By Matthew Coffina, CFA
AmerisourceBergen (NYSE:ABC) offers terrific consistency. The company felt few ill effects from health reform, the recession, the financial crisis, or the shift to the fee-for-service business model. We continue to prefer the management team over those of AmerisourceBergen's principal competitors; the new CEO seems likely to stay the course on the company's winning strategy. However, AmerisourceBergen's economic moat is gradually being eroded by consolidating customers and suppliers, even in the fragmented specialty distribution business. And as the generics wave reaches its denouement, an important tailwind to the firm's margins could turn into a headwind.
Since the 2001 merger of AmeriSource Health and Bergen Brunswig, investors could hardly have hoped for a better result in the low-margin, mature drug distribution business. Despite everything that has happened in the past 10 years--including health reform, the financial crisis, and the transition away from the inventory-hold model toward fee for service--AmerisourceBergen has consistently increased revenue, expanded margins, and returned cash to shareholders. GAAP earnings per share have compounded at a 17% annual rate during the past 10 years and a 19% rate during the past five years. The stock has returned 10% per year during this time, handily beating McKesson (NYSE:MCK) (8% annual return), Cardinal Health (NYSE:CAH) (negative 1%), and the S&P 500 (3%).
AmerisourceBergen targets 15% long-run EPS growth through a combination of market-level (mid-single-digit) revenue growth, operating margin expansion (in the high-single- to low-double-digit basis point range), and share repurchases. We think this target is optimistic, but believe that annual EPS growth closer to 12% is attainable during the next five years. While our enthusiasm is mitigated somewhat by the challenges described below, we continue to see AmerisourceBergen as a worthwhile investment for conservative investors seeking stability and earnings growth.
Steven Collis took over as CEO in July, ending the 14-year tenure of David Yost. Since then we had been mildly concerned about the possibility of a change in the company's strategic direction. AmerisourceBergen has announced three small acquisitions since Collis took over, and there was commentary on the last conference call that seemed to indicate a willingness to do larger deals and perhaps expand internationally.
We have viewed AmerisourceBergen's historical focus on North American drug distribution as a strength. In contrast, McKesson and Cardinal have pursued growth outside their core expertise, with minimal apparent benefit. For example, McKesson's health IT business may be falling behind younger, more innovative competitors, and Cardinal will probably experience few synergies from its expansion into China.
However, we were reassured by the tone during AmerisourceBergen's investor day and see few signs that a major strategic repositioning is imminent. Besides being small, the three recent acquisitions were in complementary consulting businesses with significant cross-selling potential to AmerisourceBergen's pharmaceutical manufacturer clients. International growth is likely to be deliberate, targeting small acquisitions that have the potential for internal growth and synergies with the U.S. business, along the lines of the company's Canadian expansion.
On the negative side, we believe AmerisourceBergen's economic moat is weakening over time. It seems likely that moat erosion will occur slowly over a period of years, and the firm does remain better positioned than its peers because of customer mix. The key to a worthwhile independent distribution business is relatively small customers and suppliers--distributors can create tremendous efficiencies by, for example, minimizing the number of interactions that occur throughout the supply chain, scaling infrastructure, and sharing inventories across customers.
We believe the structure of the pharmaceutical market remains conducive to successful distributors, which is why all three distributors carry our narrow economic moat rating. AmerisourceBergen takes shipments from 1,500 domestic drug manufacturers and makes deliveries to thousands of pharmacies. According to a study cited by management, replacing distributors with a direct manufacturer-to-pharmacy model would increase systemwide costs by $41 billion. Management also said it has never faced fewer questions about the need for distributors.
While competitive advantages are likely to persist for years, we still see AmerisourceBergen's moat as declining. On one side, distributors risk having their economic profits eroded by consolidating customers. Walgreen (WAG), CVS Caremark (NYSE:CVS), Wal-Mart Stores (NYSE:WMT), and other national chains, as well as mail-order pharmacies owned by pharmacy benefit managers, continue to gain market share from independent and small-chain pharmacies, which are among distributors' most profitable customers. On the other side, generic and brand-name pharmaceutical manufacturers are also consolidating, primarily through mergers and acquisitions. Upstream and downstream consolidation heightens the risk of disintermediation and reduces the distributors' bargaining power. Among the big three distributors, pricing is normally the top consideration in winning contracts, particularly for the largest accounts.
Customer consolidation is even a concern in the generally more fragmented specialty drug distribution business. James Frary, president of AmerisourceBergen Specialty Group, said 315 oncology practices have been acquired by hospitals since late 2007, a trend he called "alarming." While AmerisourceBergen may continue to service these oncologists, the economics are unlikely to be as favorable to the distributor.
Another issue is that the long-awaited peak of the generics wave arrives in AmerisourceBergen's fiscal 2012. The company estimates that drugs representing $39.2 billion in annual sales will lose patent protection this year, including such blockbusters as Zyprexa, Lipitor, Plavix, Seroquel, Singulair, and Actos. New generic launches will remain fairly strong in 2013 and 2014, but after that will trail off markedly for the rest of the decade.
The generics wave has been a major tailwind to margins in the pharmaceutical supply chain during the past several years, which has facilitated AmerisourceBergen's impressive earnings growth. However, this boon won't last forever. While gross profit dollars on generics are much higher than those for branded drugs during the initial exclusivity period, the advantage erodes quickly after that time. So far this headwind has been masked by a constant supply of new and larger generic launches, but comparisons will become increasingly difficult in the coming years.
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