Near-Term Issues Don't Affect Amerisource's Valuation

The headwinds AmerisourceBergen had to contend with over the quarter were largely split into two buckets.

Complex large-customer contracts. Over the past handful of years, Amerisource has made a concerted effort to win several major large-customer contracts--most notably Walgreens. These contracts are highly complex and require the highest level of servicing. Thus, we believe Amerisource had to upgrade several parts of its overall operations, including greater efficiency from its asset infrastructure. These investments will weigh on near-term profits and cash flow but should be highly leverageable once Amerisource ramps its volume and becomes more comfortable with the operational adjustments.

We also believe the firm was willing to renew recent contracts at materially lower levels of pricing in order to retain the business. We are not as certain regarding this strategy and believe the firm will eventually have to let some of this business migrate if there is further client pricing pushback. Most notably is the Express Scripts mail order contract, which was just renewed through another one-year extension. We believe Express may be motivated to change suppliers and thus could be in a position to demand significant discounts. We will watch closely how this relationship develops over the coming year as Express is likely to look to obtain a long-term agreement from one of the three major wholesalers.

Generic price inflation. The tailwinds of generic price inflation have waned over the past year, which has pressured the growth rate for Amerisource's bottom line. While this dynamic is a near-term issue, it is not a major source of incremental long-term value, from our perspective. Pharmaceutical manufacturer pricing strategies are influenced by many factors, and price inflation can experience periods of relatively high growth or stagnation. Thus, we believe it's important that investors consider this metric mean-reverting in nature when assessing its long-term economic influence. Any long-term extrapolation of these near-term pricing gyrations can create excellent value investment opportunities for the major three drug distributors. Amerisource has clearly entered this type of period, and investors could parlay its current equity mispricing into strong potential gains over the next several years.

Positioned to Benefit From Pharma Industry's Robust Growth The delivery of pharmaceuticals to consumers encompasses many firms along the supply chain, and AmerisourceBergen stands out as a powerful player. We believe the firm possesses a wide economic moat thanks to its colossal scale. Amerisource also plays a critical role in the pharmaceutical industry as many other supply chain participants depend on its services for streamlined product distribution and procurement. We anticipate robust growth for the pharmaceutical industry over the long term, which should provide the firm with a solid platform for continued success.

AmerisourceBergen is the second-largest pharmaceutical distributor by revenue and is the main supplier to Walgreens and Express Scripts. The firm has a highly integrated strategic agreement with Walgreens in which it supplies all of the retail pharmacy's drug inventory, including generics. This last aspect is key--supplying higher-margin generic drugs to one of the biggest generic drug retailers outlets is a major positive for profits, capital efficiency, and invested capital returns. Over the course of fiscal 2015, management did an excellent job with this major contract integration and has exceeded initial growth and profit expectations from the Walgreens partnership. We believe this reflects the strong scale, leverage, and efficiency that was gained from the new highly integrated Amerisource/Walgreens operation.

Additionally, AmerisourceBergen has the opportunity to procure its generic inventory from the already enormous Walgreens Boots Alliance Development. This dynamic allows the drug distributor to obtain its generic drug inventory at lower cost levels and drive profits, especially among its smaller pharmacy customers. Amerisource is also the largest specialty drug distributor in the United States, which positions it favorably to benefit from the fastest-growing drug category in the pharmaceutical market.

Colossal Size Results in Wide Moat We believe AmerisourceBergen has a wide economic moat. From our perspective, all three major pharmaceutical distributors possess wide economic moats as their colossal size gives them key competitive advantages. Each distributor also plays a critical role among manufacturers and retail outlets, which solidifies their long-term outsize returns. According to the Centers for Medicare & Medicaid Services, the estimated total amount of retail pharmaceutical spending in the U.S. is a little over $300 billion. The majority of this spending flows through the operations of the major three pharmaceutical distributors. This dominance results in robust and sustainable economic profits for these players.

We estimate AmerisourceBergen, Cardinal Health CAH, and McKesson MCK have a combined market share well over 90%. Combining this dynamic with slim industry profits keeps new entrants at bay. A new player would have a tough time carving out enough share to efficiently leverage its distribution assets into positive economic profits. This dynamic solidifies the long-term competitive position of the major three drug distributors. These firms are also able to obtain deep pricing discounts from drug manufacturers that many of their customers cannot acquire on their own. This dynamic makes these players an essential link in the pharmaceutical supply chain.

More critically, its massive distribution operation means AmerisourceBergen enjoys excellent asset efficiency. Effective route density, efficient warehousing infrastructure, and unparalleled logistical expertise have driven decent asset returns. However, the ability to effectively manage its capital base is the true driver of outsize returns for Amerisource. The firm is able to produce top-tier asset turns, cash conversion, and inventory management metrics that have led to outsize returns on invested capital--a trend we believe will last over the long term.

Pricing Transparency and Pressure Are Risks Two main risks face AmerisourceBergen: the push for greater drug pricing transparency and increased pricing pressure from payers. There has been a concerted push from many pharmaceutical players to create more manufacturer-to-wholesaler pricing transparency. If distributor acquisition costs become more widely known, it could hurt AmerisourceBergen's pricing power. Additionally, payers have sought to curb the growth of drug spending over the past few years, and we believe this trend will continue over the foreseeable future. If manufacturers and retail pharmacy customers are unwilling to budge from current pricing demands, AmerisourceBergen's profits could be squeezed.

The firm has a significant distribution and generic sourcing partnership agreement with Walgreens. Part of this agreement enables Walgreens Boots Alliance to acquire as much as 24% of AmerisourceBergen's equity. If the expected returns from this agreement do not materialize, there is a possibility that current shareholders will be diluted. However, on balance, we believe management made the right strategic move here, as the agreement makes AmerisourceBergen the exclusive drug supplier to one of the world's largest pharmaceutical sourcing entities.