We are upgrading MCK to Outperform from Peer Perform and increasing our year-end target price to $184 from $161 (26% upside). We believe that the core U.S. distribution business will prove resilient as we move from a stay-at-home recession to a more normal recessionary environment, and that disruption to MCK’s other businesses will prove mostly transitory and manageable. MCK is the cheapest stock in the group after adjusting for opioid liability / costs and is now at an all-time low relative valuation despite improving results and fundamentals heading into the crisis. Further, we believe MCK will show the best EPS growth in the group over the next several years as its ability to deploy capital will be less impeded by an opioid settlement than CAH and ABC.
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This morning (05/07/20) ABC reported fiscal 2Q20 adjusted EPS of $2.40, above Wolfe/Consensus EPS of $2.27. EBIT was better than our estimate, primarily driven by upside in Pharma Distribution. ABC lowered fiscal 2020 (9/30 year-end) EPS guidance by 2%, with ABC’s Other segment more impacted than Pharma Distribution. Pending more color on ABC’s guidance assumptions, we expect that the relatively small adjustment to guidance should be well received.
Last night (5/4/20) Reuters reported that ABC has approached WBA about buying WBA’s European pharmaceutical wholesaling division. ABC reportedly is willing to pay $6B for the business, which represents ~11x trailing EBIT and ~13.5x trailing earnings. The article notes that the deal would make it easier for WBA to be taken private and is another signal to us an acquisition of ABC by WBA does not appear likely. While the deal would provide an attractive level of accretion, leverage would increase meaningfully and could be >4x if the ongoing opioid litigation is settled around current expectations. It appears the discussions are still in early stages and “there is no certainty that the two companies will negotiate a deal”, according to the article.
We have updated our generic drug market tracking files to reflect March data. Overall, generic sales increased 7.6% y/y in March compared to the 1.1% decrease in February, with volumes up 10.0% y/y which primarily appears driven by the pull-forward of prescriptions into March from April ahead of COVID-19 social distancing / lockdowns. Deflation on mature generics improved for the third consecutive month following the higher rate of price deflation that we noted with the December data, possibly driven by COVID-19 disruption and / or stocking activities. In Q1 our data suggests chain store acquisition costs have declined faster than independent pharmacy acquisition costs, which implies that distributor margins for independents are expanding. See Slides 3-13 for visuals illustrating the trends discussed below.
We have updated our generic drug market tracking files to reflect February data. Overall, generic sales decreased 1.7% y/y in February compared to the 2.7% increase in January, with lower volume growth more than offsetting moderating deflation. Deflation on mature generics improved for the second consecutive month following the higher rate of price deflation that we noted with the December data, possibly driven by COVID-19 disruption and / or stocking activities. So far in Q1 our data suggests chain store acquisition costs have declined faster than independent pharmacy acquisition costs, which implies that distributor margins for independents are expanding.
Given the highly uncertain outlook for earnings and cash flow this year as a result of COVID-19, we wanted to assess each company’s comfort level vs. financial covenants where applicable and benchmark liquidity vs. recent cash flows. In short, liquidity is 2-3x annual cash flow and the CROs average a ~45% EBITDA buffer vs. covenants.
Distributors have outperformed the S&P 500 by 6% since the equity market sell-off kicked off on 2/24/10 but have underperformed the XLV by 2%. ABC has outperformed the XLV by 5%, while CAH and MCK have unperformed by 5% and 6%, respectively. We see ABC’s outperformance as a function of having the lowest leverage in the group and also the most exposure to the core U.S. Pharma distribution business. As we looked back at prescription trends during the financial crisis, we were surprised to see how well total prescriptions held up – total prescriptions never declined on a quarterly basis during 2008, 2009, or 2010. While the uncertainty introduced by COVID-19 is a completely different challenge vs. the financial crisis, we would expect prescription trends to hold up much better than other areas of health care utilization – likely boding well for distributors over at least the next couple of quarters.
On Friday (3/13/20) the New York Times provided an update on opioid settlement negotiations. The disagreement among state attorneys general continues, but the article included some notable details on potential settlement structure and the issues holding up the local governments from reaching a settlement. Based on a deal proposal outline obtained by NYT, distributors would only pay out 55% of settlement % until a state can confirm that its local govts are on board with the deal – this structure is referred to as a “cramdown”. Interestingly, Paul Hanley (a lead MDL attorney) suggested that the proposed payment amount of $19.2B would be acceptable “if it were paid over one, two or three years. But over a generation is too little, too long.”
Early this afternoon (03/10/20) Law360 reported that the upcoming New York opioid trial scheduled to start on 3/20 will now be delayed as a result of COVID-19. A status conference has been scheduled for 4/14 to see if a trial can begin shortly after that time. Recall that last week a New York appeals court rejected a request (unrelated to COVID-19) from various drug industry defendants including distributors to delay the trial. This trial combines cases brough by the New York attorney general, Nassau County (NY), and Suffolk County (NY). While the ongoing COVID-19 situation may also limit the opportunity for key stakeholders to come together and negotiate, this delay does in theory provide some additional time to continue discussions around reaching a global settlement ahead of the trial. However, we continue to see reaching a settlement specific to these plaintiffs as more likely than reaching a global settlement given 1) ongoing disagreements among state attorneys general and 2) discord between state AGs and local government plaintiffs. We note that we have not seen any reports or comments indicating NY AG Letitia James’ willingness to settle the case.
Yesterday a trial date was set for the opioid multidistrict litigation (MDL) Track 2 bellwether case in West Virginia following a status conference. Recall that the Track 2 bellwether case consists of Huntington, WV and Cabell County’s cases against ABC, CAH, and MCK. The trial is scheduled to begin on 8/31. Both the plaintiffs and defendants will have 6 weeks to present their cases, and inclusive of breaks in the schedule the case would run through the week of 12/14. Plaintiffs wanted the trial to start almost immediately, the and defendants had argued that a trial before the summer of 2021 “would be rushed”.
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