Incorporated in 1900 in Illinois, Abbott Laboratories is into the research, development, manufacture, and marketing of a wide range of health care products globally.
Its four primary areas of operation are the combined Pharmaceutical Products segments (adult and pediatric formulations for rheumatology, HIV, autoimmune disorders, gastroenterology, cardiac disease, metabolic disorders, advanced prostate cancer, endometriosis & central precocious puberty, anemia, obesity, neurology, anesthesia and infection prevention), Diagnostic Products (immunoassay and chemistry systems; assays for screening for drugs abuse, cancer, therapeutic drug monitoring, fertility, physiological, and infectious diseases; processors of genetic samples and detectors & calculators of infections agents; genomic-based tests; hematology systems & reagents; point-of-care diagnostic systems & blood tests), Nutritional Products (for children and adults), and Vascular Products (offers coronary, endovascular, and vessel closure devices, such as drug-eluting coronary stent systems, and others to treat vascular disease). Abbott also provides blood glucose monitoring meters, test strips, data management software, & accessories for people with diabetes, and medical devices for eyes.
In the second quarter of fiscal year 2011, the Proprietary Pharmaceutical Products segment accounted for 41.8% of sales, followed by Established Pharmaceutical Products (14.3%), Nutritional Products (15.7%), Diagnostics (10.9%), Vascular Products (9.3%), and Others (7.9%). Vascular Products has been the fastest growing segment with a CAGR of 12.5% over last three years. Geographically, Abbott achieved 43.2% of its FY 2010 revenues in the US, 20.7% in the EU, 5.8% in Japan, and remaining from other countries.
The second quarter FY 2011 revenues increased by 8.9% to $9.6 billion and the company expects forward earnings per share in the range of $4.58 to $4.648
Review of the Company, Business, Economics and SWOT Analysis
Abbott Laboratories (NYSE:ABT) faces the same hurdles that all major pharmaceutical companies face: generic competition, government austerity programs, intense competition, and U.S. healthcare reform. Several large European markets have announced price cuts in generic and branded drugs and we expect Abbott’s pharmaceutical product revenues to be negatively impacted. While Abbott’s revenue growth of 6.2% in Europe since FY 2008 has been strong, we do have concerns over the impact of austerity packages in these countries, and the company expects these measures to reduce its FY 2011 revenues by almost $250 million.
Additional headwinds exist in the U.S. market. It has been estimated that the U.S. health care reform legislation through the Patient Protection and Affordable Care Act (PPACA) will reduce pharmaceutical industry revenues in 2011 by approximately $400-$450 million and is expected to cost the industry more than $38 billion over 10 years (from FY 2010 to FY 2019). The legislation included a mandated increase in the Medicaid rebate from 15.1% to 23.1%. In 2013, the income tax deduction for prescription drugs by retirees will be eliminated, which will decrease Medicare part D reimbursements. In addition, the legislation imposes user fees on medical device manufacturers, which is likely to impact Abbott’s Vascular segment. Abbott attributed approximately $200 million in reduced FY 2010 revenues to healthcare reform implementation. In addition, FY 2011 revenues are expected to diminish by $400 million.
We take the contrarian view that the long-term underlying business economics for the pharmaceutical sector are moderately favorable as an aging baby-boomer generation is now well into their 60s and PPACA will greatly expand the insured population once the coverage mandates go into effect in 2014.
Surprisingly, demand for pharmaceuticals grew by ~3% in 2009, despite the aforementioned challenges. These challenges, coupled with a difficult banking environment, place formidable barriers to the entry on new market players. Furthermore, an aging population and the fast-spreading obesity epidemic will increase the demand for Abbott’s cardiovascular and vascular products.
Abbott’s pharmaceutical segment has been growing at approximately 6% over the past three years on a foundation of outperformance by autoimmune drug Humira, which grew at 18.5% over FY 2009 to $6.5 billion in revenue. The product has benefited from a well-executed lifecycle management strategy aimed at boosting sales through continued R&D and expansion of approved indications. In addition, HIV drug Kaletra and cardiovascular drugs Trilipix and Tricor ($1.6 billion in FY 2010 sales) performed very strongly in FY 2010. US pharmaceutical segment growth has been flat over the same period due to a 90% decrease in revenue from blockbuster neurology drug Depakote, as a result of patent expiration and generic competition. The Company’s excessive reliance on Humira, which represents 33% of pharmaceutical segment revenues and 17% of the total revenues, to generate revenues and fuel growth, is a risk. Humira goes off-patent in 2016 and while it will not experience the rapid pace of market share loss typical of small molecules like Depakote, blockbuster biologics such as Humira is likely to attract the large generic players to create biosimilars. This competition will slowly erode Abbott’s market share over time. In addition, novel autoimmune drugs such as Merck’s (NYSE:MRK)/Johnson and Johnson’s (NYSE:JNJ) Simponi, Pfizer’s (NYSE:PFE) JAK3 blocker, Roche’s (RHHVF) Actemra, and UCB’s (UCB) Cimzia will all potentially compete with Humira in several therapeutics indications. While Abbott stated that it plans to gain 75 new product approvals/indications in the next five years, there is a noticeable dearth of phase 3 compounds. Abbott does not have a strong track records of in-house pharmaceutical development and will need to maintain its strategy of external acquisitions to fill the void over the long-term. We are particularly focused on Abbott’s continued development programs for Humira, in addition to key research programs in oncology (multikinase inhibitor ABT-869, and PARP inhibitor ABT-888), kidney disease (bardoxolone), and for the vascular franchise.
While operating margins are lower for the nutrition (14.0%) and diagnostic (14.7%) segments compared to pharmaceuticals (37.2%) and vascular (28.5%), these segments contributed 26.5% of FY 2010 revenues and are a hedge against the triple threat of patent-exposure, European austerity, and US healthcare reform. The diagnostics group is well-positioned to take advantage of the secular growth in personalized medicine. We believe that increased R&D investment in this area can turn it into a modest growth driver. There are also opportunities to leverage this group to create synergy by identifying biomarkers and patient subsets that will benefit from Abbott’s pharmaceutical portfolio, potentially expanding its market share and leading to new indications for existing drugs.
The 2006 acquisition of Guidant’s vascular segment placed the drug-eluting stent Xience within Abbott’s portfolio. Since then, they have taken over the market, bumping once leading products Taxus (Boston Scientific BSX) & Cypher (Johnson & Johnson JNJ) into third-tier products, and indeed, knocked JNJ out of the DES market. Phase 3 trials have shown that Xience is more effective than Taxus. The next generation stent, Xience prime, was approved in 2009 and vascular product sales have increased at an impressive CAGR of 12.5% over the last 3 years. New products such as the mitral-valve repair device Mitraclip and bioabsorbable stents demonstrate a commitment to innovation in this segment.
Abbott’s internal restructuring and inorganic growth strategies are paying off well. A planned reduction in the workforce by 5%, as a part of ongoing restructuring plan, is likely to accelerate the bottom-line growth in excess of the revenues. In addition, the newly formed Established Pharmaceutical Products segment will market branded generics, ensuring better management, revenue generation and lesser generic attrition. Acquisitions of Solvay Pharmaceuticals (complimentary portfolio of pharmaceuticals and expansion in Belgium), Pirimal Healthcare (market leadership in India), Advanced Medical Optics or AMO (diverse range of medical devices and leadership position in the upcoming eye care market), and Facet Biotech (biologics for oncology drugs) are some of the latest initiatives towards strengthening Abbott’s moat. The emerging markets revenue has increased by 13.2% over last three years and 38.4% (20% organic) y-o-y in Q1 FY 2011. The management is now targeting a 15% annual growth. AMO’s LASIK procedure, which puts Abbott in the top position in laser surgical devices, is less sensitive to reimbursement policies. AMO also pushed Abbott to second position in cataract surgical device market and third position in the contact lens care products market.
The global pharmaceuticals market in FY 2010 was valued at approximately $662 billion. The Centers for Medicare and Medicaid Services project total US healthcare spending to exceed $3.5 trillion by 2014. Robust growth in international markets and an expanding middle class in China, Russia, India and South America, particularly Brazil, will drive future growth for innovative healthcare companies with global reach and effective emerging market strategies. Abbott has secured an economic moat by taking steps to maintain the long-term viability of their competitive advantages. Strong market leadership across the four operating segments, a diverse product portfolio, strong intellectual property protection and limited patent cliff-exposure for its core pharmaceutical segment, high switching costs for its vascular segment, solid emerging market growth, and its proven track-record of supplementing organic growth through strategic acquisitions puts Abbott in a strong position to achieve above-average returns. The 10-year average ROIC of 15.2% exceeds the cost of capital and at a compounded adjusted growth rate of 6%, Abbott has delivered best-in-industry top-line growth over the last 3 years.
· Product and geographic diversification
· Balanced organic and external growth strategy
· Solid early-stage pipeline in areas such as lipid management
· Effective product lifecycle management
· Relatively low patent exposure
· High profile clinical trial failures for briakinumab and Certriad. E
· Excess reliance on blockbuster Humira for revenue
· Weak late-stage pipeline
· Weak research focus on segments, except Pharmaceuticals segment
· Estimated litigation-related contingent losses between $75-$115 million
· Leverage product portfolio in emerging markets
· Decrease in operating costs through internal restructuring plan
· Opportunities for mergers and acquisitions
· Growth opportunities in Diagnostics segment on the back of increased R&D efforts
· EU pricing pressure
· Clinical trial failures for promising pipeline candidates
· Competition for Humira
· Possible failure in successful integration of multiple acquisitions
· Restrictive government regulations
Key Growth and Profitability Metrics
Abbott’s year-over-year revenue growth has been stable over the last decade with an overall increase of 8.0% during the period. The short-term average indicates a slight decline with a rebound in the last year; revenues increased by 14.3% in FY 2010. The company registered double digit growth during the recession. The yearly EPS growth has been unstable over the last 10 years, while indicating an overall uptrend. The sudden plunge in FY 2010 is explained by extraordinary gains recorded in the previous years. Abbott achieves lower net profit margins than its less-diversified pharmaceutical peers due to the lower margins of the nutritional and diagnostic segments, which accounted for 26.5% of FY 2010 sales. This is an acceptable trade-off due to the diversification and minimization of risk that these revenues provide. Abbott has demonstrated 10-year returns on equity and invested capital of 21.7% and 15.2%, respectively, clearly above the estimated 9% cost of capital. As indicated from Table 1, free cash flows (FCF) have shown fluctuation during a period of substantial acquisitions and restructuring and therefore, our 3-stage DCF valuation model employs a 5-year average as the initial year FCF.
Table 1. Long-Term Growth Rates/Averages
The figures below (Chart 1- 2) showmodest stability of margins, earnings per share (EPS) and book value per share (BVPS).
Chart 1: Profit Margins (2001-2010)
Chart 2: Earnings and Book Value per Share (2001-2010)
Balance Sheet Data and Financial Health
Abbott is a moderately levered company, which fairs better than its peers on the solvency front. It has a Debt Equity ratio of 0.5 against the industry average of 0.9. An interest coverage ratio of 11.3 also puts it in a comfortable position. However, the market average of 41.5 is considerably better than the Company. Abbott maintains a positive liquidity position, though somewhat lower than value investing perspective. At the end of the first quarter Fiscal 2011, current and quick ratios were 1.4 and 1.2, respectively against industry averages of 2.3 and 1.8, respectively. In FY 2010, the operating cash flows and free cash flows registered a y-o-y growth of 20.1% and 24.8%, respectively. Operating cash flows increased by 32.0%, while free cash flows increased by 26.7% to $1.6 billion y-o-y, in the last quarter. Net cash outflow in the quarter was $0.9 billion, primarily on account of debt repayment of $0.5 billion and an increase of $1.9 billion in investments. In FY 2010, the cash flows were affected by outflows on account of acquisitions, which amounted to $9.4 billion for the entire year.
Historically, Abbott’s cash flows from operations have exceeded its debt repayment and dividend payouts. The Company relies on these resources to cover its costs in the future. In addition, it has unused credit lines amounting to $6.7 billion that can be used for commercial paper borrowings. Cash & cash equivalents and investment securities were $5.5 billion and $6.5 billion on December 31, 2010 and March 31, 2011, respectively. Abbott depends heavily on external borrowings to fuel its inorganic growth strategy, which is also a key to its future success. The net debt was $13.4 billion and $12.3 billion at December 31, 2010 and March 31, 2010, respectively.
Efficiency and Management
Discussion of Table: Over the long term, receivables turnover ratio has indicated a slightly declining trend with some improvement in the last twelve months. The ratio currently stands at 5.3 against 5.1 at the end of FY 2010. Inventory management at Abbott is among the best in the industry as indicated by its turnover ratio of 4.5 as compared to 1.4 for the industry. Fixed asset turnover ratio has shown an uptrend over the last 10 years with highest ratio of 4.5 over the last twelve months. Days sales outstanding has shown a fluctuating trend in the range of 50-65 in the long-term, increasing to 71.2 in FY 2009 and FY 2010. In the last twelve months, the ratio has improved to 68.4.
Chairman and CEO Miles D. White is serving in the current capacity since 1999. A Mechanical Engineer and an MBA from Stanford University, White is a director of Caterpillar Inc., McDonald's Corporation and the Northwestern Memorial Hospital. Earlier, he had also served as Chairman of the Federal Reserve Bank of Chicago, The Economic Club of Chicago, and the Pharmaceutical Research and Manufacturers of America (PhRMA). Thomas C. Freyman has been serving as the Executive VP (Finance) and CFO since 2004. Freyman is a CPA and an MBA from Northwestern University. Currently, he is also a director of the Chicago Botanical Garden.
Abbott Laboratories has been generous in returning cash to its shareholders in the form of share repurchases and cash dividends. The average payout ratio in the last three years was 49.2% with a payout of 59.1% in FY 2010. Dividends declared in the first quarter Fiscal 2011 was 85.7% against 67.7% last year. Abbott repurchased 404,309 shares at an average price of $47.09 in the last reported quarter and 229,766 shares at an average price of $50.43 in the fourth quarter FY 2010. The main components of Abbott’s executive pay structure are base pay, benefits, annual bonuses, and long-term incentives. While the ROE and net income decreased y-o-y in FY 2010 by 28.2% and 19.5%, respectively, the CEO compensation reduced by only 2.5%. On the other hand, the total executive compensation increased by 6.9%. However, the overall corporate governance at Abbott Laboratories is considered among the best in the industry.
Earning’s Power Value: The conservative, no growth estimate of Abbott’s earnings power (using Greenwald’s method) is the current EPV of $53.64. This model assumes a cost of capital of 9% is based upon the current earnings and assumes zero future growth, implying that the market is assigning low expectations on the future growth potential of the Company and signifying that the company is trading at a discount to its intrinsic value. This is a situation where you can buy the current earnings, and get the growth for free
Discussion of Tables: At the current PE multiple of 15x, Abbott is trading close to the industry average of 18.5x. This is in line with the rising trend since FY 2009. Looking at the long-term trend from a value investing lens, the current and forward PE makes the stock attractive at the prevailing price. The Price to Book ratio of 3.4 is high, particularly when compared to the industry average of 2.9. Over the long-term, this ratio has shown a decreasing trend, the current level being among the lowest. Abbott’s EV/EBITDA multiple is modestly attractive at the current level, even though it is among the highest in the industry, but is fair considering the high level of growth that ABT has demonstrated.
At $50, Abbott is trading at 31% less than its weighted average intrinsic value of $72-73. In addition, a healthy 3.7% dividend will bolster returns over time.
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Disclosures: No position to disclose and no intention to purchase in the next 72 hours
About the author:
We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:
1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins
2. We understand the business
3. They are run by competent management
4. They are available at bargain prices.
We require a 25-50% margin of safety, depending on the stability and economic moat for the company.
In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.