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Abbott Labs (NYSE:ABT) started 2013 by spinning off its proprietary pharmaceutical business as Abbvie (NYSE:ABBV) on January 1, 2013. With the move, the company began a new life as a healthcare firm whose major offerings include nutritional, diagnostics and vascular products, along with a portfolio of generic drugs. Immediately after the spin-off, its stock was trading at around $32, and rallied to about $38 at the end of the year. We were bullish on the stock throughout the year and our price estimate of $40 has remained almost unchanged for more than two quarters. We expect the company to continue performing well in 2014, as demand from emerging markets is likely to recover from a recent supply disruption. The company’s focus on margin expansion is another factor that should help its performance this year.
Nutritionals And Diagnostics Are Key, Emerging Markets Drive Growth
Nutritionals and Diagnostics together account for over 50% of Abbott’s revenue, and both of these divisions have been reporting solid growth in sales over the past few years due to strong demand from emerging markets. Countries like China, India, Russia and Brazil continue to grow at a faster rate than most developed economies and have a rapidly growing middle class. For example, McKinsey & Company predicts that the urban-household income in China will double by 2022 and that the majority of its urban consumers will earn between $9,000 and $34,000 annually by that time.  As the middle class continues to grow in these markets, people are likely to increase their focus on healthy living and increase their discretionary spending on nutritional products (food supplements) and point-of-care diagnostics.
Recent Issues In China Should Not Be A Big Problem
In Q3 Abbott’s Nutritional sales were negatively impacted by a sales disruption in some emerging markets, including China. The disruption was at least partly due to a voluntary product recall, caused by a contamination scare in some of Abbott’s baby formula products. The impact of this recall is likely to be seen in the next few quarters, but is likely to be transitory because the recalled products were found to be safe for consumption during laboratory tests. The demand for world-renowned baby formula brands remains very strong in the Chinese market and we expect Abbott’s sales to rebound quickly once its supply chain recovers from the shock.
In another story, Abbott was investigated, along with several other multinational baby formula manufacturers, by Chinese regulators for price fixing and was fined almost $12.6 million in August 2013. In response, it dropped prices of its baby formula products by 4-12%, which could pressure margins. China faced a major milk scandal in 2008 when adulterated milk powder caused 53,000 infants to fall sick, out of which around 13,000 babies had to be hospitalized.  Since then, Chinese parents have shown a strong affinity towards trusted brands from multinationals, which should increase demand for Abbott’s products because it is one of the most trusted baby formula brands worldwide (read: How Abbott Could Gain From Cutting Formula Prices In China).
Diagnostics Business Likely To Pick Up The Slack
Even if Abbott’s Nutritional business reports suppressed growth in the near term due to the problems mentioned above, the company should have no problems reporting respectable revenue growth because its Diagnostics business has been performing well. In Q3 the company reported a 4.3% year-on-year increase in operational sales on the back of an impressive 10.5% operational growth in its diagnostics business. Diagnostics sales grew primarily due to strong demand from emerging markets in Molecular Diagnostics as well as the success of Point-of-Care Diagnostics in the U.S. hospital and Physician Office Lab segments. We expect Abbott’s Diagnostics sales to continue increasing over the next few years as it launches innovative Diagnostic products. It is currently developing multiple Diagnostics platforms designed to improve customer service and enhance laboratory productivity. 
Efforts To Improve Product Portfolio In Other Segments
In 2013, Abbott made two important acquisitions to boost its offerings in the Vascular and Medical Optics segments. In the Vascular segment it acquired IDEV Technologies, a stent manufacturing company, for $310 million net of cash and debt. IDEV’s flagship stent, SUPERA Veritas, already sells in Europe for treating blockages in blood vessels due to peripheral artery disease (PAD), a sickness that ails 27 million people in Europe and North America. It is also under FDA review superficial femoral artery (SFA) treatment in the U.S. In the Medical Optics business, Abbott acquired OptiMedica Corporation for about $250 million net of cash. OptiMedica’s flagship product, Catalys, allows surgeons to replace manual steps in cataract surgery with computer-guided laser technology, and provides Abbott an entry point in the large and fast growing laser cataract surgery market. According to Abbott, nearly 22 million surgeries will be performed around the globe in 2013, and this number is likely to increase in the future as the global population gets older. 
Cost Cutting Efforts
Abbott is also doing well in controlling costs despite its expansion plans. The company’s gross margin for Q3 was around 54%, an increase of 1.6% over the same period last year. Similarly, adjusted operating margins improved by 210 basis points due to a sharp decline in SG&A expenses. The increase in margins is a result of Abbott’s continued focus on making its operations more efficient. It has been working on improving production scale and yields, reducing materials costs and improving its product mix. It has also taken some astute cost cutting measures such as building new facilities closer to customers in emerging markets to cut distribution costs. Due to the initiatives mentioned above, we expect Abbott’s margins to continue expanding over the next few years.Notes:
- Mapping China’s middle class, McKinsey & Company, June 2013 [↩]
- China milk scandal: 53,000 children ill from tainted powder, The Telegraph, September 22, 2008 [↩]
- Abbott Reports Third-Quarter 2013 Results, Abbott Labs, October 16, 2013 [↩]
- Abbott to Enter Laser Cataract Surgery Market through Acquisition of OptiMedica, Abbott, July 15, 2013 [↩]