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Abbott Breakup Will Create Two Moaty Companies

We believe both businesses have strong and sustainable competitive advantages.

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 Abbott Laboratories' (ABT) decision to break into two companies is likely to yield a health-care conglomerate with two broad components: (1) a mix of businesses with narrow and wide economic moats and (2) a wide-moat pharmaceutical company. Based on our sum-of-the-parts comparable valuation, our discounted cash flow-driven fair value estimate looks reasonable, even potentially low. We will wait to review the pro forma financial statements--likely to be released in two to three months--before we assign each piece its own moat rating. In doing so, we will focus particularly on each business' returns on capital. However, based on our initial review of Abbott's product lines and its relevant competitors, we believe both businesses have strong and sustainable competitive advantages.

While we have yet to arrive at fair value estimates for both units, we believe our fair value estimate for the whole company is supported by our assessment of sales multiples placed on some of its pure-play competitors.

Medical Product Company Has Narrow and Wide Components, Some Synergies
Abbott's medical product company combines several divisions with strong competitive advantages. However, we classify most of the advantages as narrow, without a lot of structural advantages and synergies across the groups. We believe the new company's moat would directionally point toward narrow, but very close to wide. We see the main cross-divisional synergies within the established pharmaceutical and the nutritional groups, as they share distribution and branding in many markets.

Based on our internal sales multiple averages, our sum-of-the-parts analysis yields a valuation of $45 billion-$56 billion for the company.

Medical devices (narrow/wide moat). Within the device segment, Abbott operates in one of the most interchangeable markets of drug-eluting stents. This is in contrast with the cardiac rhythm management and orthopedic device industries, which offer greater product differentiation and higher switching costs for doctors. Even in this more fluid market, Abbott's Xience drug-eluting stent should maintain a market-leading presence in the near term, given its strong efficacy term. The next-generation drug-eluting bioresorbable vascular scaffold should be a major advancement, enabling the firm to hold on to its market share over the longer term. Also, the drug-eluting stent industry still carries strong initial pricing power, albeit with likely pricing declines after new product launches.

Diagnostics (narrow). A combination of switching costs and patent protection helps this group earn a narrow moat rating. Customer switching costs inhibit market share volatility because these products carry substantial up-front investment requirements and require a complex regimen of initial training to operate. These barriers account for part of the basis for the company's narrow moat. Additionally, several of Abbott's newest diagnostics have patent protection, which helps deter competition to some extent. Lastly, to a smaller degree, Abbott's products carry brand-name weight in the diagnostics market, which contributes slightly to the division's moat. However, the relatively small degree of differentiation among most of the core products prevents a wide moat rating.

Nutritionals (narrow/wide). Abbott's nutritional business exhibits a narrow to wide moat, based on strong brand recognition as well as inherent barriers to entry in the infant formula sector. Competitive threats from private-label entrants in the United States are low because the government's Women, Infants, and Children Program cuts out the need for a low-cost provider. Also, Abbott has strong, established relationships with pediatricians and hospitals. This further insulates the company's market share from competitive encroachment, because new mothers tend to follow the recommendations of their health-care providers. In addition, parents exhibit strong brand loyalty when they perceive product differentiation for their newborn children.

Established generic pharmaceuticals (narrow). Low-cost operations and branding are the keys to the narrow moat in this division. With a large portion of its operations in India, the division enjoys low-cost labor and a low tax base. Additionally, the Piramal acquisition brought in not only established distribution channels in India, but also strong brand names that signify quality. With the majority of purchases being out of pocket, the strong brand names become even more important, as individuals lack the resources to analyze the complete product offering.

Pharma Company's Strength in Biologics Supports Wide Moat Rating
While the new Abbott pharmaceutical company is highly dependent on Humira (which accounts for more than 40% of 2011 estimated sales), we lean toward a wide moat rating for this new company. We think Humira's best-in-class profile (efficacy and safety) combined with its complex structure (monoclonal antibody) should mean steady growth and only minimal generic competition when the patents expire in 2017 in the U.S. and 2018 in the European Union. The strength in this key product should create significant cash flows to fund Abbott's developing pipeline, as well as allow for external licensings and acquisitions, enabling a prolonged period of excess returns. Also, outside of Humira, Abbott holds a product portfolio of very high-margin products, which provide not only strong returns but additional cash flows to fund the next generation of branded drugs. Our valuation range for this new company is $57 billion-$65 billion.

Damien Conover does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.