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AbbVie (ABBV)

AbbVie was spun off from Abbott Laboratories (ABT) in 2013 as a standalone biopharmaceutical company focused on four primary therapeutic areas: immunology, oncology, virology and neuroscience.

The company's drugs treat conditions such as chronic autoimmune diseases in rheumatology, gastroenterology, and dermatology; oncology, including blood cancers; virology, including hepatitis C (HCV) and human immunodeficiency virus (HIV); neurological disorders, such as Parkinson’s disease and multiple sclerosis; metabolic diseases, including thyroid disease and complications associated with cystic fibrosis; as well as other serious health conditions.

The company's blockbuster arthritis drug Humira accounts for approximately 66% of sales and an even greater share of AbbVie's profits. Its next largest drugs are Imbruvica (9.1% of sales), which treats leukemia, and Viekira (3.7%), which treats hepatitis C. The company generates more than $25 billion in annual revenue and sells its drugs in over 170 countries (35% of sales are in international markets).

Business Analysis

The branded pharmaceuticals industry has extremely high barriers to entry and offers potential for excellent profitability – AbbVie generates an operating margin north of 35% today and targets a 50% margin by 2020. Major pharma players invest billions of dollars and years of time in research and development to commercialize breakthrough drugs.

While the success rate is low, a successful drug can generate billions of dollars in monopolistic profits that are protected for many years thanks to the intellectual property owned by the manufacturer. Medications are also recession-resistant products because consumers still need to treat their illnesses regardless of how the economy is doing.

However, many pharma companies still have less predictable business models. Their protected drugs will eventually lose market exclusivity and see their sales quickly erode as competitors launch rival products. As a result, these businesses must develop new drugs to replace those sales, or else they can see profits erode.

Despite the industry's challenges, Abbvie has done an admirable job maintaining a steady pace of double-digit growth in its top and bottom lines in recent years. The company's historical success is largely thanks to Humira, which generates over two-thirds of AbbVie's profits and has been the world's best-selling drug for years.
Source: Pharma Compass
The key to Humira's success has been AbbVie's ability to continually obtain new FDA approval for expanding the conditions it treats. For example, today Humira is a top choice for not only treating Rheumatoid Arthritis, but also Psoriasis and Crohn's Disease. Combined with steady gains in international markets, Humira sales have recorded strong  growth and are expected to top $18 billion in 2017.
Source: Statista
And since Humira continues to enjoy patent protection (pending court outcomes), its sales translate to very high margins, helping to lift AbbVie to some of the best overall profitability in the industry.

Of course, a mega blockbuster drug like Humira is also a double-edged sword because it can attract numerous competitors in the form of rival drug makers launching similar products targeting the same conditions.

It also creates high dependency on just a single sales and profit source, which can create more volatile results in the future, hardly something that conservative dividend investors want to see.

For now, AbbVie expects to fend off meaningful Humira competition in the U.S. until 2022, thanks largely to its arsenal of more than 70 patents that protect everything from the drug's manufacturing process to how it gets delivered to patients. 

However, the clock is ticking, which is why AbbVie is investing so heavily in R&D (close to 20% of revenue) to expand its drug offerings via one of the industry's largest and most promising development pipelines. Better yet, AbbVie has a very good track record of high returns on capital with its R&D spending, boasting some of the highest drug trial success rates in the industry.
The company's R&D success rate, combined with its strong development pipeline (eight major drugs in late stage development) and continued high expectations for Humira, are why AbbVie expects to reach at least $37 billion in sales by 2020, which would represent more than a 40% increase from 2016’s revenue level. 

Besides continued (but slower) growth from Humira, AbbVie is banking on at least 20 new medication launches by 2020 from its de-risked late-stage drug pipeline to hit its growth goals. The company's current pipeline has potential to achieve anywhere from $35 billion to $47 billion in revenue by 2025, which would more than triple AbbVie's current non-Humira revenue. 
Source: AbbVie Investor Presentation

This strong, non-Humira growth is led by Imbruvica (at least $5 billion in potential peak annual sales) and Venclexta, AbbVie's potential blockbuster blood cancer medications, which are likely to see a large treatable market since the total U.S. cancer population is expected to grow to 21 million people by 2030.

In total, AbbVie is planning to expand its offerings into four major areas, immunology, oncology, virology, and neuroscience, which have an estimated annual global market size of about $200 billion.
Combined with continued (but slower) growth in Humira, AbbVie's sales could soar 60% to 80% in the next few years. As revenue growth continues, operating margins are expected to expand by 100-200 basis points per year to drive double-digit earnings growth.
With that said, roughly half of overall sales in 2020 would still come from the company’s arthritis drug Humira, with another 13.5% from leukemia drug Imbruvica and about 8% from AbbVie's hepatitis C product. In other words, AbbVie's business would still be very concentrated despite its larger size. 

Therefore, company’s long-term success will continue to hinge on the success of its drug pipeline and its ability to protect cash flows from Humira for as long as possible from biosimilar competitors. 

Key Risks

While AbbVie's growth engine appears to be firing on all cylinders, investors need to keep in mind three major risks.

First, despite its strong development pipeline, AbbVie will remain largely dependent on Humira for the foreseeable future. For example, even if its 20+ new product launches go off without a hitch, Humira will still represent about 50% of sales in 2020.
In addition, the ongoing growth of Humira is predicated on the company successfully defending its patents in court, which might effectively push off patent expiration until 2022 (AbbVie’s composition of matter patents for Humira expired in the U.S. in December 2016 and will expire in Europe in October 2018).

The company hopes that it can litigate against biosimilar manufacturers of Humira for at least several years based on industry norms and its non-composition of matter patents. These patents covers area such as manufacturing and formulation and do not begin to expire until 2022.

AbbVie was successful in defending against a patent review case filed by Amgen, delaying Amgen's launch of a cheaper biosimilar product until 2023. The company believes it can maintain strong profitability in the U.S. through 2022, but there is plenty of skepticism surrounding the matter.

Future success is not guaranteed, and even if AbbVie proves victorious with its litigation, biosimilar competition from rivals is coming fast and furious in the coming years (35 rival products in development), fueled by Humira's rock star success.
Source: Financial Times
Another thing to consider about Humira is that, while its market share is under 25% in most areas (suggesting further growth opportunities) recent developments in immunology, including new drugs targeting pathways, mean that potentially superior products could be on the way.

These risks are why some analysts expect Humira sales to fall far short of management's expectations. For example, Morningstar's Damien Conover estimates that 2020 Humira sales could be around $11 billion, $7 billion less than management's current guidance.

Next, it's worth mentioning that the pharma industry is a very tough market to consistently do well in, owing to patent cliffs all companies face (as well as rival product launches battling for market share).

When combined with the steep costs to internally develop new medicines, many companies opt to grow through acquisitions. However, this strategy creates two major risks. 

The first is potentially overpaying for new acquisitions, and the second is that the products in those acquired pipelines may still fail to survive the FDA's 3 stage gauntlet of human trials, which are not only monstrously expensive to complete (the cost to bring a new drug to market is approaching $3 billion, according to the Tufts Center for the Study of Drug Development) but can also take as long as 10 to 12 years.

In fairness to the company, AbbVie has thus far done well with its major purchases, including its $21 billion acquisition of Pharmacyclics in 2015, which brought with it Imbruvica.

However, the majority of large mergers ultimately end up destroying shareholder value, and while the Pharmacyclics purchase worked out well, not all acquisitions are so successful.

For example, in 2014 Abbvie attempted to buy Irish drug maker Shire (SHPG) for $55 billion in a tax inversion deal that failed due to pressure from the U.S. Treasury. That failure resulted in Abbvie shareholders paying Shire a $1.6 billion breakup fee.

Finally, regulatory changes are an ongoing risk this industry, especially as government healthcare policy is constantly in flux. 

The high margins of the drug industry mean that it's easy for politicians to make hay by calling for increased regulations to drive down the price of drugs. Of course, most of the time this is just political grandstanding; however, should Medicare and Medicaid be allowed to negotiate for bulk drug purchases (which they currently can't by law), then all drug makers could see margin compression.

The Food and Drug Administration (FDA) can also pose unexpected challenges. For example, during one week in October 2015, AbbVie’s stock fell by more than 10% after the FDA warned that AbbVie’s Viekira treatment caused liver injury to a small number of patients.

Closing Thoughts on AbbVie

The pharmaceutical industry is arguably one of the most challenging areas to invest in due to its many complexities and risks, including constantly evolving drug pipelines, patent cliffs, litigation, fierce generics competition, and regulatory uncertainties that could make future growth harder to come by.

AbbVie's management has admittedly done a superb job navigating the challenging pharma waters thus far, rewarding dividend growth investors with a powerful combination of strong payout increases and excellent total returns in recent years. However, it’s still hard to get comfortable with AbbVie’s competitive landscape over the next five years.

The key issue is how long the company’s Humira drug can profit in the U.S. before meaningful biosimilar competition emerges. The difference of just a few years could really make or break the stock’s performance over the coming years. As an outsider looking in, analyzing this risk and evaluating AbbVie's large pipeline of new drugs that will launch over the next five years is very difficult.

AbbVie's growth story could continue playing out as well as management expects, but our preference is to invest in the few companies that share AbbVie's excellent financial strength but also enjoy much more diversified revenue streams, limiting downside risk in the event of any unfavorable developments with one of their drugs. Johnson & Johnson and Pfizer are two examples. 

After all, it wasn't long ago that AbbVie's shares offered a dividend yield north of 4% and traded at a P/E ratio near 10, demonstrating just how quickly prospects can change (for better or worse) when a company's operations are so concentrated. Income investors considering AbbVie need to keep this in mind and size their positions accordingly (if at all).  

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