3 Things Investors Need To Know About AbbVie's Future

Jul. 10, 2019 12:03 PM ETAbbVie Inc. (ABBV), AGN142 Comments99 Likes

Summary

  • AbbVie has taken investors on a wild ride in the past few years. Shares are 42% off their all-time high over Humira concentration concerns (plus normal pharma headline risk).
  • Long-suffering investors want to know "how low can AbbVie go?"
  • The $80 billion (including debt) Allergan acquisition caused a 16.5% single day crash, and this high-risk M&A deal likely means the stock is stuck between $65 to $75.
  • Shares might potentially fall as low as $60 in a broader market correction, but ultimately the deal will probably make AbbVie a much more valuable company.
  • Credit rating agencies believe that management will deliver on deleveraging, the dividend remains safe (a level 8 quality company), and AbbVie's 5-Year total return potential according to F.A.S.T Graphs is 19% CAGR from its 41% discounted price.
  • Looking for more? I update all of my investing ideas and strategies to members of The Dividend Kings. Start your free trial today »

(Source: Imgflip)

While there are many ways to invest in dividends stocks, my personal favorite (shared with my two fellow Dividend Kings Brad Thomas and Chuck Carnevale) is value investing. That's because buying quality companies at a large discount to fair value is how seven of the eight greatest investors in history achieved their awe-inspiring returns.

But the trick to good value investing is that it requires, in the words of famed value investor Tom Russo, a large "capacity to suffer" through many years of underperformance.

(Source: Gurufocus)

From 1984 to 2014 Russo's partnership managed to compound their investors' money at 15.5% CAGR, achieving 41% annual outperformance over three decades. But from 1995 to 1999 Russo badly trailed the market, for five consecutive years (Buffett too badly underperformed during the tech bubble). Heck, in 1999, the peak of the tech bubble mania, Russo lost to the market by 22.5%, which must have caused him (and his investors) no end of uncertainty and doubt about the long-term viability of their strategy.

But as Russo and other famous value investors have proved over the decades, discipline and the patience of a saint are what's required to truly achieve legendary returns.

Which brings me to AbbVie (NYSE:ABBV) one of my (and the Dividend Kings') highest conviction buys. My fellow Dividend Kings Chuck Carnevale recently explained why he's so bullish on AbbVie in a fantastic F.A.S.T Graph-based article.

But if AbbVie is so great, then why has its share price crashed 42% off its all-time high, and remain mired in the toilet for so long?

(Source: Ycharts)

And most importantly, at least as far as many long-suffering shareholders are concerned, is the question "how low can AbbVie go?" Here are three things to know about AbbVie, and both its short and long-term future prospects and return potential.

1. AbbVie's Allergan Acquisition Is Likely To Cap Upside In The Short Term But Create A Far Better Dividend Growth Stock In The Long Term

In several healthcare stock articles, I've warned readers that even the tightest of coiled springs (AbbVie is most definitely one of these) may not pop for a long time. That's because campaign 2020 is underway, which means 26 Democratic Presidential hopefuls will be competing to see who can sound the toughest when it comes to sticking it to "greedy healthcare companies".

And it's not just the left that talks a big game about healthcare reform. President Trump continues to attempt his own regulatory reforms aimed at lowering drug prices, a key 2016 campaign pledge (which thus far no politician has been able to deliver).

But as all healthcare investors know (or should) such headline risk is merely the price of investing in blue-chip dividend stocks in this sector. By far, the biggest reason for AbbVie's recent weakness (and why I think it's stuck trading between $65 to $75 for the next few quarters) is the $80 billion (including debt) acquisition of Allergan (NYSE:AGN).

The $188 total buyout price for Allergan represents a 45% premium which has some investors thinking AbbVie, desperate to diversify away from its cash cow immunology drug, overpaid for Allergan, which is facing rising competition for its key Botox injectible.

(Source: F.A.S.T Graphs)

In reality, AbbVie is paying about 11.3 times 2019's earnings for Allergan, hardly an absurd price given its reason for acquiring the company. And I'm not the only one who thinks so. Here's Morningstar's Damien Conover, who is one of the most conservative analysts covering the company on Wall Street.

While the Allergan acquisition carries a significant premium to the stock price, we viewed the company as undervalued. We believe management was opportunistically taking advantage of Allergan's low price combined with the need to reduce AbbVie's dependence on Humira." - Morningstar's Damien Conover (emphasis added)

Buying Allergan will reduce Humira concentration from 57% to 39%, significantly reducing the single biggest overhang to the stock since early 2018.

Mind you, Humira, which doesn't face US biosimilar competition until 2023 (about 2/3 of all Humira sales are from America) is still expected to generate a river of cash for AbbVie.

(Source: EvaluatePharma)

Even in 2024, after no less than seven biosimilars hit the market in this country, EvaluatePharma estimates that Humira's global sales will still be $12.4 billion, making it the world's second best-selling drug.

However, it's true that Humira sales are likely to fall at high single digits through 2024, which means AbbVie's purchase of Allergan makes a lot of sense. As its CEO Rick Gonzalez explained during the post-M&A conference call,

Assets of the quality of Allergan are not always available and certainly not at this value. The opportunity to access these attractive durable franchises and immediately rescale on our growth platform, and at the same time, have ample HUMIRA cash flow to deleverage before the U.S. LOE, is an incredibly compelling opportunity, and one that we did not want to pass up...Cash flow from HUMIRA provides the ability to rapidly pay down debt, which we have committed to reduce by $15 billion to $18 billion by the end of 2021 with further deleveraging through 2023." - Rick Gonzalez (emphasis added)

Basically, AbbVie is saying that it's buying Allergan for the highly stable nature of its cash flow ($4.5 billion in annual Botox revenue alone, growing at high single digits). Humira, which will generate a river of cash for the next decade, will pay off the debt (courtesy of a $38 billion bridge loan) needed to close this deal.

But let's talk about that debt because I know a lot of investors are deeply worried that AbbVie's approximately $96 billion in total debt could cause a dividend cut. In fact, purely due to very high leverage (leverage more than doubling from 2.0 to 4.4) Simply Safe Dividends, where I'm an analyst, cut AbbVie's dividend safety from "safe" (above average for US companies) to "borderline safe" (average for a US company).

I also lowered the companies quality score rating from 9/11 (SWAN) to 8/11 (Blue-Chip) purely due to the elevated debt, and heightened risks that will pose to the payout should anything go wrong.

BUT let me be clear that, for now, it appears AbbVie's dividend is not likely to get cut, and don't just take my word for it. Here's what management (which has beaten and raised its own guidance in 13/25 quarters the company has existed) had to say about the safety of the dividend.

The transaction also provides enhanced cash flow to support a strong and growing dividend...On the dividend, look, again, this just assures that we can continue to drive a strong and growing dividend. We're absolutely committed to a growing dividend, and nothing has changed. And this gives us a higher level of assurity to be able to continue to do that at a robust rate." - Rick Gonzalez (emphasis added)

Of course, given that AbbVie loves its dividend aristocrat status (under the S&P's spin-off grandfather rule) we'd expect them to claim the dividend was safe and would keep growing, right up until the company might be forced to cut it.

But here's why I, and credit rating agencies, trust that AbbVie will live up to its goals of reducing net debt/EBITDA to the low 3s by 2021 (and then keep driving it lower through 2023).

(Source: merger presentation)

Acquiring Allergan will mean four multi-billion dollar franchises and $30 billion in non-Humira revenue.

(Source: merger presentation)

More importantly, the new AbbVie is going to be generating over $19 billion in annual operating cash flow ($18 billion in FCF) and that's not counting organic growth OR the $2+ billion in annual synergies management says it will be able to achieve.

What does $18 billion in 2018 free cash flow mean? Well backing out the $7.5 billion in annual dividends AbbVie is paying that leaves $10 billion in retained cash flow with which to pay down debt. Remember that AbbVie has pledged to pay down debt by $15 to $18 billion in the first two years (2020 and 2021). Factoring in continued cash flow growth from both companies (AbbVie has several blockbusters growing like weeds right now), and the company should be able to support a modestly growing dividend (high single digits) and still achieve its debt repayment goals.

And I'm hardly the only analyst who thinks so. Here's Michael Levesque, Sr. Vice President of Moody's, explaining why the rating agency recently reaffirmed AbbVie's Baa2 (BBB equivalent) - stable rating.

"Moody's believes the deleveraging plan is credible based on the strength of existing blockbusters like AbbVie's Humira and Imbruvica and Allergan's Botox... At close, Moody's anticipates that pro forma debt/EBITDA will be approximately 4.4x. AbbVie has announced a debt reduction target of $15-$18 billion by the end of 2021. As a result, Moody's anticipates debt/EBITDA will decline below 3.5x within two years of the acquisition...The rating outlook is stable, reflecting Moody's expectation that earnings growth and significant debt reduction will result in debt/EBITDA declining below 3.5x within two years of the acquisition close...Factors that could lead to an upgrade include rapid uptake in Skyrizi, Orilissa and upadacitinib, reduced exposure to Humira's 2023 US biosimilar risk, and debt/EBITDA sustained below 3.0 times." - Moody's (emphasis added)

Management says it wants to maintain a BBB or higher credit rating, and Moody's chose not to downgrade the company below that exact level despite taking on about $60 billion in debt.

S&P did downgrade the company one notch to BBB+, but that's hardly a dangerous credit rating, especially given the company's massive pro-forma free cash flow. Management says that it expects to achieve 3.0 leverage by 2021 (thanks to organic growth and $2 billion in cost-cutting) and then keep deleveraging through Humira's patent expiration in 2023.

If AbbVie delivers (its track record of achieving its guidance is excellent) then the company should receive an upgrade from both S&P and Moody's to A- by the time Humira biosimilars hit the US market.

The new AbbVie's pro-forma sales will be $49 billion, which EvaluatePharma estimates would be enough to make AbbVie the 3rd largest drug maker in the world by 2024.

(Source: EvaluatePharma)

But keep in mind that according to Factset Research, analysts expect about 7% growth from Allergan through 2024, meaning that AbbVie might become the largest drug maker in the world within a few years.

In fact, based on 2018 sales, AbbVie WILL become the largest drug maker in the world. And given that most of its biggest rivals are growing at 2% to 4% annually, it may retain that title for many years.

(Source: EvaluatePharma)

That's because AbbVie expects its $30 billion non-Humira sales to grow at high single digits, which is potentially about three times faster than its peers.

(Source: merger presentation)

And let's not forget that AbbVie isn't just a company forced to buy its way to growth. Upa, one of two mega-blockbusters launching this year (management expects peak annual sales of Skyrizi and Upa to be $10 billion) is the second most valuable pipeline drug in the world right now according to EvaluatePharma.

(Source: EvaluatePharma)

In 2020 both new drugs are expected to generate over $1 billion in sales combined. And following the Allergen acquisition, AbbVie's R&D budget is going to soar 80% (despite massive cost-cutting) which will support a drug pipeline that will now stand at 71 new drugs/indications.

(Source: merger presentation)

Over 20 of those are expected to launch after 2023, providing a growth catalyst for AbbVie after Humira loses patent protection in the US.

Basically, the Allergan deal is a good one, that makes strategic sense, and that AbbVie's skilled management is likely to pull off. Is there a lot of execution risk? You bet, as is always the case with giant M&A.

But keep in mind that frequent M&A is baked into the risk profile of this industry, AbbVie has an above-average track record on smart strategic acquisitions, and the current valuation (including 6% yield) creates a very nice margin of safety.

2. AbbVie Remains A Very Strong Buy Today (Despite What The Price Action Might Have Your Believe)

After working with Chuck Carnevale, I've decided to switch my valuation model to a purely historically based one. This may not be perfect (no valuation method is) but it's more objective than the alternatives (such as analyst price targets or fair value estimates).

Company Current Price Dividend Yield FV Historical PE FV Historical EV/EBITDA FV Average Fair Value Estimate Potential Trim/Sell Price Discount To Fair Value

F.A.S.T Graphs Estimated 5-Year Total Return Potential

AbbVie $71.53 $115 $127 $120 $121 $151 41% 19.2%

(Source: F.A.S.T Graphs)

So let's take a look at three relevant valuation metrics commonly used for highly leveraged dividend stocks to see just why AbbVie is such a strong buy today.

  • PE ratio 8.5 (7.7 pro-forma): vs a historical average of 14.5 (sector average 17.5 right now)
  • Yield of 6.0% vs 3.7% historical average
  • EV/EBITDA of 7.1 vs 10.9 historical average

AbbVie has rarely traded at a premium, thanks to the Humira concentration risk the market typically priced in. This is why its average PE was so much less than most healthcare stocks. But today Abbvie's forward PE (based on most recent guidance) is just 8.5, and 7.7 factoring in the AGN acquisition.

Similarly, the yield of 6.0% is something you tend to see with companies with virtually no growth potential, or very risky dividends. Not aristocrats whose management has a great track record of execution and who says the payout is safe and will keep growing "robustly".

And as for debt concerns, well Enterprise Value/EBITDA (market cap + net debt/EBITDA), also called the "acquirer's multiple" which private equity uses to value companies, also shows ABBV trading at a rock bottom level.

Whichever valuation method you want to use, historical yield, PE or EV/EBITDA, AbbVie appears to be extremely undervalued. I use the average of the three to estimate the stock is about 41% below its fair value of $121. A figure that is likely to rise significantly if management delivers on its post-merger promises.

The transaction delivers immediate robust financial benefit, with EPS accretion of 10% in the first full year of the combination, increasing to above 20% at peak and an ROIC that exceeds our cost of capital in year one and increasing in subsequent years." -Rick Gonzalez (emphasis added)

Basically, AbbVie is going from a very tightly coiled spring to an even more attractive deep value investment. Just what kind of return potential does that translate to?

(Source: F.A.S.T Graphs)

Let's be very conservative and ignore the 20% long-term accretion to EPS. Let's also assume that, even after Humira concentration ends up cut in half by 2023 and leverage is below 3.0 (thus reducing the risk profile significantly) that AbbVie merely returns to its historical PE of 14.5. In that case, using the analyst consensus of just 5.7% CAGR growth through 2024, AbbVie would generate 19% CAGR total returns.

Mind you, for 2019 AbbVie was guiding for 11% EPS growth and this merger likely means double-digit growth in 2020 and 2021 as well. This means that 5.7% growth is likely on the low side. But even using less than 6% EPS growth (still among the best in pharma) AbbVie has the potential to deliver total returns on par with the greatest investors in history.

Factor in the likely faster EPS growth (high single digits is reasonable) and multiple expansion to the sector's current 17.5 (which is depressed due to heightened political fears), and this is what AbbVie's upper level potential total returns look like.

AbbVie High-End Total Return Potential: 9% CAGR EPS Growth, Sector Average PE Ratio Of 17.5

(Source: F.A.S.T Graphs)

Dividend King's Top Weekly Buy list is geared towards safe dividend stocks (level 8+ quality) that can deliver 15% to 25% CAGR total returns over five years. AbbVie, even using highly conservative valuation mean reversion and growth assumptions, could definitely achieve those levels of returns. Which is why it made the list of 18 high conviction deep value blue chips and earned a spot in the Dividend Kings Deep Value Blue Chip Portfolio.

But there is one final thing investors need to know. While I, Brad and Chuck are confident that AbbVie is likely to turn out a major winner for investors, the stock MIGHT not have bottomed yet.

3. In A Perfect Storm Scenario The Stock Might Fall As Low As $60, Patience Is Required To Profit From This Coiled Spring

The reason that deep value investing has worked so well over time is that the market has the maddening ability to ignore positive fundamentals for a long time.

(Source: F.A.S.T Graphs) - $71.22 is DK cost basis across two model portfolios

For example, since peaking in February 2018 at $116 (34% historically overvalued at the time), AbbVie's EPS and dividend have growth 57% and 62%, respectively. Yet the stock price has plunged 40% because of the hardest truth value investors have to deal with, which was beautifully explained by Benjamin Graham, the father of this strategy.

In the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company."

Basically, the market is free to be as irrational as it wants about any company. Booming sales, earnings, cash flow, and dividends can coexist alongside a steadily falling share price for many years.

This is where Tom Russo's "capacity to suffer" comes in. Deep value investing isn't just about finding quality companies trading at attractive valuations. It requires the monk-like patience to wait for the market to recognize the value of steadily rising cash flows and dividends. Some of Peter Lynch's best investments didn't even become profitable until the end of year four.

Or take the example of Disney, today once more a Wall Street darling.

(Source: F.A.S.T Graphs)At the height of the tech mania, in April 2000, Disney was in a massive bubble (most non-value stocks were) trading at a PE of 63, more than triple its long-term average. It took 12 years and earnings growth of 345% before investors finally managed to break even. This is an extreme example of why you can't ignore valuation because it has such a strong influence on long-term total returns.

More recently Disney was trading at a PE of 24 in July 2015 (about 20% overvalued). Anyone who overpaid then suffered four years of zero returns, despite 37% EPS growth.

(Source: F.A.S.T Graphs)

Those who bought at a discount to fair value (not even the bottom) in August 2016 have enjoyed a 54% total return in three years, or 16.4% CAGR total returns (vs 9.3% for S&P 500).

Or how about merely buying Disney when it hit its 10 year average PE of 17.3?

  • 7/29/2016: $96 (15.3% CAGR since then)
  • 11/30/2016: $99 (15.9% CAGR since then)
  • 9/29/2017: $98.6 (23.9% CAGR since then)
  • 1/31/2018: $108.7 (21.4% CAGR since then)

Disney is just one of many examples of how once beaten-down stocks (DIS was $99.5 or 15.0 PE on 5/31/2018) can rapidly become Wall Street darlings. But only after several years of fear, uncertainty, and doubt keep them depressed despite steadily improving fundamentals.

When it comes to AbbVie there is a large number of potential risk factors that could create a perfect storm in the short-term.

  • AGN uncertainty could keep the price between $65 and $75 for the next year (until management closes the deal and begins deleveraging)
  • 2020 campaign rhetoric could create never-ending scary headlines
  • market correction (or even recessionary bear market, 40% 12-month probability based on latest economic data) could even push ABBV to $60 or possibly lower.

I'm not a market timer, just a fundamental value investor. How realistic is a price of $60 on AbbVie, a pro-forma PE of just 5.8? Well in a rational world it would be impossible. In the world we live in? It could happen. Even if AbbVie does everything right the stock market can price great companies at truly insane prices.

But I'll remind you of my two favorite quotes from the greatest value investor (or any kind of investor) in history, Warren Buffett.

“You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right – that’s the only thing that makes you right...The stock market is designed to transfer money from the active to the patient."

Am I frustrated that AbbVie, the largest holding in my retirement portfolio isn't soaring despite management making all the right moves? Sometimes. But ultimately I remember that Buffett quote, and the lessons of the great value investors in history, who sometimes had to endure half a decade of underperformance on the way to legendary market smashing results.

AbbVie remains one of my (and the Dividend Kings's) highest conviction buys because the fundamentals point to the thesis being intact, quality management executing on its plan, and ultimately the facts and reasoning on this thesis being right. In the long-term, that is the only thing that will matter.

Bottom Line: AbbVie's High-Risk Bet On Allergan Is Likely To Work Out But Good Risk Management And Patience Will Be Required

I always remind readers that pharma isn't for everyone. All stocks can go through multi-year bear markets and pharma's industry risk profile is among the most complex you can find including

  • regulatory headline risk
  • drug trial failures
  • legal/litigation risk
  • frequent M&A

These, combined with natural market pullbacks/corrections/bear markets can mean that it truly takes a dedicated income investor to stick with quality companies while they steadily grow sales, cash flow, and dividends.

AbbVie's $80 billion acquisition of Allergan is certainly risky because it means leveraging the balance sheet to a significant degree and reducing financial flexibility for years to come. This is why I'm downgrading the dividend safety from above average to average, (quality score goes from 9/11 to 8/11) with plans to upgrade it back if management achieves its 3.0 leverage target by 2021.

But as far as AbbVie trading at $71 today? That is simply not justified by the fundamentals, nor a management team that has consistently proven it knows what it's doing.

I can't guarantee you that nothing will go wrong for AbbVie in the coming years (all companies face risks, which is why management gets paid millions to handle it). But at recent prices, AbbVie is a very strong buy, and I remain comfortable with it being the largest holding in my retirement portfolio, where I keep 100% of my life savings.

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This article was written by

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Adam Galas is a co-founder of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 5,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.


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I'm a proud Army veteran and have seven years of experience as an analyst/investment writer for Dividend Kings, iREIT, The Intelligent Dividend Investor, The Motley Fool, Simply Safe Dividends, Seeking Alpha, and the Adam Mesh Trading Group. I'm proud to be one of the founders of The Dividend Kings, joining forces with Brad Thomas, Chuck Carnevale, and other leading income writers to offer the best premium service on Seeking Alpha's Market Place.


My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives.


With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and safe and dependable income streams in all economic and market conditions.


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Disclosure: I am/we are long ABBV. 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.

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