If you're interested in buying health care companies likely to benefit from shifts in health care reform, but are nervous about the volatility in drug makers and margin risks at health insurers, consider drug distributors like AmerisourceBergen (NYSE:ABC) instead.
Drug distributing isn't as exciting as curing chronic disease
It's a low, slow-growing industry that normally rewards investors with mid-single-digit sales growth. But, an older, more heavily prescribed population and incremental drug demand tied to new insurance enrollees make the industry's steady growth increasingly attractive.
Make no mistake; the drug distribution business is big. AmerisourceBergen and competitors McKesson (NYSE:MCK) and Cardinal Health (NYSE:CAH) handle 95% of $325 billion spent annually on drugs in the United States.
And drug spending is expected to move higher after pausing in 2013. IMS expects global drug spend to increase 4%-5% next year after stalling this year. Driving the rebound will be demand from the newly insured, increased approval activity at the Food and Drug Administration, and fewer high-profile patent expirations. Despite post-recession slowing in doctor visits and elective procedures, overall prescription growth was still up 1.2% in 2012, suggesting that an improving economy could further boost drug demand as health care utilization improves.
AmerisourceBergen isn't relying solely on industry dynamics
The company doesn't make a lot of money on each sale, boasting operating margins of less than 2% on its drug segment -- a business accounting for more than 80% of sales. So, the ability to grow profit comes from growing scale -- and scale is coming thanks to a 10-year deal inked with Walgreen (NASDAQ:WBA) earlier this year. That deal is expected to boost AmerisourceBergen's sales by $25 billion in 2014 while improving the company's reach in Europe through Walgreen's Alliance Boots.
Growth also comes from specialty drugs and value-added drug services, which carry higher margin rates and are enjoying faster growth. Demand for specialty drugs continues to benefit as oncology pipelines mature, and value-added services offer upside as next-generation drugs and generics vie for market share amid tighter regulation.
Walgreen provides clarity and consistency
AmerisourceBergen kicks off substantial cash flow every year, but bare knuckle competition with McKesson and Cardinal Health always creates risk as contracts expire. The deal with Walgreen gives AmerisourceBergen a multiyear run of predictable sales. It also offers a stronger relationship with a top customer given that Walgreen received warrants to buy up to 16% of AmerisourceBergen shares for between $51.50 and $52.50 by 2017.That alliance could become even stronger once the companies start reaping benefits from combined global purchasing power. AmerisourceBergen is guiding for cost saving leverage in drug purchasing beginning in 2015.
The combination of prescription growth and margin-friendly cost cutting gives AmerisourceBergen room to continue rewarding shareholders with buyback and dividends. A healthy balance sheet with more than a billion in cash combined with a billion in annual free cash flow has allowed the company to return more than 100% of free cash flow to investors in each of the past two years.
Thanks to operational cost controls and buybacks, earnings per share have grown a compounded 17% since 2001. AmerisourceBergen earnings were up 18% to $2.96 per share last year and. In the second quarter, earnings per share were up 3.6% last quarter. The company expects EPS to grow 11%-14% to $3.06-3.11 for fiscal 2013, and AmerisourceBergen is guiding for the Walgreen deal to add $0.20 per share to earnings in 2014.
Short-term pain, long-term gain
The Walgreen deal isn't free. AmerisourceBergen's investment in systems and inventory has weakened already thin operating margins. Operating margin fell 34 basis points to 1.34% last quarter. As a result, after spending $400 million on share buybacks in the first fiscal nine months of the year, the company is likely to move to the sidelines through year end.
But those one-time investments should offer easier comparisons next year once the Walgreen deal is in full swing. And, the company's long-term approach to dividends and buybacks was reinforced earlier this year with a new $750 million buyback authorization in August. AmerisourceBergen has reduced its shares outstanding from 320 million shares in 2009 to 231 million shares exiting last quarter.
The Foolish final take
AmerisourceBergen isn't the only distributor hoping to build scale globally. McKesson and Cardinal Health are also interested in bolstering business abroad. The two companies were rumored in a bidding war for German drug distributor Celesio this past summer.
So, industry competition and margins aren't likely to ease any time soon. But, a larger insured population, greater clarity, and improving operating margins next year suggest that AmerisourceBergen will remain shareholder friendly, making the company an interesting opportunity over the coming year or two.
Todd Campbell has no position in any stocks mentioned. Todd owns E.B. Capital Markets, LLC, a research firm serving professional money managers. E.B. Capital's clients may or many not own shares in the stocks mentioned. Todd also owns Gundalow Advisors, LLC, an advisory serving high net worth investors. Gundalow's clients currently do not own positions in the 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.