This Just In: Upgrades and Downgrades

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At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Danger: falling stocks ahead
By now, you've all heard the story: Big Pharma is doomed. With patents set to expire on key drugs ranging from Advair (GlaxoSmithKline (NYS: GSK) ) to Zyprexa (Eli Lilly (NYS: LLY) ) -- and Plavix (Bristol-Myers Squibb (NYS: BMY) ), Singulair (Merck (NYS: MRK) ) and Lipitor (Pfizer (NYS: PFE) ) besides -- none of these companies will be going anywhere any time soon. Instead, they'll be scrambling to replace revenue streams as "generic" drugmakers like Teva (NAS: TEVA) swarm all over their markets, and steal their customers left and right.

But a funny thing happened on the way to the patent cliff. Bristol-Myers gained 19% over the past year. So did Pfizer. Glaxo posted a 14% increase. Why, even Lilly and Merck eked out 9% and 4% gains, respectively -- not that much different from the 8% return posted by the Dow Jones Industrial Average (INDEX: ^DJI) . Could it be that things aren't quite as bad as investors were led to believe?

Perhaps. Or it could be that we just got lucky. This, at least, seems to be the thinking at Wall Street pharmaceuticals specialist Leerink Swann.

Thanks a lot, Pfizer. Now go away
Noting that its recommendation to buy Pfizer back in February 2009 has turned out well for investors, returning 40% in just over two-and-a-half years, the analyst yesterday decided to declare victory and go home -- closing its buy rec and downgrading the stock to "market perform." Why?

According to Leerink, Pfizer in 2009 was a company suffering from a "sustained valuation disconnect between cash flows, an undervalued pipeline, and [unappreciated] potential for improved capital allocation." A series of positive drug trials, however, plus extension of the company's patent protection on Viagra (through 2019), now has the stock pricing in considerably more good news than was the case two years ago. Result: "opportunities for substantial upgrades to our currently modeled sales and net income expectations are limited in 2012."

But me ... I'm not so sure.

Devil's in the details
I mean, at first glance, Leerink's recommendation makes a lot of sense. At 13.8 times earnings, Pfizer stock is priced right in line with the average P/E ratio for major drug manufacturers. Most analysts estimate that Pfizer will grow earnings at less than 4% per year going forward. Even with Pfizer's generous 4% dividend yield, that doesn't seem to justify the near-14 P/E on this stock.

At least, it doesn't justify it if all you look at is plain vanilla "GAAP" earnings. Look a little closer at Pfizer, though, and I think you'll see the potential, at least, for even more gains in this stock. Consider: On the cash flow statement, Pfizer is showing annual cash profit generation of $19.6 billion today, or about 70% better than GAAP earnings would suggest. (You can find similar valuation disconnects at Lilly, Glaxo, Bristol-Myers, and especially at Merck.)

Foolish takeaway
Against Pfizer's $153 billion market cap, this makes for about a 7.8 times price-to-free-cash-flow ratio on the stock. Seems to me, that's plenty cheap for the 4% profits growth, and 4% dividend yield on offer at Pfizer.

In short, if you've been investing alongside Leerink Swann for years, and are sitting atop a 40% gain today, I'd certainly understand if you decide now's the time to pocket some profits and head for the exits. For those who decide to stick around, however, I believe there's more in store.

And I'm staking my reputation on it, too. In contrast to Leerink Swann, right now, I'm heading over to Motley Fool CAPS to recommend buying Pfizer shares. Tag along if you like, and keep an eye on how the pick performs over the quarters and years to come.

At the time this article was published Fool contributorRich Smithdoes not own (or short) shares of any company named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 325 out of more than 170,000 members. The Motley Foolhas adisclosure policy.The Motley Fool owns shares of Teva Pharmaceutical Industries.Motley Fool newsletter serviceshave recommended buying shares of Pfizer, GlaxoSmithKline, and Teva Pharmaceutical Industries.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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