Jefferies: Weakening Generic Drug Prices Putting Pressure On 3 Healthcare Stocks

Jefferies initiated coverage on Cardinal Health Inc CAH, AmerisourceBergen Corp. ABC and McKesson Corporation MCK Wednesday with Hold ratings.

Jefferies’ analysis of prices paid by independent pharmacies for generic drugs leads analyst Brian Tanquilut to the conclusion that generic deflation is steep and accelerated in 2017 compared to the second half of 2016, putting margin and earnings pressure on drug distributors.

“Considering that the drug distributors make the bulk of their profits from generic drugs, we believe earnings pressure for the group is unlikely to abate," Tanquilut said in a note.

Key Takeaways

Cardinal Health is “in the investor penalty box” thanks to unexpected growth guide-down, Tanquilut said, adding that the company's diversified business and recent deals could drive better-than-expected accretion, but debt paydowns are putting new deals on hold.

Jeffries likes AmerisourceBergen the best of the three; completions of a Walgreens Boots Alliance Inc WBA–Rite Aid Corporation RAD deal and already renewed large contracts last year make it the least susceptible to EPS shortfalls versus expectations. Near-term multiple expansions are unlikely, the analyst said, as visibility into drug pricing remains low and EPS growth is around 11 percent.

Worsening headwinds have pushed down growth for McKesson, although investors have reset down the guidance bar and management could note some optimism that trends will start to stabilize, according to Jefferies. Fiscal 2018 guidance will be issued Thursday, but the company will find it difficult to provide a bullish outlook, Tanquilut said.

The anticipated announcement of mid-year price increases for branded drugs is another risk factor. While average selling price data shows moderation in the inflation rate paid by independent pharmacies, this underscores decelerating growth rates for drug distributors. The Jefferies analyst said he doubts inflation rates will bounce back to those seen in 2012–2016 within the next few years, due to broad scrutiny of drug pricing by lawmakers.

Increased regulation appears to be forcing the industry to self-regulate pricing trends, Tanquilut said. Drug companies are benefiting from good dividend yields and record levels of free cash flow, despite moderating brand inflations and double-digit generic deflation, according to Jefferies. Their shareholder bases are also mostly long-only, providing valuation support despite fundamental headwinds.

Projections And Current Price/Movement

The analyst used a PE/G ratio analysis to come up with target P/E multiples for the drug distributors. Here are Jefferies' projections for the drug stocks:

• Price target: $77
• Estimated EBITDA: $3.5 billion 
• Target P/E multiple: 14x
• At time of publication: Down 0.95 percent at $71.94

AmerisourceBergen

• Price target: $95
• Estimated revenue: $155 billion
• Estimated EBITDA: $2.3 billion
• Target P/E multiple: 15x
• At time of publication: Down 3.14 percent at $86.32

McKesson

• Price target: $153
• Estimated revenue: $200 billion
• Estimated EBITDA: $4.8 billion
• Target P/E multiple: 12.5x
• At time of publication: Down 2.03 percent at $141.98