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Old 01-11-2008, 03:10 PM
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Default Pfizer's Low Price, High R&D a Proven Formula

Pfizer's Low Price, High R&D a Proven Formula (Pfizer, AstraZeneca, Eli Lilly) |

PFIZER (PFE: 24.05, -0.03, -0.12%) shares haven't looked so loathed or so appealing in more than 15 years. They go for just 10 times forecast 2008 earnings. That's a discount of about 35% to the broad market and 45% to other big drug makers. The stock comes with a 5.5% dividend yield backed up by $22 billion in cash and equivalents and free cash flow of more than $10 billion over the past year.

Or course, stocks become cheap for a reason. Pfizer's reason is a rather worrisome one. The world's second-largest drug maker by sales is struggling to bring new drugs to market. In December 2006 the company discontinued development of its most promising compound, torceptrapib. It raises the blood level of high-density lipoprotein, the so-called good cholesterol, but was linked with an unusually high number of deaths in trials. In its last quarter Pfizer took a $2.8 billion charge to walk away from Exubera, insulin delivered by inhaler instead of injection. The decision seems to have been based on disappointing sales rather than health effects. Exubera was approved in January 2006 and was forecast to produce annual sales of $1 billion to $4 billion. It brought in just $12 million during the first nine months of 2007.

The need for new drugs is urgent. Pfizer's best-selling medicine, the cholesterol fighter Lipitor, brings in more than a quarter of overall sales and loses its patent protection in 2011. Other former bestsellers like Zoloft for depression and Norvasc for high blood pressure are already losing ground to generic competitors. Last month researchers raised questions about whether Champix, a new pill to aid smokers in quitting, causes nightmares and suicidal thoughts, and whether Sutent, for kidney and stomach cancer, causes high blood pressure and heart failure.

All told, Pfizer's sales are believed to have dipped 1% last year and are forecast to decline another 1% this year, to $47.1 billion.

Pfizer isn't the only drug maker with pipeline problems. Last year the Food and Drug Administration approved just 16 first-of-a-kind drugs, a 20-year low. The problem seems related to the limits of chemistry. Researchers say those squares on the periodic table of elements can only be combined into so many compounds, and that drug makers have exhausted the most promising possibilities. Companies like Pfizer have laid off thousands of chemists over the past year. Instead, they're turning to biologists for drug development. Biotechnology involves the use of living organisms rather than chemicals to make medicines.

All those job cuts have been a silver lining for Pfizer. While sales are slipping, earnings per share increased 4% last year, and are expected to improve 9% this year. That's partly the result of cost-cutting measures and partly the effect of share repurchases. During the first three quarters of 2007 Pfizer spent $4.5 billion on its own shares, nearly as much as it spent on that generous dividend. The company seems to be deploying its resources profitably. Last year its return on equity totaled an estimated 21%, compared with a median of 17% for the S&P 500 index. This year it's expected to increase to 23%.

While Pfizer's pipeline is weak, it's not empty. There are eight molecules presently in so-called Phase III, or final, clinical trials. Four of these are new uses for existing medicines. The company is widely expected to use its cash stockpile to purchase developmental drugs or entire companies in the coming years. And the stock turned up recently in a search for big drug makers that spent more money on research and development over the past year than they had the year before, and that carry "price/R&D ratios" of below 20. Normally investors look for earnings growth and low price/earnings ratios to find promising stocks, but for drug and technology companies, research spending may be thought of as earnings that have yet to materialize. Studies have shown a strong link between stock performance and both low P/R&D ratios and increased R&D spending. (More on the strategy here.)

Two other drug makers turned up on the search: AstraZeneca (AZN: 45.37, +0.41, +0.91%) and Eli Lilly (LLY: 56.97, +0.12, +0.21%). Pfizer has the lowest P/E ratio and the biggest dividend yield. Use SmartMoney's stock screener anytime to create your own list of low P/R&D stocks.

Jack Hough is associate editor at and the author of "Your Next Great Stock."
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