Delivering Our Meds (CAH, MCK, ABC)

By Dean Lundell | August 22, 2007 AAA

If you have ever been nailed by a high-flying story stock or large downdraft in the entire market, then boring, defensive stocks can look pretty good. We're going to take a look at three companies who fit the bill. Keep in mind that boring today doesn't mean dull returns tomorrow. These three firms are relatively recession proof; they distribute pharmaceutical and medical supplies to the outlets where we buy them. In fact, these three firms distribute 90% of those drugs making one of the narrowest oligopolies there is. (To learn more on protecting your portfolio, see Guard Your Portfolio With Defensive Stocks.)

A Little Too Concentrated
Cardinal Health (NYSE:CAH), with a market capitalization of just over $28 billion and revenue of $87.5 billion, is the largest of these three firms. CAH can boast a well diversified suite of healthcare businesses that offer numerous cross-selling opportunities, but the bulk of Cardinal Health's sales and earnings stem from its pharmaceutical distribution business. The problem is that distribution is somewhat too concentrated: CVS (NYSE:CVS) and Walgreen (NYSE:WAG) alone account for 35% of CAH's revenue.

Recent developments at Cardinal are a blend of good and not-so-good news; the company has seen more than a "casual" amount of turnover in management over the past couple of years, and, due to some accounting irregularities, there are shareholder lawsuits and an SEC investigation in progress. These developments aside, CAH's board has authorized additional share repurchases and the company's goal is to return 50% of its operating cash flow to shareholders via repurchases and dividends.

Cardinal's financial results are fairly nondescript over the last five years. Revenue has grown at an average rate of 11% while earnings have grown at a 9% pace. The firm's 15% gross margin translates into a negative net margin of -5.3%. Cardinal's return on equity (ROE) is currently 17.1% and has averaged 16.2% during the previous five years. The shares themselves, while fluctuating mildly during these past five years have returned zero.

Time to Move On
McKesson (NYSE:MCK), with a market capitalization of $17 billion, generates over $94 billion in sales. MCK enjoys the largest market share in the pharmaceutical distribution business, deriving 95% of its revenue and 85% of its profits from it. McKesson also owns a 49% share in Mexico's largest distributor Nadro. Similar to Cardinal, McKesson also is vulnerable to a concentrated customer base with its top ten customers accounting for about half of the company's revenue.

McKesson has had to endure several traumas that include an accounting scandal, securities litigation, underperforming subsidiaries and a new business operating model. It's time for the firm to put all this behind it and move on. The company's broad product mix can give it good cross-selling opportunities and given that only 10% of its business comes from outside the U.S., international operations are another possibility.

The company's financial results over the past five years are, again, less than exciting. Growth in revenue came in at 13.2% while earnings fared better at 17.3%. During the past five years, McKesson's gross margin resulted in a net margin of -5.3% but an average ROE of 10.4%. It might be worth noting that MCK's current ROE is 15% and the company's shares have appreciated about 60% during the last five years.

Narrow Focus
AmerisourceBergen (NYSE:ABC) is the result of a merger of Amerisource Health and Bergen Brunswig in 2001. It is the smallest of this trio with a market capitalization approaching $8.7 billion and sales of more than $65.3 billion. Of these three firms, AmerisourceBergen is the most focused on distribution as the two larger firms also have some manufacturing capability.

While AmerisourceBergen does not have an overly concentrated base of major customers, it tends to focus on smaller and independent customers. This is good news because its revenue has a broad based. However, it also makes the firm more vulnerable as its customers have to compete with the giant drug chains that can more easily compete on price. However, AmerisourceBergen is particularly strong in specialty and oncology drugs.

Financially its story is similar to our first two. During the last five years revenue has grown at 30.5% and earnings have seen a growth rate of 16.6%. During this last five-year period AmerisourceBergen's gross margin of 15% resulted in a -5.3% net margin and a ROE of 10.4%. This has climbed to 13.5% currently. Finally, the stock over the past five years has improved roughly 40%.

The Big 'So What?'
If you have done the math by dividing market cap by sales you will have noticed that they are all at substantial discounts to 1.0. Cardinal Health is at 0.32, McKesson at 0.19 and AmerisourceBergen at 0.13. Now consider what happens when 78 million baby-boomers in the U.S. alone start needing more and more pharmaceutical help.

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