2 Ignored Health Care Stocks with Huge Upside

In the healthcare industry, when it comes to pharmaceutical drugs, the focus is usually on the major pharmaceutical companies (like Merck (NYSE: MRK) and Johnson & Johnson (NYSE: JNJ)) that produce the drugs, and the retailers (like CVS (NYSE: CVS) and Walgreen (NYSE: WAG)) that sell them on store shelves or in the pharmacy.

This ignores the middlemen that get the drugs from the manufacturer to the retailer, which is an important and growing business that is dominated by three primary players. And though profit margins are miniscule, shareholder returns have been very impressive. Additionally, the valuations of the two largest players are very appealing from an investment standpoint.

McKesson (NYSE: MCK) is the largest of the three industry leaders. Last year, it reported just over $16 billion in revenue, while Cardinal Health (NYSE: CAH) logged $11.3 billion and AmerisourceBergen (NYSE: ABC) reported almost $8.9 billion. That’s a combined $36.2 billion in revenue that is growing along with the overall market and should see a significant boost as more than 30 million new patients are added into the system from recent healthcare legislation.

#-ad_banner-#McKesson reports the highest margins, if there is such a thing in the industry. During the past twelve months, its net profit margin, or net income divided by sales, was 1.2%. Cardinal and AmerisourceBergen both logged net margins below 1%.

Those razor-thin margins may scare away many investors, but returns on equity (ROE) are quite high for the group. This is because these firms turn over their assets very rapidly and though only a couple of cents per dollar of sales make it to the bottom line, these companies make very efficient use of their assets, meaning they are constantly sending inventory to customers and doing so rapidly.

McKesson’s ROE has fallen just below 20% in the past couple of years. AmerisourceBergen’s ROE reached nearly 22% in the past 12 months. Cardinal has been the laggard in this department and reported an ROE of just over 8%, but is projected to see higher returns as it spun-off a stodgy division that produced medical equipment and products. As such, it is refocusing on running its drug distribution operations.

To put these returns into context, the average ROE for all 500 companies in the S&P 500 Index is just over 17%, so McKesson and AmerisourceBergen are quite above average. AmerisourceBergen is known as the purer play in the industry, as McKesson runs a technology solutions group that helps hospitals use software to run more efficiently. This unit is highly profitable and boosts total company profit margins and earnings. Cardinal isn’t quite a pure play either — it still sells some medical equipment and products.

Before you throw in the towel on Cardinal because of its low ROE, it is important to note that the company has been the subject of takeover rumors lately. There is speculation that a private equity firm or group could take it private. Private equity firms have a reputation for circling the wagons on firms with steady and high cash flow.

All three of these companies definitely qualify. They consistently generate more cash flow than their businesses need to run. This leads to returning excess capital to shareholders in the form of dividends and share buybacks. Specifically, free cash flow last year reached almost $2 billion at Cardinal, exceeded $2 billion at McKesson and was over $600 million for AmerisourceBergen.

Action to Take —> At current share prices, McKesson and Cardinal trade at price-to-free-cash-flow multiples of 8.3 and 6.3, respectively. They both sport forward P/E multiples of 13.5. AmerisourceBergen trades at more than 15 times trailing free cash flow and forward earnings.

At these levels, McKesson and Cardinal are the more appealing options. AmerisourceBergen has the ability to grow faster since it is the smallest player, but at the current valuation, I think this is already priced into the stock.

McKesson and Cardinal should continue to grow in lockstep with the healthcare industry and will again see a boost as new patients enter the system. Also, investors could spot these stocks’ low valuations and expand their low multiples as investors pick up the shares.

Overall, I estimate these two stocks to achieve annual returns between +8% and +12% in the next five years on a combination of profit growth, share repurchases that will boost per share earnings, and modest but growing dividend payments. If returns hit the high end of my estimations, these two stocks could be +75% higher by the end of this period and could even double if healthcare legislation boosts sales and profits are higher than expected.