This Baby May Outdo Its Parent

By Robert Barker

Some orphans are better off without their parents -- corporately speaking, that is. My hunch is this may apply to shares due to spring forth next year from health-care giant Abbott Laboratories (ABT ). The offspring, a new company composed of Abbott's hospital-supply businesses, doesn't even have a name yet.

When it picks one, I won't be surprised if it doesn't recall Abbott's, because that name lately has been mud. In 1999, Abbott settled a Food & Drug Administration action by paying $100 million and agreeing not to sell certain products until it fixed manufacturing problems. Two years later, it flunked a reinspection at a cost of another $129 million and still awaits the FDA's go-ahead. Abbott had to take a $274 million charge in 2001 after settling yet another probe, this one into sales of Lupron, a prostate-cancer drug. And just last June, it charged earnings $622 million after agreeing to plead guilty to obstructing the feds' investigation into how its nutritional products were sold to hospitals and billed to Medicare.

This rap sheet has done nothing to help Abbott shares, near $42 now from a high last year of $58. Yet for the hospital-supply company that Abbott is spinning off, the good news is that all of the units that have been getting into trouble will be left behind with the surviving parent, which is keeping the Abbott name. If all goes according to plan, Abbott shareholders will get 100% of the new company's shares sometime in the first half of 2004.

What will they find in their portfolios? A profitable, relatively low-risk company with sales set to grow at perhaps 5% a year. With estimated annual revenue now of $2.5 billion (table), the new company figures to do a steady business selling such hospital staples as patient-controlled pain-medication-delivery systems, the clot-dissolving drug Abbokinase, and generic anesthetics. Christopher Begley, an Abbott veteran who will be the new company's CEO, told me that after capital spending, it figures to generate $300 million in cash flow.

This would imply a certain market value for the new company, except that a key detail remains blank. Abbott hasn't yet disclosed how much debt it intends to load onto the spin-off. It expects this fall to file papers with the Securities & Exchange Commission that will detail the new company's capital structure. Until then, however, you can estimate some values for the spin-off by looking at how two key public company rivals -- Alaris Medical Systems (AMI ) and Baxter International -- are regarded by investors today.

With sales of $496 million over the past four quarters, Alaris is smaller but faster-growing than the Abbott spin-off. Under a total debt load that's nearly nine times its equity, Alaris is also probably much more leveraged than the spin-off will be. At $17 a share, Alaris' enterprise value -- that is, its market capitalization plus net debt -- comes to 2.9 times sales and 22 times its free cash flow. Baxter, by contrast, is much bigger, with sales of $8.4 billion, and has much less debt -- just 1.6 times equity. At $28 a share, it gets 2.6 times sales and a healthy 33 times free cash flow.

What does this suggest for Abbott and its spin-off? Judging by its direct rivals, the spin-off company should command rich multiples of sales and cash flow. At the same time, without its steady, cash-creating hospital-supply operations, Abbott in the future will be more dependent on iffier sales of patented drugs and medical devices. In other words, the new Abbott will be potentially faster-growing and more profitable, but decidedly riskier.

Once the spin-off is complete, every Abbott shareholder can choose to keep both stocks or sell one or both. David Jones, co-founder and chairman of health insurer Humana (HUM ), is set to lead the spin-off's board. In April, he retired from Abbott's board, where at last report he held the most stock among outside directors. That means he stands to become a huge initial shareholder in the spin-off. Yet Jones doesn't intend to stand pat. He told me, "I plan to buy at least 100,000, or maybe 200,000 shares" in the open market. Without the burden of Abbott's baggage, this spin-off could take off.

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