ABC - AmerisourceBergen: Focused On Megatrend-Driven Margin Expansion

2023-05-16 13:39:10 ET

Summary

• In the past quarter, AmerisourceBergen (+9.37%) has experienced superior share price action to both the market (SPY: -0.16%) and the healthcare industry (IXHC: +0.93%).
• This is reflective of the inelastic nature - thus reduced recessionary impact - of the company's services as well as scale expansion.
• Highlighting said scale growth, ABC's Q2'23 revenues grew 9.94% YoY to $63.46bn alongside free cash flow growth of 284.61% to $526.65mn in the same period.
• The firm has now pivoted to prioritizing margin growth, driven by specialty and integrated product offerings.
• Due to a strong operational proposition, in addition to the company's undervaluation, I rate ABC a 'buy'.

AmerisourceBergen ( ABC ) is a US-based global leader in pharmaceutical sourcing and distribution services, focusing on provisions of efficacious supply chain infrastructure, leadership in specialty and biopharma manufacturing, etc.

Introduction

To drive value for all stakeholders, ABC has laid out 5 strategic initiatives; enhanced core market leadership, utilization of infrastructure advantages to increase efficiency and customer support, investment in innovation, expansion in specialty offerings, and end-market participation in pharmaceutical outcomes.

Through the continuation of these initiatives, I expect to see adjusted diluted EPS growth similar to historic levels, with ~12% CAGR since FY16 and still ~11% CAGR excluding the COVID-19 healthcare premium.

Due to these activities, ABC has recorded $247.54bn in TTM revenues, alongside a same-period EBITDA of $3.31bn.

Valuation & Financials

General Overview

In the past quarter, ABC - up 9.40% - has seen superior growth to both the general market, represented by the S&P500 ( SPY ) - down 0.16% - and the healthcare index ( IXHC ) - up 0.92%.

Such divergent growth from the general market and industry emphasizes the company's ability to drive consistent cash flows and scale growth in spite of macro headwinds, including higher interest rates and inflationary pressures.

Comparable Companies

The inherent scale advantage required to adequately compete in the healthcare distribution market means that ABC faces competition from a concentrated group of larger firms. These firms include Cardinal Health ( CAH ), McKesson ( MCK ), and a relatively smaller firm, Henry Schein ( HSIC ).

As demonstrated above, ABC has experienced the best quarterly price action of all peers. This is not without reason, as illustrated both by the multiples-based value of the firm as well as ABC's growth metrics.

For instance, at 14.96 and 14.38, ABC maintains the lowest respective trailing and forward P/E ratios among peers. Additionally, in spite of headwinds and tailwinds concurrent for the entire industry, the operational prowess of ABC has enabled superior revenue growth, and the second-best earnings growth and overall returns. Such progress is further emphasized by ABC's astounding 809.53% ROE, which, though, is largely driven by leverage from higher debt.

The price of ABC's growth has been significant levels of Debt/Equity, though the firm's 0.08 debt/assets ratio, as derived from TradingView, demonstrates an ability to balance between creditors and shareholders in my opinion.

Valuation

According to my discounted cash flow analysis, the fair value of ABC, at its base case, is $198.20 up from a current price of $172.50, meaning the stock is currently undervalued by 13%.

I assume a discount rate of 11%, a highly conservative metric, to both address ABC's higher debt levels and potential recessionary pressures. Moreover, continuing the conservative theme of my model, I project a net margin growth rate of 2%, in line with inflation.

Alpha Spread's multiples-based relative valuation tool more than supports my thesis of undervaluation, calculating, at its base case, an undervaluation of 52%, meaning the firm's true value is $358.07.

However, I believe Alpha Spread is overpricing ABC due to the tool's inability to account for ABC's higher debt/equity ratio.

As such, using a weighted average skewed towards my DCF, the true value of ABC should be $224.33, representing an undervaluation of 23% from the company's current price.

Leveraging Healthcare, Margin-Expanding Megatrends

Even without a level of innovation, ABC's leadership in pharmaceutical distribution is centric to leveraging it to a growing healthcare demand, as a product of ongoing demographic shifts and earlier diagnoses of chronic health issues. The number of people aged 65 or older in the US is expected to rise to 73.1mn by 2030 and 86mn by 2050, for instance, both as the baby boomer generation retires and as individuals live longer. ABC is well-positioned to leverage this increased demand, leading with key customer partnerships in retail, specialty, and health systems in the US and Europe regions.

Another trend ABC aims to employ is the increased demand for new pharmaceuticals, generics, and drug-centric therapy. Through their pre-existing platform, such as 'Good Neighbor Pharmacy' or the 'Elevate Provider Network' and through expansions into higher-margin categories such as life sciences through M&A activity, ABC is well-positioned for scale and margin growth while innovatively servicing consumers. Most recently, ABC acquired specialized life science service provider PharmaLex for EUR1.28bn in cash. This supports ABC's ambition to become a leader in specialty and biopharma manufacturing services and takes the firm one step closer to vertical integration.

And to ultimately continue to achieve these goals - particularly higher margins - ABC has focused on promoting organic and inorganic growth above shareholder returns for the time being. While the company is committed to a reasonable dividend - currently at 1.13% and achieving an A+ and A on Dividend Safety and Dividend Consistency on its Seeking Alpha Quant scorecard - and opportunistic share repurchases, internal investment, and strategic M&A is the priority.

Wall Street Consensus

Analysts largely seem to support my positive view of the company, projecting an average 1Y price increase of 9.75% to $189.13.

Even at the minimum predicted price decline of -0.19% to $172, investors would still be positive through dividend income, which should be resilient in the face of significant macro volatility.

Risks & Challenges

Regulatory Pressures

The healthcare industry remains one of the most inherently scrutinized industries by regulators. As such, potential regulatory structures may put downward pressure on ABC's already compressed margins and materially reduce cash flow levels.

Poor M&A Selection

As ABC seeks to capture the dynamic growth of the healthcare market, from the growing size to changes in therapeutics, ABC has approached M&A with a heavier hand. However, failure to adequately select acquisition targets may lead to further reduced margins and larger debt levels.

Global Expansionary Risk

Beyond contending with the varied and complex nuances of different regulatory structures of different regions, moving into new markets without adequately consolidating or expanding margins in current ones can undercut success in core businesses. For instance, ABC maintains a larger margin in its American market than European one, which is reducing net cash flows.

Conclusion

In the short term, I expect that ABC will revert to fair value, driven by strong scale growth.

In the long term, I project that healthcare megatrends and the firm's ability to pursue them alongside margin expansion will catapult ABC into a further upward trajectory.

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