Is Abbott Labs Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what Abbott Laboratories' (NYSE: ABT  ) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Abbott's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always be reported at a steady rate, we'll also look at how much Abbott's free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Abbott's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Abbott managing its resources well? A company's return on equity should be improving, and its debt to equity ratio declining, if it's to earn our approval.

Healthy dividends are always welcome, so we'll also make sure that Abbott's dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let's take a look at Abbott's key statistics:

ABT Total Return Price data by YCharts.

Passing Criteria

3-Year Change* 

Grade

Revenue Growth > 30%

33%

Pass

Improving Profit Margin

2.3%

Pass

Free Cash Flow Growth > Net Income Growth

36.2% vs. (8.6%)

Pass

Improving Earnings per Share

(9.7%)

Fail

Stock Growth (+ 15%) < EPS Growth

68.6% vs. (9.7%)

Fail

Source: YCharts. *Period begins at end of Q2 2009. 

ABT Return on Equity data by YCharts.

Passing Criteria

3-Year Change*

Grade

Improving Return on Equity

(31.9%)

Fail

Declining Debt to Equity

(6.8%)

Pass

Dividend Growth > 25%

27.5%

Pass

Free Cash Flow Payout Ratio < 50%

43%

Pass

Source: YCharts. * Period begins at end of Q2 2009. 

How we got here and where we're going
With six out of nine passing grades, Abbott has some of the features we like to see in a good long-term investment. Unfortunately, the pharmaceutical manufacturer is falling victim to many of the same patent-cliff issues that have beset its peers, although it seems to have fewer devastating expirations on the horizon than Merck (NYSE: MRK  ) and Eli Lilly (NYSE: LLY  ) , which both face the expiration of a significant number of revenue-generating drugs.

Merck and Lilly have responded to this threat by increasing their R&D spending. Abbott, on the other hand, has reduced its research spending. It seems more content to use an existing blockbuster like Humira to treat more ailments than the drug was originally designed for. That can help save research funds, but it's hardly an opportunity available to most drugs, in Abbott's portfolio or in a competitor's. Abbott's reliance on Humira seems more worrisome in light of its planned split into two companies, which would create a drugmaker that relies on one drug for nearly half its sales.

Humira is so important to Abbott's bottom line that the company's trying to block Obamacare's effort to approve biosimilars that would compete with its blockbuster. Humira has an advantage as long as it maintains its patent protection, since it continues to improve its sales despite challenges from Merck's Remicade and Pfizer (NYSE: PFE  ) and Amgen's (Nasdaq: AMGN  ) Enbrel. The competition continues to push forward with potential challengers to Humira's dominance, with Pfizer and Lilly developing oral alternatives, and other mega-cap pharmaceutical companies shepherding their rheumatoid arthritis drugs into phase 3 trials.

Abbott's pending split could create two faster-growing smaller companies, but without the same aggregate scale, it could also result in two companies less able to fend off the challenges of deep-pocketed industry leaders. Abbott's stock growth has already outpaced either its EPS gains or the improvement in its free cash flow. Other pharmaceutical companies are in similar positions, but that doesn't excuse Abbott shareholders from the need to closely watch its pipeline, and to otherwise keep a close eye on management's efforts to improve earnings.

Putting the pieces together
Abbott has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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Keep track of Abbott by adding it to your free stock Watchlist.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights.

The Motley Fool owns shares of Abbott Laboratories. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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