|Shares Out. (in M):||206||P/E||0||0|
|Market Cap (in $M):||30,367||P/FCF||0||0|
|Net Debt (in $M):||4,000||EBIT||0||0|
This write up will focus on McKesson from the angle of Amazon's threat to MCK and the industry:
We are big fans of Amazon. We are loyal Amazon shoppers; we are users of its Kindle. I went a bit Alexa crazy and has Alexa speakers in every room of his house. We wish all of our companies were run by the likes of Jeff Bezos. Amazon has been one of the most innovative and disruptive companies of this (and maybe even the last) century.
Amazon has been incredibly successful in areas that lie outside of what has been historically perceived as its core business (book selling); thus every announcement or speculation that Amazon will enter into a particular industry sends stocks of the whole industry into a tailspin. Investors sell first and ask questions later. When Amazon announced its purchase of Whole Foods, grocery stores declined as much as 30%. Even Tesco, separated by an ocean from Whole Foods, was down on the news.
A big part of Amazon’s success has come from not being taken seriously by its competition. Amazon was able to create a huge lead in AWS (Amazon Web Services) because the competition (Google and Microsoft) did not give it enough respect. The competitors thought “What does a book seller know about the cloud?” Well, according to Jeff Bezos, this sort of thinking gave Amazon a much bigger lead over its rivals. Today, however, everyone – and we mean EVERYONE – takes Amazon seriously. Indeed, fear of Amazon is reaching paranoia levels.
The stock of McKesson took a 20% dive during the fourth quarter on speculation that Amazon will start distributing pharmaceuticals in the US. We took this speculation seriously, but as we investigated it further, we realized that Amazon will need to learn how to walk on water first before it can disrupt McKesson’s business. After the market cooled off from fourth-quarter worry about Amazon, McKesson (MCK) regained its losses. Then in January news that Amazon, JP Morgan, and Warren Buffett’s Berkshire Hathaway will join forces to drive down healthcare prices in the US sent healthcare sector stocks including McKesson down.
McKesson is the largest distributor of pharmaceuticals in the US. Its 2018 sales are on their way to exceed $210 billion. It is important to point out that MCK is not a retailer but a distributor. It is one of three railroads for drugs in the US. It distributes drugs to thousands of independent pharmacies as well as the giants like CVS, Rite Aid and Walmart. It has two distinct distribution businesses: branded and generics. Though these businesses may look similar on the surface (drugs are drugs), the economic models of branded and generic businesses are very different.
In the distribution of branded drugs (about 70% of MCK revenue and 30% of profits) McKesson has a fee-for-service model. Pharmaceutical companies want to be involved in high-value activities: inventing and manufacturing drugs. Getting drugs to thousands of pharmacies on a timely basis and collecting accounts receivable is not the business they want to be in. They don’t have the scale and distribution knowhow of McKesson, Cardinal Health, and Amerisource Bergen – the three amigos that control 90% of drug distribution in the US. Thus the likes Pfizer and Bristol Meyers pay drug distributors a small “fee for service,” and pharmaceutical companies (not distributors) negotiate prices with pharmacies.
Over 90% of McKesson’s profit in this segment is driven by volume, and only 10% is linked to changes in drug prices. Pfizer, for instance, despite its might, would still have higher distribution costs than McKesson because it doesn’t have McKesson's scale and focus on distribution efficiency. Thus Pfizer is happy to pay McKesson the “fee for service” and not think about drug distribution.
In its generic drug distribution business (about 30% of sales, 70% of earnings), McKesson uses its enormous buying power to buy drugs low from generics manufacturers and sell high to pharmacies. Since it can source the same drug from various manufacturers, it uses its buying power to muscle better prices from the likes of Mylan and Teva. Drug distributors are a significant deflationary force in generic pricing – good for consumers, not great for Teva or Mylan.
Here are some of the reasons why Amazon’s adventure into drug distribution could lead to miserable failure:
1) Amazon cannot match McKesson’s buying and thus negotiating power when it comes to generics. Current Amazon sales of pharmaceuticals are somewhere between zero and slightly above zero. McKesson’s sales are pushing $210 billion, about $65 billion of which comes from generics.
Walmart is the fourth largest pharmacy in the US, with sales of $20 billion. It had self-distributed drugs, but in 2016 it signed a distribution deal with McKesson. Walmart realized it could get better prices for generics by buying them through McKesson than on its own. Amazon, with near-zero sales, doesn’t stand a chance.
2) Amazon has no structural advantage. In the fight against Barnes & Nobel and Best Buy, Amazon could charge lower prices than brick and mortar retailers because it had a structural advantage – it did not own stores and have all the extra costs associated with them. On one of his conference calls, the McKesson CEO said that “McKesson was Amazon, before Amazon was Amazon.” We agree. McKesson has highly specialized warehouses designed to distribute drugs. It can get any drug to any pharmacy in the US in a matter of hours.
3) McKesson’s pretax margins are pushing a whopping 1.7%. If Amazon is looking to cut fat in the pharmaceutical industry, this is not where the fat is.
4) Distributing and selling drugs is not like selling or distributing … well, almost anything else. First, some drugs require refrigeration and others are controlled substances; and thus distributing them puts an extra regulatory (and self-policing) burden on distributors. McKesson has paid fines and recently got plenty of negative publicity from 60 Minutes for distributing opioid pain medications to legal pharmacies who illegally sold the medicine on the black market.
Second, unlike in almost any other industry, pharma consumers are price-insensitive. If you are on Medicare, Medicaid, or a copay/low-deductible private insurance plan, you really don’t care if you are paying the lowest price because you don’t see the price (other than for copay) – someone else is writing a check for the medicine. Thus, for this group of drug consumers, which constitutes the bulk of the US population, lower drug prices are not a carrot that will change their behavior.
And third, let’s say Amazon starts an online pharmacy and self-distributes. Digital Millennials are not the ones consuming most of the drugs in the US. Their less-internet-savvy parents and grandparents, the older population, are the ones that are gulping drugs like they were Diet Coke at 7-Eleven. This demographic still has brick and mortar habits that are less likely to be broken anytime soon. Also, major pharmacies already have mail-order operations that mail chronically consumed drugs. It would be logical for Amazon to try to get into this almost-trillion-dollar pharma business, but its success here will be very limited, and it will take decades to gain a meaningful market share
5) Let’s say Amazon opens an online pharmacy and succeeds. It would probably take five to ten years to reach sales of, let’s say, $10 billion (half of Walmart’s drug sales). Let’s assume that it self-distributes and thus will not use McKesson, or that it decides to employ the services of Cardinal Health. This fateful event would steal less than a year of growth from McKesson in five to ten years. We can live with this.
The laws of economics still apply, even to companies like Amazon. The only competitive advantage it has against drug distributors is that Wall Street completely ignores its profitability and focuses only on revenue growth. We can see a very low-probability scenario where Amazon bleeds billions of dollars annually trying to take market share from drug distributors. But distributors are very strong financially and have great scale and a tremendous purchasing-power advantage. Even if this very, very unlikely scenario plays out, distributors’ stocks may take a dive but their business will be fine in the long run.
McKesson is one of the most interesting stocks we see in the US stock market today. As we have showed, its business is future-proof. The demand for its product is not cyclical and is likely to continue to grow as the US population ages. Higher or lower interest rates, recession or no recession, inflation or deflation, McKesson’s earnings power will continue to march higher for a long time.
MCK has a conservative balance sheet: It can pay off its debt in less than two years. We are satisfied with management’s capital allocation. McKesson pays a lower dividend than its competitors; however, it has purchased a third of its shares over the last decade. It will earn about $13 this year and estimates its earnings should be close to $15 in 2019. At a conservative 15 times earnings, McKesson is worth about $225. However, McKesson has spun off its technology business into Change Healthcare, which will (most likely) go public in 2019. McKesson owns 70% of Change Healthcare, and we estimate McKesson’s interest is worth about $25-30 a share. Thus our conservative estimate of McKesson’s value is about $250.
Fear of Amazon fades away, MCK get rerated.