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Hi All,

If you're bored at work or just feel like helping out a poor college kid, please feel free to read. Any feedback is appreciated! (How can I make this thesis stronger?)

McKesson Corporation (MCK)
Price: $137
Shares: 212mn
MC: 29bn
Net Cash: -6.7bn
EV: 35.7bn

The Healthcare Industry usually experiences a mild sell-off during the election period. Unfortunately over the past two years, pharmaceutical distributors were hit hard with lower-than-expected inflation rates in generic and branded drug prices. MCK in particular suffered more than 40% in market value due to major contract losses (which do minimal damage to profitability), customers consolidating, and overall negative attention the healthcare market is receiving from the media.

MCK is currently valued at EV/FCF of 15.4x (trailing) and P/FCF of 12.5x (trailing), at its historical lows. It's competitors are also at an attractive valuation but still trade at a premium to MCK's multiple.
(I calculated FCF = NI + D&A - MCX)

Description:
McKesson (MCK) is the largest distributor/wholesaler of pharmaceuticals in the U.S. This business is essentially the backbone of pharmaceutical supply chain; wholesalers typically contract with manufacturers to purchase drugs and is then responsible for delivering orders to various customers--such as independent/retail pharmacies, PBMs, hospitals, etc. MCK is also in the business of software solutions but I won't be going into much detail. At the end of the day, distributors make their money from fixed/variable fees based on the wholesale cost of each drug.

The big 3--MCK, Cardinal (CAH), and AmerisourceBergen (ABC)--controls almost 90% of the U.S. drug distribution market. The competitive landscape is not likely to change significantly in the near term b/c of the high barrier to entry and the low risk of contract loss (contracts are long-term in nature and usually renewed). Recent major contract losses from Rite Aid and Target were due to acquisitions by Walgreens and CVS--who source pharmaceuticals from competitors. Despite these losses, retail sales have minimal impact on profitability--due to its lower margins--and MCK has already diversified its business into Canada and Europe and actively growing its software services.

There are several reasons why MCK is an attractive business:
(1) MCK achieved excellent ROIC: FY16 of 37% and 5-year average of 35%. Compared to other distributors in industrials, food, etc., MCK provides better return on invested capital due to its economies of scale and low working capital requirements.

(2) Because of its superior scale and diversification, MCK's pricing power reflect higher-than-average gross margins of 6%--ABC and CAH achieved 3% and 5%, respectively. MCK is the only distributor that is expanding into tech and recently announced the acquisition of CoverMyMeds (will continue operating separately in Ohio). Given the razor thin margins of the distribution business, I believe MCK is making the right move expanding into software solutions to reap higher margins.

(3) Medicine and healthcare is a general necessity so the distribution business is very resilient even in a market downturn. If you look back nine years, MCK achieved stable cash flows even through the financial crisis and double digit growth of 17% CAGR. Both manufacturers and customers rely heavily on the distributor: they source pharmaceuticals from hundreds of manufacturers at a price point that's impossible to achieve as a stand-alone customer and they help manufacturers reach more customers efficiently.
FCF (in millions) = NI + D&A - MCX
3/31/16: 2,655 = 2258 + 885 - 488
3/31/15: 2,117 = 1476 + 1017 - 376
3/31/14: 1,720 = 1263 + 735 - 278
3/31/13: 1,673 = 1338 + 581 - 246
3/31/12: 1,580 = 1254 + 551 - 225

(4) Volatile drug prices have less impact on earnings as distributors slowly renew their contracts with manufacturers under a fixed fee structure. Today, nearly all branded drug volume is distributed under a fee-for-service (FFS) agreement--essentially, branded drug makers pay distributors a mix of fixed/variable fee for the various downstream services they provide. What many people don't seem to point out is that for each drug MCK sells, the manufacturer pays MCK a fee that is 90% fixed and 10% variable. As a result, branded drug price inflation/deflation is not a meaningful driver of profitability. On the generic side, there are no FFS agreements, instead distributors speculate and purchase generics in anticipation of price increases; MCK is different though, it owns a generic drug manufacturer, NorthStar Rx, and has been sourcing more generics from there since 2002.

Consider this scenario: If MCK grows revenue 1% terminally and maintains an operating margin of 1.5% (low-end of historical avg) at an 8% discount rate, MCK is priced about where it sells for today ~30bn. MCK provides a high margin of safety and a good entry point into a stable business.

Few risks/concerns to note:
-- Customer consolidation: CVS and WBA has been actively acquiring other retail pharmacies (Target pharmacy, Rite Aid, and other pharmacies in Europe). MCK faces threat of more contract losses from existing customers being acquired.

-- High Debt: MCK also has a lot of debt (net debt: $6.7bn), while it's not enough to cripple earnings, it has the highest debt/equity compared to its peers.

-- Complaints about NorthStar Rx generic drugs: some patients experienced serious side effects or no effects at all.

Catalyst:
-- CoverMyMeds acquisition: In short, this startup was founded by a pharmacist and a software developer to attack the problem of administrative paperwork (prior authorization process) involved in prescribing drugs. One of the fastest growing healthcare startups--current customers include major retail pharmacies and insurance companies, such as CVS/Caremark, WBA, Aetna, Humana, etc.

-- Aging demographic: In 2014, people 65+ represented 14.5% of the US, by 2040 it'll reach 21.7%--more than twice the "number" in 2014.

-- Share repurchases: Bought back a total of 30% of its shares over the last ten years. Management expects to continue buying back shares.

Comments (6)

 
Best Response
Apr 24, 2017 - 5:25pm

May possibly be a minor point, but something that I know drives some PMs crazy is reading reports that make these sweeping statements with no foundation, then sort of use that as the springboard for the entire thesis.

You start out with:

"The Healthcare Industry usually experiences a mild sell-off during the election period".

Really? All sorts of questions one could ask, but for starters: define 'election period'.

It's competitors -> Its

You note that you're not going to go into much detail regarding the software solutions business, but maybe indicate what %age of revenue and profit it generates?

wholesalers typically contract with manufacturers to purchase drugs and is -> ....purchase drugs and are

CVS and WBA has been -> have been

I'd expect working capital requirements to be relatively low...so why the high debt?

I'm sure people more knowledgable than me will pitch in, but those were my initial $0.02,

- If you think hiring a professional is expensive, wait until you've hired an amateur
 
Apr 24, 2017 - 7:10pm

Dragon Ash made some good points. One thing I would add is making a decision tree in order to look at certain outcomes. So look at their current contracts and how much rev/profit they generate. And if they lose certain contracts how will that affect your FCF and valuation. Using this can really give you a great floor valuation and you can check the upside/downside potential based on their contracts which seems to be their largest driver of revenue.

 
May 8, 2017 - 9:22pm

I don't know if EV/FCF is a metric that makes sense.

You said the share price dropped 40% after some insignificant contracts were cancelled. Go deeper into that, why are they insignificant. Did the price drop exclusively because of the contracts, or is there another element to it that you may be missing.

Debt may be high. But how are cash reserves and cashflows, if they are able to cover payments and the principal, it shouldn't be a big issue.

30% buyback in 10 years, sounds great, but a portion of that could have been stock options. Anyway, better a decreasing number of shares than increasing.

Not sure how you're calculating ROIC, seems a little bit too high. But I could be wrong and the company could have some serious moats.

Anyways. Nice post. I'd say really investigate that 40% drop. Remember you are trying to prove the market wrong. If you can prove their wrong about that 40% drop. You just might have a decent investment (if the downside is minimal).

Absolute truths don't exist... celebrated opinions do.
 
May 14, 2017 - 3:17am

As has already been said, it's too vague. What percent profit do you expect in an upside case? What percent loss do you expect in a downside case? What percent loss could be possible in a downside case? Some of the claims made initially seem rather vague, unsubstantiated, and/or not really all that relevant to the stock in question, referring more to the healthcare sector as a whole. Also if they dropped 40% because of contracts being canceled, the market is pricing in a severely negative impact on future profits that deserves to be thoroughly analyzed. Also, you don't really explain why you use the valuation metric you use. Given the higher debt load, you should also explain more why this isn't a problem (maybe they have a lot of very stable free cash flow for instance). You should also explain in detail the impact of customer consolidation and the acquisition. The biggest problem is that you don't go into enough detail, quantify impacts, or estimate potential upside and downside.

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