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August 29, 2008 | By Ben McClure

There is no denying it; Pfizer (NYSE:PFE) faces a big problem. With Lipitor, its marquee cholesterol drug, coming off patent in 2011, the drug giant has just three years to replace more than a quarter of its total sales. Its drug development pipeline is a problem that investors cannot afford to ignore. Even so, given that the stock is trading below $20, I reckon there are good reasons for contrarians to consider a bet on the drug giant.

The Cash Keeps Flowing

Normally I don't put much stock in to comparisons of current and past prices, but Pfizer probably warrants an exception. At $19.18, Pfizer's share price isn't far off its 10-year low. The stock trades at just 14.3-times trailing earnings and just 7.6-times earnings for the coming year. As far as I can recollect, Pfizer's P/E has spent most of this decade so far in the 20s. Expectations for this company are pretty much as low as they can go.

Deeply discounted, the stock price doesn't account for the buckets of cash Pfizer produces. By my calculations, Pfizer had $14 billion in free cash flow after CAPEX. Even accounting for patent expirations and slowing sales, that suggests the stock is trading at a price-to-free cash multiple of less than 10. You will be hard pressed to find a multiple that low anywhere else in the pharma sector. Pfizer's restructuring program, expected to shave off $2 billion of annual costs by the end of 2008, could drive-up cash flow further even if revenues flat-line.

Pfizer's $1.28 dividend yields a whopping 7%, which ranks it at the top among its peers, including Merck (NYSE:MRK) at 4.2%, Bristol Meyers Squibb (NYSE:BMY) at 5.7%, GlaxoSmithKline (NYSE:GSK) at 4.4% and Eli Lilly (NYSE:LLY) at 4.0%. Pfizer should generate more than enough cash flow to sustain that attractive dividend over the next couple of years.

Pfizer is sitting pretty with $28 billion of net cash on its balance sheet. This is more than enough to support continued share buybacks. In 2008 it plans to buy back as much as $10 billion worth of stock. (To learn more, read Measuring The Medicine Makers.)

Replacing Lipitor

A pipeline turnaround can't be ruled out. Admittedly, it's hard to make out any big blockbusters emerging in the next year or two, but Pfizer has 16 compounds in phase III trials and expects to have as many as 26 in phase III by the end of 2009; 15-20 drugs are due to be submitted for FDA approval between 2010 and 2012.

There is also the opportunity for Pfizer to use its cash pile to make acquisitions, license in new drugs and pursue strategic alliances. Expect drug deals that expand its development portfolio to be catalysts that lift the stock.

Bottom Line

The way I see it, Pfizer has the cash to beef-up its drug development pipeline, either through its own R&D efforts or by acquiring them. At the same time, it has the financial clout to sustain its hefty dividend and future share buybacks, which together represent generous rewards for investors willing to wait for things to turn around. Moreover, Pfizer's low P/E provides a solid margin of safety.

To learn how contrarian investors find value in the worst market conditions, read Buy When There's Blood In The Streets.

By Ben McClure

Ben McClure is director of McClure & Co., an independent research consultancy. Before founding McClure & Co., Ben was a highly-rated European equities analyst at city of London-based Old Mutual Securities. He also spent several years as a business/technology journalist at the Economist Group. Mr. McClure graduated from the University of Alberta School of Business with an MBA.

At the time of writing Ben McClure did not own shares in any of the companies mentioned in this article.