Is Abbott An Attractive Opportunity?

| About: Abbott Laboratories (ABT)

The rapidly aging population, rising incidences of chronic diseases worldwide, increasing population and increasing prosperity in emerging nations will lead toward high growth in the healthcare industry. In emerging markets, healthcare investment is forecasted to double to 30 percent of the global healthcare over the next decade.

These factors are expected to positively impact the financial position of Abbott Laboratories (ABT). Abbott Laboratories is the largest international healthcare company with the strongest foothold in the emerging markets. The company mainly operates in five segments: medical devices, diagnostics, nutrition, established pharmaceuticals and proprietary pharmaceuticals. At the start of 2012 Abbott split into two companies: AbbVie and New Abbott. Its research based pharmaceutical business became AbbVie while the diversified medical product businesses became New Abbott.

The company has a very sound position in worldwide markets. It has a leadership position in immunoassay diagnostics, blood screening, worldwide adult nutrition, pediatric nutrition, branded generics and in the development of several medical devices.

Based on Abbot's strong market position and the supportive industry conditions, it is expected that the company's stock has an upside potential offering investors a highly attractive opportunity to capitalize.

Let us explore the historical performance of the company.

Historic Performance

As a result of the favorable industry scenario, net sales for Abbott have increased over the years. In the last five years, the sales of the company grew at a CAGR of approximately 6.2%. In 2012 the growth rate plunged significantly but still remained positive. The reasons behind this plunge include a YoY decline in the sales of pharmaceuticals and vascular segments within the company. The revenues in pharmaceuticals and vascular segments were down by 4.36% and 7.86%, respectively, in comparison to 2011. Geographically, sales declined in the Netherlands by 10.67%, in Italy by 5.2%, in France by 10% and in Spain by 11.4%. The decline was offset by an increasing demand in the company's pharmaceuticals in other sales regions especially in the United Kingdom where the YoY revenue growth was 8.03%.

Moreover, 56% of Abbott's revenues in 2012 were subjected to various forms of rebates and allowances which reduced its consolidated net revenues.

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In 2010, Abbott's revenues increased sharply due to increased sales of HUMIRA and the acquisition of Solvay Pharmaceuticals. This provided Abbott with a complementary portfolio and expanded its presence in the international market. The acquisition added approximately $3.1 billion to the company's net sales in 2010. Both these factors also considerably improved 2011 revenues.

Management's Efficiency

Abbott's management has been successful in controlling its selling costs resulting in a continuously improving gross margin over the years. The margin has improved by approximately 20% from 2008 to 2012. In 2012, management took the initiative to streamline various commercial operations in order to reduce costs and improve the efficiency of the company's diagnostics, established pharmaceuticals and nutritional businesses. This resulted in the reduction of the costs of the goods sold, a reduction in research and development costs and selling as well as a reduction of general and administrative expenses as a percentage of total sales.

The increase in the gross margin of 2011 was primarily due to the improved margins in the established pharmaceutical, diagnostics and diabetes businesses.

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Net margin of Abbott in 2012 was better than 2011 and 2010 but it is lower in comparison to 2008 and 2009. The factors affecting the net margin in 2012 include increased interest expense, a $1.35 billion loss on the extinguishment of debt and a $62 million loss for the impairment of certain equity securities. The interest expense increased to bridge facility fees related to the separation of AbbVie from Abbott. However, this was partially offset by a lower tax rate in 2012 compared to 2011 and 2010.

The working capital turnover of the company has been worsening over the years. The ratio has declined to 2.21 times in 2012 as the working capital of Abbott has significantly increased in 2012 in comparison to prior years. The increase is due to the increased amount of cash generated from operating activities as well as additional income and investments from the net issuance of long-term debt due to the separation of AbbVie from Abbott. The lower turnover shows that Abbott has generated lower revenues compared to the money it uses to fund the revenues.

The profits generated on shareholders' investments have improved in 2012 in comparison to 2010 and 2011 as a result of considerable improvement in 2012 net earnings.

Future Outlook

The table below shows the projected cash flows of Abbott for the next four years. For valuation purposes, I have grown the revenues based on the global market outlook for all five segments of the company. The terminal growth taken was 1.5% as the company operates in a mature industry. I expect the company's net margins to slightly decline as the proprietary pharmaceuticals segment is expected to show the least growth in upcoming years. Interestingly, for Abbott proprietary pharmaceuticals is the most efficient segment. A lower demand for proprietary pharmaceuticals means declining margins for Abbott. However, despite lower margins, its net income growth would exceed the industry average.

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To calculate the weighted average cost of Abbot's capital, I have used the CAPM model. The beta used in the model is taken from Morningstar. The market risk premium of 6% is the consensus premium used in the US market and the risk free rate of 2.7% is the long-term yield on US treasury securities.

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The target price of the company equals $38.9 giving a potential return of more than 15%. The price is derived based on the above calculations of projected cash flows and the company's WACC. It is expected that the company's stock price would reach this level in the next year thus posing an attractive opportunity to earn goods profits on their money.

I have tested the valuation of the company by using a sensitivity analysis based on various terminal growth scenarios and WACC regimes. The company's stock provides a maximum upside potential of 97% whereas under the worst case scenario it provides a downside potential of 19%.

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Since the company provides a high upside potential and a low downside potential I would give buy recommendation on this stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.