First Quarter 2004 Update and Company Reports

Cardinal Health (CAH $72) is the leading U.S. distributor of pharmaceuticals and medical products, with one-third of U.S. drug prescriptions and medical/surgical and laboratory products flowing through its logistics system. Cardinal owns Pyxis, producer of machines that dispensed 1 billion pills last year, and, in the process, automates hospitals and enhances patient safety. Cardinal also does contract manufacturing, packaging, and development of both patent and generic drugs. More than 80 of the top 200 patent drugs use Cardinal manufacturing, technology or services. It packages nearly 500 million pharmaceutical doses per day, employs 5,000 pharmacists and supplies 21,000 retail locations. Its products are used in one out of every two surgeries. The FDA’s concern over counterfeit drugs, in particular imported ones, will lead to monitoring the passage of drugs from manufacturer to patient. The FDA is in the process of requiring bar codes on drug labels, which will include the drug’s National Drug Code number, lot number, and product expiration date. Because of its broad participation in healthcare and its efforts to integrate the drug delivery process, Cardinal is well equipped for the monitoring task.

Most of Cardinal’s revenues and half of earnings is earned from pharmaceutical distribution. This business is changing as healthcare responds to increased levels of consumption, driving up both costs and benefits to the U.S. economy. Profit margins are being squeezed as pharmaceutical manufacturers reduce supply channel inventories in an effort to get more control of their businesses. Many pharmaceutical manufacturers had gotten into the habit of leaving large inventories in the hands of distributors, in part to make sure drugs were available when needed and in part to help them make the quarter’s earnings expectations. Well-capitalized Cardinal led drug distributors in its ability to build giant inventories in anticipation of drug price increases, providing compensation for ensuring a ready supply of drugs to drug stores and hospitals. However, in 2002, Bristol Myers had three large drugs lose patent protection just after building very large inventories at distributors. The painful correction of this catalyzed the pharmaceutical manufacturers to take advantage of “just-in-time” delivery technology to gradually eliminate channel inventories. (Pfizer did not participate in this game and has kept distributor inventories at 17 days for years.)

Reduced inventories means reduced inventory profits. Indeed, in the quarter just reported, Cardinal had no earnings growth from its pharmaceutical distribution business, despite 12% revenue growth. Accordingly, the distributors and manufacturers are now negotiating a new form of compensation based on a “fee for service.” The transition is likely to take at least another year and result in a permanent reduction in distributor profit margins.

Three drug distributors control 90% of the market, creating an oligopoly. Prices can be stable if the members of the oligopoly are reasonable about pricing, both high and low. However, one of the three, McKesson (MCK 32), bid the huge Veterans Administration drug supply contract at a money losing level, in order to win it way from Amerisource-Bergen (ABC 58), a troubling development. Such behavior puts even more pressure on profit margins.

However, there is a bright side to the transition occurring in pharmaceutical distribution – a great reduction of the capital expended to carry inventories. And, inventories alone consume half of Cardinal’s invested capital. The value of a business is the present value of its future cash profits stream, after deducting a charge for capital employed in the business. The declining cost of inventory investment partially offsets the damage to valuation caused by reduced profit margins. Plus, inventory liquidation releases cash that can be used to buy back stock.

Still in place are many long-term positives. Cardinal benefits from increased volumes of generics. Generic manufacturers pay distributors more per pill than patent drug manufacturers, because they need the distribution. The only way one generic drug differentiates itself from another is by price, so a competition to pay the distributor more ensues. The distributors are also direct beneficiaries of the Medicare Bill. It will help the elderly, healthcare’s prime demographic market, to afford more drugs.

Concern for a no-growth profit report from the dominant pharmaceutical distribution portion of Cardinal’s business led me to take some time off from a stock that otherwise is a good long-term hold. You may remember that a similar problem created a buying opportunity in Cardinal about a year ago. The just released March quarter results did indeed show zero growth in pharmaceutical distribution profits. However, other parts of Cardinal’s business produced truly exceptional results, and the business as a whole produced operating earnings growth of 8.9%, still a little light in my opinion. In hindsight, holding on would have been a better decision.

Long-term, Cardinal is using its growing cash horde to repurchase stock, pay dividends, and make acquisitions, all lending support to growing shareholder value. And, Cardinal’s other businesses are growing at healthy double-digit rates. Medical demographics continue to be excellent, as the population ages. Earnings per share should be about $3.60 in the fiscal year ending in June 2004 and, if the earnings growth problem in pharmaceutical distribution is fixed, $4.20 in 2005. Intrinsic value varies from $63 to $73, depending on the pharmaceutical distribution business.

Gilead Sciences (GILD $60) is a biopharmaceutical company that discovers, develops and commercializes molecular solutions to life-threatening infectious diseases. The company currently markets six drugs worldwide and is experiencing rapid growth. Research and clinical programs are focused on antiviral and antifungal drugs. It is a leader in the global fight against HIV/AIDS. The World Health Organization estimates that 40 million people worldwide are infected with AIDS, including 1.6 million in the US and Europe.

Viread and Emtriva are both AIDS drugs that work by blocking reverse transcriptase, an enzyme involved in the replication of HIV. Both drugs permit oral once-per-day dosing. One of the major challenges in treating HIV-infected patients is drug resistance. Clinical studies indicate few patients develop resistance to Viread, including patients who have developed resistance to other therapies. The combined revenue of both drugs will likely approach $1 billion next year. Also, the company awaits FDA approval of the co-formulation of Viread and Emtriva into one pill, once-per day dosing, believing that this will set a new standard for the treatment of HIV.

Hepsera for chronic Hepatitis B stops the progression of liver damage. Hepsera disables the virus that causes Hepatitis B by interfering with the activity of an enzyme known as HBV polymerase, which is necessary for the virus to replicate. It is effective in 30% of cases, less than competitor Interferon, but is cheaper and side effects are much easier on the patient. Interferon, which causes flu-like symptoms, is taken for six months by injection, compared to a once-a-day pill with Hepsera. With an estimated 10% of the population of Asia infected with chronic Hepatitis B, this product addresses a huge unmet medical need.

Tamiflu is a pill for the treatment and prevention of Influenza A and B. It disables all common strains of the flu virus and is 92% effective, if taken before symptoms manifest. If taken after symptoms manifest, it reduces flu duration by 30%. It has been a surprisingly poor seller, probably because surprisingly few people have even heard of it. Marketing partner Roche is missing a big opportunity. A supply of this should be in everyone’s refrigerator.

AmBisome injection is prescribed for life-threatening fungal infections that take advantage of depressed immune systems due to aggressive chemotherapy regimens and HIV. Vistide is an antiviral medication for the treatment of CMV retinitis in AIDS patients.

The pipeline appears relatively bleak, but includes two drugs targeted at lymphocytes, the primary site of HIV replication. GS 7340 is based on the active ingredient in Viread and GS 9005 is a novel protease inhibitor.

Net earnings should exceed $1.40 this year, followed by about $1.90, $2.50 and $3.00 in following years. The future of currently marketed products is bright, but a relatively scant pipeline does not support the current 44 price/earnings ratio. Also, the company is worried that distributor inventories are excessive, and that destocking could cause the company to “miss a quarter.” A stock decline caused by such a transient event could create an opportunity.

Steven L. Ré, CFA April 23, 2004

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets sometimes go down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.