Still A Dividend Growth Stalwart?

Last week Abbott Laboratories (ABT) announced that it plans to separate into two publicly traded companies around the end of 2012. One, retaining the Abbott name, will focus on diversified medical products. The other, “New Pharmaceutical Company,” will focus on research-based drugs. Both companies will be global leaders in their respective industries on the day they begin.

In the announcement, Abbott stated that the “two publicly traded companies will offer shareholders distinct opportunities given unique investment identities, business profiles and attributes,” and that the decision “builds on a decade of strategic and operational advancements.” Miles White, chairman and chief executive officer, stated:

Today's news is a significant event for Abbott, and reflects another dynamic change in our company's 123-year history, strengthening our outlook for strong and sustainable growth and shareholder returns.

An 81-slide presentation about the split-up is available here (pdf).

The split itself is intended to take the form of a tax-free distribution to Abbott shareholders of a new publicly traded stock for the New Pharmaceutical Company. The stock distribution ratio will be determined at a future date.

Rats!

As a dividend growth investor with a large position in Abbott, my first reaction was, “Rats!” Abbott has been a dividend-growth stalwart since I have been following the strategy. The company has been in my Top 40 Dividend Growth Stocks publication every year that I have produced it (2008-2011), and it was sure to make it again in 2012.

The company has offered terrific dividend characteristics, yet it seemed to be perpetually undervalued, thus always being prominent as a potential purchase candidate. In public and private portfolios, I have made 10 separate purchases of Abbott since 2008 and never sold a share. In my public Dividend Growth Portfolio, created in 2008, Abbott was a charter member and comprises about 9% of the portfolio’s value. Both of my dividend reinvestments in 2011 went to purchase more shares of Abbott.

The company’s 1, 3, 5, and 10-year dividend growth rates all stand at 9% to 10% annualized. It raised its dividend 9% in 2011. The stock yields about 3.6% and has raised its dividends for 39 consecutive years. This is a classically beautiful dividend-growth stock.

But dividend-growth investing is buy-and-monitor, and you can’t ignore a strategic left-turn like this when it apears on your radar screen. We need to understand what this does to Abbott as a dividend-growth stock. Sometimes the interests of dividend-growth investors diverge from the interests of investors who are following other strategies. This may be one of those times. The common wisdom about the split is that it is being done to “maximize shareholder value.” Theoretically, this can be done by getting the stock’s price up, raising dividends, or both. Usually, however, when that phrase pops up, the focus is on the stock’s price.

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And Abbott’s price jumped about 6% on the news, as you can see in the chart. The announcement day is the thick black bar towards the right edge of the chart, which also shows a big jump in trading volume that day. Since then the euphoria has died down a little and the stock has slid back.

Let’s look at the split, first the official version and then again by applying some educated guesswork as to what might happen to the dividend.

New Abbott: Diversified Medical Products Company

This company will have about 56% of the annual revenues of the old Abbott, or about $22 billion. The major business lines consist of Abbott’s existing diversified medical products portfolio:

• Nutritional products, such as Similac, Isomil, Ensure, and Prosure.
• Established pharmaceuticals, which means generic drugs marketed around the world.
• Diversified diagnostics.
• Coronary stents and catheters.
• Other medical devices, including optics and diabetes products.

About 2/3 of revenues of the New Abbott will come from overseas, including about 40% from emerging markets. Abbott is the leading pharmaceutical company in India, and it has a growing presence in many other emerging markets. The combined businesses of the New Abbott are growing at about 13% per year. Abbott expects to deliver sustainable double-digit ongoing EPS growth from this company. That said, these businesses generate only about 40% of Abbott’s profits currently.

Mr. White will remain chairman and CEO of the New Abbott. He said the expected:

Abbott will be one of the largest and fastest-growing global diversified medical products companies, with a compelling portfolio of durable growth businesses in medical technology, branded generic pharmaceuticals and nutritionals. We will continue to grow our product lines, market share and global presence, especially in emerging markets.

New Pharmaceutical Company

The new company, with about 45% of Abbott’s revenues ($18 billion), but 60% of its profits, will include Abbott's current portfolio of proprietary pharmaceuticals and biologics. It will focus on select specialty products developed via breakthrough innovations. The principal current businesses are:

• Humira.This drug will produce about half the sales of New Pharmaceutical Company. It is a genuine blockbuster product, approved for relieving symptoms (such as pain and swelling) of certain autoimmune disorders, including rheumatoid arthritis and Crohn's disease. Abbott has been successful in expanding the ailments that Humira has been approved for. This has fueled a high growth rate for the drug, about 23% over the past year. Its patent expires in 2016.
• Cholesterol treatments TriCor and Trilipix, producing about 10% of sales.
• Kaletra, an anti-HIV treatment with about 7% of sales.

Abbott is generally considered to have a good R&D pipeline of future branded drug prospects. Areas of development include oncology, Hepatitis C, MS, immunology, chronic kidney disease, women's health, and neuroscience. More than 20 compounds or indications are currently in Phase II or Phase III trials, including four new indications for Humira. Abbott has had a strong commitment to research and the development of new pharmaceuticals. The combined businesses of New Pharmaceutical Company are also growing at about 13% per year.

Richard A. Gonzalez, currently executive vice president, Global Pharmaceuticals of the existing Abbott, will become chairman and CEO of New Pharmaceutical Company. He is a 30+ year Abbott veteran and was previously president and chief operating officer of Abbott. He is coming out of retirement. He also said the expected:

The research-based pharmaceutical company will be a leader in its industry with a strong and sustainable portfolio of specialty medicines and a promising pipeline of future products.This business has been delivering market-leading performance and is well positioned for future success.

What About the Dividend?

Abbott addressed the dividend in the announcement. “It is expected that the two companies will each pay a dividend that, when combined, will equal the current Abbott dividend at the time of separation.” Not unexpectedly, they said nothing about growth in subsequent years.

When I evaluate dividend-growth companies, I place significant emphasis on the stock’s Story. In the Story, I try to understand what the company does, how it makes money, and why it is likely to experience continuing success. Specifically as to dividends, I want to see evidence of a strong dividend-raising culture combined with the wherewithal to carry it out for the foreseeable future. The wherewithal comes not only from great financials, but also from attributes like industry dominance, strong management, coherent strategies, great brands, and sustainable competitive advantages. If I can’t find or understand those things, I won’t invest in the company.

When I last analyzed Abbott in January, I gave it high marks for its Story. As I review that analysis today, this sentence jumps out at me: “Non-drug businesses (like nutritionals) help shield [the company] from effects of periodic loss of patents on branded drugs.” In other words, Abbott is a diversified, multi-line healthcare conglomerate, not just a drug company. I saw that diversification as a strength, just as I see it as a strength for Johnson & Johnson (JNJ).

Now they are splitting it up. There will be duplicate boards, executives, departments, managers, employees, and cost structures. Both new companies will lose the protection from cyclical revenue changes that came when all the business units operated under the same umbrella.

When companies make significant, transformative strategic shifts, my experience is that everything comes up for reconsideration. Consultants swarm, transition committees are formed. Hundreds of PowerPoint presentations are created. Ideas come out of the woodwork, and it is not unknown for strange ideas to get traction that they would never have received in the old company. The neat, clean original vision gets worked over. Executives jockey for position. Ego often wins over logic. Original intentions can get run over by the momentum of “change is good.” Former statements can become inoperative.

In a reorganization, former cultural imperatives get re-examined. That’s what worries me here, because it is a source of risk to continued dividend growth. Abbott has a strong culture and practice of raising its dividend annually (currently at 39 years and counting). Will that culture survive? Will it survive in both new companies? In just one? Which one?

Who can tell? I can’t. I think I know where this is going. Absent more information leading to an ability to predict with confidence that both new companies will adopt the dividend practices of their parent, I will sell Abbott, in all or in part. I will have a tear in my eye if it happens.

There’s no sense of urgency to sell. I believe that current dividend practices will remain in place until the actual split at the end of next year. An important test will come next April, when Abbott’s usual dividend increase would normally occur. If the increase drops to 2%-3%, I would probably consider that a signal to get out right away. By the way, Abbott will probably incur considerable “one-time” charges between now and the split-up date, and after the split-up, it is likely that former cost-saving synergies will be destroyed as each new company wants to go its own way. What Abbott is doing on the cost side is the opposite of what most companies try to accomplish when they merge.

But who knows? Between now and then, some important information might come out:

• Some outside company may see that one or the other of the businesses is actually in play and make an acquisition offer, which could drive up Abbott’s share price.
• Abbott may specifically address the dividend-increase issue, as ConocoPhillips (COP) recently did in regard to their split-up. If so, it will become a game of Who Do You Trust?

If I end up selling Abbott, I will probably do it by sticking a sell-stop a small distance under its price, hoping to milk any additional price gains out of the stock before I let it go. In any event, I presently do not consider Abbott a candidate for further purchase, and I doubt it will show up on 2012’s Top 40 list. If it does, it will have a special red flag beside its name.

Disclosure: I am long ABT, JNJ.