A Common Cold for Drug Distributors?


By Amy Tsao After the market closed on June 30, drug wholesaler Cardinal Health (CAH) dropped a bombshell. It advised that earnings growth for fiscal year 2004 ending that day would be some 11%, much lower than its previous estimate of "midteens or better." The reason: An unexpected drop in drug-distribution revenues -- its core business -- as well as a falloff in other smaller activities. And looking forward, it said earnings growth for fiscal 2005 would be about 10%, instead of the mid-teens range it had earlier projected. Analysts now see 11% earnings growth, to $3.93 per share, for fiscal 2005, ending next June.

The result: Cardinal stock tumbled 25%, closing at $52.86 on July 1. Competitors McKesson (MCK) and AmerisourceBergen (ABC) took hits as well, falling 7.2%, to $55.67, and 9.7%, to $30.96, respectively.

"DEEP IN THE WOODS." Drug-distribution stocks might seem cheap to some after this tumble. But investors might want to tread warily: Even though the losses at McKesson and AmerisourceBergen were tangential, Cardinal doesn't appear to be alone in its woes. "We think the group is dead money for several months -- if not for several quarters," says Robert W. Baird & Co. analyst Eric Coldwell, who rates all three stocks hold. (Coldwell's firm makes a market in Cardinal stock.)

Until its latest estimate revision, Cardinal was considered the most diversified of the drug-distribution sector trio and best positioned to handle an ongoing transition in the way these companies book contracts with manufacturers. Beginning in late 2003, the industry pushed to change the payment system for distributing medical products (drugs, devices, and other supplies) to customers (hospitals, doctors' offices, etc.). Wholesalers essentially want "fee for service" deals with manufacturers that would create less volatility in profit margins.

However, the switchover to such contracts could remain problematic. "The dramatic hit to Cardinal suggests other wholesalers are pretty deep in the woods," says Coldwell. Cardinal had expected many customers to have agreed to these new contracts by now. Instead, the majority are still in negotiations.

CASE OF THE SHAKES. In Cardinal's case, investors have another layer of uncertainty. In May, the Securities & Exchange Commission announced a formal investigation into how the outfit reports revenues. With the June 30 earnings warning, Cardinal said the SEC expanded its probe, and the U.S. Attorney's Office also launched a separate inquiry on the same issue. Cardinal says it's cooperating fully with the authorities, but has yet to provide further details of the investigations.

Chesterbrook (Pa.)-based AmerisourceBergen and San Francisco-based McKesson are also struggling through the same business-model change as Cardinal, but they "had set their expectations more reasonably than Cardinal had," says Andy Speller, analyst at A.G. Edwards. (Speller and his firm have no conflicts to disclose.)

Both outfits have their own vulnerabilities in the near term. Earnings at McKesson could fall short, says David Francis, analyst with Jefferies & Co. Though it beat AmerisourceBergen earlier this year to win a $2.9 billion contract with the Veteran's Administration away, Francis thinks the deal could be less profitable than expected.

DIVERSIFICATION HELPS. He's somewhat more optimistic on AmerisourceBergen, rating it a buy. (Francis and his firm hold no positions in either stock.) The reason: Investor expectations were dampened following the lost of the V.A. contract to its rival, and the stock's valuation is still cheapest of the three.

Over the long term, more diversification outside of drug distribution, along with more fee-for-service contracts could give this troika more stability. But in the meantime, the road may be a bit bumpy. Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column


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