The Unusual Argument Explaining Why Drug Wholesalers Are Getting Slammed Today

By Markets Fool.com

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What happened

McKesson Corporation (NYSE: MCK) had some bad news for investors when it announced fiscal 2017 second-quarter earnings today. Unfortunately, the bad news was extended to investors of industry peers Cardinal Health (NYSE: CAH) and AmerisourceBergen (NYSE: ABC), too. All three stocks -- which together control 85% of the drug wholesale market -- were down at least 11.7% by noon.

ABC Price data by YCharts

Investors weren't taking any chances by hanging around for when AmerisourceBergen and Cardinal Health report earnings next week.

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So what

It may seem like an odd argument for anyone following the biggest stories in the healthcare industry this year, but McKesson Corporation said that fewer price increases on drugs -- and smaller rates of increases when they do occur -- forced the company to miss expectations for its fiscal 2017 second quarter. McKesson Corporation saw quarterly revenue grow 2% compared to the year-ago period, although EPS fell 49% in the same comparison.

But the argument does make sense. Each of the three companies generates revenue from stocking branded pharmaceuticals in inventory and distributing them throughout the market. Prices are negotiated under contracts and revenue is derived from capturing a percentage of the value, logistical and otherwise, that the drug wholesalers deliver for drug manufacturers and brand owners. Falling drug prices, or, more accurately, drug price hikes occurring at a slower pace than management at McKesson Corporation originally envisioned when determining full-year financial guidance months ago, will indeed need to be rectified by lower guidance and analyst expectations. And that's exactly what happened.

The worry is that AmerisourceBergen and Cardinal Health will have similar news when they announce earnings next week, since they operate in the same ecosystem and with nearly identical business models. However, while a significant part of each company's business, sourcing and distributing drugs is only part of operations. The companies also distribute medical supplies and devices, source consumer products including cosmetics, and offer data solution services, among other practices. Cardinal Health even offers its own brand of medical and surgical products. Are unexpected results in store next week?

The 15 analysts covering Cardinal Health's quarterly earnings expect generally good numbers on Monday, according to numbers compiled by Yahoo! Finance. The average revenue estimate is just over $31 billion, which would represent growth of 10.7% from the year-ago period. However, analysts are expecting a drop in adjusted EPS from $1.38 in the year-ago period to $1.21 in the most recent quarter, although estimates call for earnings growth to resume in the next quarter. It's also worth pointing out that Cardinal Health has beat the Street's EPS estimates in each of the last four quarters.

The 14 analysts covering AmerisourceBergen's quarterly earnings expect good numbers as well, also according to numbers compiled by Yahoo! Finance. The average revenue estimate is $37.8 billion and the average EPS estimate is $1.23, representing growth of 6.7% and 5%, respectively, from the year-ago period. The company has beat the Street in each of the last three quarters, and missed by one penny in the fiscal 2015 fourth quarter.

Now what

Today is an ugly day for drug wholesalers. If significant parts of their business are built on artificially inflated drug prices, now coming under intense scrutiny, then it makes sense for investors to reconsider their long-term growth potential. At the very least, they'll need to further diversify their operations, which could be a painful and expensiveendeavor. That may make them appear cheaper now -- all sporting price-to-earnings ratios less than 16 -- than the businesses are worth long term.

Or, this could all be a substantial overreaction by the market. Investors will need to wait for AmerisourceBergen and Cardinal Health to report next week to get a better read on the state of the industry and how, or if, congressional hearings over drug pricing is affecting their businesses.

Of course, let's not forget that lower prices for branded pharmaceuticals and reduced rates of price increases are great news for patients.

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Maxx Chatsko has no position in any stocks mentioned. Follow him on Twitterto keep up with developments in engineered biology and materials science.

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