It has been a grim few years for the three giants that move the vast majority of prescription drugs from factories to U.S. pharmacy counters.
Investors have halved the share prices of two of them, McKesson (MCK) and Cardinal Health (CAH), since June 2015; AmerisourceBergen ’s (ABC) is down a third. The companies face declining prices for generic drugs, hundreds of lawsuits accusing them of liability in the opioid crisis, and proposals out of Washington that some worry could upset their business models.
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But for long-term investors who can stomach the risks, there is an opportunity in this complex, little-understood corner of the health-care industry.
With so much going wrong, the companies are trading at steep discounts to the broader S&P 500 index (.SPX) and well below their historical averages.
McKesson, at a recent $134.84, and Cardinal, at $45.27, are both priced near nine times estimated 2019 earnings, down roughly a third from their five-year averages of 13 and 14 times estimated earnings, respectively. AmerisourceBergen, at a recent $86.44, is priced at 12 times estimated earnings, down 20% from its five-year average of 15. “We just think that the reaction has been overdone,” says Charles Rhyee, a Cowen analyst who has Outperform ratings on McKesson and AmerisourceBergen, and Market Perform for Cardinal.
While these companies face challenges, they remain essential to the drugmakers and pharmacies they serve. Indeed, they effectively have a triopoly, and their dominance is only increasing: Together, they accounted for 94% of the U.S. drug-distribution market in 2018, up from 87% in 2012, according to the Drug Channels Institute, an industry research group. And while their net margins are thin, they enjoy consistent profits.
The business of the drug distributors is complicated even by health-care industry standards. At its core, it is a logistics business aimed at quickly moving drugs to pharmacies across the country. McKesson alone has 30 distribution centers in the U.S., plus two redistribution centers and a repackaging facility. That complexity creates a moat against potential upstarts.
“How easy is it to set yourself up to be a distributor of level-three narcotics on a national scale?” asks Tony Scherrer, director of research at Smead Capital Management, which has invested 2.1% of its portfolio in AmerisourceBergen. “The answer is, it is very complex.”
Deepening the moat are the companies’ narrow net margins, which average just 1% for Cardinal and McKesson over the past five years, and 0.5% for AmerisourceBergen. Those margins are tied to the unusual way the sector operates.
Unlike most other logistics providers, drug distributors actually take ownership of the drugs in their custody. In the case of name-brand drugs, that means the companies buy drugs from manufacturers at a percentage discount off the list price, tying their profits to the list price of the drug. They then resell the drugs to their customers at the list price. Generic sales work differently, but in those cases, too, the distributors’ profits are tied to the price of the drugs they’re moving.
That dynamic has not gone unnoticed by regulators and other officials looking to cut drug prices. As a result, some industry experts expect that the companies will end up severing the link between their fees and the list prices, and shift to a per-unit model. That might be welcomed by investors.
“Their balance sheets would be lighter, and their profits would be more constrained and predictable,” Adam Fein, CEO of the Drug Channels Institute, wrote in an email, echoing comments in a blog post he penned last year. “Essentially, they would evolve into stable, consistently profitable utilities for the U.S. drug-distribution system.”
Some executives have signaled openness to such a change. At a conference hosted by investment bank Barclays in March, an analyst put the question to Cardinal Chief Financial Officer Jorge Gomez and AmerisourceBergen CEO Steven Collis.
Gomez said that, as long as his company is paid, he doesn’t mind how the fee is calculated. “There is a service we provide; there is a dollar amount that is linked to that service,” Gomez said. “How you express that dollar amount—as a rate, as a flat fee, or any other mechanism that the industry could come up with—[we are] somewhat agnostic to that.”
Collis, however, rejected a wholesale change in how the fees are calculated. “It’s important to us that our fees are denominated based on the revenues that we generate,” he said. “We think, in the long run, that’s going to be the most resilient economic model for us.”
McKesson didn’t attend the Barclays conference, but in an email to Barron’s, its CFO, Britt Vitalone, wrote that the company had already shifted its compensation to be more fixed than it was in the past. “Regardless of where the pricing model lands, our objective is to be paid a fair value for the services we perform,” Vitalone wrote.
Which of the three is the better bet? All pay dividends: Cardinal has a dividend yield of 4.3%; McKesson, 1.2%; and AmerisourceBergen, 1.9%. One thing to consider is their partners. AmerisourceBergen is closely linked to Walgreens Boots Alliance (WBA), which has a major stake in the distributor and was in since-aborted talks last year to acquire it outright. The companies cooperate on generic-drug sourcing. Cardinal has a similar relationship, minus the ownership stake, with CVS Health (CVS), as does McKesson with Walmart (WMT).
Much of the differentiation is tied to the ancillary businesses that each company pursues in addition to its core drug-distribution operations. Cardinal has been dragged down by its medical segment, which sells medical, surgical, and laboratory products, and was facing significant challenges. And AmerisourceBergen has been troubled by problems at PharMEDium, a drug compounder.
Yet, while their growth prospects are not what they used to be, all three companies generate a healthy amount of cash and will arguably play an important role however health care changes. And it won’t take much improvement for investors to see a return on stocks this cheap.
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