Abbott's Underlying Strength in Devices Softens Near-Term Turbulence in Nutrition and Diagnostics

Senior Equity Analyst

Debbie Wang

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Nutrition

Diagnostics

Established Pharmaceuticals

Medical Devices

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Since 2013, Abbott has continued to improve the profitability of its four segments: nutritionals, devices, diagnostics, and established pharmaceuticals. Although the company has made progress over the last 10 years, it still lags key rivals on profitability measures despite competing in businesses that are characterized by attractive margins.

Abbott's efforts to improve efficiency, including streamlining its distribution channels and building facilities in lower-cost locations like China and India, have demonstrated some success. But there is still room for improvement as we look at the company's consolidated profitability. We like that management has turned its attention to new sources of growth. In our view, Abbott's FreeStyle Libre blood glucose monitor franchise is one of the most compelling innovations the firm has ever launched. Further, the pandemic provided a boon to Abbott's diagnostics segment that should continue to pay off through a stream of consumable revenue now that the base of installed platforms has substantially expanded. The addition of St. Jude's heart-focused portfolio (along with smaller tuck-ins) significantly broadens Abbott's cardiac device product offering, raising the firm's ability to compete as hospital clients seek to winnow suppliers.

As with all medtech companies, Abbott's big challenge, over the longer term, is to fuel innovation. The bar for securing reimbursement for new technology has risen as payers have become more stringent about clinical data before committing to payment. While Abbott has seen recent success with FreeStyle Libre, we're less impressed with its historical record on new product launches. Compared with key medical device competitors, including Boston Scientific, Medtronic, and Edwards Lifesciences, Abbott hasn't cultivated similar revolutionary advancements. The firm's forte seems to focus on incremental improvements to the existing technology platforms it has acquired over the last 15 years. Thanks to healthcare reform, this approach makes it more challenging to yield robust returns in the future.

Business Strategy & Outlook

We've given Abbott a narrow economic moat rating. We think the addition of St. Jude's portfolio of cardiac devices has pushed Abbott toward the wider side of a narrow moat, but we're not fully convinced that it has tipped into the wide moat category, especially if the firm cannot nurture the kind of ongoing (and occasionally revolutionary) innovation that is necessary to secure reimbursement over the longer term.

In most cases, Abbott is one of three or four competitors that dominate the market, including nutritionals, cardiac rhythm management devices, surgical heart valves, continuous glucose monitors, coronary stents, venous closure, and immunoassays. In these markets, Abbott enjoys the benefits of intangible assets that give rise to economic profits. 

We think the nutritional business is one of the moatiest parts of Abbott, where it wields a leadership position in this highly consolidated market that is estimated to be $35 billion worldwide. The firm has developed intangible assets in the form of brand trust with new parents as well as pediatricians. We think Abbott has also developed other intangible assets through its various proprietary formulations of specialty infant formulas for babies with allergies and metabolic challenges. 

Aside from strength in developed markets, the firm faces brighter growth prospects in emerging markets, where the growth of middle-class families has spurred demand for pediatric and adult nutrition products. Thanks to the strong Similac and Ensure brands, Abbott is in an advantageous position to introduce new formulations and line extensions and penetrate new markets. Abbott made substantial investments early on to build out its infrastructure in emerging markets, including its new venture with New Zealand-based Fonterra to build out a large-scale dairy farm hub in China. The firm should reap the rewards of this investment as it expands the nutritional business. We think this agreement with Fonterra may help Abbott lower its nutritional cost inputs in China but do not believe this will be substantial enough to qualify as a moat source. 

These building blocks and experience with nutritionals should also play out well when applied to Abbott's established pharmaceutical product segment, which is sold outside the U.S. This business, frequently called branded generics, operates more like a consumer business than traditional branded drugs. For example, Abbott's branded generics will mainly be sold in less developed markets that often lack a well-developed infrastructure for distribution. Instead, Abbott must sell its products directly to pharmacy chains and physicians. As a result, brand recognition and reputation are key factors that Abbott can leverage. Selling to a fragmented market also translates into less pricing pressure for Abbott. This could change over the longer term once more emerging markets turn to the tender system that characterizes developed nations. However, that change remains further off.

We think Abbott benefits considerably from legacy St. Jude's impressive expertise in cardiac rhythm management, structural heart, and heart failure. Intangible assets in this segment include specialized engineering knowledge, expertise in navigating the regulatory pathway, and importantly, strong sales representative relationships with practitioners.

However, the jury is still out on Abbott's ability to nurture and renew innovation in this area over the long haul. Thus far, Abbott has done a credible job of commercializing what was already in St. Jude's pipeline, but we are less confident about Abbott generating greater leaps of innovation based on its track record with earlier acquisitions.

The diagnostics segment deviates slightly from the other divisions, in terms of primary moat source. Instead of intangibles, we think Abbott's diagnostics business displays signs of switching costs that are often seen in the life sciences market. Once the durable testing platform is installed and technicians are trained on it, Abbott generates an ongoing stream of revenue from higher-margin consumables, supplies, and reagents.

Finally, Abbott also relies on intellectual property to ward off competitors in the device and diagnostic segments and protect some level of differentiation in its products. However, we do not think of patents as bullet-proof in the medical technology arena, particularly because competitors can engineer a different way to a similar solution. Nonetheless, developing products that tiptoe around competitive intellectual property seems to foster product differentiation that can add to a firm's intangible assets.

We think the firm has earned a narrow moat in each of its four segments, which translates to a narrow moat for the entire company.

In terms of environmental, social, and governance risks, we see a few modest issues, but none that are likely to result in any permanent impairment of Abbott's narrow moat. First and perhaps the most serious is Abbott's exposure to product defects or recalls of its life-saving devices. However, we recognize that many of these invasive, life-sustaining products receive Food and Drug Administration approval through the premarket approval pathway, which in itself provides a substantial shield against liability claims. Other less-invasive products that are regulated under the 510(k) portion of the FDA's medical device law are more vulnerable to liability issues. 

Second, some of Abbott's electronic devices and stores of patient data might be vulnerable to hacking. This is an issue that has come up before with legacy St. Jude cardiac rhythm management devices. Again, we've seen little in terms of financial or competitive implications when these instances of digital vulnerability come to light. We speculate this may be because hackers do not necessarily have much to gain financially from messing with these medical devices. 

Third, Abbott is relatively more reliant on M&A for its product pipeline. This leads to the risk of overpayment for new technology, which can diminish returns on invested capital. From a longer-term perspective, optimization of this acquisition strategy also means Abbott needs to hang onto the engineers and sales reps that come along with these acquisitions.

Narrow

Economic Moat

Abbott Labs

St. Jude Medical was an American global medical device company headquartered in Little Canada, Minnesota, U.S., a suburb of Saint Paul. The company had more than 20 principal operations and manufacturing facilities worldwide with products sold in more than 100 countries. The company was acquired by Abbott Laboratories in January 2017.

St. Jude Medical

Abbott Laboratories engages in the discovery, development, manufacture, and sale of a broad and diversified line of health care products. It operates through the following business segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Medical Devices. The Established Pharmaceutical Products segment refers to the international sales of a line of branded generic pharmaceutical products. The Diagnostic Products segment markets diagnostic systems and tests for blood banks, hospitals, commercial laboratories, and alternate-care testing sites. The Nutritional Products segment caters to the worldwide sales of adult and pediatric nutritional products. The Medical Devices segment includes electrophysiology, heart failure, vascular and structural heart devices for the treatment of cardiovascular diseases, and diabetes care products for people with diabetes, as well as neuromodulation devices for the management of chronic pain and movement disorders. The company was founded by Wallace Calvin Abbott in 1888 and is headquartered in Abbott Park, IL.

Earnings data Q1 2024

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In the closing of the recent trading day, Abbott (ABT) stood at $104.94, denoting a +0.57% change from the preceding trading day.

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