Why Long-Term Investors Should Consider Abbott Laboratories

| About: Abbott Laboratories (ABT)

Summary

Currency headwinds overshadow strong healthcare fundamentals.

Company has more margin upside than peers.

Dividend has increased for 44 consecutive years.

Introduction

Now is a good time to consider a buy-and-hold position in Abbott Laboratories (NYSE:ABT), a leading medical equipment maker that has increased its dividend for 44 consecutive years. Currency headwinds kept 2015 sales and earnings flat despite healthy fundamentals in virtually all of the company's markets, and the current price implies a similar story for 2016. This is a great opportunity for the patient investor. The continued expansion of health care, ageing populations in developed markets, and rising middle classes in emerging economies will support long-term demand for medical products. FX movements currently overshadow strong health care fundamentals that should drive stable growth in earnings and capital appreciation over time. What's more, the current dividend yield of 2.55% is more than double the sector average.

Segment Analysis and Outlook

Abbott's business segments and their percentages of total revenues are as follows: nutritional products (38%), diagnostic testing products (26%), branded generic pharmaceuticals (20%), and vascular products (15%). The company generates 70% of its revenue outside the US, with emerging markets accounting for 50% of total sales. While this exposes the company to currency movements, the fact that the majority of sales come from faster-growing markets means that ABT can outpace many of its healthcare peers. Over the past five years, the company has averaged mid-upper single digit sales growth on a constant currency basis. While the US has stalled, international sales have averaged 9.4%, driven by emerging markets. Looking forward, the strongest growth will come from China, Latin America, and India, and we forecast average annual top-line growth of 4-5% on a constant currency basis through 2020.

Abbott's corporate finance team has been busy over the past few years. In 2015 Abbott sold its developed markets pharmaceutical business to Mylan, and its animal health business to Zoetis. In January 2016 the company agreed to acquire Alere, a manufacturer of point-of-care diagnostics. With the exception of pharmaceuticals, the company has increased profit margins and returns in each segment by streamlining distribution networks and shifting production to low-cost regions such as China and India. But Abbott is still less profitable than its closest peers, and there is room to grow margins through additional efficiency improvements.

Figure 1: Segment Analysis

Nutrition

2013

2014

2015

EBIT Margin

18.7%

20.1%

25.0%

Op ROA

35.9%

42.5%

55.0%

%Capex/%Assets

1.05

0.74

0.71

       

Diagnostics

2013

2014

2015

EBIT Margin

22.1%

22.8%

25.0%

Op ROA

30.4%

36.4%

41.0%

%Capex/%Assets

1.29

1.75

1.82

       

Pharma

2013

2014

2015

EBIT Margin

19.3%

20.0%

17.6%

Op ROA

38.0%

27.8%

29.7%

%Capex/%Assets

0.95

0.90

0.81

       

Vascular

2013

2014

2015

EBIT Margin

32.0%

36.5%

38.0%

Op ROA

56.2%

71.0%

69.0%

%Capex/%Assets

0.39

0.27

0.33

Click to enlarge

The improved profitably has occurred despite lower third-party reimbursements that have caused prices to fall. Pricing pressures will persist, but Abbot has important competitive advantages that will partially mitigate them. With the exception of pharmaceuticals, Abbott is one of a few dominant players in the market for its products. The company's brand strength, efficient scale, and intangible assets allow the firm to maintain stable market shares, and position the firm to reap the rewards of growing end-market demand.

In nutritional products, the company's second-highest returning segment, the company has made key infrastructure investments in China, India, and the US to better serve local markets. These investments in manufacturing facilities have not only lowered costs but also raised barriers to entry by strengthening Abbott's distribution channels. Thanks to its strong brand and local infrastructure, the company is poised to benefit from an increasing rate of chronic disease in developed markets and a growing middle class in emerging economies.

In the diagnostics business, Abbott's strong intellectual property provides a temporary moat. Because of rapid innovation and short product lifecycles the company must continue to innovate to defend market share over time, but there is nothing to suggest that it won't be able to. We like the Alere acquisition because it gives Abbot exposure to the faster growing point-of-care segment of the diagnostics market and diversifies the customer base to include less-price sensitive private medical practitioners.

After the sale of its developed market pharma business to Mylan, Abbott's pharmaceutical segment focuses almost exclusively on emerging markets. In 2014, the company purchased CFR Pharmaceuticals, which more than doubled Abbott's share of the branded generics market in Latin America, and acquired Veropharm to establish a presence in Russia. The branded generics market has become more competitive due to the increasing substitution of generics for prescription drugs as well as the introduction of new generics. However, because emerging markets typically have less developed distribution systems, brand and reputation are important competitive forces as companies sell directly to customers. Thus branded generics typically earn higher margins than non-branded generics, and Abbott's reputation for quality and reliability provides a key advantage.

Conclusion

Abbott trades at a forward P/E of 17 compared to a peer group average of 19.5, which reflects the company's inferior profitability (operating margin of 14.5% vs. peer average of 18.1%), and weak growth outlook for 2016. The peer group consists of similarly sized medical equipment makers, including Medtronic (NYSE:MDT), Stryker (NYSE:SYK), Boston Scientific (BSK), Intuitive Surgical (NASDAQ:ISRG), Zimmer Biomet (NYSE:ZBH), Edwards Lifesciences (NYSE:EW), St. Jude Medical (NYSE:STJ), and Smith & Nephew (NYSE:SNN). Abbott has more margin upside potential and emerging market exposure than most of these companies. Consequently, when currencies stabilize we expect ABT to grow earnings at a faster rate than its peers. The P/E ratio will adjust accordingly. Until then, Abbott offers a safe and attractive divided that will continue to grow over time.

Disclosure: I/we 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.