Two events have captivated investors.
There’s a historic election upon us.
And there’s also a pandemic sweeping across the world.
While it’s easy to get caught up in the news cycle, investors should do something else.
They should focus on the best long-term investments that can prosper regardless.
Indeed, I’ve invested in a way that totally ignores elections… and all other short-term noise.
And that allowed me to go from below broke at age 27 to financially free at 33, as I lay out in my Early Retirement Blueprint.
I now control a six-figure portfolio that I call the FIRE Fund.
This portfolio has prospered over the last decade, throughout all inevitable bumps in the road.
That’s because high-quality dividend growth stocks comprise the Fund.
They’re able to do that because they’re often world-class enterprises producing reliable and rising profit.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Many of these businesses are positioned to do very well over the long run.
That’s regardless of who’s running the country.
One has to do their homework on fundamentals and valuation.
The latter aspect can have a particularly sharp impact on the success of an investment.
Price tells you what you pay. But value tells you what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Ignoring short-term noise and investing in high-quality businesses at attractive valuations positions your portfolio to prosper over the long term.
The good news is, the process of estimating a stock’s intrinsic value isn’t that difficult.
Fellow contributor Dave Van Knapp has made it easier than ever with the introduction of Lesson 11: Valuation.
Part of a larger series on dividend growth investing, this lesson provides a valuation template that can be applied to almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
AbbVie Inc. (ABBV) is a global pharmaceutical company with a particular focus on immunology and oncology.
With a corporate history that can be traced back to 1888, AbbVie is now a $149 billion (by market cap) pharmaceutical behemoth that employs almost 50,000 people and sells its products in more than 175 countries.
Humira, an immunosuppressive medication, is by far their largest and most important product, accounting for approximately 45% of FY 2019 revenue. This drug had net revenue of almost $15 billion last fiscal year.
Humira has been both a blessing and a curse.
On one hand, it’s been an absolute blockbuster, becoming the best-selling drug in the entire world.
On the other hand, it’s become such a large and outsized percentage of revenue, that biosimilar competition threatens to crush the company’s future earnings. The dreaded “patent cliff” is coming, with Humira’s patent protection expired in Europe and expiring in 2023 in the US.
Understanding this, AbbVie has gone out of their way to protect the business through licensing deals, additional patents, R&D spending, and a huge acquisition.
Regarding that last point, AbbVie just recently completed its $63 billion acquisition of Allergan PLC, which greatly expanded and diversified its drug lineup.
Investing in a global pharmaceutical company is a pretty straightforward proposition.
You’re betting on the continuation of what’s already been playing out for many years. The world, quite simply, is growing larger, older, and richer.
That means greater demand for, and access to, quality medicine.
This means AbbVie should be able to continue growing its profit and dividend for many years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has already increased its dividend for eight consecutive years.
That might seem surprisingly short.
But the track record is only so limited because AbbVie was spun off from legacy company Abbott Laboratories (ABT) in 2013. Thus, the dividend growth track record is as long as it can be.
What they may lack in length, they make up for in terms of the growth rate.
The five-year dividend growth rate is 20.9%, which is incredible.
That comes on top of the juicy yield of 5.86%.
It’s not often that you find double-digit dividend growth paired with a yield this high.
This yield, by the way, is almost 220 basis points higher than the stock’s five-year average yield.
And while the dividend payout ratio of 103%, based on TTM GAAP EPS, looks high, that’s largely because of volatile GAAP earnings that do not accurately reflect profit.
Free cash flow covers the dividend almost twice over, which indicates a very safe dividend.
Revenue and Earnings Growth
This combination of a high yield and high growth rate is very appealing.
But it’s ultimately those future dividends and dividend raises that today’s investors care most about.
Investors are putting today’s capital at risk for tomorrow’s rewards and results.
Toward that end, I’ll now build out a growth trajectory for the business, which will later help us estimate intrinsic value.
This trajectory will partially rely on what the company has already done historically in terms of top-line and bottom-line growth.
Then I’ll compare that against a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast in this way should tell us a lot about where the business might be going.
AbbVie grew its revenue from $18.790 billion in FY 2013 to $33.266 billion in FY 2019.
That’s a compound annual growth rate of 9.99%.
Very impressive. And this result does not yet include Allergan, as that transaction didn’t close until May 2020.
I ordinarily use 10 years of growth data in my analyses; however, AbbVie didn’t become an independent company until 2013. So I’m going back to inception.
Earnings per share increased from $2.56 to $5.28 over this period, which is a CAGR of 12.82%.
Again, very impressive.
Modest buybacks helped to propel some of this excess bottom-line growth.
Admittedly, AbbVie’s GAAP results have been lumpy over the last few years, which makes it difficult to pinpoint growth. But taking a high-level, long-term view of the company shows a captivating growth curve.
Looking forward, CFRA believes that AbbVie will compound its EPS at an annual rate of 6% over the next three years.
That would be about half of what the business has done over the last decade.
CFRA notes biosimilar competition for Humira as the key issue, which will start to ramp up markedly in 2023 when the US competition comes online.
The Allergan acquisition offsets this concern to a degree. There’s also the robust pipeline: AbbVie had 60 compounds or indications in clinical development at the end of 2019.
The last few years have been a “golden era” for AbbVie. I wouldn’t extrapolate this kind of growth out indefinitely.
However, I do applaud AbbVie for doing all they can to protect the business model generally and Humira specifically.
While I would have preferred to see strategic bolt-on acquisitions toward this end, which would have avoided adding so much debt to the balance sheet, the Allergan move goes a long way toward cushioning the upcoming blow. I think AbbVie felt like it had to move fast and go big.
I do find it curious that CFRA is expecting such a dramatic slowdown in growth over the next few years. Humira still has a nice runway in front of it. 2023 is when turbulence starts to seriously enter the picture, but even then it’s not like Humira sales will totally disappear.
In the end, a mid-single-digit bottom-line growth rate is more than enough to fund similar dividend growth. That’s very appealing when paired with a yield near 6%. And they could very well do even better than that.
Moving over to the balance sheet, AbbVie is heavily indebted. In my opinion, this is the weakest area of the business.
The company started off in 2013 with plenty of debt. And they haven’t improved this situation in recent years.
To the contrary, the Allergan acquisition creates a larger and more diversified business with much more cash flow, but it does so at the expense of even more debt.
There’s no long-term debt/equity ratio here because of a high amount of treasury stock creating negative common equity.
However, the interest coverage ratio came in at under 5 last fiscal year, which is mildly concerning.
Credit ratings are as follows: Moody’s, Baa2; Standard & Poors, BBB+.
It’s not a terrible balance sheet. But it could certainly be improved.
Profitability, as one would expect, is highly robust. The best-selling drug in the world will allow for that.
Over the last five years, AbbVie has averaged annual net margin of 21.03%. Return on equity is N/A due to negative common equity.
There’s really a lot to like about this business. It’s a world-class pharmaceutical company offering a juicy yield.
And with strong competitive advantages like patent protection, IP, R&D, and global scale, the company is positioned about as well as it can be.
Litigation, regulation, and competition are omnipresent risks in every industry.
Competition will soon become even more fierce when Humira comes off patent in the US in 2023.
The upcoming “patent cliff” for Humira, due to product concentration, is a major near-term risk.
While AbbVie has one of the biggest pipelines out there, compounds that fail to go to market can be major setbacks.
The balance sheet is heavily indebted, creating liquidity risk and limiting future acquisitions.
Lastly, there’s integration risk with the massive Allergan acquisition.
The risks are clear, but so is the value.
With the stock down 20% from its 52-week high, I think the valuation is quite attractive right now…
Stock Price Valuation
The P/E ratio of 17.71 compares very favorably to both the broader market and the stock’s own five-year average P/E ratio of 27.4.
However, lumpy GAAP earnings have skewed the P/E ratio.
But every other basic valuation metric shows a depressed valuation.
We can look at cash flow as an example.
The P/CF ratio is sitting at 8.3, which is well off of the stock’s three-year average P/CF ratio of 13.4.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 4%.
That DGR might look shockingly low when compared to what AbbVie has done since inception.
But we have to keep in mind that the “golden goose” that is Humira will be laying less “golden eggs”. That’s just a matter of fact. And I think investors will have to moderate their expectations.
This is a very cautious valuation model, which is accounting for the heavy debt load, additional biosimilar competition, and merger integration risk.
AbbVie could do much better than this over the long run. But I’d rather err on the side of caution with so many moving parts.
The DDM analysis gives me a fair value of $122.72.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I was extremely conservative with my valuation, yet the stock still looks dirt cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates ABBV as a 3-star stock, with a fair value estimate of $97.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates ABBV as a 3-star “HOLD”, with a 12-month target price of $95.00.
I came out high, which is surprising. Averaging the three numbers out gives us a final valuation of $104.91, which would indicate the stock is possibly 30% undervalued.
Bottom line: AbbVie Inc. (ABBV) is a world-class pharmaceutical company that practically prints money with the best-selling drug in the world. With a market-smashing yield near 6%, a moderate payout ratio, big dividend growth, and the potential that shares are 30% undervalued, this could be one of the best long-term investments available for dividend growth investors.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon
Note from DTA: How safe is ABBV’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 50. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, ABBV’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & IncomeWe Just Bought These Stocks for the Income Builder Portfolio [Buy Alert!]
While there are many things to like about these fine companies, their dividend growth ranks high on the list.