Cardinal's a Critical Link in the Pharma Supply Chain
Its core operations will be needed no matter how market dynamics shift.
We believe Cardinal Health (CAH) plays a critical role in the healthcare market, and as a result, it possesses a wide economic moat. The drug distributor is able to turn its significant size and market share into key competitive advantages. Cardinal is an important cog in the pharmaceutical industry, as many supply-chain participants depend on its services for streamlined product distribution and procurement. We expect the use of pharmaceuticals to increase over the next several years, which should provide a solid platform for Cardinal’s continued success.
Cardinal is the third-largest pharmaceutical distributor by revenue and is the main supplier to CVS Health’s retail pharmacy network. The company also supplies several large provider group purchasing organizations and mass retailers. The razor-thin profitability of these contracts and the enormous amount of capital needed to build a top-tier global drug wholesaling/distribution operation have formed a solid competitive foundation for Cardinal that has largely kept new entrants at bay.
Cardinal has also made a few strategic moves that we believe will be beneficial over the long term. For one, it has partnered with CVS Caremark in jointly sourcing generic drug products. This should allow it an opportunity to offset current profitability issues and drive economic value longer term, as the combined sourcing entity will be able to garner top-tier pricing discounts from generic manufacturers.
However, we are not enthusiastic about Cardinal’s push into medical equipment manufacturing and distribution. As we had initially believed would be the case, these operations have provided significant headwinds as pricing and manufacturing issues have formed. Although healthcare spending growth continues to exceed GDP growth, this is not the case for low-tech medical and surgical products, which generally experience market growth in the low single digits. We believe these assets could suppress returns on invested capital and detract value from the company’s top-tier core drug distribution operations. Accordingly, we are pleased that the new management team has taken the step of restructuring these noncore businesses.
Immense Size Results in Wide Moat
We believe the three major pharmaceutical wholesalers possess wide economic moats, as they can turn their colossal size into a key competitive advantage. Each distributor also plays a critical role among manufacturers and retail outlets, solidifying their long-term competitive positions. According to the Centers for Medicare & Medicaid Services, the estimated total amount of retail pharmaceutical spending in the United States is close to $400 billion. The majority of this spending flows through the operations of the major three pharmaceutical distributors. This dominance drives robust and sustainable economic profits for these players.
We estimate that Cardinal Health, AmerisourceBergen (ABC), and McKesson (MCK) have a combined market share of well over 90%. Combining this dynamic with slim industry profits keeps new entrants at bay, as a new player would have a tough time carving out enough share to efficiently leverage its distribution assets into positive economic profits. Additionally, the plethora of regulatory compliance and industry relationships that are required to be a viable drug wholesaler adds to the stalwart barriers to entry. These variables solidify the long-term wide economic moats of the major three drug distributors. These companies are also able to obtain significant pricing discounts from drug manufacturers that many of their customers cannot acquire on their own, making them an essential cog in the pharmaceutical industry vertical.
More critically, Cardinal’s top-tier distribution operations allow it to build 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 Cardinal. The company 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 next several years.
Regulation and Pricing Pressure Are Risks
Cardinal faces three main risks: the push for stricter regulation of pharmaceutical industry players, increased pricing pressure from payers, and its expansion outside core drug wholesaling activities. There has been a concerted effort from certain healthcare market stakeholders to have the federal government enact pricing controls over all drugs sold in the U.S. If distributor acquisition costs increase as a result, it could hurt Cardinal’s returns. Additionally, payers have sought to curb the growth of drug spending over the last few years, and we believe this trend will remain in place for several years. If manufacturers and retail pharmacy customers are unwilling to budge from current pricing demands, Cardinal’s profits could be squeezed. Finally, Cardinal has moved to drive growth through expanding into noncore businesses, such as medical device/consumable product manufacturing and distribution. We believe these markets are not lucrative and could drain economic profits.
Cardinal is in relatively solid financial health. The company’s highly efficient distribution assets produce excellent free cash flow, and its healthcare-related operations provide a solid foundation for long-term financial stability. Its capital leverage did increase materially in 2018, as it funded two thirds of its $6.1 billion acquisition of Medtronic’s patient recovery business with debt. However, the company’s strong cash generation should allow it to easily pay down its debt obligations.
Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.