Article authored by Cristiano Bellavitis, portfolio manager of Integer Investments
At the beginning of 2017 we argued that one of the few sectors that had the potential to offer returns in 2017 was 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 Time interview, Trump said "I am going to bring down drug prices… I don't like what's happened with drug prices." We were skeptical that this would happen and, in fact, Trump policies so far failed, in particular the healthcare reform. Trump says and tweets about a lot of things. It is difficult to speculate what exactly will happen, but it is well known that politicians attract votes with promises they already know they can't maintain.
Despite these uncertainties, Trump's words have negatively impacted pharmaceutical companies' stock prices. We wrote two articles on the pharmaceutical sector. The first one suggested to buy generics' producers, especially Akorn (NASDAQ:AKRX). The company received an acquisition offer and climbed 52% in a few months. Then we recommended readers to look into drug distributors such as Cardinal Health (NYSE: CAH), McKesson (NYSE: MCK) and AmerisourceBergen (NYSE: ABC). We claimed that they were approximately 30% undervalued. We started a position in ABC and, after a 20% price growth, a few days ago we closed our position.
The graph below (source: Google Finance) shows the extraordinary performance of Akorn. Further, it shows that MCK and ABC outperformed the S&P500 by a wide margin, while CAH slightly underperformed. Today we look at these companies again and see whether CAH can catch up with MCK and ABC.
For two main reasons. First, 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 (NYSE: 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 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 (distributors charge a commission based on the dollar value which is influenced by drug prices times volumes). We like pipelines and distributors for their safety and stability.
Which one to buy?
Three companies are interesting in this space: Cardinal Health (NYSE:CAH), McKesson (NYSE:MCK), and AmerisourceBergen. As previously mentioned, CAH is lagging MCK and ABC. Is this a market imperfection or just a reflection of a lower quality business? Truth being said, in our previous article we mentioned that we expected CAH to have more conservative price changes, and this is what happened. So this might just be a reflection of the company's stability.
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 still discounted based on a cash flow model. Simply Wall St. estimates that the discount ranges from 29% for ABC (left), to 32% for MCK (middle) and 32% for CAH (right).
The above model assumes perpetual growth rate of 2.3% in line with GDP growth. It also applies a discount rate of 8.5% calculated though a CAPM.
Based on our own valuation model, we estimate the fair price of the three companies as follows. We apply a discount rate of 7.5%, a long term growth rate below the minimum estimated by Reuters analysts, and use a WACC as supplied by GuruFocus.
- ABC: $105/share (with 4% long term growth rate), current price is $93.6, potential upside 12.2%
- MCK: $145/share (with 3.4% long term growth rate), current price is $165.7, potential downside 12.5%
- CAH: $86/share (with 2.5% long term growth rate), current price is $75.8, potential upside 13.4%
Based on these values, we find that ABC and CAH are still discounted but not by a wide margin as they used to be. Yet, we find contradicting evidence on MCK. The main difference is in the WACC where MCK "suffers" a higher cost of capital, estimated in 8.3%, 2% higher than the competitors. This difference is due to the MCK higher beta of 1.22, which compares with 0.88 for ABC and 0.87 for CAH.
Also in terms of EV/EBITDA 2017, valuations are similar (8.8X for CAH and 8.7X for MCK and 8.9 for ABC). A decision based on valuation would suggest that distributors do not offer significant value at the current prices. Eventually, someone could short MCK and go long ABC and CAH. But what about the quality of these stocks?
Let's look at profitability. ROE is robust for all three companies, yet ABC has a considerably higher ROE of 41% over the last 3 years.
(MCK is on the left, CAH middle, ABC right; graphs provided by Simply Wall st)
Looking at the statistics of the last year, ROE is very high for MCK and ABC (approximately 40%) but still good for CAH (19.8%). ROA is not high but this is due to the nature of the business. CAH offers a slightly higher 4.4%. Finally, ROC is a good 13/18% for all three companies. Again, it is difficult to differentiate the three companies.
However, margins clearly differentiates the three companies (source: 4-traders). Cardinal Health has much higher margins that its competitors. Net margin is 0.9% for MCK and 0.75% for ABC, while it is 1.1% for CAH. Operating margin is 1.3% for ABC, 1.8% for MCK, and 2.16% for CAH.
Despite the fact that these differences might look trivial, in relative terms CAH has much higher margins. 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 are helping to drive better margins compared to its competitors. The screenshot below (source: GuruFocus) shows that CAH managed to increase its operating margins from 2014. However, margins seems to be coming down in recent quarters. This might raise a red flag for the future.
Further, as it can be seen below, CAH is considerably more efficient than the competitors to collect sales and payables (although it could manage its inventory more efficiently). Considering that the business is commoditized, CAH might be under pressure in the future, but for the moment this is a strong positive. It is difficult to say what will happen but we have the impression that CAH margins will come under pressure and this will limit profit growth (as also highlighted by forecasted growth rates).
These companies operate on thin razor margins, so they should 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 CAH 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 (right) 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 (left) and CAH (middle) have reasonable levels of debt both in relation to equity and EBITDA (graphs provided by Simply Wall st). Debt to EBITDA is equal to 1X for CAH, 0.8X for MCK and 0.1 for ABC, all very conservative.
These three companies pay dividends. Yet, CAH offers a 2.51% yield, while ABC offers a 1.6% yield and MCK only 0.69%. 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 (NASDAQ: 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 (source: Reuters):
- ABC: 8.8%
- MCK: 3.59%
- CAH: 4.9%
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 $93, 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 at the end of 2016. The market was pricing in political disruptions. We argued that distributors should not be affected by potential changes and we suggested that ABC, MCK and CAH would outperform. Now after an average performance of 14.3% (8.9% for S&P500), we decided to re-analyze the three companies. We have provided several metrics that show that the companies are quite similar. We like the higher margin of CAH and the future growth potential and shareholder friendliness of ABC.
At current prices we don't see much upside. ABC is still our best pick, while MCK seems to be overvalued. We won't start a position but a potential strategy would be to go long ABC and CAH and short 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. Thank you for reading!
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ABC, CAH over the next 72 hours. 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.
Additional disclosure: We are long CVS, and we might start a short position in MCK.