Dividend Growth Stock of the Month for March 2019

AbbVie (ABBV) was founded in 2013, when the former Abbott Laboratories was split into two companies. When AbbVie became its own company, it took the biopharmaceutical assets of the old Abbott.

AbbVie is the largest biopharmaceutical company in the world (by market capitalization), slightly ahead of Amgen (AMGN). It has about 30,000 employees around the world, and it is headquartered in North Chicago, IL.

ABBV is a Dividend Challenger with 7 straight years of dividend increases – each year since its formation.

As with many stocks that we present as Dividend Growth Stocks of the Month, price declines over the past few months have brought AbbVie into a more attractive valuation range for purchasers.

The question we attempt to answer here is whether the price declines reflect fundamental deterioration in the company, or whether the company remains strong and robust, simply available now at a better price than a year ago.

To analyze ABBV, I use the approach described in DGI Lesson 14: Grading Dividend Growth Stocks to Find the Best Ones for Your Portfolio.

AbbVie’s Dividend Record

This is a very good dividend picture.

The only flag is the short 7-year streak of increasing dividends. Counterbalancing that, though, are two facts:

• AbbVie has raised its dividend each year since it became a freestanding company.
• Dividend raises are in AbbVie’s DNA, as it was spun off from Abbott Labs, whch was a Dividend Champion before it split itself into two companies.

Currently, AbbVie is in the unusual position of being not only a high-yielding stock, but also one with a fast dividend growth rate.

• Its 5.3% yield is 85% higher than the average of all stocks on the Dividend Champions document (CCC).
• Its 5-year DGR of 17.5% per year is 21% faster than the average of all CCC stocks.

The company appears to be committed to its dividend growth program. It touted its record thusly in a recent industry presentation.

[Source: Industry conference presentation]

In Simply Safe Dividends’ scoring system, ABBV’s dividend safety gets a score of 69/100, meaning that its dividend is rated as safe and unlikely to be cut. (For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)

AbbVie’s Business Model and Quality

AbbVie is a biopharmaceutical company. It discovers, develops, manufactures, markets, and sells pharmaceutical products around the world. It focuses on four primary therapeutic areas: immunology, oncology, virology, and neuroscience.

AbbVie’s largest product is Humira, which is an injectable biologic tumor necrosis factor (TNF) blocker treatment for rheumatoid arthritis (RA) and similar conditions. Humira accounts for half or more of the global prescription drug market for rheumatoid arthritis, and for about 60% of AbbVie’s total revenue.

Humira is also approved for many other uses, 15 altogether, including psoriasis, ulcerative colitis, and Crohn’s disease. The challenge facing AbbVie is that Humira’s patent protections are beginning to expire. Humira patents expired in Europe last year. Companies such as Amgen (AMGN) and Novartis (NVS) began offering bio-similar products at much lower prices.

That said, Humira is protected in the U.S. (by patents and deals with several large potential competitors) until 2023, and a majority of Humira’s sales take place in the USA. The continuing protection in this country buys time for AbbVie to bring other products to market before inevitably losing its market dominance with Humira to lower-priced alternatives.

Beyond Humira, AbbVie has a multitude of drugs either already in the market or in various stages of development and approval. In the immunology section of its business, for example, here are the various projects underway and products in the market (including Humira).

[Source: Industry conference presentation]

Beyond immunology, cancer drugs are AbbVie’s next biggest growth area. Imbruvica is AbbVie’s next-largest seller behind Humira. It is already marketed for several indications, chiefly blood cancer, with more potential indications in clinical trials.

[Source: Industry conference presentation]

AbbVie’s pipeline is particularly strong in potential cancer drugs.

AbbVie, in a recent conference presentation, put forward what it believes are its attractive points for investors. I circled what I think is the most important consideration for dividend growth investors: AbbVie’s philosophy on capital allocation, including “returning capital to shareholders,” which means through dividends and share buybacks.

[Source: Industry conference presentation]

Morningstar grades AbbVie as having a Narrow moat, its second-highest grade, based on its patent-protected drugs, intellectual property, and a powerful salesforce. Many large pharmaceutical companies sport a Wide moat, but AbbVie’s moat rating is hindered by the degree of its reliance on a single product – Humira – for so much of its success.

Here is a summary of AbbVie’s business quality rankings:

The bottom line on AbbVie is that its business looks strong for several years. After that, much depends on the introduction and success of new drugs to financially replace the money it makes from its franchise drug, Humira.

AbbVie’s Financials

I usually begin this section by seeing how Value Line rates a company’s financial strength. Then I go through specific financial metrics and see if I agree with Value Line’s overall assessment.

Value Line gives AbbVie its 3rd-highest Financial Strength grade:

Let’s look at some key financial categories and see if we agree.

Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.

The average ROE for all CCC stocks is 17%, and for S&P 500 companies it is about 13%. The following chart shows ABBV’s ROE 2009-2018.

[Source of all yellow-bar graphs: Simply Safe Dividends]

ABBV’s ROE is obviously very strong. But ROE can be inflated (and therefore become misleading) by high levels of debt. We’ll look at ABBV’s debt next.

Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.

High leverage creates risk. The higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt repayments create a constant draw on the company’s cash flows.

A typical D/C ratio for large companies is 50%. ABBV’s debt ratio is double that.

ABBV’s D/C ratio is above 1.0. In other words, its capital structure has more debt than capital.

In my opinion, this is a risky way to finance a company. The saving grace here is that ABBV’s credit rating is good at A-. S&P describes its “A” level ratings this way:

An obligor rated A has strong capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

While I consider ABBV’s high debt to be a caution flag, I don’t think it is a knock-out concern for the stock. I base that conclusion on the facts that its credit rating is “investment grade,” Simply Safe Dividends rates its dividend as safe, and the company creates strong cash flows, as we will see below.

Operating margin is one of my favorite financial metrics. It measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.

Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range.

As you can see, AbbVie’s operating margin is excellent, and it has been excellent since the company was formed. ABBV’s operating margin has been running 3 times the average S&P 500 company. The company does a great job of converting revenues into profits.

Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.

AbbVie has delivered positive earnings every year since its formation. Earnings have increased in 6 of the 8 years since the company was split off, including the last 4 years in a row.

In its recent 2018 earnings announcement, ABBV guided to about a 10% increase in diluted earnings for 2019. Consensus analyst projections for the next 3-5 years are for 9% annual earnings growth, which is OK for a company this size.

Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the money a company has available for dividends, stock buybacks, and debt repayment.

Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.

AbbVie’s cash flow has been strong.

Estimated FCF for 2018 was a 32% increase over 2017, per FASTGraphs. That would make 5 increases in the past 8 years.

AbbVie’s strong cash flows enable it to fund ongoing R&D in search of the next generation of drugs.

Share Count Trend shows whether the company’s outstanding shares are increasing, decreasing, or remaining flat.

I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.

AbbVie’s share count has been basically flat since the company was formed.

Here is a summary of the items above:

I think that Value Line’s financial grade of A for AbbVie is fine. I see the company’s finances as very good in spots, but degraded by the high use of debt.

AbbVie’s Stock Valuation

My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.

Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.

The basic valuation estimate usually uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a baseline “fair value” reference line.
In the following chart, the fair-value reference line is orange, and the black line is AbbVie’s actual price:

Since the black line (ABBV’s price) is beneath the reference line, that suggests that ABBV is undervalued.

To calculate the degree of undervaluation, we make a ratio out of the P/Es. I circled in blue ABBV’s actual P/E of 10.0. So for the valuation ratio, we have 10 / 15 = 0.67. In other words, AbbVie is 33% undervalued as estimated by this first method.

We calculate AbbVie’s fair price by dividing the actual price by the valuation ratio. We get $81 / 0.67 = $121 for a fair price.

Note that I round dollar amounts to the nearest dollar. That’s to avoid creating a false sense of precision in making valuation assessments. Since valuation involves future events, it cannot be precisely known.

Step 2: FASTGraphs Normalized. The second valuation step is to compare the stock’s current P/E to its own long-term average P/E.

This doesn’t change things much. ABBV’s 5-year average P/E is 15.2 (circled), which is practically the same as the 15 ratio used in the first step. As before, the stock appears to be undervalued.
Using the same calculation methods as above, we get the following results for ABBV’s valuation.

• Valuation ratio: 10 / 15.2 = 0.66
• Fair price: $81 / 0.66 = $123

Step 3: Morningstar Star Rating. Morningstar takes a completely different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.

My experience with Morningstar is that they have an admirably comprehensive and detailed approach. They make logical, conservative projections of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money.

The resulting net present value of all future earnings is considered to be the fair price for the stock today.

Morningstar gives ABBV 4 stars on their 5-star scale, meaning that they consider the stock to be undervalued.

Morningstar calculates that ABBV’s fair price is $102, meaning that it’s selling at a 21% discount.
Notice that they assign a “Medium Uncertainty” status to their valuation. That again reflects the uncertainties associated with Humira’s inevitable decline, offset by the countervailing impacts of new drugs and therapies that AbbVie has in its pipeline.

Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield.

This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa). This chart shows ABBV’s current yield (green dot) compared to its 5-year average (horizontal line).

[Source: Simply Safe Dividends]

AbbVie’s 5-year average yield is 3.6%, while its current yield is 5.3%. When the current yield is higher than the historical average, that suggests undervaluation.

ABBV’s current yield is 47% above its 5-year average. Flipping it around to get a valuation ratio, we get 3.6% / 5.3% = 0.68, or 32% undervalued.

When using this method of valuation, I cut off the disparity at 20%, because this is an indirect way of estimation fair value.

Using the cut-off valuation ratio of 0.80, ABBV’s fair price computes to $81 / 0.80 = $101.

Valuation Summary:
All 4 valuation methods are in agreement that ABBV is undervalued. Together they suggest a fair price of $112.

Note that the low valuation undoubtedly reflects investors’ uncertainty about AbbVie’s future fortunes, particularly its ability to grow in light of the inevitable declining contribution of Humira sales to AbbVie’s financial picture.

For comparison, CFRA has a 12-month price target of $88. In January, my colleague Jason Fieber caculated ABBV’s fair value as about $106.

Miscellaneous Factors

Beta

Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:

• They present fewer occasions to react emotionally to rapid price changes like sudden price drops that can induce a sense of fear.
• There is industry research that suggests that low-volatility stocks outperform the market over long time periods.

ABBV’s beta is higher than the market’s, with a 5-year beta of 1.3 compared to the S&P 500, which is defined at 1.0. That means that its price has been more volatile than the index.

This is a negative factor.

Analyst’s Recommendations

In their most recent report on ABBV, CFRA shows the recommendations of 18 analysts who cover the company. Their average recommendation is 3.4 on a scale of 5, where 5 means “buy” and 3 means “hold.” The rating translates to “hold.” This is a neutral indicator.

What’s the Bottom Line on AbbVie?

Here are AbbVie’s positives:

• Strong dividend record, combining a high yield (5.3%) with a consistently fast rate of growth (17%+ over the past 5 years).
• “Safe” Dividend Safety grade of 69/100 from Simply Safe Dividends, suggesting that the dividend is unlikely to be cut. Management has stated that it is committed to “returning capital to shareholders” through dividends and share buybacks.
• Solid business model, although the company’s success is highly dependent on a single product, Humira. AbbVie has a strong pipeline of drugs in development, although how many of them will turn into blockbusters is unknowable.
• Narrow moat rating from Morningstar.
• Decent financials, although debt level is high.
• Stock is more than 20% undervalued.

And here are AbbVie’s negatives:

• It is highly dependent on Humira. While that drug’s success is outstanding, its financial contributions face inevitable declines as it loses patent protections and similar competitors become available for prescription.
• It has too much debt, although it does have a good investment-grade credit rating of A-.
• Its stock price is more volatile than average.

In my opinion, AbbVie’s long-term attractiveness really boils down to your assessment of the company’s ability to replace declining Humira revenues with sales from other drugs, including those under development and nearing the marketplace.

From a shorter-term perspective, AbbVie seems like a very attractive dividend growth opportunity, given its high yield and proven propensity for increasing its dividend.

For other analyses of ABBV, please see these articles:

• My colleague Mike Nadel made ABBV a December addition to DTA’s Income Builder Portfolio. He explains his selection in this article.
• My colleague Jason Fieber selected ABBV as his Undervalued Dividend Growth Stock of the Week in mid-January.

Finally, remember that this is not a recommendation to buy, hold, or sell AbbVie. Always do your own due diligence. Think not only about the company’s quality, dividend outlook, and business prospects, but also about how and whether it fits your personal financial goals.

— Dave Van Knapp

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