The Industry
Pharmaceutical distribution is the wholesaler/middleman link in the drug distribution chain. These companies buy meds directly from the big suppliers like Pfizer (PFE) and Merck (MCK), warehouse them, and then distribute them to the tens of thousands of pharmacies throughout the United States.
The industry has its attractive points. First, it is largely shielded from economic cycles. Drugs are in many cases non-discretionary for those that need them, and the distributors are not subject to the price and patent risk that branded drug developers are. Also, it's a natural oligarchy. Profit margins are meager, barely above 1%, and has high barriers to entry due to the distribution networks and customer/supplier relationships required. It is unlikely that anybody new is willing to commit that kind of time and capital for those operating margins! Due to these facts, there are only three players that control 75% of the nation's drug distribution, and they are all current Magic Formula stocks: Cardinal Health (CAH), McKesson (MCK), and AmerisourceBergen (ABC). This limited competition serves to keep pricing rational as well, all but eliminating the risk of a price war.
The downside to the industry are the prevailing trends. Distribution services are most advantageous to small pharmacies that cannot reasonably deal directly with dozens of suppliers, and would have no bargaining power even if they could. However, patient sales are increasingly moving towards the large national pharmacies like CVS (CVS) and Walgreen (WAG) and the prescription-by-mail benefits managers like Medco (MHS) and Express Scripts (ESRX). These guys have little need for distribution services, as they are plenty large enough to handle negotiations with drug suppliers and already have distribution networks to individual locations. Less of a problem is the ongoing consolidation on the supplier side, as deals like Pfizer-Wyeth and Merck-Schering create larger sellers less anxious to give price concessions.
The Statistics
Let's compare the 3 competitors by some valuation, efficiency, and financial health metrics:
| Stock | Enterprise Value | Earnings Yield | Return on Equity | Dividend |
|---|---|---|---|---|
| CAH | 12.0B | 15.71% | 13.88% | 2.40% |
| MCK | 15.4B | 11.52% | 14.00% | 0.80% |
| ABC | 6.9B | 15.64% | 18.04% | 1.00% |
The Rankings
Which stock looks like the most attractive MFI investment? The statistics are relatively close for all 3 stocks. All 3 have similar profiles for debt as well. The statistics don't show a clear winner. So, we need to dig a little bit into business prospects. The following are MagicDiligence's ranking of the three stocks in order of increasing attractiveness based on assumed business prospects:
3. Cardinal (CAH)
Although the cheapest of the three and paying the best dividend, Cardinal also has the least attractive profile going forward. The bulk of Cardinal's business is to big customers like CVS and Walgreen (45%), and an increasing amount of business is coming from bulk sales to the drug-by-mail providers. The problem with this is that bulk sales generate margins below 0.5%, not where you want to be. Cardinal's customer base is just not that attractive, and the company has no other businesses to fall back on after it spun off CareFusion (CFN).
2. McKesson (MCK)
McKesson has similar problems, with nearly 30% of business coming from CVS and Rite Aid (RAD - a misnomer). There are two concerns with this. One, McKesson's CVS business comes from a legacy contract with since-acquired Caremark, and CVS could decide to consolidate under its legacy supplier, Cardinal. Second, Rite Aid has been losing ground to its competitors for years and is by far the weakest national chain, possibly facing bankruptcy. On the other hand, McKesson also has an attractive medical software business, a sweet spot in the discussion over health care reform. This segment had good growth prospects, higher margins, and has decent moat potential stemming from high switching costs.
1. AmerisourceBergen (ABC)
AmerisourceBergen benefits from having a cheaper valuation than McKesson and a better customer profile than either competitor. No two customers account for more than 20% of sales, meaning AmerisourceBergen has an attractive roster of small pharmacies that truly need its services. Bergen also is the most efficient of the three, focusing solely on its distribution business and growing share through acquisitions. Returns on equity and capital exceed those of the other two.
In all, this looks like a decent place to look for a new MFI position. Any of the three is a fair choice, and depending on your goals, one may be more attractive than the other (Cardinal, for example, might appeal to dividend investors).
Disclosure: Steve owns PFE
Steve Alexander
[www.magicdiligence.com]
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User Comments:
1. Kkissinger says on Oct 29, 2009 at 1:08 PM:
I think your analysis is spot on with two exceptions; one is the strength of McKesson's management: Hammergren and Co. are outstanding. The other is the HCIT business that McKesson has. Theirs is the broadest footprint in the industry and their $3+ Billion IT business is achieving 12-14% in net income. The promise of HC Reform will be long in being realized to be sure as providers lack the skills and resources to implement whatever "meaningful use" will ultimately be defined as, but McKesson is well positioned to help with implementation whenever the curve starts to turn.
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