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In a list with the “cheapest” stocks in the SP 500 right now, McKesson (NYSE: MCK) is on the seventh place with a P/E of 7.54 at the time of writing (and with current volatility, this might be already incorrect again). This alone should be reason enough to examine the stock and check out if we have a bargain at our hands or if there are good reasons for the stock being so cheap and beaten down.
MCK data by YCharts
In the following article, we first try to understand the business model and examine a little closely how McKesson is making money. After that, we will look at the company’s valuation a little closely and provide an intrinsic value calculation. In a third and fourth chapter, we look at the growth potential of the sector and the competitive advantage of the company. Finally, we analyze a few different risk factors.
To examine and analyze any company, it is important to understand how it generates revenue and profit. McKesson is a global leader in healthcare supply chain management solutions, retail pharmacy, community oncology and specialty care, and healthcare information technology. In the company’s own words, the business is quite simple:
“McKesson delivers pharmaceutical and medical products and business services to retail pharmacies and institutional providers like hospitals and health systems throughout North America and internationally. We also provide specialty pharmaceutical solutions for biotech and pharmaceutical manufacturers, as well as practice management, technology and clinical support to oncology and other specialty practices.”
Basically, McKesson is divided in two business segments: distribution solutions (pharmaceutical distribution and services) and technology solutions (products and services). The technology solutions segment provides clinical, financial and supply chain management solutions to healthcare organizations. As the segment generated only $2.6 billion in revenue (about 1.3% of the overall revenue of $198.5 billion), it can be neglected at least as long as we are talking about the company’s revenue. However, when focusing on operating profit and operating margin, the segment is contributing about one-eighth of the company’s operating profit due to higher margins.
The distribution segment generated about $195.9 billion in revenue in the last year. We have to point out that although the distribution segment is generating almost all of McKesson’s revenue, it has an operating margin of only 1.7%, while the technology solutions segment has an operating margin of 12-13%. The distribution solutions segment distributes branded and generic pharmaceutical drugs and other healthcare-related products internationally and provides practice management, technology, clinical support and business solutions to community-based oncology and other specialty practices.
McKesson is the largest pharmaceutical distributor in the United States with more than 40,000 customers. The business supplies branded, specialty and generic pharmaceuticals and other healthcare-related products to customers like retail national accounts, independent retail pharmacies and institutional healthcare providers such as hospitals and health systems. The company is also one of the largest pharmaceutical distributors in Canada. Aside from North America, McKesson also provides distribution and services to the pharmaceutical and healthcare sector in 13 countries in Europe. Its wholesale network delivers daily to 50,000 pharmacies in Europe. The retail pharmacy business serves patients and consumers in European countries directly through over 2,400 of its own pharmacies and over 5,500 participant pharmacies operating under brand partnership agreements.
We already mentioned that McKesson has a P/E below 8 right now, but the number is misleading. The company reported $23.28 GAAP EPS for the full year 2017, but we have to point out that in the fourth quarter, it reported additional $3,947 million as “gain on net asset exchange, net” which led to earnings per share of $16.79 for the quarter. Much more realistic are the adjusted earnings per share of $11.61 for the full year and $3.39 for the fourth quarter (on a non-GAAP basis). Using these numbers, we get a realistic P/E of 14, which is still very cheap. For the fiscal year 2018, the company expects adjusted earnings per share between $11.80 and $12.50.
It seems important to point out that GAAP earnings per diluted share from continuing operations are “only” expected to be between $4.80 and $6.90 for 2018. And while EPS on a GAAP basis as well as the adjusted earnings per share both have shortcomings, we should be careful not just to take that number best suited for the point we are trying to make (in this case, that McKesson is undervalued). And if we take the lower end of GAAP guidance, the forward P/E ratio would be 33.3, and therefore, rather high.
For a more accurate intrinsic value calculation, we will not use simple valuation methods like the P/E ratio, but apply a discount cash flow analysis. In the Investor Day Presentation (slide 14), McKesson claims it is on the path to double-digit adjusted EPS growth – meaning the company expects at least 10% EPS growth. If we take McKesson’s free cash flow of the last years (not 2017, as the free cash flow was exceptionally high), we can use about $2,173 million free cash flow as the basis for our calculation (free cash flow of the past four quarters) and also assume the company will grow 10% for the next decade. As usually, we use a 10% discount rate, and for perpetuity, we assume 3% growth (very conservative for a wide-moat company). All these parameters lead to an intrinsic value of $254.59 for McKesson, making the company extremely undervalued. It would have to grow about 4% for the next decade and 3% for perpetuity to be fairly valued right now. The important question right now is if the company will be able to grow at least 4% annually for the next 10 years and then 3% for eternity.
Wide Moat Due To Competitive Advantage
In order to ensure above-average growth rates, a company usually ne some form of competitive advantage, because otherwise competitors will enter those segments of the market that pledge high growth rates and increasing revenue. McKesson has built a distribution network, especially in North America, that is hard to match for new competitors. The top three distributors – McKesson, AmerisourceBergen (NYSE: ABC) and Cardinal Health (NYSE: CAH) – have a market share of 90%, and even McKesson, with its distribution system already in place, has extremely low net income margins. Over the last years, McKesson’s net income margin has fluctuated about 1%.
These factors show us how difficult it is for new competitors to enter the market, as gross and operating margins for new competitors would be terrible. With very little revenue and extremely high costs of revenue at the beginning, it is almost impossible for new competitors to match McKesson’s prices and profitability. While the company has to spend about 25% of each year’s net income as capital expenditures, the costs for new competitors to build a similar distribution network would be much higher.
(Source: Own work based on data from Morningstar)
We learned above, that McKesson (as well as AmerisourceBergen and Cardinal Health) doesn’t have to worry much about new competitors entering the market because of the competitive advantage and the wide moat the company has. McKesson mostly has to worry about its two competitors, but if we look at four different metrics – return on assets, return on invested capital, net income margin and gross margin – McKesson seems to be superior to its closest rivals. Gross margin was the highest in the last ten years, and net income margin also was in most years higher than the margins of Cardinal Health and especially the margins of AmerisourceBergen. On average, the net income margin over the last decade was 1.17% (Cardinal Health had a net income margin of only 1.01% and ABC only 0.55%).
But not just margins are better, the return on assets and return on invested capital are also higher. Return on assets for McKesson was 4.29% on average during the last decade (compared to 4.03% for Cardinal Health and 2.91% for AmerisourceBergen). Return on invested capital for the company is on average 14.62%, compared to 13.52% for AmerisourceBergen and 10.44% for Cardinal Health. I think it is safe to say that McKesson doesn’t have to fear its closest two competitors, at least not based on the different presented metrics.
Global Growing Healthcare Market
A wide moat is certainly one of the most important “assets” a company can have, as it protects the business and keeps competitors at a healthy distance. But a moat is only helpful if the overall business is increasing. A moat is pointless if revenue for all companies operating in a certain sector is declining as the overall demand is fading (it might help the company to survive a little longer, but can’t stop the decline forever). Therefore, it is also important to look at the sector the company operates in and analyze if the sector as a whole is promising increasing revenue for the companies.
(Source: 2017 Investor Day Presentation)
The spending on pharmaceuticals and the market is expected to grow in the high single digits in the next years, not just in the United States, but also in Europe and globally. Especially the aging society in developed countries will maximize the demand for pharmaceuticals and healthcare solutions. But the demand in emerging countries is also rising. The increasing demand for pharmaceuticals and drugs will lead to more and more products that need to be distributed and leads to increased revenue for McKesson. But not just the demand for drugs will expand in the years to come, the demand for medical-surgical supply will also increase as the demand for surgery and operations will rise.
In case of McKesson, not just the distribution segment, but also the technology solutions segment will profit from these mega-trends that will continue over the next years and decades. Combined with the competitive advantage, I think it is not only reasonable, but also extremely conservative, to assume at least 4% growth for the next decade.
We already wrote above, that it is very hard for new competitors to enter the markets due to the high costs and extremely thin margins. It would take some big corporations, that have massive capital resources and can spend millions or even billions of dollars upfront and can stand being not profitable for quite some time. A few days ago, Berkshire Hathaway (NYSE:BRK.B), JPMorgan Chase Co (NYSE: JPM) and Amazon (NASDAQ:AMZN) announced forming their own insurance company. The project aims to improve healthcare for the employees of the three companies (about 1.3 million people) and wants to provide affordable healthcare coverage for the U.S. employees. The company should be free from profit-making incentives.
Although we know very little about the new project right now, it had the power to disturb the markets quite a bit. Companies like Walgreens Boots Alliance (NASDAQ:WBA), CVS Health Corp. (NYSE:CVS) or Express Scripts (NASDAQ:ESRX) took dramatic hits that day. Considering how little we know about the project, the sell-off seems like an overreaction. However, it wouldn’t be the first time that Amazon made other stocks tank after some announcement. Target (NYSE:TGT) or Kroger (NYSE:KR) are examples from 2017 and two stocks that declined quite a bit as the market panicked. But after a few months, both stocks have recovered nicely so far (about 50% gains), as market participants seemed to realize they overreacted. A similar development could also be the case for McKesson.
For long-term investors, it is however more important to analyze if these sell-offs are justified as we have a real threat at our hands or if they create a great entry point. The three companies (Amazon, Berkshire and JPMorgan) certainly have the power and financial resources to build a similar distribution network as McKesson. Nevertheless, I don’t think McKesson has to fear the newly formed insurance company. But it doesn’t really matter if the new company will hurt revenue and profits in the long term – what really drive the stock markets are expectations. And right now, market participants assume that Amazon, Berkshire and JPMorgan will hurt McKesson, and this might lead to cheap stock prices.
Additionally, there are two other risks I like to point out. One is the dependency on CVS Health Corp., which is McKesson’s largest customer and accounted for about 20% of total revenue last year. If the company would lose CVS as customer, the effect on revenue as well as profitability would be quite dramatic. We are also facing the risk of being too optimistic about revenue growth for the entire healthcare sector. Most analysts expect growth rates in the high single digits, and therefore, much higher than GDP growth.
Although McKesson was even cheaper a few months ago, and it looks like we have missed out on our chance to buy the company at a very attractive price, investors should not panic. First of all, the company is still very attractively valued, and McKesson is still a buy. Additionally, as already mentioned above, the rumors about Amazon, Berkshire Hathaway and JPMorgan forming a new company might lead to a further declining stock price. Finally, we are confronted with an US stock market at one of the most overvalued states it has been during the last century. If the stock market should enter a corrective phase or even a bear market – and it will at some point in time (No, the first signs of panic in the last few days are not what I mean) – many individual stocks will be drawn down with the overall market even if the companies are already cheap. In my opinion, we can stay patient and probably will see price levels of $140 or even $120 again.
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Disclosure: I am/we are long TGT.
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.