How to Profit from This Big Agreement in the Pharma Distribution Business

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Recently, Walgreen (NYSE: WAG) and its partner Alliance Boots have announced that they reached a 10-year agreement with AmerisourceBergen (NYSE: ABC) for the distribution of branded, generic and specialty pharmaceuticals to Walgreens’ retail stores and specialty pharmacies. At the moment, Walgreen is distributing more than 80% of its own drugs, but with this long-term agreement AmerisourceBergen will increasingly handle distribution for Walgreen. The deal seems to be quite beneficial for both companies, as both will benefit from larger scale to improve their efficiencies, reduce costs and make patient access to pharmaceuticals much easier.

AmerisourceBergen and Walgreen

AmerisourceBergen is considered one of the biggest global pharmaceutical services companies on the market, with a geographically diverse network of distribution service centers in the U.S., Canada and other big markets. The majority of its revenue, $78.35 billion, or 98.6% of the total revenue, came from pharmaceutical distribution. Its largest customer in fiscal 2012 was Medco Health Solutions, accounting for around 17% of its total revenue. AmerisourceBergen has quite a concentrated customer base, with its top 10 customers representing around 41% of its total 2012 revenue.

Walgreen is considered the largest pharmaceutical store chain operator in the U.S., with a total of 8,385 stores including 7,930 drugstores, 11 specialty pharmacies, 366 worksite health and wellness centers, 76 infusion and respiratory services facilities and 2 mail service facilities in fiscal 2012. Around 63% of its total 2012 sales was generated from prescription drugs sales, while the non-prescription drug sales and general merchandise accounted for 12% and 25% of the total sales in 2012, respectively.

Walgreen is expanding its business

Recently, Walgreen made an aggressive expansion in the European market and some emerging markets by acquiring 45% of Alliance Boots for around $6.7 billion. Walgreen also had a call option to purchase the remaining 55% of Alliance Boots within 6 months of Feb. 2015. With that deal, Walgreen could tap into 3,330 health and beauty retail stores, including pharmacies in more than 3,200 stores. The Alliance Boots’ deal has made Walgreen a leading global pharmaceutical retailing empire.

Business integration for better operating efficiency

As the part of the deal with AmerisourceBergen, Walgreen and Alliance Boots have the right to buy up to 7% of AmerisourceBergen’s total shares outstanding in the open market and warrants exercisable for 16% of its total diluted equity. During the equity acquisition and warrant exercises, a Walgreen executive and an Alliance Boots executive will be appointed in AmerisourceBergen’s current nine-member board. Thus, in the next several years, we would expect the integration of all these three businesses to further improve the operating efficiency and have more bargaining power in the pharmaceutical industry.

Cardinal Health is quite uncertain

The contract with AmerisourceBergen replaced Cardinal Health’s (NYSE: CAH) contract, which will expire in August 2013. The loss of the Walgreen contract would make Cardinal Health struggle, as Walgreen was one of the two biggest customers of the company, accounting for around 21% of the total 2012 sales. The biggest customer of Cardinal Health was CVS Caremark, representing 22% of its total sales in 2012. However, both of Cardinal Health’s contracts with CVS Caremark and Walgreen would expire in June and August 2013, respectively. After the agreement between Walgreen, Alliance Boots and AmerisourceBergen was announced, Cardinal Health lost 7% on the market and dropped to around $42 per share.

At the current price, Cardinal Health is worth around $14.3 billion on the market. The market values Cardinal Health at 6.54 times EV/EBITDA. Walgreen, at around $46 per share, has a total market cap of around $43.5 billion. The market values Walgreen at a much higher valuation, at 10.5 times EV/EBITDA. AmerisourceBergen is the smallest company among the three with $11.5 billion in total market cap. At $50 per share, AmerisourceBergen is valued at only 8.7 times EV/EBITDA.

Foolish takeaway

Even with the lowest valuation, Cardinal Health is exposed to huge business uncertainty. Among the three, I personally think Walgreen would be a stock to hold in the long run due to its market leading position, the potential improvement in operating efficiency and a reasonable valuation.

Anh HOANG has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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