Thesis and Background
The healthcare sector is a great place for income and value investors with its stable prospects and secular support. Both Bristol Myers Squibb (NYSE:BMY) and AbbVie (NYSE:ABBV) are attractive candidates under their current conditions.
As my wife and I are reviewing our accounts to prepare for early (and hopefully long) retirement, they both really sparked our interest. This article has three goals. First, it will go over some of the business fundamentals of both companies. Secondly, it will go through our detailed thought process in choosing ABBV over BMY. And finally, we also think they are the best examples to illustrate the general barbell strategy employed in our newly launched marketplace service.
A bit of background about ourselves and our barbell strategy. My family is in the final stage toward retirement (after about 15 years of work). Through our own personal journey, we learned the key to building and protecting wealth is to pursue growth and income with ISOLATED risks. Sadly, we’ve seen too many people around us make the tragic mistake of mixing growth with income generation, or even worse, focusing on growth before ensuring adequate income. That is why we urge our readers to ALWAYS build two portfolios (and also why we provide 2x such model portfolios in our service) – one for income in the short term and one for growth in the long term – the so-called barbell model.
Under this context, we will compare BMY and ABBV to show the traits we seek in the short-term end of our barbell. We are specifically looking for:
A) Adequate and safe dividend income in the long term. We’re searching for a high current yield that’s well-protected by sustainable financials. ABBV is a clear winner in this regard. ABBV has consistently paid higher dividend yield than BMY as you can see from the chart below. ABBV is also a more consistent dividend stock (it is a Dividend Aristocrat) than BMY, as to be detailed later. Finally, ABBV’s current yield is around 3.6 percent, which is much higher than BMY’s 2.6 percent by almost a whole percent (or more than 38% in relative terms).
B) Reasonable valuation and a good margin of safety. And you will see later that in this regard, both BMY and ABBV are reasonably valued and both trade at about 10x FW PE. This is one of the main reasons why they both sparked our interests in the first place.
C) Then we will detail the reasons why we only own ABBV even though we like both. As you will see, the primary reason is that ABBV offers better dividends payout management and a more secure future. We feel BMY is more susceptible to policy uncertainties, both political and insurance policies, against high drug prices.
All told, our view is that in relative terms, ABBV is a more conservative investment and BMY a riskier one (again, only in relative terms). And being conservative is the name of the game of the survival end of our barbell.
The remainder of this article will dive in and elaborate on the above aspects.
How did our barbell perform?
Before going into further details, you must be wondering how our barbell portfolio has performed. We hold a rather concentrated portfolio with about a dozen tickers diversified across different asset classes. Currently, our stock portfolio holdings are shown in the next chart. Using the date I first published it on 5/31/2021 as the inception date, its performance relative to the S&P 500 (represented by SPY) is shown below, and also plotted on a weekly basis in the second chart. The chart plots a relatively short timeframe compared to our horizon and there is no need to read too much into the numbers. At its current level (~19% ahead of SPY), it can change within a few days of random market fluctuations. A few notes:
- As you can see, they all tend to be stocks with a good combination of quality and valuation. Our own journey has shown that sticking to FEWER but well-understood holdings not only generated higher returns but also LOWER risks (our 11-stock port has not lost money in the past year – with SO MUCH happened over the past year).
- We further divide them into two groups (withdrawal/survival vs aggressive growth) and hold them in our barbell portfolios. And that further helps us to achieve a superior return in a consistent and relaxed way with only a handful of holdings.
- AAPL has been a legacy holding and its returns are not included in these charts (otherwise, it will completely dominate the picture). Also these returns did not include dividends, so the actual returns from our holdings are slightly better than reported here.
BMY vs ABBV: profitability and dividend safety
Both BMY and ABBV currently offer an attractive dividend yield of about 2.6 and 3.6%, respectively. Dividends from both are supported by healthy profitability as you can see from the following chart. Comparing profitability is ultimately subjective and my impression here is that they both enjoy superb profitability when the metrics are considered holistically. For example, BMY enjoys a higher gross margin of 80.1% than ABBV’s 69.8%. However, ABBV made it up with a higher net income margin of 22% compared to BMY’s 13.3%. To put things under perspective, the average profit margin for the overall economy fluctuates around 8% and rarely goes above 10%. And as a rule of thumb, 10% is a very healthy profit margin and 20% is a very high margin.
Also, note that ABBV’s ROE of 83% is distorted and not comparable here given its unique capital structure. Although its return on Assets of 13.3% is higher than BMY’s 6.1% by a good margin. Finally, ABBV is also larger in absolute sizes ($22.8B of operation cash vs $16B from BMY). A larger scale adds another layer of safety.
And I’m sure we’re all familiar with the standard criteria for determining dividend safety, such as earnings payout ratio and cash flow payout ratio. The payout ratios of BMY and ABBV are shown in the figures below in terms of earnings and cash flow. As can be seen, BMY and ABBV have both managed their dividend payouts consistently in the past, and ABBV even more so. ABBV’s earnings payout ratio has been on average 78% in recent years, lower than BMY’s 86% by 8%. Besides being lower, ABBV’s payouts are also more consistent as you can see and BMY’s payout ratios fluctuated beyond 100% several times over the past decade.
The cash payout ratio paints the same picture as seen in the second figure. Here again, ABBV’s payout ratio has been on average 44% in recent years, lower than BMY’s 54% by 10% this time. Again, ABBV’s cash payout ratio has also been more consistent.
BMY vs ABBV: dividend cushion ratios
The above pay-out ratios we commonly quote enjoy simplicity, and we like to go a step further for a more comprehensive assessment of dividend safety. As detailed in my earlier article here, the major limitations of the above simple payout ratios are twofold:
- The simple payout ratio ignores the current asset. Obviously, for two firms otherwise identical, the one with more cash on its balance sheet should have a higher level of dividend safety.
- The simple payout ratio also ignores the upcoming financial obligations. Again, obviously, for two firms otherwise identical, the one with lower obligations (debt, CAPEX expenses, et al) should have a higher level of dividend safety.
We find the dividend cushion ratio an effective tool to address the above issues. A detailed description can be found in Brian M Nelson’s book entitled Value Trap. And a summary is quoted below:
The Dividend Cushion measure is a ratio that sums the existing net cash (total cash less total long-term debt) a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less all capital expenditures) over the next five years and divides that sum by future expected cash dividends (including expected growth in them, where applicable) over the same time period. If the ratio is significantly above 1, the company generally has sufficient financial capacity to pay out its expected future dividends, by our estimates. The higher the ratio, the better, all else equal.
We made one revision to the above method here. Instead of subtracting the total long-term debt, we subtracted the total interest expenses over a past five-year period. This revision is to adjust for the status of businesses like BMY and ABBV. Such mature businesses probably will never have the need to repay all the debt at once. But it does need to service its debt.
With this background, the dividend cushion ratios for BMY and ABBV are calculated and shown below. As can be seen, BMY has been maintaining an average dividend cushion ratio of 2.69x in recent years, and ABBV has been maintaining an even higher cushion ratio of 2.74x. Both are significantly above 1, confirming their safe and conservative dividend payout in the past.
Valuation and Projected Returns
The following table compares their valuation. As can be seen, there are some variations in the following numbers depending on which metric you focus on. But my overall impression is that their valuations are very comparable and both very reasonable.
BMY is valued at about 10.1x FW PE and ABBV at 10.64x FW. In terms of cash flows, BMY is valued at 10.1x cash flow and ABBV at 11.5x cash flow. To put things under historical perspective, for ABBV, its average valuation has been somewhere between 10x to 11x in the past decade. And my fair valuation for BMY is in a similar range between 9x to 10x cash flow. So both are trading very close to their fair valuation (give or take about 5%).
Looking forward, both are projected to grow their profit at about 4~5% per year in the next few years. Given the fair valuation, 4~5% per annum would also be my projections for their total return in the next few years. And in ABBV’s case, a dominant fraction of the total return (3.6% of it) will be supported by its current dividends, adding another layer of safety to the investment.
Conclusion and risks
BMY and ABBV are representative examples to illustrate the barbell strategy we apply on our real-money accounts and also in our marketplace service. Both are excellent fits for the survival/withdrawal end of the barbell given their appealing dividends, safety, and fair valuation.
Although we only hold ABBV for a few considerations tailored to our own investment style and risk profile. Overall, we feel ABBV is a more conservative investment compared to BMY. Again, BMY itself is conservative under the overall scheme of things. Just less so when compared to ABBV. Their total return potentials are about the same, in the mid-single-digit, say 4% to 5%. But in ABBV’s case, a larger portion, 3.6% of it, will come from the current dividend. ABBV also features a lower earnings payout ratio (by about 8%), cash payout ratios (by about 10%), and thicker dividend cushion (on average 2.74 vs 2.69 in recent years).
Finally, we also feel ABBV’s business fundamentals to less risky and more secure than BMY, as discussed next.
Finally, both face risks. Some risks are common to both stocks and some unique to each of them. Specifically,
- In both BMY and ABBV’s cases, there can be sizable volatility risks in the near future. Both stocks have seen their prices rally substantially YTD against the backdrop of an overall market correction. ABBV’s share price advanced 10.1% YTD and BMY advanced even more (23.7%), while the overall market suffered a 17% loss. Given such a rapid rally and the unfolding macroeconomics risks, investors should be prepared for some volatility risks ahead.
- For BMY, its “big-three” are Revlimid, Opdivo, and Eliquis. Due to high demand and minimal competition, BMY was able to charge higher selling prices for all three of these drugs. Take its Eliquis for instance. It routinely retails at $856 for a one-month supply for patients without a prescription drug plan. To me, this feels like an unsustainable model and invites competition and policy scrutiny. Patient advocate groups, the Biden Administration, and healthcare companies are all very vocal about the need to reduce untenably high drug prices. Furthermore, even though there are 50+ pipeline drugs for BMY, I do not see any of them as proven winners, far less blockbusters compared to its big-three.
- For ABBV, the Humira issue is a main risk in the next few years. Humira is not just AbbVie’s best-selling medicine (raking in about 37 percent of its total revenues in 2021), but also one of the all-time best-selling drugs. And it will go off patent next year in the US markets. After its exclusivity ends, cheaper Humira generics are slated to emerge in 2023 and pressure Humira sales, margin, or both. Rinvoq and Skyrizi continue to gain traction and show promise as a successful replacement. However, their eventual success is yet to be seen and the approvals in their target markets are always uncertain.