By CrossProfit

05/24/2007

The big three distributors dominating the pharmaceutical distribution market in the US are; Cardinal Health (CAH), Mckesson Corp. (MCK) and AmerisourceBergen (ABC). Market cap is approximately $26.6B, $17.9B and $9.8B respectively.

Out of the big three, ABC had the highest top line growth last quarter, however when discounting for share buybacks, ABC showed little improvement to the bottom line.

Recently, the FDA Oncology Drugs Advisory Committee recommended tighter restrictions on erythropoiesis-stimulating agents including more expansive warning labels, restricting the drugs from certain uses and limiting how long the drugs are used for. This caused Amgen (AMGN) to slide severely as a large chunk of its revenue is generated from these drugs. The drugs are used to treat chemotherapy induced anemia. ABC is the primary distributor for the Amgen product.

Revenue Growth

Revenue grew 8.8% YOY to $16.51B, led by a 9% gain in the company’s pharmaceutical distribution segment.  Being that we anticipated stronger revenue growth for the first calendar quarter, we maintain our ABC revenue growth estimate for calendar year 2007 to come in at 7.0%. 

Margins

In this cut throat business, pharmaceutical distributors work on 1% to 3% margins. Historically, ABC’s margins have been somewhat erratic and lower when compared with competitors Cardinal Health (CAH) and McKesson (MCK).

The all important pharmaceutical distribution margin decreased steadily from its peak in FY2002 of 1.67% throughout FY2005. Starting from a low point in FY2005 of 1.08%, ABC is slowly but surely improving distribution efficiencies. FY2006 margins came in at 1.15% and the latest quarter boasts operating margins of 1.35%.

This is still below peers.   

Earnings per Share

For FY2007 second quarter (FY ends September), AmerisourceBergen earned $0.68 per share, up slightly from $0.61 per share a year ago, taking into account share buybacks reducing the share count by 19M shares.

Anemic Outlook

According to CIBC World Markets analyst, Charles Rhyee, nearly 7% of ABC’s distribution revenue is generated by selling Amgen (AMGM) anemia drugs that according to Rhyee are all covered in the aforementioned FDA ruling. We can not confirm the accuracy of this statement at this time.

Rhyee is quoted as saying that as much as $1.7B in ABC’s revenue is at stake. We can not confirm this either. What we can confirm is that Rhyee lowered his target price from $57.00 to $56.00 which is now more in line with the CrossProfit evaluation line. Standard & Poor’s Seligman is maintaining a $59.00 target, though it is fair to say that Seligman has recently been more bullish than others on this sector.

We find the above explanation for Rhyee’s actions a bit perplexing. First, revenue impact should not exceed $500M – and this is the worst case scenario. Second, the market has been concentrating on revenue growth and future guidance this past earnings season. Normally EPS is the stimulant. We have all noticed that companies that beat EPS estimates declined and others that missed were rewarded. It all depended on revenues and outlook. Such being the case, ABC beat the street revenue estimates and gave an upbeat outlook, confirming previous guidance. In theory the stock should have rallied. Even EPS was a penny ahead of consensus.

We think what is really behind the market psyche is ABC’s inherent structural weakness that even Seligman doesn’t deny. In a nutshell, we are referring to supplier dependency.

Client Diversification

ABC has sufficient client diversification. There is no one client that ABC is dependant upon. As clients move to other suppliers, ABC recruits others to replace them. This is quite normal for this business. As mentioned, this is a cut throat business.

Drug stores, both chains and independent, account for 42% of sales. Hospitals and mail order account for 52% of sales. Specialty pharmaceuticals and others account for 6%. ABC’s top ten customers comprise about a third of sales.

Supplier Concentration

The real ‘scare’ in our opinion was the fact that ABC derives more than 5% of its revenues from distributing Amgen’s products. Johnson & Johnson (JNJ) is another large ABC supplier. It would be ironic if all of this turned out to be some form of JNJ manipulation in the everlasting legal disputes with Amgen. So far, ABC has steered clear of taking sides in this war and works well with both adversaries.

The top five suppliers represent approximately 45% of revenue (see note below). What Rhyee is really saying is that ABC is too dependant on a limited number of suppliers that account for more than 5% of sales. Should one of them suffer a genuine severe setback, ABC could feel the consequences.

Guidance

AmerisourceBergen reaffirmed its earnings guidance of $2.45 and $2.60 per share, ex-items, versus the consensus estimate of $2.58 per share. CrossProfit estimated 2007 EPS (calendar year) is unchanged at $2.65.

There is no change to the evaluation line (symbol = ABC).

Disclosure: No conflicts.

Note: We attempted to receive updated information from ABC. Estimated figures are based in part on 2003 data. In reply to our inquiry, Barbara Brungess, Director, Corporate & Investor Relations noted (5/18/2007) that ABC company policy prohibits commenting on research reports. I believe that our request for specific information was misunderstood.

Saul Sterman

CEO CrossProfit

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