Does This Diversified Health Care Giant Have Long-Term Growth Potential?

The future of diversified health care giant Abbott Laboratories (NYSE: ABT  ) has been a murky one, ever since it spun off its branded pharmaceuticals business, AbbVie (NYSE: ABBV  ) , a year ago.

By detaching itself from AbbVie, the manufacturer of top-selling rheumatoid arthritis treatment Humira, Abbott sacrificed growth for stability. Abbott shielded itself from upcoming issues such as Humira's patent expiration in 2016 while concentrating on slower-growth businesses such as medical devices and nutrition products.

Yet since the spin-off, however, Abbott Laboratories has woefully underperformed AbbVie, the overall market, as well as industry peers Johnson & Johnson (NYSE: JNJ  ) , Boston Scientific (NYSE: BSX  ) , and Medtronic (NYSE: MDT  ) .

ABT Chart

Source: YCharts.

Therefore, investors are rightfully wondering if Abbott made the right choice in spinning off AbbVie. Let's analyze some recent developments, and I'll explain why I believe Abbott is on the right track and will reward patient investors.

A mixed third quarter
Shares of Abbott climbed 6.5% on Wednesday after the company reported its third-quarter earnings, which missed on the top line but beat on the bottom line. The company's profit declined 50.3% year-over-year to $0.61 per share, due to the prior-year quarter's earnings being distorted by the AbbVie spin off.

Excluding one-time items, Abbott earned $0.55 per share, topping the Bloomberg consensus estimate by $0.04. Revenue rose 2% year-over-year to $5.37 billion, falling short of the $5.77 billion that analysts had expected.

Digging deeper into Abbott's four core businesses
To better understand where Abbott's sales came up short, we should take a closer look at its four main business segments -- established pharmaceuticals division (EPD), medical devices, diagnostics, and nutrition.

 

Q3 Revenue

Growth (YOY)

Percentage of Total Revenue

EPD

(branded generics)

$1.2 billion

2.9%

22%

Medical Devices

$1.3 billion

1.9%

24%

Diagnostics

$1.6 billion

8%

30%

Nutrition

$1.1 billion

1.9%

20%

Sources: Abbott 3Q earnings report, author's calculations.

Abbott reported that EPD sales were weaker than expected due to a slowdown in emerging markets, where sales fell 3.4%. The EPD generated half of its sales from emerging markets in 2012. Sales of branded generics in developed markets such as Europe and Japan declined. However, Abbott's sales growth in generics compares favorably to other generic manufacturers. Last quarter, sales at generic drug giant Teva Pharmaceutical fell 1.4%, while sales at its rival Mylan rose 0.8%.

Abbott's medical devices segment growth was primarily fueled by a 7.3% increase in sales of its medical optics products. Abbott's vascular business rose 0.6% thanks to stable sales of its stent systems, while sales of diabetes care products inched up 0.4%, supported by ongoing demand in emerging markets. Meanwhile, Abbott's diagnostics segment was the company's fastest growing business, fueled by strong demand for laboratory and point of care products

Abbott's positive growth in medical devices and diagnostic products compares favorably to industry peers J&J and Boston Scientific. J&J reported a 2% sales decline in its medical devices and diagnostics segment in the third quarter. Boston Scientific, which reports earnings next week, reported a 1% decline in sales last quarter. Medtronic's revenue rose at the same rate as Abbott's devices segment, at 1.9%, last quarter.

Abbott's nutrition business grew less than expected, due to a recall of infant formula in China in August. The recall weighed on sales of pediatric nutrition products, which account for 55% of the segment's sales. Abbott also expects lower demand for its pediatric nutrition products in international markets over the next three quarters. However, demand for its adult nutrition products, which include its Ensure nutritional shakes and drinks, remained strong.

Therefore, the main reason that Abbott's third-quarter sales fell short of expectations was its recall in pediatric nutrition. Otherwise, Abbott's EPD and medical device businesses bounced back nicely from the second quarter, when they reported sales declines of 2.3% and 1.6%, respectively.

A big dividend boost and margin improvements
Abbott also increased its dividend by 57% to $0.22, raising its forward annual dividend yield to 2.7%. Although that yield still doesn't measure up to J&J's 2.9% and AbbVie's 3.5% forward annual dividend yields, it is a big step above Medtronic, which offers 2%. Boston Scientific doesn't currently pay a dividend.

Abbott's margins also improved during the third quarter -- an encouraging sign for future bottom line growth.

 

Q3 2012

Q3 2013

Adjusted gross margin

55.2%

55.9%

Adjusted operating margin

17.1%

19.3%

Source: Abbott 3Q report.

The road ahead isn't murky anymore
Looking forward, Abbott will likely encounter the same problems that its industry peers are facing -- austerity measures in Europe, budget concerns in the United States, and possible declines in elective surgeries. However, Abbott is well diversified across 14 emerging markets, which it considers the key to unlocking long-term growth beyond developed markets.

In closing, the positive sales growth across all four of Abbott's businesses is tough to ignore, especially when their growth rates compare so favorably to industry rivals. In addition, Abbott's big dividend boost now puts it on the same page as J&J as a conservative income play in the health care sector. Yet Abbott's 5-year PEG ratio of 1.4 is far lower than J&J's ratio of 2.7 -- indicating that Abbott could still have plenty of room to run.

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