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The big news hitting Big Pharma is the $160 billion merger of Allergan (NYSE: AGN) and Pfizer (NYSE: PFE). This is a great move for Pfizer and its shareholders.
Pfizer has become a moribund company with flat-to-negative earnings growth. Its balance sheet and cash flow have been fantastic, though. Pfizer’s $36 billion in cash and investments offset by $33 billion in debt is giving the company plenty of leeway financially. Meanwhile, Pfizer generates over $15 billion in free cash flow every year, and only pays out about 40% of it as its 3.42% yield.
Allergan has to like the deal, also. Allergan’s $12 billion in cash and investments and $4 billion in free cash flow are its good news, although the company is weighed down by $41.4 billion in debt, on which it is paying almost 10% interest. Allergan also has a really broad set of pharma products.
Now there’s talk of splitting this merged behemoth into two companies. One would focus on newer drugs such as Botox and Prevnar, while the other would contain older drugs such as Lipitor. Does it make sense to split at all? If so, should investors hold both companies, or should one be discarded in favor of the other?
Why a Pfizer Split Makes Sense
First, I think a Pfizer split is a good idea simply because the whole Allergan-Pfizer package is going to be tough to manage. There will also be savings in overlap. It would also give investors a choice between going for more established pharma business without the risk of innovative drugs. On the other hand, if combined, then you have a diversified entity. In that case, you want to hold both.
Now, let’s look at why a split makes more sense. Pfizer’s stock-and-trade is research and development. It develops new drugs. That can mean big money for big new drugs, but it also means big expenses that would suck out profit from Allergan’s established business in generics.
The generics business and slow-growth pharma would be a reliable company that would probably pay a nice dividend. These would include off-patent drugs like Celebrex, Teflaro, and Lipitor. The innovation company would have more potential for straight-up capital appreciation, as newer drugs like Ibrance and Botox will provide robust revenue, thus giving investors a choice of owning one, the other, or both.
Combined, the company will generate $63 billion in annual sales, about two-thirds of which comes from Pfizer. But it will also run up $9 billion in R&D costs.
Beyond the Pfizer Deal
I would think that conservative and retired investors might want to stick with the older drugs and generics entity. Younger, patient investors who want that chance for capital appreciation might choose the other, or own both for the sake of diversification.
Is there an even better move? Can investors choose a whole other approach? Personally, if you want an alternative to the conservative play mentioned above, then think about Novartis (NYSE: NVS). Just like pre-merger Pfizer, it isn’t growing EPS, but it has $12 billion of free cash flow and pays out 58% of it as a 3.13% dividend.
Alternatively, if you want the high-growth option, consider th First Trust NYSE Arca Biotech ETF (NYSEArca: FBT).
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