AmerisourceBergen Corporation (ABC)
Investment Research Report

Pharmaceutical Distribution: A Unique Business
We all complain about the high cost of prescription drugs and the unending spiral of higher prices.  For patients in need of vital medication, this is the part where The Affordable Care Act (ACA) has made very little progress.  For investors, drug stocks offer a hedge against these infuriating events.  There is no question that a good inflation hedge these days is hard to find.

But which are the right drug stocks?  The traditional approach has been to speculate on which company will produce the next billion dollar blockbuster.  If you have an advanced degree in pharmacology and a lot of luck, sometimes this approach works.

The wholesale drug distribution industry offers a better path.  There are several reasons distributors are situated in the sweet spot.  Whatever company turns up with the next blockbuster, distributors’ revenues and profits will benefit.  Whenever drug prices are increased, distributors pass on such costs to their customers.  The administration of healthcare is shifting under ACA, and distributors are better equipped to adapt than most other healthcare providers.

Over time, pharmaceutical distributors have become highly efficient machines with respect to speed, accuracy and cost of distribution.  As a result, large retail chains are handing over more of these warehousing and delivery functions to outside distributors.  Smaller volume customers like assisted living facilities are not in the business of warehousing.  As this segment grows, so does the supply chain.

Consolidation Is Speeding Growth
Today six companies lead the industry.  There are hundreds of smaller companies making the pharmaceutical distribution industry less concentrated than many other areas of healthcare.  But industry consolidation has been underway for many years and still there is much room for more to come.

The combination of each of these separate factors is making pharmaceutical distribution one of the fastest growing major segments of Healthcare.  This is especially true when risk is taken into account.  Here is a key investment point:  The industry is growing at an above average pace.  Stock valuations, on the other hand, are well below average and that makes for some appealing opportunities.

Enter AmerisourceBergen
What makes AmerisourceBergen so attractive?  Well consider this.  The company is the second largest pharmaceutical distributor in the United States behind McKesson Corp (MCK: $177).  However, AmerisourceBergen ranks third in terms of market value behind Cardinal Health (CAH: $86).  AmerisourceBergen is 50% of McKesson’s market cap.  And here lies opportunity for the astute investor.  

First, let’s take a close look at the company and what has been going on. AmerisourceBergen is a market leader in pharmaceutical distribution handling about 20% of all of the pharmaceuticals sold and distributed throughout the country.  The company has 26 pharmaceutical distribution centers in the US, nine centers in Canada, and four specialty centers in the US.   This enables customer delivery within 24 hours of order placement.  They are the Amazon Prime of the pharmaceutical distribution business.

Customers include the full gamut of Healthcare including acute hospitals and healthcare systems, doctors, retail pharmacies, and assisted living facilities.  Products include a full range of brand name and generic pharmaceuticals, over-the-counter products and healthcare supplies.

Efficiency Is The Competitive Edge
For many years, the company has been a model of distribution efficiency for the industry.  Since profits are typically less than 3 cents on every dollar of sales, being a low cost service provider is vital to success.  And, by perfecting this process the company is a price leader.  These skills provide a template that can also be applied to other products in the Healthcare field.  

Until recently, pharmaceutical distribution accounted for virtually all of the company’s business.  But in 2015, the company extended it distribution expertise into veterinary pharmaceuticals with the purchase of MWI Veterinary Supply for $2.6 billion.  MWI is a leading animal health distribution company in the United States and in the United Kingdom, with annual revenues estimated to be $3 billion.  This opens the door to major new markets both in the United States as well as abroad.  

In November, the company acquired PharMEDium Healthcare Holdings, a privately held leading national distributor of sterile preparations to acute care hospitals in the United States for $2.7 billion in cash.  We believe this addition will be easily assimilated into their existing distribution system and add to earnings late 2016 and on into 2017.

Recent Results: Acquisitions Have Depressed Profits
For the past few years AmerisourceBergen’s core distribution business has grown by 13% annually with similar increases in profitability.  Acquisitions of more than $6 billion have temporarily depressed profitability due to financing costs and to the less efficient nature of the companies acquired.  However, the growth opportunities make these wise long-term decisions. The upturn is already underway.

AmerisourceBergen
Year Ended Sept 30
(in thousands)

The Upturn Begins
In the first quarter ended December 31 revenues increased 9% to $37 billion and per share profits reached $1.46.  Management offered revenue guidance for 2016 of a 9% increase to $147 billion and profits of $5.80.  Wall Street took a close look at first quarter results and fully agreed with management forecasts.  For next year these same analysts agree that revenues will rise further by 8% to $160 billion and profits by 11% to $6.45.

Financial Condition: Key Measures Are Very Strong
AmerisourceBergen’s balance sheet measures $1 billion in cash and long term debt of $4.5 billion.  Acquisitions are the sole reason long-term borrowing.  Management is dedicated to getting this debt down dramatically.

In a distribution business financial efficiency is measured by how well short-term capital is managed.  In this case, Accounts Payable is three times the size of Accounts Receivable.  In plain English, their customers pay every two weeks while suppliers get paid in six weeks.  In this way the company uses none of its own capital to run the day-to-day business.  That’s pretty darn efficient.

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