McKesson Corp. (MCK, Financial) is the dominant company in the pharmaceutical supply industry by revenue and is the main supplier to both CVS Health (CVS, Financial) and Walmart (WMT, Financial). Yet, with Amazon.com Inc. (AMZN, Financial) looking to disrupt the industry and be a big supplier to hospitals, everyone is scared, and for good reason.
Fees, administration, marketing and shipping costs account for up to 30% of health-care supply costs, according to Citigroup Global Markets data. Areas where Amazon is highly proficient.
The e-commerce giant is currently testing a program with a Midwestern hospital system that is using Amazon Business to order medical supplies for its approximately 150 outpatient facilities. The country’s leading online retailer already sells a small amount of medical supplies, but wants to turn the business portal into an online store where hospitals can purchase medical equipment and supplies for its outpatient clinics, operating rooms and emergency rooms.
This may be a good thing for the industry as a whole, but consumers buy differently than businesses. Companies like McKesson and Cardinal Health (CAH, Financial) should worry greatly about the competition from Amazon. If it can lower the costs of similar products, that will most certainly cut into the profits they currently enjoy, but maybe it should. The costs industry wide have ballooned to obscene levels. So much so that Amazon, JPMorgan (JPM, Financial) and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) are creating internal services to combat the costs for their employees.
McKesson has seen its revenue double and its profit rise by five times since 2008. Plus, it is only spending 12% of net income on capital expenditures with zero costs from innovation. If they are going to compete with Amazon, then they will likely need to spend money to build a better platform. The jury is still out on whether that will be necessary or not. Amazon is already juggling so many business segments with razor-thin margins that trying to enter a new one seems like a bad decision.
According to Centers for Medicare and Medicaid Services, the estimated total amount of retail pharmaceutical spending in the United States alone is close to $400 billion. The majority of this spending flows through three companies - AmerisourceBergen (ABC, Financial), Cardinal Health and McKesson - with a combined market share north of 90%. However, gross margins hover around 5% and each of these companies had to build to scale before booking the massive profits currently enjoyed.
10-year financial comparison
Amazon
Revenue: $771 Billion
Income: $9.3 Billion
Dividends: $0.00
Forward price-earnings: 95 times
McKesson
Revenue: $1.37 Trillion
Income: $17 Billion
Dividends: $7.60
Forward price-earnings: 11 times
Amazon is the better all around business, no doubt about that, but the price you pay for the stock makes it necessary for it to achieve the 10 times growth trajectory in the next 10 years. As THE darling of Wall Street, traders, money managers and individual investors (even millennials) are overpaying today for the expectation of massive future success. In fact, Amazon is priced like investors think it will be the trillion-dollar company.
For McKesson, there is a margin of safety built in. The company is the undisputed leader in its industry and is already trading at a lower multiple than its five-year average. Even if profits do fall because of increased competition (not likely), the price investors pay today would protect them long term. I do not know if that’s the case with Amazon, which needs to continue growing at breakneck speed. That’s not to say that it cannot or will not, just that entering the medical supply industry presents a greater risk to doing so.
Amazon’s stock trades at $1,460 and has a market capitalization of $704 billion. McKesson trades at $148 with a $31 billion market cap. If Amazon becomes a top player in this industry, will that translate into higher valuations for its medical supply segment than the current industry leaders? I am not so sure, but I would rather pay 11 times earnings for consistent earnings power than 95 times earnings for potential earnings growth.
Disclosure: I am not long or short any stocks mentioned in this article.
