Description

 Note - the above 2017 and 2018 numbers are based upon 3/31 fiscal year end (i.e. 2017 is for the year ending 3/31/17)

McKesson Corp. (MCK) has grown revenue, cash flow, earnings, book value and dividends per share at double digit rates over the past five and ten years.  During the past year, a number of mostly temporary issues have depressed results and valuation, providing opportunity to invest in an above average quality business set to ride favorable long-term demographic trends.  Longer-term tailwinds should enable the stock to outperform as shorter-term headwinds abate (or reverse) and the P/E multiple expands to market parity or better over the next 3 years.

2016 was a year of adverse conditions for McKesson:  competitors reduced pricing, customers consolidated, branded drug prices rose more slowly, fewer generic drugs were launched and generic drug price deflation increased.   In January, noting weaker generic drug pricing trends, the company reduced earnings expectations for fiscal 2016 (March 31st year-end).  In March, McKesson announced a restructuring plan to lower operating costs, with pretax charges of $300 to $330 million expected through the end of the company’s fiscal 2018.    In October, citing “pricing challenges”, the company reduced guidance for fiscal 2017, with the stock dropping 24% the day of announcement.    

McKesson has a 183 year history and delivers 1/3 of all prescription medicine in North America.   As a wholesale distributor of drugs and other health care products, MCK enables drug manufacturers to use less working capital while efficiently reaching 100,000 customer locations.   It also offers customers, such as pharmacies and health care providers, the benefit of broad selection, reliable access and pooling of purchasing power.   McKesson operates through two segments: Distribution Solutions and Technology Solutions.  

Most of Technology Solutions will be contributed to a new, Blackstone-backed health care information technology company, Change Health Care, likely during the first half of 2017.   For its contribution MCK will receive $1.25 billion and own 70% of Change.   There is some potential in this transaction:   business performance has been disappointing under MCK and Blackstone may be more equipped to extract the expected $150 million annual synergies; it is intended the business undergo a public offering and subsequent spin-off of shares to MCK shareholders; as a health care IT company with 60% of revenue subscription-based, Change HC could command a healthy multiple.

One of the main reasons MCK sold off was a price war in independent pharmacy distribution.  This is especially bad for MCK; Morgan Stanley estimates that independents account for 11% of McKesson’s U.S. distribution revenue and as much as 40% of operating income.  It is our position that heightened competitive pricing should only be temporary.     MCK has indicated it repriced its independent pharmacies and held onto them.  The industry is oligopolistic; MCK, ABC and CAH distribute roughly 90% of all drugs in the US and have maintained fairly stable revenue share.    There is a long history of rational pricing behavior here and price wars do eventually end (or reverse).   When that occurs, long term tailwinds should allow for double digit earnings growth to return.

The concentrated industry structure is unlikely to change.  Wholesale drug distribution is a scale business; size benefits negotiations with drug manufacturer customers and in delivering drugs through an effective distribution system; the drug distribution supply chain is complex due to regulations and handling requirements.   The industry typically operates with net income margins of 1% or below; these low margins should help protect the business model from being attacked by politicians, customers or upstart competitors.   One indication of the benefits of scale and MCK being well-positioned was the recent agreement between Walmart and MCK to jointly source generic drugs.  

Another issue has been customer consolidation, which pressures pricing power and profitability; 1/3 of MCK’s contracts renew each year.  Acknowledging this more permanent change, we incorporate lower margins in our projections.  The acquisition of MCK’s second largest customer, Rite Aid is pending regulatory approval.    Both Morgan Stanley and Deutsche Bank estimate losing Rite Aid would reduce annual earnings by $0.20 to $0.25.   However, the sell side has incorporated this reduction into their projections and $4 billion of acquisitions announced during 2016 should help offset Rite Aid.

Despite extremely low profit margins, MCK delivers excellent returns on capital due to good cash conversion and inventory turns along with minimal capital spending requirements.  MCK is a good cash generator: cash flow from operations (blue bar below) has grown at a fairly steady rate, with minimal capital expenditure requirements (red bar).   Acquisitions have been a source of growth and absorb some of this cash flow.  Guidance for 15% growth in fiscal 2017 cash flow was not reduced with earnings.

Exemplifying its cash flowing ability, relative to its $30 billion current market capitalization, MCK deployed $25 billion of capital over the period F2010-16 through a combination of acquisitions/buybacks/dividends/debt payback/capex.   Shares outstanding decreased from 286 million in the year 2000 to 212 million currently.   MCK bought back $2 billion (6.6% of shares outstanding) at an average $140 share price during Q4 16.

Slowing in branded drug inflation has been a headwind, moving from roughly 15% in in 2015 to a sell-side estimated 10% to 12% during 2016, with a number of drug companies committing to single digit price increases moving forward.   Our projections are not based on rising branded drug prices (revenue growth to be driven by volumes, described below).    The recent deflation in generic drug prices is not uncommon; generic drug prices declined during 8 of last 10 years and MCK delivered double digit revenue growth.    As health care spending trends toward “value-based reimbursement (VBR), it is possible there is more spending on generic drugs; MCK makes more on generics than on branded drugs.

Should generic drug deflation continue and/or should branded drug prices fail to increase by the expected mid-single digit rate due to regulatory change, the distributors should be able to change how they price their service, as it is a necessary function which is unlikely to disappear.   Some support for this ability can be found in the industry’s previous move from a model in which branded drugs were typically purchased, then held in inventory before being sold at potential mark-up to what is now typically a fee-for-service model.

For perspective on the magnitude of current headwinds, sell-side research coverage on MCK indicates current fiscal-year earnings will be adversely affected by lower branded drug inflation in the range of -$0.01 to -$0.05 per share, by generic drug deflation in the range of -$0.05 to -$0.10 per share and reduction in generic drug launch by -$0.08 to -$.0.12 per share.

We see a powerful longer-term offset to current drug pricing pressures: unit growth.   MCK is set to ride a demographic tailwind, as the number of people over 65 years old is expected to grow 50% during the next 15 years.   This is important; pharmaceutical volume among those older than 65 is twice that of the 19-64 age group.  Global drug volumes are expected to increase 6% CAGR 2015-2020 (7% in North America, with 1/3 of that growth made up of higher margin specialty drugs) and generic drug volumes (higher margin for MCK) are expected to grow at a higher 9.3% CAGR over 2016-20, according to the IMS Institute for Healthcare Informatics Global use of Medicines Report 2015-2020.   Starting with sell-side consensus revenue for fiscal 2017 (one quarter remaining), we model revenue growth of 6% annually.

A potential indication of value was rare insider buying during November:   $100,000 by the General Counsel and $136,000 by a director.   No other insiders have purchased shares since at least 2004.

Valuation

MCK trades at a forward P/E of 0.7x relative to the S&P 500 (relative P/E since 1999 below).    As operating conditions improve, we expect the stock to trade at a market multiple or better.

We project a $201.84 stock price based upon fiscal 2020 earnings of $11.21 and applying a P/E of 18 – spreadsheet below.

Risks

Our valuation upside is driven in large part by multiple expansion.  Should we be wrong and the recent price war continues, it would be unreasonable to expect multiple expansion.  Similarly, a now more concentrated customer base may have reduced MCK pricing power, which would justify the current, lower P/E.  

Catalyst

End of price war and demographically-driven, multi-year volume growth