There Is Little Difference Between These Drug Supplier Stocks

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Includes: ABC, CAH, MCK
by: Chain Breaker

Summary

AmerisourceBergen Corporation, Cardinal Health, Inc. and McKesson Corporation posted returns that doubled the market in 2014.

An analysis of ten financial parameters was completed to identify which of these stocks would be a better investment in 2015.

You are likely to make money owning either of these stocks, but investing in CAH or MCK makes this prospect less risky.

Introduction

The healthcare sector had a great year in 2014, with the Health Care Select Sector SPDR ETF (NYSEARCA:XLV) giving a 25.1% total return. This compares to a 13.5% total return for the SPDR S&P 500 ETF (NYSEARCA:SPY), representing the market as a whole. Among the big pharma and biotech stocks in the healthcare sector are the often overlooked drug distributors. The principle players in this industry are AmerisourceBergen Corporation (NYSE:ABC), Cardinal Health, Inc. (NYSE:CAH) and McKesson Corporation (NYSE:MCK). Table 1 below compares the 2014 total returns for these stocks compared to XLV and SPY. All three performed similarly to the Healthcare ETF (or slightly better) and on average doubled the return of the market.

Table 1: 2014 Total Returns for Drug Supplier Stocks (data compiled from Yahoo! Finance)
ABC CAH MCK XLV SPY
% Change 30.0 23.0 29.3 25.1 13.5

The increasing number of Americans with health insurance thanks to the Affordable Care Act likely had much to do with the outperformance of these stocks. It may also be what propels these stocks to higher prices in 2015. There has also been some deal-making in this space. All three firms have been making strategic acquisitions and striking deals with customers in order to position themselves for success in the future.

For the reasons mentioned above, I have had McKesson on my watch list for a while. However, my portfolio's healthcare allocation was taken up with other stocks. In preparation for a spot that may be opening soon, I wanted to see if McKesson would be the right stock to buy, or if one of its competitors would be a better fit. This article aims to compare the stocks of AmerisourceBergen Corporation , Cardinal Health, Inc. and McKesson Corporation and objectively identify the one that is worth an investment.

Stock Comparison Analysis

To compare these stocks, I set up a screen that evaluated them based on ten financial parameters. I performed a similar analysis to identify Oil & Gas Exploration & Production stocks worthy of in-depth analysis in a previous article. In this current piece, I tabulated the values of the chosen parameters (described in detail below) and calculated the mean value and standard deviation. For each parameter, I gave each stock a number of points based on how it performed relative to the mean value; six points for a value more than one standard deviation better than the mean, three points for a value within one standard deviation of the mean, and 2 points for a value more than one standard deviation poorer than the mean. I limited this analysis to ABC, CAH and MCK since they are the three principle drug wholesalers and distributers in that trade on the market. Financial data was obtained from Finviz after the market close on 15-Jan-2015. The parameters used and values obtained are provided in Table 2 and are described in detail below.

Table 2: Analysis Results

Table 2: Analysis Results

Dividend Yield

All other things being equal, I'd rather own a stock that pays a dividend than one that does not. As stock prices decline, a stock with a sizeable dividend may offer some yield protection on the way down. However, stocks with very high dividend yields are often red flags as the dividend often gets cut or suspended. It is understood that this parameter may favor larger, more mature companies over their smaller, faster-growing counterparts. Both ABC and CAH pay very modest dividends of 1.27% and 1.69%, respectively. MCK pays a paltry dividend of 0.45%. Since ABC and CAH are within one standard deviation of the mean (1.14%), I gave these two stocks three points each. Since MCK's dividend is more than one standard deviation below the mean, I gave this stock only two points.

Forward P/E Multiple

The Forward P/E Multiple is the ratio of the stock's current price to its expected earnings per share for next year. Stocks with low P/E values are considered cheap, while stocks with high P/E values are considered expensive. Buying a stock when it is cheap can make you money if you hold it until it reverts back to a normal multiple, or more if you sell it when it reaches an expensive multiple. Cardinal Health and McKesson sport near-market multiples of 16.9 and 16.7, respectively. AmerisourceBergen is more expensive with a higher multiple of 18.2. With the average value between these three of 17.3, CAH and MCK receive three points each for being within one standard deviation of the mean. ABC's multiple is more than one standard deviation above the mean, so I only give this stock two points for being more expensive.

5-Year PEG

Although Forward P/E can be used as a price tag for stocks, there may be a reason why one stock has a higher multiple than another. Although it may be more expensive, I'd likely pay a higher multiple for a stock that is growing at a higher rate than its peers. Furthermore, a stock with a low Forward P/E may in fact be expensive if it is growing at a slow rate. For these reasons, I like to normalize the Forward P/E by dividing it by the 5-year growth rate estimate. This produces the PEG ratio. Generally speaking, I regard stocks with PEG values under 1.00 as cheap and those above 2.00 as expensive. However, I really use this as a tool to measure relative value when comparing stocks to each other.

AmerisourceBergen and Cardinal Health have similar PEG values of 1.37 and 1.51, respectively. At its current stock price, McKesson can be regarded as cheap with a PEG of 0.97. ABC and CAH receive three points each for their PEG values within one standard deviation of the mean PEG of 1.28. MCK receives six points for a PEG value more than one standard deviation below the mean.

Revenue Growth

Using valuations based on earnings is an acceptable way to compare stocks. However, companies that are able to grow revenues to produce earnings growth are preferable to those that do so with financial engineering. I use revenue growth rate over the past five years to compare the earnings prospects of a stock. A stock with a robust revenue growth rate is less likely to use financial engineering to meet Wall Street's earnings expectations.

The revenue growth rates of these three companies are quite different. Over the past five years, Cardinal Health appears to be bringing in less and less money with a -1.0% growth rate. Over the same period, McKesson increased its revenues by 5.2%. AmerisourceBergen more than doubled this rate with a 10.8% growth rate. Since their revenue growth rates are within one standard deviation of the mean, CAH and MCK receive three points each. ABC only receives two points since its growth rate is more than one standard deviation below the mean.

Gross Margin

Gross margin is the percentage of revenue that remains after the firm pays for the goods sold. One look at the single-digit margins of these three companies and you can tell that the only way you make money in the wholesale drug distribution business is by selling a lot of product. Nevertheless, there does appear to be some differentiation among these three firms. The gross margins of Cardinal Health and McKesson are somewhat similar at 5.8% and 6.3%, respectively. For this, they each receive three points. However, AmerisourceBergen has gross margins of only 2.5%, more than one standard deviation below the mean. For this, ABC receives only two points.

Operating Margin

Operating margin is the percentage of revenue that remains after the company pays out money to run the business in addition to the goods sold. It is a measure of how well management can control expenses. With gross margins so low, there is not much left on a percentage basis to operate the business. However, all three firms manage to maintain similar, positive operating margins. All three stocks get three points.

Net (Profit) Margin

After items such as taxes, interest payments and other items are deducted from operating margins, you are left with net margin (also known as profit margin). A company that is well-run will operate its business in such a way as to minimize these expenses and maximize these margins. The nature of this business results in the razor thin profit margins reported by these three stocks. Since all three stocks have net margins within one standard deviation of the mean, they each receive three points.

Debt/ Equity Ratio

I prefer to own stocks that have little to no debt over those that are highly levered. To normalize the dollar amount a firm may have on the books with the size of the firm, I use the debt/ equity ratio to compare stocks. All three stocks have debt on the balance sheet, but all three have debt/ equity values that are within one standard deviation of the mean. They each receive three points.

Return on Assets

Return on Assets (ROA) is defined as net income expressed as a percentage of total assets. It is a measure of how well a company uses its assets to generate profit. ROA can vary widely between industries, so it is best used to compare a stock versus its prior history or to another stock in its industry. All three firms post single-digit ROA's and are within one standard deviation of the mean, so each stock receives three points.

Return on Equity

Return on Equity (ROE) is defined as net income expressed as a percentage of shareholder's equity. It is a measure of a firm's profitability based on the money shareholders have invested. Like ROA, it is best used to compare stocks in similar industries or as a historical comparison. All three stocks receive three points since they have similar ROA values that are within one standard deviation of the mean.

Results

AmerisourceBergen scored a grand total of 28 points, more than one standard deviation below the mean score of 30.7. The score was impacted by a Forward P/E that was substantially higher than its competitors and gross margins that were substantially lower. ABC did not outperform the others in any parameter of this screen.

Cardinal Health scored 32 points, which was within one standard deviation of the mean. The sub-par 5-year revenue growth was off-set by a better debt/ equity ratio. McKesson also scored 32 points. Its lower dividend yield was offset by its lower PEG ratio compared to the other two stocks.

Although this screen tested these three stocks against ten different financial parameters, it did not identify a clear winner. One way to find a winner using the data already obtained would be to give more weight to the parameters that are most important. For instance, if you deemed the valuation parameters (P/E and PEG) as the most important in this test, you could double the points earned in this section. Recalculating the grand total would identify McKesson as the winner. If you were in no rush to put your money to work, you could also do a deeper dive into CAH and MCK to see which firm has the brighter prospects. A third tie-breaker would be to assess the intrinsic value these stocks and determine which one offers you a deeper discount to fair value. Technical analysis of the stocks on a long and short term basis could also be used to determine which stock is a better buy right now.

With no skin in the game yet, I am going to do some more digging. I'll take a look at the tie-breaking strategies above and see whether CAH or MCK comes out on top. I'll report my findings in a future article. However, if I were already holding either of these three stocks, I would not sell it in favor of one of the others. The fact is these three stocks are quite similar, and an objective analysis bears this out.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.