Description

Long McKesson (MCK):

We think McKesson is an attractive long term investment.   With the turbulence in the overall market and healthcare in particular, we think McKesson is a rare combination of 1) a good business, 2) sustainable growth, 3) a strong balance sheet, 4) good management and 5) attractive valuation.  We think McKesson can provide 20% annualized returns over the next 3-5 years with little risk.  Most importantly, I think MCK (and other 2 major drug procurement platforms) are part of the solution (not the problem) to the controversial topic of drug pricing.

The following write-up will try to be brief but also touch up on the key issues for the thesis.  I’d be happy to answer any questions in the comments section.

Business Model

McKesson is the largest drug distributor in the US.  The business model is relatively simple:  distributors pick up pharmaceutical drugs from branded and generic drug manufacturers, take them to a distribution facility where they pack them and ship them to retail pharmacies, hospitals, physicians offices and other dispensaries.  The following illustrates a simple hypothetical generic drug going from manufacturer to end consumer.

Why is this a good business?

Drug distribution is attractive for several reasons, in our view.

1)      Demographics:  the US has an aging population that will likely be consuming more and more prescriptions over the decades to come

2)      Barriers to entry:  given the high regulatory barriers, significant market share concentration (the Big 3 distributors – MCK, ABC, and CAH have over 90% market share) and economies of scale, there are significant barriers to entry in the business

3)      Economies of scale:  one of the most important aspects about the drug distribution business is that it helps lower the cost of drug procurement with scale.  The largest purchasers of drugs (MCK, the CVS/Cardinal Health JV, the Walgreens/Alliance Boots/Amerisource Bergen JV) are very important to the drug supply chain because their size and leverage allows them to buy at significant discounts to list prices and those savings are partly shared with their customers.  This is very important given the hot-button issue on drug pricing right now.  We will discuss this topic further below, but this chart illustrates the leverage that comes with scale in drug purchasing:

4)      Drug distribution versus other distribution models:  We think the drug distribution business is also superior to some other industry distribution models due to some unique factors such as the complexity of their supply chain (many drugs require specific refrigeration and handling) and regulatory barriers.  However, the biggest advantage, in our view, is the combination of low overall gross margins (higher on generic, but low on branded), high inventory turns and fast cash cycles driven by the high value-to-weight ratio of drugs.  This allows drug distribution companies to provide significant value to their customers (in the form of low gross profit margins) while generating good economics (high ROIC and low capex needs).  It also reduces the risk of disintermediation because you are not making 50% gross margins by being a middle man.  A comparison with food, industrial, technology or building products distributors highlights this:

5)      Lastly, drug distribution businesses generate more profits from generic drugs than high priced branded drugs, due to the increased negotiating leverage that they have with multiple generic manufacturers compared to an exclusive branded manufacturer.  So drug distribution companies are incentivized to have more cheap generic drug use and help lower the overall cost of healthcare in the system.  Now, drug distributors DO benefit from price inflation because they receive a fixed % fee on the price, but we think these business broadly lower the cost of care by using their size to purchase drugs at discounts and sharing a portion of those with their customers.

In short, we think that wholesale drug distribution is a good business.

Sustainable growth

We think McKesson as sustainable growth from: 1) organic sources such as the overall growth of the industry (driven by demographics) and long term contract wins (as more companies use distributors to procure drugs), and 2) inorganic sources such as synergies from the Celesio acquisition and other potential M&A (like the recent Sainsbury and UDG acquisitions in Europe).

Strong balance sheet

MCK (along with CAH and ABC) all have great balance sheets with net debt/EBITDA of 1x or less with strong FCF.

Good management

CEO John Hammergren took over as CEO after MCK’s disastrous acquisition of HBOC Inc. in 2001.  Since then, MCK’s shares have generated a total return of over 600% (14% annualized over 14 years) compared to 109% (5% annualized) for the S&P 500.  There was some controversy over Hammergren’s pension and retirement benefits, but 1) the compensation program has been changed in response and 2) we don’t think the compensation was that big a deal given the return provided to shareholders over his tenure.  Relevant articles and details are in the proxy statement:

WSJ; For McKesson's CEO, A Pension of $159 Million: http://www.wsj.com/articles/SB10001424127887323998604578565491579124154

WSJ; McKesson Changes Executive Compensation Program; http://www.wsj.com/articles/SB10001424052702303801304579410802217819202

Attractive valuation

There is clearly a lot of turbulence in the healthcare industry, but there are reasons why we prefer MCK to other stocks – as illustrated above:  growth prospects, business model, balance sheet and management.   Regarding valuation, there are three primary topics to discuss, two industry wide and one specific to McKesson:

1)      Generic drug price inflation

2)      What’s the right valuation multiples for drug distributors (and the overall market)?

3)      MCK’s recent contract losses/wins/other adjustments to near term earnings

First, generic price inflation.  As mentioned above, distributors benefit from generic price inflation because a) they get a fixed % fee that goes up with price increases and b) to a lesser extent, they have some inventory that appreciates with price inflation.  Generic price inflation has been a tailwind in the past couple of years, and it has recently moderated and become a hot button issue because of the behavior of Valeant and folks like Martin Shkreli (who I’m sure everyone now knows about: http://www.forbes.com/sites/matthewherper/2015/09/24/my-lunch-with-shkreli-what-we-should-learn-from-pharmas-latest-monster/).

While we acknowledge that distributors benefit from generic price inflation, we think their impact has been over-exaggerated and any impact is already reflected in the valuation.  The chart below illustrates how generic inflation benefits a distributor and estimates the impact on a company like MCK – ranging from 20c to 60c on a company with nearly $13 in EPS.

To the extent people think drug prices are going to go down substantially, either through legislation or other factors, I can suggest an offsetting short position in Valeant, Mallinckrodt, or any other highly levered roll-up drug company that needs price gouging to exist.

Second, what’s the right multiple for the overall sector?  We all know that some sectors come in and out of favor and right now, I think drug distributors (and MCK in particular) are a bit out of favor.  The chart below shows the P/E multiples of the sector over the past 15 years and the issues that investors focus on.   

We think that MCK’s current valuation is attractive and make the following comments:

·         The 2002/2003 low valuation may not be as relevant because the business model shifted from a “buy-and-hold” inventory model to a fee-for-service model

·         The 2008/2009 low valuation is largely based on the global financial crisis.  If we have a bear market with a 40% decline, all stocks are going down

·         I think it’s important to put these multiples above in context of overall market multiples and interest rates.  The chart below shows the multiples relative to the S&P 500, especially during election years when drug price reform becomes an important topic:  If you are worried about MCK or CAH or ABC going to 10x earnings, then you can probably short the S&P 500 down to 10x earnings as well.

Lastly, specific to MCK, what has happened recently with contract losses/wins/other adjustments?  There has been some near term negatives for MCK that we think are largely coincidental and have caused the sentiment on the stock to depress even beyond the industry issues mentioned.  So what happened:

·         MCK (which has generally not had substantial contract losses) lost 3 contracts in short order in the last month:

o   UNH acquired CTRX in July and CTRX used CAH as their distributor, so the mail service/specialty distribution contract for UNH’s OptumRx business was transferred from MCK to CAH

o   CVS acquired OCR in August and is planning to bring OCR’s generic purchasing contract from MCK onto its purchasing JV with CAH

o   CVS acquired the in-store pharmacies from TGT (where MCK is the distributor) and may move that business over to their JV as well

These factors, along with the generic inflation fears and the market turbulence in August and September, have caused MCK’s stock to drop 25% from its peak compared to 9% for the S&P and 10-17% for CAH/ABC.

Let’s quantify and qualify these items:

·         Quantify:  the UNH/CTRX contract (7c), CVS/OCR contract (15c), and TGT contract (9c) = ~$0.30 on a stock earning close to $13 (ie. 2%) and lower generic inflation could add another 30c so we are talking about a 4% hit to earnings that sent the stock down 25%.  (We are happy to outline details behind these in the comments section).

·         Qualify:  Is something systemically wrong with MCK that they lost these contracts?  Or were these just 3 random M&A events that happened to occur close to each other and during a period of market stress?  We think the latter

In mid Sept, MCK signed an expansion of a distribution agreement with Albertson’s to include the new Safeway stores that Albertson’s acquired (potential positive contribution of +$0.30 per share).  MCK also announced the acquisition of the distribution business of United Drug in Ireland and some Sainsbury grocery store pharmacies in the UK (combined impact of +$0.12 per share).

Based on all of these adjustments, it’s unclear if MCK is going to earn $12.50 or $12.70 this year.   While some people would prefer to own a stock at 19x earnings that will beat by 1% rather than a stock at 15x earnings that may miss by 2%, we are happy choosing the latter.

In our view, all of the above is really just noise.  Long term, we think MCK will grow earnings at double digits and these data points won’t matter much over a period of years.  Let’s look at the 10 year earnings record for MCK to evaluate the growth and predictability of this company during times of varying generic price inflation, patent expiration and economic/market strength/weakness:

As we can see, MCK has grown earnings by 18% annually with remarkable consistency and visibility.  It would be difficult to spot the fact that 2008/2009 was a massive recession based on these numbers.  We believe this speaks to the durability of this business model.  So why the fixation on these near-term data points?  We believe that this is just the way Wall Street works and even in an industry as stable as the pharmaceutical supply chain.   Consider the following:  each of the largest players in the this industry had a moment when they were extremely out of favor and their stock prices fell substantially as people questioned their long term prospects:

·         CVS:  In Nov 2009, CVS dropped 20% in one day when they cut guidance because of integration issues when they acquired Caremark.  People questioned whether the integrated retailer/PBM model could work.  

·         Walgreens: In July 2012, Walgreens fell 10% over 3 days when they announced the acquisition of Alliance Boots and analysts frowned upon the deal’s financial and strategic merits

·         ESRX:  Last summer, ESRX stock dropped substantially and stayed weak on a combination of Medco merger integration issues and insider selling

If you look at the earnings of these companies during that time and thereafter, you would expect to see some serious turbulence given the stock price reactions.  But as shown below, the earnings were extremely stable and those hyper reactions to near-term data points were excellent buying opportunities.  We believe that MCK represents a similar opportunity today (granted, at a higher valuation than in 2008/2009/2012 or even last year):

In summary, why do we think that MCK deserves more than 15x earnings?  I think many of the issues facing the stock today are largely transitory and won’t impact the double-digit earnings growth rate over time.  MCK has actually underperformed near every other pharmacy supply chain company in the past year and trades at a 20% discount to these peers despite equal, if not better, growth prospects:

Also, MCK has historically shown an appetite to repurchase shares at the current (or even higher) valuations and with a clean balance sheet, significant FCF and the low likelihood of significant M&A (as they digest Celesio), we think the company will be aggressively buying back stock at these levels.

In this market, where else can you find a large, liquid, well-run company, with less than 1x leverage, generating FCF, growing earnings double-digit and trading at less than 15x earnings?  If there are other options out there, I’d love to hear them.

In conclusion, we think MCK is probably worth a 17.5x multiple on $13 in earnings = $228 or 23% above today’s price and that value will compound at 15% annually for several years.   

We didn’t discuss the IT segment, Celesio synergies, the put-option or go into detailed quarterly earnings estimates because frankly, we don’t think they are central to the thesis.  

Catalyst

Share repurchase activity

Contract wins

Celesio synergies

Illustration of double-digit earnings growth in next few quarters