Dullness Reigned Supreme in Healthcare in 2022

In a year of stock market turmoil, healthcare investors sought out stability and turned to boring but steady investments.

This wasn't a year for investing in biotech companies that are aiming for medical breakthroughs, though there were exceptions. Instead, it was a year when investors rewarded companies for making a lot of money and keeping things simple.

McKesson MCK -0.04% was at the top of the pack among drug distributors.

Cardinal Health is a leading healthcare company that provides products and services to help improve the lives of patients and caregivers. The company offers a wide range of products and services, including pharmaceuticals, medical supplies, and information technology solutions. Cardinal Health is committed to providing quality products and services to its customers.

The three biggest drug distributors in the U.S. are all up over 50% for the year. AmerisourceBergen Corp. (ABC) is the only one of the three that is down for the year.

The three companies that control about 90% of drug distribution in the U.S. saw their stock prices rise by an average of 27%.

The distribution of drugs is not the kind of thing that will get standing ovations at fancy healthcare conferences, but someone needs to move drugs from point A to point B. And it can get pretty complex, especially when dealing with biologic drugs such as cancer therapies, which must be handled with care (and where margins for distributors are highest).

The healthcare industry has been under a cloud of uncertainty for years, facing thousands of opioid-related lawsuits. However, in February, a massive $19.5 billion landmark settlement with a majority of U.S. states helped to bring the legal threats to an end. This has lifted a major overhang for the group, according to Jared Holz, a healthcare specialist for Oppenheimer.

Mr. Holz says that in 2022, companies that didn't benefit much from Covid-19 tended to outperform. In 2021, the biggest gainers were the vaccine-makers, with Moderna and BioNTech more than doubling in value while Pfizer added 60%. All three vaccine-makers are down this year, as a return to normal benefits the rest of the sector.

McKesson, the largest of the three distributors, has benefited from both the Covid pandemic and the return to normalcy. The pandemic has helped its business due to the U.S. government's selection of McKesson to distribute Covid-19 products. However, a return to normal has also been beneficial, as people are able to go back to the doctor's office for screenings and procedures that may have been skipped during the height of the pandemic. According to David Toung, an analyst at Argus Research, this ultimately leads to more prescriptions. Combined revenues for the big three grew by over 6% to approximately $180 billion in the latest quarter compared to the previous year.

What investors love most about distributors is how much cash they reliably generate. Even with a hit from the opioid payments spread across 18 years, distributors still sport an impressive cash flow, according to Baird analyst Eric Coldwell.

"Cash is king, and distributors are accelerating cash flow conversion from already healthy levels," he wrote in a note. The group sports a free cash flow yield of about 7%-8%, which compares favorably with the Dow Jones Industrial Average at about 5%.

Even though it's been a great year, valuations are still reasonable. All three distributors trade at less than 15 times next 12 months' earnings, which is below the 16.7 average for the S&P 500.

AmerisourceBergen may outperform its rivals next year, according to Mr. Toung. Its stock may have underperformed this year partly because Walgreens Boots Alliance has been selling its holdings. Baird's analysts believe AmerisourceBergen is a good investment at its current price, citing the company's solid 2023 guidance and relative discount to McKesson.

This year, distributing drugs proved to be a winning formula. Returns are unlikely to be as impressive next year, but they are still expected to be a good investment.