Trying to profit from trends is very difficult as an investor.
One never knows if a trend is going to last, or how big it’ll get.
Instead, I like to invest in secular growth.
I’m not talking about businesses that try to capture trends.
I’m talking about businesses that experience persistent growth.
I’ve invested in companies like this over and over again, building up my FIRE Fund in the process.
That’s my personal six-figure stock portfolio, which produces enough five-figure passive dividend income for me to live off of.
I built this portfolio using the tenets of dividend growth investing.
This is a long-term strategy whereby you buy and hold shares in world-class businesses that pay reliable, rising dividends.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on hundreds of US-listed dividend growth stocks.
Following this strategy helped me to retire in my early 30s.
I explain exactly how I accomplished that feat in my Early Retirement Blueprint.
Riding the wave of secular growth with high-quality dividend growth stocks was a big part of my success.
But valuation is always important.
Price is only what you pay. Value is what you actually get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
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.
Buying high-quality dividend growth stocks benefiting from secular growth, and doing so when they’re undervalued, can lead to a tremendous amount of wealth and passive income over the long term.
The good news about this is, estimating a stock’s intrinsic value isn’t all that difficult.
Lesson 11: Valuation, put together by fellow contributor Dave Van Knapp, makes that valuation process much easier.
Part of an overarching series of “lessons” on dividend growth investing, it provides an easy-to-follow valuation template that can be applied to almost any dividend growth stock.
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 $190 billion (by market cap) pharmaceutical behemoth that employs 48,000 people.
AbbVie sells its products in more than 175 countries.
Humira, an immunosuppressive medication, is by far their largest and most important product, accounting for approximately 43% of FY 2020 revenue. This drug had net revenue of nearly $20 billion last fiscal year.
Humira has been both a blessing and a curse for AbbVie. Much more of the former than the latter to date, but that could be changing soon.
On one hand, it’s been a total blockbuster. It’s the best-selling drug in the world.
On the other hand, it represents an outsized percentage of total revenue. Biosimilar competition now threatens to severely harm 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 be proactive. They’ve attempted to protect the business through licensing deals, additional patents, R&D spending, and a massive acquisition.
Regarding that last point, in 2020, AbbVie completed its $63 billion acquisition of Allergan PLC. This was a transformative acquisition which instantly and significantly expanded and diversified the combined product portfolio.
AbbVie’s stock has recently corrected. The FDA announced on September 1st that AbbVie’s drug Rinvoq would require a new and updated warning label. The stock is now down more than 10% from its late August high. This pullback is partly why I’m featuring the stock today.
Investing in a major pharmaceutical company is largely a bet on favorable demographic trends.
You’re betting on the continuation of what’s already been playing out for many years. The world is growing larger, older, and richer.
A larger pool of older people who have more capital is almost a straight line to greater demand for, and access to, top-notch therapeutics.
This bodes well for AbbVie’s ability to grow its profit and dividend for the foreseeable future and beyond.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it stands now, AbbVie has increased its dividend for nine consecutive years.
However, that short track record belies the company’s true dividend growth heritage.
AbbVie is actually a Dividend Aristocrat. That’s because of the multi-decade dividend growth track record that was built up when they were a part of legacy company Abbott Laboratories (ABT).
Abbott Laboratories spun off AbbVie in 2013. That explains this newer, shorter track record. But make no mistake about it: AbbVie’s dividend growth pedigree is of the highest quality.
The five-year dividend growth rate of 18.5% is rather incredible, especially when you think about how this is a dividend that’s really been growing for decades.
However, the most recent dividend increase was a more down-to-earth 10.2%.
But this is still more than enough dividend growth when you consider that the stock yields 4.9%.
That’s more than three times higher than the broader market’s yield.
It’s also 100 basis points higher than the stock’s own five-year average yield.
This is an extremely compelling combination of yield and dividend growth here.
And with the payout ratio at 41.4%, based on midpoint guidance for this year’s adjusted EPS, investors should be able to count on plenty more healthy dividend increases to come.
These dividend metrics are nothing short of impressive.
Revenue and Earnings Growth
But we are looking in the rearview mirror here, somewhat.
It’s future dividends we care most about.
Investors risk today’s capital for tomorrow’s rewards.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later assist in the valuation process.
I’ll first show you what the long term has looked like in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast like this should give us a pretty good idea as to where the company might be going from here.
AbbVie has increased its revenue from $18.790 billion in FY 2013 to $45.804 in FY 2020.
That’s a compound annual growth rate of 13.57%.
I usually look at a ten-year period for business growth. But AbbVie went independent in 2013. That’s why 2013 is the starting point in this case.
Meanwhile, earnings per share advanced from $2.56 to $10.56 over this time frame, which is a CAGR of 22.44%.
Now, I used adjusted EPS for FY 2020. That’s because the company routinely takes charges and reports lumpy and arguably inaccurate GAAP EPS. I see the adjusted number as more indicative of their true earnings power.
These are gaudy numbers, which isn’t a total surprise when you have the world’s best-selling drug in your portfolio.
As I foreshadowed, however, investors are going to have to brace themselves for a serious cooling-off. I don’t think it’s reasonable to expect AbbVie to continue posting numbers like these.
Looking forward, CFRA believes that AbbVie will compound its EPS at an annual rate of 4% over the next three years.
Humira is largely responsible for this forecast.
CFRA states this: “ABBV’s revenues have historically been largely tied to sales of its Humira (57.6% of pre-merger adjusted net revenues), which began to experience biosimilar competition outside of the U.S. (OUS) in October 2018. In 2020, U.S. Humira sales grew 8.4% Y/Y while OUS sales of Humira declined 13.6%. In 2021, we expect U.S. sales to grow 8% and OUS sales to decline 17%.”
And that’s the story here. AbbVie still lives and dies by the Humira sword.
That said, the Allergen acquisition does help to soften the blow, particularly when looking out over the longer term. The pipeline, which has grown, is strong: AbbVie had more than 90 compounds or indications in clinical development as of the end of 2020.
But since Humira has such an outsized effect on the company, the drop in growth over the next few years will almost certainly still be very noticeable.
Speaking on this, CFRA states the following: “Although the acquisition provides revenue diversification, robust long-term free cash flows, and organizational synergies, we don’t think AGN’s assets do much to help offset the upcoming loss of exclusivity for ABBV’s blockbuster drug, Humira.”
I don’t see this as all doom-and-gloom, though. It’s simply a case where growth expectations are going to have to shift.
Mid-single-digit business growth, which should translate to similar dividend growth, is nothing to shake your head at. After all, the stock yields nearly 5%.
Also, it’s not like Humira is completely disappearing. It will still likely sell well. Just not as well as it used to, due to the increased competition.
To add perspective, AbbVie is guiding for $12.57 in adjusted EPS at the midpoint for FY 2021. That would represent 19.0% YOY growth in adjusted EPS. So the slowdown in growth might not be all that sharp.
Moving over to the balance sheet, this is probably the weakest part of the business.
AbbVie is heavily indebted. The Allergan acquisition exacerbated this.
The long-term debt/equity ratio is 5.9, while the interest coverage ratio is over 2.
Low common equity pushes up the debt/equity ratio. But the interest coverage ratio is precariously low, in my view.
Credit ratings are as follows: Moody’s, Baa2; Standard & Poors, BBB+.
AbbVie will need to improve the balance sheet, which will divert future cash flow away from dividend increases. Combined with the slowing growth of the underlying business, double-digit dividend increases are unlikely to persist.
Profitability is very robust. Selling the top drug in the world will do that.
Over the last five years, the firm has averaged annual net margin of 18.9%. An average of return on equity is not applicable because common equity is frequently negative.
Despite some chinks in the armor, I still see AbbVie as a high-quality, desirable business.
And they’re protected by durable competitive advantages that include economies of scale, a global distribution network, patent protection, IP, and R&D.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Competition will soon become even more vicious when Humira comes off patent in the US in 2023.
Patent cliffs are always a risk with pharmaceutical companies. The risk here is severely heightened with AbbVie, due to the drug in question and the near-term time frame. Growth over the next few years will almost surely be much less impressive than growth over the last few years.
Any broad changes to the US healthcare system would likely affect AbbVie.
All pharmaceutical companies have pipeline risk. The pipeline is pressured to produce successful drugs in order to support sales, rationalize R&D, and mitigate patent cliffs.
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.
There are certainly some risks here, but I also see a lot of quality and value to be had.
Regarding the value, this stock’s recent correction has made it rather attractive…
Stock Price Valuation
The stock is trading hands for a forward P/E ratio of 8.5.
That’s based on midpoint guidance for this fiscal year’s adjusted EPS.
While I think the market is right to assign a low multiple here, because of the near-term uncertainty around Humira, this seems a bit extreme.
The P/CF ratio of 9.3 is well off of its own five-year average of 12.2.
And the yield, as noted earlier, is substantially 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 a 9% discount rate (due to the elevated yield) and a long-term dividend growth rate of 5%.
This DGR looks awfully conservative when you line it up against the demonstrated long-term double-digit dividend growth from the company. There’s also the double-digit EPS growth to look at. And the payout ratio is not dangerously high.
However, there’s a lot of uncertainty regarding just how well this company will perform when Humira loses its patent protection. And the balance sheet needs attention (and cash flow).
I’m assuming long-term mid-single-digit dividend growth here, which is taking CFRA’s near-term EPS growth forecast into account.
It might prove too cautious. But I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $136.50.
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.
Even after a careful valuation, the stock still looks 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 $108.00.
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 $125.00.
I came out slightly high this time. Averaging the three numbers out gives us a final valuation of $123.17, which would indicate the stock is possibly 15% undervalued.
Bottom line: AbbVie Inc. (ABBV) is a high-quality pharmaceutical company that owns the best-selling drug in the entire world. With a market-smashing yield near 5%, a moderate payout ratio, a dividend growth legacy that dates back decades, double-digit long-term dividend growth, and the potential that shares are 15% undervalued, this is a Dividend Aristocrat on sale 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 70. 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 Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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