AbbVie - Stemcentrx Impairment, A Worrying Sign?

|
About: AbbVie Inc. (ABBV)
by: The Value Investor
Summary

AbbVie started the year on a bad note as it basically has written down the value of a fairly recent multi-billion acquisition.

Reality is that enormous cash flows and growing non-Humira sales look encouraging, but reduced concentration risks on Humira would be welcomed.

Shares look very cheap, but leverage ratios could increase rapidly in case Humira sales drop while dividend commitments are high.

All in all I consider shares to be largely fairly valued at this point, despite the cheap optics.

AbbVie (ABBV) had some bad news to share with investors at the start of the year although much of this has already been priced in. The company took a large impairment charge on a past acquisition, as this latest disappointment comes at a time when investors are growing fearful about the reliance on top selling drug Humira.

Reality is that AbbVie made some important progress in 2018 by growing non-Humira sales in 2018, yet despite this progress and a cheap multiple, I am not jumping on board just yet.

The Impairment Charge

AbbVie has recorded a massive $4 billion impairment charge on Stemcentrx, a company which it only acquired as recent as 2016, as it warns at the same time that another one billion in assets might have to be impaired as well.

When the company announced the deal less than three years ago, AbbVie touted that experimental lung cancer drug Rova-T could be commercialized in 2018 and generate billions in potential revenues. The huge impairment charge is essentially an admittance that the initial $5.8 billion upfront deal has been a failure.

The Challenges

AbbVie has been a hugely successful company in recent years, driven by the enormous cash flows provided by Humira, among others. The company has grown from a $20 billion business in 2013, to $25 billion in 2017. In an upbeat presentation dated early 2018, the company even laid down a road map for $47 billion in sales by 2025, including a $12 billion contribution from Humira, indicating that besides growth, reliance on Humira would come down a great deal as well.

This comes as Humira is expected to grow in the meantime, with the company initially targeting $18 billion in sales for 2017 at the start of 2018, and guiding for $21 billion in sales by 2021.

When I last looked at the shares in April of 2018, I concluded to not buy the dip just yet at $92 per share, which came after shares lost 25% of their value from a $125 peak exactly a year ago. I was a bit cautious based on the 2017 results which revealed total revenues of $28.2 billion, of which $18.4 billion (65% concentration) from Humira. With adjusted earnings running at $5.60 per share, multiples looked reasonable at 16-17 times, yet those were adjusted earnings, concentration risks were very real, and a $27.6 billion net debt load worked down to a roughly 2.5 times leverage ratio, pretty steep as well.

The caution has served me well with shares currently trading at $89, essentially unchanged although we are about 9 months further in time and investors had to digest some disappointments in the pipeline.

2018 Results

Alongside the earnings release for the year 2017, AbbVie did announce that 2018 adjusted earnings could come in as high as $7.33-$7.43 per share, with GAAP earnings seen nearly a dollar lower at $6.45-$6.55 per share.

The company has actually seen a solid start to 2018 with first quarter sales up 21.4% in reported terms, with Humira sales up 14.4%, thereby reducing reliance on the drug to 59% of sales. Strong growth was driven by a 38% increase in Imbruvica sales to $762 million for the quarter, and HCV sales more than doubling to $919 million. The company was happy to use the operational momentum to keep buying back stock and delivering on dividend hikes to please investors as the real solution to reduce concentration on Humira still had to be solved of course. This is as investors would like to avoid a "Gilead" scenario.

Second quarter sales growth of 19% was solid as well with Humira sales up 10%, making up 63% of second quarter sales. Third quarter results, as released in early November, showed that sales were up 18% with Humira sales up 9%, for a 62% concentration.

For the year of 2018, the company now sees adjusted earnings at $7.90-$7.92 per share, a healthy increase from the initial outlook as GAAP earnings are seen slightly lower at $6.43-$6.45 per share. The $1.47 per share discrepancy is comprised out of a range of items including asset amortization, milestone payments, acquired R&D, charitable contributions, as many of these are quite structural and involve real cash outflows. This excludes the $4 billion impairment charge discussed above which amounts to little over $2.50 per share, making that GAAP earnings are probably seen around $4 per share in 2018, or even lower.

Of course this has been paid for yet it is real value having gone up in smoke. The good news is that AbbVie has seen solid growth so far this year, including Humira, which makes that diversification progress has only gone so far. The good news is that non-Humira sales rose by 35% year-on-year in Q3 and came in just above $3.1 billion, creating a franchise with $12.5 billion in annualized sales.

About The Valuation

Note that despite a compelling dividend of $4.28 per share, for a near 5% yield, and continued share buybacks, AbbVie continues to have great liquidity thanks to solid earnings. Cash, equivalents and investments total $10.3 billion as total debt has risen to $40.5 billion, for a net debt load just above the $30 billion mark.

With adjusted earnings of close to $8 per share and 1.5 billion shares outstanding, that works down to $12 billion in adjusted earnings. After adding back a billion in interest per year and a 15% tax rate representing another $2 billion, I peg adjusted EBITDA at about $15.5 billion based on "regular" depreciation charges of half a billion. This works down to a leverage ratio of around 2 times.

Hence, the $5 billion impairment is not the biggest worry, at little over $3 per share, but it could pose real risks to the $35 billion non-Humira revenue outlook seen in 2025. These sales only run at $12.5 billion now indicating that real progress is needed in the six years to come, and Stemcentrx was earmarked to contribute greatly to this anticipated growth.

Reality is that the valuation today looks more compelling than in April when shares were trading at the same level while Humira continues to grow but more importantly, non-Humira sales continue to show real progress.

Back-Of-The-Envelope

AbbVie's non-Humira franchise of $12.5 billion is growing by 35% per year. With big pharma names with stagnant sales easily trading at 4-5 times sales, I believe that this business might fetch about 8 times sales, or about $100 billion given the growth.

The question is than what Humira is worth. With operating margins for the company as a whole around 40% and Humira being a $20 billion franchise currently, I see earnings of Humira at $8 billion on an operating basis. Applying a 5 times multiple, given the upcoming headwinds, I am happy to attach a $40 billion valuation to that. The combined $140 billion valuation looks like a lot, but note that at $89 per share, the equity valuation amounts to $133 billion with 1.5 billion shares outstanding. Including net debt, the enterprise value amounts to $163 billion, indicating that shares are more or less fairly valued, or even slightly overvalued.

This changes entirely if the 2025 targets are to be achieved. In that case a more established pharma business with $35 billion in non-Humira sales might be worth $200 billion, or so. With Humira perhaps being worth a few billion at the time and fat retained earnings in the meantime having reduced the share count by 5% per annum, I see valuations at $150-$200 per share.

Trading at $89 that offers compelling upside, but requires real execution towards $35 billion in non-Humira sales, which looks too demanding especially given the recent setback in the pipeline. On the other hand, it assumes no real contribution from Humira anymore in five year's time, as it remains to be seen how the sales trajectory will work out.

Another potential worry is the dividend trap as the dividend is quite compelling, but represents a high payout ratio, with the company probably not very likely to cut dividends in case Humira sales might improve in the future. Furthermore, reduced earnings could easily increase leverage ratios quite a bit. For now, I see shares as largely fairly valued, as I would like to see shares start with a seven handle before initiating a small position.

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.