We first discussed our investment in McKesson (NYSE:MCK) in our mid-year letter to investors. The stock continued to decline (almost without fail) into year-end. Whenever this happens, we naturally wonder what we are missing. With the stock trading at single-digit multiples, the risk of overpaying for the business appeared minimal. But of course, we needed to understand why it was cheap. In our view, MCK was down for three reasons:
I. Industry concerns around drug pricing and the political environment;
II. Uncertainty regarding Amazon's (AMZN) entry into the healthcare supply chain; and
III. Potential liability from the opioid epidemic. So, the question then becomes, can we identify a catalyst to change investor perception? The short answer is "yes."
With Democrats winning the House, gridlock should create a more stable political environment for healthcare. Meanwhile, continued earnings growth and free cash flow generation should ultimately convince investors that the sky is not falling, and as a result, multiples should improve. And any settlement for less than the eye-popping headline risk of $100 billion should quell investors' worst fears about the company's opioid liability.
Despite the ongoing headline risks, we believe that pharmaceutical distributors are among the most attractive, high-quality distribution businesses one can own. While drug prices may fluctuate in the short term, the long-term outlook for prescription drug growth will almost certainly increase the number of scripts sold in the US.
McKesson benefits from high barriers to entry in the form of regulatory hurdles, rational competition between the top three distributors (who account for 90% market share), and demand growth that shows little sensitivity to economic conditions. Yet, investors are valuing the stock at a significant discount to the group, despite returns on capital far above the profits generated by other distributors.