Amazon.com has been one of the most innovative and disruptive companies of this century, with incredible success in areas that lie outside of what has been historically perceived as its core business (book selling).
Thus every announcement or speculation that Amazon /zigman2/quotes/210331248/composite AMZN +0.82% will enter into a particular industry sends stocks of that industry into a tailspin. Investors sell first and ask questions later. For example, when Amazon announced its purchase of Whole Foods, shares of rival grocery stores declined as much as 30%. Even Tesco /zigman2/quotes/203761082/delayed UK:TSCO -0.68% , separated by an ocean from Whole Foods, was down on that news.
A big part of Amazon’s success has come from not being taken seriously by its competition. Amazon was able to create a huge lead in AWS (Amazon Web Services) because the competition ( /zigman2/quotes/202490156/composite GOOGL -0.03% and Microsoft /zigman2/quotes/207732364/composite MSFT +0.90% ) did not give Amazon enough respect. Competitors thought, “What does a book seller know about the Cloud?” Well, according to Amazon CEO Jeff Bezos, such thinking gave Amazon a much bigger lead over its rivals. Today, everyone takes Amazon seriously. Indeed, fear of Amazon is reaching paranoia levels.
McKesson /zigman2/quotes/206975466/composite MCK +0.78% shares, for example, took a 20% dive during the fourth quarter of 2017 on speculation that Amazon would start distributing pharmaceuticals in the U.S. As a McKesson shareholder, my firm took this speculation seriously, but upon further investigation, it became evident that such concerns were overblown. After the market cooled off from fourth-quarter worry about Amazon, McKesson shares recovered.
Then in January 2018, Amazon, JPMorgan Chase /zigman2/quotes/205971034/composite JPM +0.85% , and Berkshire Hathaway /zigman2/quotes/208872451/composite BRK.A +1.75% /zigman2/quotes/200060694/composite BRK.B +1.61% announced they would join forces to drive down U.S. health-care costs, slamming health-care sector stocks including McKesson.
Earlier this week, Amazon.com announced an online pharmacy offering. How big of a punch could this be?
McKesson is the largest distributor of pharmaceuticals in the U.S. Its 2020 sales are on track to exceed $235 billion. It is important to point out that McKesson is not a pharmacy but a distributor, so it does not compete head on with Amazon in selling drugs. It is one of three railroads for drugs in the U.S. McKesson distributes drugs to thousands of independent pharmacies, as well as giants like CVS Health /zigman2/quotes/209664499/composite CVS +1.05% , Rite Aid /zigman2/quotes/201733831/composite RAD +4.42% and Walmart /zigman2/quotes/207374728/composite WMT +0.29% . McKesson operates two distinct distribution businesses: branded and generics. Though these businesses may look similar on the surface, the economic models of branded and generic businesses are quite different.
In the distribution of branded drugs (about 70% of McKesson’s revenue and 30% of profits) McKesson has a fee-for-service model. Pharmaceutical companies want to be involved in high-value activities: chiefly, inventing and manufacturing drugs. Getting drugs to thousands of pharmacies on a timely basis and collecting accounts receivable is not the business they want to be in. They don’t have the scale and distribution know-how of McKesson, Cardinal Health /zigman2/quotes/206646342/composite CAH +1.08% , and AmerisourceBergen /zigman2/quotes/201066379/composite ABC +0.55% — that collectively control 90% of drug distribution in the U.S. Thus the likes of Pfizer /zigman2/quotes/202877789/composite PFE +1.28% and Bristol Meyers Squibb /zigman2/quotes/202559280/composite BMY +0.36% pay drug distributors a small “fee for service,” and pharmaceutical companies (not distributors) negotiate prices with pharmacies.
More than 90% of McKesson’s profit in this segment is driven by volume, while just 10% is linked to changes in drug prices. Pfizer, for instance, despite its might, would still have higher distribution costs than McKesson because it doesn’t have McKesson’s scale and focus on distribution efficiency. So Pfizer is happy to pay McKesson this service fee and not think about drug distribution.
In its generic drug distribution business (about 30% of sales, 70% of earnings), McKesson uses its enormous buying power to buy drugs at low prices from generics manufacturers and sell at higher prices to pharmacies. Since it can source the same drug from various manufacturers, it leverages better prices from the likes of Mylan /zigman2/quotes/209413137/composite VTRS +1.45% and Teva Pharmaceutical Industries /zigman2/quotes/205657894/composite TEVA +1.38% . Drug distributors are a significant deflationary force in generic pricing — good for consumers, not great for Teva or Mylan.
So McKesson has a wide protective moat, which includes the distinct possibility that Amazon’s adventure into drug distribution could lead to miserable failure. Here’s why:
1. Amazon cannot match McKesson’s buying power or negotiating power when it comes to generics. Current Amazon sales of pharmaceuticals are somewhere between zero and slightly above zero. McKesson’s sales are pushing $235 billion, about one-third of which comes from generics.
Walmart is the fourth-largest pharmacy in the U.S., with sales of $20 billion. It had distributed drugs, but in 2016 it signed a distribution deal with McKesson. Walmart realized it could get better prices for generics through McKesson. Amazon, with near-zero sales, doesn’t stand a chance.
2. Amazon has no structural advantage. In the fight against Barnes & Noble and Best Buy /zigman2/quotes/205918291/composite BBY +0.44% , Amazon could charge lower prices than brick-and-mortar retailers because it had a structural advantage — it did not own stores and have all the extra costs associated with them. On one of his conference calls, McKesson CEO John Hammergren said his company was Amazon before Amazon was Amazon. Indeed. McKesson has highly specialized warehouses designed to distribute drugs. It can get any drug to any pharmacy in the U.S. within hours.