Profit From The Market's Misunderstanding Of This Spinoff Company
There's no such thing as afree lunch , but spinoff companies are as close to free as you can get.
When a company is spun off, there's a high level of forced selling. One of the best ways to think about spinoffs: "There's a natural constituency of sellers and not a natural constituency of buyers," according to "Margin of Safety " author andhedge fund manager Seth Klarman.
Simply, many shareholders who ownshares of theparent company are not interested in owning the spinoff. This can be for a variety of reasons, such as different business fundamentals, weak management, or negativecash flow . In most cases, investors are selling the company for no good reason. While on the other side, the buyers are limited, as themarket is inefficient in digesting data on new spinoff companies.
Spinoffs Versus The Market
Yet, over the longterm , spinoffinvesting tends to outperform the broader market.
This is not new information. A 1993 study titled "Restructuring Through Spinoffs" found that spinoff companies outperformed the S&P 500index by 30% on average during their first three years. A similar study by Lehman Brothers concluded that between 2000 and 2005, spinoff companies outperformed the market by a whopping 45% during their first two years. JPMorgan Chase ( JPM ) came to similar conclusions, finding that spinoffs outpaced the market by 20% during their firstyear and a half between 1985 and 1995.
So far this year, spinoff companies have maintained that standard. The Guggenheim Spin-Off ( CSD ) exchange-tradedfund is up 30% this year, compared with the S&P 500's 16.5%.
Earlier this year, Abbott Laboratories ( ABT ) completed a split after realizing the company had grown into two distinct units. AbbVie ( ABBV ) now trades as the former pharma business of Abbott Labs, while Abbott continues as a health care products and medical devices company.
The idea of breaking up the health care and pharma businesses was to make the companies easier to value. However, it appears the market has gotten this one wrong. Spinoffs are great ways to fix mistakes. As a result, spinoffs generally have weak management, lower margins, lower returns onequity , or negativeearnings . This is not the case with AbbVie. Thestock had a nice run out of the gate, but interest and tradingvolume have since cooled off.
But investors should give AbbVie another look. Sometimes the market fundamentally misunderstands spinoffs. In this case, the market is treating AbbVie like a typical problematic spinoff -- but in reality, AbbVie appears more fundamentally sound than Abbott itself.
Breaking Down The Numbers
AbbVie is trading with a price-to-earnings (P/E ) ratio of 13, which is well below Abbott's 60. AbbVie has an impressive 33%operating margin for the past 12 months, compared with Abbott's 20%. Abbvie is also churning out areturn on capital employed (ROCE, equal tooperating income divided bycapital employed) of 43.5%, compared with Abbott's 21.6%.
While the companies' business models are debatable, there's no denying the strength of AbbVie'scash position anddividend yield . AbbVie has $5.50 in cash per share, which covers 12% of the share price, and the company generated $4 per share in cash flow from operations over the trailing 12 months.
AbbVie has a solid 3.6% dividend yield, which is in line with (and in most cases above) other major pharma companies and dwarfs the 1.6%yield of Abbott, its former parent. Yet unlike some of its peers, AbbVie'sdividend payout (as a percentage of earnings) is below 50%. AbbVie's board has also authorized a $1.5 billion share buyback program, representing just over 2% ofshares outstanding .
What About The Business?
AbbVie's key drug is Humira, an anti-inflammatory product used primarily for rheumatoid arthritis. In 2012, Humira accounted for around half of AbbVie's $18.4 billion pro formarevenues . Last year, the drug accounted for about 50% of the market for rheumatoid arthritis drugs, which is expected grow to more than $25 billion in 2017, up nearly 40% from 2012.
One concern is the fact that Humirawill losepatent protection in 2016 in the United States and in 2018 in Europe. However, AbbVie's total research and development (R&D) pipeline has more than 20compounds in Phase II or Phase III development, including five key products planned for launch before 2016.
Humira is also approved for a number of other uses, which includes HIV, Crohn's disease, psoriatic arthritis and several other ailments. These uses and the drugs in AbbVie's pipeline should help AbbVieoffset any fall-off in Humira revenues.
AbbVie, which gets more than half itsrevenue from outside North America, has a number of growth opportunities in the U.S. and internationally.Emerging markets should see tailwinds from increased spending on health care, and in the U.S., theAffordable Care Act (akaObamacare ) is expected to provide coverage for more than 30 million uninsured Americans next year. All in all, the company has company- and industry-specific tailwinds for which the market appears to be mispricing ABBV.
Risks to consider: As with any pharma company, there are risks thatpatents will be challenged or the company will fail to produce new revenue-generating products. AbbVie faces patent expirations for its top drug Humira in the next several years, which could be a negative if its other products fail to come to market in a timely fashion.
Action to take --> Consider buying shares of AbbVie, which has a well-developed R&D pipeline and a cheap valuation. With just a modest 20 times P/Emultiple on AbbVie management's 2013EPS forecast of $3.10, the stock should trade north of $60. Its solid cash position and robust dividend also give the stock somedownside protection.