AbbVie Inc.: Bull Thesis Strengthened By Marginal ROCE Results

Aug. 19, 2021 8:06 AM ETAbbVie Inc. (ABBV)18 Comments

Summary

  • My last article analyzed AbbVie Inc. under the framework of perpetual growth and Buffett’s 10x Pretax Rule.
  • Based on such examination, an investment here is similar to owning an equity bond with a 12.5% yield and at the same with a coupon payment that increases 6~8% per year.
  • This article furthers the analysis by examining its marginal efficiency of capital to gauge the future direction of its profitability, and the results further strengthen the bullish thesis.
  • Also, this article will address some of the comments received in my last article in more depth.

AbbVie headquarters building facade of an American publicly traded biopharmaceutical company
Michael Vi/iStock Editorial via Getty Images

The investment thesis

My last article analyzed AbbVie Inc. (NYSE:ABBV) under the framework of perpetual growth and Buffett's 10x Pretax Rule. Based on such examination, an investment here is similar to owning an equity bond with a 12.5% yield and at the same with a coupon payment that increases 6~8% per year.

This article furthers the analysis by examining its marginal efficiency of capital to gauge the future direction of its profitability. More specifically, this article will analyze the marginal return on capital employed ("MROCE") of ABBV. To me, ROCE and MROCE are the most two important metrics for analyzing a business. They reveal the two most fundamental aspects of the same central issue of profit Sustainability. ROCE tells us how profitable the business has been or is SO FAR, and MROCE sheds insights into which direction the profitability is likely to go. The MROCE results show that ABBV is currently in a very scalable stage, and likely with expanding profitability margin ahead.

Finally, my last article has received many comments. And I thought it would be helpful to go beyond the exchanges made in the comments and address some of them in more depth here, particularly around two themes: the pipeline and the 10x pretax rule.

Overview and Recap

This section provides a very brief recap of my last article to facilitate the new discussions. If you're a devout Buffett cultist like this author, you must have noticed or heard that the grandmaster paid ~10x pretax earnings for many of his largest and best deals. The list is a really long one, ranging from Coca-Cola, American Express, Wells Fargo, Walmart, Burlington Northern, and the more recent Apple and of course ABBV as seen from the chart below. Though whether his ABBV investment turns out to be a good as his other calls is yet to be seen. But the results have been positive so far. He bought 25M shares during Q3 and Q4 of 2020 in a price range of $87-$107, and the market price as of this writing is $115, as shown in the chart below. Pretax earnings are also referred to as "EBT", Earning Before Taxes, in this article. As seen, whenever the price is far above 10x EBT, it has been a good time to sell, and vice versa.

ABBV price Vs. 10x Pretax Earnings

Source: author based on Seeking Alpha data

Buffet himself also mentioned and discussed the 10x pretax multiple times in his shareholder meetings and Q&A sessions. An example quote is provided below (highlighting was added by me):

Buffett: "Geico would be valued differently than Gen RE and other insurance businesses because it's rational to assume a large underwriting profit and significant growth. You cannot say that about many insurance businesses. I would love to buy a new bunch of operating businesses with similar competitive positions to the ones we own now at nine to ten times pretax earnings."

Based on this framework, the thesis from my last article was:

  • Paying 10x EBT for a business that will stagnate forever is like owning a bond with a 10% yield.
  • In ABBV's case here, the current valuation is significantly lower than 10x EBT. It is at 8x EBT, equivalent to purchasing a bond yielding 12.5%.
  • At the same time, there is a good prospect of 6%~8% long-term growth - a growth rate that can be funded organically and sustained by the business itself.
  • So an investment here is similar to own a bond with a 12.5% yield and at the same with the coupon payment increase of 6~8% per year, leading to a very favorable odds of double-digit return in the long term.

Comments about the pipeline

Many readers provided many excellent comments regarding the pipeline. Especially the next blockbuster to complement or replace Humira.

When I evaluate pharmaceutical companies, I take a slightly different approach. I do not invest because I have high confidence in certain drugs that they are developing the pipeline. In other words, I do not bet on a few particular ideas. Instead, I feel more comfortable betting on the process. I've studied many high stake R&D cases in detail and have been involved firsthand in quite a few of them myself. There are a few key lessons that I've learned. First, the success or failure of a given project is largely a matter of chance and luck - no matter how much resources we throw at it and how high a priority management has assigned to it. Second, the successful cases are only made to appear as a planned success - AFTER they become successful.

An illustrating example here involves Pfizer's Viagra, a huge blockbuster drug. But did you know that Pfizer's original goal in that project was to develop a drug to treat cardiovascular problems? It certainly was not a successful project as a cardiovascular drug for many reasons. However, a negative and unintended side effect, accidentally discovered by a nurse, made the drug into the success as we know it today.

So instead, I focus more on the process with the understanding that if the process itself is sound and efficient, sooner or later a good idea will be developed into a successful project as long as there are plenty of ideas to be tried.

As seen from the next chart, ABBV maintains a large and healthy pipeline. This large pipeline consists of ~100 total drugs. And the acquisition of Allergan added more into the pipeline. I have some understanding of a few of them, but I have to be honest and confess that for most of them, I do not understand them nearly enough to form any judgment about their potential or likelihood of success. I bet the folks involved in the day-to-day R&D on these drugs do not know for certain. I am certain that many of them will fail. But again, it does matter if many of them fail. For me, all that matters is that A) they have a sound and efficient process, and B) they have plenty of ideas to be tried. They certainly have enough ideas to try, and the best way to evaluate the efficiency of their process is by ROCE and MROCE, as detailed in the next two sections.

AbbVie R&D Pipeline

Source: ABBV pipeline update

Return on capital employed ("ROCE")

ROCE stands for the return on capital employed. Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how effectively the business uses its capital to earn a profit. For businesses like ABBV, I consider the following items capital actually employed:

1. Working capital, including payables, receivables, inventory. These are the capitals required for the daily operation of their businesses.

2. Gross Property, Plant, and Equipment. These are the capitals required to actually conduct business and manufacture their products.

3. Research and development expenses (an essential expense for a business like ABBV).

As aforementioned, many of the drug development projects won't be successful. So instead of betting on some particular ideas, the process matters more for me. ROCE provides a good measure of the effectiveness of the process. If the business does not have an effective process, it will be reflected in a high requirement of the working capital to conduct its daily business, a low utilization rate of its properties and equipment, and/or wasted R&D money.

Based on the above considerations, the ROCE of ABBV over the past decade is shown below. As seen, it was able to maintain a respectably high ROCE over the past decade: on average 64% for the past decade. To put things in perspective, the next chart compares ABBV's ROCE against a few other businesses, both within its industry and outside. The ROCE data are directly pulled from my recent published analyses. And in case you want to see the details of how I got these numbers, you can look up my recent articles under these tickers.

The purpose here is certainly not to compare oranges with apples. The purpose here is to put ABBV's ROCE into perspective. As can be seen, they are all good quality and mature businesses. And ABBV earns a very competitive ROCE among them. Furthermore, if you are familiar with the portfolio Warren Buffett built for BRK, you would recognize that many of the stocks are in this portfolio. So the stocks shown in this chart are not really a random collection after all. They are all considered excellent long-term compounders by Warren Buffett.

ABBV ROCE over the past decade

Source: author and Seeking Alpha.

ABBV ROCE comparison

Source: author and Seeking Alpha.

Marginal return on capital employed ("MROCE")

In addition to ROCE, an equally important concept is the marginal return on capital employed ("MROCE"). To me, ROCE and MROCE are the most two important metrics for analyzing a business. They reveal the most fundamental two aspects of the same central issue of profitability. ROCE tells us how profitable the business has been or is SO FAR. And MROCE sheds insights into which direction the profitability is likely to go.

A bit of background and introduction for readers who are new to the concept. From what I've learned, the legendary economist John Maynard Keynes first explicitly expressed this concept, although people before him have observed and thought about it for some time already. What the concept tries to capture is a basic law in economic activities: the law of diminishing returns. Warren Buffett likes to say that interest rate acts like gravity on all economic activities. Well, diminishing returns act like gravity on all economic activities too, if not more so, as long as human nature does not change in any fundamental way.

The next chart illustrates the concept. As long as shareholders are seeking profit, a public business will first invest its money at projects with the highest possible rate of return (i.e., picking the lowest hanging apples first or getting the most bang for the buck first). Therefore, the first batch of available resources is invested at a high rate of return - the highest the business can possibly identify. The second batch of money will have to be invested at a somewhat lower rate of return since the best ideas have been taken by the first batch of resources already, and so on. The last batch of money invested may earn a rate of return that is only above the cost of capital. And finally, the end result is a declining MROCE curve as shown.

AbbVie - MROCE

Source: author

The ROCE we normally talk about and companies report refers to the average of this curve - averaging the return on all batches of money invested. Obviously, the average is very useful information by itself. It tells us how efficiently the business has been converting resources into profit so far - but its limitation is that it only tells us the efficiency of the resources that have already been invested SO FAR. What is of equal importance to investors is the MROCE, which tells us how much incremental profit the business WILL generate when the next batch of resources are invested.

For investors, a dream business to invest in would be a business that enjoys a flat MROCE curve as shown by the solid blue line. This would be a business that is perfectly scalable. A business that earns a consistent and stable profit for every batch of resources invested. However, such a business is really only a dream business. I mentioned earlier that diminishing returns act like gravity on all economic activities - because they really do. There has been no business (at least not so far in human history) that can keep growing while at the same time maintaining a constant return on capital. At some point, gravity always catches up and the return begins to decline (as shown by the dashed blue line).

So for investors, the next best deal is to invest in a business that A) has a high and stable ROCE, and B) that is still in the scalable stage (the gravity of diminishing return has not caught up yet). And as shown in the next chart, ABBV seems to be such a business at such a stage.

This chart shows the MROCE and ROCE for ABBV over recent years. The ROCE data are the same as those shown in the previous section. The MROCE data are estimated by the following steps. First, the capital employed was calculated for each year. Second, the earnings were calculated each year. Third, then the incremental of capital employed year over year was calculated. Similarly, the incremental earnings year over year were also calculated. And finally, the ratio between the incremental earnings and incremental capital employed was calculated to approximate the MROCE. During years when there were large fluctuations in either the incremental earnings or the capital employed, a multi-year running average was taken to smooth the fluctuations.

The results shown in the following chart show that at this stage, ABBV has been actually able to maintain an MROCE that is above the average ROCE so far. As seen, the ROCE has been on average 64% in recent years, and the MROCE has been on average 95%. So this result suggests that ABBV has not reached the stage of diminishing return yet - gravity has not caught up yet. And if the current MROCE continues, the average ROCE will keep improving.

ABBV - MROCE vs. ROCE over recent years

Source: author and Seeking Alpha data.

Questions about the similarity between 10x EBT and 10% bond yield

Another common question my last article received was about the similarity between 10x EBT and 10% bond yield. The question is why/how buying a business at 10x EBT is similar to buying a 10% yield bond even with no growth. For readers who are already familiar with this framework of thinking, please definitely skip the remainder of this section.

The reasoning behind the question is that: if there's no growth in earnings, then the share price will just stay fixed at the purchase price (assuming no change in valuation multiples) and our return will be whatever the dividend yield is (i.e., it does not have to be 10%).

The key is to understand the 10x EBT framework is to think as a long-term business owner, not as a stock trader. So now imagine ourselves as a long-term business owner, and the following steps will show why buying a forever staging business at 10x EBT will be like buying a 10% yield bond in the long run.

  • First, bond yield is quoted in terms of pretax return, not after-tax return. That is why we use EBT here.
  • Second, now let's follow the question's the assumptions made in the question, i.e., A) there's no growth in earnings, and B) there is no change in valuation multiples (i.e., valuation stays at 10x EBT).
  • Third, under these assumptions, the share price will stay fixed at the purchase price IF the business pays out all earnings as dividends. In this case, the dividend yield will be 10% pretax, exactly like a 10% yielding bond.
  • However, if the business does not pay out all earnings as dividends, then obviously the dividend yield will be below 10% pretax. However, in this case, the share price will NOT stay at the purchase price anymore. It will increase because now the business begins to accumulate cash in its bank account. And its price will be 10x EBT (following the assumption that the valuation multiple stays fixed at 10x EBT) plus the cash sitting on its bank account. Now if we add up the return we get from the dividends (whatever it is) and the return we get from the price change, our total return would still be 10% pretax.

Conclusion and final thought

My last article analyzed ABBV under the framework of perpetual growth and Buffett's 10x Pretax Rule. The analysis shows that ABBV has been earning a remarkable ROCE. Combined with its strong cash generation, the business is poised for healthy organic growth. At a valuation of 8x EBT, an investment here is similar to buying an equity bond with a 12.5% yield and at the same with a coupon payment that increases 6~8% per year.

Building on the previous results, this article furthers the analysis by examining its marginal efficiency of capital to gauge the future direction of its profitability. More specially, this article analyzed the marginal return on capital employed ("MROCE") of ABBV. ROCE tells us how profitable the business is/has been SO FAR. And MROCE sheds insights into which direction the profitability is likely to go.

The results show that at this stage, ABBV seems to be maintaining an MROCE that is above the average ROCE. The ROCE has been on average 64% in recent years, and the MROCE has been on average 95%. So this result suggests that ABBV has not reached the stage of diminishing return yet - gravity has not caught up yet. And if the current MROCE continues, the average ROCE will further improve.

Thx for reading! Look forward to your comments and thoughts!

This article was written by

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** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** PhD,  2006, Stanford University, Stanford, CA 

Department of Mechanical Engineering, with concentration in  advanced and renewable energy solutions

** 15 years of investment management experiences 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Diverse background and holistic approach 

Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities. 

I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.

Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.

Disclosure: I/we have a beneficial long position in the shares of ABBV either through stock ownership, options, or other derivatives. 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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