As we mentioned in our previous two articles about TEVA (TEVA) and Akorn (AKRX), one of the few sectors that has the potential to offer returns in 2017, in our opinion, is the pharmaceutical sector. Political claims sent pharma stocks into a tailspin. Both Clinton and elected President Trump repeatedly campaigned that they wanted to lower drug prices. In a recent Time interview, Trump said "I am going to bring down drug prices… I don't like what's happened with drug prices." Do we know how he is going to do that? Obviously not.
Trump says and tweets about a lot of things. It is difficult to speculate about what exactly will happen, but it is well known that politicians attract votes with promises they already know they can't maintain. A recent example is the Brexit campaign where "leave" campaign argued that leaving the EU would provide £350M/week in savings that could be redirected to the NHS. We all know that this was just a political bluff.
The Trump campaign was similar to the Brexit campaign. Full of promises, no details and lots of propagandistic tweets. Despite these uncertainties, Trump's words have negatively impacted pharmaceutical companies' stock prices. The graph below shows that both pharmaceutical companies, even generics (light orange), have fallen 15%-20% since the beginning of the year.
We believe that Trump will make a lot of noise and send a lot of tweets, but won't implement many changes. However, even if these changes materialize, the pharma industry is not a unique blend of firms. Value and opportunities can be found in various sub-segments. In our previous articles, we have explained why we think that generics are unreasonably under attack. Today, we talk about another segment of the pharma industry that has been hammered with little reason: distributors. We will focus on three stocks: Cardinal Health (CAH), McKesson (MCK) and AmerisourceBergen (NYSE:ABC). These stocks have lost between 20% and 30% of their value this year (source: Google Finance).
For two main reasons. First, as we mentioned in our previous articles, demographics are key. Everyone knows that the world population is aging. The following infographic summarizes what is going to happen over the next decades. In U.S. for example the population over 65 is increasing from 19% to 27% of the overall population. Across the world, the share will move from 11 to 22%, or from 750 million people to 2 billion (triple)! Pharma companies are going to benefit from these demographics, I challenge you to find any other business with similar tailwinds.
Second, most of the pharma issues are driven by political turmoil. Politicians argue that pharma companies fix prices and charge too much. However, distributors have operating margins in the range of 1-2%, who can argue that they fix prices and make too much money? Cardinal Health wrote in its latest annual report (page 35): "we operate in markets that are highly competitive. Because of competition, our businesses face continued pricing pressure from our customers and suppliers." This doesn't sound to us like a price where price fixing can easily materialize. If anything, alliances such as Red Oak Sourcing between Cardinal Health and CVS (CVS) have the single aim of negotiating better drug prices for consumers. Hence, we think that distributors will not be scrutinized as much as biotech firms. In a recent interview with Forbes (video here), Cardinal Health CEO talked about the potential changes that could materialize in the healthcare industry:
I do think that we're going to see a more active consumer. I think transparency is likely to increase and I do think that the system is becoming more patient-centered, and I think that's a good thing."
He claimed that the changes ahead of us are "actually good for our business." Truth being said, he does not explain why/how they are good. We do not think that they will be significantly good, but they won't be bad either. In more details, a lot of things can change, and at this stage, it is difficult to predict if there will be any changes, and if so, where will these changes be concentrated. However, as we mentioned above, we like distributors because shares price political issues (they have been sold-off) despite limited impact from potential political issues.
We like to think of drug distributors as the pipelines of the pharma industry. Biotech firms are the explorers. Pipelines make more money when volume increases, and demographics (coupled with potentially more affordable drugs) will increase volume. On the other hand, biotech firms make more money when they discover "oil" and drugs. Notoriously, exploring oil companies are much more sensitive to the price of oil than pipeline owners. Distributors are not 100% immune from drugs' price declines, but they are much more insulated. We like pipelines and distributors for their safety and stability.
Which one to buy?
Three companies are interesting in this space: Cardinal Health, McKesson, and AmerisourceBergen.
CAH operates as a healthcare services and products company worldwide. The company's Pharmaceutical segment (89% of revenues) distributes branded and generic pharmaceutical, OTC healthcare, specialty pharmaceutical, and consumer products to retailers, hospitals, and other healthcare providers. It also offers distribution, inventory management, data reporting, new product launch support, and contract pricing and chargeback administration services to pharmaceutical manufacturers, in addition to several other services to other healthcare providers. This segment also operates nuclear pharmacies and cyclotron facilities that manufacture, prepare, and deliver radiopharmaceuticals, as well as operates direct-to-patient specialty pharmacies. The company's Medical segment (11% of total revenues) distributes a range of medical, surgical, and laboratory products and services to hospitals, ambulatory surgery centers, clinical laboratories, and other healthcare providers, as well as to patients in the home. The U.S. represents 96% of CAH revenues. The company was founded in 1979.
Similarly, MCK operates as a pharmaceutical distribution services and information technology company in the U.S. and internationally. It offers pharmaceuticals and medical supplies, and services for healthcare operations. The company operates in two segments: Distribution Solutions (98% of revenues) and Technology Solutions (2% of revenues). The former segment distributes branded and generic pharmaceutical drugs and other healthcare-related products; and provides practice management, technology, clinical support, and business solutions to community-based oncology and other specialty practices. In addition, this segment operates retail pharmacies in Europe and supports independent pharmacy networks in North America; sells financial, operational, and clinical solutions to pharmacies. The latter segment offers technology solutions to healthcare suppliers. As previously mentioned, this is a minor segment. The U.S. represents 80% of MCK revenues. McKesson was founded in 1833.
Finally, ABC is also a distributor of pharmaceutical products in the U.S. and internationally. ABC Pharmaceutical Distribution segment represents 97% of the company total revenues. It also provides pharmacy management, staffing, and other consulting services; supply management software to retail and institutional healthcare providers; and packaging solutions to various institutional and retail healthcare providers. In addition, this segment provides pharmaceutical distribution and other services primarily to physicians who specialize in various disease states, primarily oncology, as well as to other healthcare providers, including hospitals and dialysis clinics; distributes plasma and other blood products, injectable pharmaceuticals, vaccines, and other specialty products; and offers third party logistics and outcomes research, and other services for biotechnology and other pharmaceutical manufacturers. The company was founded in 1985.
All three companies are discounted based on a cash flow model. Simply Wall St. estimates that the discount ranges from 35% for ABC (left), to 30% for MCK (middle) and 26% for CAH (right).
Based on our own valuation model, we estimate the fair price of the three companies as follows:
ABC: $127/share (38% discount)
MCK: $209/share (33% discount)
CAH: $106/share (32% discount)
Also in terms of EV/EBITDA, valuations are similar (8X for CAH and 7.5X for MCK and ABC). We can see that estimates and discounts are pretty much in line with Simply Wall St. The companies also offer similar level of discounts, so a decision based on valuation cannot really be made with regard to the best stock to buy. So, how about quality?
Let's look at profitability. ROE is robust for all three companies, yet ABC has a considerably higher profitability. ROA is not high but this is due to the nature of the business. Finally, ROC is a good 15/17% for all three companies. Again, it is difficult to differentiate the three companies.
(ABC is on the left, MCK middle, CAH right; graphs provided by Simply Wall st)
However, one metric clearly differentiates the three companies: Operating margin. MCK and ABC have a margin of approximately 1.25%, while CAH has 2.2%. Yet, it is important to note that MCK's margin, over the last few years, has been consistently higher than 1.5%, so this reduction might be temporary. However, despite the fact the absolute difference is minimal, in relative terms it is almost double. Thin margins are never a good thing, but in this type of business they are the norm. CAH has put various efficiency measures and cost control activities that is helping to have better margins compared to its competitors. This might be one of the reasons why CAH trades at a smaller discount compared to its peers.
These companies operate on thin razor margins, so they have to make efficiency their top priority. Analyzing three measures of efficiency we can have a better understanding of these companies: days inventory, days sales outstanding, days payable (source: GuruFocus).
Days sales outstanding
In theory, shorter days of inventory show better operational efficiency; shorter days sales outstanding show a better ability to collect revenues, and longer days payable show that the company can delay paying its suppliers (reducing operating cash). From these metrics, we notice that ABC is the most efficient of the three, while MCK slightly less efficient.
Over the next few years, all three companies will benefit from future technologies to improve their supply chain. These cost savings will provide huge benefits. Labor will be replaced by robots, and trucks will start to be progressively self-driving.
We investigate the level of debt for the three companies. In this metric, ABC (left) has a worryingly high level of debt compared to equity. Yet, it is actually the company with the lowest level of leverage compared to EBITDA. MCK (middle) and CAH (right) have reasonable levels of debt both in relation to equity and EBITDA (graphs provided by Simply Wall st).
These three companies pay dividends. Yet, CAH offers a 2.47% yield, while ABC offers a 1.86% yield and MCK only 0.79%. The three companies also buy back shares. Over the last ten years, ABC reduced its share count by 42%, MCK by 25%, CAH by 19% (source: Google Finance). ABC is definitely the most shareholder friendly, while MCK the least.
The three companies are run by competent managers. We read the latest two annual statements for all three. CAH has a very user friendly annual statement. It is very easy to understand the business and its key factors. Yet, the letter from the CEO is very plain and did not strike us as an insightful one. We also read the 2014 letter, that supposedly had to explain the loss of an important client like Walgreens (WBA), but not much was explained. We find this to be a negative. MCK and ABC letters are a little less clear in terms of business description, and the management discussion is slightly better, but again not convincing.
What we like about these companies is that they generally have a linear growth, in line with the economy and the demographics of the business. According to GuruFocus, over the last 10 years, ABC increased its revenues by 15.7%/year and its operating profits by 7.4%/year. This compares with MCK revenue increase of 11.1%/year and operating profits by 15.4%/year. CAH had a more conservative run with revenues climbing by 5.1% a year and operating profits by 5.9%. For the future, analysts expect a long-term growth rate of the three companies as follows:
In relation to ABC, it is important to note that the 2015 negative earnings are primarily due to almost a $1B of cost associated to Warrants' costs. As of September 2014, ABC became Walgreens' primary distributor of both generic and branded pharmaceuticals. In fiscal 2016, WBA accounted for 30%, or $44 billion, of the ABC's revenue. As part of this deal, ABC granted a large number of Warrants to WBA to acquire ABC stocks at a strike price just above $50/share. Since now ABC stock price is around $80, and WBA exercised its warrants, for a dilution of ABC shareholders. Now WBA owns 25% of ABC shares. The collaboration with WBA has obviously strengthened ABC business, and it looks like the benefits outweigh the costs of the warrant.
The pharma industry experienced a strong selloff this year. The market is pricing in political disruptions. However, distributors should not be affected by potential changes. Today, we have described and analysed three companies that, in our opinion, offer good value. Based on multiple valuation models, ABC, MCK and CAH are discounted by approximately 30%. We have provided several metrics that show that the companies are quite similar. We like the higher margin and future growth potential of CAH. Yet, over the last few years MCK and ABC have offered much better returns. ABC is very shareholder friendly, while MCK seems to be a high-quality company with the right balance. We believe that three strategies are possible, depending on the level of risk that an investor is comfortable with:
- Lower risk/reward: buy all three companies
- Average risk/reward: buy CAH. CAH seems to be the most stable and less volatile of the three, and its margins offer a better protection.
- Higher risk/reward: buy either ABC or MCK.
As always, thank you for reading. If you wish to follow our future articles, just click the " Follow" button next to our name at the top. We would also be interested to know what you think about the pharma industry, and these three particular companies. If you would like us to cover a company, please let us know in the comments. If you are interested to know more about Integer Investments, visit our website www.integerinvestments.com. Thank you for reading!
This article was written by
Disclosure: I am/we are long ABC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.