Description

Buy McKesson (MCK) and short Cardinal (CAH) to capture MCK’s upcoming Change Healthcare (CHNG) IPO catalyst coming up imminently in Q2.  This is more an event driven, pair trade. Although if you really want to be a contrarian / value investor, you can also buy MCK outright, since I think there are a lot of headwinds & bearishness priced that will likely abate.   

I prefer the pair trade in the short term to play the upcoming IPO catalyst over the next few months.   

I think the upcoming Change Healthcare IPO could lead to a 5-10%+ pop in MCK shares.  Hedging with CAH takes out pretty much all of the industry and most the idiosyncratic risk.  And it’s a pretty short term catalyst, which makes the setup pretty attractive

- MCK is quite cheap at 7.25x EV/fiscal 3/31/2020 EBITDA, 8.4x P/E, and 13.2% FCF yield.  

  - Admittedly, there are many cyclical and secular headwinds including declining generic drug prices and a shrinking generic drug market, reimbursement pressure, margin pressure, drug price pressure, and customer pressure.  

  - Without stock buybacks, MCK's organic EPS growth is basically flattish YoY.  Since it's not growing and facing many risks, it arguably should trade at such a low multiple.  With buybacks and acquisitions, they’re growing EPS at around a 6% CAGR

  - MCK is also facing many large near term uncertainties ranging opioid liability,  government changes to drug rebates and drug pricing,

- admittedly, the Change Healthcare IPO is fairly well known so an IPO wouldn't really be a surprise catalyst.  They announced the IPO in October 2018 and updated the S-1 in April. And they’ve been talking about spinning it for years.  

    - However, in chatting with sell siders and buy siders, it comes up in roughly 1 in 10 conversations and people aren’t focused on it.  Expectations for the IPO are fairly low, so if they can spin the story well in a hot IPO market, I think this could surprise to the upside

   - again this isn’t a huge needle mover.  Maybe it could lead to a 5-10%+ rise in MCK shares.  But for a short term trade, in a very beaten down stock and under owned subsector (3% of the float is shorted), I think it’s interesting,  especially if you hedge out the sector risk by shorting CAH if you want

For a longer term value trade, I think the market is pricing in too much negativity for MCK’s core business, much of the overhangs likely abate with minimal impact to MCK (e.g. opioids, changes to rebates), and generic deflation is stabilizing and seeing inflation in some circumstances

- I think there’s possibly 75% upside in MCK’s stock over a year (details below)

   - although I’d wait till after the CVS contract renewal with CAH and MCK is announced (expires 6/30/2019) before getting outright long MCK.  I think CVS likely renegotiates lower pricing with CAH and MCK

- Furthermore, the entire healthcare sector is under pressure from concerns about a shift to universal healthcare, and is currently experiencing a rotation outflow into more cyclical sectors

  - I think these concerns are overdone and the sell off is likely more due to rotation into more cyclical sectors,  which I think is a buying opportunity

Change Healthcare IPO details

McKesson (MCK) is IPOing  Change Healthcare (ticker CHNG),  expected to happen this quarter

- Change Healthcare is ~10% of MCK's earnings. It's accounted for by the equity method in MCK's financials and included in EPS.  But it's not consolidated in financials

- this isn't too much of a surprise since it's been talked about for years (they were talking about spinning it to shareholders before) and the IPO was already announced in October 2018

  - they also approximate the value of Change Healthcare on their balance sheet at $3.6bn.  

    - at $3.6bn, they're valuing it at 11.75x LTM EBITDA, which is admittedly a rather a full / maybe overvalued multiple in my opinion

- overall, the IPO should be value enhancing since MCK (and peers Amerisource - ABC and Cardinal - CAH) trade at around 7x-7.5x EV/2019 EBITDA,  but Change Healthcare is maybe worth around 9-10x EV/EBITDA in my opinion (similar to the valuation range people are using for a similar company Conifer - which is owned by THC).  I wouldn't be surprised if it's worth more though given the IPO market and ability to put a positive narrative / spin on the company.

  - Healthcare investors love healthcare spins/subsidiary IPOs since they’ve generally worked well, e.g.:

      - Elan is working well,

      - Zoetis was a home run,

      - Alcon seems great,

      - Bioverativ spun out of Biogen was spun out at $45 and taken out a year later by Sanofi for $105

      - Baxalta was spun out of Shire in 2016 and sold to Shire for a 45% return  

      - Abbott’s spin of AbbVie has worked out well

      - Mead Johnson was a grand slam after IPOing out of Bristol Meyer at $25 and purchased by Reckitt Benckiser at $90

      - Why have these healthcare spins generally worked?   Because they’ve generally been mismanged or underallocated within the parent conglomerate,  they’re allowed to focus on their own, and they the long term tailwinds of secular healthcare growth.  They aren’t spinning off junk to get rid of it..They’re creating value

  - Admittedly, LTM EBITDA for Change Healthcare was $928mm and it's had no rev or EBITDA growth.   

    - however, similar to Elan, I think they can create the narrative that there’s much room for operational and managerial improvement and they could gain a higher multiple

- there were reports that it could IPO for $12bn, i.e. 12x $1bn of EBITDA, since the healthcare services group trades at around 12x EBITDA,  but I think Change Healthcare is worse and less special than peers and deserves and discount

- Sum-of-the-parts valuation on EV/EBITDA post IPO

 - valuing the core MCK business at 7.25x, and Change Healthcare at 10x LTM EBITDA = $9.3bn valuation for Change), i.e. maybe the IPO could lead to a ~5% pop

 - using the $12bn valuation for Change ($12x $1bn of EBITDA, giving them credit for a return to future growth), it could be a ~13% pop

    - As noted above, the market loves healthcare spins and could put the $12bn valuation on it in the short term

- Change Healthcare has $5.7bn net debt and is  ~70% owned by MCK (rest owned by Blackstone and Hellman & Friedman)

Change Healthcare history / details

- it's a healthcare technology company that provides software and analytics used by hospitals, physicians, pharmacies, healthcare providers and insurers

 - they help healthcare providers increase patient access,  ensure clinically appropriate care, and manage claims and payments across the revenue cycle.

  - their payer solutions address payment accuracy, consumer and member engagement, network management, and the transition to value-based payment.

  - their consumer solutions provide digital tools to help patients access their personal information and make choices based on quality, cost, and convenience.

- in layman’s terms, this basic stuff that the entire healthcare industry needs to improve given all the poor billing and collections and confusion across providers and patients.  Also simply enabling better collection and transfer of data, test results, images, etc has a lot of room for improvement. It’s not really all that sexy or special, but there’s much room for growth in this industry as healthcare providers and payers need help improving all the basic plumbing of getting and paying for healthcare

- there are a lot of companies doing this.  Conifer (owned by hospital Tenet Healthcare - ticker THC) has a similar division with similarly mediocre financial performance and has been trying to sell that division for  years without any luck. UNH has a similar division as well, etc.

- in fiscal 2018.  Change Healthcare served 2,200 government and commercial insurance payers, 900k physicians, 118k dentists, 33k pharmacies, 5.5k hospitals, and 600 labs.  They facilitated $1 trillion in adjudicated claims and 14bn healthcare transactions

- over the last 9 months, revs were -0.5% YoY, and EBITDA was -2% YoY,  pretty mediocre results

 - they're been investing in systems and process to realize synergies, which has been depressing margins

- it was formed in 3/2017 through a merger of McKesson's technology solutions business with Change Healthcare (which was owned by Blackstone and Hellman & Friedman).   MCK got 70% of the the combined company

- Blackstone originally bought Change Healthcare in 2011,  it was formerly known as Emdeon

IPO

- Underwriters are GS, Barclays, and JPM

- They filed an S-1 on March 15, 2019, and an amended S-1 on 4/5

https://www.sec.gov/Archives/edgar/data/1756497/000119312519099290/d638353ds1a.htm

Services they provide:

Thoughts on McKesson

MCK's business

- MCK is one of 3 major drug distributors in the US.  It's a very consolidated market

- drug distributors are very sensitive to the health of the generic drug market.  Basically, they make the majority of their money on generics where they can exert their bargaining power on generic manufacturers to get lower prices,  but get paid on higher prices.

- also, drug distributors hold drugs in inventory,  in a rising drug price environment, they can re-sell those drugs at higher prices

- branded / specialty drugs are much lower margin and can be done at breakeven margins or a loss in order to secure more profitable generic business (which are around 20-25% gross margins)

Headwinds & Major Uncertainties / Mitigants

The drug distributors have been under much pressure from  numerous fronts:

- pharmacies (e.g. WBA, CVS, and RAD) have been under pressure from lower reimbursement, aggressive competition with everyone just trying to grab share at the expense of margins, and unfavorable movement in generic and branded drug prices

   - of course, pharmacies are the major customers of the drug distributors.  Pressure on WBA and CVS is bleeding through to MCK and peers

    - CAH and MCK have contracts with CVS that expire  on 6/30/2019, it is likely that the distributors concede some of the economics and lower pricing,  leading to lower margins for the drug distributors. Hence why I suggest hedging MCK long with CAH short

      - it is extremely unlikely that CVS makes a dramatic switch of distributors,  but likely will just get better economics out of both CAH and CVS. CVS has enjoyed pitting the 2 drug distributors against each other to get better terms.  That said, if CVS really feels the need to get better pricing and boost earnings in the near term, they have a closer relationship with CAH and could possibly move away from MCK.  I think this is an extremely small possibility though

- concerns about the fallout from the government's push to remove rebates (basically fees paid by pharma companies to PBMs/distributors) to gain favorable placement on formularies.  Distributors are generally compensated based on list/gross drug prices. A shift to to net drug pricing would lower list prices by around ~30-50% depending on the drug. I don't think attacking rebates really changes anything on a net basis for the end patient (since the final net price,  is basically unchanged) but it does impact PBMs and distributors since they take a cut of the rebates as payment for services. The middlemen would shift to more of a fee-for-service business model,  but that shift would be rocky / uncertain

   - however, over the last year, the distributors have already adding clauses in contracts with manufacturers to keep economics the same in the event that there’s a change in net pricing.  At the end of the day, distributors provide a useful service (distribution, inventory management, tracking, etc.) and get paid rather little for it. Drug manufacturers don’t want to do this themselves,  so they will pay the distributors something similar. Distributors only make 1-1.5% EBIT margins

- generic drug prices have been under pressure, and have been down MSD % YoY,  which is typically the norm

  - generic drug prices deflation has gotten been less bad,  but likely will stay negative as is historically the case. Hence this headwind is abating.  I don’t think we’ll get back to a time where generic drug prices rise across the board, but generic drug manufacturers are have been exiting unprofitable business and over the last quarter or 2 we’ve started seeing pockets of generic price inflation, which is finally a tailwind and could provide some upside to consensus # for the space

- branded drug prices inflation has been muted due to government and public pressure after numerous bad actors (e.g. Valeant and Turing) in recent years

  - I don’t think this will abate,  but branded drugs still have the pricing power

- continued reimbursement pressure from payors, pharmacies and PBMs flow through to drug distributors.  

   - this is seemingly an ongoing trend though.  CVS and WBA have also called this out and expect it to keep happening over 1-2 years

- opioid litigation concerns.  While most of the obvious pressure will fall on the branded opioid drug manufacturers (like Purdue who very aggressively and criminally promoted oxycontin),  the plaintiffs are looking to attack deep pockets, and the distributors have very deep pockets and are also caught up in the uncertainty. Sizing an eventual $ amount of damages is very hard,  but could be very high (e.g. a few billions vs. MCK's market cap of $22bn, so maybe a 5-10%+ negative impact to MCK shares). On the plus side, some sell siders have already been including $1bn in damages, and MCK has $2bn of cash and is only 2.4x levered, so they could handle a

  - Bellweather multi-district trials are set to happen in October 2019,  so for this short term trade, likely won’t matter too much

  - the distributors are being accused of failure to prevent suspicious orders and lack of customers due diligence  

   - again, I think the plaintiffs are reaching to far since distributors are merely the middle men.  The real culprits are the doctors who prescribed these and others who had egregious and mal-intent

- concerns around Amazon and their nascent efforts to get into drug distribution and pharmacy.  Amazon recently acquired PillPack an online pharmacy

   - however, the current drug distributors are already very efficient and have huge scale,  I think it's be very complicated and unnecessary for Amazon to recreate a whole drug distribution supply chain.  

- The outgoing CEO John Hammergren (CEO since 2001) stepped down on 4/1/2019 and was replaced by internal candidate Brian Tyler

  - usually, when there is a CEO change, the new CEO will reset expectations / clean house to set himself up for beats and raises / underpromising and overdelivery.  They’re set to provide fiscal 3/31/2020 guidance on upcoming earnings, so there’s a risk there. Although drug distributors have already been slashing numbers for a long time now

Valuation / Upside

- MCK is indeed cheap,  but perhaps deservedly so given all the above headwinds

- it trades at 7.2x EV/FYE 3/31/2020 EBITDA,  and 8.4x FYE 3/31/2020 P/E

 - they generate ~$3bn in FCF, so 13.2% FCF yield

- 1.3% dividend yield

  - after the dividend, they spend about half of the FCF on acquisitions and half on stock buybacks,  hence they've been shrinking shares by around 6% annually

- they're expected to grow revs by LSD % over the medium term (mostly due to continued branded drug price inflation),  and MSD % EPS growth CAGR (mostly driven by stock buybacks). Without stock buybacks, EPS would be flattish due to due to continued margin contraction from the above reasons

MCK fiscal 3/31/2020 EPS growth estimate :

- clearly, essentially all the growth (and more) is due to stock buybacks (buying back around 6% of shares), without that,  EPS would be flattish

So arguably, MCK needs to trade at such low multiple given its lack of organic growth and the many overhangs.  

Yes it is cheap, and arguably a lot of bad news is priced in (which could turn out to be overblown), but making that call is difficult as the pressures have been ongoing for the last 4 years without letting up

However, with generic deflation tailwinds starting to abate, and numbers seemingly bottoming/stabilizing, I think there’s potential for rebound in growth over the next 1-2 years.  If that happens, and as these overhang abate, these multiples are way too cheap

- Modeling in some abatement in generic deflation and stabilizing in margins, there’s possibly 5% upside to fiscal 3/31/2021 numbers, and MCK could get back to low teens headline EPS growth CAGR and MSD organic EPS growth CAGR (excluding buybacks), the stock at 13.5% FCF yield and 8x P/E would be way too cheap.   

  - It possible trade back to 12x P/E on fiscal 3/31/2021 EPS of $16.28,  so upside to $195. Thas 66% upside

  - add in the 5-10% value from Change Healthcare, plus the 1.3% dividend yield, this could be 75% upside

Comparables

- Cardinal (CAH) trades at 8.6x P/E and 7x EV/EBITDA

- Amerisource Bergen (ABC) trades at 9.7x P/E and 7.2x EV/EBITDA

- MCK at 8.4x P/E and 7.2x EV/EBITDA

so they're all roughly the same multiples, which makes sense since they’re all quite similar in terms of business, market share, etc.

Cardinal Short / Hedge

I think Cardinal is a great hedge against the MCK long

CAH has been underperforming its peers for many reasons

- it’s medical distribution segment has been been a disaster and under pressure from a bad acquisition (bought Cordis in 2015 from J&J for $1.94bn) and general industry pressure (Owens Minor - OMI) is facing similar difficulty.   Owen’s Minor stock is down from $40 in 2016 to $3.5 now…. Clearly CAH chose a bad time to get big in the space

    - This was supposed to be accretive,  but has ended up being a black hole for earnings and revs

    - CAH also doubled down by buying Medtronic's Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency business for $6.1 billion in 2017.  This acquisition papered over the Cordis’ woes

    - CAH has been taking a hatchet to unprofitable SKUs (cut 20% of Cordis SKUs)  and trying to shift to distributing products they own

On the pharma side, CAH has also been overearning from their relationship with CVS and the benefits from the CVS partnership with RedOak (a drug purchase consortium that they started in 2014) are abating

Cardinal also has less exposure to specialty pharmacies (which distribute more complex, higher priced drugs), which is where all the growth is.  CAH has 13% as a % of pharma revs vs. peers at 20%. Hence they’ve been growing more slowly

This is why CAH’s pharma segment EBIT is still projected to be down 10% YoY, vs. MCK down LSD/MSD, and ABC seeing stable pharma EBIT.   

To summarize, given CAH’s underperformance and more headwinds relative to MCK and ABC, I think it should trade at a discount.  It’s trading at roughly the same multiple, so it’s a decent pair trade for MCK.

Also, it helps hedge out the CVS contract renewal risk since both CAH and MCK are exposed into the upcoming 6/30/2019 expiration date.  

What is needed to be more constructive on the sector?

- the generic drug prices and market needs to inflect higher

  - there are signs that the generic market is stabilizing as numerous generic manufacturers have exited unprofitable drugs.  However, the industry competition has increased with more entrants

  - negatively, branded drug companies have become more adept at slowing transitions to generics,  limiting the growth of the generic drug market

- branded drug inflation rises - given the overall political and industry scrutiny, this is unlikely to happen

- clarity around the rebate rule changes and opioid litigation and Amazon and Medicare-for-All concerns

  - all these, except Amazon will likely be resolved within the next 1-2 years and likely with little impact to MCK and distributors

Healthcare Sector

- the overall healthcare sector is currently undergoing a rotation away from it and a rolling bear market, leading to sudden & sharp price price declines on seemingly no news

- the proximate cause is due to continued political and regulatory uncertainty around the Democratic push towards universal healthcare (aka Medicare for All by Bernie Sanders), changes to drug pricing and drug rebates, and other political rhetoric.

 - However, I think that the sell off is more due to positioning and technical factors rather than fundamental fears; although the scary political headlines were certainly the spark.

· In our opinion, Medicare for All is extremely unlikely given the immense costs, disruption, and the general U.S. reluctance towards more socialism. To have a chance, Democrats would also have to have overwhelming control of Congress and the White House after the upcoming elections, and a very liberal / social democrat would have to become president.  Looking at political odds of each of these happening, it would put the odds of Medicare for All happening at around <1% or LSD at best

- This uncertainty and political overhang happens in healthcare every few years (or at least with a subsector within healthcare).  Whether it's pharma bashing, or PBM bashing, or Obamacare, or Hillary Care, or Valeant/Turing/spec pharma bashing, or Republican Repeal & Replace, or PAMA, or constitutional challenges to the ACA, or opioids, etc.  this is unfortunately par for the course in healthcare investing.

   · While I think the current healthcare sell off is a longer term buying opportunity, we will be cautious given that the political jawboning will continue especially into the upcoming election year

· I believe that this current selloff is further exacerbated by the recent rotation away from defensives and growth sectors into cyclical and value sectors.

Charts

MCK stock chart 5 years

- clear downtrend, tough to call a bottom,   

MCK stock chart 15 years / history review

MCK and the entire drug industry had a large run from 2012-2015

- this was caused by near perfect conditions for the industry and extreme generic price drug inflation and branded drug price inflation caused by:

 - the FDA cracking down on generic drug manufacturers (many foreign companies) for quality reasons.  They also were slow to approve new generic drugs. This led to a dearth of generic drugs and price skyrocketed (basic supply / demand in a commodity industry)

 - some large mergers made the industry more consolidated

 - at the same time, drug manufacturers became adept at gaming the PBM and HMO system and raised branded drug prices

 - the distributors also formed very large buying consortiums, allowing them to exert more pressure on manufactures and improve their margins

This environment reversed sharply in 2015 as

 - FDA began approving more generic drugs and allowing more generic manufacturers to operate dramatically depressed drug prices

 - very bad press from Valeant, Turing and the rest of the industry put a stop to massive branded drug price increases.  In addition, generic drug manufacturers were also accused of collusion and ant-competitive behavior

Since 2017-2018, the large generic drug companies have been exiting the business and walking away from unprofitable products, this is leading to some stabilization in generic price deflation,  but it's still negative

MCK P/E ratio - last 10 years

- yes their multiple is low, however  we don't believe that the elevated P/E ratio of 15-20 from 2013-2015 is representation since that was an abnormally favorable period for them

- a more normalized P/E ratio of 11-14x is more reasonable,  so there is potential for a re-rating if the above headwinds abate

EV/1 year forward EBITDA multiple - 10 years

The generic industry continues to get more competitive with the large manufacturers losing share to upstarts in India and China.  This is partly to blame for the generic drug price declines

As shown below,  drug distributor margins are highly correlated to generic drug prices

Generic drug price approvals have ramped up:

Generic Rx sales growth YoY

- admittedly, generic pricing and sales have become less bad,  but the industry is unlikely to return to meaningful generic price inflation and branded drug price inflation

Catalyst

- Change Healthcare IPO coming up in Q2 2019

- Generic deflation abates and pockets of generic inflation

- Changes to drug rebates take effect in Jan 2020 and the distributors realize similar revs and margins

- Opioid litigation resolved with little impact to distributions

- Fears around Medicare for All calm down,  rotation back into healthcare