A severe case of rampant generic drug deflation continues to hamper the share prices of Cardinal Health and AmerisourceBergen. We are monitoring the drug deflation numbers posted by the drug wholesalers as a key gauge of the investment merits of the group.
By Alexander J. Poulos
Key Takeaways
Our interest in the drug-distribution industry centers on the group’s highly-predictive revenue model and the strong competitive positions of many underlying participants, emanating from their difficult-to-replicate distribution networks. The drug distribution industry is currently an oligopoly with McKesson, Cardinal Health and AmerisourceBergen controlling over 90% of the business.
Generic drug price deflation continues to have a noticeable impact on the drug distribution industry as witnessed by the poor performance during the past two years of the industry heavyweights comprising of McKesson, AmerisourceBergen and Cardinal Health. AmerisourceBergen, for example, is expecting generic drug price deflation of 7%-9% during fiscal 2018.
AmerisourceBergen expects its top line to grow at an 8%-11% clip in fiscal 2018, but the increase in expenses and the deflationary wholesale trend nets out the expectation to arrive at guidance for flat operating-income performance during fiscal 2018 versus 2017. Operating cash flow trends during the first six months of its fiscal 2018 have been quite disappointing, raising concerns that its adjusted free cash flow targets might not be achieved.
Cardinal is selling more, but it is earning progressively less on every sales dollar, as segment profit margins in the drug distribution segment declined to 2% in its most recently-completed fiscal third-quarter 2018 results versus 2.15% in the comparable period last year. Small changes in margins have a big impact on profits given the earnings leverage within the distributor business model.
Looking ahead, Cardinal reduced its adjusted non-GAAP earnings per share outlook for fiscal 2018 to the range of $4.85-$4.95 from $5.25-$5.50 and noted that fiscal 2019 will be more challenging than previously expected, pointing to pressures at Cordis, customer repricing, the loss of PharMerica and ongoing deflation in generic pricing.
We love the competitive advantages of many operators within the drug-distribution industry, but we are not interested in adding exposure at this time. We would need to see an abatement of the deflationary trend in generics, and we’d also like to see better share-pricing performance, as the latter would indicate greater market support for the respective equities and further conviction that fair equity values are greater than where share prices are currently resting.
Shares of McKesson, Cardinal Health and AmerisourceBergen yield 0.9%, 3.5%, and 1.65%, respectively.
Drug Deflation is Not Abating
A deflationary spiral is one of the worst business conditions as the lack of pricing power erodes profitability even with a subsequent increase in volume. Deflation continues to have a noticeable impact on the drug distribution industry as witnessed by the poor performance during the past two years of the industry heavyweights, comprising of McKesson (MCK), AmerisourceBergen (ABC) and Cardinal Health (CAH). Share prices in the industry group peaked in 2015, but they have severely underperformed the raging bull market—an anomaly which we directly attribute in part to the deflationary forces affecting the industry.
The pharmacy industry spearheaded by CVS Health (CVS) and Walgreens (WBA) also have exhibited the same weakening characteristics, with peak share prices in 2015 followed by a slow steady slog lower. We do not believe the poor relative and absolute performance of these two industries can be blamed entirely on the threat of Amazon (AMZN) entering the field, though the hefty prices paid for acquisitive actions following the announcement could have added more pressure. Instead, the often-overlooked primary reason may be poor pricing conditions, particularly with respect to generic drugs.
Yet, hope springs eternal with the often-hyped, yet difficult-to-pinpoint “green shoots,” which many had thought had been formed in the prior quarter, with a moderation in the deflationary trend. The thesis heading into the recent earnings confessional was that the pace of drug deflation would ease, helping to firm up the top line and augment segment profitability at many participants. While the wholesaler industry has tried to diversify its product offerings, a large component of profitability comes from drug distribution with the most profitable segment being the generic drug component.
Latest Performance at AmerisourceBergen and Cardinal Health
AmerisourceBergen stepped up to the earnings confessional May 2, with a rather dismal fiscal second-quarter 2018 report. Deflationary trends continue to offset robust revenue expansion, which came in at 10%+ in the quarter thanks in large part to a customer, Walgreens, adding 1,932 Rite Aid stores via a recently-completed acquisition. The all-important pharmacy distribution segment (over 95% of total revenue) posted operating income of $489 million during the recently-completed March 2018 quarter versus $485 million in the comparable quarter in 2017, reflecting only a slight increase, despite double-digit segment top-line expansion in the period. Consolidated firmwide adjusted operating income decreased 0.4% from last year’s quarter.
AmerisourceBergen issued 2018 guidance that factors in a 7%-9% generic price deflation (-7 percent to -9 percent). The company expects its top line to grow at an 8%-11% clip during the year, but the anticipated 8%-10% increase in expenses coupled with deflationary trends across generics largely nets out expectations for operating-income expansion, with the company expecting adjusting operating income to be flat in 2018 relative to the prior year. Adjusted diluted per share is expected at the lower end of the range of $6.45-$6.65 for fiscal 2018, and while free cash flow is expected to be robust at $1.35-$1.6 billion for the fiscal year, underlying trends could be better (operating cash flow has been negative during the first six months of the fiscal year). Its cash stood at $2.1 billion at the end of its fiscal second-quarter of 2018, but net debt stood at $2.2 billion.
The picture may be even more bleak at Cardinal Health as evidenced by the reaction to its fiscal third-quarter 2018 earnings, released May 3. Cardinal’s all-important distribution segment (roughly 90% of revenue) posted a decent jump in revenue of 5% over the comparable period in 2017, but the deflation bugaboo with respect to generics destroyed margins as segment profit declined to $596 million versus $611 million in the prior-year period. Cardinal is selling more, but it is earning progressively less on every sales dollar, as segment profit margins declined to 2% versus 2.15% in the comparable period. During its fiscal third-quarter 2018, consolidated non-GAAP operating earnings advanced ~3%, while non-GAAP adjusted earnings per share declined ~9%, mostly due to a higher tax rate. Though Cardinal ended its fiscal third quarter with $2.2 billion in cash, its net debt position stood at a hefty $7.4 billion.
Looking ahead, Cardinal reduced its adjusted non-GAAP earnings per share outlook for fiscal 2018 to the range of $4.85-$4.95 from $5.25-$5.50, reflecting its updated thoughts on the performance of Cordis, which it acquired in calendar 2015, and a higher-than-expected tax rate for the year. Despite the negative earnings revision and hefty net debt position, Cardinal still raised its quarter dividend 3% May 9, perhaps hoping the market may overlook deteriorating underlying trends in favor of an increased payout. On its conference call following its fiscal third-quarter report, the company noted that fiscal 2019 will be more challenging than it originally expected, pointing to unexpected headwinds from Cordis, “customer repricing, the loss of PharMerica and continued generic deflation.”
Attempts to Diversify the Business
The low profit margins endemic in the wholesale drug distribution business have led to a move to diversify the core business into adjacent higher-margin lines of operations to raise the overall profit margin of the parent company. We applaud the move on the part of both AmerisourceBergen and Cardinal Health, but we feel that until the deflationary spiral abates both are “swimming upstream.”
Cardinal is further along in its diversification, with a tad over 10% of overall revenue emanating from the Medical Segment business, which houses an eclectic mix of higher-margin niche businesses that are often complementary to the core wholesale business. The Medical Segment business, for example, posted a jump of 15% in revenue to $3.916 billion during the company’s most recently-completed fiscal third-quarter results thanks in large part to the acquisition of the Patient Recovery line of business. Segment profit margin clocked in at 5.09% versus 4.34% for a delta of 75 basis points, translating into 34% growth in segment profit. Thus far, all seems well in this division, but it remains small, even if the acquisition spree undertaken by the former CEO at Cardinal to bring in new lines of business seems to be performing as expected.
That said, however, when we drill down further, some notable red flags emerge, most notably in Cardinal’s Cordis business line, which derives over 70% of its sales overseas. Cardinal is primarily a domestic company, so the company may have overreached a bit in acquiring a business that does not have great overlap with your existing lines of business. Cordis was a division of Johnson & Johnson (JNJ) which has extensive experience in overseas markets, and we find it notable that J&J was looking to divest the business, even though it has a world-class line of surgical supplies. Issues with stocking and inventory levels bedeviled Cordis, and the division recently had a change at the top, a direct result, in our view, of a number of notable setbacks. The new management team has made direct promises it will fix the issues, but we remain skeptical.
The “diversification story” is a similar one at AmerisourceBergen, but from a smaller base as the non-distribution segment accounts for nearly 4% of overall sales headlined by MWI Animal Health. Though revenue performance advanced nicely in its non-distribution segment during the fiscal second quarter (up 12.6%), year over year profit comparisons were not favorable due to the quality control issues that continue to plague PharMEDium—a division that compounds medications. Operating income at AmeriSourceBergen’s non-distribution segment during its fiscal second quarter fell more than 6%.
Our Interest in the Industry
Our interest in the drug-distribution industry centers on the highly-predictive revenue model and the strong competitive positions of underlying participants, emanating from their difficult-to-replicate distribution networks. The drug distribution industry is currently an oligopoly with McKesson, Cardinal Health and AmerisourceBergen controlling over 90% of the business in the industry. Share prices across the industry sold off during the summer of 2017 upon reports of Amazon mulling an entry into the space, which has yet to occur if ever. We believe the threat of Amazon is a credible one, however, but the cost to build out a network to rival the other three is prohibitive at this time. Amazon may be better served building out a network to bring one-hour delivery nationwide first, before embarking on becoming a drug wholesaler, as Walmart (WMT) and Target (TGT) seem prime to convert the existing store network into a quasi-distribution center with various delivery options such as curbside delivery or at home delivery via Shipt.
Conclusion
Both Cardinal and Amerisource are trading at the lower end of our fair value estimate range with Cardinal trading well below our $68-$96 range in what we believe is an overreaction to the latest quarterly earnings report, which led to a precipitous fall in the equity of over 20%. Cardinal is now yielding over 3% with excellent rankings across its dividend metrics. Cardinal’s Dividend Cushion ratio clocks in at an impressive 2.8. AmerisourceBergen’s metrics are also attractive, but the equity yields a tad under 2% with excellent dividend coverage metrics, too. Amerisource’s Dividend Cushion ratio is an impressive 3.7.
We love the competitive advantages of many operators within the drug-distribution industry, but we are not interested in adding exposure at this time. We would need to see an abatement of the deflationary trend in generics, and we’d also like to see better share-pricing performance, as the latter would indicate greater market support for the respective equities and further conviction that fair equity values are greater than where share prices are currently resting.
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Independent Healthcare Contributor Alexander Poulos does not own any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.