Abbott Labs 07Q2 Review: Confirms Premise Again Despite Confusion

Abbott Laboratories (ABT) reported earnings for their 2007 second quarter (ended June 30, 2007) and once again beat EPS estimates by a penny while beating revenue estimates by an modest amount.  This has become the "expected" quarterly result for Abbott in recent quarters. The company almost always beats revenue estimates slightly and either meets or beats earnings by a penny. This type of predictability is cherished on Wall Street, although it makes for very little reaction to quarterly reports. However, a fair amount of confusion resulted from the cancellation of the sale of diagnostics divisions to GE last week. Eight of the twelve analysts following ABT withdrew their estimates just prior to the quarter's results. Nevertheless, for our long term investment premise, this quarter is another confirmation.  We recommend continued holding of the ABT position we first advocated in April of 2003.

2007 Q2 Results

The following table summarizes the quarter's results for Abbott, with comparison to consensus estimates.

Source: Reuters

Note: In yesterday's preview of Abbott's earnings report, we inadvertently published the consensus estimate for Abbott that exclude revenue from the diagnostics divisions, which had been expected to be sold to General Electric. The revenue estimate above includes the estimates for those divisions. The sale of the diagnostics divisions was cancelled last week.

In a slightly confusing situation, 8 of the 12 analysts covering Abbott withdrew their estimates for revenue and earnings just two days prior to the report. The above estimates are from just four analysts covering Abbott, one of whom did not report a revenue estimate.

This unusual situation is likely due to the short time period between announcement of the cancelled deal (which amounted to nearly 10% of Abbott's total revenues) and the reporting of the Q2 results. Rather than rework their entire forecast, most of the analysts simply withdrew their estimates from the Reuters consensus estimates.

Nevertheless, the results can only be viewed as positive by major money managers.

In addition, the report confirmed both our long investment premise elements and validated our opinion that the cancelled sale of the lower-margin diagnostic divisions would not be a negative for Abbott.

Judging ABT's Earnings Report

One of the key elements of our long term investment premise for Abbott is the growth of branded drugs, not only in absolute amounts, but as a percentage of total revenue.

The implication of a rising mix of branded drugs in the revenue totals is an expansion of margins, particularly gross margins. This should occur simply because the monopoly position of branded proprietary drugs allows for much higher gross margins on a per-unit basis. As absolute sales rise, in conjunction with an increasing mix of branded drugs, overall gross margins should increase significantly.

The table below summarizes the expectations for these four significant trends at Abbott. However, our metrics were largely based on expectations of continuation of trends already in place. Those trends were significantly boosted last quarter, as Abbott reported total revenues that excluded revenues from the diagnostics division. This made all of the measured metrics for branded drugs and pharmaceuticals based upon a lower total revenue number. This quarter, those division's revenues were included in total revenue. (See below for more information.)

This quarter is best summarized as "flat" in terms of margin expansion trends. Since there is a great deal of seasonality in Abbott's model, we think it is best to view the four-quarter running averages as the primary metrics, not a purely sequential analysis.

However, the strong expansion of the operating margin metric is very positive. It demonstrates how powerful earnings can be driven when branded drugs become an increasingly important mix in Abbott's revenue.

Confusion Over Cancelled Diagnostic Sale

Aside from the 8 analysts withdrawing their estimates for Abbott at the last minute, the cancellation of the sale of Abbott's diagnostics division to GE provides further confusion for analysis of trends.

Last quarter, Abbott reported revenue from the diagnostics division as "discontinued operations," which means that their reported total revenue excluded the diagnostics divisions revenues. Those revenues and income were treated as "one-time" events and excluded from most analysis, including our own.

This quarter, since the deal has been canceled, Abbott reported the diagnostic revenues as par of total revenue.

While this is correct, it greatly distorts the trends of branded drugs and pharmaceutical revenue mix. Last quarter, those numbers were "artificially" high because of the lower total revenue numbers.

Taking this into consideration, it makes the lower than expected revenue mix numbers from branded drugs and pharmaceuticals less disappointing.

We have not yet taken to time to reexamine those trends by adjusting the first quarter results to add the diagnostic division revenues back in. We will make those calculations and publish our results. It could be that it turns this apparently flat quarter into a stronger continuation of the trends on which our premise is based.

Overall Judgment

This quarter is best summarized as "flat" in terms of margin expansion trends and branded drug revenue mix metrics. Offsetting this is the consideration that last quarter's results were distorted due to the exclusion of the diagnostic division sale.

While gross margin and the branded mix numbers both declined sequentially and fell short of our expectations, the declines were not severe enough to cause the four-quarter running averages to decline. Instead, those averages were mostly flat. It is likely that those running averages will increase, once the adjustment for the now-included diagnostic division revenue is added back to Q1.

For this reason, we tend to view these results as "neutral" for the most part, but leaning towards positive.  The extremely positive results at the operating margin level, however, make the quarter a positive confirmation of our long term investment premise.

Branded Drug Sales

While the mix of branded drugs as a percentage of total revenue declined, the absolute numbers increased sequentially. In addition, the absolute numbers for pharmaceutical sales also increased sequentially.

While Q2 is traditionally stronger than Q1 at Abbott, we view the sequential increase in the revenue numbers as very positive for our premise.

HUMIRA sales showed incredibly strong growth, with Q2 sales of $735 million, versus last quarter's sales of $571 million. Depakote also showed a strong increase in sales, with $404 million in Q2 versus $326 in Q1. Only Biaxin showed a sharp decline, with sales of $170 million in Q2 versus $300 million in Q1.

New Drug Pipeline

Although Abbott has a significant pipeline of drugs in development, there were no announcements about progress of any of the pipeline drugs.

Lowered Guidance

Some attention is being paid to the fact that Abbott lowered guidance for the upcoming third quarter results.

However, since only three analysts updated their forecasts for Q3 to include revenues from the diagnostic divisions, it is fair to say that the range of estimates in place for Q3 currently are "incomplete." 

If the other eight analysts following Abbott had updated their forecasts to reflect the cancelled sale, it is likely that the guidance given by Abbott would have been "in-line" with estimates.

We therefore are placing little significance on a comparison of Abbott's guidance to analyst estimates.

Conclusion

The basic elements of our long term investment premise can be summarized as follows:

• Continual, if not sequential, total revenue growth
• Increased revenue contribution from pharmaceutical products
• Increased percentage of branded drugs in total revenue and pharmaceutical revenue
• Increased margins as a result of a higher mix of branded drugs in total margin
• Possible new revenue streams if and when any of Abbott's drugs in development become an approved proprietary product.

The most important element in this premise is the increased contribution to revenue from the sale of high margin branded drugs. For the most part, this trend is continuing.

The mix metrics look lowered, but the distortion from Q1 is likely the reason. The fact that the actual metrics did not lower the four-quarter running averages for our trends, even when the distorted Q1 numbers are included, is very positive.

Analyzing trends at Abbott has required a significant amount of careful adjustment, to remove acquisition and other charges. The necessary adjustments for the cancelled diagnostic sale make the analysis even more complicated. It appears that this complication was more than most analysts were willing make in just a couple of days prior to Abbott's report.

We will post our analysis of our trends, adjusted to have Q1 include the diagnostic division revenue, after those calculations are made. Since the unadjusted results provide a confirmation of our premise, we expect the adjusted analysis to be an even stronger confirmation.

Continued holding of ABT is, therefore, the appropriate conclusion from this quarter's report .

Comments may be emailed to the author, Robert V. Green, at rvgreen@briefing.com

Note: In accordance with Briefing.com's Trading Policy, the author has a personal position in Abbott Laboratories.

Abbott Laboratories (ABT): July 18, 2007, mid-day: $54.12 +0.73 (+1.4%)