Amerisource Stung by Cutback - TheStreet

A major industry transition continues to cause painful side effects for

AmerisourceBergen

(ABC) - Get Report

.

With inventories -- and the profits they once generated -- falling, the drug distributor foresees a "difficult" year that will leave results far below Wall Street expectations. The company warned on Monday that inventory levels could plunge by roughly $1 billion, or 20%, this year and drag earnings down with them.

"We expected ABC to cut guidance," wrote Baird analyst Eric Coldwell, who has an outperform rating on the stock. "But the cut was worse than expected."

AmerisourceBergen slashed its full-year profit forecast from between $4 and $4.10 a share to between $3.10 and $3.50 a share. It also issued preliminary 2006 guidance that fell short of expectations.

Still, the company continued to portray 2006 -- and the years that follow -- as quite promising.

"We are very disappointed in our earnings performance during this tough transition year," admitted CEO David Yost. But "as difficult as this fiscal year is, I remain optimistic about fiscal 2006 and beyond."

Industry Shift

For now, however, a shift away from huge inventories -- which historically allowed distributors to profit when drug prices rose -- continues to hurt results.

In the past, drug distributors would often stock up their inventories ahead of seasonal price increases and then profit by selling the drugs at the higher rates. But some critics felt the practice, known as "speculative buying," actually fueled the regular growth in drug prices. So the entire industry has shifted to a straight "fee-for-service" strategy, charging manufacturers a set fee for delivering drugs instead.

In the end, AmerisourceBergen believes the current sacrifices will pay off. Specifically, the company says the change will bring "more stable and predictable operating margins" while lowering its capital requirements. Indeed, the company has already seen its cash picture improve during the transition period.

It now expects cash flow from operations to approach $1 billion -- more than double its previous forecast -- in 2005.

"Lower inventories have a silver lining," Coldwell noted. The "higher cash flow provides room for capital structure improvements, including ongoing share repurchases."

During the current quarter, AmerisourceBergen completed a $500 million share repurchase program. The company said that additional share repurchases should help it meet profit targets both this year and next. It pledged that extra cash flow will continue to be "deployed prudently."

Excess Capital

But some question the company's use of cash so far. During a conference call on Monday, one analyst said the company's cash deployment had already fallen well short of his firm's expectations.

"Why are you guys going to get smarter in terms of how you deploy this capital?" the Banc of America analyst asked. "What, really, can we expect to change?"

AmerisourceBergen executives simply said they expect to be "very disciplined" when using the extra cash flow. They said they have considered acquisitions, particularly in their "sweet spot" range of $100 million to $200 million, but have recently found nothing more attractive than shares in their own company. They insisted that some acquisitions, which promise tempting short-term gains, turn out to be bad ideas in the end. Thus, they said, they will continue to invest in "a business we know very well" until something better comes along.

Still, others voiced some concerns about the company as well. Indeed, Bear Stearns indicated that AmerisourceBergen was failing to keep up with its competitors --

Cardinal Health

(CAH) - Get Report

and

McKesson

(MCK) - Get Report

-- in the shift toward fee-for-service contracts. Both of those companies have said they expect half of their branded drug business to be operating under the new fee agreements in a matter of days.

In contrast, AmerisourceBergen has simply said that all of its branded business should be under fee contracts by the end of the year. Still, the company insisted on Monday that it is "tracking very consistently" with its peers.

The company went on to explain that its own year-end target will coincide with the launch of the Medicare Modernization Act. It is counting on that act, which promises prescription drug benefits to the senior population, for "incremental" sales increases next year.

Indeed, the company recently celebrated opportunities presented by the aging population as a whole.

"Father Time is our friend," Yost said during a UBS-sponsored conference last month. "The older people get, the more drugs they take; they more drugs they take, the older they get. It's really a wonderful thing."

Future Opportunities

Coldwell sees opportunities as well. To be sure, he acknowledges that AmerisourceBergen has struggled in recent months. Even before Monday's warning, he notes, the company found itself facing profit challenges as a result of major contract losses caused by "irrational industry pricing behavior."

Still, he says, the company may now enjoy more opportunities than others to expand its margins. In the meantime, he says, the company features unique characteristics that separate it from the pack. He points to the company's "near pure-play status" as a drug distributor and its "conservative management style" as particular examples.

Thus, he continues to maintain his outperform rating on the company despite its lower outlook.

"We are incrementally negative in the short term," Coldwell wrote, "but this event may provide an attractive buying opportunity for longer-term investors."