1/26/2010
By Brian Sozzi, Research Analyst

In a late December note (amidst my maniacal studying of holiday retail trends), I outlined a compelling case for building positions in the PBM/drug wholesale sector.  I stated: "Whatever one's opinion on the soon to be law healthcare reform package, the fact is that there are money making investment opportunities as a result of the scheme.  A subsector well positioned to benefit from an increase in those obtaining access to care are the pharmaceutical benefit managers (otherwise known as "PBMs") and drug wholesalers.  The main players in this drug middleman sector include Express Scripts Inc. (ESRX), Medco Health Solutions (MHS), AmerisourceBergen (ABC), and Cardinal Health Inc (CAH).  An honorable mention goes to the struggling CVS Caremark (CVS).  PBMs and drug wholesalers are cash rich companies that stand to become much richer as the healthcare debate shifts to political complaining about the actual law."

Obviously, with Scott Brown's win the healthcare debate has changed dramatically.  Gone may be the expensive, anti-growth measures put forth by the Obama Administration.  Who knows the end result, but any change in how healthcare is delivered to the presently insured and those likely to become insured will be welcome news to the PBM/drug wholesale sector.  However, even if one were to assume those uninsured people stay uninsured, the fact is that the government is friendly toward the expansion of generic drugs.  Over time, it's hoped by industry insiders that "bio-generics" reach the market, all in an effort to reduce the significant costs of having to purchase brand drugs for chronic illness (or having to purchase brand drugs at all).  A tighter focus on generics is music to the ears of the management teams at PBMs and drug wholesalers as this is the best medium from which to expand gross margins and maximize earnings power.    Generics account for only about 22% of prescription drug spending in the country, although they represent nearly three-quarters of the prescriptions written.  That means 78% of the nation's drug bill goes toward the 25% of prescriptions written for name-brand medicines. 

Post analysis of a homerun quarter from the usual unexciting drug wholesaler AmerisourceBergen Corp. (ABC), I see it appropriate to reiterate my Buy recommendation on the stock (held since April 2009).  Furthermore, I have raised my price target to $39.00 from $33.00 on assumptions for a quicker than previously modeled for rate of growth in FY10 and FY11.  Central to such financial expectations are the following: (1) new business wins demonstrating the strength of AmerisourceBergen's service offerings in an environment that is very profit enhancement minded, (2) increasing penetration of existing customer accounts, (3) continued impressive management of generic drug opportunities arriving in the marketplace, (4) structural changes to the business that are creating strong fixed cost leverage, and (5) cash rich, strategically capitalized balance sheet that positions AmerisourceBergen to increase dividends, repurchase shares, and go after acquisitions that boost long-term growth rates.  I have valued the stock using a 16.0x multiple on my revised FY11 EPS est. of $2.44 (previous $2.20), a multiple that is the mid-point of the five-year range.  Note Wall Street Strategies is included in the Thomson Reuters consensus estimates.

As implied above, AmerisourceBergen had one heck of a December quarter.  The predominant growth driver for the company was generics, with a half dozen or so releases helping to contribute close to $0.12 to the EPS line.  Excluding quarterly generic launches, management estimated that EPS would have risen by a still robust 20% y/y.  I have been pleased by management's efforts to monetize generic opportunities, improving the value-added structure for both long-term care pharmacies and retail pharmacies.  It's imperative for these customers to maximize profits per script, and by the looks of AmerisourceBergen's revenue momentum it's hitting all the right notes.

I assign a high probability of AmerisourceBergen continuing to outpace consensus estimates for the remainder of FY10 as current guidance does not appear to incorporate a major, positive generic launch impact.  The use of free cash flow to repurchase shares is an added earnings consideration.  In the end, my view is that the stock is very attractively valued, in spite of the run up from the March 2009 nadir.  The company is recording industry leading rates of top and bottom line growth and arguably has the most competitive balance sheet.  Multiple expansion, in my judgment, is a reasonable expectation as AmerisourceBergen realizes growth rates above market rates and those of key competitors.

Brian Sozzi
Wall Street Strategies

Add a Comment!