Large Cap Health Care Distributors Creating Wealth– Including Cardinal Health Inc. (NYSE:CAH), and McKesson Corp. (NYSE:MCK)

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With over $20 billion worth of blockbuster drugs losing patent protection by the end of 2011 (over $100 billion in the next 5 years), many investors frantically attempt to analyze how much market share generic pharmaceutical manufacturers will snatch away from branded pharmaceutical manufacturers. Even within the generics industry, competition is often fierce, as companies hurry to optimize manufacturing and distribution capabilities in order to offer low prices for the copy-cat drugs. Instead of debating the value propositions between branded and generic drug companies, and the implied victors of this long-anticipated war, of which the generics have been winning countless battles, the pharmaceutical distributors look to be obvious winners.

Health care distributors serve as the “middle men” between manufacturers and various health care providers, such as hospitals, pharmacies, physicians’ offices, long-term care facilities, and even to mail-order pharmacies that have made it convenient for patients with acute illnesses to receive products delivered to their doorstep. These companies distribute mostly pharmaceuticals, both brand and generic, but some of them also distribute other products needed in hospitals (latex gloves, reusable surgical equipment, and disposable consumables), as well as the software and hardware that is critical in getting health care systems connected in the recent health care IT push. The fact that manufacturers and health care providers cannot provide this valuable distribution service themselves gives distributors reason to exist, because they provide important services that help keep the health care engine moving. However, they are often pressured on both sides of the health care supply chain (manufacturers on one end and health care providers on the other end) to provide price concessions when negotiating contracts and risk getting their already-thin margins squeezed. As long as the distributors can maintain a somewhat healthy level of low margins and more than make up for it by distributing massive volumes, there exists the potential to remain profitable. Whether their profit is enough to cover their cost of capital will determine if they earn the right to be considered wealth creators.

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First, we’ll take a look at McKesson Corp. (NYSE:MCK), the largest health care distributor, to understand why they’ve earned the deserved title as a wealth creating company. The Applied Finance Group's (AFG’s) Wealth Creation Report (WCR) is shown visually in the three charts shown below. MCK is a wealth creator because it has improved its Economic Margin (EM) and grown its asset base to take advantage of its ability to earn profits. In turn, the market has rewarded its shareholders, consistent with backtests that prove that there is a relationship between a wealth creation strategy and share outperformance. Looking at the expected EM in 2010, however, it is unclear whether MCK will be able to sustain further levels of EM improvement for very long.

AmerisouceBergen Corp. (NYSE:ABC) is the smallest of the 3 major U.S. health care distributors and its shares have outperformed its 2 bigger peers year-to-date. An important distinction between MCK (above) and ABC is that ABC is expected to have an impressive EM improvement in 2010, while MCK’s EM improvement is comparably mild. Normally, a link between EM improvement and asset growth would lead to share outperformance, but ABC had negative asset growth in the years between 2004 and 2009. This is explained by ABC’s active share repurchase program, which many investors see as a beneficial use of excess cash flow, attracting those who like this cash distribution method.

Finally, Cardinal Health, Inc. (NYSE:CAH) has been in continual restructuring since its merger with Scherer in 1999, but the biggest multi-year restructuring plan began in 2005. Just recently CAH spun off its medical device segment, which was the business that had the most growth opportunities and greatest profit potential. Nevertheless, the remaining pharmaceutical and medical supplies distribution businesses are still expected to show positive EMs. It seems that investors were unsatisfied with CAH’s various restructuring initiatives and its shares underperformed, even in years when EMs were improving. Today, shares outperformed a small amount. Today, EM is expected to improve post the spin off (shown at a much lower level in 2010 vs. 2009 in the chart below).

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Beyond the value that health care distributors bring to the table for various health care companies, the growing trend in increased generic utilization (both at the retail pharmacy level as well as mail-order delivery) will help distributors improve their profitability, due to the higher margins that distributors earn on purchasing and distributing generic drugs. Still, not all distributors are made the same, as the WCR for these 3 companies has shown, and due diligence is necessary before making an investment decision.

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