McKesson - Quality Growth Play At A Fair Price

| About: McKesson Corporation (MCK)

Summary

McKesson is a healthcare distributor who is benefiting from long-term tailwinds and a strong market positioning.

While the company has delivered on great growth and shareholder value, some headwinds are emerging.

After shares have lost a third of their value from last year's highs, value is starting to emerge as structural tailwinds outweigh temporary issues.

McKesson (MCK) is a powerhouse in healthcare distribution. While the wider pharmaceutical and biotechnology space has come under pressure on the back of scrutiny regarding drug price increases, individual pricing decisions have a modest impact on McKesson which acts as a middleman in the industry.

This means that McKesson makes its money from high volumes and value of the overall drugs being distributed throughout the system and does not rely on prices for individual drugs. While the public backlash can have real implications for individual drugs and their manufacturers, McKesson should benefit from increased usage of drugs over time.

McKesson's Business

McKesson has been around for a long time, and while it is a very large business already it managed to aggressively expand its scale in recent years. The company benefited from solid organic growth as the US population is aging and drug development has been quite active. While McKesson is still very much a play on the US, it has pursued overseas expansion with the 2014 purchase of German-based Celesio.

McKesson is of course mostly a distributor of drugs and related items. These products are distributed to independent pharmacy customers, purchase alliances, branded pharmacy retailers and healthcare providers, including hospitals.

The company aims to distinguish itself from competition through a focus on specialty solutions, leading market scale and focus on technology. The latter should improve speed and accuracy of order fulfillment in order to drive customer service. These lower-margin distribution services generate over 98% of the annual revenues of $179 billion in the fiscal year of 2015. The technology solutions business, which is based on connectivity, supply chain solutions and patient care, generated little over $3 billion in sales last year.

A Stellar Growth Story

McKesson has grown its business at a very aggressive pace over the past decade. Revenues roughly doubled from $87 billion in the fiscal year of 2006 towards $179 billion in 2015. Part of this growth has been driven by dealmaking as the company has spent roughly $10-$15 billion in terms of acquisitions over the past decade. Most of these investments related to the $5 billion purchase of Celesio, a deal which added 22 billion euro in annual sales.

While the actual revenue numbers are very high, margins are very low as McKesson is in essence a simple distributor. It acts as an intermediary between pharmaceutical producers and healthcare participants, including pharmacies. That being said, McKesson has benefited from an increase in scale and value-added offerings, trends which pushed gross margins up from 4.5-5.0% of sales in 2006 towards 6% by now. This allowed the company to increase its operating margins from 1.0-1.5% of sales towards 2% by now.

The combination of revenue growth and margin improvements has allowed the company to triple its operating margins over this ten-year time period. Shareholders have furthermore benefited from the fact that the company has bought back a quarter of its outstanding shares over this time period, allowing earnings per share to increase by a factor of 4 times.

This improved profitability has been well-reflected in the share price of McKesson. Shares rose from $50 in 2006 to peak at nearly $250 in early 2015. Ever since, shares have retreated quite a bit and now trade in their $150s, levels last seen by the end of 2013.

It should be stated that while long-term capital appreciation remains very strong, investors receive relatively little in the form of a current payout. Even after the latest sell-off, the dividend yield comes in at just 0.7%.

It seems that a too hot momentum run, increased scrutiny for the entire sector and slower growth (potentially a result of the increased scrutiny) have all been weighing on the shares. The question is if current levels start to offer appeal after investors lost a third of their value this past year.

Exploring The Current Slowdown And Concerns

Part of the disappointing share price performance relates to the fear among investors about the implications of a changing political landscape. A potential reversal or adjustment to the Affordable Care Act could have big implications, while increased drug price scrutiny could have a similar impact.

In my eyes, these are two temporary headwinds. Even if these trends could become more pronounced, McKesson will benefit from an increase in demand for drugs as societies are aging. With development being quite active, it is likely that producers will be able to cure more diseases in the future, resulting in additional demand for drugs. As McKesson is very diversified in terms of exposure towards individual drugs, and its producers, I only expect growth to slow down in an adverse scenario.

Another concern is the rapid expansion strategy of Walgreens (NASDAQ:WBA), not being a customer of McKesson. This pharmacy chain made a huge move to expand in Europe over the last couple of years with the acquisition of Boots. Last year, it made a similar move at home when it bought Rite Aid (NYSE:RAD). With Walgreens being a customer of AmerisourceBergen (NYSE:ABC), McKesson might potentially lose a very valuable customer.

Even if operational growth is slowing down, and/or McKesson might lose an important customer, the company has a few more levers to pull. This includes overseas expansion following the 2014 acquisition of Celesio. With the near half a billion acquisition of UDG Healthcare, the company is now gaining ground in the UK and Ireland as well, in its goal to set up a significant European base.

The company has furthermore been quite active with regards to dealmaking at the start of the year. In February, McKesson spent a combined $1.2 billion in order to buy Vantage Oncology and Biologics, in line with its strategy to focus on specialty services in the field of Oncology. This deal was followed by the $2.2 billion purchase of Katz Group, a healthcare distributor in Canada.

Despite these positive steps, shares remain down 20% so far in 2016. Part of these losses can be explained by the updated earnings guidance at the start of the calendar year. On January 11, McKesson revised its 2016 adjusted earnings guidance to $12.60-$12.90 per share, with modest growth projected for the fiscal year of 2017.

While the 2016 guidance has only been narrowed from an original $12.50-$13.00 per share range, it seems that the negative market reaction relates largely to the softer earnings growth projected for 2017. This disappointing guidance relates large from weaker generic pricing and inflation trends, as negative trends could create negative risks towards this guidance.

While the company remains on track to achieve this year's targets, it is important to realize that adjusted earnings are not equivalent to actual GAAP earnings. Amortization, LIFO inventory and acquisition-related charges are expected to hurt earnings by $2.30 to $2.40 per share. This implies that GAAP earnings are seen at roughly $10.40 per share.

Appealing Valuation And Future Drivers Outweigh Concerns

At $155 per share, the valuation seems very reasonable by all means. With $10.40 in GAAP earnings and $12.75 in non-GAAP earnings, shares now trade at 15 times GAAP earnings and 12 times adjusted earnings.

The recent dealmaking has put some pressure on the balance sheet, although it remains healthy. McKesson ended the calendar year of 2015 with $3.4 billion in cash and equivalents and $8.7 billion in debt. This net debt load of $5.3 billion is equivalent to roughly 1.2 times trailing EBITDA of $4.5 billion. The trouble is that the 2016 deals are not being paid for yet. The three deals which are announced this year will increase the debt load by $3.4 billion towards $8.7 billion. This means that leverage is likely to come in around 1.8 times EBITDA after taking into account a modest profit contribution from the acquisitions.

To tackle the very modest profit growth in the fiscal year of 2017, and the worsening operating conditions, McKesson already announced 1,600 job cuts, equivalent to 4% of the workforce. These costs savings, the gradual realization of synergies from Celesio and other deals, and continued growth of the overall market should aid earnings growth going forward. These drivers and the much more fair valuation should support the shares, even if the company faces some challenges as well.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MCK over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.