Long Opportunity: The Abbott Labs Split Strategy

|
 |  About: Abbott Laboratories (ABT), Includes: ALG, BMY, JNJ, MDT
by: James Shell

I was asked by one of my followers to take a look at the imminent split of Abbott Laboratories (NYSE:ABT) a highly respected $68B Pharmaceutical company.

To summarize, the company has recently announced that it will split into two parts, of roughly equal revenues. The details of the split, including the exact detail on what the ABT shareholders can expect to get out of the deal are still forthcoming. The announcement was made last October, and is discussed in some detail in ABT's 2011 Annual Report.

This kind of split happens fairly routinely, and it is always for the same reason: The management feels that the stock price does not reflect the value of the company, and by splitting the company into more than one part, each part can find its own level in the marketplace based on its earnings, growth, and strategic mix.

Here is a stock screener of very elite companies in the Pharmaceutical industry: Market capitalization of over $10B and Operating Margin of greater than 20%, which means these companies are big, and participate in non-commodity markets.

Company Symbol Mkt Cap Op Marg TTM EPS Growth (1) PE (2) PE (3) PE (4)
Novo Nordisk NVO $64.5B 33.87% 19.78% 27 24.6 20.6
Allergan ALG $29.4B 25.95% 14.69% 26.5 23.1 20.1
Eli Lilly LLY $47.9B 24.84% 13.54% 9.4 12.7 11.2
Shire PLC SHPGY $18.3B 27.74% 12.87% 18.2 15.9 14.1
GlaxoSmithCline GSK $117.4B 29.87% 10.19% 14 13.2 12
Valeant Pharmaceuticals VRX $16.7B 21.95% 12.06% 19.1 13.4 12
AstraZeneca AZN $55.3B 35.98% 3.57% 6 7.2 6.9
Teva Pharmaceuticals TEVA $43.0B 24.83% 7.95% 9.2 8.1 7.5
Johnson & Johnson JNJ $178.3B 24.95% 6.17% 13 12.7 11.9
Abbott Laboratories ABT $97.5B 23.08% 6.62% 13.3 12.3 11.6
Pfizer Inc PFE $174.0B 29.32% 3.62% 10 10.2 9.8
Bristol-Myers Squibb BMY $56.3B 32.72% -2.29% 14.6 16.9 17.3
Merck & Co MRK $117.0B 24.87% -2.60% 10.2 10.1 10.4
Sanofi SNY $102.2B 21.25% 0.57% 8.2 9.7 9.7
Average 14.2 13.6 12.5
(1) EPS Growth This year vs Projected Next Year
(2) Last Year
(3) This Year
(4) Next Year
Click to enlarge

You can see what Abbott's management is thinking: You feel that your stock should be worth just as much as Bristol Myers-Squibb at 16.9 times this year's earnings, or at the very least as much as the average in this group, 13.6 times earnings.

ABT Stock Price $/Share
Current 61.9
Last Yr This Yr Next Yr
ABT PE 13.3 12.3 11.6
Last Yr This Yr Next Yr
At Average PE 66 68 145
At BMY PE 68 85 92
At NVO PE 126 124 110
Click to enlarge

So, from their point of view, the value of ABT in the marketplace should be at least 10% higher than it currently is, if not considerably higher.

So the project of the day is to try to figure out what the pieces of ABT are worth, based on limited information.

The most useful source of information is the table on Page 52 of the ABT annual report, which gives the segment sales and growth rates for the past three years. We also have a little operating income data which allows us to understand a little about segment profitability on Page 40.

Click to enlarge.

Click to enlarge

A good summary of the split was presented at the JPMorgan Healthcare Conference in January. A "Research-Based Pharmaceutical" company will be spun off, and renamed AbbVie. This will include a line of proprietary drugs, anchored by the product Humira, sales of which are growing at a rate in excess of 20% per year, and also a portfolio of new drugs which are now in the R&D pipeline.

Here is a summary of the businesses by segment:

2011 Data Sales ($B) Operating Income ($B) Profit Margin %
Proprietary Pharmaceuticals 17 7.11 41.8%
Established Pharmaceuticals 5.4 1.3 24.1%
Nutrition 6.06 0.797 13.2%
Diagnostics 4.126 0.766 18.6%
Vascular 3.333 0.96 28.8%
Click to enlarge

The "Proprietary Pharmaceutical" business, renamed AbbVie, should be an extremely attractive company. Here you have a $17B company, with a 40% profit margin, growing in excess of 11% per year.

Here is some detail of the potential product line of AbbVie, which shows that most of the growth in this business between 2010 and 2011 was outside the US:

Sales ($M) YOY Growth %
Total US Proprietary $9,455 8
HUMIRA 3,427 19
TRILIPIX/TriCor 1,372 1
Niaspan 976 5
AndroGel 874 35
Lupron 540 12
Synthroid 522 16
Kaletra 326 -10
Total International Proprietary 7,567 15
HUMIRA 4,505 23
Kaletra 844 -5
Lupron 270 2
Total Proprietary $17,022 11%
Click to enlarge

One of the details that we are missing is the allocation of R and D expense between the two companies, as well as the substantial Sales, General and Administrative expense. We do not know exactly how much of this 40% operating margin will make it to the bottom line.

If you do a stock screener for $17B Pharmaceutical companies with greater than 40% operating margin, and 11% 2010-2011 revenue growth, you get zero results: The spun-off AbbVie will be the leader in the industry.

Par Company BMY JNJ AGN
Par Company Price/Sales 2.66 2.76 5.43
AbbVie Sales 2012-2013 20 20 20
AbbVie Market Cap at "Par" Price/Sales 53.2 55.2 108.6
Click to enlarge

In the absence of better data, I am using Price/Sales ratio as a way to get an idea of the value of AbbVie. The danger in this is that no two companies' product lines are exactly alike, the product development processes, markets, liability issues, and everything else may be completely different. The price/sales ratio also is a measurement of how the stock prices of the companies are regarded in the marketplace, and also may be different.

However, if you are the management of AbbVie, you have to be confident that you are at least as proficient as your rivals in the marketplace BristolMyersSquibb and Johnson & Johnson (NYSE:JNJ), both of which are trading at slightly higher Price to Sales ratios than ABT right now. On the high end, the management may aspire to be as good as Allergan (NYSE:ALG) which is a $5B leader in the field of making people beautiful, with products such as botox, lap bands, and various implantables, with a 20:1 PE and a Price to Sales of 5.41.The current ABT is selling at 2.46 times sales. Valuing them at BMY's price/sales of 2.66, or JNJ's price/sales of 2.76 give a value for just the AbbVie portion of ABT of the low-to-mid $50B's and using Allergan's industry leading 5.43 times sales, considerably higher.

The remaining business, which will retain the Abbott name, will consist of the "established pharmaceuticals," which do not require the same level of nurturing, and are stronger internationally. The Nutrition business is anchored by the company's two brands Similac and Ensure. These products are basically food items, are not complicated from a product development standpoint, and have some direct competitors. This segment has the lowest margin, but is the fastest growing internationally. There are two specialty businesses, "Diagnostics", featuring a line of products in the laser eye surgery industry. and "Vascular" which includes the company's stent products. Both of these products are mainly focused on US markets, are more slowly growing, and are in the middle as far as operating margin is concerned.

Here is some detail on the Established Pharmaceuticals.

Sales ($B) Growth %
Established Pharmaceuticals 5,413 20%
Clarithromycin 542 40%
TriCor
(fenofibrate) 320 29%
Creon 296 58%
Serc 233 30%
Duphaston 223 64%
Synthroid 116 12%
Total Established Pharmaceuticals 5,413 20%
Click to enlarge

You can further see the rationale in splitting the Proprietary segment off from the rest of the company based on the operating margins, per the table on Page 40. These products, which have been around for awhile, are growing at 20% per year.

We should be able to conservatively deduce the market cap of the ABT part of the "Established Pharmaceuticals" business by the same method.

Par Company BMY JNJ AGN
"Established Pharm" Sales (2012-2013) 6.492 6.492 6.492
ABT "Est" Market Cap at "Par" Price/Sales ($B) 17.3 17.9 35.3
Click to enlarge

Adding the "proprietary" to the "established" hypothetical market capitalization gives a market capitalization low $70B range.

We do not have to use guesswork to estimate the value of the nutrition business. Recently there was a transaction in which Pfizer's nutrition business was sold to Nestle. Nestle paid $12B for a business with $2.5B in sales, a price to sales ratio of 4.8.

Here is ABT's current segment sales data:

Sales ($B) Growth %
Nutritionals 5,989 9
U.S. Ped Nutritionals 1,268 5
International Ped Nutritionals 1,926 15
U.S. Adult Nutritionals 1,368 2
International Adult Nutritionals 1,427 13
Click to enlarge

Allowing for similar 2012-2013 growth, and making the assumption that the value of this business can be extrapolated from the Nestle transaction, you get a potential market capitalization for this piece of over $31B. Plus there is some additional opportunity for low-cost overseas manufacturing and additional growth in developing nations.

So, adding the $50-55B "Proprietary business," the $17-20B "Established" business, and the $31B "Nutrition" business gives roughly $100B which is the current market capitalization. The remaining two businesses are essentially valued at "zero" in the eyes of the market.

There is a par company for ABT's vascular segment. Medtronic (NYSE:MDT) is a $36B market cap company with revenues of $16B selling similar vascular products, with a price/sales ratio of 2.34.

($B)
Current Vascular Business (Sales est.) 2.18
MDT Price/Sales 2.34
Vascular Mkt Cap at MDT Rate ($B) 5.11
Click to enlarge

A stock screen of 23 companies in the "Medical Equipment" sector of greater than $1B market capitalization gave an average price/sales ratio of 2.5

($B)
Current Diagnostic Business (Est 2012-2013 Sales) 3.328
Average Price/Sales (23 companies) 2.5
Market Cap Diagnostic Business @Average Price/Sales 5.828
Click to enlarge

So to summarize: The sum of the individual parts of ABT as it currently stands, given a reasonable growth assumption, and given similar price/sales ratios of comparable companies in each segment is as follows:

Hypothetical Sum of Parts Low Case Med Case High Case
Proprietary Pharm 53.20 55.20 108.60
Established Pharm 17.27 17.92 35.25
Nutrition Business 31.39 31.39 31.39
Vascular 5.11 5.11 5.11
Diagnostic 5.83 5.83 5.83
Total Theoretical "Market Cap" of the Parts 112.80 115.45 186.18
Shares (NYSE:B) 1.57 1.57 1.57
"Value" of ABT $/share 72 74 119
Current ABT Selling Price 61
Click to enlarge

In the low case, we're looking at a 12-15% upside, in the high case, we're looking at a nearly doubling of the current stock price. These results are consistent with the ones we did above using comparable market PE ratios.

Needless to say, everywhere there is an "if", "Estimate", or other assumption above, there is a chance for error. The managers of ABT have the added benefit of knowing the cost structure and more importantly, the allocation of debt, overhead, R&D expense and other factors across these segments, so their numbers will be considerably different, and in some cases may be much better.

Also we do not know exactly how the shares of the new company will be distributed among the existing ABT shareholders. We will have to review our calculations in light of new information as it arises.

But, you have to say on the surface of it, we have an already well respected company at the very top of their industry, engaged in growing and highly profitable markets, and with an opportunity to capture additional value by splitting strategically. There is an opportunity for an investor if he or she wishes to take it.

Naturally our information is incomplete. We will have to get a more detailed picture later.

The world is full of chaos, and there are no guarantees on anything.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.