AbbVie Looks Undervalued

AbbVie ABBV reported fourth-quarter results that were largely in line with both our and consensus expectations. The 10% operational sales growth the company expects in 2017, driven by Humira gains, is also in line with our expectations. We continue to view the stock as undervalued despite our significantly below-consensus sales expectations for immunology drug Humira by 2020 ($11 billion versus consensus of $19 billion). Despite the likely biosimilar headwinds for Humira over the next few years, we believe the combination of well-positioned currently marketed drugs and a strong pipeline secures a narrow moat rating for the firm.

Strong sales once again from Humira (up 16% operationally, mainly from volume gains in rheumatoid arthritis) and cancer drug Imbruvica helped offset weakness in the virology group, leading to total sales growth of 7%, but a new hepatitis C drug launch should help stabilize the infectious disease segment in late 2017. While AbbVie continues to lose share in the fast-moving hepatitis C market, we expect the launch of its doublet will be much more competitive than Merck's MRK Zepatier and more on par with Gilead's GILD offerings, allowing AbbVie to gain close to one fourth of the market with $3 billion in annual sales.

Despite the expected gains from hepatitis C drugs in the pipeline and several new immunology and oncology drugs, we expect total sales growth to flatten by 2019 as biosimilars take share from Humira, AbbVie's leading drug (63% of total sales). While the exact timing of the launches is uncertain, close to 10 Humira biosimilars are in phase 3 development, filed, or approved, and we expect multiple competitors by 2018. Amgen's AMGN approved Humira biosimilar is likely to lead the launches in the United States following an uncertain litigation time frame.

Moat Based on Patent-Protected Portfolio…
We believe AbbVie has a narrow economic moat, supported by patent-protected drugs, intellectual intangibles, and a powerful salesforce. As is the case for most drug firms, the core of AbbVie's moat lies in its portfolio of patent-protected drugs. However, unlike AbbVie's Big Pharma peers, which tend to carry wide moats, one drug (Humira) represents the majority of AbbVie's sales and profits. We believe the company's excess returns are likely to persist for 10 years, but given emerging branded competition to Humira in the immediate term and a potential generic biosimilar threat in the 2017-18 time frame, we cannot be as certain of this for our 20-year outlook, which would be needed for a wide moat rating. AbbVie needs to improve its pipeline to be more ready for the eventual biosimilar competition to Humira.

Nevertheless, AbbVie derives enormous cash flows from its current product portfolio to fund ongoing discovery and development of the next generation of drugs. The large cash flows create an economy of scale that enables AbbVie to fund the average $800 million required for a new drug. While not as strong as other Big Pharma firms, AbbVie's research and development has created a database of intellectual insights that should help increase the odds of successful drug development. Finally, AbbVie's entrenched salesforce in one of the most sought-after therapeutic areas of immunology should help the firm launch its next generation of drugs and make the company a leading candidate for smaller drug firms needing help to develop and commercialize innovative new drugs.

…But Humira Competition Looms
AbbVie's moat trend is negative, as several competitive threats are targeting Humira. New branded drugs are launching in all of Humira key therapeutic areas, including rheumatoid arthritis, psoriasis, and Crohn's disease. However, we don't expect Humira will lose a high degree of market share to these new drugs; slow market erosion over the longer term is more likely. In addition, while the 2017-18 Humira patent losses are likely to bring new competitive threats from generic manufacturers, the damage should be partly mitigated by the biologic complexity of manufacturing and marketing a generic version of the drug.

Without a strong late-stage pipeline, AbbVie lacks the products needed to replace increasing branded and generic competition. Additionally, major industry headwinds have created roadblocks in the path to creating the next generation of drugs. The Food and Drug Administration has grown increasingly risk-sensitive, approving only very safe drugs or drugs in highly needed areas like cancer. Insurance companies are reducing coverage for follow-on drugs, forcing drug firms to push for true innovation and reducing the power of their distribution networks. Lastly, governments around the world are evaluating comparative effectiveness programs and more aggressive price negotiations, raising the bar and increasing the need for future innovation.

Like other drug companies, AbbVie faces the risks of new product failures, reimbursement challenges for new drugs, and drug pricing cuts by large payer groups that are growing increasingly price-sensitive. Further, AbbVie's high concentration of Humira sales makes the company significantly exposed to any new competitive threats to the drug, both from biosimilars and new branded competition.

Despite the high dependence on one key drug, AbbVie holds a strong balance and should produce robust cash flows over the next several years. While acquisitions increased AbbVie's debt/EBITDA ratio to 3.5 times in 2015, we expect strong cash flows and reduced acquisition activity to bring this metric down to 2.5 times by 2019. Nevertheless, by 2020, the increasing pressure from Humira competition is likely to put financial pressure on the company. We expect pipeline assets to help mitigate these headwinds.