Buying The Latest AbbVie Sell-Off With Vigor

Background

The mega-cap biotech AbbVie (ABBV) was spun off from Abbott (ABT) 5 1/2 years ago as the second step in ABT’s deconglomeration. It appears that it has returned roughly 22% per year since then. I believe that the stock is undervalued and that the combination of the Citron short sale recommendation and the general market sell-off Friday have left ABBV unduly depressed. Thus, it may be attractive for patient investors. My goal is mid-teens annual returns for some years to come. Please note that as stated elsewhere, I am not a financial adviser, so please do your own homework on this name and all other stocks I comment on.

One technical reason to consider ABBV of all biotechs is that only ABBV has broken well above of its 2014-5 trading range. Thinking back to the tech stock recovery after the 2000-3 Tech Wreck, very few leading names went to new highs. The only one that comes to my mind is Apple (AAPL), and it paid to buy AAPL on any sell-offs from 2003 onward (and earlier than that, of course).

Let’s look at ABBV vs. a large cap-oriented biotech ETF (IBB) as well as the S&P 500 (SPY) on a 5-year chart;

Chart

ABBV data by YCharts

That chart looks good to me in favor of ABBV.

In addition, ABBV has had much higher dividend pay-outs than the rest of IBB, so its outperformance is that much greater.

As I have opined many times, my key starting point for most stocks is whether they have strong, bottom left-to-top right chart patterns. The second question, of course, is whether investors have finally overestimated the company’s strengths and the stock should be avoided on a valuation basis.

In the rest of this article, I will present my point of the view that in the current situation, it is reasonable to invest as if past is prologue, and play it as if ABBV will continue to outperform the general market and possibly the biotech sector (though I believe that a sharp snapback for other leading biotechs is very possible).

The first reason involves simple arithmetic:

ABBV is a cheap stock and should not be so heavily discounted

In Q2, ABBV had a number of one-time expenses including a tax issue and a $500 MM payment into its partnership with an Alphabet-backed (GOOGL) pharma R&D company, Calico. So, this is one case where GAAP tends to obscure earnings power. More important is to take ABBV’s upgraded full-year non-GAAP forecast of around $7.80 EPS and subtract the completely valid amortization charges and some minor other charges. That gets me to around $7.00 EPS as a valid baseline to use when looking forward to 2019 and beyond. (Note, at some point the costs related to the Calico venture will have to stop being treated as special and will simply be general R&D costs.)

Using $7, then ABBV is around 13X full-year EPS, which translates to an earnings yield (reciprocal of the P/E) of 7.8%.

Because ABBV has about a 100% conversion of EPS to free cash flow, owners of the company have an attractive return from the start based on today’s interest rates and today’s lower earnings yield on the SPY as a whole. s

The next question is whether earnings can be sustained at this level and grow at least at a moderate pace. Here’s why I’m bullish on ABBV and bearish on Citron’s short-selling case.

The brilliance of ABBV’s life-cycle management of the Humira franchise; Part 1: Humira top-down considerations

I would urge anyone interested in this topic to think about the points that ABBV’s CEO Rick Gonzalez made more than once in Friday’s conference call. These points are supported and supplemented by an ABBV presentation from June regarding its plans to sustain and possibly grow its Humira franchise.

Big picture: ABBV is a Big Pharma, mature company that knows the patent game inside and out. So it knew that biosimilars were coming and when they were coming, and from Day 1 of its existence outside of the ABT umbrella, it was planning on both growing Humira sales and taking the expanding Humira franchise, protecting it as much as possible with patents in the US, and supplanting it globally with superior, next-generation products.

The plan has succeeded brilliantly to date. Humira sales annualized at almost $21 B in Q2 and are growing at a healthy pace, especially in the US, and finally essentially all from volume gains. ABBV has pointed out its view that given Humira’s numerous indications, it and other biologics are significantly under-used, not over-prescribed. So it has asserted, correctly so far, that the many newer biologic and oral potent entrants to the RA, psoriatic disease, and IBD markets would enlarge the market rather than lead to the Humira franchise shrinking.

What happens next is that biosimilars will enter in the EU in Q4. ABBV keeps saying that it has a very good plan to minimize the sales decline there, but it will share no details publicly (i.e., it won’t tip off its competitors). So I’m going to keep an open mind, and remember that selling prices in the EU are less than in the US, so profitability will be hurt less by loss of exclusivity in the EU than in the US.

Here, I expect sales to grow until late January 2023, when Amgen (AMGN) will enter with Amjevita. ABBV has made a patent-licensing deal with AMGN and two other biosim companies in which the licensees acknowledge the validity of the licensed patents and agree to pay ABBV an undisclosed royalty. This will likely lead to three biosim competitors entering the US market by July 2023. That’s the latest count, and presumably more will enter, but we do not know whether there will be litigation or whether other companies will also work out a deal with ABBV.

Assuming Humira keeps biosims at bay under the above scenario, US sales that annualized at $14.1 B in Q2 can keep growing. There may still be a few months left of a small royalty that ABBV owes to another company on Humira, but I seem to recall that if so, it will end by around year-end 2018. With Remicade subject to biosim competition and Enbrel fading, the prescribing community appears to be standardizing on Humira as the TNF inhibitor of choice. ABBV must be congratulated for this victory. The best molecule has won, and Humira is the leader in moderate-to-severe versions in all its indications. It took great science and great marketing to achieve this.

With ongoing management continuity, I consider this to be a valuable intangible that should allow ABBV to have a higher P/E.

So, what’s the Humira franchise worth? (Part 2)

It’s worth whatever ABBV can wring out of the EU, 4 1/2 years of biosim-free sales in the US, then an unknown pace of decline in the US, royalties on biosim sales, and sales from the rest of the world, including Japan and China.

I estimate matters this way, and note this is guesswork, not fact:

At year-end 2018, sales may annualize near $22 B. I multiply that by 4.5 years, ignoring the sales from the month of January 2023 before AMGN enters with its biosim. Then I assume that the drop-off in sales in the EU is matched by growth elsewhere, mostly in the US. So I multiply $22 B by the 4.5 years between Q3 2018 and Q4 2022, inclusive. That gives $99 B; call it $100 B.

Then I make the guess that if there were simply one Humira company with no other focus, the all-in after-tax profitability from these 4.5 years of operation will be 60%. This assumes a 20% tax rate. So that gives $60 B as profits from Humira up to US biosim entry. Whether one should adjust for the time value of money (present value discount), and if so at what rate, is up to each of us. Traditionally, Humira has needed none of that due to rampant price increases, but those days may be gone.

Moving on, the next question is what Humira will produce beginning in 2023. It’s a great unknown. I do estimate that sales will be around $20+ billion as a starter, and I use a matrix of possibilities. Focusing on the US, it is possible that biosims will be a relatively minor encroachment. Or, on the other end of the spectrum, perhaps they will act much more like generics and quickly do what generics did when they were only partly accepted by doctors and patients. In those days, perhaps the late 1980s or early 1990s if memory serves, a rule of thumb was that the brand would see sales drop 80% when generics appeared. Now, it is more like a 98-99% sales drop.

In this case, my mid-range scenario is that most patients who are stabilized on Humira are going to be sticky with Humira, but that new patient starts on Humira will drop off sharply. So I could see annual sales dropping as follows (exemplary, not a prediction):

  • $17.5 B in 2023
  • $15 B in 2024
  • $12.5 B in 2025
  • $10 B in 2026, etc.

Thus I think it’s reasonable to allot $20 B for the value of the Humira franchise from 2023 onward, including all territories and assuming a 50% after-tax profitability of the franchise, i.e. a present value of future sales of $40 B.

This analysis suggests Humira’s profit stream may come to $80 B.

But there’s more to Humira than just its sales. It provides a greeting card for planned, major product launches.

Here come “risa” and “upa” (Part 3)

ABBV has two very late-stage assets to advance beyond Humira – which represents 20th century technology – that it plans to develop into major profit centers soon. ABBV will go to the many Humira prescribers and develop a switch/start strategy that leads them from Humira to either risankizumab and/or upacitinib. The June presentation, slide 3, shows the strategy. Almost every Humira indication is expected to be replaced by one or both of those two drugs. In addition, the atopic dermatitis indication is in my view likely to be gained by upa, and Humira does not have an AD indication.

ABBV knows vast amounts of non-public details about the prescribing habits of many thousands of doctors. It will have a doctor-by-doctor marketing plan where appropriate (high prescribers), along with mass marketing technique. The details of the registrational studies for risa and upa, and supporting smaller studies, have been determined by a mixture of science and marketing. In addition, the choice to in-license risa from Boehringer Ingelheim and to develop upa in-house has been informed by extensive proprietary knowledge of autoimmune disease mechanisms.

These and other advantages are why ABBV is so optimistic about the future of its Humira franchise writ large, meaning Humira plus follow-on drugs beginning with risa and upa. For some meatiness, here are some of ABBV’s prepared remarks on the topic from the conference call, mixing CEO and CSO comments:

Upadacitinib has the potential to be best in class therapy in RA offering meaningful advantages over products on the market today or those we see in development… We’ve evaluated Upadacitinib in a comprehensive set of studies in patients with moderate-to-severe RA… and believe that it will offer meaningful advantages over products on the market today or in development… [including] the potential of Upadacitinib as first line monotherapy in methotrexate-naïve RA patients.

If upa can gain a first-line indication for RA, the sky is (metaphorically) the limit for its sales potential just in that indication. But ABBV is seeking 6 other indications for upa, almost all of them major opportunities to improve the standard of care and thus reap well-deserved significant financial rewards. So I believe that upa has major, mega-blockbuster potential.

Upa was either invented at ABBV or brought in-house very early, so I think that the only royalties or other fees ABBV will owe on sales of upa might be for its access to the controlled release technology that allows upa to be given once a day rather than twice daily. If such a deal was made, typically royalty rates would be small. So I see upa as having massive upside potential. Upa could reach the US market in Q4 2019.

As far as risa goes, 4 major indications are being sought for it. The CSO had this to say about it:

Moving now to our other late stage immunology asset, risankizumab. We recently submitted our US and European regulatory applications in psoriasis. Based on the very high and durable rates of skin clearance we saw in the registrational studies. We believe risankizumab has the potential to significantly improve upon current treatment options for both bio-naïve and TNF inadequate responder patients with moderate-to-severe psoriasis, while offering the convenience of quarterly dosing.

I agree. A top-notch clinical profile and an injection only every three months can allow risa to become a significant success.

I am modeling risa to reach the US market in Q2 2019.

Assuming timely approval of upa and risa, ABBV will have several years to build their franchises in conjunction with its life-cycle management of Humira. Success here will be a major achievement in this industry. Few companies have ever done this sort of thing, and the importance of success in this multi-year, carefully-planned effort explains some of the impatience that the CEO showed in some of his responses to questions from analysts about reimbursement issues of the day.

There is much more to ABBV, and…

Two young products each have major potential

Leaving Humira et al aside, ABBV may have mega-blockbusters from its cancer drug Venclexta and from Orilissa. Venclexta is shared in some fashion with Roche (OTCQX:RHHBY), but I have not seen detailed terms. My assumption, and it’s just an assumption, is that Venclexta profits will mostly accrue to ABBV. I think the drug bids fair to represent an important advance in the treatment of certain fairly common hematologic cancers, and I believe there is lengthy patent protection for it.

Orilissa (elagolix) was approved this month for endometriosis. Currently it can only be used for a limited time period, not for years and years, but ABBV has a program underway to limited the bone loss it causes. Success in this project could allow Orilissa to see very large sales. A second, also potentially major, indication, for uterine fibroids, is moving through Phase 3. Elagolix was invented by Neurocrine Biosciences (NBIX), but I have been unable to determine the royalty/milestone arrangement between NBIX and ABBV.

In any case, it’s important that both Venclexta and Orilissa are approved, not just pipeline possibilities, though especially for Venclexta, additional important indications are being sought.

I give these two drugs significant though as-yet undetermined value.

Then there’s all the rest of ABBV

ABBV has other major assets. These include its approximate half-share of profits from Imbruvica, Mavyret, Creon, Duodopa, Synagis, Synthroid and even Lupron.

This article is long enough, but in the future, I’d like to devote some time to explaining why part of why I have come to admire ABBV’s business savvy relates to what it has done with all these franchises.

Finally, there is all the rest of ABBV’s R&D effort. I actually do not think it’s ideal, as exemplified by its unusual overweighting of antibody-drug conjugates in its pipeline. But overall, ABBV’s product development track record speaks for itself.

Now, a word about the short selling attack that drove ABBV into the $80s.

Citron strikes again, but I bought the dip

The idea of shorting a massively profitable company that is on a product development roll, that routinely beats and raises expectations, and that costs a short seller the 4% dividend yield upfront in addition to financing the short sale, is strange. Even stranger, I thought, was the Citron thesis that ABBV is headed to $60 for the stated reason that it may be forced to charge full price rather than, say, half price to get on formularies (if I have their reasoning right).

In the real world, drug companies charge mostly wealthy foreigners list price, with rare exceptions, if the drugs list above $40,000 per year. The reasons for ubiquitous rebates come largely from the government. I found the Citron presentation thin rather than broad-based, and quite unpersuasive.

So I’m thinking that it’s nice to see a reason for a great company’s stock to fall so hard, and to be able to take a stand against the shorts.

Risks

In my very humble opinion, ABBV is less risky than the “average” stock, though it’s difficult to define what an average stock is. The company is committed to dividend increases, and with a current dividend a little above 4% and likely set to be increased again next year, numerous stockholders will see little reason to sell if the stock drops some more.

Please see the 10-K and other documents for ABBV’s list of its many risk factors.

Concluding remarks

ABBV appears to me to have emerged as an appealing combination of Big Pharma savvy with strong biotech science. Disappointments have been few lately, largely limited to the cost of the Stemcentrx deal, poor results so far from its PARP inhibitor veliparib, and the dismal failure of the MS drug Zinbryta (shared with Biogen (BIIB). There are no guarantees of success for ABBV’s grand plan to grow its autoimmune franchise through the Humira patent cliffs beginning in the EU this year and in the US apparently in early 2023. However, I would be satisfied if a drop-off occurs but was only mild. It turns out that as with Gilead (GILD) in 2010-1 and Lilly (LLY) around the same, very often pharma companies bottom when the Street worries a lot about patent cliffs. So long as ABBV continues to develop great products, whether in-licensed or invented in its own labs, I expect the Street to give a high P/E on Humira-related trough earnings.

Thus I began accumulating ABBV more seriously again on Friday and plan to do more of the same assuming it continues to trade in the low $90s or lower. ABBV has a stated market cap around $142 B based on diluted shares outstanding in Q2, and may have an enterprise value of $180 B or more. That’s a tad daunting, but I look at the ongoing and growing earnings stream, the numerous approved and late-stage pipeline growth drivers, and find that in the market we have, this looks like a superior stock. Clearly there are regulatory, legislative, and market risks, though.

My goal from ABBV is primarily capital gains, as well as income from dividend growth. My theme is for the stock to work higher, perhaps trading sustainably above $100 next year, then above $110 in 2020, and so on. This would provide somewhere around 15% annual total returns. Also, my base case is for ABBV to perform well versus household pharma names such as J&J (JNJ), Pfizer (PFE) and Merck (MRK) – though any stock can trade almost anywhere for almost any reason. So that’s not a prediction, just my own rationale for owning ABBV but not these other names (note, I do buy and flip PFE for small capital gains now and then).

Thanks for reading and sharing any comments you wish to contribute.

Submitted Sunday morning.

Disclosure: I am/we are long ABBV,RHHBY,GILD,AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.

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