With the current pressure on prices within the healthcare market, you can notice the higher volatility in this segment. We already own a big slice of healthcare in our portfolio ($JNJ, $AMGN and $GILD), so we checked out a favorite of the past few weeks in the DGI community: Cardinal Health. And made a deep dive into two of it’s peers – AmerisourceBergen and McKesson to compare the competition.
Medical distribution is a sub industry within healthcare which are less dependent on drug prices than, for example, biotech. Therefore it’s a nice ‘escape’ from the pressured drug manufactures, but you will still be able to profit from the longterm potential of the medical and pharmaceutical industry.
If you’re interested in investing in healthcare stocks, you must have noticed that the market is behaving rather volatile due to higher drug prices and high profile politicians taking a stand against them.
Looking at a companies fundamentals you could say that because of a strong business, market circumstances would not have to be such big of a deal. And on the long term there will be enough room to grow.
Except this time, the risk caused by the circumstances the companies are in, is an important factor you should not leave out. For instance, imagine what a tweet could mean for the stock price. Pretty much nothing, you would expect. But what if the person tweeting is Bernie Sanders…?
Well, than this happens:
So, you might want to sit this one out.
Of course there are lots of other opportunities to benefit from higher healthcare demand than investing in drugmakers. For instance: medical distribution companies.
Industry stock analysis
This industry does not entail retail sales of drugs and medical supplies or manufacturing the drug or professional equipment itself. Rather they only distribute the products and goods. More specific: medical and surgical instruments and equipment (about 55% of revenue); supplies (about 25%); and orthopedic and prosthetic appliances (10%)
There a several different companies (big & small) operating in this sector. For now we focus only on these three companies (in order of market cap):
- Cardinal Health
All three companies have a wide economic moat and are considered growth stocks. These three literally dominate the whole medical distribution business. Although there is much to like about all three of the companies, there are some different elements we are especially focused on: dividend, revenue growth, debt ratio and earnings per share. Therefore we made a list of some financial metrics in order to compare the 3 companies with each other.
AmerisourceBergen looks the most interesting. They are 20% below fair value, a high dividend growth rate and also maintain a high revenue growth. The lower dividends are a bit lower than we would like, but have still lots of room to grow according their pay out ratio of only 18%. The biggest downside however, is the high debt to equity ratio of 2. Compared to their peers and the industry it’s alarmingly high.
McKesson is the largest company of the bunch. They have a high earnings per share ratio, are far under fair valued and have a very low debt to equity ratio. But for such a big company they have a rather low dividend yield and an low growth rate for dividends. As a dividend investor these factors makes it less attractive.
Cardinal Health would be the DGI community’s favorite. They have the longest history (20 years) of paying dividends with a very attractive yield of 2.2%. Their dividend growth rate is lower than $ABC, but still very likable. And even with a pay out ratio of 41% there is still lots of room to let the dividend grow over time. However, we found 1 thing that is less admirable. Their revenue growth and EPS is compared to their peers, a bit low. So in terms of competitive advantage, the others seem to do better. (Which obviously says nothing about what’s to come in the future, but is just the current state of business)
Which one to buy?
At the moment were still doubting between Cardinal Health or AmerisourceBergen. But what to do with the high debt of $ABC? It could mean the investment will be more risky.
Yesterday evening I was talking to Mr. Divnomics about the above companies. We haven’t made a clear decision yet in which one we want to buy. But I couldn’t put my finger on the reason as to why $ABC has taking up so much debt in comparison with their industry peers. He said that in order to make a clear decision, we need to see the bigger picture of the story. So I decided to look a bit further then only 1 number and try to give some context.
In general, a high debt to equity ratio means that a company has been aggressive in financing its own growth with debt. This can result in volatile earnings as a result of the additional interest expense.
In order to take a look on why their using the debt to grow, we looked at the interest coverage rate and the underlying business fundamentals.
The interest coverage rate of $ABC in 2015 was only 3.7, but the past 12 months (ttm) it was already increased to 14. This means that $ABC could pay of its current debt 14 times, based on their available earnings. So they would have no problems paying back, or having debt expenses burden the company for a long while. That eases it down a little.
In their shareholders letter of 2015 we found two things that could explain their higher debt ratio:
- The acquisition of PharMEDium in the end of 2015
- The announcement to make substantial capital investments in their information technology platform and distribution facility infrastructure
In the times of low interest rates, it’s not at all surprising to find companies who use debt to fund acquisitions or other investments that stimulates rapid growth. In this light, their hight debt to equity ratio is not so horrific as at seemed, but is rather understandable.
Which one do you think is more interesting? Should we go for the higher dividend yield? Or maybe the higher dividend growth? And are there any other stocks you keep an eye on?
We’re very interested in your opinion and feedback. Which you can leave below in the comment section. It’s much appreciated, as always.
Disclaimer: if you find any of these stocks interesting, we strongly suggest you need to do your own research or seek out some professional advice. Discussing possible choices with your broker or investment adviser can help you make well-informed choices.