“What everyone knows is usually unhelpful at best and wrong at worst.”
“Experience is what you got when you didn’t get what you wanted.”
In preparation of writing this series, I was reminded of the above wonderful quotes from the great Howard Marks (Trades, Portfolio). My three-year-long humbling experiences with the U.S. pharmaceutical distributors have proved the validity of Marks’ wisdom. I’m glad I wrote down my original thesis in 2015 when I presented the ideas to my previous employer. It’s always fun to look back and have a laugh at my inanities, but this one sure is a doozy.
What follows is what I knew a few years back. Most of what I knew are what Marks would call “what everyone knows” and, boy, indeed they are unhelpful at best and wrong at worst.
Below are excerpts from my notes in early 2016:
The American pharmaceutical distribution industry, after many years of consolidation, has come to be dominated by the “Big Three” players – AmerisourceBergen (ABC, Financial), Cardinal Health (CAH, Financial) and McKesson (MCK, Financial). Each of the “Beg Three” possesses enormous scale as a result.
There were a few secular tailwinds that serve as the long-term growth drivers for them.
- Demographics – the aging of population. The number of Americans aged 65 or plus is projected to increase from 45 million today to 70 million in 2030 – a compound annual growth rate of 3% a year.
- Population growth and expansion of coverage – American’s population grows at about 0.8% a year, about 0.3% from natural birth and 0.5% from immigration. Furthermore, more coverage means more drug prescriptions. While it’s hard to calculate an exact percentage, every 1 million expansion translates into about 0.3% growth.
- International expansion – All “Big Three” players have expanded internationally, but with different geographic exposures. In terms of emerging markets, AmerisourceBergen has more exposure in Latin America, whereas Cardinal Health has more exposure in China (Note,: Cardinal health has sold their China business to Shanghai Pharma).
- Global generic sourcing – Again, all “Big Three” players have established joint ventures or partnerships with a sourcing partner – AmerisourceBergen with Walgreens (WBA, Financial), McKesson with Rite Aid (RAD, Financial) and Celesio (XTER:CLS1, Financial) and Cardinal with CVS Health (CVS, Financial) (Red Oak joint venture). Each of them has identified the strategic opportunity to drive down product costs by aligning closely with other large pharmaceutical purchasers to increase buying power. These early-stage relationships are drivers of margin expansion for several years.
- Deflation protection – The “Big Three” buy inventory from the manufacturers and take ownership. They then mark it up (although the markup is heavily influenced by manufactures) to the customers. However, their contracts protect them from deflations – the manufacturers take on the risk of deflations themselves.
- Expanded services – all three have come out with more integrated service, technology and consulting solutions that make their services more valuable.
- Specialty drug growth – this segment grows faster than the generic drug segment. AmerisourceBergen has the most exposure to this faster growing segment.
- Medical and surgical devices – Cardinal and McKesson also participate in this fast-growing segment, although with different exposures.
There were also a few widely known issues with the “Big Three” distributors. For instance:
- Customer dependence - All three of them are heavily dependent on their largest customers, which can account for more than 20% of revenue. All three of them have lost a big customer due to customer consolidation or contract expiration. Cardinal lost Express Scripts (ESRX, Financial), AmerisourceBergen lost Longs Drugs and McKesson’s potential loss of Rite Aid were all significant revenue draggers. However, as the customer base has consolidated to a level that further consolidation remains very limited, the risk of large customer loss due to mergers has mitigated.
- Generic inflation - One of the concerns in 2015 and early 2016 was the moderation of generic inflation. Generic inflation benefited the “Big Three” leading up to 2015, but then moderated. It seems AmerisourceBergen and Cardinal were more conservative in terms of purchasing inventory upfront and waiting for price increases to kick in. McKesson has been more aggressive in advanced purchasing of inventory, which led to the lowering of guidance due to weaker-than-expected generic inflation in 2015.
So, to me, back in late 2015 and early 2016, it seemed there were a lot of tailwinds going for the “Big 3,” while there were a few seemingly near-term headwinds.
The problem was, again to quote Marks, “What everyone knows is usually unhelpful at best and wrong at worst.”
All of the above information – tailwinds and issues, is what I call first-level information. Everybody who should know it, knows it. Most of it isn’t wrong, it’s just unhelpful.
Also based on the above information, I pitched McKesson in March 2016 with an average cost of about $153 a share and AmerisourceBergen in May of 2016 with an average cost of about $78 a share. When McKesson and AmerisourceBergan sank on the news of a pricing war in October 2016, we were lucky to average down. We didn't lose any money, but things have definitley not turned out the way I thought they would.
Looking back, I would say we bought McKesson based on first-level information and first-level thinking. But because I obviously didn’t get what I wanted, I went in a little deeper to explore what I didn’t know, which led to the raw materials of the rest of this article series.
