Abbott Laboratories (ABT): A Top Dividend Aristocrat Down 15% From Its High

When it comes to dividend growth stocks there are few better choices than the legendary dividend aristocrats, S&P 500 companies which have raised their dividends for at least 25 consecutive years.

 

Investors can read analysis on all of the dividend aristocrats here.

 

Abbott Laboratories (ABT) is a dividend aristocrat with a long track record of paying dividends dating back to 1924. The company has also raised its dividend for over 40 consecutive years.

 

Let’s take a closer look at this medical conglomerate to see just what makes it so special.

 

With Abbott’s stock down more than 15% since its high in 2015, find out if Abbott is reasonably priced today for long-term dividend growth investors.

 

Business Description

Founded in 1888 in Abbott Park, Illinois, Abbott Labs is one of the world’s largest medical companies. Abbott spun off its research-based pharmaceuticals business AbbVie (ABBV) in January 2013 and has four main business units today:

 

Nutritional Products (34% of sales): Pediatric and adult nutritional formula such as Similac and Ensure

 

Medical Devices (25%): Devices to treat structural heart issues, such as stents, pacemakers, implantable defibrillators, and products to monitor blood glucose levels.

 

Diagnostic Products (23%): chemical systems to diagnose: cancer, drug abuse, cardiac diseases, fertility issues, infectious diseases, therapeutic drug monitoring, as well as instruments to automate and test DNA and RNA.

 

Established Pharmaceuticals (18%): branded generic drugs to treat a wide variety of conditions including: pain, fever, inflammation, migraines, dyslipidemia (high cholesterol), gynecological disorders, pancreatic insufficiency (diabetes), and hypertension (high blood pressure).

 

Abbott’s revenues are widely diversified across segments, and the company sells more than 10,000 different products. This creates very stable and predictable cash flow, far more secure than standalone drug makers such as Pfizer (PFE) (see our analysis on Pfizer’s high dividend here).

 

In addition to product diversification Abbott’s business is truly global, with 69% of sales coming from outside the U.S. and providing good access to faster growth opportunities overseas (close to 50% of Abbott’s sales come from emerging markets).

 

Business Analysis

All of Abbott’s businesses have some unique competitive advantages. Roughly 50% of the company’s total sales are made directly to consumers. These products primarily reside in the Abbott’s adult and pediatric nutrition segment and its branded generic drugs.

 

These businesses operate more like consumer packaged goods companies than traditional healthcare businesses in some ways. They benefit from Abbott’s decades’ worth of marketing spending to build up brand recognition, the company’s extensive investments in R&D to understand consumer preferences, and Abbott’s deep distribution relationships that help the company maintain prime shelf space where its products are sold.

 

With over a century of operational history, Abbott has acquired and reinforced dominant market share positions in many areas. Abbott is the world’s number one player in adult nutrition and is the U.S. leader in pediatric nutrition. The company’s 50 consumer nutrition brands are number one or number two in 25 countries.

 

Within branded generics, Abbott is number one in India, Russia, and several other Latin American countries. Abbott’s moat in this business is driven in part by the company operating in largely oligopolistic business segments. There are generally just three or four major players it must compete with in most markets, reducing pricing pressure.

 

In fact, Abbott’s generic drugs business is 100% focused in overseas markets. Since many of these markets have very weak distribution networks, the company has a big advantage courtesy of its strong relationships with local pharmacies and physicians.

 

Abbott’s strong brand recognition allows it to generate healthy margins, and because none of its drugs are patented, it doesn’t face patent expiration risk and the kind of ferocious competition that is a major concern for most patented drug makers.

 

The company’s medical devices and diagnostics businesses are a bit more challenging to maintain because they require heavier R&D investments to adapt to the industry’s faster pace of change. However, Abbott has still managed to hold leading market share in numerous key categories, such as LASIK, blood screening, cataract surgery, and amino-acid diagnostics.

 

New entrants have a hard time challenging Abbott because of the high amount of government regulation in these markets (e.g. pharmaceuticals, medical devices), the steep investment costs needed to develop competitive products (Abbott invests 6-7% of its revenue in R&D), the need for global distribution networks, and the protection provided by patents and trademarks.

 

Through organic reinvestment or bolt-on acquisitions, Abbott can quickly adapt to changing healthcare trends to remain relevant, plugging new products into its extensive distribution network.

 

Despite the company’s competitive advantages, however, you might think that Abbott has a major growth problem. Sales, operating margin, and free cash flow per share are all below where they were five years ago.

 

 

However, the apparent decline in sales, earnings, and margins are in fact a byproduct of the company’s 2013 spinoff of its patented pharmaceutical division into AbbVie.

 

That, plus the strong rise in the dollar since 2014, has resulted in slower growth than before the spinoff. However, excluding currency effects, each of the company’s business units managed to put up reasonable growth in 2016.

 

In addition, the company has done an excellent job leveraging its large size and global ingredient sourcing to generate strong economies of scale, resulting in steadily improving margins across its most important segments.

 

 

 

From 2013 through 2016, Abbott’s overall gross and operating margins increased from 53.2% to 56.9% and from 10.8% to 14.7%, respectively.

 

In fact, thanks to its quality management team, led by CEO Miles White who has been with Abbott for 33 years, ongoing efficiency gains and cost cutting (from streamlining distribution channels and lower cost manufacturing plants) have helped Abbott generate above average margins and returns on capital (adjusted for the St. Jude acquisition).

 

Company	Operating Margin	Net Margin	Return on Assets	Return on Equity	Return On Invested Capital
Abbott Labs	14.7%	15.7%	8.3%	15.8%	11.2%
Industry Average	12.8%	8.4%	3.5%	7.1%	NA

Sources: Morningstar, Earnings Release

 

Over time, analysts expect further margin improvement with operating margins approaching 19.4% by 2019, according to Morningstar. Part of that will be from the $500 million in St. Jude cost synergies that management thinks it can achieve over the next three years.

 

Beyond profitability improvements, Abbott’s growth runway appears very long, courtesy of the rapid aging of the global population.

 

 

In addition, its strong presence in the world’s fastest growing economies, where healthcare spending remains far below the world norm, means that its diversified business lines should generate steady growth for decades.

 

 

Despite Abbott’s numerous attractive qualities, income investors need to be aware of several risks.

 

Key Risks

Like all medical companies, Abbott Labs faces a few key risks.

 

First of all, while it operates as one of the big four medical device makers (Stryker, Medtronic, and Johnson & Johnson), which limits competition and helps boost margins, each of its competitors is well capitalized and has an excellent track record of innovation over time.

 

In other words, if a rival comes out with a revolutionary new device it can win market share very quickly and force Abbott to go back to the drawing boards to improve its own product offerings.

 

Due to concerns over rising costs, there is also risk that healthcare providers will move to multi-line contracts, meaning bulk purchases of medical equipment that their patients need.

 

Since Abbott’s medical prowess is mainly in cardiac and diabetes equipment, this could give it a competitive disadvantage. Even the St. Jude acquisition won’t help offset this risk much because that purchase was mainly designed to strengthen its cardiac device business (although it did add neuromodulation for pain control as well).

 

Finally, Abbott’s big bet on strong growth in emerging markets is predicated on two assumptions. First, that economic growth in these countries will bounce back from the recent slump, and that their currencies will rebound.

 

Currently the slowdown in China’s economy (largely due to unsustainable debt levels) has triggered a crash in commodities that has greatly impacted Latin American growth rates.

 

With U.S. GDP growth relatively healthy and interest rates on the rise, the dollar has strengthened to a 15-year high. That means that when Abbott converts local currency into dollars for earnings (and dividend payment) purposes, much of the growth benefit from its overseas businesses gets offset.

 

In fact, in 2016 the strong dollar ended up offsetting 2.6%, or 54%, of the company’s total sales growth. Eventually the dollar should return to lower, historic levels. However, that might not occur for several more years, resulting in ongoing growth headwinds.

 

Finally, in terms of company-specific risks, be aware that Abbott Labs is currently embroiled in a messy legal battle with Alere, a diagnostics device maker it had previously agreed to buy for $5.8 billion ($8.4 billion including debt assumption) prior to striking the deal to acquire St. Jude Medical.

 

That deal has turned into a bit of a nightmare, with Alere failing to file financial statements, having to recall a major product because it doesn’t work, and losing Medicare reimbursement.

 

Abbott has spent months trying to back out of the deal. However, if the courts end up forcing the deal to be completed, it could mean harm to Abbott’s balance sheet.

 

In fact, on the assumption that the deal is completed S&P recently downgraded Abbott’s credit rating from A+ to BBB.

 

In addition to financial risk, large acquisitions such as St. Jude Medical and Alere create execution risk. They represent major capital allocation bets, and management’s strategic rationale needs to be right.

 

Overall, many of Abbott’s key risks are balanced out thanks to the company’s cash flow diversification and numerous opportunities for long-term growth (i.e. the company isn’t overly dependent on any one thing to go right).

 

Each of Abbott’s four unique segments has different risks and growth opportunities, and the company’s geographical diversification reduces overall regulatory risk in any given market as well.

 

Dividend Safety Analysis: Abbott Laboratories

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Abbott Labs has a Dividend Safety Score of 89, indicating its dividend is very safe and dependable. When it comes to dividends Abbott Labs is a legend, with 93 years of uninterrupted dividend payments to its name.

 

If you adjust for the spinoff of AbbVie, then Abbott Labs, with 45 consecutive years of dividend growth, is not just a dividend aristocrat, but just five years away from becoming a dividend king.

 

Abbott’s impressive payout growth track record and safe dividend are due to two main factors.

 

First, the company has historically maintained very conservative EPS and FCF payout ratios, meaning plenty of extra cash to cushion its dividend in bad times. Note that recently the FCF payout ratio has risen to unusual levels due to acquisition-related charges associated with the St. Jude acquisition.

 

 

Based on 2017 earnings estimates, Abbott’s projected EPS payout ratio for the year sits at a very healthy 40%. This level provides plenty of flexibility and is especially safe considering the recession-resistant nature of many of Abbott’s products.

 

The second big protective factor is the strong balance sheet, even with the uncertainty over the Alere situation continuing.

 

Specifically, Abbott’s strong current ratio, low leverage ratio, and high interest coverage ratio mean that Abbott has no trouble servicing its debt or short-term liabilities, even if it ends up forced to pay full price for Alere.

 

 

That’s thanks to Abbott having a lower than average debt levels ahead of the ultimate Alere legal outcome. Thus, even if Abbott ends up losing the case, its balance sheet would wind up no worse than the industry average, and it would maintain its investment grade credit rating.

 

Company	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
Abbott Labs	2.76	9.68	20%	1.56	BBB
Industry Average	3.56	NA	37%	2.11	NA

Sources: Morningstar, Fastgraphs

 

In other words, Abbott would still have strong access to relatively cheap debt, thus allowing it the financial flexibility to continue growing its business without threatening its payout.

 

Thanks to the company’s low payout ratio, solid balance sheet, and dependable cash flow generation, Abbott’s dividend should remain very safe for many years to come.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Abbott Labs has a Dividend Growth Score of 62, indicating that investors can expect better than average (median S&P 500 dividend growth over the last 20 years is 5.9%) income growth.

 

Abbott’s quarterly dividend grew by 8.3% in 2016 and has increased from 14 cents per share in 2013 (immediately following the spinoff of AbbVie) to 27 cents most recently, nearly doubling over the course of three years.

 

With a payout ratio sitting near 40%, Abbott has flexibility to continue raising its dividend even in a challenging environment that temporarily depresses earnings. However, the company’s future dividend growth over the course of many years will primarily depend on its long-term earnings and free cash flow growth.

 

Fortunately, even without AbbVie’s strong revenue growth, the company should be able to generate long-term sales growth of 4%, courtesy of successful product launches and the continued rise of healthcare spending in developing countries.

 

Analysts project long-term EPS growth close to 11% per year, which could be a bit overly optimistic (very few companies ever achieve long-term double-digit EPS growth).

 

However, ongoing cost cutting and margin growth, as well as steady buybacks, could certainly result in long-term EPS growth of 8-9%, with dividend growth achieving similar levels.

 

Valuation

Abbott trades at a forward P/E multiple of 17.3 (roughly in line with the S&P 500’s forward P/E multiple) and offers a dividend yield of 2.5%, which is in line with the stock’s five-year average dividend yield of 2.5%.

 

With earnings expected to grow at a high-single digits rate over time, Abbott’s valuation appears to be reasonable and offers 10-12% annual total return potential (2.5% dividend yield plus 8-9% annual earnings growth), assuming earnings growth forecasts are correct.

 

However, there are a lot of moving parts to Abbott’s investment story today that will undoubtedly impact the company’s future.

 

From uncertainty with Alere (will Abbott be able to terminate the $5.8 billion deal?) to the recent closed deal to acquire St. Jude Medical, Abbott has made some major capital allocation bets that will take time to play out.

 

Since I already have a full position in Abbott, the stock doesn’t appear to be a bargain today, and I prefer to see some of the dust settle with the company’s big acquisitions, I’m not looking to add.

 

Closing Thoughts on Abbott Laboratories

While Abbott Labs is currently facing some major growth headwinds, overall the company has proven itself to be one of the best long-term blue chip dividend growth stocks you can own.

 

After all, it’s very shareholder-friendly corporate culture, improving profitability, and highly diversified business model is well suited to taking advantage of some of the next century’s largest economic mega-trends (especially in emerging markets).

 

While the stock looks reasonably priced for long-term dividend growth investors, management needs to deliver meaningful value from Abbott’s recent acquisition of St. Jude Medical. For now, I’m willing to give them the benefit of the doubt and remain a long-term shareholder, doing my best to follow the best habits of highly effective dividend investors.