugs, our price estimate can see an upside of 5%-10%. This is going to be a difficult task but focus on certain key segments will be critical to this success.

Our price estimate for Pfizer stands at $35, implying a slight premium to the market.

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See our complete analysis for Pfizer

Besides streamlining R&D investments, Pfizer is likely to adopt other measures to boost its earnings.  For instance, it may still be interested in tax inversion deals, even though the prospect has become less attractive with the recent amendment to the U.S. tax laws. However, it will need to acquire a much bigger target for the deal to make sense. Tax savings and effective deployment of foreign held cash will make the company more competitive globally. The U.S. government is pushing for a bill that will levy one time tax on foreign cash holdings of U.S.  corporations. Even though the bill may not be passed anytime soon, we believe Pfizer is likely to make use of its foreign cash reserves by funding acquisitions before such bill becomes a law. In other words, we believe that one of the likely courses for Pfizer could be to spin off its global established products and go for a big acquisition that bolsters its oncology and vaccine pipeline.

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Notes:
  1. Pfizer, Germany’s Merck to Develop Tumor Treatment, The Wall Street Journal, Nov 17 2014 []