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Abbott Labs Lacks Diversification

NEW YORK (TheStreet) -- Given that shares of Abbott Labs (ABT - Get Report) are up by more than 10% since the company released its third-quarter earnings report Oct. 16, readers are gleefully reminding me that I didn't give the company much love ahead of the announcement.

It's true that Abbott's lack of revenue growth didn't give me that "warm and fuzzy" feeling about its competitive position against the likes of Roche (RHHBY) and Johnson & Johnson (JNJ). But it was far from a teardown piece. If I may quote myself:

"I believe the only way to justify buying this stock -- even on this recent pullback -- is for management to demonstrate not only better operating balance between the company's four remaining business segments, but Abbott has to show that it can compete more effectively against Johnson & Johnson in areas like medical devices."

I continued:

"Likewise, I believe Abbott can stabilize its stock and inject some confidence if management shores up the company's performance in its Established Pharmaceuticals business, or what the company calls 'branded generics.' If that that segment can show better than 2% growth, it would be an encouraging sign."

I concluded:

"I do see opportunities for Abbott to steal market share in devices and diagnostics. But it may require a strategic acquisition, or possibly two, for Abbott to gain the sort of leverage it needs to execute its global ambitions. While this recent pullback does make the stock appear more attractive, absent better growth and diversification, I'm still not at the point where I want to risk my own money here."

I believe these are compelling arguments, if I do say so myself. Let's also not forget that even with the recent gains in the stock, these shares are down 5% since May. And with Abbott posting (reported) revenue growth of only 2% in the quarter, which missed consensus estimates, I don't believe management fully addressed my operational concerns, many of which have caused this stock to lag behind its peers.

While Abbott did show modest improvements in areas like diagnostics, which grew 8% on a reported basis, I remained stunned at what's become an "unhealthy" situation in the company's Established Pharmaceuticals business, the "branded generics" department I mentioned above. As noted, ahead of the report, I cited better-than-2% growth as cause for optimism. But Abbott went in the other direction. Instead, the Pharma business declined 3% year over year (reported).

Even more discouraging was that Abbott's Nutrition business, the company's largest segment, grew just 2%. It's true that the unfavorable foreign tax rate of 2.3% took a toll on the revenue performance. But even in local currency, nutrition revenue grew less than 1%, which paled in comparison to the 6% growth posted in the July quarter.

That said, there were some encouraging operational signs. Gross margin expanded by roughly 0.6%, enough to beat consensus estimates and suggesting not only that recent investments in the nutrition business have been beneficial, but more importantly, that management's goals of achieving 20% operating margin over the next two years remains on track. This operational improvement, which included growth of 2 percentage points in operating margin, led to a 12% climb in operating income.

In that regard, it does appear as if Abbott's international expansion plans in emerging markets are beginning to work, given that every global market outperformed Abbott's U.S. revenue by a meaningful margin. So while overall growth was broadly unimpressive, as with Johnson & Johnson, Abbott is still raking in the profits, which -- I believe -- was the primary catalyst to the recent surge in the stock.

However, there are still plenty of concerns that management needs to address. Yes, it's encouraging that growth in emerging markets has started to pick up. I will also grant that achieving 20% operating margin by 2015 now looks doable. But I'm still concerned about the reliance on the nutrition business, which seems to be where management's focus remains. To that end, I'm willing to give management more time to execute. But it's not time for investors to get comfortable.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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