Lowering Our Pharma Distributor Moat Ratings and Valuations

We have reassessed the pharmaceutical distributor segment in light of the evolving competitive and regulatory environment. On the basis of the continued decline of pharmaceutical spending growth and external shock threats, we have lowered our economic moat ratings for AmerisourceBergen ABC, Cardinal Health CAH, and McKesson MCK to narrow from wide with a negative trend. We also reduced our fair value estimates to $86 per share from $106 for AmerisourceBergen, to $55 per share from $82 for Cardinal, and to $130 per share from $210 for McKesson.

The role of pharmaceutical distributor continues to evolve in an increasingly competitive and highly regulated environment. Scale and regulatory requirements have provided insulation to maintain share and generate market returns, but competitive pressures continue to build with declining reimbursement, healthcare consolidation, and decline in overall pharmaceutical spending growth.

The three leading distributors effectively operate as an oligopoly and are entrenched within their customer base. McKesson is the largest pharmaceutical distributor, with global contract manufacturing capabilities, and is more vertically integrated with providers and retail pharmacy chains in Canada and Europe. AmerisourceBergen is the closest to a pure-play pharmaceutical distributor, with a platform based inside of or very close to providers and retail pharmacies. Cardinal Health is the smallest of the three, with private-label commodity manufacturing capabilities and medical devices. The companies’ investments in IT infrastructure provide the ability to navigate the highly regulated drug market. Scale also enables these companies to negotiate on behalf of providers and retail pharmacies. The required infrastructure, regulatory hurdles, and required logistics management insulate the distributors from new entrants.

AmerisourceBergen, McKesson, and Cardinal Health represent 90% of the market. The role of a pharmaceutical distributor has evolved with the increasing number of new therapies, formation of government regulatory organizations, and regulatory requirements and licensure of manufacturers, retail pharmacies, and pharmaceutical distributors. Through this evolution, these companies have continually invested in information technology and physical infrastructure to provide the logistical support efficiently. Their scale also provides the ability to negotiate lower prices with drug manufacturers across a comprehensive portfolio of generic, branded, and specialty drugs on behalf of providers (acute hospitals, clinics, and so on), mail pharmacies, and retail pharmacies.

With the current lack of pricing transparency, significant variations between list and invoice prices, day-to-day pricing volatility, and regulatory compliance and recalls, providers and retail pharmacies do not have the IT infrastructure to quickly manage the available information nor negotiate competitive pricing with manufacturers. The big three distributors have the ability to provide assistance with inventory management, compliance, and financing. They also support the commercialization of new drugs and logistics of products for manufacturers. These are functions that clients could perform themselves but choose not to because of the required investment and distraction from their core business.

All three distributors have secured a moat due to scale, but an uncertain drug pricing environment and growing customer leverage limit this moat to narrow. Pharmaceutical revenue growth has declined as a result of slower inflation and shifts in revenue mix toward generic drugs. Consistent with overall pharmaceutical spending trends, we expect revenue growth for the big three pharmaceutical distributors to decline, with overall growth in pharmaceutical spending of 3%-4%, a decline from double-digit growth in 2014 and 2015. Over the past three to four years, operating margins for the industry have declined, and these lower levels are likely to persist in the long term.

The significant decline in pharmaceutical market growth has caused distributors to seek out alternative growth channels through acquisitions, but entry into these new areas outside of core competencies has been costly. External shocks such as the elimination of rebates or increased price transparency would diminish some of the pharmaceutical distributors' value as negotiators. With more transparency on pricing, providers and manufacturers would be less likely to need a middleman to negotiate rates, which would give customers more leverage to renegotiate distribution contracts and further deteriorate distributor margins.