The Pharmaceutical distribution industry is in a period of transition. Competitive threats are heightened with the rumored entry of Amazon (AMZN) into the drug distribution business. In addition, rising demand for generics has caused price deflation, which has eroded profit margins in an industry that already carries low margins.

This has brought down share prices for the three major U.S. pharmaceutical distributor stocks. As of 6/18/18, shares of Cardinal Health (CAH), McKesson (MCK), and AmerisourceBergen (ABC) have declined approximately 29%, 8%, and 1% in the past 12 months, respectively.

However, all three companies have remained steadily profitable during the difficult operating climate. They also pay dividends to shareholders, and raise their dividends each year. 

The stocks are listed in order of their expected returns. More information can be found in the Sure Analysis Research Database, which ranks stocks based upon the combination of their dividend yield, earnings-per-share growth potential and valuation to compute total returns.

This article will discuss the top 3 pharmaceutical distribution stocks.

Drug Distribution Dividend Stock #3: Amerisource Bergen

• Annual Expected Returns: 12.8%

AmerisourceBergen was formed in 2001, by the merger of AmeriSource and Bergen Brunswig. Today, the company provides pharmaceutical products and business solutions to a variety of customers, which include healthcare providers, veterinary practices, and livestock producers. ABC generates annual revenue of $150 billion, with a presence in more than 50 countries around the world. ABC sources over 1.5 million products, delivered from over 30 distribution centers, which is a major competitive advantage.

On 5/2/18, the company reported strong second-fiscal quarter financial results. Revenue of $41.0 billion increased 10.5% year-over-year. Adjusted earnings-per-share increased 9.6% for the quarter. Both figures beat analyst expectations. Revenue and earnings-per-share beat analyst forecasts by $480 million and $0.12 per share, respectively, which meant the results were well above expectations. Revenue growth was due to a 10.4% increase in the core Pharmaceutical Distribution Services segment.

Margins eroded in the Pharmaceutical Distribution segment, but only slightly. The second-quarter earnings report showed stabilization in this core part of the business.

Source: Earnings Presentation, page 6

Even though the operating environment is challenged for healthcare distributors, ABC continues to grow, thanks in large part to acquisitions. Last year, ABC acquired H. D. Smith, the largest independent pharmaceutical wholesaler in the U.S., for $815 million in cash. The acquisition is expected to be slightly beneficial to adjusted earnings-per-share in 2018, and to boost earnings-per-share by $0.15 in fiscal 2020. This is a positive long-term deal for ABC shareholders, as it will strengthen the company’s position in its key market, and enhances its scale in U.S. pharmaceutical distribution.

In 2018, ABC expects to generate earnings-per-share in a range of $6.45 to $6.65. The company has guided investors to expect earnings toward the bottom of the range. Still, this would represent a satisfactory growth rate of nearly 10%, which is a strong result given the challenges in pharmaceutical distribution right now. ABC is expected to grow earnings-per-share and dividends by 10% per year over the next five years.

ABC stock currently trades for a price-to-earnings ratio of 14.2, which is slightly below our fair value estimate of 15. If the stock valuation returns to our estimate of fair value, it would be a 1.1% annual boost to total shareholder returns, and the stock pays a 1.7% current dividend yield. Lastly, we expect 10% annual earnings growth for the company, which will lead to strong shareholder returns of 12.8% annually.

Drug Distribution Dividend Stock #1: McKesson

• Annual Expected Returns: 13.4%

McKesson was founded by John McKesson and Charles Olcott in 1833. Today, it is one of the largest healthcare distributors in the U.S. McKesson offers supply chain management, retail pharmacy, community oncology and specialty care solutions to pharmaceutical manufacturers, healthcare providers, pharmacies, governments and more. McKesson’s supply network includes more than 4,700 retail pharmacies.

Source: JP Morgan Healthcare Conference, page 4

On 5/24/18 McKesson reported fourth-fiscal quarter, and fiscal 2018 financial results. Overall, the report was mixed—revenue of $51.6 billion increased 6% year-over-year and beat analyst expectations by $380 million. This was a strong top-line result for McKesson, reflecting strong volume growth. Revenue increased 5.3% in the core North America pharmaceutical segment, while revenue rose 19% in the international markets. The Medical-Surgical segment generated 8.7% revenue growth for the quarter. Revenue increased 5% for the full year, but gross profit declined 1%, reflecting a nearly 6% increase in the cost of sales.

McKesson’s adjusted earnings-per-share declined 1% in fiscal 2018. For the upcoming fiscal year, McKesson management expects adjusted earnings-per-share of $13.00 to $13.80, which would represent 3%-9% earnings growth for fiscal 2019. Earnings growth this year is expected to be fueled by a more stable operating environment, with much less price deflation in pharmaceutical distribution, as well as tax reform and share repurchases.

McKesson generates a lot of cash, which it can use to invest in growth, as well as reward shareholders with dividends and share repurchases.

Source: JP Morgan Healthcare Conference, page 13

McKesson recently increased its share repurchase authorization by $4 billion, to a new total of $5.1 billion. At the current share price, this represents roughly 17% of the market capitalization, which could by itself add 3% to McKesson’s annual shareholder returns.

On 4/25/18, McKesson announced a new multi-year strategic growth initiative. Going forward, the company will focus on expanding supply chain services for pharmaceutical and medical supply manufacturers, boosting its presence in the high-growth specialty pharmaceutical market, and new offerings in patient care delivery. Over the next five years, we expect 7% annual earnings growth.

Due to its earnings growth potential, and a very low dividend payout ratio, there is plenty of room for the company to increase its dividend at a high rate. McKesson delivered a 21% dividend increase last year, and the company will likely raise its dividend by 10%+ in 2018.

Based on fiscal year earnings-per-share of $13.60, McKesson stock currently trades for a price-to-earnings ratio of 10.7, which his significantly below average. In the past 10 years, McKesson stock traded for an average price-to-earnings ratio of 14, which we view as a reasonable fair value estimate, since the company has a positive earnings growth outlook going forward. If the stock returns to our fair value estimate over the next five years, valuation changes would add approximately 5.5% to annual shareholder returns.

McKesson stock is not particularly attractive for income seekers such as retirees, due to its relatively low dividend yield of 0.9%. However, the company can grow its dividend each year going forward, thanks to a low payout ratio and positive earnings growth. In addition, the stock appears to be undervalued. We believe McKesson can generate annual returns of 13.4%.

Drug Distribution Dividend Stock #1: Cardinal Health

• Annual Expected Returns: 23.6%

Cardinal Health serves over 24,000 pharmacies in the U.S., and more than 85% of U.S. hospitals. The stock has a market capitalization of $16.5 billion, and the company generates revenue above $130 billion annually. Cardinal Health also has an impressive history of dividend growth. It is on the list of Dividend Aristocrats, a group of 53 stocks with 25+ consecutive years of dividend increases.

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On 5/3/18 the company reported fiscal third-quarter financial results. Revenue increased 6% to $33.6 billion in the quarter. Unfortunately, GAAP operating earnings declined by 10% to $546 million. On an adjusted basis, earnings-per-share decreased by 9% to $1.39. Cardinal Health saw price deflation in the pharmaceutical segment, due to generics, which drove down segment operating profit by 4% last quarter.

Pharmaceutical segment operating profit declined by 3% last quarter reflecting the margin erosion from price deflation. Fortunately, the medical segment continued to perform well, with revenue and operating profit growth of 15% and 34%, respectively.

Source: Earnings Presentation, page 6

For the full year, the company now expects to generate adjusted earnings-per-share between $4.85 and $4.95, down significantly from the $5.25 to $5.50 it was expecting previously.

Despite the recent challenges, we believe Cardinal Health has a positive growth outlook. The U.S. is an aging society, which means demand for pharmaceutical and medical products should only grow moving forward. Acquisitions will help drive future growth. For example, in 2017 Cardinal Health acquired the Patient Recovery business from Medtronic (MDT) for $6.1 billion, to broaden the company’s product offerings. Cardinal Health management expects the Patient Recovery acquisition to add $0.21 of earnings-per-share in 2018, and $0.55 in 2019. Cardinal Health also announced a new $2 billion share repurchase authorization, which will help boost earnings growth.

Since 2010 (the year after the spinoff of CareFusion) Cardinal Health has reported 13.5% annual earnings growth. While we believe the company will not reach this level of earnings growth moving forward, we expect 9% annual earnings growth over the long term, which is still a strong growth rate. We forecast earnings-per-share of $5.38 on an adjusted basis for fiscal 2018.

Based on our earnings forecast, the stock is trading at a price-to-earnings ratio of 9.8, which is significantly below our fair value estimate. In the past 10 years, Cardinal Health stock held an average price-to-earnings ratio of 16.8. If Cardinal Health trades up to our fair value estimate, the valuation expansion will add 11% per year to shareholder returns. Combining 9% earnings growth and the 3.6% dividend yield, Cardinal Health’s total returns could exceed 23% per year.