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Health-Care Distributors: This Triple Play Equals a Home Run

The Thomson Reuters/University of Michigan's preliminary reading on the overall index on consumer sentiment fell to 75.2 in October, down from 77.5 in September. This was the lowest figure since January, according to a recent report by CNBC. Investors look at consumer sentiment, among other things, as an important gauge of market direction. Health care traditionally has been a defensive play for investors when they are uneasy with economic conditions and unsure which way the markets will go.

Of the 55 companies in the S&P 500 Health Care Sector, McKesson (NYSE: MKC  ) , Cardinal Health (NYSE: CAH  ) , and AmerisourceBergen (NYSE: ABC  ) are among this year's top performers. Better yet, if you hold shares of all three of these health-care distributors, you can be assured of top performance along six factors (revenue, cash flow, earnings quality, expectations, valuation, and yield). This "triple play" could mean a "home run" in terms of performance going forward and as a defensive investment in these uncertain times.

Health care has become highly segmented in the U.S., but this creates opportunities for investors all along the supply chain. Pharmaceutical companies like Merck or Bristol-Myers Squibb develop and manufacture the drugs, but stock performance is dependent on each company's drug pipeline, patents, and FDA approvals following a series of successful clinical trials, among other things. Big pharma discovered that it is more efficient and less costly to outsource distribution of their products and logistics services through companies like those in our "triple play." The distributors also ship product to pharmacy chains like Walgreen, as well as doctors, clinics, and hospitals for dispensation. Lastly, health-care insurers provide coverage so that consumers can better manage the cost of health-care services.

Our three highlighted distributors earn a significant portion of their revenue by storing and transporting drugs and medical products, and each exhibits positive revenue trends. Perhaps more important is that none of our trio has significant increases in days sales outstanding, or DSO, which means revenue recognition is unlikely to be aggressive. As "middle men," our distributors have razor-thin margins due to the extremely high cost of goods sold. Success depends on efficiently managing the supply chain. Our trio exhibits low days in inventory, or DSI, and inventory as a percentage of revenue. Their stock price performance generally reflects these positive revenue trends, as shown in the charts below.

MCK Revenue Quarterly Chart

MCK Revenue Quarterly data by YCharts.

CAH Revenue Quarterly Chart

CAH Revenue Quarterly data by YCharts.

ABC Revenue Per Share Quarterly Chart

ABC Revenue Per Share Quarterly data by YCharts.

Of the three, AmerisourceBergen shows the best revenue performance year over year at 13% growth. McKesson's revenue grew 5%, and Cardinal had a -5% revenue decline year over year, although revenue turned positive last quarter. We would rate the quality of AmerisourceBergen's revenue stream lower than the other two because its accounts receivables jumped 16% year over year, slightly higher than revenue growth. While not guaranteed, continued strong demand for its services should propel revenue (and share price) higher going forward.

Cash flow
All three companies exhibit very low operating cash flow margins, but all had positive operating and free cash flow last quarter. Each of these companies should receive high marks for controlling their receivables (DSO) and payables (DPO),  two variables that can be used to skew operating cash flow. A look at each company's cash conversion cycle, or CCC, indicates excellent cash management, contributing to positive cash flow. The CCC is calculated as DSO plus DSI-DPO. In plain language, CCC is the amount of time needed to sell inventory, collect receivables, and pay the bills without incurring penalties. Cardinal Health had a cash conversion cycle of only eight days; McKesson's was nine days; and AmerisourceBergen had a CCC of minus three days, which suggests efficient management of the sales channel.

Earnings quality
McKesson had a 30% increase in EBITDA last quarter, as well as a 15% rise in earnings per share year over year. Cardinal's EBITDA increased 16% year over year but negative net income pushed earnings per share into the red zone. Cardinal's earnings shortfall appears to be a short-term, one-time occurrence in an otherwise stream of positive quarterly earnings averaging 18% year over year. AmerisourceBergen's EBITDA for its June quarter declined 38% from a year ago to $229.4 million.

















Cardinal Health
















Sources: Capital IQ, Yahoo! Finance.

When EBITDA margin over the last 12 months, or LTM, minus operating cash flow margin LTM expands, it signals that earnings are not making their way to cash flow. All three companies exhibit positive operating and free cash flow, and the chart above indicates that all have decent earnings quality.

As we all know, Wall Street expectations affect stock price. McKesson seems to have the edge in this category over its rivals as well, as consensus earnings for the coming September quarter are $2.03, or 5.7% higher. McKesson's revenue is estimated to be only 7.7% higher than last year at $32.16 billion. A Raymond James analyst recently increased his recommendation from market perform to outperform for the stock due to a Wall Street Journal report that the company is in "advanced" talks to buy German rival Celesio.

Cardinal could actually take advantage of the Street's consensus estimate of a -12.2% drop in revenue to $422.73 billion. One analyst recently noted that he expects Cardinal to open dozens of new specialty drug locations in China in the coming years, and that manufacturers will work with Cardinal to help ensure they don't lose sales to counterfeit competition. He also expects the company to expand its home health business.

Expectations for AmerisourceBergen are highest, with revenue estimated to be 22.9% higher than last year at $23.9 billion. Forbes magazine recently reported that the company is a favorite among analysts due to its stock buyback activity, so analysts' expectations to meet earnings are well-founded.

Companies with low expectations and good earnings quality, such as Cardinal, are likely the better bet. Any positive surprise with respect to revenue or earnings should propel shares higher.

These health-care distributors have very low price-to-sales ratios, which is another way of saying that revenue generated per share is excellent and that the shares could be undervalued in relation to revenue. McKesson's price to sales ratio has not deviated from its 0.2 times over the previous three years; AmerisourceBergen's 0.2 times ratio is double its historical ratio of 0.1 times, and the same is true for Cardinal. Price to cash flow from operations ratios are at the lower end of the range for all three companies, meaning expectations are moderate.

Both McKesson and AmerisourceBergen have negative tangible book values (liabilities higher than assets), but this should be of little concern since inventory assets don't stay with any of these companies more than a few days.

We already know from the charts above that year-to-date stock returns have been impressive. Traditional valuation metrics like P/E ratios compared to stock appreciation are of little help, since by this standard all three companies would be considered overvalued. However, expectations are low, and there is only minimal chance of revenue shortfalls. Best of all, demand for distribution and logistics services should continue unabated into the foreseeable future for several reasons, among them: the health care supply chain will remain segmented, and the baby boomer generation will require more of the products and services these companies can deliver.

Ratios (Quarter ending June 2013)




Price to Sales




Price to Cash Flow from Operations




Price to Tangible Book Value

Not Measurable


Not Measurable

Trailing Price to Earnings




Yield $(Pct)

$0.96 (0.70%)

$1.21 (2.2%)

$0.84 (1.3%)

Year-to-Date Return




Sources: S&P Capital IQ, Yahoo! Finance.

A defense against portfolio threats
The health-care industry trends in place should assure investors that demand for logistics and distribution services should continue, which spells relief for investors who are concerned with today's uncertain markets. Moreover, the undeniable macroeconomic trend of the aging baby boomer population will continue to create demand for better drugs, medical equipment, and services. Ownership of the health-care distributors is a relatively safe way to guard against portfolio losses. As always, Foolish readers should base investment decisions on fundamental analysis of financial trends, including revenue, cash flow, and earnings quality.

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