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McKesson Corporation (MCK) announced on Thursday that it will acquire PSS World Medical (PSSI) in a deal valuing the company at $29.00 per share. Shares in McKesson rose more than 4.0% on Thursday on the back of the deal and the company's quarterly results. Shares of PSS rose 33% on the back of the offer, and closed Friday's trading session at $28.57 per share.

The Deal

McKesson announced that it would buy PSS World Medical for $29.00 per share. The purchase will form a leading provider of medical supplies, services and technology to physician and extended care customers.

McKesson will use the distribution infrastructure, private label offering and sales and customer service teams to provide the best of both companies to customers. Customers will have access to a broad array of medical products and services.

The deal including the assumption of debt, values PSS at $2.1 billion. CEO and Chairman John H. Hammergren commented on the deal:

"The combination of McKesson's Medical Surgical business and PSS World Medical is an exciting next step in McKesson's commitment to improve business health and clinical performance across healthcare. The unified organization will bring extensive distribution capabilities, deep product and technology expertise and a broad portfolio of business services to an expanding industry, helping our customers improve efficiency and productivity, and deliver better care."

PSS reported $2.1 billion in annual revenues in 2011. The company reported a net income of $74.3 million for the year. McKesson pays roughly $1.5 billion for the equity of PSS. This values the company at 0.7 times annual revenues and roughly 20 times annual earnings. McKesson furthermore assumes roughly $600 million in debt outstanding from PSS.

McKesson estimates that annual synergies could exceed $100 million per annum in four years time.

The transaction has already been approved by the board of directors of both companies. The deal is subject to customary closing conditions, including regulatory clearances and approval from PSS's shareholders.

Valuation

McKesson ended its second quarter of its fiscal 2013 with $2.8 billion in cash and equivalents. The company operates with $3.6 billion in short and long term debt, for a net debt position of $0.8 billion. Financing of the deal should not provide any difficulties given the limited debt position of McKesson at the moment.

For the first six months of its fiscal 2013, McKesson generated revenues of $60.6 billion. The company net earned $781 million, or $3.31 per diluted share. At this rate, the company could approach annual revenues of $125 billion. Net income could total $1.7 billion, or $7.00 per diluted share.

Currently the market values McKesson at $22 billion. This values the company at 0.2 times annual revenues and 13 times annual earnings.

Currently, McKesson pays a quarterly dividend of $0.20 per share, for an annual dividend yield of 0.9%.

Investment Thesis

Year to date, shares of McKesson have risen some 20%. Shares started the year in the high seventies and gradually rose to highs of $97 in July. Shares fell back to $85 after setting a peak in the summer, and are currently exchanging hands at $92 per share.

Over the past five years, shares of McKesson have risen some 60%. Shares fell from $60 in 2008 to lows of $35 later that year and at the start of 2009. Shares steadily recovered to $97 earlier this year. Between 2009 and its fiscal 2013, the company boosted annual revenues from $106 billion to an estimated $125 billion. Net income is expected to double from $823 million in 2009, to an estimated $1.7 billion this year.

For the first six months of its fiscal 2013, McKesson generated $59.0 billion in distribution revenues, 97% of firmwide revenues. Operating margins for the division are just 1.9%. Technology solution revenues came in at $1.66 billion, while operating margins came in at 11.4%.

The $2.1 billion revenue addition of PSS will significantly boost McKesson's technology solution division. Furthermore the deal valued at 20 times annual earnings, seems rather favorable given the outlook for $100 million in annual synergies from 2016 and onwards.

The deal seems rather favorable for both parties. I am not surprised that shareholders in McKesson react enthusiastic to the deal given the fair price and high estimated synergies. I refrain from investing as I fear the "conglomerate discount". The company's boring distribution activities carry low margins and low valuations. I think the technology division, including the acquisition of PSS, would command a much higher valuation on a stand-alone basis.

Source: McKesson's Excellent Acquisition Of PSS World Medical