Pfizer’s share buyback: elixir for shareholders, jagged little pill for R&D

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Ian Read, CEO of Pfizer, wants you to believe that he's a really good guy, so good that he will use tax savings associated with his purchase of Allergan to fund extra research and development. It means more useful drugs to make our lives longer, healthier and happier.

What's not to like? A lot, it turns out.

Allergan Inc. is best known as the maker of Botox, the wrinkle-zapping drug, and is based in Ireland, famous, or infamous, for its low corporate tax rates. In late November, Pfizer Inc., the maker of Lipitor and Viagra, announced it would buy Allergan for $160-billion (U.S.), making it the biggest pharmaceuticals deal yet.

Allergan is not moving to the United States. Instead, Pfizer is moving to Ireland in a so-called tax-inversion move that has encouraged so may big American companies to abandon the relatively high-tax United States. The tax inversions were one of the main drivers of the record pace of mergers and acquisitions in 2015.

While President Barack Obama has denounced tax inversions as "unpatriotic," and the U.S. Treasury is devising rules to stamp them out (apparently with no success, so far, as the proposed Pfizer-Allergan deal shows), Mr. Read would have you believe it's all for the good of the drug-buying public.

In a Wall Street Journal interview in October, the Scottish-born Mr. Read said he had been lobbying the U.S. government for lower tax rates. The tax hit, he argued puts Pfizer at a "tremendous disadvantage" among global competitors. "We're fighting with one hand tied behind our back," he said.

What he failed to say was that the culprit was not only high taxes. Also to blame was the gusher of money that Pfizer hosed out on dividends and share buybacks, especially the latter, for decades.

The numbers are astounding. According to research compiled by Canadian economist William Lazonick, the co-director of the University of Massachusetts Center for Industrial Competitiveness, and published in the blog of the Institute for New Economic Thinking, Pfizer spent $95.5-billion in buybacks and $87.1-billion in dividends between 2001 and September, 2015. The amounts were equivalent to 117 per cent of the company's net income over that period.

Share buybacks and dividends are purely discretionary. While big, stable, profitable companies are expected to pay dividends, the ever-more-popular buybacks are purely a form of legal stock manipulation designed to boost earnings per share by reducing the number of shares outstanding.

Buybacks invariably help to lift share prices, rewarding executives who now typically get well more than half of their total compensation from stock awards and stock options (Mr. Read bagged $22.6-million in 2014, of which 77 per cent came from stock awards and options).

The pace of buyback has accelerated since Mr. Read became Pfizer CEO in late 2010. From the start of 2011 through September, the company has spent $44.7-billion on buybacks, equivalent to 71 per cent of net income (if dividends are included, the figure rises to 121 per cent of net income). During the same period, it booked $16.2-billion in income taxes. In other words, Pfizer under Mr. Read has spent almost three times as much on buybacks than income taxes.

So much for the theory that the high tax load was crimping the company's ability to compete. If Pfizer wanted to compete more effectively, all it had to do was shave a few billion off the buyback bill and redeploy it into R&D. But never mind; the quest for shareholder value is, apparently, paramount. At Pfizer, it looks like R&D was the victim of the buyback bonanza.

Mr. Lazonick calculated that R&D has been the equivalent of 14.3 per cent of sales since 2011. From 2005 to 2014, the figure was 15.5 per cent; in the previous decade, 17.8 per cent.

Companies such as Pfizer live and die on blockbuster drugs, like Lipitor, a sales monster now in decline because its patent expired in 2010.

Pfizer, however, appears more adept at buying blockbuster drugs than developing them itself. Pfizer bought Warner-Lambert in 2000 to get its hands on Liptor. Since then, it has been a takeover machine. In came Pharmacia, Wyeth, King Pharmaceuticals and, now, Allergan. If the company had developed more drugs on its own dime, it might have had more blockbuster drugs. But that might have come at the cost of cutting back on the share buybacks.

Pfizer is not the only big company enchanted by buybacks. Among S&P 500 companies, they have become an addiction. According to data released in December by FactSet Research, buybacks rose 16 per cent, to $156-billion, in the third quarter of 2015 over the second quarter. In the 12 months to the end of September, S&P companies spent 64.6 per cent of their net income on buybacks.

During that period, 130 companies actually spent more on buybacks than they generated in net income, according to FactSet. Many big companies, including Intel, Microsoft, Cisco and Exxon Mobil, use buybacks with abandon. So did BlackBerry before it got slaughtered by Apple and Samsung.

We'll never know how much more competitive those companies might have been if they had spent less on buybacks and more on R&D.

But innovation costs money. So do buybacks. North American-style capitalism obviously prefers buybacks. Pfizer does and now it is reduced to complaining that its tax bill is too high to allow it to become truly competitive.