Seeking Alpha
Profile| Send Message|
( followers)  

We have been following the story of the split of Abbott Laboratories (NYSE:ABT) for about a year. The company has split into two smaller companies of roughly equal revenues, Abbott Laboratories which consists of an established pharmaceutical business, and AbbVie (NYSE:ABBV), a "cutting edge pharmaceutical" business, whose cornerstone is the product Humira, which consists of about 47% of the company's sales.

I have theorized that both of these stocks are undervalued in the marketplace right now, in previous articles linked here, and here.

Today's project is to answer a simple question: What will happen to the price of ABBV once the patent for Humira expires in 2016?

For a lot of investors, an event three years away is not worth worrying about, but for a certain class of investors, those which like to make money, the matter is of considerable importance. There is a third class, the people that received their shares of ABBV in the split, and are conflicted on what to do next.

On the basis of the research we did in the previous article, we built a base case of what is going on in ABBV as follows:

2013 Est
Growth Est Base
Sales $B $19.44
Humira only $B $9.10
COGS $B $5.39
Humira COGS $B $2.46
R&D $B $2.99
SG&A $B $5.81
NOI $B $5.25
Tax Rate 0.12
Net Earnings $B $4.61
Shares (Post-Buyback) B 1.52
EPS $3.04
PE Ratio 12.5
Est Stock Price $37.94
Dividend/Share $1.60
Cash Per Share (Annual) $1.44
Cash Per Share(Accum) $5.05
Cash % of Mkt Cap 13%

A couple of notes: This represents the condition of ABBV based on the proforma financial statement that Abbott issued last June, and the earnings outlook that the management issued in January. So this base scenario is what the company will be looking like sometime toward the middle of the year, if the management's "low double digit" sales growth takes place, and also considering the share buyback that the company announced in January.

Note that the company is still going to be an enormous generator of cash. The company started out life with approximately $7B in cash, and promptly bought back $1.5B in stock, which should leave them with about $5.5B, or about $3.20 per share. Add to that the cash generated in a year with sales at their current levels, namely the EPS minus the dividends. This would amount to an additional $1.40 per share, even after the generous $1.60 in dividends.

Next, an estimate of what the company will look like in 3 years, at the current growth rates:

2013 Est 2016 Pre Expiration
Growth Est Base 10%-8%-6%
Sales $B $19.44 $24.11
Humira only $B $9.10 $11.28
COGS $B $5.39 $6.68
Humira COGS $B $2.46 $3.05
R&D $B $2.99 $3.62
SG&A $B $5.81 $6.51
NOI $B $5.25 $7.30
Tax Rate 0.12 0.12
Net Earnings $B $4.61 $6.43
Shares (Post-Buyback) B 1.52 1.52
EPS $3.04 $4.23
PE Ratio 12.5 12.5
Est Stock Price $37.94 $52.85
Dividend/Share $1.60 $1.60
Cash Per Share (Annual) $1.44 $2.63
Cash Per Share(Accum) $5.05 $12.94
Cash % of Mkt Cap 13% 24%

I've estimated a growth model of 10% in 2014, 8% in 2015, and 6% in 2016, just to be conservative. Just to keep the calculation conservative, we are looking at a P/E ratio of 12.5, which is roughly where the stock is currently trading in the marketplace. On that basis, we'd be looking at a stock that is earning $4.23 per share, and based on the estimate of cash flow in the third year, will have generated an additional $7.50 per share. This is estimated conservatively by tripling the positive cash flow in the slower third year.

Based on all of this, I would not blame anybody for wanting to hold this stock, or add to their position, and sell the whole thing right around the end of 2015.

Also note that despite the price appreciation, the cash position of the company as a percentage of its float will be on the order of 24%. With that much cash, there are plenty of options.

One is, the company could increase its R&D expenditures, speed more products through its development pipeline, and/or acquire product lines of profitable products through acquisition. This would potentially let the company diversify its product line, and if lucky, give them a chance for another "home run", a household name product that is profitable for many years. There are many statements in the analyst presentations to the effect that this is what they are going to try to do.

Another is, the company could buy back its own shares. If the management did nothing more than keep the ratio of cash to market capitalization the same as it is now, at 12%, there could be a 12% stock buyback, which could raise the price of the stock to around $60 per share, while still maintaining the dividend where it is. The nice part of this strategy is that unlike the introduction of new products, or the acquisition of new product lines, this strategy is much lower risk, and in fact is 99% likely to be successful in raising the stock price.

There is a third option, and for this, we have a guinea pig:

GlaxoSmithKline (NYSE:GSK) is a highly respected cutting edge pharmaceutical company. In 2010, this company had two major products come off of patent, Valtrex and Wellbutrin, whose sales volumes decreased 60% and 40% respectively because of lost market share due to generic products eroding the marketplace.

For those who wish to follow along, this information came from the 2011 Annual Report, the 2012 fourth quarter earnings announcement, and the Dividend History Calculator from the GSK Website.

Here is what happened to the company in that time period:

2009

2010

2011

2012

Sales (B)

£28,368

£28,392

£27,387

£26,431

COGS (B)

£7,380

£7,592

£7,259

£7,078

R&D

£4,106

£4,457

£3,912

£3,474

SG&A

£9,592

£13,053

£8,429

£7,855

NOI

£7,290

£3,290

£7,787

£8,024

Between 2010 and 2012, the company's sales decreased by roughly 8%, but the profitability has actually increased by nearly 14% since then. The way that the management accomplished this was by restructuring. The company took a substantial write-off in 2010. The R&D expenditure as a percentage of sales was reduced from 14% to 13%, and the SG&A expense, after the 2010 write-down, was reduced from 34% to 30% per the following:

2009

2010

2011

2012

R&D/Sales

14%

16%

14%

13%

SG&A/Sales

34%

46%

31%

30%

Here is what happened to the price of the company's ADR's in that time frame:


(Click to enlarge)

Even if you had the bad luck of buying GSK immediately before the patent expirations, you would have been back to break-even in 14 months. Actually, because the GSK dividends are quite generous and were unaffected by all of this, the proverbial investor with the worst timing ever would have been negative on the investment for only a few months.

So here is a potential scenario for a similar strategy for ABBV:

2013 Est 2016 Pre Expiration 2017 Post Expiration 2017 Restructured
Growth Est Base 10%-8%-6% 4% 4%
Sales $B $19.44 $24.11 $19.20 $19.20
Humira only $B $9.10 $11.28 $5.64 $5.64
COGS $B $5.39 $6.68 $6.94 $6.94
Humira COGS $B $2.46 $3.05 $1.52 $1.52
R&D $B $2.99 $3.62 $2.88 $2.50
SG&A $B $5.81 $6.51 $5.38 $4.61
NOI $B $5.25 $7.30 $4.00 $5.15
Tax Rate 0.12 0.12 0.12 0.12
Net Earnings $B $4.61 $6.43 $3.52 $4.53
Shares (Post-Buyback) B 1.52 1.52 1.52 1.52
EPS $3.04 $4.23 $2.32 $2.98
PE Ratio 12.5 12.5 12.5 12.5
Est Stock Price $37.94 $52.85 $28.95 $37.29
Dividend/Share $1.60 $1.60 $1.60 $1.60
Cash Per Share (Annual) $1.44 $2.63 $0.72 $1.38
Cash Per Share (Accum) $5.05 $12.94 $13.65 $14.32
Cash % of Mkt Cap 13% 24% 47% 38%

Note: I am assuming that the post-expiration sales of Humira are 50% of what they were before, which is an average of the 60% and 40% above, and so within the realm of plausibility. If the company has the bad luck that the timing of its new product pipeline does not make up for the difference, it is looking at a stock price of about $29 on the basis of the growth estimates above minus the reduced sales of Humira. The good news on this is that the company will have been generating cash at a furious rate between now and then, and if that is the case, as much as 47% of the market capitalization of the company will be available in cash for share buyback purposes.

I have a couple of different post-expiration scenarios, both before and after "restructuring". In the "restructuring", I've hypothetically reduced the R&D expense from 15% to 13% of sales, which does not sound like much, and also reduced SG&A from 28% of sales, which is where it is right now, to 24% of sales, which would represent keeping SG&A at its current levels. With those two "minor" changes, the company would be able to improve earnings to the extent that the stock price would be exactly like it is today, with the added benefit that there would still be 50% of the market capitalization available in cash.

I will leave aside the question of why ABBV wouldn't avoid the rush, and do the restructuring strategy anyway, particularly since their SG&A expense is already considerably higher, as a fraction of sales, than their rival GSK.

So, the original question was: "What will be the price of ABBV after the patent on Humira expires?" The answer is also very simple: Whatever the management wants it to be. With that much cash being generated by this highly profitable business, the three options above are all on the table, and even if the company does not find the next wonder drug, ABBV will always be able to buy back substantial amounts of its own stock and/or increase the dividend, or do "restructuring" and reduce the company overhead activities to fit a smaller footprint. The latter two of these strategies are practically guaranteed to be successful in adjusting the stock value to whatever target the management has in mind.

We also have the guinea pig of GSK, which says that the investment has a chance to be pretty solid for a patient investor with enough time to ride out a temporary bump in the stock price while the restructuring takes place. A more aggressive investor would unload the stock in 2015 before the patent expires, and buy it back after the expected correction.

As usual, anyplace in the above article where I say the word "if", "could", "estimate" or "probably" , or especially the words "practically guaranteed", there is an opportunity for error.

And as usual, I will remind you that the world is full of chaos and there are no guarantees on anything.

But, on the surface of it, knowing like we do that ABBV has at least two years to generate cash before its patent expiry event, there is no compelling reason to be afraid of the Humira patent expiration, and in fact, between now and then there is plenty of reason to be optimistic that an investment in ABBV would be successful.

Do with this information what you will.

Source: AbbVie: Don't Fear The Humira Patent Expiration