Description
As a result of the current evolution in the compensation structure of the pharmaceutical distribution industry combined with certain industry trends and company specific trends, I believe that Mr. Market is currently selling AmerisourceBergen at what I consider to be its intrinsic value without assigning any value to growth. As I will describe below, I believe that ABC will improve its ROIC to sustainable levels of 14-15% and I believe that there is significant value to this growth that you will get for free at current prices. Including the value of growth, ABC is worth approximately $113 per share based on a normalized earnings stream and is currently valued in the market at approximately $60 per share (a more detailed valuation is provided at the end). Without growth, ABC has an EPV of $64 a share which is more in line with its current market value. I believe that the market is over-penalizing ABC for its currently depressed ROIC and earnings power and is irrationally reacting to the current negotiations with manufacturers. It is also important to note that current negotiations have caused a temporary compression in gross margins on branded drugs, not generic drugs which actually have much better economics.
ABC is currently trading at historical low multiples off of a historically depressed earnings stream. ABC is currently trading at about 1.5x book value (vs. a 10 year low of 1.4x book value) and has a TEV/EBIT multiple of approximately 8.0x (vs. a 10 year low of 7.1x). ABCs ROIC is currently approximately 7.0% due to gross and operating margins that are significantly below levels that have been experienced in the past 10 years. I believe that current pharmaceutical trends which favor increased growth in the market for generic and specialty drugs along with an operating expense efficiency program will lead ABC to gain significant operating margin expansion.
The key drivers to this operating margin expansion are as follows:
1) Generic drug growth picking up to 15-20% in 2006 and 2007 from levels closer to 10% historically. I believe this pick up in generic drug growth will come from an increase in unit volume as several branded drugs come off patent and as the Medicare Act becomes active. Generic drugs are about (1/3) of the cost of a branded drug, but have a much higher gross margin (3-5x as large) due to the fact that there are many generic drug makers which provides the distributors leverage in negotiations. This leads to gross margin dollars per generic drug that are greater than that of a branded drug. Therefore, as generic growth outpaces the growth of branded drugs, this will have a significant effect on gross margins.
2) Specialty drug growth picking up over the next few years and outpacing branded growth of 8-12%. This growth should come from increased production of injectable and infusable drugs being produced by biotechnology and pharmaceutical companies because of their increased effectiveness with several hard to treat diseases. The distribution of specialty drugs as well as the services provided when distributing these drugs have higher gross margins due to the fact that these drugs are harder to transport and have more involved handling and temperature requirements.
3) Operating expense efficiency improvements driven by current rationalizing of old distribution facilities, building of new improved facilities and implementing new distribution technology in all facilities. ABC expects to decrease operating expenses as a % of revenues from 1.74% to 1.50% by the end of 2007. This 24 basis points of operating margin expansion accounts for about half of the 50 basis points in operating margin expansion I am assuming by the end of 2007.
With these three drivers, I see ABC improving its ROIC from current levels of 7.0% to levels more in the range of 14-15% (which I should note are above historical levels of 10-12%). Even though the operating margins I assume for ABC by 2007 are towards the lower end of its historical range, the ROIC improves due to a reduction in working capital that ABC has experienced over the past year due to a movement towards a fee-for-service business model. Just so we are on the same page, I should note that my calculation of ROIC is as follows (EBITDA – taxes)/(net working capital +gross PP&E + goodwill and intangibles). The reason I use EBITDA and don’t subtract depreciation or some form of cap-ex is because I am using the gross pp&e number as opposed to the net. The EBITDA calculation also adds back amortization which I feel is necessary since I am using a gross goodwill and intangible number.
At this point, there are probably two questions on everyone’s mind: 1) Why are the 14-15% numbers sustainable and 2) Why wouldn’t new entrants come into this business given that ROIC excluding goodwill would be approximately 20-25%?
1) I believe that a sustainable ROIC of 14-15% is not unrealistic as ABC operates in an oligopolistic market in which the three largest players control 80-90% of the market and each player maintains a pretty equal market share (30%). The market has slowly evolved to the current structure as consolidation has been high over the past 10 years due to the economies of scale inherent in this business. The last wave of consolidation ended in the 2000-2002 period and the three major players have been adjusting to the rational dynamics that one would expect to exist in an oligopoly market. As the distributors increasingly recognize the benefits of rational behavior (which for the most part it seems they do) and as current negotiations continue to clear, I would expect the ROIC in this industry to improve. I believe that the 14-15% ROIC is sustainable for ABC due to the nature of the industry and the fact that the economies of scale maintained by the three large players is such that it would be very difficult for a new entrant to compete especially since competition in this industry is focused on price points and each of the current distributors have 3-5 year contracts in place with the end customers. The biggest threat to sustaining these returns is irrational behavior exhibited by the distributors themselves. Historical analysis would indicate that this irrational behavior is rare but not non-existent although after speaking with each competitor it seems reasonable to believe that behavior will be increasingly rational moving forward.
2) It could be argued that the goodwill on the balance sheet over-estimates the value of the brand name, distribution know-how, etc. that is associated with this business and that it would only take a new entrant the value of the net working capital, pp&e and maybe a small percentage of the intangibles and goodwill to replicate the assets of the business. If you assumed that the drivers I have explained above are viable, then a new entrant could potentially replicate current distribution assets and earn an ROIC of 20-25%. However, I think it would be very difficult for a company that was trying to enter the pharma distribution business to just come in and convince the end customers (chain stores, independent pharmacies and hospitals) to just use their services. If you speak with a Walgreens, for example, they will tell you that the distributors do not make many mistakes and service is pretty good. I think they would be very wary of a new entrant in the business and would not be very inclined to use their services (plus all the end customers are tied up in 3-5 year contracts with the distributors and the distributors offer the end customers several other services including packaging, automatic dispensing, working capital management, etc. that are tailored to their business and thus make the relationship more sticky). Also, even if returns are very high, if a new entrant tried to enter this business, the three incumbents could match any prices they charged which would definitely disincline any partners in the supply chain from employing the new entrant. And the incumbents would probably be willing to just charge at cost and due to economies of scale, there is no way an entrant could match those prices. Just the threat of this will probably keep someone from trying to get into the business and is probably the reason not many entrants have tried to get into the business (over the past 50 years, very few companies have tried to get into the business and the ones that have were acquired out of bankruptcy or were acquired as they struggled to survive).
For those interested in how the economics of the industry are changing, I have provided some detail below:
Current Negotiations:
The economics of the pharmaceutical distribution industry were historically based on the premise that the distributors would purchase inventory at cost from the manufacturers, hold the inventory in warehouses until the value of the inventory increased and then sell the inventory to the end customers (hospitals, mail order facilities, pharmacies, etc.). Due to large increases in the price of pharmaceutical products, the distributors were able to maintain 10-15% top-line growth (5-7% annual price increases and 5-7% unit volume growth). However, this model is very inefficient because it does not match up the supply and demand sides of the market and causes there to be excess inventory in the distribution channel. Currently, distributors are negotiating with pharmaceutical manufacturers to create a fee-for-service compensation structure in which distributors are paid a fee (which is calculated as a percentage of the value of the products moving through the distribution channel) for the value of the services they provide. This compensation structure makes sense as it should provide a more consistent and visible earnings stream for the distributors as well as allowing the manufacturers to match up production of products more efficiently with demand for those products. In my mind, it makes a whole lot of sense for the manufacturers to move towards this fee-for-service distribution model which is common for the distribution channel in several other industries.
Booz Allen recently put together a consulting report on the cost of replicating the services of the pharmaceutical distribution industry and estimated that it would cost the pharmaceutical manufacturers $10.5 billion in annual expenses (while the distributors make approximately $5.3 billion in gross margin dollars). It would therefore not be very economical for the manufacturers to take the business into their own hands. (Although I do recognize that this report was sponsored by a distribution trade association). I also spoke with someone at Pfizer (I will leave his name and position anonymous, but I can assure you it was someone who’s opinion is at least somewhat important) who used to work at Cardinal Health. All his opinions were from the perspective of his experience at Cardinal. He agreed with the fact that the current distribution system was the most efficient means of getting drugs from the manufacturers to the end customers. He also agreed that ultimately the manufacturers would negotiate terms for a fee-for-service based compensation in which distributors would be compensated based on the services they provide. He felt that distributors would maintain historical operating margins because it just makes sense economically for the manufactures to continue to use the distribution channel and not try to destroy the distributors.
Valuation
2005E EPS: $3.95
2006E EPS: $5.24
2007E EPS: $6.44
Assuming that as the air clears on current negotiations and the earnings stream of the distributors is more transparent, I do not think it is too aggressive to assume that they could maintain 13-15x forward eps multiples. This would imply a stock valuation of $68-78 by year end 2005 and $83-$96 by 2006 year end. This would imply annualized returns of approximately 20-25% over the next two years.
Another valuation metric I used was to assume that you should value ABC today based on what you think their normalized earning power is and what the value of incremental reinvestment potential is worth. In order to do this, I used the following formula:
Capital*(ROIC-Growth)/(Cost of Capital –Growth).
Capital=approximately $6 billion
Normalized ROIC=approximately 14.5%
Cost of Capital=approximately 10%
Growth=approximately 6% (which is in line with industry unit volumes growth not including price inflation)
This leads to an implied enterprise value of $12.8 billion. Subtract out net debt of approximately $800 million and you get a market value of $12 billion and there are 106 million shares outstanding leading to a stock price of $113 per share. If you assume that it will take until the end of 2006 for everything to clear and for ABC earning power and value of growth to be recognized, this would lead to this share price being recognized in 2 years. That would lead to annualized returns of about 35%+.
And if you don't believe in the above analysis, maybe the following fact will comfort you:
statistical analysis has shown that if a stock is a poor performer for three years in a row, the next three years are usually promising. Well, ABC has not done anything in three years...
Catalyst
- Generic drug growth, specialty drug growth and the finishing of ABCs operating expense efficiency program will lead to significant operating margin expansion over the next 2-3 years which will contibute to strong growth in the bottom line
-My eps estimates for 2006 and 2007 are above the street and so if ABC does what I believe it will, investors will respond very well to the outperformance of expectations
-As current negotiations end and everything is cleared up, multiples will improve and earnings will be more transparent