Why Abbott Looks Cheap

The pharmaceutical juggernaut Abbott Laboratories looks reasonably cheap these days. Its shares have been going down for the past few weeks and it's a good buying opportunity in my opinion. Here's why.

Consistent Dividend Growth

Abbott has grown dividends consistently for over 25 years. It's part of the Dividend Aristocrats index maintained by S&P. Not only that, but ABT has grown dividends an annualized 9.33% over the last 11 years. On average, the year-over-year dividend growth has also been around the same ballpark, 9.45% (the average and the annualized 11-year return can differ in case most of the growth was in one or just a few years as opposed to consistent over time. When they match, it's a sign the growth has been sustained over time).

Consistent Earnings Growth

A consistent dividend growth needs to be accompanied by a consistent earnings growth too or the dividend is not sustainable. Over the same last 11 years, ABT has had an annualized earnings growth of 9.31%, which comes in very close to its annualized dividend growth. This means that dividend growth is supported by earnings growth directly, which is a good sign. It means the company is passing through all of its extra earnings back to shareholders via dividend increases.

Some people prefer to see earnings growth slightly surpass dividend growth to be on the safe side. But by doing so, it means the company is increasing its cash reserves and I would want to understand why. It could mean an acquisition is coming up or the company is expecting to have higher expenses going forward (patent disputes, lawsuits, etc). So, higher earnings growth per se is neither good or bad, but must be understood. In the case of Abbott, for the past 11 years earnings and dividend growth have matched, which can only mean the company is growing smoothly and not becoming lopsided in anyway, neither increasing cash reserves nor depleting it, hence a very good sign in my opinion.

Consistent Sales Growth

Just because earnings growth have been consistent during this time does not necessarily mean the company is actually generating more cash since earnings can be so easily manipulated. However, 11 years is a long time, especially when the earnings can be seen in form of dividends during this time (it's a lot harder to fake real cash in your pocket than it is on an income statement). Nonetheless, let's see how Abbott fares in sales growth, which is a more direct way of assessing where growth is coming from.

For the past 10 years, sales have grown an annualized 8%. This is only slightly less than the 9% earnings growth, which indicates that for the most part sales have kept pace with earnings. It also indicates that the company has been aggressive at cutting costs at a rate of 1% per year. In the long run I'd expect earnings and dividend growth to slow down to catch up to sales growth. Still, 8% is a good growth rate to have.

Dividend Yield is Moderately High

At a price of approximately $45.50 and with an annual dividend of $1.76, ABT sports a dividend yield of 3.8%, which is pretty decent in today's market. When factoring in a 8-9% growth, it means investors can expect a return of 11-13% on their investment going forward, minus inflation and plus any share price appreciation.

Implied Price using Dividend Discount Model

Treating a share of ABT as a bond and investing in it just for the dividend using the Dividend Discount Model, I came up with a price range for ABT of between $59 and $44. This means that ABT is undervalued at the time of writing. My assumptions were a 10-11% discount and 7% dividend growth, which, given the track record of sales growth of 8% is still a little conservative.

Other Considerations

Other things to consider before investing: why is ABT going down in the past several weeks? No single news piece accounts for this decline, but a more thorough investigation is warranted.

One a price-to-earnings basis, ABT looks fairly valued with a tailing P/E of about 15. However, its forward P/E is only 10, since ABT expects to earn between $4.54 and $4.64 per share in 2011.

Conclusion

All things considered, ABT looks cheap to me. I'm buying shares of Abbott (ABT) at the time of writing. Please do your own analysis before buying.

Disclosures: I own shares of ABT at the time of writing.

Dividend Discount Model in Action -- LLY Stock Analysis

Recently, I noticed a stock on my watch list that hasn't returned to its pre-financial-crisis level: Pharmaceutical company Eli Lilly (LLY). Here's my analysis.

For a mature dividend aristocrat such as LLY, the dividend discount model is usually a good start in valuing the stock.

LLY has raised its dividend for over 25 years. Over the last 10 years, LLY has raised its dividend a compound 7.86%. Year-over-year, the minimum raise has been 4%, the maximum 13% and the average raise was close to 8%.

Meanwhile, earnings per share (EPS) growth has only compounded by 1.65%. So the growth in dividend is probably not sustainable without further improvements to the bottom line, such as cost cutting or acquisitions.

If we assume a 1% growth in dividends (to match the growth in EPS) in perpetuity, and tag it with a 9% discount (my minimum expected return from solid stocks), the dividend growth model yields a price of $25.

LLY currently trades at around $34, has a forward P/E of 7.8 due to analysts-expected EPS of about $4.25 for 2009.

LLY's 10-year average EPS is only $2.00, though. The growth expected this year and next is attributed to a strong drug demand, the acquisition of ImClone and cost cutting. The company's own EPS guidance for 2009 suggests EPS between $4.20 and 4.30. It's unclear how sustainable this new EPS level is.

Historically, LLY P/E ratio has been quite high: the average low P/E was around 22 while the average high P/E was 34. Counting on market euphoria to bring the P/E back to its historical lofty levels is never a good idea. My comfort range of P/E for a large and mature company such as LLY is between 10 and 15. Using LLY's average 10-year earnings of $2.00, we get a price tag of between $20 and $24.

Looking at dividend and EPS growth and checking the P/E ratio is only part of the analysis. I said earlier that it's usually a good start because mature companies such as LLY often have stable earnings, growth, debt load and share count. But a further look at the balance sheet is always helpful. Consider the trends in the graph below.



Looking at various balance sheet indicators as a percentage of sales can help spot worrisome trends. In this case, it's encouraging to see that both research and development (R&D) and accounts receivable have been moving inline with sales. Inventory had a run up in the past that warrants further investigation, but doesn't appear to be out of control. Selling, general and administrative expenses (SG&A) have been growing slightly faster than sales, which might indicate that LLY is not as efficient as it used to be 10 years ago. Nonetheless, the trend is not sky-rocketing either.

Overall, these trends are somewhat reassuring that the dividend discount model is meaningful as it shows the fundamentals are not quickly deteriorating.

Conclusion: from a purely dividend discount valuation and a check against a conservative P/E multiple and a conservative EPS estimate, my initial fair value for a share of LLY is between $20 and $25. Further investigation into drugs in the pipeline, patent expiration and integration of acquisitions is necessary to further determine earnings power and hence fair value.

Disclosures: No shares of LLY held at the time of writing.

Are "generics" a threat to drug companies?

Every time I read something about a drug company it always comes with warnings about fierce competition and the threat of generics. Fierce competition I can understand. There are many drug companies out there. But the threat of "generics" is something I started questioning recently.

The theory is that when patents expire, opportunistic drug companies will step in and produce the same drug for less and bring down the nice margins enjoyed by the original manufacturer of the drug. The nice margins were nice because the drugs were protected by patents. When this is no longer the case, goodbye profits. Or so goes the theory.

But does this really happen and is it really that bad?

Why can't drug companies lower their prices and compete head-to-head with generics when their patents expire? Are the big drug companies that inefficient that they can't lower prices enough to compete? They surely have better financial position than the generics. Given that they compete with other drug companies, I'd expect them to be reasonably efficient and be constantly lowering their cost structures.

Wouldn't some customers even pay a small premium to get a branded drug as opposed to a generic one? Of course some will, just look at sales of Tylenol compared to other generic cold and fever drugs. Anyone can mix paracetamol and acetaminophen cheaply. But Tylenol still sells more than others and people do pay a premium for the brand. Why wouldn't people pay a small premium for Plavix or Lipitor, two of the cholesterol-lowering drugs that are coming off-patent soon, the former by Bristol-Myers Squibbs and the latter by Pfizer?

Plus, is it really the case that big pharma companies cannot lower costs enough to compete with those like Teva, the israeli-based generic maker?

I simply don't believe that.

Assume the worst: big pharma is inefficient at running their drug factories (the plants that mix the powders and packages the pills -- all that is needed for a generic manufacturer). In this case, they could: 1) sell their "assembly line" and let a more competent operator run it, 2) buy one of the generic makers or 3) don't even bother with production and sales and worry only about development of new drugs. Many biotechs and smaller drug makers operate in the latter mode.

Now, suppose that this is not the case, that big pharma companies can lower their prices upon patent expiration enough to compete with generics. Then what happens? They now must compete on who has the most efficient sales channel, distribution and marketing teams, just like they had to do against their bigger rivals to begin with.

So, what does really happen? Let's see.

Let's look at three big-pharma: Bristol-Myers Squibb (BMY), Pfizer (PFE) and Merck (MRK) and compare them with generic giant Teva (TEVA), Watson Pharmaceutical (WPI) and Mylan (MYL).

What do they have in common?

BMY, PFE and MRK are all 3-star stocks as rated by S&P currently. Their analysts all "caution" us against "generic competition".

TEVA, WPI and MYL are all 5-star stocks as per S&P.

And yet, BMY, PFE and MRK trade between 9 and 12 price-to-earnings ratio, sport a 4 to 6% dividend yield and have return-on-equity that averaged from 22 to 34% over the last 9 years.

Compare these with TEVA, WPI and MYL trading between 14 and 43 price-to-earnings ratio, having dividend yields of zero to 1.29% and return-on-equity that averaged from 5 to 15% over the last 9 years.

The table below summarizes the comparison:


Note on methodology: I picked BMY and TEVA due to my own interest in them and then I randomly selected two others from each group. The big-pharma group I selected based on the first two names that came to mind and for the other two generics I picked the top two by capitalization. Of course, there are probably counter-examples to this situation too. P/E and div. yield from Google Finance. Avg 9-year ROE courtesy of S&P.

Conclusion: I don't buy the argument that generics are better investments (3 versus 5 stars), nor that generics create such a large threat. Sure, they eat into profits just like any competitor would. But the fear of generics does not justify, by itself, the low valuations of big-pharma nor a 5-star rating for the generics.

Disclaimers: None (no securities mentioned held long nor short at the time of writing -- though I'm considering starting a position in BMY, pending further analysis).