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Mr. Valuation Thinks AbbVie Will ‘Humira’ Us For A Few More Years

2015-04-09

Introduction

It is not enough to simply identify a great company to invest in. Before investing in any common stock, it is critically important to evaluate and understand the valuation that the market is currently valuing it at. If valuation is too high, you are exposing your money to higher risk while simultaneously reducing your potential future returns. By paying too much for even the best-of-breed company, you are severely limiting the benefit that investing in a quality business is capable of providing you.

Fundamentally speaking, the essence of the potential profit to you from investing in a common stock is derived from the earnings power of the underlying business. True investors are buying into the business, and ultimately will benefit from the profits the business generates on their behalf, as long as they purchase those profits at a reasonable and sound valuation.

One of the simplest and most commonly used ways to determine the value of a publicly-traded business is by checking the company’s P/E ratio. The formula is very simple, it is simply the current price ((P)) divided by earnings ((E)). At first glance, this seems simple enough, but often it is not as simple as it appears.

The company’s stock price is reported in real time on most financial websites that offer a quoting service. But businesses only report earnings on a quarterly basis. Consequently, when we are between the quarterly reports, we really don’t have a precise earnings figure upon which to calculate the P/E ratio.

As a result, not all financial websites report the P/E ratio on the same basis. Some will report P/E ratios based on trailing twelve month earnings (TTM), others might report the P/E ratio based on forward earnings, and some will report P/E ratios on both.

Unfortunately, this can lead to a common mistake that is often made when looking at a P/E ratio on a quoting service. The price or numerator (the top number) is current and accurate. However, it is the earnings or the denominator (the bottom number) that can be problematic. If you are using trailing earnings , your denominator might be too small, thereby causing the P/E ratio to be higher than it really is. If you are using forward earnings, they might not manifest as expected, thereby causing the denominator to be too large, which makes the P/E ratio calculation look lower than it truly is.

Consequently, I have always preferred to calculate current P/E ratios by taking a blended approach. Admittedly, like the trailing or forward calculations, a blended P/E ratio might not be perfectly accurate either. However, I do believe that a blended P/E ratio calculation will be more precise than the two other alternatives. Trailing twelve months’ earnings can be getting stale, especially when we are in the late innings of the next quarter. Earnings estimates out to the next year may be too optimistic. However, giving credit to the current quarter’s earnings estimates are more likely to be realistic or close to it.

Therefore, by blended P/E ratio, I mean a weighted average of the most recent actual reported earnings plus the closest quarterly forecast earnings. This gives the most weight to the past “actual” reported earnings, but also includes an appropriate consideration of the company’s continuing earnings power post their last report. For most companies, at least the kind that I am most interested in investing in, the blended P/E ratio calculation will be using a moderately higher denominator than trailing twelve months. In other words, I believe the blended P/E ratio calculation is based on a more current level of earnings.

Later in the article, when I present my investment thesis for AbbVie (ABBV) as a high-yield, attractively valued, blue-chip, dividend growth stock, I will present a more detailed explanation of the blended P/E ratio.

AbbVie Visible Growth For The Next Several Years

AbbVie should produce strong cash flow and earnings growth and reward shareholders with dividend increases and capital appreciation for the next several years on the back of its leading immunology drug Humira. This single blockbuster generates over 50% of total sales and a significant portion of AbbVie’s current and intermediate-term future earnings.

Importantly, Humira’s patent will expire in late 2016 in the US and in 2018 in Europe. However, many analysts, including yours truly, believe that Humira sales will continue to grow over the intermediate future from approvals in rheumatoid arthritis, psoriasis, and Crohn’s disease. Humira offers leading efficacy and a very benign side effect profile that is appealing to practitioners. Additionally, Humira’s rather complex biologic composition may serve as a deterrent to generic competition.

Nevertheless, AbbVie is acutely aware of its need to generate sales and earnings beyond Humira. In addition to the loss of patents on Humira and on other of its drugs, the company also faces growing competition from other pharmaceutical company launches. Even though AbbVie’s pipeline for 2015 is quite promising, to include a potential blockbuster for hepatitis C that could generate over $3 billion annually of new sales, the company will need additional products to maintain earnings growth beyond 2018.

Consequently, I believe the recent acquisition of Pharmacyclics (PCYC) and its potential blockbuster drug Imbruvica to treat hematological cancers represent clear evidence that AbbVie’s management recognizes its need to diversify its offerings. However, it did pay a rather stiff price, especially considering that Johnson & Johnson (JNJ) holds a 50% partnership for the development and commercialization of Imbruvica. Nevertheless, Imbruvica represents a strong addition to AbbVie’s promising pipeline of blood cancer drugs that should establish it as a leader in that market.

On the plus side, even though AbbVie faces significant challenges from growing competition and patent expiration on key drugs, the company generates significant cash flows from its product portfolio that should support continuing discovery and development of next-generation drugs. According to S&P Capital IQ, AbbVie invested approximately $3.3 billion on research and development in 2014. However, considering that it costs approximately $800 million to successfully take a drug through the approval process, the risks of generating continued growth are rather large.

AbbVie: Recent Weakness Creates High-Yield Buying Opportunity

Since AbbVie was spun off from the original Abbott Labs (ABT) and operated as an independent publicly-traded company, its performance to its shareholders has been exceptional. In spite of the fact that AbbVie’s stock price has fallen approximately 15% off of the highs it set in late 2014, this A-rated, high-yielding blue-chip has outperformed the average company as represented by the S&P 500 index in rather dramatic fashion, as evidenced by the following performance results:

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ABBV1

The following operating earnings and price correlated F.A.S.T. Graphs on AbbVie since it was spun off illustrates the recent price weakness that I referenced above. By utilizing the tool’s calculator functionality, we see the 15% drop in price, but we also discover that the dividend softened the blow somewhat. This speaks loudly to the value of the dividend, but it also simultaneously illustrates the risk of paying too much for even the best of companies.

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ABBV2

But more importantly, the next earnings and price correlated graph reveals two vitally important facts. First of all, we see that the primary cause of AbbVie’s recent poor performance was a result of the company becoming rather richly valued. Therefore, the recent poor stock performance is clearly attributed to overvaluation, and not a deterioration of the company’s earnings or dividends.

But most importantly, these graphs also reveal that AbbVie’s stock price has now moved into better alignment with its intrinsic value based on operating earnings. Consequently, its more attractive valuation coupled with an expected acceleration in next year’s earnings indicates that AbbVie is once again an attractive, high-yield opportunity for retired investors and dividend growth investors.

The reader should note that the P/E ratio of 16.4 reported in the FAST FACTS box to the right of the graph represents the blended P/E ratio discussed above. Importantly, the calculation is based on AbbVie’s reported adjusted EPS of $3.32 for 2014 (operating earnings), plus a pro rata portion of 2015 EPS guidance.

The precise earnings used in the denominator for this calculation can be determined by dividing the current price on the graph of $58.81 by the reported blended P/E ratio of 16.4, which will give you a blended earnings figure of $3.59. This is slightly more than the trailing twelve months’ (2014 reported) operating earnings of $3.32, but significantly less than the $4.34 estimated guidance for 2015. In other words, this blended P/E ratio valuation calculation is giving full credit to historical earnings, but also includes a pro rata portion of current earnings.

This is important considering that AbbVie reports on a calendar-year basis (fiscal year). Consequently, the first quarter of 2015 is already complete (March 31), however, companies typically report approximately 45 days after the quarter ends. Therefore, in this specific case, trailing twelve-month numbers that are completed and reported only include the quarter that ended in December 2014. This is what I mean by trailing twelve-month numbers getting stale.

Hopefully, this clarifies the blended P/E ratio calculation and supports why I prefer it. Personally, I consider this blended calculation significantly more accurate than trailing twelve months or forward earnings calculations.

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Yahoo Finance Says AbbVie’s P/E Ratio Is 54!

There is another problem with the way many websites report P/E ratios that I believe is important, and potentially misleading regarding attempting to ascertain fair value. In addition to reporting trailing twelve months’ earnings, most websites, to include Seeking Alpha, will also calculate the P/E ratio based on diluted (GAAP) earnings figures.

The following screenshot of a quote from Yahoo Finance illustrates my point. Both the P/E and the EPS numbers are acknowledging trailing twelve month reporting by including this clarifier. However, none of these websites, at least the ones that I’ve reviewed, acknowledge what type of earnings metric they are reporting and basing their P/E ratio calculation upon.

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ABBV4

The earnings and price correlated F.A.S.T. Graphs presented above more appropriately calculates the blended P/E ratio based on operating earnings. However, subscribers do have the option to graph any company utilizing four additional earnings metrics and one for cash flow. The following screenshot of the navigation bar shows these options. I have circled the diluted earnings (GAAP) option.

Slide1

This next earnings and price correlated graph is presented utilizing the diluted earnings option. Here we see the $1.10 diluted number for 2014 reported on the Yahoo Finance site. However, the reader should note that there is a very low correlation between the company’s stock price and its diluted earnings. This is very typical, because the market tends to ignore GAAP accounting metrics in favor of operating earnings. The reader should also note that no forecasts are provided for diluted earnings.

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The following headlines from AbbVie’s fourth-quarter and year-end 2014 financial results press release illustrates that it reports both operating and GAAP earnings results.

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There is an important reason as to why I have presented the above dissertation on valuing a company based on the appropriate earnings metric. I believe that AbbVie is a very attractive, blue-chip dividend growth stock that is currently soundly valued. However, had I simply looked at a quote from most websites, as indicated above, a reported P/E ratio above 54 would have immediately caused me to overlook this investment opportunity. This is why I consider this type of reporting potentially misleading.

AbbVie – Looking To The Future

As depicted above, AbbVie appears soundly-valued based on a reasonable operating earnings P/E ratio, especially when consideration is given to future earnings growth. In its most recent financial report, AbbVie guided for adjusted operating earnings of $4.25-$4.45 for 2015.

The forecasts on the historical graph above and the “Forecasting Calculator” below depict 2015 operating earnings per share at $4.34, which is approximately in the middle of company guidance. This represents an earnings growth rate of just less than 31% for 2015. Utilizing the calculator function, that rate of earnings growth would imply an annual rate of return in excess of 33% by year-end 2015 and a total annual return of approximately 15% (calculation not shown on the graph) by year-end 2017.

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ABBV7

AbbVie’s Long Business Description – Courtesy S&P Capital IQ:

For those readers interested in learning more about AbbVie’s business and products, I offer the following long business description courtesy of S&P Capital IQ:

“AbbVie Inc. operates as a research-based biopharmaceutical company worldwide. The company develops and markets advanced therapies that address various complex and serious diseases.

The company’s products are focused on treating conditions, such as chronic autoimmune diseases, including rheumatoid arthritis, psoriasis, and Crohn’s disease; hepatitis C (HCV); human immunodeficiency virus (HIV); endometriosis; thyroid disease; Parkinson’s disease; complications associated with chronic kidney disease and cystic fibrosis; and other health conditions, such as low testosterone.

The company also has a pipeline of promising new medicines, including approximately 30 compounds or indications in Phase 2 or Phase 3 development across such important medical specialties as immunology, virology/liver disease, oncology, renal disease, neurological diseases, and women’s health.

Products

HUMIRA

HUMIRA is a biologic therapy administered as a subcutaneous injection. It is approved to treat various autoimmune diseases (rheumatoid arthritis (moderate to severe), psoriatic arthritis, ankylosing spondylitis, Crohn’s disease (moderate to severe), plaque psoriasis (moderate to severe), juvenile idiopathic arthritis, ulcerative colitis (moderate to severe), axial spondyloarthropathy, pediatric Crohn’s disease (severe), and pediatric enthesitis-related arthritis) in the United States, Canada, and Mexico (collectively, North America), as well as in the European Union.

HUMIRA is also approved in approximately 60 other markets, including Japan, China, Brazil, and Australia. The company continues to dedicate research and development efforts to expanding indications for HUMIRA, including in the fields of rheumatology, gastroenterology (pediatric Crohn’s disease and pediatric ulcerative colitis), dermatology (pediatric psoriasis and hidradenitis suppurativa), and ophthalmology (uveitis). Phase 3 trials are ongoing in preparation for regulatory applications for uveitis in the United States and the European Union. Regulatory applications for hidradenitis suppurativa have been filed in the United States and the European Union. The company continues to work on HUMIRA formulation and delivery improvements to improve convenience and the overall patient experience.

HCV Products

VIEKIRA PAK is an all-oral, short-course, interferon-free therapy, with or without ribavirin, for the treatment of adult patients with genotype 1 chronic HCV, including those with compensated cirrhosis. VIEKIRA PAK was approved by the U.S. Food and Drug Administration in December 2014. In Europe, the company’s HCV treatment is marketed as VIEKIRAX + EXVIERA and is approved for use in patients with genotype 1 and genotype 4 HCV. The European Commission granted marketing authorization for this treatment in January 2015.

Additional Virology Products

The company’s additional virology products include Kaletra and Norvir for the treatment of HIV infection and Synagis for the prevention of respiratory syncytial virus infection in high risk infants.

Kaletra: Kaletra (also marketed as Aluvia in emerging markets) is a prescription anti-HIV-1 medicine that contains two protease inhibitors, such as lopinavir and ritonavir. Kaletra is used with other anti-HIV-1 medications as a treatment that maintains viral suppression in people with HIV-1.

Norvir: Norvir (ritonavir) is a protease inhibitor that is indicated in combination with other antiretroviral agents for the treatment of HIV-1 infection.

Synagis: Synagis is a product marketed by the company outside of the United States that protects at-risk infants from severe respiratory disease caused by respiratory syncytial virus.

Metabolics/Hormones Products

Metabolic and hormone products target various conditions, including testosterone deficiency, exocrine pancreatic insufficiency, and hypothyroidism. These products comprise:

AndroGel: AndroGel is a testosterone replacement therapy for males diagnosed with symptomatic low testosterone that is available in two strengths, such as 1 percent and 1.62 percent.

Creon: Creon is a pancreatic enzyme therapy for exocrine pancreatic insufficiency, a condition that occurs in patients with cystic fibrosis, chronic pancreatitis, and various other conditions.

Synthroid: Synthroid is used in the treatment of hypothyroidism.

The company has the rights to sell AndroGel, Creon, and Synthroid in the United States.

Endocrinology Products

Lupron (also marketed as Lucrin and Lupron Depot) is a product for the palliative treatment of advanced prostate cancer, treatment of endometriosis and central precocious puberty, and for the preoperative treatment of patients with anemia caused by uterine fibroids. Lupron is approved for daily subcutaneous injection and one-month, three-month, four-month, and six-month intramuscular injection.

Other Products

The company’s other products include the following:

Duopa and Duodopa: The company’s levodopa-carbidopa intestinal gel for the treatment of advanced Parkinson’s disease is marketed as Duopa in the United States and as Duodopa outside of the United States.

Anesthesia Products: Sevoflurane (sold under the trademarks Ultane and Sevorane) is an anesthesia product that the company sells worldwide for human use.

Dyslipidemia Products: The company’s dyslipidemia products (TriCor, Trilipix, Niaspan, Simcor, and Advicor) address the range of metabolic conditions characterized by high cholesterol and/or high triglycerides.

Zemplar: Zemplar is a product sold worldwide for the treatment of secondary hyperparathyroidism associated with Stage 3, 4, and 5 chronic kidney disease.

Marketing, Sales, and Distribution

The company utilizes a combination of commercial resources, regional commercial resources, and distributorships to market, sell, and distribute its products worldwide.

The company directs its primary marketing efforts toward securing the prescription, or recommendation, of its brand of products by physicians, key opinion leaders, and other health care providers. Managed care providers (health maintenance organizations and pharmacy benefit managers), hospitals, and state and federal government agencies (the United States Department of Veterans Affairs and the United States Department of Defense) are also primary customers. The company also markets directly to consumers themselves, although in the United States all of the company’s products must be sold pursuant to a prescription.

In 2014, the company’s products were sold in approximately 170 countries. The company’s products are sold worldwide directly to wholesalers, distributors, government agencies, health care facilities, specialty pharmacies, and independent retailers from company-owned distribution centers and public warehouses.

In the United States, the company distributes pharmaceutical products principally through independent wholesale distributors, with some sales directly to pharmacies and patients. In 2014, three wholesale distributors (McKesson Corporation; Cardinal Health, Inc.; and AmerisourceBergen Corporation) accounted for all of the company’s sales in the United States. Outside the United States, sales are made either directly to customers or through distributors, depending on the market served.

Research and Development Activities

The company spent approximately $3.3 billion on research to discover and develop new products, indications, and processes and to improve existing products and processes in 2014.

Regulation

The company’s operations are affected by trade regulations in various countries that limit the import of raw materials and finished products and by laws and regulations that seek to prevent corruption and bribery in the marketplace (including the United States Foreign Corrupt Practices Act and the United Kingdom Bribery Act, which provide guidance on corporate interactions with government officials) and require safeguards for the protection of personal data. The company is also subject to laws and regulations pertaining to health care fraud and abuse, including state and federal anti-kickback and false claims laws in the United States.

History

AbbVie Inc. was incorporated in Delaware in 2012.”

Summary and Conclusions

In today’s low interest rate environment, retired investors and dividend growth investors alike face many challenges in finding adequate sources of income. The fact that the overall stock market as represented by the S&P 500 is currently moderately overvalued complicates matters even more. However, as I have often opined “it is a market of stocks, and not a stock market.”

Consequently, I believe it also follows that attractive investments can be found in all markets if you’re willing to look close enough. I believe that AbbVie currently represents a sound and attractive dividend growth opportunity. The company has well-defined prospects for growth, at least over the next few years, is available at a sound valuation, offers a very attractive current yield, and is widely considered a blue-chip dividend growth stock.

Disclosure: Long ABBV at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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