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The Drug Wholesale Trade Goes All In

As many of their customers brace for changes under ObamaCare, U.S. drug wholesalers are in expansion mode — heading overseas and forming purchasing co-ops wherever they see fit.

This massive piece of the healthcare puzzle is home to three huge competitors. Two of those, McKesson (MCK), the largest, and No. 3 AmerisourceBergen (ABC), are expanding heavily into Europe — mainly through joint partnerships.

The No. 2 player, Cardinal Health (CAH), has also been looking for new business outside the U.S., especially in China. But on Dec. 10 it announced a partnership with CVS Caremark (CVS) to form what it claims will be the largest drug-buying venture of its kind in the U.S.

Combined, the three top drug wholesalers handle more than 80% of all drugs distributed in the U.S. They provide drugs to retail pharmacy chains, independent pharmacies, hospitals and nursing homes.

"Distributors are the most diverse players in the health-care supply chain," said analyst Eric Coldwell of Robert W. Baird & Co. "They are not reliant on specific product classes or devices. They sell across the board.

Boots, Celesio And CVS

All three top drug distributors saw shares prices soar more than 60% so far in 2013. The gains hoisted the medical-wholesale drug supply group to a top 20 ranking among IBD's 197 industry groups.

AmerisourceBergen was the first to deal in Europe. In March, it joined a partnership forged last year between Walgreen (WAG) and Alliance Boots, the Swiss firm that runs Boots, an international pharmacy chain. Not only did AmerisourceBergen get the nod to distribute pharmaceutical products to more than 8,000 Walgreen stores, it can buy generic drugs through a Walgreen-Alliance Boots global sourcing joint venture.

McKesson is following AmerisourceBergen into Europe with its planned $8.3 billion acquisition of German drug wholesaler Celesio, announced in late October. Total revenue for the combined company is expected to be more than $150 billion, up from $122 billion in the fiscal year ending in March. It'll add an estimated $1 to $1.20 a share to McKesson's earnings in the first year.

Celesio sells drugs to customers in 13 European countries and Brazil. Plus, it runs 2,200 pharmacies in six European countries, including the U.K., where its Lloyds pharmacy chain is second only to Boots.

McKesson expects to gain full control of Celesio in the fiscal year starting in April. The plan has met some resistance from New York-based hedge fund Elliott Management, which claims McKesson's offer — at around $31.55 a share — substantially undervalues Celesio. The fund owns 25% of Stuttgart-based Celesio.

In terms of big deals, Cardinal is no longer the odd man out. In the agreement announced this month, Cardinal and CVS Caremark will form a generic-drug buying operation in the U.S., to begin in July, using their combined clout to score better pricing.

The venture will source and negotiate generic supply contracts for both Cardinal and CVS. ISI analyst Ross Muken estimates their combined generic purchasing comes to about $12 billion-$14 billion a year.

He figures Cardinal alone will save $235 million-$275 million a year, adding 25-35 cents to its earnings once the combined operation is fully up to speed.

Brands Vs. Generics

Wholesalers generate more revenue from selling brand-name drugs than generics. But generics are more profitable. "With more purchasing volume, they can extract additional discounts from generic suppliers," said Adam Fein, president of Pembroke Consulting.

Pharmacies typically buy brand-name drugs from wholesalers. Smaller pharmacies also tend to buy their generic drugs from wholesalers. But larger pharmacies usually buy generic drugs directly from manufacturers. That's why small, independent pharmacies have traditionally been drug wholesalers' life blood.

AmerisourceBergen's new ties with Walgreen and Alliance Boots, and now Cardinal's with CVS change that dynamic.

"It's a big deal for AmerisourceBergen," said Fein. He says Walgreen will contribute almost $28 billion to AmerisourceBergen's revenue in fiscal 2014.

The Cardinal and CVS buying group also is viewed positively. Muken calls it "an unmitigated positive" for Cardinal, a move that put the company back "on equal footing" with its two rivals.

In the drug wholesaling business, revenue is not the main measure of success. Profits are, especially operating profits.

Coldwell expects AmerisourceBergen to show near-term EPS dilution and margin erosion from the Walgreen deal and from its recent contract win with pharmacy-benefits manager Express Scripts (ESRX), the latter of which he calls "exceptionally low-margin.

Cardinal's loss of both customers this year led to a $3.7 billion downshift in revenue. But shedding the tight-margin agreements helped expand its gross margin to more than 5% in the last quarter, Coldwell noted.

Cardinal still distributes branded drugs and some back-up generics to CVS retail stores. CVS mostly self-distributes generics.

ObamaCare, Generic Tail Winds Wholesalers buy drugs from most manufacturers. The more customers they amass, the better they are able to leverage discounts. Analysts see ObamaCare feeding the industry's leverage as more uninsured patients gain insurance coverage and access to medicines.

New health insurance enrollees from ObamaCare could add up to 1% incremental revenue growth for drug wholesalers next year and another 3% or more in 2015, Coldwell says.

Yet, as wholesalers, drug distributors dodge the reimbursement dynamics their customers face, where revenue and profit are sensitive to changes in health plans, budgets and health-care reform, Coldwell says.

And unlike drug, biotech or medical-device firms, distributors aren't as dependent on a small number of products.

The flow of new generic drugs slowed this year following a huge wave that peaked in 2011 and 2012. "Another wave of generics is coming," said Coldwell. "We've started to see a modest recovery in generic launches and that will continue to build over the next 12 months," he said.

Brand-name drugs with sales of $73 billion will lose patent protection between 2013 and 2016, says Fein, who adds it's the last phase of the generic wave that started building five to 10 years ago, as brand-name drugs lost protection.

Among the many brand names going off patent next year are the MS drug Copaxone, acid-reflex drug Nexium and sleep aid Lunesta.

Inflation Plus Purchasing Power

Then there's the specialty-drug revolution that will keep drug distributors busy and profitable, analysts say. The drug industry is shifting from traditional, pill-based medicines for large patient populations to high-priced specialty therapies targeted to rare diseases and small patient populations.

"Wholesalers are a key part of the channel for specialty drugs administered by hospitals and outpatient departments and they have also started new specialty distribution businesses that target physician offices and clinics," Fein said.

The drugs, usually biologic in origin, often need special handling. This means higher profit margins for wholesalers dealing with them.

Mergers and acquisitions will also keep fueling wholesalers' growth, analysts say, along the lines of McKesson's $2 billion buy of PSS World Medical and Cardinal's $2 billion takeover of home-care products distributor AssuraMed earlier this year.

Cardinal has completed a number of small to midsize acquisitions of U.S. distributors, and has followed a similar course in China. Cardinal's China revenue jumped 29% in the last quarter over the earlier year, but Deutsche Bank analysts estimate that it accounts for just 2% of total revenue.

Analysts were not surprised by the latest deal from Cardinal and CVS. Prior to the announcement, Deutsche Bank analysts estimated that the McKesson-Celesio combination would give McKesson twice the generic purchasing volume of Cardinal while the AmerisourceBergen and Walgreen-Alliance Boots partnership has two-and-a-half times the purchasing volume.

Meanwhile, generic drugs are fetching slightly higher prices vs. the previous deflationary pricing environment. But even with deflation, distributors are able to wrangle profits through negotiations with manufacturers.

"Now they have negotiation power plus inflation," Coldwell said, adding that generic prices are up in the low single digits. "We think (price inflation) will be viable well into 2014 if not beyond."