Abbott (ABT, Financial) is a dividend aristocrat with excellent long-term growth potential. The company maintains a diversified mix of healthcare products that are sold around the world. Many of these products are recession-resistant and will enjoy more demand as consumer wealth increases in emerging markets, where Abbott generates about half of its total sales.
The company’s dividend is extremely safe and appears to offer upper single-digit growth potential going forward. These are the types of companies we love to own in our Top 20 Dividend Stocks portfolio when they trade at a fair price. Let’s take a closer look at the business.
Business overview
Abbott has been in business for more than 125 years. The company spun off its research-based pharmaceuticals business (AbbVie) in the beginning of 2013, leaving it with four diversified healthcare segments – nutritionals (34% of sales through Q3), generic drugs (19%), medical devices (25%), and diagnostics (23%). About half of the company’s sales are made directly to consumers and patients, and the company sells over 10,000 different products.
By geography, over 70% of Abbott’s revenue is derived outside of the U.S., and about 50% of total sales come from emerging markets.
Business analysis
Each of Abbott’s businesses has some unique competitive advantages. Around half of the company’s sales are made directly to consumers and patients. These products primarily reside in the company’s adult and pediatric nutrition segment and its branded generic drugs.
In some ways, these businesses are more like consumer packaged goods companies than traditional healthcare businesses. Their market positions benefit from decades of marketing campaigns to build up brand equity, research expenses to meet consumer tastes, and distribution relationships to maintain valuable shelf space.
With over 125 years of business history, Abbott has built up leadership positions in many of these markets. The company is the global leader in adult nutrition and has the number one spot in U.S. pediatric nutrition. In total, the nutrition segment has 50 consumer brands and is #1 or #2 in 25 countries. Within branded generics, Abbott holds top market positions in India, Russia, and several Latin American countries.
Abbott’s medical devices and diagnostics businesses are a bit faster-moving, requiring constant R&D investments to generate profitable sales growth. Once again, however, Abbott holds leading market share positions in several key categories – LASIK, cataract surgery, amino-acid diagnostics, blood screening, and more.
Breaking into these markets is a challenge for new entrants for several reasons. Some markets are heavily regulated by the government (e.g. medical devices, pharmaceuticals, nutritional products), require high investment costs (Abbott invests 6% to 7% of sales in R&D, or about $1.3 billion last year), need global distribution, and face patent or trademark protection.
In addition to relatively high barriers to entry, Abbott plays in markets where growth in healthcare has high demand. Consumers in emerging markets (50% of Abbott’s sales) often pay out-of-pocket for medicine and can’t afford expensive brands, creating significant opportunity for Abbott’s branded generics. As spending on healthcare in emerging markets continues to rise with economic growth, almost all of Abbott’s product lines should benefit.
Many of Abbott’s product categories are also recession-resistant. The company’s 2015 third quarter results were reported during a time where many other businesses were being adversely impacted by the slowdown in China. Abbott, however, reported double-digit growth in each of its segment’s China operations. The company appears to be playing within healthcare areas with high demand.
Should Abbott identify an emerging healthcare trend that it would like to participate more fully in, the company has the balance sheet to acquire its way into the market. We think the company’s balance sheet could enable it to easily pull off $10 billion to $20 billion in deals if it saw the right opportunities.
Abbott has historically been acquisitive. The company purchased CFR Pharmaceuticals for $3.4 billion in September 2014 to double its branded generics presence in Latin America; bought Topera for $250 million in December 2014 to enter the electrophysiology market; and purchased Veropharm in December 2014 for $315 million to establish a pharmaceuticals manufacturing base in Russia.
Deals like these strengthen the company’s future growth prospects and help it further widen the moats of its existing businesses. Once Abbott has developed or acquired new product offerings, it can take advantage of its strong brands and global distribution network to grow them quickly.
As long as Abbott’s management team can continue generating results from the company’s R&D and acquire the right complementary businesses to remain in the right profitable niches abroad, the company’s future looks bright.
Key risks
One of the things we like about Abbott is its cash flow diversification. The company’s operations are balanced between four unique segments, which each have different risks and growth opportunities.
This is similar to owning a diversified portfolio of stocks rather than relying on just one for dividend income, reducing your risk. For example, when Abbott’s pediatric nutrition business was dealing with product recalls in China two years ago, its other segments continued performing well and helped insulate the company’s overall earnings. The company sells over 10,000 different products and doesn’t depend on any single one for growth.
The same is true of Abbott’s geographical mix. The company generates about 70% of its revenue from outside of the U.S. and sells its products in over 150 countries. This is important within healthcare because each country has a unique set of government regulations that can alter the profitability of different business lines.
In the U.S., for example, the Patient Protection and Affordable Care Act has meaningfully weighed on the medical device industry by subjecting them to a new 2.3% sales tax. Since Abbott is in many different countries with diverse lines of products, it is better protected from unexpected regulatory or economic growth changes.
With that said, Abbott’s concentration in emerging markets (50% of sales) is hurting the business today. The strong U.S. dollar is hurting reported sales and earnings growth and also slowing growth in some emerging markets. The recession-resistant nature of many of its healthcare products is helping, but the company is not out of the clear yet.
Another risk that could hurt near-term profits for several quarters is raw material cost inflation within Abbott’s nutritional segment. The company has benefited from several years of lower priced commodities. However, even management notes that this tailwind could reverse course:
At some point that will turn, and we’ve tried to put plans in place to be able to mitigate that when the time comes, so I think that will be some pressure on us sometime in the future and we should probably anticipate that at some point.
We bring this up because Abbott’s nutritional products business has improved its margins from 15.7% in 2012 to 21.0% in 2014, a large jump driven mostly by manufacturing and distribution process changes, but also by some luck (raw material tailwinds). Regardless, we think this would provide a nice long-term buying opportunity.
Overall, we think the diversity of Abbott’s business, numerous sources for potential future growth, and the company’s healthy balance sheet reduce a lot of its fundamental risk. We will continue to watch pricing and profitability trends in emerging markets, which are the company’s biggest long-term profit drivers, but the business looks to be headed in the right direction today.
Dividend analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Note that historical data prior to 2013 includes AbbVie and, therefore, is not necessarily representative of ABT.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Abbott’s dividend appears to be extremely safe. The company achieved an excellent dividend Safety Score of 68, suggesting that its current dividend payment is safer than 68% of all other dividend-paying stocks. Factors contributing to Abbott’s strong rating are its relatively low payout ratios, healthy balance sheet, and recession-resistant products.
Using 2016 consensus earnings estimates, Abbott’s payout ratio is 40%. For a business with stable cash flows like Abbott, this is a really healthy level that provides the company with plenty of dividend protection and room for growth.
Unfortunately, we don’t have a meaningful amount of historical fundamental data to further analyze Abbott because its spinoff of AbbVie happened just three years ago. However, we previously highlighted the recession-resistant nature of the company’s products, and Abbott’s business model generates predictable free cash flow to fund sustainable growth and the dividend.
We can also look at the company’s balance sheet. Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.
Abbott’s balance sheet is in great shape, and the company’s long-term debt rating was A+ by Standard and Poor’s as of December 2014. As seen below, the company has about $5 in cash on hand for every $1 it paid out in dividends last year. Abbott’s net debt to EBIT ratio is also very conservative at 0.8x. This means that Abbott’s net debt could be covered with less than 1.5 years of EBIT. Investors shouldn’t lose any sleep worrying about the company’s financial health.
Source: Simply Safe Dividends
Abbott’s 2.1% dividend yield is very safe, but it’s not much income for investors living off dividends in retirement.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Abbott’s Growth Score is 76, suggesting that its dividend’s growth potential is higher than 76% of all other dividend-paying stocks in our database. Abbott has paid dividends since 1924 and increased its dividend for 43 consecutive years. The stock is one of the more notable companies on the dividend aristocrats list.
After spinning off AbbVie in early 2013, Abbott paid a quarterly dividend of 14 cents per share. The company increased its dividend by 57% in 2014, raising the payment to 22 cents per share. In 2015, Abbott raised the dividend again to 24 cents per share, a 9% hike.
Looking ahead, we think Abbott could easily continue raising its dividend by 7% to 10% per year as its earnings compound at a similar rate. Using 2016 earnings estimates, the company’s payout ratio is a modest 40%. This also provides plenty of room for continued dividend growth even in a challenging environment that weighs on earnings growth.
The company also has over $6 billion in cash on hand, nearly five times greater than the total amount of dividends it paid out last year. With only $8 billion in debt, Abbott has plenty of flexibility to reinvest in the business, acquiring other companies, and raise the dividend.
Valuation
Abbott trades at about 19x forward earnings and has a dividend yield of 2.1%. The stock’s current valuation doesn’t seem unreasonable, but it also doesn’t appear to be a bargain. We believe Abbott can continue growing its earnings at a high single-digit rate, which implies that the stock’s future total returns could range from 9% to 11% per year.
Given the softness in emerging markets and currency headwinds working against Abbott’s business today, we might get a better chance to buy the company. Today doesn’t look like the time to go “all in” on the stock, but a starter position seems reasonable.
Conclusion
Abbott’s dividend is extremely safe with above average growth potential. The company’s diverse product lines reduce some of the company’s fundamental risk while providing numerous opportunities for long-term growth. Abbott also maintains a conservative balance sheet that it can use to acquire complementary product lines and return more cash to shareholders.
The stock’s dividend yield is relatively low today at 2.1%, but dividend growth prospects are solid considering the company’s strong earnings growth and 40% payout ratio. Should near-term macro headwinds (stronger dollar, softening emerging markets) impact the stock price, we would strongly consider accumulating a position. For now, we will continue watching some of our other favorite blue chip dividend stocks.
Disclosure: The author holds no position in ABT.
