Abbott Is Cheap, But AbbVie Will Likely Be Cheaper

May.19.12 | About: Abbott Laboratories (ABT)

Background: I bought my first shares of Abbott (NYSE:ABT) on April 13, 2010 at $52.44/share. As of Friday's close the total return of ABT thus far has beaten the S&P Total Return Index, 26.5% to 13.02%. I added to my ABT holding once, on weakness, at $47.93/share on January 3, 2011, as my analysis at the time showed it was more than 20% undervalued. That portion of the investment has even more thoroughly trounced the S&P Total Return Index, thus far, returning a total return of 35.9% to 4.86%. This is primarily because in October 2011 Abbott announced it would spin off its pharmaceutical business, which investors (or more accurately, given their entry timing, speculators) appear to have cheered. This new company will be called AbbVie.

The question now is, what is ABT/AbbVie worth, and what are its business prospects? My conclusions are 1) Humira is the key to valuing ABT/AbbVie; 2) the combined company is still cheap, but not as it was in 2011 when I added; 3) AbbVie is likely to get dumped post spin-off, and may prove a truly compelling buy at that time.

It's All About Humira: In 2011 Humira generated over 20% of ABT's total revenues. If you look at the pharmaceutical company, AbbVie, which ABT is about to spin off, Humira will easily be over 40% of AbbVie's total revenues. And after the spin-off, Humira will constitute 80% of the profits of AbbVie. Thus, the patent expiration of Humira is the single most important thing that any investor in ABT or in AbbVie needs to think about. (That and what will replace it!) As you can see here and here, the Humira patent expires in December 2016. Four and a half years, ladies and gentlemen. I submit to you that is not a lot of time.

Valuation Analysis: I focus on Humira above because it feeds into the valuation analysis. As hard as discounted free cash flow analysis is for any stock, and as prone to exaggeration and misinterpretation and risky assumptions, I think that is even more true with regard to a pharmaceutical company. There is a gambling aspect to saying whether a company can replace drugs or devices that go off patent. Nonetheless, let us see where the analysis leads us.

I use a 10% discount rate for ABT/AbbVie, which is my best calculation of its WACC, after consulting Morningstar's report, Wikiwealth, and Dr. Google. But mainly I have considered Morningstar, though notably Morningstar uses a lower WACC of 9.3%, which would raise ABT's valuation. (For some reason, my calculated WACCs are always higher than Morningstar's, and until I figure out why that is, I prefer to err on the side of being conservative.)

Looking at the recent past, ABT has actually experienced very significant (for a company its size) free cash flow growth in the last nine years -- on the order of 11.59% annualized, with most of this growth coming in the last five years to boot! Sadly, you cannot, as a conservative analyst, credit ABT/AbbVie with this kind of growth going forward, because the growth is in large part Humira-derived, and the non-pharmaceutical components of the legacy ABT business have not been growing nearly as quickly. Accordingly, I set my annualized growth assumption at a much lower rate for the next ten years, of 4%. This is intended to be a blend incorporating 10%+ annualized growth through 2016, followed by assumed stagnation and perhaps even some annualized free cash flow diminution as Humira is lost. Incorporated in this assumption is another one: that the two separated companies will grow at about the same cumulative rate as ABT would have grown as one company. (I think that's a fair assumption: see my "Random Thoughts" section below.) The only thing that will change is investor perception.

Using these assumptions, I derive a value per share of a bit more than $69.50. As of this writing, that means the stock is more than 11% undervalued. That is not quite enough tempt me into adding at this time. I would like to see the price at approximately $55.50/share before I add any more, in order to derive my 20% margin of safety.

Random Thoughts on M&A and Spin-offs:

Let me just say I am not an ardent fan of mergers & acquisitions, and likewise I am not a fan of most divestitures and spin-offs. There is no inconsistency in those positions. Both are based in the idea that I like to see a company with strong organic growth, where management does not pay much attention at all to the stock price, figuring the market will take care of that eventually if management does its job. M&A is typically the strategy of a company that lacks sufficient internal growth opportunities, and it often results in overpayment for earnings streams, and what Peter Lynch famously called "diworsification." (Though note that ABT acquired Humira in an acquisition ... .)

Spin-offs, by contrast, are virtually always a strategy designed to "unlock value," and seeking to "unlock value" in this manner is a really good sign of a management that is paying altogether too much attention to stock price! Execute, people, and let the market eventually figure out how awesome or crappy you are. This spin-off is no exception, and page 3 of the 2011 annual report explicitly states this is the primary rationale for the split, along with a supposed divergence in the priorities and regulatory structures of the businesses (as if that hasn't always been the case!). Don't buy that bologna, this split-up is about quickly "unlocking" a bunch of shareholder value.

Warren Buffett on page 9 of the 2011 Berkshire annual report explained why a long-term investor should welcome years of a languishing stock price, as long as the company buys back tons of shares. (Notably, Abbott has not had a share repurchase program running over the past five years, though it wisely repurchased some in 2009.) Buffett even goes through the math. I highly recommend his letter, as I recommend all of his letters.

But, c'est la vie. I am terribly not pessimistic about this split because I agree the branded pharmaceutical business has nothing inherently to do with the other businesses. There is no logical reason why they need to be together, they aren't even in most cases sold through the same sales channels. They only reason they have all been under one roof in the past is because of prior empire-building and attempts to diversify. So while I don't think this spin-off will add anything substantive, I don't see it taking away much either.

AbbVie is the Most Likely Source of Opportunity: I think the spin-off is about one thing: Humira. The importance of that drug to this company likely already has investors worrying about what happens when it starts to fade away in 2016. Thus, one can expect shareholders to dump AbbVie shares after they are spun-off, and to cling to their Old ABT shares.

I am hopeful that enough people will jettison AbbVie to create a stronger buying opportunity there. Though Humira will go off-patent in 2016, it will likely lose sales more slowly than normal drugs because it is a harder-to-make biologic. And moreover, every stock has its price. I think the likelihood of "undershoot" when shareholders dump AbbVie is high. This would likely be a short-term opportunity. I, like most investors, think the medical devices/generics/nutritional company is a better long-term hold. Other things to watch for: 1) how the split allocates Old ABT's debt; and 2) what sorts of management incentives management takes with regard to each separate company. These decisions may provide important clues to discerning investors.

Disclosure: I am long ABT.

Additional disclosure: I have owned shares of ABT since Spring 2010 and I added in January 2011. I have no plans to sell or add to my positions at this time.