From Morgan Stanley overnight:
The reason the S&P healthcare sector is lower on the day...
... with distribution names getting hammered, is because in a report published overnight, Morgan Stanley analysts predicted that the sector, and severeal specific names, are most in danger of being targets of Amazon's unstoppable monopoly juggernaut, soon to be scheduled for Bezosian eradication.
As MS explains, it has identified "attractive subsectors and profit pools that Amazon could drain to fund disruption." MS assumes a 5% hit to prices when Amazon enters a sector, estimate the EPS impact on healthcare companies, and look at what the stocks are pricing in after the recent sell-off.
Healthcare distribution, encompassing medical, dental and drug distributors, drug retailers, and pharmacy benefit managers (PBMs), has the best fit with the Amazon playbook. Amazon’s expertise in logistics and B2B positions it to distribute commoditized products (supplies) to consumers/purchasers (e.g., hospitals, dental offices) potentially to be bundled with Amazon Web Services (AWS). They already target Medical Supplies distribution within Amazon Business, posing approximately 20% of earnings risk from more competitive price dynamics for select stocks.
Three strategic reasons for Amazon to enter retail pharmacy, using Whole Foods as a launch pad: to (1) drive Prime subscriptions via 55+ pharmacy customers, (2) improve returns on its Whole Foods investment, and (3) expand Prime Now. With the highest profits and lowest barriers to entry, retail plays to AMZN strengths. Price transparency and lower copays could reduce profits by ~10%, and lead companies to rethink strategies to stay competitive, as we have already begun to see with the rumored CVS/AET deal. While some investors believe Amazon will partner with or acquire a PBM, we are skeptical given such move would limit market opportunity.
The chart below shows the helthcare segments most at risk of "disruption", or market share loss to Amazon market, versus the gross profit opportunity for Amazon.
The bank gives the following explanation:
The market has been inundated with mixed headlines attempting to decipher Amazon's healthcare plans. Overlaying sectors' gross profit pools – a focus of Amazon's strategy – onto their risk scores, Retail Pharmacy emerges as a field of opportunity that we explore in depth. We are mindful of Jeff Bezos's strategic view that “your margin is my opportunity.” He will enter a profitable business and run it close to break even, reinvesting dollars back into the product/service they are building/launching to become a truly disruptive force within the ecosystem. ( Exhibit 1 ) Nevertheless, Amazon has been tight lipped about its intentions and we cannot predict their timing, though we ultimately think they will go down this path.
As Bloomberg adds, "the S&P Healthcare Distributors index is holding at a critical support level; should Amazon enter the business, the industry’s shares could be under both technical and fundamental pressure. Other sub-sectors are also under pressure, including services and facilities such as hospitals." Of all names, Cardinal Health (see below) is leading the decliners even though there’s widespread debate about whether Amazon would try to tackle the drug distribution business.
Digging down into the subsectors, MS sees the following industries as most at risk from Amazon "disruption":
Medical supply and Life Sciences distribution are less rich targets but look like low-hanging fruit for Amazon's B2B and logistics strengths on basic goods. Cardinal with 10%-12% of profits geared to selling commoditized medical supplies is most at risk. We estimate a hypothetical 5% price cut across its book could lower profits by 22% due to the deleveraging effect. For McKesson, a 5% price cut toward the applicable portion of its medical-surgical business could lower profits by 9%. Our base case valuation assumes only a 3% cut in calendar 2019. AmerisourceBergen doesn't distribute medical supplies and remains immune in the near-term. Over the longer-term, if Amazon were to disrupt drug pricing within the drug supply chain, we estimate it could have a 4%-5% impact on the distributors' earnings.
Drug retailers have the most opportunities to adjust their business models and lower cost structures to defend against Amazon. Within the drug supply chain, the threat of Amazon’s entry into drug retail is accelerating vertical integration, and is cited as a driver behind the rumored CVS/Aetna merger. In our view, the combination would diversify profits away from the supply chain, help create a narrow preferred network, and act as a first step in repurposing the retail footprint to create a new healthcare-retail delivery model. If drug retailers don't change this model, we estimate ~10% risk to profits. CVS has also announced free same-day delivery in New York City, proactively preparing for a potential Prime Now entry, in our view.
The PBM and Manufacturing models in near-to-medium-term seem most resilient; however, longer-term cracks could weigh on the 20-30% of PBM operating profits tied to rebates. Meanwhile, hurdles in manufacturing are high, but may offer pockets of private label opportunity in the most commoditized products. Specialty Drugs appear well insulated.
Finally, MS' detailed breakdown identifies several names, as well as sector backdrops and other inputs all driven by Amazon's implied strategy, that now influence corporate valuation.
Amazon's entry into healthcare will likely take time (building out grocery was a 10 year endeavor) and we fully acknowledge that sub-sectors with solid fundamentals, that can deliver earnings power and growth, can outperform even with the Amazon threat in the background. This phenomenon occurred in food delivery after Amazon announced its entrance into New York. Grubhub (GRUB) dropped 12%, losing ~$250 million in market cap on the initial news, but quickly recovered those losses over the next two weeks. That said, with limited organic growth levers, we see more risk to select healthcare sub-sectors.