McKesson: An Undervalued Gem, In A Frothy Market

Summary

• McKesson is a mission-critical player in the healthcare supply chain, and is executing well in the current environment.
• It should see continued near-term growth from the distribution of COVID vaccines, and could see long-term growth from its Ontada technology.
• I also highlight the valuation, dividend, balance sheet, and risks worth considering.

Photo by marchmeena29/iStock via Getty Images

There are two sides to every coin, and the same holds true for the stock market. While some stocks remain inexplicably expensive, there are other stocks that remain inexplicably cheap. I see McKesson (NYSE:MCK) as fitting into the latter category. In this article, I show what makes McKesson an ideal value buy for a long-term growth portfolio, so let's get started.

Why McKesson Is A Buy

McKesson is a 187-year-old company and is the biggest of the "Big 3" drug distributors, alongside peers AmerisourceBergen (ABC) and Cardinal Health (CAH). It's ranked #8 on the Fortune 500 list and is a global leader in healthcare supply chain management, retail pharmacy, community oncology and specialty care, and healthcare information solutions. In FY'20, McKesson generated $231B in total revenue.

McKesson appears to be hitting on all cylinders, with Q3'21 (ended December 2020) revenue and adjusted EPS growing by 6% and 21% YoY, respectively. The revenue growth was due to the overall drug market growth and higher specialty volumes, partially offset by branded to generic conversions. In addition, margin improvements also contributed to the acceleration in bottom-line growth.

(Source: Q3'21 Investor Presentation)

This was driven by revenue and margin growth in the Medical-Surgical solutions segment, with COVID-19 tests being a key driver. Revenue for this segment was up by an impressive 43% YoY, to $3.1B, and adjusted operating margin was 9.1%, up 55 bps YoY. Lastly, EPS got a boost from McKesson's tax-free exit from its Change Healthcare investment, which, in addition to share repurchases, lowered its shares outstanding by 10% YoY.

Looking forward, I see the total return story at McKesson continuing, as the Board authorized another $2.0B for share repurchases, representing 6.5% of McKesson's $30.8B equity market cap at present. Management has done an impressive job of reducing the share count in recent years.

As seen below, 30% of McKesson's shares have been repurchased by the company since 2016, from 234.3M to 164.6M shares, equating to a 30% earnings boost from buybacks alone. This represents a tax-efficient return of capital to shareholders, considering that buybacks are not subject to another round of taxes in the same way that dividends are subject to, at the individual taxation level.

(Source: Seeking Alpha)

McKesson should also see continued growth in 2021 stemming from vaccine distribution, given its selection by the federal government in helping with this rollout. This is supported by record-breaking 4 million vaccine doses that were administered in the U.S. on a single day early this month. As of February, McKesson had already assembled enough kits to support over 250 million doses.

Lastly, I see McKesson benefiting from higher margin growth in its oncology segment, through the recent launch of its Ontada technology platform, which has garnered McKesson a partnership with the biopharmaceutical giant Amgen (AGMN). This was noted during the recent conference call:

"Most recently, we launched Ontada, an internally developed technology and insights business dedicated to transforming the fight against cancer. Ontada builds off our existing capabilities and combines real-world data and research with the leading suite of technologies to help deliver innovative solutions that improve patient outcomes.

Shortly after the launch of Ontada, Amgen and McKesson announced a strategic agreement to advance cancer care and improve outcomes by accelerating the development and access to life-changing medicine."

Turning to the balance sheet, McKesson maintains solid financials, with $3.6B in available cash, and a net debt to EBITDA ratio of just 1.5x, sitting well below the 3.0x-level that I prefer to see. This has earned McKesson a BBB+ credit rating from the S&P.

It's worth noting that McKesson's 0.9% dividend yield is rather low, with an extremely safe payout ratio of just 9.8%, and a 5-year CAGR of 9.1%. This fits in with management's capital returns strategy of prioritizing share buybacks. I see this as being a prudent strategy for investors who don't prize current dividend income. This is considering McKesson's attractive valuation. At the current forward PE of 11.3, share buybacks generate an earnings yield of 8.9%. Plus, as mentioned earlier, unlike dividends, buybacks are not subject to another round of taxes at the individual shareholder level.

I continue to see value in McKesson at the current share price of $193.57, with a forward PE of just 11.3. This is also considering the robust 7-15% annual EPS growth that analysts expect over the next 3 years. As seen below, McKesson is also trading well below its historical valuation range, with a normal PE of 13.8 over the past decade.

(Source: F.A.S.T. Graphs)

Risks to Consider

It's worth noting that the ongoing opioid litigation has long been an overhang for McKesson and other drug distributors over the past couple of years. In the Q3'21 earnings release, management believed that it can probably and reasonably settle for $6.7B. This is worth paying attention to, until a settlement is finalized. In addition, McKesson's hospital supplies business could see a delayed rebound, if there is a surprise surge in COVID-19 cases. These are risks worth considering.

Investor Takeaway

McKesson is a mission-critical element of the healthcare supply chain. It has adapted well to the current environment and should see continued near-term benefits as an essential supplier of kits for COVID vaccines. Long-term McKesson should see higher margin growth stemming from its Ontada technology platform, which has resulted in a key partnership with Amgen.

Meanwhile, McKesson maintains a strong balance sheet, and share buybacks will remain accretive at the current valuation. Lastly, McKesson remains undervalued from forward growth and historical valuation perspectives. MCK is a Buy.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

This article is for informational purposes and does not constitute as financial advice. Readers are encouraged and expected to perform due diligence and draw their own conclusions prior to making any investment decisions.

Comments

[Jonk]

Mck has to overcome its reputation as a legal drug runner. But still, it has recovered remarkably well from the opioid disaster.

[PreCambrian]

It has 90% debt to capitalization. Seems quite high.

[john boy]

@PreCambrian
Ouch

[ChubbyChief]

@PreCambrian ?? Net debt of less than $1 billion. Their low "capitalization" / book value is related to their extensive buyback history. It was founded ~180 years ago, so book value is probably less relevant.

[john boy]

Pe of 11, This is an undervalued company wife worked for them in sales in late 90's was on their products board earlier. great company

[nj77]

Nice article. Distribution businesses are great compounders. Few questions. CROCI? Shareholder composition? Insider buying? M&A? Geographic expansion?