AbbVie: A Great Company, But Is It A Good Value?

| About: AbbVie Inc. (ABBV)

Summary

Shows how to analyze your own portfolio using a unique valuation methodology based upon Free Cash Flow Return or Invested Capital.

Explains the difference between how a company operates on Main Street and is valued on Wall Street.

Introduces a conservative approach to investing by practicing the strategy of "Capital Appreciation through Capital Preservation.".

Introduction

I want to start out with a very appropriate quote from Warren Buffet, the Oracle of Omaha. It comes from his 2008 letter to shareholders in the Berkshire Hathaway (BRK.A, BRK.B) annual report:

This quote is especially important today considering the high valuations of most stocks traded on U.S. exchanges. I believe AbbVie (NYSE:ABBV) is a good, relatively high dividend-yielding company (currently yielding 4.1 percent) that will provide several years of solid dividend income for its shareholders. But is it a good value at its current valuation? There are many ways to value a company, so I want to introduce one that I like but is not so well known and very consistent with the methodology employed by the Oracle himself.

For a good description of its drug pipeline and what is coming off patent, please see this short article.

The Macro Environment

Before I get into the valuation of the company, let me first provide a little support for my early statement about high valuations. The chart below shows us that according to the Shiller "Graham P/E," which uses the ten-year average of earnings for the S&P 500 to smooth out some of the volatility, the market has been this overvalued at three other points in history since 1900: 1929, 2000 and 2007. Ring any bells?

Now, I want to show another chart from Mr. Shiller's site at Yale. This one depicts the ten-year moving average of dividends for the S&P 500. I want you to keep in mind that dividend increases have been soaring over the past few years, yet the yield of those dividends has been falling fairly consistently, with the exception of recessionary periods when the market crashes and stock prices fall more than dividends, thereby increasing the relative yield.

Here is a chart showing the annual dividend for the S&P 500, just as a refresher, from here.

Notice the ascent of dividends since 2010. Now look back at the earlier chart, and please notice the lack of ascent of the yield. My point in all this is that real value is getting harder and harder to find in stocks these days.

At this juncture, I want to share another quote from Warren Buffett's letter to shareholders from the 1958 annual report of his partnership. This one speaks to how he looks for "undervalued securities":

"To the extent possible, therefore, I am attempting to create my own work-outs by acquiring large positions in several undervalued securities. Such a policy should lead to the fulfillment of my earlier forecast-an above average performance in a bear market, and a normal performance in a bull market. It is on this basis that I hope to be judged."

Judging by his compounded annual return over the 50 years from 1965 to 2015 of 21.6 percent, I would have to say he and his investors are pretty happy. Consistent returns of that magnitude are getting harder to achieve, but the principle is still rock-solid, in my humble opinion.

Finding value require patience, and lots of it. You will find that theme in many of my articles. Cash is not trash; it is an option on finding value in the future. The best time to have loads of cash available to invest is after stocks have tumbled significantly due to a recession, and not when stocks are hitting all-time record highs.

I tend to invest for dividends. I want to keep adding consistently rising streams of income for future use. I keep collecting those dividends and letting the cash pile up until I find something that I consider to be a good value. How do I define a good value?

I use three methods primarily: the DDM (dividend discount model), the simple P/E (price/earnings) relative to the historical P/E and the Friedrich method using the FROIC (free cash flow return on invested capital). The later method was new to me until about a year ago, but I have come to use it more and more.

Full disclosure: I am now associated with the creator of the Friedrich Algorithm. I would not associate with something that I did not trust.

Valuing AbbVie

AbbVie does pay a nice dividend that currently yields 4.1 percent, but I do not expect the dividend increases to continue apace with the recent history. Since the company was spun off from Abbott Labs (NYSE:ABT) (on January 2, 2013), the compound annual rate of dividend increase has been 12.5 percent. That rate of growth could slow due to its top revenue generating drug, Humira, coming off patent. However, it is not apparent when the loss in revenue, if any, will occur, due to tactics being employed by AbbVie as well as other makers of biologic medical treatments. The share price has been basically flat for the last two years, demonstrating the questions surrounding the Humira patent which contributes over $14 billion in annual revenue, over 60 percent of AbbVie revenue. The company does have some promising drugs in its pipeline in late-stage trials, though. So, revenues may not fall off a cliff and could rebound nicely in the future. This is always a concern with the pharmaceutical industry.

A yield of 4.11 percent is enticing and does demonstrate that management intends to use the dividend to reward shareholders in a meaningful way. The payout ratio is nearly 63 percent, so there is not a lot of room for growth there. My expectation for dividend growth going forward is only about 4.6 percent. With the already high yield, I would not expect total return of more than eight percent per year from ABBV over the very long term. My reasoning is that much of the growth experienced by the company (and much of the pharmaceutical industry) has come from significant annual price increases in existing drug therapies. With healthcare reform again up in the air, I do not expect that trend to continue, since Congress is already aware of the situation, which increases the likelihood of action to stem rising costs. (These are my assumptions; yours may differ and yield a more aggressive or conservative outcome.) That means at least half (or a little more) of the total return will come from dividends. These expectations yield a current fair value of $59.37 per share. The current price is $62.83. So that is not far off the mark.

As we move on to the P/E valuation, I see that according to the Old School Value (OSV) site (email sign-in required), which I also like as a source of data, the normal P/E (or average P/E at fair value) is 18.2; the current P/E (as of the market close on Wednesday, March 01, 2017) is 17.3. This would imply that the stock may be priced at a slight discount to its value. OSV lists a DCF (discounted cash flow) model value of $83.95 and an EBIT multiple value of $69.84 (consistent with the P/E relationship mentioned above). I do not think either takes into consideration the potential for slower growth.

Now I want to explain how to analyze a stock using free cash flow return on investment. We will take a deep look into the numbers for AbbVie and, at the same time, explain the methodology involved in this analysis.

Main Street (the real world) is where AbbVie operates and Wall Street (the hype casino) is where its shares trade. AbbVie shares available for purchase on Wall Street are in the public domain, and the company has little control over the price at which each share will trade. AbbVie is required to release its earnings reports each quarter, and from time to time, it also provides press releases to its shareholders (and the general public), giving updates on how its operations are doing on Main Street.

Main Street is where AbbVie invests in its own operations and creates products/services that its customers can purchase. How well AbbVie management does in pricing and selling those products determines the profitability the company. Wall Street then reacts based on the success or failure of management to meet goals set by analysts with guidance from AbbVie management. Main Street and Wall Street thus have a seemingly symbiotic relationship. The disconnect that often occurs between the two is the result of perceptions and the ability of almost anyone to buy or sell any stock at any time. Expert analysis is not required to invest on Wall Street. The rise of such competitive forces such as hedge funds, dark pools and HFTs (high frequency traders - using algorithms) that account for the majority of trading volume most days has created a far different investing environment than that which existed 30 or more years ago when I got started as an investor.

It seems to me that we are subject to much more of a herd mentality and momentum investing than ever before. Fundamental analysis and investing for the long term have become unfashionable on Wall Street. That is probably because it does not produce as much revenue for the powers that be on Wall Street. They need ever-rising volumes to keep respective revenues and profits rising.

This results in advice coming from Wall Street to be potentially very dangerous for individual investors. Many individual investors experience emotional swings about individual stocks and tend to follow the herd in and out, creating more volume and revenue for Wall Street and often more taxable revenue for the government. During bull markets, investors experience euphoria as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and stampede over the cliff like lemmings. Thus, we have the classic case of "greed vs. panic." It is the game that Wall Street plays to its advantage, not ours.

I am a fan and student of both Benjamin Graham and Warren Buffett. Our Friedrich Algorithm was designed to assist all investors (both pro and novice alike) and give them the ability to quickly compare a company's Main Street operations to its Wall Street valuation. Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500, an ETF, mutual fund or individual portfolio.

The Berkshire Hathaway 1986 letter to shareholders contains a ratio which Mr. Buffett entitled "Owner Earnings." It is what we would consider to be a version of "Free Cash Flow." This is one of the many gems hidden throughout the letters and footnotes where one can find explanations from Mr. Buffett on the key ratios that he and Charlie Munger used in analyzing stocks. In that letter, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

"[Owner earnings] represent A) reported earnings plus B) depreciation, depletion, amortization, and certain other non-cash charges... less C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."

I like the free cash flow ratio, as I believe earnings can be manipulated but a company's ability to create cash flow is more representative of its underlying operational efficiencies and financial well-being. Arnold Bernhard, the founder of Value Line Investment Survey, was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. Our 60-year backtest of the DJIA from 1950-2009 used data from Value Line.

In the backtest mentioned above, we demonstrated that if one can purchase a company whose shares are selling for 15 times or less its Price-to-Free Cash Flow Ratio, the probability of success will dramatically increase in most cases. We have renamed the ratio the Bernhard Buffett Free Cash Flow ratio in honor of both men. The following is how that ratio below is calculated.

Price-to-Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-term Debt)/Diluted Shares Outstanding))

The above are the ratios to use when analyzing a stock on Wall Street, and below are the ratios we use when analyzing a stock on Main Street.

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/ (Long-term Debt + Shareholders' Equity)

What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it has an FROIC of 20%, which we consider excellent. This is just one of the key ratios that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street, the news will eventually show up on Wall Street's radar.

So, let us begin our analysis and at the same time try to teach everyone how to do a similar analysis on one's own portfolio. In analyzing AbbVie's Price-to-Bernhard Buffett FCF ratio, we must first analyze the company's Sherlock Debt Divisor. Here is a detailed definition of what that ratio is:

Sherlock Debt Divisor. A major concern that we have these days in analyzing companies is the amount of debt relative to its operating cash flow, and whether management is abusing this situation by taking on more debt than it requires. Debt can be used wisely to create leverage, and leverage can be extremely beneficial within certain parameters. On the other side of the coin, too much reliance on debt can be unsustainable and put a company's future in jeopardy. So, what we have done to determine if a company's debt policy is beneficial or abusive is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that rely too heavily on debt and reward those who successfully use debt as leverage. To do this, we take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, we reward it. Conversely, we punish those whose long-term debt exceeds their working capital. If the result of this calculation is higher than the current stock market price, then leverage is being employed. A company with too much leverage will generate a result of this ratio that will adjust our other ratios, making the stock less attractive as an investment.

Having successfully defined the Sherlock Debt Divisor, we now need the following four bits of financial data in order to calculate it for AbbVie. TTM (trailing 12 months) is about as close to real-time data as we can get, based on when each company reports. We last updated the reports on AbbVie a few days before the company reported quarterly earnings

Market Price Per Share = $62.83

Working Capital = Total Current Assets - Total Current Liabilities

Total Current Assets = $16,187,000,000

Total Current Liabilities = $9,781,000,000

Working Capital = $6,406,000,000

Long-term Debt = $36,440,000,000

Diluted Shares Outstanding = 1,631,000,000

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-term Debt)/Diluted Shares Outstanding))

Sherlock Debt Divisor = $62.83 - (($6,406,000,000 - $36,440,000,000)/1,631,000,000))

Sherlock Debt Divisor = $62.83 - ($-18.41) = $81.24

Since AbbVie has more Long-term Debt than Working Capital, we must penalize it by using the higher price of $81.24 as our new numerator in all of our calculations.

Price-to-Bernhard Buffett FCF Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = $81.24

Net Income per diluted share = $5,953,000,000/1,631,000,000 = $3.65

Depreciation per diluted share = $1,1 89,000,000/1,631,000,000 = $0.73

Capital Spending per diluted share = $479,000,000/1,631,000,000 = $0.29

$3.65 + $0.73 - $0.29 = $4.09

Price-to-Bernhard Buffett Free Cash Flow Ratio = $81.24/$4.09 = 19.86

Now, if you go to our Friedrich Legend (on what is considered a good or bad result), you will notice that our result of 19.86 is considered good.

We last ran our datafile for AbbVie on March 1, 2017, and our Friedrich Algorithm gave a recommendation to our subscribers that AbbVie is a "Hold," as our Friedrich Datafile and Chart below show. The current share price is below the Main Street Price (estimated fair value) of $68.15, but above the Bargain Price ($45.44). There, you will also find the last ten years of AbbVie's Price-to-Bernhard Buffett Free Cash Flow results.

Now that we have shown everyone how to calculate our Price-to-Bernhard Buffett Free Cash Flow ratio, let us now move on and explain how to calculate our FROIC ratio.

This is how we calculate it:

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/ (Long-term Debt + Shareholders' Equity)

Net Income per diluted share = $5,953,000,000/1,631,000,000 = $3.65

Depreciation per diluted share = $1,189,000,000/1,631,000,000 = $0.73

Capital Spending per diluted share = $479,000,000/1,631,000,000 = $0.29

Revenue Growth Rate TTM = 12.5%

(($3.65 + $0.73) (1.125%)) - ($0.29) = $4.64

Long-term Debt = $36,440,000,000

Shareholders' Equity = $4,636,000,000

Diluted Shares Outstanding = 1,631,000,000

($36,440,000,000 + $4,636,000,000) / 1,631,000,000 = $25.18

FROIC = (Forward Free Cash Flow)/ (Long-term Debt + Shareholders' Equity)

$4.64/$25.81 = 17.98%

FROIC = 18%

Now, if you go to our Friedrich Legend again (on what is considered a good or bad result), you will notice that our result of 18% is a good result, and it tells us that AbbVie generates $18 in forward free cash flow for every $100 it invests in total capital employed. Better yet, if we scroll back up to the datafile table, we see that AbbVie has been churning out strong free cash flow since it was spun off six years ago. This is outstanding! But I cannot fathom that growth of this magnitude will continue unabated with Congress and the new Administration looking for ways to overhaul the healthcare laws. I could be wrong, but politicians like to go after easy targets in the public eye, and the rising cost of drugs is in the sweet spot of that bullseye. It may be just too tempting.

On Main Street AbbVie is doing great, while on Wall Street it is far from overbought. Now, if you can build a portfolio containing similar excellent Main Street results and buy all at attractive Price-to-Bernhard Buffett Free Cash Flow ratio results, then your portfolio should be a star on both Main Street and Wall Street. Finding companies that have excellent results on Main Street and Wall Street (simultaneously) these days is, unfortunately, like trying to find a needle in a haystack. In order to prove this point, we have analyzed the S&P 500 Index using the exact same methodology and produced final Main Street (FROIC) and Wall Street (Price-to-Bernhard Buffett FCF) results for the entire index.

The final results for the S&P 500 Index are:

FROIC = 12%

Price-to-Bernhard Buffett FCF = 38.34

For FROIC, we consider any result above 20% to be excellent and any result above 10% to be good, so the S&P 500 index, in having an FROIC of 12%, can be considered good and tells us that (as a group on Main Street) the components of the index are doing well.

The problem is that Wall Street has "overbought" the index, giving it a score of 38.34 for our Price-to-Bernhard Buffett FCF ratio. That ratio considers a stock a bargain when it trades under 15 times and overbought when it trades over 30 times. Therefore, the S&P 500 index is some 8.34 points, or about 28%, in "overbought" territory. This is just one more indication of a stock market that is highly overvalued.

When analyzing the S&P 500 Index components, we set up certain rules to use when analyzing any group of stocks, such as one's own portfolio:

1) If a stock has a negative FROIC result, we automatically assign it a score of 100 for its Price-to-Bernhard Buffett FCF ratio, in order to keep everything consistent and logical, as you can't have a negative Price-to-Bernhard Buffett FCF ratio when analyzing portfolios.

2) Then, at the same time, the maximum FROIC allowed is 100%, so we can keep everything consistent and logical as well, as anything higher distorts the results for the group.

3) We also give a zero result for FROIC for any "cash position" in the portfolio and a 22.50 result for the Price-to-Buffett Free Cash Flow (which is 15 (buy) + 30 (sell) = 45/2 = 22.50). This was done to force one never to feel comfortable in cash, unless one has no choice in the matter, like we are now. Our real-time research clearly shows that the markets are overvalued, as measured by our analysis of the S&P 500 index.

Going forward, if you want to duplicate this same analysis for your own portfolio, it will require some effort on your part in order to calculate the FROIC and Price-to-Bernhard Buffett ratio for each holding. For those who don't want to do the leg work on your own, we offer a service where we have done the calculations for 4000 US stocks and soon (as early as mid-year) to be 16,000 global stocks from 27 countries.

Point and Counterpoint

I often like to include at least one well-written article on either side of the valuation argument to give readers some other points of view to consider. Below are two on AbbVie that I found interesting. The first article likes the company and the second believes it is facing major headwinds. Enjoy!

Conclusion

It is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor tool box in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below, and don't forget to hit the "Follow" button next to my name at the top of this article. Now that we are able to analyze indices, we will begin the process of analyzing ETFs, Mutual Funds and certain popular portfolio managers' (gurus) portfolios in a series of articles here on Seeking Alpha. That effort will, of course, be in addition to providing analysis on individual stocks. Since most use the S&P 500 Index as the comparative benchmark, we can see how each is doing in a side-by-side comparison.

For those who would like to learn more about my investment philosophy, please consider reading "How I Created My Own Portfolio Over a Lifetime."

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.

Additional disclosure: Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the Disclaimer at the end of this article. Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.

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