This article was coproduced with Dividend Sensei.
Warren Buffett famously talked about how he likes to wait for “fat pitches”:
“I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity lost. All day, you wait for the pitch you like. Then, when the fielders are asleep, you step up and hit it…
“Wait for a fat pitch and then swing for the fences.”
Wall Street is fixated on the stimulus negotiations, which aren’t progressing. Economists expect no deal until early next year.
At last check, the S&P 500 was still 33% historically overvalued. That’s about 4% within its all-time high, making a lot of the markets’ pitches less than advisable to try connecting with.
However, AbbVie ( ABBV) is a very high-quality dividend aristocrat that’s been falling steadily for weeks – for no fundamental reason.
This creates the opportunity for prudent long-term income growth investors to lock in not just a safe 5.7% yield, but also some of the best long-term return potential Wall Street has to offer.
How confident are we in recommending pharmaceutical juggernaut AbbVie right now?
Dividend Kings owns AbbVie in all its portfolios. I do too on a personal level, and so does Dividend Sensei. He’s even placed 15 limits to buy more of it should it continue falling despite objectively excellent fundamentals.
There are six reasons behind this optimism and why we think that prudent income investors and retirees should consider it today.
Reason 1: An Exceptionally Generous and Safe Dividend
As our regular readers recognize, Dividend Kings and iREIT have no interest in yield traps with unsafe dividends. This is why we look at a wide spread of safety metrics, including the 18 below.
Using historical S&P dividend cut data in recessions going back to 1945, we can estimate the risks of a dividend cut in any given downturn.
Here’s why AbbVie scores 4/5 (above-average) for its mouth-watering 5.7% yield…
- 2020 consensus free cash flow payout ratio: 73% vs. 60% safe for pharma
- 2021 consensus FCF payout ratio: 46%
- 2022 consensus FCF payout ratio: 42%
- Debt/capital: 80% vs. 40% or less safe versus 54% debt/capital adjusted for Treasury stock
- Debt/EBITDA (earnings before interest, taxes, depreciation, and amortization): 4.6 versus three or less safe versus 3.2 2021 consensus
- Interest coverage: 5.1 versus 8+ safe versus 6.2 2021 consensus
- Quick Ratio: 0.7 vs. 1+ safe versus 1.37 eight-year median
- Current Ratio: 0.86 vs. 1+ safe versus 1.53 8-year median
- S&P credit rating: BBB+ stable outlook = 5% 30-year bankruptcy risk
- Moody’s credit rating: Baa2 (BBB equivalent) stable outlook = 7.5% 30-year bankruptcy risk
- F-score: 5/9 vs. 4+ safe, 7+ very safe = low short-term bankruptcy risk
- Z-score: 1.11 vs. 1.81+ safe, 3+ very safe = high long-term bankruptcy risk vs. 2.22 eight-year median (historically low risk)
- M-score: -2.09 vs. -2.22 or less safe = medium accounting fraud risk versus -2.68 eight-year median (historically low risk)
- Dividend growth streak: 47 years (an aristocrat under the S&P grandfather spin-off rule)
- Dividend-Cut Risk in This Recession: 2%-4%
- Dividend Cut Risk in a Normal Recession: 1%
So what can we make of all that?
Acquisitions, Approvals, and Additional Data That Looks Real Good
That’s all despite how AbbVie’s new Allergen business acquired this May – specifically the Botox part – suffered immensely in Q2 thanks to the shutdowns. As a result, debt/EBITDA rose to 14.6 and interest coverage fell to 1.2.
It also resulted in asset ratios shifting around driving the advanced accounting safety metric Z and M scores to suboptimal levels.
Yet ratings agencies aren’t concerned about Abbvie’s balance sheet thanks to its massive free cash flow – basically the money left over after operating expenses and investing in future growth.
Speaking of future growth, ABBV has 60 drugs in its pipeline, including some already-approved blockbusters. Management expects just immunology-focused Skyrizi and Rinvoq to drive over $10 billion in peak annual sales in the coming years.
More than 30 of the five dozen are in late-stage trials, and the company has a great track record of hitting its approval goals. So it has a good shot of succeeding with the 11 major submissions it’s made or making this year and next.
Back to Allegan for a moment, that acquisition made Abbvie the world’s:
- Third-largest drug maker as measured by operating cash flow
- Fourth-largest drug maker as measured by revenue
And the new platforms it now owns (minus Humira, which goes off patent in 2023) should grow at about 8.5% through 2025… about 3x the larger industry’s pace.
(Source: investor presentation)
Some Additional Insider and Outsider Input
On the company’s Q2 conference call, CFO Rob Michael said that AbbVie is well positioned to:
- Pay down debt rapidly
- Support its growing dividend
- Pursue new pipeline opportunities
The pharmaceutical generated operating cash flow of $6.9 billion for Q1 and Q2. And its balance at the end of June was $6 billion. With its continuing debt repayment initiatives, AbbVie expects to see a net debt-to-EBITDA ratio of 2.5x by the end of next year.
Though even then, it plans to continue deleveraging through 2023.
For the record, that 2.5x number matters because it’s the level S&P generally considers safe for most A-rated companies.
Source: Dividend Sensei
AbbVie was rated as A- stable before it bought Allergan. And S&P does expect it to improve again over the next two years. Though, for now, it believes “the company has about $12 billion of debt capacity at the BBB+ rating.”
Moody’s also downgraded ABBV to Baa2 due to that extra acquisition-induced leverage. Then again, it’s not concerned about the path going forward either. “Even with earnings pressures related to the coronavirus pandemic,” it expects gross debt/EBITDA to fall below 3.5x in the next two years.
All the way through 2022, the 17 analysts who cover ABBV expect double-digit earnings growth. Other than a single and year for free cash flow in 2020, ABBV’s FCF is expected to soar, including 74% in 2020 and almost 20% the year after that.
And EBITDA and EBIT – what leverage and interest coverage ratios are based on – are similarly expected to grow like weeds. By the end of this year, it should reach safe levels. And by the end of next, they’re expected to fall enough to fit in with S&P notions of an A- stable credit rating…
In which case, we’ll upgrade it as well to a 5/5 safety.
As things stand now, AbbVie should be hiking its dividend by 10% in the next few months, 7% in late 2021, and 4% in 2022. That may be slower than its investors are used to, but that’s still incredible long-term income-generating potential regardless.
Assuming analysts are correct, anyone buying ABBV today will be getting almost 7% of their investment back each year. And over time, that dividend should grow in-line with long-term cash flows at 7% compound annual growth rate.
Reason 2: An Exceptional Track Record of Meeting and Beating Expectations
How good are analysts at forecasting the growth rate for ABBV’s earnings and cash flows?
When it comes to earnings, the margins of error are small to the downside, with AbbVie beating two-year forecasts 66% of the time. That track record goes all the way back to its spinoff from dividend aristocrat Abbott Labs (ABT) in 2012.
As a side note, yes, the newer company can still be a dividend aristocrat thanks to the S&P spin-off grandfather rule. Essentially, AbbVie retained its parent’s track record in this regard and has maintained it since.
This also means that, in 2023, it will likely become a dividend king.
Here’s another promising fact about AbbVie’s track record. It beat quarterly expectations 92% of the time over the last four years. And in over half of them since first forming, the company has beaten and raised its own guidance.
There are few other stocks with such a consistent and exceptional record in this regard.
Then there’s free cash flow. Analysts expect ABBV to retain $12.8 billion in free cash flow this year – including a robustly-growing dividend and after paying its generous dividend.
Admittedly, analysts aren’t as spot-on historically speaking here as with earnings. Still, AbbVie’s beaten two-year forecasts 60% of the time since its spinoff, giving analysts an average -1% margin of error.
This means that ABBV historically grows FCF as expected. Meanwhile, analysts average just -4% on EBITDA over the past six years, a very small margin of error.
Their pre-tax profits estimations are more significant, however, at -11%. But remember that ABBV’s 2022 consensus interest coverage ratio is currently forecast to be 11.5. So even that would mean a 10.2 interest coverage ratio.
Even if ABBV missed 2022 EBIT forecasts by 23% – the most its missed by since its spinoff – interest coverage would still be 8.6, which is above the 8+ level rating agencies consider safe.
Besides, the bottom-line conclusion is that analysts are generally very accurate at forecasting how fast ABBV will grow. And, in many ways, we can thank management for that.
Reason 3: Exceptionally Competent and Committed Management
We rate AbbVie 3/3 on its management quality and dividend-friendly corporate culture.
To be clear, that’s slightly higher than Morningstar’s assessment of the company. It says that “AbbVie’s management team has demonstrated Standard stewardship,” though even it acknowledges part of its critique might not be entirely fair.
“While the failed acquisition attempt for Shire is concerning, we believe the new abrupt U.S. Treasury laws largely caused the acquisition to collapse, somewhat giving management a pass. Nevertheless, the $1.6 billion breakup fee related to the failed Shire deal does show that management didn’t gauge the political landscape correctly.”
Morningstar also isn’t impressed with “the $6 billion acquisition of Stemcentrx.” Though it labels the Allergan purchase as “a fair use of capital” and grudgingly admits that “execution has been going well” under CEO Rick Gonzalez – who began working with Abbott 43 years ago, holding many managerial positions over his time there.
Morningstar voices concern about “his relatively short tenure in the key field of drug commercialization and development.” And it complains about “some optimistic long-term projections set by the management team.” But that’s about all we find worth mentioning in that regard.
We’ll be the first to admit that the pharma industry is a very complex world. Even the most skilled management teams aren’t going to have a perfect track record.
Yet ABBV almost has tripled its dividend since going independent – and safely too. It’s obvious both in word and action that management cherishes the aristocrat status it inherited from Abbott.
Over the long term, the team wants to pay out about 50% of FCF as safe and growing dividend.
For those who, like Morningstar, want to focus on the missteps it’s made with Stemcentryx and Shire though… keep reading on.
Reason 4: One of the Highest-Quality Pharma Giants on Earth
The way we judge a company’s business model is by looking at profitability over time through:
- Net margins
- Operating margins
- Return on equity
- Return on assets
- Return on invested capital
- Free cash flow margins
Since the spin-off, AbbVie’s profitability has been at least stable, if not improving, over time.
Return on assets did fall on the Allergan acquisition, which added a lot of new debt to the capital structure. But historically, AbbVie is among the most profitable of drug makers.
As mentioned before, it generated a negative return on capital in Q2. Yet over the past year, it managed to generate 292% return on capital anyway – the money it takes to run the business.
ABBV’s median ROC is 180% over time. This means it generated $1.80 in annual pre-tax profits for each $1 it took to run the business.
- 8% is considered good for most companies
- 80% is the average for the 9/11 quality blue-chips Dividend King tracks
- 127% is the average for the best of the best
And yet ABBV trumps even that! Its ROC has been rising 17% CAGR over the past five years, lockdown results and all.
But ROC is hardly the only reason we consider it one of the highest-quality companies in pharma or out of it.
Out of the 990 large global drug makers in the world, just 101 have been more profitable over the past year. And 10 boast superior-quality return on capital.
Reason 5: A Classic Buffett Style “Fat Pitch” Investment Opportunity
In this overvalued market, any company growing at double digits and boasting a wide and stable moat tends to be overvalued. But not AbbVie.
AbbVie has grown at 15% CAGR since its spinoff. Yet, due to the Humira concentration risk and 2023 bio-similar competition cliff, the market has never priced it at the high premiums it does for other drug makers.
The Market Values BMY at 18x-20x Earnings Regardless of Growth Rates
Yet even using its historically conservative market-determined fair value multiples, ABBV looks near 47% undervalued for 2021’s consensus estimates. And remember this company is famous for beating estimates, sometimes by as much as 20%.
AbbVie was trading at ultra-value, anti-bubble, Buffett-style “fat pitch” levels at last check with a 6.9x 2021 earnings per share consensus versus 13.7 historical market-determined fair value.
If it grows as expected through 2022 and returns to historical fair value, analysts expect about 49% CAGR total returns. Compare that to the S&P 500, which is likely to deliver slightly negative returns over the next two years.
Longer term, almost 200% total returns equaling 22.3% CAGR are possible by the end of 2025.
That is, of course, a possibility. It’s not a guarantee. But even using reasonable conservative expectations, we still get about 16% CAGR risk-adjusted expected annual returns.
And if AbbVie grows the 7% analysts are expecting, new investors today would lock in approximately 13% long-term returns for the next 20-plus years (when valuation changes cancel out).
Short term, meanwhile, offers the potential for up to 27% returns. Incidentally, that’s precisely what the pharmaceutical delivered from January 2013 to September 2020.
Bottom line, this stock is dirt cheap. For now.
Reason 6: A Very Reasonable, Prudent, High-Yield Blue-Chip
So how prudent is this investment relative to the S&P 500? Its:
- 45% discount to fair value earns it a 4/4 score for valuation timeliness
- BBB+ credit rating implies a 5% chance of bankruptcy risk for a 6/7 score for preservation of capital
- 34.2% (vs. the S&P’s 10.1%) five-year potential for return via dividends earns it a 10/10 for return of capital
- 15.9% (vs. the S&P’s 3.23%) five-year risk-adjusted expected return earns it a 10/10 return on capital score
There’s a lot to like here, to say the least.
Risks to Consider: Why AbbVie Isn’t Right for Everyone
The biggest short-term fundamental risk for AbbVie involves its deleveraging efforts.
Over the last three months, its 2022 FCF consensus estimate has fallen by 30%. 2021’s rose by 14% and 2022’s by 20%.
You can probably blame the Allergan acquisition for that, especially how Botox is such a major revenue driver for it – but must be administered in a doctor’s office. In fact, Allergan has an overall greater reliance on provider-administered drugs and economically-sensitive products than AbbVie.
In addition, AbbVie’s growth will likely falter because of fewer new patients starting on medicines until social distancing fully eases. And we could be in for another round of lockdowns before that happens.
We also can’t forget that ABBV, like all drug makers, has a complex risk profile. It faces potential new drug failures, lawsuits, drug pricing cuts, patent expirations, and regulatory risks.
This brings us to the risks of major healthcare reform which is a major component of Democrat candidate Joe Biden’s platform. At this point, the models I follow give a high chance that he’ll win but a low probability of either party gaining enough votes in the Senate to make for easy deal-making anytime soon.
That’s why Morningstar estimates the probability of major healthcare reform in the next decade at 5% or less.
One way or the other though, there’s still the issue of volatility risk to consider. ABBV may be incredibly undervalued right now, but that was also true back in March, when it started at a price-to-earnings of nine and fell to a P/E of six.
During market panics and especially global margin calls as we saw in March, valuations and fundamentals don’t matter at all. And while AbbVie’s 31% price drop was better than the S&P 500, the average dividend aristocrats, and even utilities… it still fell.
If a second wave happens and/or if a double-dip recession occurs, it could fall further.
So, as always, if you’re going to buy into this analysis, make sure to do so in a diversified and prudently risk-managed portfolio.
When exactly the market will stop hating AbbVie isn’t clear. But it’s very obvious that the big pharma company is making all the right moves to de-risk itself of its largest fundamental issue.
And that gives us a lot of confidence about the stock and its prospects.
ABBV’s growth in 2020, 2021 and 2022 is likely to be in the double digits, with its dividend growing about 22% over that time. And its leverage is expected to fall to levels that could earn it back its A- stable S&P credit rating.
Given the objectively strong fundamentals of this dividend aristocrat, we have no reservations about recommending AbbVie as a stellar high-yield investment idea for 2021 and beyond.
As the most undervalued dividend aristocrat right now in a market that’s becoming highly irrational, we consider AbbVie to be a prudent pick at a reasonable price.
That’s why both Dividend Sensei and I are happy to consider adding to our positions over the coming weeks. At the time of this writing, we have plans to buy it early next week, ahead of earnings.
That earnings report that could see management hike the dividend another 10%, for one thing. For another, AbbVie could deliver its usual expectation-beating greatness, once again proving that patient income investors’ facts and reasoning are right.
Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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Disclosure: I am/we are long ABBV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Dividend Kings owns ABBV in all its portfolios. Dividend Sensei has a position in ABBV.