This is from the AMM Dividend Letter released February 28, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
You’ve probably never heard the story of Grace Groner but it’s an important one.
Grace lived in Michigan, worked as a secretary, wore secondhand clothes, never owned a car, and lived in a modest one bedroom house. Upon her death, this woman of modest means left Lake Forest College an estate of over $7 million to establish internships and study abroad programs. The donation is expected to generate over $300,000 a year for the college.
How was a woman of such modest means able to give away over $7 million upon her death?
After graduating from Lake Forest College in 1931, Grace started working for Abbott Labs (ABT) as a secretary. She worked at Abbott Labs for 43 years. The key to her wealth was a simple decision she made early in her career. At age 26 she took her savings, about $180, and bought 3 shares of Abbott Labs at $60 per share and then never sold.
Along its way to becoming a global pharmaceutical/medical device behemoth Abbott split its shares a dozen times, paid dividends, and grew its dividend year-in and year-out. Living below her means Grace didn’t have a need for the dividends, instead she reinvested them. Her initial $180 investment compounded into $7 million, 39,000 times her original investment, a compound annual growth rate slightly over 15%.
Yes, Grace was very fortunate in making an early investment in one of the great health-care and dividend growth companies of the 20th century. While Grace’s wealth may be considered a happy accident her investment strategy, dividend growth and reinvestment, is a proven way to build wealth over a long period of time.
According to Longrundata.com, a nifty website with a dividend reinvestment calculator, if you had bought $1,000 worth of Abbott Labs 20 years ago (January 1, 1994), well after Grace Groner’s initial purchase, you would now have $10,667 as of February 27, 2014. That’s over 10x you’re original investment and an annualized return of 12.46%. Because of Abbott Labs commitment to growing its dividend, the yield on your original purchase would now be around 24%.
Spending less than you earn, investing in dividend growth companies, and reinvesting those dividends is a tried and true path to building wealth over the long-term. Just like Grace Groner.
Sincerely,
Your Portfolio Management Team
Dividend Stock in Focus
AbbVie (ABBV): $50.91*
*price as of the close February 28, 2014
In late 2012 Abbott Labs, in an effort for investors to better evaluate its two distinct business lines, spun-off its biopharmaceutical division, Abbvie, to existing shareholders in a tax-free corporate restructuring. Abbvie is an example of a “Restructuring/Special Situation” (as described in the last letter) that we feel has an opportunity to eventually become a dividend stalwart.
Following the spinoff, shares of ABBV declined in to the low $30 range on fears of Abbvie’s largest drug Humira losing its patent in 2017. Our opinion at this time was that these fears were overblown and that the market was mis-pricing the risk of the patent loss. The essence of this mis-pricing is related to the difference between a chemically synthesized drug (which is easier for generic manufacturers to develop and bring to market) vs. a biologic like Humira which is more complicated and costly to develop in generic form. More on this below.
Our initial time frame for an investment in a spin-off is at least one year. This allows us time to evaluate the new stand alone business as it pertains to management, strategy execution, and dividend policy. Additionally, research has shown that corporate spin-offs in general continue to outperform the broader stock market for 2-3 years following the spin-off. During our initial holding period if our outlook for the new stand alone company improves and our valuation estimate continues to increase we may continue to buy shares in the new company.
The strong growth and cash flow from Humira, the continued development of their drug pipeline, and management’s commitment to returning capital to shareholders through dividends has increased our estimate of fair value for the company and changed our holding period from one year to multiple years.
Catalysts for Dividend Growth and Price Appreciation:
Biologic vs. Chemical Compound:
Abbvie’s near term fortunes are heavily dependent on the blockbuster drug Humira. Over 50% of Abbvie’s sales and over 70% of their profits come from Humira. The main concern surrounding Abbvie is the loss of Humira’s patent in 2017 in the U.S. followed by the loss of its European patent in 2018. Once “off patent” there is a risk that generic drug makers will start selling their own form of Humira for much less than Abbvie, stealing market share and hurting Abbvie’s profitability. As discussed above, however, the fact that Humira is a biologic rather than a chemically synthesized drug provides a layer of protection or “moat” to help protect it from would be generic competition.
Chemically synthesized drugs are produced through a combination of chemical processes that can be repeated in a predictable and highly dependable way. Well known examples of these kinds of drugs include Tylenol, Lipitor and Viagra.
When a chemically synthesized drug goes off patent it is easier for a generic drug maker to get FDA approval for its version. The generic drug maker does not have to put its generic drug through clinical trials, it only has to prove that their drug is equivalent to the name brand drug and therefore will produce the same data as when the name brand drug went through its trials.
Unlike these drugs, biologics are proteins currently too large and complex to be created chemically. Instead, scientists enroll the help of microorganisms (plant or animal cells) by splicing the necessary DNA sequence coding the protein/biologic into the microorganisms’ DNA. Then the microorganisms produce the targeted biologic.
In contrast to chemically synthesized drugs it is difficult, and sometimes impossible, to characterize a complex biologic by testing methods available in the laboratory. Some of the components of a finished biologic may even be unknown.
In short, for biologics the product is the process. Manufacturers must ensure product consistency, quality, and purity by ensuring that the manufacturing process remains substantially the same over time. In contrast, a chemical drug manufacturer can change the manufacturing process extensively and analyze the finished product to establish that it is the same as before the manufacturing change.
The trouble with creating generic or “follow-on” biologics is that any deviation from the process in producing the original pioneering biologic, whether it be different cell lines, purification techniques, etc., can cause vast differences between the original biologic and the follow-on biologic. This can have dangerous consequences.
For example, Epogen and Eprex are both proteins of identical structure, Epotein, focused on treating anemia due to Kidney failure. However, they are each produced by two slightly different methods. The slight difference in productions leads to a dangerous reaction in patients taking Eprex. Patients taking Eprex began producing antibodies at a much higher rate than patients taking Epogen. Eprex patients experienced an allergic reaction to Epotein so severe that they also became allergic to the Epotein produced naturally by their own body. Instead of improving medically, Eprex patients became more ill.
As discussed above in the case of Epogen and Eprex, the potential differences between the original biologic and the follow-on biologic means the follow-on must undergo testing for efficacy and safety too. Per new regulations, the potential follow-on biologic must have animal toxicity tests performed and possibly animal immunogenicity tests if there are elevated concerns about impurities and excipients.
It is more than likely that follow-on biologics will be required to undergo clinical studies. The scope of these clinical trials will depend upon the uncertainty surrounding the biosimilarity after structural and functional characterization and animal studies.
More tests mean more time and more costs to develop a generic biologic. Humira is way too profitable a drug to not have potential competition but the complexity of production and the costs associated with bringing a generic competitor to market make it that much harder for generic drug makers to immediately cut into Abbvie’s Humira profits.
Pipeline:
Hepatitis C: Abbvie has an extremely effective HCV combo being developed to treat Hepatitis C. The SVR12 rates (the undetectable amounts of virus RNA at 12 weeks after stopping treatment) in the early phase III trials are around 96%. While they will face strong competition from both Merck and Gilead, Abbvie is still looking to grab $2-3 billion in peak sales in the very attractive HCV market.
Leukemia: Abbvie is in partnership with Roche to develop ABT-199, a treatment for Chronic Lymphocytic Leukemia (CLL), one of the most common forms of Leukemia. It targets the Bcl-2 protein that prevents the CLL cell from dying. ABT-199 switches off the Bcl-2 protein allowing CLL cells to die naturally and making them more susceptible to chemotherapy.
In a recent Australian clinical trial people with an extremely poor prognosis achieved an 84% response rate and the bone marrow cancer was cleared in 23% of the people. From Anthony Steele the Head of Support Services for the Leukemia Foundation of Australia.
This drug means people with an incurable cancer, who undergo many periods of intensive treatment, periods of remission and with an expectation that the disease will relapse, now have hope that a treatment will be made available to end this life-long cycle.
Endometriosis: Elagolix is focused on the treatment of endometriosis and is currently in phase III trials. Compared to the standard care for endometriosis, Elagolix is as effective with less side effects, goes into effect quicker, and easily reversed. Ovulation returns after the first month of cessation, a key aspect for women who want to get pregnant. It is also a once day oral tablet versus an injection for the current methods. Elagolix is also in phase II trials for uterine fibroids, an indication that could be larger than endometriosis. JP Morgan Equity Research potentially sees a $1 billion combined market for Elagolix.
Conclusion:
Abbvie is a company whose story is still lead by Humira but the narrative is turning into one about its pipeline. However, when calculating fair value we can’t base it on potential. We have to calculate fair value on what we can currently account for. Our estimate of fair value has risen over the year and currently sits at $58 per share.
Chart courtesy of Stockcharts.com
