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Even with sluggish patient volume, reimbursement pushbacks, and the medical device tax, it hasn't been a bad year for the med-tech sector, and there aren't all that many bargains left. Abbott Labs (NYSE: ABT) is certainly not a med-tech pure play (more than 50% of revenue comes from non-device businesses), but it gets grouped into the sector all the same, and this does appear to be one of the few remaining bargains. While Abbott still has work to do on its margins, and more growth in the device business would be very welcome, these shares look like a relative bargain in an increasingly expensive market.
Third-quarter results show margin progress
In a quarter that has seen med-tech companies come in solid on revenue and a little light on margins (though it's still very early in the cycle), Abbott flipped the script. The company's 4% constant currency growth (all growth numbers will be constant currency unless specified otherwise) wasn't so bad, and the miss wasn't by much. Still, it underlies one of the fundamental challenges for this story.
Abbott's diagnostics business continues to be a growth leader, rising more than 10% this quarter on broad strength across core lab (up 9%), molecular diagnostics (up 16%), and point of care (up 17%). This was quite a bit better than what Johnson & Johnson (NYSE: JNJ) reported, though the real test will be in how these results stack up against Roche, Siemens, and Danaher.
Devices were also a little stronger than expected, with growth of about 4%. Vascular sales grew more than 2%, diabetes was up 1% (not bad relative to the double-digit decline at Johnson & Johnson), and optics was up a strong 12% (also quite good relative to J&J).
The other businesses came in soft. The pharmaceutical business saw some revenue growth (sub-1%), but key emerging market growth has slowed to just 2%. Nutrition, Abbott's biggest segment, came in about 4% light on revenue (with growth of more than 3%), as a recall in China affected sales.
While revenue was slightly disappointing, progress on margins was definitely encouraging. Gross margin improved about 60 basis points and slightly surpassed expectations. Operating income rose about 15% on an adjusted basis, with margin expanding almost 2.5 points. As Abbott's margins (particularly in devices and diagnostics) have been suboptimal relative to its peer group, this is solid progress that should encourage shareholders.
Managing/improving growth still on the to-do list
There aren't all that many mid-sized/large device companies with great growth right now, so Abbott is in relatively good company. There is also reason for optimism, as products like MitraClip, Absorb, and Xience Xpedition should help the growth rate. Even so, I think the coronary stent market is destined to be a tough one from here on -- Abbott, Medtronic (NYSE: MDT), and Boston Scientific are likely to leapfrog each other from launch to launch, with not all that much growth on a sustained long-term basis.
On the other hand, I do think the company has an opportunity to focus more attention on its peripheral vascular business. This market is getting crowded (Johnson & Johnson and Medtronic have prioritized growth here as well) and Abbott lacks the product breadth of Covidien, but peripheral artery disease is significantly undertreated relative to coronary artery disease, reimbursement is pretty solid, and acquisitions like IDev (and its SUPERA Veritas stent platform) should support growth.
The nutrition business will also be interesting to watch. It is an intensely competitive business (with companies like Mead Johnson, Nestle, and Danone offering serious competition) and the Chinese government has been pushing back on the price of formula. Even so, I think Abbott may have an advantage on Mead Johnson, Nestle, and Danone by virtue of its stronger adult nutrition franchise (Ensure) -- a business that Abbott has been marketing in China for only a short time now. It's also not just about China; rising incomes in markets like India, Indonesia, Vietnam, and Brazil are making these countries more attractive as well.
The bottom line
I don't expect Abbott to improve its margins to a point where it is a market leader, and I do have some concerns about the long-term profitability of nutrition, but I nevertheless believe that there is ample room here for Abbott to generate more cash flow per dollar of revenue. With that, my mid-single-digit revenue growth assumption fuels a double-digit free cash flow growth estimate and a fair value of almost $40.
I look for Abbott to continue taking cash flow from nutrition and pharmaceuticals and reinvesting it into acquisitions and R&D in diagnostics and devices. I also believe management has made solid progress on the much-needed margin improvements. With that, Abbott may not offer the most exciting top-line potential, but I believe the value in the shares merits further due diligence for investors looking for a lower-risk health care and nutrition play.
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