AbbVie Inc.: Dissect Its Growth Sustainability And Capital Allocation Like Buffett

Oct. 12, 2021 12:04 PM ETAbbVie Inc. (ABBV)14 Comments30 Likes

Summary

  • My last article on AbbVie Inc. examined its wide moat, high return on capital employed, and superb scalability.
  • This article examines the stock with a focus on its growth sustainability and capital allocation effectiveness like Buffett - as a long-term business owner.
  • And the results show excellent prospects of sustainable growth with its high return on capital, strong organic cash generation, and effective capital allocation.
  • Also, given the price volatilities in the past few weeks, this article analyzes the sensitivity of the long-term return with respect to the entry price.

Abbvie

vzphotos/iStock Editorial via Getty Images

Investment Thesis and Overview

If you are reading this, chances are you already know that AbbVie Inc. (NYSE:ABBV) is a major holding in Warren Buffett's portfolio. He bought a total of 25M shares during Q3 and Q4 of 2020 in a price range of $87-$107, and his current position in ABBV is worth about $2.3B. A quite sizable position even in his elephant portfolio. The healthcare sector is indeed a great place for value investors, ranging from legends like Warren Buffett to ordinary investors like myself for many good reasons. It caters to a fundamental human need that is not going to change or go away anytime soon. All signs show that the need will only intensify with population growth, longer life expectancy, more interconnected world, et al. The following projection from the US Medicare and Medicaid center highlights such long-term secular support. National health spending is projected to grow at an average annual rate of 5.4%, far exceeding inflation, for 2019-28 and to reach $6.2 trillion by 2028.

Under this background, my last article on AbbVie Inc. (ABBV) examined its wide moat, high return on capital employed, and superb scalability. This article examines the stock with a focus on its growth sustainability and capital allocation effectiveness. And the results show excellent prospects of sustainable growth with its high return on capital, strong organic cash generation, and effective capital allocation. Also, given the price volatilities in the past weeks, this article analyzes the sensitivity of long-term return with respect to the entry price.

US health spending

Source: Image from Getty Images provided via SA, and projection provided by US Medicare and Medicaid.

Sustainable Growth and Return on Capital Employed ("ROCE")

When we think like a long-term business owner like Buffett, not a stock trader, the long-term growth rate of our business is governed by two factors only - ROCE and reinvestment rate. More specifically, it will be a produced of these two factors, i.e.:

Long term growth rate = ROCE * Reinvestment Rate

The reason is straightforward. If a business earns more profit on every $1 of capital employed, then it only needs to plow back a smaller fraction of its earnings to further grow its future earnings. Vice versa, if a business earns a lower profit on every dollar of its capital employed, then it can (or has to) crank up the reinvestment rate if it wants to maintain a given rate of growth. Details of the discussion and analysis on ROCE have been provided in my earlier article and won't be repeated here. Here I will just make a few comments in response to some of the comments received from readers:

1. Some readers ask what is the difference between ROCE and the more commonly quoted return on equity ("ROE").

ROCE is the profit earned on the capital ACTUALLY employed, and it would be the same as ROE if the book value equals the capital actually employed. But more often than not, the book value is not the capital actually employed. Consider the following two extreme cases. In the first extreme, the business has returned all of its equity back to the shareholders (e.g., MCD) and the book value is negligible or even negative. So ROE has no meaning at all in this case, but this doesn't mean the business no longer requires capital to earn profit. The other extreme case is a business that sits on a large amount of cash (e.g., BRK as a good example). Whether holding a large amount of cash is good or bad is a different topic for another day. Here we just focus on the effects on ROE. As a business accumulates more and more cash, the book value increases, and therefore, ROE decreases. But this doesn't mean the business is becoming any less profitable at all. It could just still be the same profitable business that has more and more cash on hand.

2. Many readers provided many excellent comments regarding the pipeline. Especially the next blockbuster to complement or replace Humira and the recent FDA decision regarding RINVOQ.

A detailed discussion of the pipeline can also be found in my early article. This article focuses more on the overall process of their research and development PROCESS on an overall level. Analyzing drug development at an individual level is very important, and analyzing it at a process level is equally important. Because as long as a drug business has plenty of ideas to be tried (which ABBV certainly has), then the key is a sound and efficient process. And the best way to evaluate the efficiency at a process level is ROCE.

Based on the above considerations, the ROCE of ABBV over the past decade is shown below. In these results, I consider the following items capital actually employed A) Working capital, including payables, receivables, inventory, B) Gross Property, Plant, and Equipment, and C) Research and development expenses are also capitalized. As seen, it was able to maintain a remarkable high level of ROCE over the past decade: it has been on average 66%. And to puts things under perspective, the average ROCE of the FAAMG stocks as a group is about 60%. And ABBV's 66% average is very competitive even when put up against this group of overachievers. Also, note that the ROCE for ABBV has also been expanding rapidly and significantly over the past decade. And its current ROCE is about 85%, significantly above the historical average.

ABBV ROCE

Source: Author and Seeking Alpha.

Capital Allocation and Reinvestment Rate

Next, let's look at the reinvestment rate. How much to reinvest probably is the most important capital allocation decision management has to make. And fortunate to ABBV, its management enjoys enviable capital allocation flexibility. The capital allocation picture is really simple here: ABBV earns a load of cash organically from its operations and but does not needs to spend much. Just take a look at its finances this year. It generates more than $20B of operating income. The biggest item for ABBV is its generous dividend - about $8.8B this year or 44% of its operating income - a great indicator of its capital allocation flexibility.

The reasons that ABBV could afford such generous dividends are most twofold. Firstly, ABBV has a pretty light debt burden - its net debt interest expenses are about $2.5B or about 12.5% of its operating income. And secondly, thanks to its remarkable ROCE as aforementioned, it does only need a small amount of capital reinvestment to fuel its future growth - more on this later.

When we expand our horizon a bit wider and examine its capital allocation over the past decade, the picture changes a bit but the takeaway is the same. As seen, dividend payment has always been a major ticket item. The major change is that in the earlier part of the decade, it chooses to use its capital more heavily on share repurchases, which makes sense to me given the depressed stock prices in those years (2015 is a really good example). Another major change is that the ABBV has cranked up its maintenance CAPEx cost in recent years as you can see. Its maintenance CAPEx used to be around 15% on average for the early part of the decade, but it has cranked it up to an average of 40% in the past two years. It is a sign that the company is spending more on research and development and retiring old equipment more aggressively.

All told, ABBV currently spends about 68% of its OPC on dividends and maintenance CAPEx So it leaves about a whopping 32% of the OPC - a large amount of organic income - for the business to allocate freely. It can use it for a variety of things: reinvest to fuel further growth, buy back shares, pay down debt, or retain to strengthen its balance sheet, et al. It obviously makes total sense to reinvest all of it to fuel further growth given its high ROCE of 66%. Every $1 reinvested would grow $0.66 of additional earning.

But the problem is that for businesses at this scale, there are just not that many opportunities to reinvest the earnings. As a result, ABBV has been allocating a good part of the remaining earnings to buy back shares as seen. And even as the business is cranking up its research and development efforts as aforementioned, the reinvestment is still "only" about 7.5% in recent years based on my analysis. However, note that a 7.5% reinvestment rate is totally in line for a mature mega-cap business. For example, the average reinvestment rate in the FAAMG group is below 10% except for Facebook and Amazon.

With a ROCE on the order of 66%, with 7.5% of its earnings plowed back into the business, it can grow by 5% per year - organically! Buffett said that there are businesses that, at the end of the day, point to a bunch of depreciated properties and equipment and tell the investors, "these are our profits." He hates these businesses. From this above discussion, ABBV is the exact opposite of the businesses that he hates - it earns a load of cash but does not needs to spend much that to grow (so it can afford to return most of it to shareholders as dividends).

ABBV use of cash

Source: Author and Seeking Alpha data.

Long-term Return

As aforementioned, the focus of this article is on the long-term return prospects. So let's look past the short-term uncertainties and valuations and think like a long-term business owner, not a stock trader. If you, like this author, subscribe to the concepts of owner's earning, perpetual growth rate, and equity bond, then the long-term return is simple. The long-term return is simply the sum of two parts: the owner's earning yield when we made the investment ("OEY"), and the perpetual growth rate ("PGR") of the owner's earning. That is:

Longer-Term ROI = OEY + PGR

The reasons for the simplicity in the long term are primarily twofold. The first reason is that all fluctuations in valuation are averaged out (all luck at the end even out). Second, it doesn't really matter how the business uses the earnings (paid out as a dividend, retained in the bank account, or used to repurchase stocks). As long as used sensibly (as ABBV has done in the past), it will be reflected as a return to the business owner. That is why valuation metrics like PE do not appear in this framework at all.

As we've already figured out the PGR part above, here we will just need to figure out the OEY part to be able to project our long-term return. OEY is the owner's earnings divided by the entry price. All the complications are in the estimation of the owner's earnings - the real economic earnings of the business, not the nominal accounting earnings. Here is a crude and conservative estimate, I will just use the free cash flow ("FCF") as the owner's earnings. It is conservative in the sense that rigorously speaking, the owner's earnings should be free cash flow plus the portion of CAPEx that is used to fuel the growth (i.e., the growth CAPEx). At its current price level and its current earnings, the OEY is ~11.2% for ABBV or ~8.9x price to FCF - too attractive a valuation for such a high-quality business.

Now with both pieces ready, let's put them all together and see our long-term returns as shown in the next chart.

Again, at its current price levels, the OEY is estimated to be ~11.2%. And at the current reinvestment rate level of 7.5%, the growth would contribute another 5% into the return as aforementioned. So in the end, the total long-term return would be quite attractive 16.2% per annum. And as you can see, in this case, most of the return is generated by the owner's earning - a typical situation for a Buffett-style value stock.

And the beauty of such a Buffett-style value stock is that its return does not depend sensitively on the growth rate. We would still receive a solid return even if the rate of growth turns out to be worse than what we hoped for. As an illustration, the star symbol in the chart shows what our return would be should the business grows slower than the 5% analyzed about - for whatever the reason (either lower reinvestment rate or worsening ROCE). As seen, in this case, our long-term return would be reduced to ~14% due to the decreased growth contribution. However, it is still a solid double-digit return!

ABBV long term ROI

Source: Author and Seeking Alpha.

Short-term Volatility Risks

Finally, given the recent price volatilities and for those of us who would like to wait for a better entry price, the next chart shows how much the long-term return potential would change as a function of the entry price. Before going any further, I have to confess that I have zero ability to read technical price/volume trading charts and make calls on short-term price "targets". The only intention here is to analyze how the long-term return will change when our entry price changes.

Fortunate for investors like myself who are not good at market timing, the long-term return potential doesn't change that much within a pretty wide range of entry price, as shown in the green box. The green box shows a range where the price moves up or down 10%. And as seen, the long-term ROI changes only by a bit more than 1% per annum. This chart confirms something that you've probably already heard before - if you hold onto something for the long term, the entry price does not matter that much.

Furthermore, the very reasonable valuation of the stock provides a shield against short-term volatility risks, as corroborated by the consensus estimates shown in the next chart. Based on 12 Wall Street analysts offering 12-month price targets, the average price target is $128 with a high forecast of $142 and a low forecast of $112. The average price target represents a 15% change from the current price and even the lowest forecast does not project a loss.

Lastly, a final word of caution before wrapping up. The above statement refers to the long-term RATE of return, not the absolute DOLLAR AMOUNT of return. When/if you indeed get to enter at a price 10% lower, yes, it is correct that this wouldn't impact your long-term rate of return by a lot as seen. But a 10% lower entry price would give you at least 10% more return in absolute dollar amount - because you get to buy 10% more shares with the same dollar amount you have, plus the whatever extra return brought about by the higher RATE of return. But again, since I have zero ability to time the market in the short term, I am content with a good RATE of return already.

ABBV sensitivity of long term ROI

Source: Author and Seeking Alpha data.

ABBV ratings

Source: TipRanks

Conclusion and Final Thought

My last article ABBV examined its wide moat, high return on capital employed, and superb scalability. This article examines the stock with a focus on its growth sustainability and capital allocation effectiveness.

ABBV has been an exemplary dividend growth stock and cash cow in the past, and naturally, investors should wonder whether such a growth trend could sustain and what happens if it cannot. This article examines the two key elements for growth sustainability: the consistency of its return on capital and the capital allocation effectiveness. The results show that:

  • it has been maintaining remarkably high and consistent profitability of 66% ROCE and has been reinvesting in itself effectively. Also, the ROCE for ABBV has also been expanding rapidly and significantly over the past decade. And its current ROCE is about 85%, significantly above the historical average. Given such high ROCE and its strong cash generation ability, the growth is expected to remain at a healthy rate for the near future.
  • Of course, ABBV would run into some speedbumps and some of the drug developments can fail, leading to reduced ROCE or reinvestment rate or both. However, even with a significantly slower growth rate, as analyzed in this article, the long-term return would still be in a double-digit range (around ~14%) - still a very solid investment.

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.

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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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