Description

I believe AmerisourceBergen (ABC) at current prices presents an attractive investment opportunity to buy a competitively advantaged company within a high quality, secularly growing industry at a cheap valuation.

ABC is one of the three largest wholesale distributors of brand, generic and specialty pharmaceuticals in North America. Over 80% of its earnings come from this business, which is the focus of this write-up.

On May 5, 2016, ABC revised its FY2016 guidance downward by 5% and estimated its FY2017 earnings would only grow 4% to 6%–below prior consensus estimates of double-digit growth. The reduced outlook stemmed primarily from lower-than-expected generic drug prices (went from a state of inflation to deflation), which was also one of the main culprits that caused MCK to cut its earnings guidance back in January. Since then, ABC’s stock price has declined and now sits close to a 52-week low, trading at ~13.4x consensus CY2017E EPS of ~$6.00.

Historically, the big three distributors (MCK, ABC and CAH) on average have traded at a slight premium to the S&P 500. Based on consensus estimates, they currently trade at an approximate 20% discount to the S&P 500. In fact, this is the largest discount these companies have traded at relative to the market since 2009.

Source: Avondale Partners “Industry Update: Pharmaceutical Distributors” dated April 18, 2016

The last four presidential election cycles (including the current one) have seen the pharmaceutical supply chain underperform the S&P 500 in the year prior to the election. Prior to this election cycle, the last three cycles saw these companies enjoy significant outperformance in the year after the election.  Of course, past performance does not guarantee future results.

Source: Bloomberg, J.P. Morgan

Part of the reason pharma companies and others associated with the industry tend to perform poorly prior to a presidential election is that they are easy political targets. In the current campaigns, it has been bipartisan to speak negatively about the pharma industry, which has continued to raise branded drug prices in excess of inflation. What most politicians ignore is that rising proceeds from branded drugs help fund increasing levels of R&D. Much of this growing R&D spend goes toward finding new, life-saving and/or prolonging therapies that save the healthcare system money by reducing far more expensive reactive, downstream treatment costs.

I prefer to invest in healthy, growing industries. U.S. prescription drug expenditures are expected to grow at a ~6% CAGR through 2024. The three main drivers of this robust growth are new drug therapies, volume growth of existing therapies and rising prices for branded drugs.

Specialty Rx growth should be a large driver of increased pharmacy spend, particularly as it relates to new drug therapies for inflammatory conditions (such as rheumatoid arthritis), multiple sclerosis and oncology.

Existing therapies should see robust volume growth due to the country’s aging demographics. As you can see below, we’re in the first inning of this 50-year tailwind. The number of 65 year-olds in the U.S. will grow by ~50% over the next 15 years. This population consumes many more Rx on average compared to people under the age of 65. Additionally, as the population ages, the prevalence of chronic conditions such as diabetes should grow and so should the consumption of Rx.

In addition to these tailwinds, large scale distributors such as ABC should benefit from another generic wave, albeit smaller than the previous one, that could last through the end of the decade. This is because there is an approximate 20% gross profit per Rx lift in the generic post-exclusivity state compared to the branded one.

Brand Rx Sales Going Generic

I believe that pharmaceutical distribution is a recession resistant business. The three largest distributors control over 90% of the U.S. market. A growing, consolidated market generally results in rational competitive behavior, which helps explain why so few major distribution contracts have changed hands over the past decade. This also helps explain why these companies have consistently generated mid-teens unlevered after-tax returns on invested capital.

Therefore, one can think of these distributors as controlling a vital part of the infrastructure that efficiently gets pharmaceuticals from manufacturers to patients. By being large scale, low-cost providers, these companies are in the enviable position of being able to take a rising toll on an ever-increasing flow of pharmaceutical “traffic.”

Despite brand Rx making up the largest piece of revenue for distributors due to high prices, generics make up a larger portion of gross profit because there is a lot more generic volume distributed coupled with higher gross profit dollars per Rx.

On the brand side of the business, 80%-90% of the volume is distributed on a “fee for service” (FFS) basis. Branded manufacturers pay distributors a fee for the various downstream services they provide. An inventory management agreement caps the amount of brand inventory a distributor can hold. As a result, brand price inflation is not a meaningful driver of its business model. The remaining 10%-20% of the brand volume not covered by FFS agreements, typically from smaller pharma manufacturers, can allow distributors to benefit from spec buying ahead of price increases.

On the generic side of the business, distributors are not paid on a FFS model basis from generic manufacturers. Distributors can choose how aggressive they want to be by increasing inventory ahead of anticipated price increases. After a price increase, lower cost inventory can be sold at the now higher price. Once that inventory is exhausted, the incremental benefit goes away. Distributors are protected against price deflation on a drug specific basis such that manufacturers will make distributors whole for any price declines. This helps ensure an efficient supply channel for generics by reducing out-of-stock levels. Over the past few years, large generic sourcing entities formed such as the joint venture between ABC-WBA can drive greater purchasing discounts from manufacturers and therefore a larger sell spread.

Currently, MCK sources and distributes all of Rite Aid’s (RAD) pharmaceuticals. Walgreens Boots Alliance (WBA) is in the process of acquiring RAD, provided the FTC allows the deal to proceed. Through its joint venture with WBA, ABC has a contract to source all of WBA’s pharmaceuticals through the end of 2026. Should the WBA-RAD transaction close, the ABC-WBA distribution joint venture would likely subsequently take over the distribution of RAD’s volume. Since WBA now owns ~24% of ABC, WBA would likely want to see its investment in ABC continue to do well by helping it further grow its profits.

What is interesting to note is that analysts’ FY2018 consensus estimates for MCK, ABC and WBA appear to exclude the RAD business. One would logically question the omission. Completing the RAD deal would boost WBA’s and ABC’s earnings at the expense of MCK, while blocking it would allow MCK to retain the business and keep the associated earnings power to the detriment of ABC and WBA.

Here’s my take on it. After MCK lowered its earnings guidance earlier this year, management did the smart thing on its most recent quarterly call by discussing all of the known short-term negative impacts to its business over the next couple of years. This helped re-set expectations lower in order to have a better chance of exceeding them over time. On the last earnings call, CEO John Hammergren said, “Now clearly, in FY '18, we also have the transition with Rite Aid and obviously, you see us making lots of moves now to prepare to grow through those challenges, but we'll talk about that more as the time approaches. But other than that additional headwind that we'll face in that fiscal year, I think the business continues to perform as it has in the past.”

Similarly, when ABC gave its 4% - 6% earnings growth guidance for FY2017 in May, CFO Tim Guttman said, “We are not including any new business resulting from our relationship with our largest customer (WBA).”

In my opinion, if WBA’s pending acquisition of RAD receives FTC approval, ABC could see a boost to its FY2018 EPS by upwards of 10%. While consensus estimates from analysts do not factor in the RAD business for any of these companies’ earnings beyond FY2017, it does not necessarily mean the market has done that as well. However, based on the recent trading multiples for these companies relative to their historical averages, it appears that not much of the RAD benefit, if any, is being factored into the current market valuation of ABC.

Over the past decade, the big 3 distributors combined have been able to increase their operating profit at a high-single digit CAGR while there has been generic price deflation in 8 out of the last 10 years. This has been in large part due to the massive brand-to-generic conversions we’ve seen, particularly over the past 5 years.

If we assume brand drug price inflation is less than what it has been in the past coupled with continual generic price deflation, operating profit should still be able to grow at least mid-single digits for many years to come. A larger portion of the pharma distribution industry’s profit growth over the next 10-20 years should come from greater unit volume from existing and new therapies as opposed to brand drug price inflation and brand-to-generic conversions.

ABC sports a forward 7%-8% unlevered after-tax free cash flow yield. Factoring in this free cash flow, which will be used for share repurchases, dividends (current 1.7% yield) and acquisitions, one should get to at least a total annual return of low-mid double digits assuming no P/E multiple expansion. Should ABC’s P/E multiple expand to its 10-year average over the next few years, one is looking at a potential ~20% IRR—and that is not even including the potential benefit from the RAD business.

On 9/30/16, TRICARE announced it was moving its preferred retail pharmacy relationship from CVS to WBA. As a result, the distribution of these Rx should move from CAH to ABC and the lift to ABC’s EPS could be an incremental ~1%--while not huge, every little bit helps. Thus adding in this benefit plus the potential RAD business, one could get a ~25% IRR over the next 2-3 years.

Risks: Two key risks are lower than expected generic price deflation and/or brand price inflation. However, the one I'm most concerned about is capital allocation. Management has been willing to pay high multiples to get into new, faster growing businesses. It bought World Courier (specialty logistics services) in April 2012 for $0.5B or ~15x LTM EBIT. Then in Feb. 2015 ABC paid $2.6B or ~19.5x LTM (~17.5x NTM) EBITDA for MWI Veterinary Supply. Most recently in Nov. 2015 it purchased PharMEDium, the leading national provider of customized outsourced compounded sterile perparations, for $2.7B or ~28x LTM (~19x NTM) EBITDA. What helps incentivize management to not make poor capital allocation decisions is that 25% of its performance based stock compensation is tied to ROIC and the other 75% is tied to EPS. Therefore when its stock price is undervalued, management would be incentivized to allocate capital disproportionately towards share repurchases over pricey acquisitions.

Important Disclosure

The provision of this report does not constitute a recommendation to buy or sell the security discussed herein.  The report is an example of the author’s company write-ups / research process; its breadth and coverage may differ materially from other such reports.  Certain statements reflect the opinions of the author as of the date written, are forward-looking and/or based on current expectations, projections, and/or information currently available.  The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term.  The views are those of the author acting in his individual capacity and not as a representative of the firm; in no way does this report constitute investment advice on behalf of the firm.

Catalyst

WBA’s acquisition of RAD receives FTC approval. Post-election, the market realizes large scale pharma distributors such as ABC have businesses that are largely unaffected by any potential changes to the pharmaceutical industry and their P/E multiples get re-rated up to historical averages.