A Pile of MCK?

McKesson Corporation (MCK), founded 1833, is the largest distributor of drugs, medical products, and supplies in the US.

Distributors like MCK connect pharmaceutical manufacturers like Pfizer, Merk, and Bristol-Meyer-Squibb to outlets like Walmart, Albertsons, and hospital pharmacies.

Industry Landscape

McKesson’s fingerprints can be found somewhere on nearly a third of all prescriptions in the US. MCK is a supplier to more than 75% of US hospitals with more than 200 beds. The breadth of their products and services, combined with their geographical scale allows them to offer attractive package deals to their customers.

The US distributor market has characteristics of a mature oligopoly. 90% of the market is dominated by three relatively equisized players.

McKesson  (MCK): ~$30B market cap, ~$200B revenue
Cardinal Health (CAH): $17B market cap, $130B revenue
AmerisourceBergen (ABC): $19B mcap, $150B revenue

As a result, pricing in the US is mostly rational.

While US retail is a $400B opportunity, Europe is a ~$200B market.

MCK has recently been growing its presence in Europe, Canada, Brazil etc., where the distributor landscape is much more fragmented, and opportunities from consolidation abound.

In 2016-17, MCK merged its legacy technology solutions business with Blackstone owned Change Healthcare to form a new IT company. MCK owns 70% of the new firm. This allows McKesson to focus on its core drug distribution business. The end-game is to spin it off as an independent company.

Financial Overview

As of 09/2017, TTM revenues were $202B. However, the margins in this business are brutal. Despite the huge topline number, only $4.5B flowed to the bottomline.

Operating margins are generally in the 1.5-2% range, with net margins slightly over 1%.

It is hard for me not contrast these terrible margins with the fat 15-20% EBIT margins for industrial distributors like Fastenal (FAST) or MSC Industrial Direct (MSM). It is no surprise that FAST or MSM boast impressive returns on capital and equity. The ROIC and ROE for both these industrial distributors is in the 15-25% range.

It might therefore come as a surprise that McKesson also has racked up impressive ROIC (10-12%) and ROE (15-20%) numbers, despite terrible margins.

How in the world is it able to do that?

The short answer is that it plays the Costco game.

If you sell a lot of stuff without using much capital, then you can generate high returns on capital. The sales/capital ratio for industrial distributors (FAST and MSM) is in the 1.5-2.0 range.

For MCK, sales/capital is in the 7-10 range!

ROIC = NOPAT/IC = (Sales/Capital) * (EBIT Margin) * (1-tax rate)
ROE  = NI/Equity = ROIC * (1 - interest/EBIT) * (1 + debt/equity)

If we use normalized numbers for sales/capital (8.5), EBIT margin (1.75%), tax rate (30%), interest/EBIT (10%), and debt/equity (0.75), one can easily see how MCK hits ROIC in the 10-12% range, and ROE in the mid-high teens.

Unlike FAST or MSM, the healthcare market, and MCK by extension, is more recession resistant. It can afford the luxury of running a more leveraged operation to lower its cost of capital and turbo-charge returns to equity (and it does!).

Nevertheless, debt levels remain manageable; the entire debt can be paid off in 2 years from operating cash flows. Indeed, the company is delevering (a little).

MCK has grown topline at a steady 7-10% rate for nearly 10 years now. The business survived the 2008-09 crash relatively unscathed. The share count has declined almost 30% from 290M in 2008 to 214M in the most recent quarter. The company also pays a small dividend (~1%).

Headwinds

  • Although brand Rx drugs constitute a large fraction of the revenue (~60%), generic drugs constitute most of the gross profit (~65%). After a blockbuster 2015 in which the price of Gx increased, subsequent deflation has pressured profits.
  • 2016 was an election year, and drug prices were in the spotlight. These temporary unfavorable pricing dynamics should eventually normalize.
  • There is continued uncertainty regarding the future of healthcare reform, and any regulatory risk that may entail.
  • Customer consolidation (Target/CVS, RiteAid/Walgreens) affects contracts. Their resulting heft implies a weaker negotiating position for distributors.
  • Just recently (11/20/2017), the stock fell more than 3% on a report that Amazon would slice away a significant portion of MCK’s revenue. I think this fear is overblown. Just look at the low margins in the business. They provide a basis to mount a strong defense against Amazon.

Valuation

If there are no major disruptions, we should anchor expectations close to the return on equity (~15%).

Terminal Model

Let’s use a simple terminal model. TTM revenues were $202B. Since CapEx is modest, we can assume FCF ~ NI (FCF margins 1%), and growth rate of 5% for the next decade or so, and a cost of capital of 9%, we get a TV of $52.7B.

Subtracting the net debt ($5.8B), and dividing by the number of shares, we get an IV/share of $220.

Relative Valuation

Historically, MCK has traded in P/E band of 11x-24x, with a midpoint around 17. For 2018 and 2019, S&P estimates EPS to be $12.14 and $12.98, respectively. At a P/E of 17, this implies a target price of 17*$12.14 = $207.

At current prices of $130-150, shares are attractively priced.

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ALJJ Update

I initiated a small position in ALJ Regional Holdings earlier this year. I was hoping to add more when the stock drifted below $3, but was not able to build out the position to its desired size.

I thought ALJJ was worth at least $3.60, and quite possibly $5-$7.

Then a few weeks ago, I read Dave Waters’ (Alluvial Capital) letter to partners. I have tremendous respect for him as an investor and writer.

He made ALJJ his largest position. Some key takeways from his assessment:

  • accounting obfuscates FCF (amortization of intangibles); true cash flow > reported earnings
  • using numbers, not terribly different from the ones I used, he came up with a valuation of $4.70, somewhere between my bear and base cases
  • the jockey, Jess Ravich, provides upside optionality

I have been waiting patiently for the price to dip back closer to $3 to increase my position.

 

Oaktree Update

I looked at OAK over a year ago. At that time, I thought OAK was worth at least $38, and more likely close to $54 based on normalized earnings.

I added to the position earlier this year, when the price dipped to $40.

Over the past week or so it dipped back to the low $40s, after spending much of the year in the mid to upper 40s.

The overall narrative remains unchanged. It is a high-quality asset manager, focused on debt securities, which seeks to earn money the right way – by making outsized returns for its clients. With the stock market getting somewhat frothy, it remains poised to capitalize on any significant downturn or crash.

Valuation

I used the same template as the previous valuation. I used updated numbers from their Q3-2017 report for balance sheet items. For earnings, I used TTM numbers.

Screenshot from 2017-11-10 20-39-19

The year-to-year performance of OAK is quite lumpy. The IV increased from $38 to $66 based on TTM numbers. I believe that the average numbers are probably more reliable. They suggest that the IV remained roughly unchanged (increase from $54 to $57).

Based on these numbers, OAK is looking attractive at these levels.

Leucadia Update

In September 2016, I thought Leucadia was worth somewhere between $27-$32. At the  time, it was trading around $19, having bounced off of of lows in the summer. The company was still under-earning, although some of the winds had started to shift.

Earlier last month, the company put out an investor presentation (link), and I came across this well-reasoned article in SeekingAlpha, which pegs the intrinsic value around $33.

I updated my SOTP analysis, and come up with a fair value near $32.

Screenshot from 2017-11-10 07-37-11

The discount to intrinsic value has narrowed considerably from 50% ($19 versus $30 in 09/2016) to about 20% ($26/$32). The intrinsic value itself has improved marginally, mostly on the backs of improvements at National Beef and Berkadia.

The dividend has also been increased by 60% from 25c/share to 40c/share. At current prices, this implies a yield of over 1.5%.

I continue to hold.

Portfolio Moves: Sold Apple

After 4.5 years, I finally closed my Apple position last week.

I started buying in early 2013 in the low $60s (accounting for the 7 for 1 split). In 2016, I added to the position in the low-mid $90s. For quite some time it was my largest or second-largest position.

apple

No matter how conservative I got, I couldn’t come up with a value below $120. Last fall, I wrote:

The narrative is either “its going gangbusters” or “its going down the toilet”. Right now, we seem to be closer to the latter.

The narrative shifted over the past year, as Apple racked up an impressive 80% run.

As usual, I began selling way too early ($120), and finally exited my last sliver on November 10 at $175. Overall, my cost basis was $71, and my average exit price was $130 and change.

Counting dividends, Apple returned between 18-20% CAGR. Not spectacular, but considering the size of the position, and its relative safety (in my opinion), it is my kind of long-term trade.

At current prices of $175/share, AAPL doesn’t seem to be as great a value.

Why?

Last year, Apple earned about $9/share. It has about $31/share of excess cash. Using a conservative 12x multiple on the earnings, and a 20% repatriation haircut on the excess cash, I get a valuation of about $135. If you use a 15x earnings multiple, you can justify paying up $160.

I don’t know what the right multiple is. I hesitate using a high multiple because (i) Apple relies heavily on the iPhone, which regardless of how the winds are blowing currently is subject to disruption/erosion, and (ii) earnings are starting to saturate/grow more slowly.

I don’t think AAPL is grossly overvalued. However, I prefer to sit this one out.

Apple might quite possibly march onward to become the first trillion dollar company. I’ll be happy to watch the fireworks, and cheer on from the sidelines.

Under Dog

Over the past three years, Under Armour’s (UA) market cap has fallen by nearly 80%. Just over the past year, shares have lost 2/3 of their market value.

The most recent quarterly (Q3 2017) earnings report was brutal. Everything that matters was revised downwards. A series of external pressures (North American weakness, price war etc.), and internally inflicted wounds (ERP integration mismanagement etc.) have conspired to make 2017 a year UA would like to forget.

This is what happens when a growth story goes wrong. The sentiment against the company is overwhelmingly negative. The short ratio is around 10-12%, and the days to cover based on normal volumes is now about 15.

Is UA broken for good? Or are its troubles temporary? Will the company plough through this bad patch, and return to “normal”? Is the rational behavior at this time, to fold and cut our losses, or to hold our noses and double down?

Back Story

Previously, I thought UA was worth somewhere in the high teens. That was earlier this year, when the stock was trading near $20.

UA

Since I was learning a new put-writing option strategy, I thought UA – with its high volatility – might be a good candidate to experiment with. I began writing $20 strike puts in Feb 2017, and kept rolling them until August. After Q2 results, the stock dropped to the $15-16 range, and I got assigned my first set (400) of UA shares.

At that time, I revalued UA, and thought the long-term thesis remained mostly intact, and began writing more puts. This time at $16.50 strike. I kept doing this, until Q3 earnings were declared on 10/31. The stock subsequently dropped further, and now hovers between $10-11. The puts are deep in the money, and will likely get assigned when they expire on 11/24/2017 (500 more shares).

All said and done, I now have 900 shares at an average price of $15.50 (~$14k). My total maximum target allocation for UA is $25k (for a 5% position), which means I could more than double my ownership at current prices.

Valuation

After I factor in the disastrous Q3, and modest improvements over the next three years, followed by a return to industry averages by year 10, I get a DCF value of $15-16.I think this is a conservative estimate.

At current prices of $10-$11, the stock may be undervalued by nearly a third.

UA

Any improvement beyond the currently depressed valuations, any unexpected return to 10-20% growth rates in the near/medium term, and resulting multiple expansion could easily double the target price.

Five years from now, we might look back at this period as a good buying opportunity.

Just Do What?

Nike is a monster. It is the largest athletic apparel and footwear manufacturer in the world.

It sports mouth-watering returns on invested capital (25-30%), and has been consistently growing revenues and EBIT in the 6-9%/year range for well over 10 years now.

It is a growing, profitable, wide-moat business with an iconic brand.

Its has sales of over $34B, net-income of $4.2B, which towers over Adidas ($20B sales) and Under Armour ($5.5B) sales. Footwear and apparel account for 65% and 30% of revenues, respectively; the remaining sliver comes from equipment sales.

International sales now account for over half of Nike’s sales (~55%). About 30% of its revenues are DTC (website and company owned stores). In the medium-term both these slices are likely to continue growing.

Unlike Under Armour, Nike is a shoe company gate-crashing into the apparel market. The total addressable apparel market is $135B, almost 2x that of footwear. The size of the market and the popularity of athleisure provides a tailwind, and a new market for Nike to grow into.

It has stellar management (interview with CEO), and high insider ownership.

Essentially it is a great business. Usually such businesses are not cheap.

However, a glance at its chart reveals that it currently sits close to its 2-year low.

Screenshot from 2017-10-08 16-49-46

Might this be a good time to ease into NKE? Before we look at valuation, it might be useful to understand what the bear case might be.

Amazon. Of course.

It is killing retailers (Footlocker etc.) which still account for a majority of Nike’s sales. It is also jumping into Amazon branded apparel.

While I respect Bezos too much to dismiss Amazon, I think the actual threat posed by Amazon to Nike is far weaker than perceived.

Nike is a powerful identity brand. Like Ferrari, Harvard University, and Rayban. Unlike Gillette, Tide, or Hanes underwear, whose brands were protected through the premise of lowering search costs. Amazon (or Dollar Shave Club or Kirkland) could kill such categories with their store branded products. And they probably will.

Perhaps a bigger threat is that the apparel industry is subject to fashion trends. Nike knows how to engineer performance shoes that are sought after. The transition to a casual fashion brand may be not be easy.

The game is different. Just because someone has a black belt in karate, doesn’t mean they will do well in the boxing ring.

Currently, the North American market environment is overly promotional. This will eat into margins. However, over a few years, one would expect this latest catfight for market-share to have play out, and settle. So while this does present short-term headwinds, perhaps we should be thankful to it for allowing us to buy a great company at a reasonable price.

Which finally brings us to valuation.

Graham’s formula for growth companies, suggests a fair P/E ratio of (8.5 + 2g). In NKE’s case growth is approximately 7% for quite a few years to come. So that would suggest a reasonable P/E of 22. For FY2018, EPS is expected to be around $2.40.

This would imply a fair value of 22*$2.40 = $53, which is close to today’s share price.

One could also use a terminal value formula to come up with an alternative fair P/E, and isolate the drivers of value.

P/E = Value/NOPAT(t+1) = (1 - growth/ROC)/(COC - ROC)

If we assume Nike is a truly great company capable of growing profitably for quite some time, we might assume growth = 7%, COC = 10%, and ROC = 25%. This yields a fair P/E of 24, which after subtracting the $2.50 debt/share brings us to a fair value of $55.

If we treat Nike like a solid (but not extraordinary) company, with growth ~ 4%, and ROC = 20%, we get estimates of value between $35-40.

Thus, despite the fall in stock price Nike is not really cheap. For $50-$55, we are, at best, buying a wonderful company for a fair price. It will probably turn out to be a fine investment. However, this is not a back-up-the-truck price, just yet.

In my opinion the $35 estimate provides a lower bound. It implies a P/E less than 15 for a company like Nike!

Given the liquidity of the stock and share price, NKE might be an ideal candidate for selling cash secured puts. I would like to try to build a sizeable long-term position in NKE, especially if I can reduce the cost basis to the lower of mid $40s.