If the management at Abbott Labs (NYSE:ABT) was hoping that its decision to split the company in two (basically spinning off the pharmaceutical business) would generate buzz and enthusiasm around the company, it seems that they succeeded. Whereas most analysts are skeptical about the ability for large drug and device companies to produce meaningful long-term growth, it seems like most sell-side analysts are happy to assume a good growth runway for this large (and generally conservative) med-tech conglomerate.
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Q4 Results May Hint At Some of the Challenges
When Abbott reported earnings a few weeks ago, the results got a generally positive reception. Although sales were a bit light (roughly 4% growth), margins were quite good. Revenue was light relative to expectations across the board, as Humira and stent sales were slightly disappointing, but analysts didn't seem to care much, since margins were strong (leading to a one-cent earnings beat) and guidance was positive. (For related reading, see A Primer On The Biotech Sector.)
Where Will Pharma Growth Come From?
In some respects it looks like Abbott is getting out of the drug business while the getting is still reasonably good. Abbott has a reasonably strong franchise (with sales up about 4% in the fourth quarter), but the future looks pretty challenging.
Abbott is going to see about one-quarter of its current sales go off patent between today and 2016, with Tricor and Niaspan being the prime drugs involved. Then, later in 2016, the ultra-blockbuster Humira goes off patent, as well, and becomes vulnerable to direct biosimilar competition. It's not as though Humira is completely safe between then and now, anyway; Pfizer (NYSE:PFE) and AstraZeneca (NYSE:AZN) are both looking to launch oral rheumatoid arthritis drugs and other TNF injectables are going to see biosimilar competition that could impact pricing.
Making matters worse, Abbott's pipeline is not strong over the next couple of years. The company has some promising cancer drugs in Phase 2 and a roster of hepatitis C treatments, but there's just not enough data here yet to get excited (though bulls can credibly rebut this by saying there's no negative data here yet, either).
Still, there are only four drugs in Phase 3 development. While Neurocrine's (Nasdaq:NBIX) Elagolix (which Abbott is developing through a partnership) could surprise, it's hard to see how the pipeline today will add much more than 10 to 15% in incremental sales by 2016.
Devices - Deep and Broad, but Dynamic?
The company's non-device business looks considerably more stable, but growth could be an issue here as well.
Abbott certainly has a strong stent franchise, as its Xience platform leads the market and rival Boston Scientific (NYSE:BSX) has numerous internal challenges and distractions. The trouble, though, is that beyond a vessel sealing device (the MitraClip) and an absorbable stent platform, there's not a lot of pizazz in the pipeline. Unlike Medtronic (NYSE:MDT) and St. Jude (NYSE:STJ), Abbott isn't working on transcatheter heart valves or renal denervation therapies, and the company is going to find that competing with Covidien (NYSE:COV) and Bard (NYSE:BCR) in peripheral vascular therapy is no picnic.
This theme repeats across the board. Abbott's nutrition, diabetes and diagnostics business are all strong competitors, but it doesn't seem that the company has been investing in the sort of R&D necessary to really drive leading-edge growth. That's not a problem if the story on Abbott is to be about margins and sustainable cash flow, but it makes the growth thesis that many sell-side analysts are pitching a little harder to believe.
The Bottom Line
Abbott is not especially cheap on backward-looking metrics when compared to other major pharmaceutical and device companies. When it comes to the forward cash flow picture, it really depends on just how much optimism investors want to put into the numbers. There are analysts, for instance, who are calling for 10% year on year growth in 2016 sales, but I just don't see how the company will produce that.
The good news, though, is that the company really has improved its free cash flow conversion and the margin structure here looks about as good as it ever has. That means that even with lower revenue growth assumptions than the sell-side, Abbott stock works on a free cash flow-based model. Investors need to be a little cautious (as low revenue growth med-tech stories don't get much traction), and Abbott could certainly use a more exciting pipeline across its businesses, but patient investors can buy Abbott today and see good value for their money. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.