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.

One thought on “A Pile of MCK?

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