Description

AmerisourceBergen (ticker ABC)
Price of $54.31. Valuation below based on this morning’s open price of $53.70.
Market cap of $6040M
Stock Down from 52-week high of $83 and down significantly over last few weeks.

ABC is the largest pharmaceutical distributor in the US, distributing products and services to hospital systems, the acute care market, alternate care facilities, independent community pharmacies, and regional chain pharmacies. The Company is also a leader in the institutional pharmacy marketplace and is also engaged in other businesses like specialty packaging, bar coding, etc. These other businesses are faster growing and higher margin, but the core distribution business is what drives this company. ABC and this industry are widely followed and are likely familiar to many of you so I won’t go into too much detail here, but will touch on the key points and the discussion surrounding the recent price drop. Note that the 10K is very fresh as it was released about a week and a half ago, and that the company hosted a very thorough investor day on December 5th. If interested I would ask the company for the booklet they distributed that day, it was very comprehensive.

Pharma distribution is a good business to be in. The business has nice fundamental demand, driven by increased utilization rates (people are using more drugs (especially the older age groups) and drug price inflation (roughly 5% annually), and offers solid returns on capital and FCF. Also, pharma distribution is defensive in nature. IMS estimates this is a $196B market that will grow 11-14% annually over next 4 years. Contracts are multi year and visibility is strong. ABC is the largest player in pharma distribution (following Bergen acquisition) followed by Cardinal (CAH) and McKesson (MCK). These 3 players basically own the business. Consolidation over the last few years, particularly when Bergen was taken out, has lead to a much more rational playing field. Talking to the various companies and industry sources, ABC and CAH are believed to be the most rational on the pricing front, with the worry being that MCK may become more aggressive as they are now the #3 player versus being #1 a few years ago. In general though, no one seems to be interested in a price war, and the players are looking elsewhere for additional growth, like specialty distribution, specialty packaging, etc.

Valuation
ABC’s Long term goals: 15%+ EBIT growth, 20%+ ROCC, and 20%+ EPS growth
ABC sells at only 13.5X Sept 2003 EPS estimates. MCK (March year end) sells at about 14.2X and CAH (June year end) at 18.3X.
ABC has grown EPS at 24.1% CAGR since 1996.
Proforma sales have grown 16.1% CAGR since 1997.
EBIT CAGR proforma since 1997 of 19.5%
EBIT margin has improved to 1.9% in 2002 from 1.6% in 1997.
ROCC (EBITDA/ (AR+Inv+netPPE-AP) has been north of 24% each year since 1997.
Net debt is not an issue at roughly $1.2B, or slightly over the roughly $1B in EBITDA expected in 2003. In fact, the company is underlevered. They should be buying back a lot of stock, but they have a covenant that restricts dividend and stock repurchase payments and talking to the CFO it does not sound like they are in a hurry to try to rework any covenants. ABC investment ratings should continue to improve.
2002 ROCC of 25.5% (defined below)
TEV/EBITDA for 2003 is about 7.9X. Pretty good for a company expected to grow EPS 20%+ for years to come, without the aid of share repurchases, and that is not dependent on the economy. TEV/EBITDA for CAH is 10.6X and it’s 7.7X for MCK.

While all 3 players have solid industry fundamentals at their back, I think that ABC comes with an added margin of safety as part of their expected growth is coming from synergies and cost cutting from the Bergen acquisition which the company can control (more or less). ABC expects a $150M run rate in cost cuts by end of 2004. Additionally, and this is really exciting for a value investor, ABC thinks they can fund all capital requirements of the new DC system (closing 27 DC’s, expanding 7 DC’s and building 6 new ones) via inventory reductions of $400-450M. And talking to CEO David Yost after the Dec 5th investor meeting, it sounds like he thinks they may be able to do even better a few years out. They think the new DC system will reduce inv by 3 days at $150M per day. (he also thinks a Medicare drug benefit will happen and will be a positive.)

Following the Bergen acquisition, the first year of the new ABC was a great success, with EPS growing 40%, far surpassing ABC’s expectations. (Some have grumbled that they should have smoothed the EPS growth. I am not in that camp.) Sales were up 16% pro forma, consolidated 7 DC’s and synergies are ahead of schedule. Company is still in the process of integrating Bergen and will complete it’s new DC system over the next few years. Management plans this new system to be the lowest cost and best service in the industry.

ABC significantly trails both CAH and MCK in GM and EBIT margins. Part of the reason is that CAH and MCK have other higher margin businesses in their mix that make up a greater % of their business than at ABC, but ABC trails in distribution margin as well on less aggressive forward buying and a less efficient DC system at this point. This is a positive as ABC has room to improve and possibly beat numbers.

CAH has the best margins because of its skill in forward buying and its superior DC system. ABC ranks well compared to MCK and CAH in WC control and inventory turnover, but this fact also highlights a weakness at ABC and an area where they can really improve. MCK and CAH are more aggressive in forward inventory buying to capture profits as drug prices increase (expected to rise about 5% annually). This practice is very profitable, but has not been a big focus for ABC until now. Note, on this topic there has been a lot of discussion suggesting that drug makers will be able to stop this practice as it screws up their manufacturing schedule by clouding what the real demand is. Spec buying has been a part of this business for a long time and it will not go away. My understanding is that the drug makers cannot stop the distributors from forward buying as they do not know when it is happening, and how do they say no when someone wants to buy their products? The distributors already make razor thin margins and they will get paid one way or another as some companies choose to pay distributors not to spec buy. Unlikely that the drug makers will make this area a serious issue.

So why has the stock fallen so much and priced so cheaply in the market?
There have been several issues hanging over this stock which I believe have been overblown, hence the opportunity.

1) I think some of the investor concerns started with slowing of expected industry sales rate from mid to high teens seen over last few years, to low to mid teens projected for the next few years. Industry slowing on fewer blockbuster drugs and also the rise in generics. Key point, generics are cheaper so they hurt the top line, but the distributors make more gross margin $ on generic sale than branded. IMS projects industry sales growth of 11-14% over next 4 years. (Compared to other industries in today’s world, pretty good, especially when this growth is not dependent on the health of the economy.)
2) They originally targeted 20% or better EPS growth following Bergen acquisition. Then in year 1 they did 42% eps growth, but kept guidance at 20% for year 2 at Dec 5th meeting, refused to manage numbers. This is very impressive in my opinion. Oddly, analysts found some way to see this announcement as a reduction in guidance by a few pennies. You’d have to ask them how they took such outperformance and displayed it as underperformance.
3) Concern over contract losses, started when ABC lost Tenet Contract a few weeks ago, then exacerbated by an analyst note that was a bit misunderstood by the market, in my opinion. (And in his opinion as well as he then put out another note to clarify his opinion after he did some more work.) Report suggested that ABC was at risk of losing more contracts as it goes through Bergen integration. Fact is ABC has no more contracts up for bid than anyone else and there seems to be no evidence of customer issues. Contracts will switch every now and then, but ABC is at no more risk than anyone else. ABC is known for leadership in service levels to hospital customers. Certainly integration of a major acquisition poses serious challenges, but so far management is doing an excellent job. Company hosted a call with Bear analyst about a week and a half ago. Stressed comfort in 2003 EPS and sales guidance. Know they lost $450M Tenet contract, and may lose a $300M one because of an acquisition by competitor customer in the next few years. This is not a material move on $45B sales base. Company says no significant customers, $1B customer, are up for rebid until 2004. (CAH and MCK each have a rebid coming up for $1B+ customers.) Company does not see pick up in industry pricing pressures, no price war coming. ABC will maintain disciplined in its leadership role. ABC could win new business, or get new contracts through Novation and Premier contracts.


3 customer contracts were cited as being at risk: Anthem, Kaiser, and Veterans Administration. While I have not talked to Anthem or Kaiser yet, others have, including several analysts, and they show no signs of dissatisfaction.


1. VA is up for renewal in May 2004, $2.5-3B annually. Systems are highly integrated and recent acquisition of Automed furthers this relationship as VA uses Automed in most of its hospitals.
2. Kaiser contract ($800M) was rumored to be up for rebid, but company has confirmed that is was extended into 2004, sign that things are good.
3. Anthem, no signs of dissatisfaction.


4) Speculation that Bergen customers are being forced to use Amerisource systems and that is causing friction is false. Company stress customers can use either order entry system and there will be no forced conversions for years.

5) Sector rotation away from defensive issues as market rallied.

Also, if ABC was so worried about hitting numbers, with the recently announced Bioservices acquisition, why call it accretive to 2003 numbers, why not call it neutral and give yourself some room?

All in all, I think ABC is a really strong business selling at an attractive price. The concerns discussed above have been overblown providing investors with a good opportunity. ABC looks like a good place to consider putting some capital in my opinion.

Happy New Year to you all and good luck in 2003.

Catalyst