Auditing Abbott Labs (ABT)

Abbott Laboratories (ABT) is a large, global and uniquely diversified drug company that consists of four, main segments: Pharmaceutical Products, $16.5 billion in 2009 sales (54% of total); Nutritional Products, $5.3 billion (17%); Diagnostic Products, $3.6 billion (12%); and Vascular Products, $2.7 billion (9%).

Its strong and diverse product line-up led Morningstar to conclude that the company had a wide economic moat and, as a result, a competitive advantage.

ABT was the Stock To Study in the May/June 2010 issue of Better Investing magazine.  The STS is expected to double in investment value (appreciation and dividends) within five years which is Better Investing’s goal. 

I just compared CarolT’s SSG, which I got from BI’s First Cut page, with two of mine and with Take Stock.  Both my SSGs use the same judgments, but Armin-1 uses S&P data (like Carol did) while Armin-2 uses Morningstar-Hemscott data.  Carol’s SSG and First Cut write-up were also reprinted in the May/June issue of BI.

Company Background: 

– Acquisitions are a major driver of ABT’s growth.  In recent years, the company has substantially invested in increasing its low-cost drugs and broadening its geographic presence, especially in underserved growth markets: 

• May 2010: announced that it would buy the Indian drug company Pirmal Healthcare for $3.7 Billion.  Pirmal does contract manufacturing and research for other drug companies and also makes 350 generic drugs;
• April 2010: bought Facet Biotech for $722 Million which had an experimental drug for multiple sclerosis and several treatments for cancer;
• Feb 2010: bought Solvay Pharmaceuticals, a unit of the Belgian company Solvay, for $6.2 Billion which is expected to add nearly $3 Billion to ABT’s 2010 Sales, mostly outside the U.S.;
• Nov 2009: acquired the remaining stake in Evalve, a leader in the non-surgical treatment of structural heart disease, for $320 Million;
• Oct 2009: bought Visogen, a privately-held company specializing in intraocular lens technology for cataract patients, for $400 Million;
• Feb 2009: acquired the remaining stake in Advanced Medical Optics, the leading seller of LASIK surgical devices, for $2.8 Billion;
• Jan 2009: bought Ibis Biosciences, a maker of diagnostic products to detect infectious diseases, for $175Million.

– Humira, ABT’s best selling drug and a treatment for rheumatoid arthritis, generated $5.5 Billion in 2009 sales, up about 22% from 2008.   

** Humira is approved for six uses and is a leading therapy for autoimmune diseases. 

– Depakote, once one of Abbott’s blockbuster drugs, lost its patent protection in 2008 and accounted for only $331 Million in 2009 sales, down 74.5% from 2008; 

– ABT’s nutritional products are leaders in the infant formula market (Similac and Isomil) as well as in the adult nutritional market (Ensure and Glucerma);

– ABT’s Xience line of drug-coated stents was approved for sale in July 2008 and its Model V reportedly became the top seller in the U.S in 2009; 

** ABT acquired the vascular business and the Xience stent from Guidant Corp as part of its acquisition by BSX which, by agreement, also sells the Xience under the Promus name. 

** ABT is developing a new type of stent made of an absorbable material rather than metal and could be three years ahead of its competitors.   

– Much of the info in this Company Background section came from the STS article in Better Investing magazine supplemented by ABT’s latest Annual Report and Wikipedia. 

– ABT’s direct competitors according to Yahoo Finance are Merck (MRK), Sanofi –Aventis (SNY), and Roche Holding (RHHBY) while Morningstar reports its close competitors as Pfizer (PFE), Baxter International (BAX) and Johnson & Johnson (JNJ). 

Legal Problems: 

– ABT’s 2009 Annual Report mentions numerous lawsuits, mostly in a vague and unsatisfying manner: 

• An (unspecified) number of patent infringement lawsuits are pending and ABT is also appealing a $1.67 Billion judgment against it in a federal jury trial regarding its Humira drug;
• In May 2006, the U.S. Department of Justice intervened in a civil whistle-blower lawsuit claiming that ABT had wrongfully inflated prices for drugs paid by Medicare and Medicaid (potential liability unspecified);
• Several civil actions by State Attorney Generals are pending seeking to recover damages on behalf of state Medicaid programs (number of lawsuits, issues and potential liability unspecified);
• Several other civil actions are also pending that claim ABT and other drug makers reported false pricing info (number of lawsuits, issues and potential liability unspecified);
• The company has identified its potential liability for environmental cleanup at not more than $3 Million per site and $15 Million total;

– ABT estimates its possible loss from these legal matters at around $170-310 Million, and has recorded $215 Million as a reserve.  [2009 Annual Report,  page 55]                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

** Apparantly, this reserve does not include anything for the $1.67 Billion judgment against the company and Abbott seems to be hiding much of the potential bad news.  

 SSG Discussion: 

– After the comparison table that follows, I discuss several key SSG issues, ABT’s declining ROE, its high Debt, and overall Financial Condition.

Abbott Labs               (ABT)	Carol	Armin-1	Armin-2	Take Stock
Date	5/3/10	5/4/10	Same	Same
Data	S&P	Same	MStar-Hemscott	Same
Price	$50.87	$50.79	Same	$50.19
52 week High &          Low Price	$66.79 & $42.10	Same & $42.00	Same & Same	Not Used
Last Quarter of     Reported Data	Q1 ending 3/31/10	Same	Q4 ending 12/31/09	Same
Software Used	TK6	Same	Same	TS Online
Project Growth      From End of	Last                 Quarter	Same	Last                Quarter	Last                  FY
Sales Growth	6.00%	10.00%	Same	4.00%
EPS Growth	4.80%                  (from PP)	10.00%	Same	4.00% initial 1.09% final
High PE	18.4	15.3       (from 2009)	15.0    (Same)	19.9
High EPS	$4.81	$6.14	$6.16	$4.04
High Price	$88.50                  (7% < VL)	$93.90           (1% < VL)	$92.40	$80.17               (16% < VL)
Value Line Estimated High Price =$95-115 as of 4/16/10
Low PE	11.0                      (from 2009)	Same	10.9	15.4
Low EPS	$3.81     (TTM)	Same	Same	Same
Low Price	$41.90                (Low PE x          Low EPS)	Same	$41.50 (Same)	$58.67               (exceeds        curr price)
Upside/Down	4.2	4.8	4.9	Impossible    to Calculate
Total Return	14.0%	16.2%	Same	12.9%
SSG Buy Under	N/A	$52.95	$51.93	$45.96
RV/PRV             (outliers removed)	83.2/79.2            (2007 out)	(no outliers)	Same	Not Used
RV/PRV                          (no outliers)	N/A	79.0/71.7	Same	Not Used
Quality	A                          (2nd highest)	Same	Same	2.6                     (fails)
PTPM – 5 yr ave	22.00%              Trend even	Same              Same	20.90%   Trend up	Same                  Trend N/A
ROE – 5 yr ave             Ending Year Equity	26.70%        Trend down	Same     Same	24.60% Trend up	27.1%              Trend N/A
ROE – 5 yr ave            Beginning Yr Equity	N/A	29.40% Trend up	29.10% Trend up	Not Used
Debt to Equity –          5 yr ave	46.80%              Trend up	Same     Same	46.60% Trend up	Not Used

Carol’s SSG: 

Estimating Future Sales and EPS Growth: 

– Carol checked three estimates of future Sales growth (from Morningstar, Value Line, Manifest Investing) and used the lowest of the three (6.00%) from Morningstar. 

** Value Line’s 7.50% was for Sales per Share (not Sales) and VL makes no estimate of future Sales growth.  

** Overlooked was Zacks.com which estimated 9.59% Sales growth for the next 5 years. 

– Carol then used the Preferred Procedure to estimate future EPS growth which involves four estimates for the next 5 years: Sales growth, Pre-Tax Profit Margin, Taxes, and Shares Outstanding. 

** Carol relied on her 7.50% Sales estimate and made no changes in the PP’s defaults which resulted in 4.80% EPS estimate.   

** Had she checked some analysts, Carol might have seen that her 4.80% EPS estimate seems unduly low.  

Armin’s SSGs: 

Estimating Future Sales and EPS Growth: 

– When I did my SSG, the seven analysts I ALWAYS check were estimating long-term EPS at an average of 11.06% with the high at 12.00% (S&P and CNNMoney via FactSet CallStreet) and the low at 9.90% (YahooFinance via Thomson First Call). 

** Value Line was 10.00%, Reuters.com was 10.34%, and Morningstar and Zacks.com were 11.60%.  The seven analysts at Reuters ranged from 13.00% high to 4.20% low. 

** I decided to estimate future EPS growth at 10.00% based on the estimate from Zacks (rounded), the lowest of the seven. 

 ### To learn more about Estimating EPS, click here 

Final Results: 

– Only Armin-1 and Armin-2 satisfied the SSG Buy Criteria of a minimum 3.0 Upside/Downside and a 15% Total Return.  Moreover, I add another requirement: not to substantially exceed or fall below Value Line’s High Price estimate: 

•  Carol (with S&P data) got a 14.00% TR and a 4.2 U/D with a Forecast High Price that was 7% below the low end of VL’s $95-115 High Price estimate;
• Armin-1 (with S&P data) got a 16.2% TR and a 4.8% U/D with a Forecast High Price that was 1% below VL;
• Armin-2 (Hemscott-Morningstar data, but with the same judgments as Armin-1) got a 16.2% TR and a 4.9 U/D with a Forecast High Price that was 1% below VL; and
• Take Stock (Hemscott-Morningstar data) got a 12.9% TR, doesn’t use the U/D concept, and a Forecast High Price that was 16% below VL.

– Carol considered ABT a Buy even though her SSG got a 14.00% TR: 

** BI’s Stock Selection Handbook says that 15.00% is only a goal for our entire portfolio and not something that every stock must achieve.  [Handbook, pages 65-66, 2003 edition]. 

** I disagree and seek a 15% TR for every SSG Buy: that way, my criteria are clear and unambiguous, and don’t depend on the vagaries of my (unspecified) portfolio. 

Return on Equity (ROE): 

– ROE with Ending Equity (26.70%) is trending down with S&P data and any downtrend is often a red-flag warning sign of deteriorating fundamentals. 

** However, this downtrend does not trouble me for several reasons: 

• ROE with Starting Equity (27.10%) is trending up;
• The difference between the two ROEs is insignificant;
• ROE with Ending Equity is better than its S&P Industry Average (26.70% vs 19.80%, Pharmaceutical Industry); and
• Both ROEs with Morningstar-Hemscott data are trending up.

DEBT: 

– ABT had $16.5 Billion in total debt as of 12/31/2009, according to the company’s latest Annual Report, largely incurred to finance recent acquisitions. [2010 A. R.,  PDF page 63]

– Carol was not concerned with ABT’s Debt and her First Cut write-up mentioned:  “Debt and Return on Equity may be a cause of concern for some.  Interest coverage of about 15; they have managed well over 10 years with this higher level of debt.”  

– However, ABT’s Debt to Capital Ratio (40.49% with S&P data) is much higher than five of its direct or close competitors: MRK @ 28.22% and SNY @ 14.32% identified by YahooFinance and PFE @ 21.30%, JNJ @16.63% and BAX @ 35.93%) identified by Morningstar.   

** Moreover, ABT’s 40.49% Debt to Capital Ratio is also higher than its 38.70% S&P Industry Average (Pharmaceuticals). 

– The one-click Annual Report spreadsheet by Bob Adams found that ABT’s Debt was a concern, but not it’s Interest Coverage: 

** The 49% Long-Term Debt to Equity Ratio got a red-flag warning and may be excessive since normal is less than 25%; 

** The Interest coverage at 14.8x (Pre-Tax Profit exceeds interest paid on LT Debt) got a green flag or very good.  

Financial Condition: 

– VL rated ABT an A++ for Financial Strength, its highest grade, with $16.5 Billion in Debt ($11.3 Billion Long-Term) and $8.8 Billion in Cash as of 12/31/09. 

– Morningstar observed that ABT held less cash than its peers because of acquisitions, but that its cash flow was more than adequate to meet interest expenses. 

– The Bob Adams’ one-click spreadsheet gave ABT’s 2009 A.R. a 41 out of 100 with 9 Bullish and 8 Bearish results: 

** The Bullish-good things included: Sales are increasing and increasing faster than Cash Flow; ROE and Free Cash Flow/Sales are very good. 

** The Bearish not-so-goods included: Accounts Receivable and Inventories are increasing and the Cost of Sales is increasing faster than Sales.  

 ### You can get this super-duper, free and easy-to-use spreadsheet, and a summary of its many features, by going to my Favorite Links page: click here 

Armin