Nowadays, there seems to be numerous thorny issues dogging the health care industry including patent expirations of major branded drugs in the next three years, greater adoption of generic medicines by consumers, the expected negative impact of Obamacare, a rapidly shifting drug distribution landscape -- to mention just a few. It looks like the halcyon days when the industry effortlessly expanded both its topline and bottom line in double digits are long gone. The drug distribution business is not considered to be naturally geared for high growth, and revenue growth in the low single digits is the norm here.
AmerisourceBergen (NYSE:ABC) is, however, proving this thesis to be wrong with its impressive revenue growth rates. The firm's 25.7% revenue growth in the fourth quarter is more than double the industry average of 12.54%. Better still, the firm is expected to grow its revenues at a blistering 30.1% clip in 2014, from its continuing operations alone, easily dwarfing the industry average of 18.89% for a similar time span.
AmerisourceBergen operates in the downstream drug distribution business. The firm, together with its two archrivals in the space, Cardinal Health (NYSE:CAH) and McKesson (NYSE:MCK), account for over 90% of the $325 billion-a-year drug distribution business in the U.S. each year.
Although AmerisourceBergen is expected to grow its bottom line at a slower pace than the industry in 2014, with 30.1% EPS growth against an industry average of 60.74%, that growth is still considerably better than the S&P 500 average of 19.74%. The lower EPS growth can be attributed to the company's heavy investments in systems and inventory that have strained its already thin operating margins. AmerisourceBergen experienced a considerable degree of margin compression in the third quarter as a result of these factors, shaving off 34 basis points from its 1.68% operating margin. The company derives less than 2% operating margins from its drug distribution segment -- a segment that makes up 80% of its overall revenues.
With such razor-thin margins, AmerisourceBergen relies heavily on scale and high volume sales for its profits. Luckily for the company and its investors, scale is soon coming, thanks to the firm's deal with Walgreen (NASDAQ:WBA).
Walgreen deal changes the name of the game
AmerisourceBergen signed a huge multi-year agreement worth $400 billion with Walgreen in March 2013. The deal saw AmerisourceBergen become Walgreen's official distributor beginning from Sept. 1, 2013, running till Aug. 30, 2023 -- a good 10 years. The deal also officially ended Walgreen's relationship with long-term partner Cardinal Health.
Walgreen, together with its partner, Alliance Boots, got a 7% stake in AmerisourceBergen as part of the deal, with an option for a further 23% stake. AmerisourceBergen will do doubt benefit hugely from the agreement. The deal provides excellent future revenue visibility for the firm. In 2014 alone, the company will see its sales grow by $25 billion, representing 30% of its annual revenues. But even better, the deal eliminates the huge risk AmerisourceBergen faces whenever its contracts expire, and it has to face bare knuckle competition with its bigger rivals McKesson and Cardinal Health. With at least 30% of the company's sales covered for the next 10 years, a huge competitive risk element has been removed from the picture.
AmerisourceBergen now has a good chance to get a foothold on the European market, which it will now gain access to, thanks to Alliance Boots' 11,000 European stores strewn across 21 countries. The company will also access Alliance Boots' generic and more expensive branded drugs.
AmerisourceBergen has an aggressive share buyback and cost control program, that has enabled the firm grow its EPS a compounded 17% since 2001. From 320 million outstanding shares in 2009, the firm had brought down that number to just 231 million by the end of the third-quarter of 2013.
The company's EPS grew 18% in 2012 to $2.96, while this year's EPS is expected to grow to $3.06-$3.11.
Baby boomers and increasing use of specialty drugs to drive new growth
Baby boomers now represent one of the most important demographic opportunities for growth in the health care sector. The U.S. population is rapidly aging, with the number of seniors 85 years and over expected to increase at 2.9% annually, while that of people over 65years of age will grow at 1.5%. Both rates are far higher than the 0.4% growth expected for younger folks below 65 years.
Senior citizens consume about three times as much drugs as younger folks. The rapid increase in the population of seniors has led the Centers for Medicare and Medicaid Services, or CMS, to estimate that drug spending will increase at 6.5% every year from 2015 through 2022.
Older citizens are also the biggest consumers of specialty drugs. Specialty drugs are used in the treatment of complex illnesses such as rheumatoid arthritis, various types of cancers, hepatitis C, multiple sclerosis, and many more. Specialty drugs are much more costly than other regular drugs. Although only 4 % of patients use them, they account for a very significant 25% of overall health care costs. A recent report released by CVS Caremark pointed out how the market for specialty drugs is expected to quadruple to hit the $400 billion mark by 2020. Drug distribution companies such as AmerisourceBergen will benefit hugely from the increased spending on specialty drugs.
The rapidly evolving drug distribution landscape comes with potential payoffs, as well as some challenges. AmerisourceBergen's two rivals Cardinal Health and McKesson are looking to expand their businesses abroad. The two are rumored to be in a bidding war for the giant German drug distributor Celesio. This might lead to higher competition for AmerisourceBergen and possibly put its squeezed margins under some pressure.
But the overall positive effects of greater adoption of generic drugs, greater use of specialty drugs, a larger insured population, and better future revenue visibility courtesy of the Walgreen deal, will more likely than not offset these headwinds, and make AmerisourceBergen an interesting opportunity for several years to come.
Fool contributor Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends McKesson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.