Healthcare conglomerate Abbott Laboratories (NYSE:ABT) reported its Q4 2013 earnings on January 22. At $5.66 billion, fourth quarter worldwide sales increased 3.3% y-o-y on an operational basis. However, reported sales increased only 0.4% due to an unfavorable 2.9% foreign exchange impact. Nutritionals, the company’s largest segment, continued to be impacted by the supplier recall that was initiated in international markets in August last year. It reported a marginal 1.1% increase in operational sales y-o-y, excluding a 2% negative impact of foreign exchange.
The diagnostics division was again the star performer for Abbott, as its operational sales increased almost 9% in the quarter y-o-y, including mid-teens growth in emerging markets. The other strong performers were Vascular and Medical Optics, which reported operational sales growth of 3.8% and 15% respectively. On the cost side, Abbott’s fourth quarter adjusted gross margin ratio was 55.4%, up 60 basis points over last year. It was guided by continued improvements in the Nutritionals and Diagnostics businesses, which reported a rise in operating margin by 300 basis points each.
In 2014, the company forecasts operational sales growth in mid-single digits, excluding the impact of foreign exchange. Abbott forecasts that operational sales will be driven by Diagnostics, Nutritionals and Medical Optics in the new year. Sales in emerging markets were $2.3 billion, increasing 9% on an operational basis in Q4 2013. The company expects these markets to continue driving growth in FY 2014 as well.
Our price estimate of $40 for Abbott Labs is almost in line with the current market price. We are in the process of updating our valuation.
Nutritionals Business Suffers Due To International Product Recalls And Adult Nutrition Sales In U.S.
In Q2 2013, Abbott was asked by regulators in China, Vietnam and Saudi Arabia to recall some of its baby formula products on concerns that they contained bacteria that cause food poisoning.    Although no health issues were detected during later investigations, Abbott claims that the recalls caused significant disruption to its sales in these countries. The company estimates that this supplier recall reduced global nutritional operational sales growth by more than 5% in Q4 2013. Global Pediatric nutrition sales declined 2% this quarter, including 3% in international markets.
Management expects sales to remain impacted on this account until the middle of 2014, and is making additional marketing investments in these countries to revive sales.  ((Abbott Reports Fourth-Quarter 2013 Results, Abbott Labs, January 22, 2014)) We expect the impact of these recalls to fade in the next few quarters as Abbott’s marketing initiatives bear fruit. Thereafter, the company should start gaining market share again at a healthy rate as it launches new products and expands its geographical presence.
Another factor for weak growth in Nutritionals revenue was a decline in U.S. adult nutrition sales. This was because of Abbott’s exit from certain non-core business lines in the U.S. to improve margins in the segment. Although international adult nutrition sales increased 14% on an operational basis, the 5% decline in the U.S. markets offset most of those gains.
Diagnostics Continues to Drive Growth
Diagnostics has been Abbott’s most consistent growth driver, delivering high single-digit operational sales growth for the past three years. Worldwide sales in this segment grew by 8.8% in Q4 on an operational basis, driven by Point-of-Care Diagnostics (14%), and Core Laboratory Diagnostics (9.3%). The core laboratory diagnostic sales growth came from both developed and emerging markets, which is encouraging. In point-of-care diagnostics, worldwide sales grew in double digits because of continued growth in the U.S. hospital and physician office lab segments as well as a double-digit growth in emerging markets.
We expect Abbott’s Diagnostics sales to continue increasing over the next few years as it launches innovative Diagnostic products. In the Core laboratory diagnostics, Abbott plans to broaden its ARCHITECT assay menu and expand its presence in both developed as well as emerging markets like China, India and Brazil. 
R&D Costs Decline Despite Growth In R&D Centers
Research and development costs declined 16% in the fourth quarter y-o-y, from $460 million in Q4 2012 to $386 million in Q4 2013. This is because of two primary factors: firstly, Abbott is increasingly focusing on making its R&D activities efficient and cost-effective. This means that it is working to reduce its R&D costs as a percentage of sales, thus making new products cheaper to innovate and develop. The company is enjoying the fruits of this exercise as R&D costs as a percentage of sales decreased from over 8% in Q4 2012 to 6.8% in Q4 2013.
Secondly, Abbott is investing in local R&D centers, closer to the markets they cater to. It recently opened an R&D center in China and also initiated plans for a center in Singapore. The company aims to grow its existing R&D resources in emerging markets by more than 30% over the next few years. This should help the company reduce costs by reducing wage costs as well as help develop more locally acceptable products, especially in the nutrition segment.
The Pharmaceutical major aims to stabilize R&D costs as a percentage of sales around 6% for fiscal year 2014. This means that we can expect it to cut R&D costs further in the next few quarters.Notes:
- China Asks Abbott to Recall Some Formula Products, WSJ, August 5, 2013 [↩]
- Vietnam recalls Abbott milk over contamination suspicion, Tuoi Tre News, August 5, 2013 [↩]
- Abbott recalls 9 batches of baby formula in Saudi Arabia, CNTV, August 7, 2013 [↩]
- Abbott Reports Third-Quarter 2013 Results, Abbott Labs, October 16, 2013 [↩]
- Abbott Reports Fourth-Quarter 2013 Results, Abbott Labs, January 22, 2014 [↩]