When Abbott Laboratories (NYSE:ABT) announced in December that the Food and Drug Administration had preliminarily signed off on restarting operations at the company's Lake County, Ill., diagnostics plant, investors breathed a collective sigh of relief. Abbott has begun to enjoy the fruits of being back in the agency's good graces, with the FDA's approval earlier this month of 11 diagnostic tests made at the plant.
Difficulties at the site had long been a thorn in Abbott's side. According to SEC filings, the problem reached a head in Nov. 1999 when the medical products company signed a consent decree with the U.S. government agreeing to bring the site up to FDA quality-control standards.
At the time, Abbott recorded a $168 million charge to cover the $100 million fine it paid to the government, as well as costs connected to contractual obligations, inventory exposures, and asset impairments. The saga dragged on, as the FDA inspected the plant twice more and both times found Abbott's quality controls lacking. As a result, in the second quarter of 2002, the medical products maker recorded another charge, this time of $129 million. With a concerted effort, Abbott fully rehabbed the plant and closed an unpleasant chapter in its relationship with the FDA.
It should be noted that Abbott is not alone in tangling with the agency over manufacturing. The regulatory body fined Schering-Plough (NYSE:SGP) $500 million in 2002 for faulty practices at its Puerto Rico facility. The conflict contributed to the holdup of U.S. approval for Asmanex, an asthma medication, and Schering is only now beginning to emerge from the dark cloud hanging over it after two years of investigations. In 2003, the FDA informed Eli Lilly (NYSE:LLY) that approval of its antidepressant drug Cymbalta was subject to amelioration of problems at an Indianapolis manufacturing site. Lilly managed to dodge a proverbial bullet by improving its compliance.
The message in Abbott's travails and these other episodes should be clear: Manufacturing matters. In analyzing pharmaceutical stocks, investors justifiably tend to concentrate on pipelines, drugs' market potential, and the results of late-stage (particularly phase III) clinical trials. However, it makes sense to keep an eye on the less glamorous manufacturing side of drug development. Clearly, falling out of favor with the FDA in this area can translate into sizable fines. More importantly, downtime can have a serious negative effect on revenue, since even small delays in drug approval can mean millions in lost sales, and, worse, a permanent loss of market leadership to a competitor.
Monitoring manufacturing
Abbott's problems with the FDA grew over time, and only insiders within the company in the beginning knew about looming problems with the agency. Without this inside knowledge, it otherwise would be impossible to know exactly when a major regulatory headache is on the horizon. Enter the FDA's own website, which maintains an online database of documents (called "Warning Letters"), a tool that takes some measure of pharma companies' manufacturing compliance.
The regulatory body issues these statements as a formal notification of manufacturing violations, as well as non-compliance in other areas such as lab practices, and labeling. As their name suggests, Warning Letters are a first step in the enforcement process. In most cases, offending firms quickly fix the problems and go on their merry way. But in rare instances, such as those cited above, the situation escalates and the offender is forced to sign a consent decree, pay fines, and clean up its act.
The database is relatively easy to use. Just type in a company's name, click enter, and any letters for the company on record are displayed. The search results page also provides the topic of each letter, so users can zero in on manufacturing-related documents. Without formal knowledge of the drug-making process, there is no way to determine the severity of issues raised in individual documents. However, by perusing the contents of each letter and monitoring how many letters a company has and how frequently violations occur, investors can get a sense of that company's standing with the FDA, and possibly receive an early warning of trouble ahead. A search for "Abbott," for example, shows the company has not received any Warning Letters since 2002, which is a good sign.
Abbott's spinoff
For Abbott, an improved relationship with the FDA comes at the right time. Sometime in the first half of this year, the drug firm plans to spin off its Hospital Products Division in a stock distribution to existing Abbott investors. The move will create a new company called Hospira.
The diagnostics segment responsible for Abbott's past regulatory woes will not become part of Hospira, but by cleaning up the mess at the facility, Abbott demonstrated to investors that it's on the right track with the agency. This, in turn, should give shareholders receiving Hospira stock some assurance that the hospital products company is also on solid ground with the regulatory body.
As an independent company, Hospira will become one of the largest players in the hospital products space, with about $2.5 billion in sales. Based on revenue, the new firm will be about one-third the size of its largest competitor, Baxter International (NYSE:BAX).
More importantly, Hospira's financial performance has faltered somewhat recently. After achieving 7% revenue growth from 2000 to 2001, sales increased just 3.5% from 2001 to 2002, and in the first nine months of 2003 the top line inched up 1.6% vs. the same period in 2002.
The picture for profitability is more encouraging. In the first nine months of 2003, operating earnings were up 19% vs. the first three quarters of 2002. Still, this growth comes on the heels of declines in operating earnings from 2000 to 2001 and from 2001 to 2002.
Given these mixed results, the decision to separate the two units makes good strategic sense. The move will improve Abbott's profitability and accelerate its growth. Its drug business is surging, driven by sales of its new rheumatoid arthritis drug Humira, which is expected to bring in $700 million in 2004.
In addition, with the Lake County, Ill., facility back online, Abbott can begin to turn around its ailing diagnostics segment. Over the long term, Hospira will probably also benefit, since it won't have to compete with Abbott's pharmaceutical business for resources and management attention. The hospital products division enjoys an established position in the marketplace, and with projected annual cash flow from operations of between $300 million and $500 million, it will have the means to improve its performance.
With clear sailing ahead on the regulatory front, as well as better strategic positioning, both firms appear to be good long-term investments. And by buying Abbott shares now, investors can take advantage of a time-honored sales pitch: a two-for-one deal.Want to uncover the investment stars of tomorrow? Take a free 30-day trial toMotley Fool Hidden Gems.
Fool contributor Brian Gorman is a freelance writer in Chicago, Ill. He does not own shares of any companies mentioned in this article. The Motley Fool is investors writing for investors.
