Cencora Continues to See Robust Growth From GLP-1s at the Cost of Margin Depression

Equity Analyst

Keonhee Kim

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U.S. Healthcare Solutions

International Healthcare Solutions

Pharmaceutical Distribution Services

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Cencora is one of three leading domestic wholesalers of branded, generic, and specialty pharmaceutical products. With over $200 billion in annual U.S. healthcare distribution sales, the company supplies roughly one third of the domestic drug distribution market. Its two close competitors are Cardinal Health and McKesson. Together, the three operate as a pharmaceutical wholesale and distribution oligopoly, supplying over 90% of the U.S. market.

Cencora simplifies distribution logistics by shipping products to centralized wholesaler locations, as opposed to shipping directly to pharmacies and various customer locations. Additionally, Cencora takes legal ownership of its suppliers’ products and absorbs all inventory and credit risk associated with delinquent pharmacies, clinics, and providers.

We expect the U.S. distribution space to continue to grow at a low- to mid-single-digit rate over the next five years, fueled by an aging population, introduction of new pharmaceuticals, and increased use of specialty medicines. We believe Cencora is well positioned to enjoy these dynamics and expect it to maintain its leading position over our forecast period. The company has partnerships with some of the biggest customers in U.S. drug distribution, including Walgreens, Cigna, and Kaiser Permanente, so the rising demand for pharmaceutical products will be a nice tailwind for its top line. 

In 2021, Cencora expanded its international presence by purchasing Alliance Healthcare, one of the leading drug wholesalers in Europe. European drug distribution has over 750 smaller full-line wholesalers, but three main distributors—Alliance, Celesio, and Phoenix—control roughly 80% of overall distribution in the region. Beyond distribution, Alliance provides consulting and logistical services, which are higher-margin businesses, to pharmaceutical manufacturers. Cencora has since acquired PharmaLex, which provides business and consulting support to biopharma firms. While the firm is still working on fully integrating this business, we think it could be another avenue for future growth.

Business Strategy & Outlook

We assign Cencora a narrow moat rating because we believe the characteristics of the U.S. drug distribution market and the unlikelihood that customers will move to a different distributor (switching costs) should uphold the company’s competitive position and continue to support economic profits for at least the next 10 years. 

Pharmaceutical wholesalers fill a central role in the supply chain for prescription drugs with over 90% of all prescription drugs in the United States going through wholesalers. While pharmaceutical distribution is their cornerstone, drug wholesalers have a complex role that extends beyond distribution and have developed essential partnerships with their customers. By contracting directly with manufacturers for branded and generic pharmaceuticals (and leveraging their substantial purchasing power), the big three wholesalers (McKesson, Cencora , and Cardinal Health) are able to consistently negotiate for the lowest rates on the market, typically significantly below the wholesale acquisition cost. Additionally, a full-line wholesaler will typically stock over 21,000 stock-keeping units associated with prescription drugs and negotiate with around 1,200 different manufacturers, a task less efficiently accomplished by retail pharmacies on their own. 

The three big wholesalers act as an oligopoly. They make up over 90% of the overall U.S. drug distribution market, effectively servicing the market, and they have done so for the past 20-plus years. We anticipate most of the market to continue to be serviced by these three players over the next 10 years, with minor changes in market share among them.

Drug distributors work extremely efficiently and effectively to service their customers. Their largest customer base is chain pharmacies/stores, but they also serve independent pharmacies, hospitals, long-term care centers, and mail-service pharmacies. Most of the top 15 pharmacies by sales in the U.S., which make up nearly 75% of overall pharmacy industry prescription revenue, have some sort of partnership with one or more of the three big wholesalers that have lasted for many years. In 2020, approximately 85% of dispensed prescription drugs in the U.S. were sold to retailers, which includes chain pharmacies and mass merchandisers (55%), independent pharmacies (15%), and food stores (13%). The three wholesalers already have long-standing relationships with the biggest retail pharmacies. Also, retail pharmacies are growing faster than other customers; since 2017, they have increased at an average rate of 2.8% compared with a decline of 0.9% in mail orders.

Cencora covers roughly a third of the U.S. drug distribution market. Walgreens, the firm’s largest customer, made up roughly 32% of total distribution revenue, or over $64 billion, in fiscal 2022. Cencora also serves Cigna, Good Neighbor Pharmacy, and Kaiser, which made up 13%, 6%, and 5% of total distribution revenue, respectively. It extended its pharmaceutical distribution partnership with Walgreens through 2029. This is a mutually beneficial situation for both companies for a multitude of reasons. Walgreens is Cencora's largest customer and has been for more than 10 years. Knowledge that is gained over the years of partnership is hard to replicate with a new wholesaler. This is especially true for big retailers because we estimate that Cencora has specific coordination and management systems that could take months to develop for a new distributor. Furthermore, it is highly unlikely that a customer will get better pricing by switching from Cencora to either Cardinal Health or McKesson because the cost of time lost during a transition and restructuring phase would not make it viable for a new distributor to offer better rebates than the original distributor. Distributors also offer consulting, logistics, and data and analytics services to its customers. We estimate that Cencora offers different and customized services to its customers, especially its big retailer customers, so both the distributor and customers can work at maximum efficiency and effectiveness. We believe these services make the relationship between Cencora and its customers stickier. For customers, switching to a new distributor would mean loss of operational expertise that they have achieved over the years of working with their original distributor. In our view, these combined reasons act as a catalyst behind big retailers sticking with their distributors and locking down their relationships with long partnerships. This can be seen from the fact that there have not been any major retailers switching their distributors during the last 10 years, and we expect this trend to continue for the next 10 years. 

Cencora also sources generic drugs through its generic procurement joint venture that it has with Walgreens. The joint venture, started in 2012, combines the purchasing power of Cencora and Walgreens to obtain strong buy-side margins from generic drug manufacturers. This is crucial for a drug distributor’s profitability because while generic drugs make up roughly 10% of wholesalers’ top line, they make up over two thirds of their gross profit. Since there are multiple generic drug manufacturers that aim to effectively produce the same drug, they have to compete with each other to win over a contract with one of the three big wholesalers. This provides major pricing power to Cencora, compared with purchasing branded drugs, which helps them drive a significantly higher margin from generic drugs. Switching costs would entail unraveling of the joint venture and result in pharmacies facing higher acquisition costs for generics, which constitute the vast majority of dispensing volume. Since Walgreens has a financial stake in this relationship, it is highly unlikely that it will stop working with Cencora and move to a new distributor, especially in the next 10 years.

Narrow

Economic Moat

Cencora Inc

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Earnings data Q2 2024

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Cencora, Inc. is a pharmaceutical sourcing and distribution services company. It operates through the United States (U.S.) Healthcare Solutions and International Healthcare Solutions segments. The U.S. Healthcare Solutions segment focuses on the distribution of specialty, brand-name, and generic pharmaceuticals. The International Healthcare Solutions segment includes pharmaceutical wholesale, related operations, and global commercialization services. The company was founded by Emil P. Martini in 1947 and is headquartered in Conshohocken, PA.

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