McKesson: A Royalty On The Pharmaceutical Industry
According to Warren Buffett, the best business is “a royalty on the growth of others, requiring little capital itself.” To illustrate, he’s used the example of a monopoly toll bridge. McKesson fits this mold and offers a 10% earnings yield to boot.
A little over a year ago, Dan wrote up McKesson. It’s a stock we’ve been studying for years and one that continues to intrigue us. Rather than rehash Dan’s article, I’ll briefly reiterate his key insights and then focus on what’s happened over the past year.
Industry Background
McKesson is a pharmaceutical wholesaler. They buy branded and generic drugs from manufacturers and deliver them to pharmacies. The industry is an oligopoly in the US. McKesson, AmerisourceBergen, and Cardinal Health together move over 90% of drugs. McKesson is the largest of the bunch, but market share is relatively evenly split across the three.
Pharmaceutical wholesalers are middlemen who sit between large and fragmented markets. On one side, there are 1,300 manufacturers, like Pfizer, Eli Lilly, and Teva. On the other are 180,000+ dispensation points, like your local Walgreens, CVS, Walmart, and hospital.
Distributors offer two delivery models. Self warehousing means distributors deliver pharmaceuticals to the retailer’s warehouse. From there, the retailer distributes them to its stores itself. Direct to store means distributors deliver pharmaceuticals directly to each retailer’s stores. The distributors are so efficient that 93% of sales are direct-to-store. Even pharmacies with enormous scale, like Walgreens and CVS, can’t match distributors’ efficiency. McKesson services most pharmacies on 24-hour notice and can deliver to many multiple times per day. 83% of customers receive more than five shipments per week. Route density drives efficiency and keeps the cost of incremental deliveries low.
How Distributors Add Value
Branded
McKesson adds value to branded pharmaceutical manufacturers by handling their logistics, inventory, compliance, and credit risk in return for a fee for service. Pharmaceuticals are controlled substances, and warehousing and trucking them around the country is no trivial task. A massive compliance burden accompanies the actual logistics.
The Drug Supply Chain Security Act (DSCSA) requires that each pill’s every movement be traceable. The Controlled Substance Suspicious Order Monitoring (SOM) makes McKesson liable to the DEA if its customers illegally order or sell drugs. More on that later. Finally, Know Your Customer regulations compel McKesson to check pharmacies’ licenses and make on-site inspections.
Specialty drugs add operational hurdles to the logistical and compliance challenges. For instance, Pfizer’s COVID-19 vaccine must be stored at -70 degrees Celsius. Pharmaceutical distribution isn’t as simple as Amazon Prime’s two-day shipping.
Pfizer is good at formulating new pharmaceuticals, and it’s best for society and shareholders if they’re left alone to focus on that. Distributors handle everything else, so manufacturers don’t have to.
Generics
McKesson earns higher margins but lower revenues from generic drugs. Generics are branded drugs that have lost their patent protection. Instead of a fee for service, McKesson buys generic drugs, marks them up, and sells them to pharmacies.
While this might sound predatory, it’s not. McKesson aggregates tens of thousands of pharmacies’ purchasing power to negotiate rock bottom prices. McKesson is a deflationary force in generic drug pricing. Individual pharmacies would never be able to get the wholesale deals McKesson strikes with generic manufacturers. McKesson modestly marks up the generics and passes the bulk of the savings on to the pharmacies.
This is similar to how Costco works, except that Costco applies a 14-15% markup. McKesson’s markup is just 5%. McKesson is not a source of fat in the pharmaceutical supply chain. While it’s true that branded drugs cost more in the US than abroad, generics cost 16% less in the US than elsewhere (Axios). McKesson cannot affect branded drug prices, but it does help reduce generic drug prices.
Competitive Position
You might wonder, how does a 5% gross margin and a 1% net margin make McKesson a good business? McKesson compensates for low margins with rapid inventory turns, which produces attractive returns on capital. Return on capital, not margin, ultimately drives shareholder returns. Despite razor-thin margins, McKesson earned over 50% on its equity in 2019 (adjusted for non-cash charges).
I’d argue that McKesson’s low margins are an asset, not a liability. Low margins act as a barrier to entry. Disruptors target fragmented markets with high margins. The pharmaceutical wholesale industry is already so consolidated that there’s no market share up for grabs. Without scale, disruptors have no chance at profitability. The industry is so efficient that there’s no meat left on the bone for anyone else. This protects the incumbents.
I think of the three pharmaceutical wholesalers as toll bridges that connect manufacturers with pharmacies. Every time a drug crosses its bridge, McKesson earns a small toll. The more drugs that cross the bridge, the more McKesson earns.
Drugs have to get from A to B. It’s a mission-critical task. No matter how healthcare gets reformed in the future, drugs will still need to move. Someone will have to move them, and no one has shown an ability to compete with the incumbent wholesaler’s efficiency and low costs. McKesson earns its tolls.
Scale and a consolidated market act as barriers to entry, which means no one will build new toll bridges. If Walgreens and CVS can’t generate enough scale on their own, who can? The market got spooked a few years ago when Amazon bought PillPak, an online pharmacy. What the market missed was that PillPak relies on AmerisourceBergen for distribution. Online pharmacies aren’t new — Walgreens and CVS have owned them for years. In each case, online pharmacies were built on top of the existing distributors. McKesson is unlikely to face a significant challenge from a new entrant to the industry.
The industry’s oligopoly structure makes a price war among the existing toll bridges unlikely. Oligopolies tend to be profitable for everyone involved — think Boeing and Airbus, or Kellogg and General Mills. McKesson, AmerisourceBergen, and Cardinal Health are all about the same size and have similar margins. They have no incentive to start a major price war with each other. They occasionally trade customers, but their relative market share has been remarkably steady over the last fifteen years. McKesson is unlikely to face a significant challenge from inside the oligopoly.
As a result, McKesson effectively earns a royalty on the success of the pharmaceutical industry. Manufacturers risk their own money to research, develop, and manufacture new drugs. When they’re successful, more drugs flow across the toll bridge. It seems virtually certain to me that more drugs will cross McKesson’s toll road in the years to come. I’d also bet that the price of those drugs goes up over time. Both forces provide McKesson a tailwind.
Variant Perception
Today McKesson trades for just 10x earnings. That means that McKesson’s owners reap a 10% earnings yield. That’s more than double the median stock’s 4.5% earnings yield (22x PE). 10x is an attractive price for a business in a strong competitive position that's poised to profit from the pharmaceutical industry’s growth. Why is it so cheap?
One reason is uncertainty over healthcare reform. There’s a narrative out there that distributors earn high returns on capital by jacking up consumer prices. As I’ve mentioned, this is wrong. McKesson is not a source of fat in the pharmaceutical supply chain.
No matter how the American healthcare system changes, drugs will still need to get from A to B. So far, no one has been able to do that as efficiently as the existing distributors. This gives me confidence that McKesson will earn a fair return no matter how the system changes. McKesson and AmerisourceBergen both have profitable international subsidiaries. They know how to turn a profit in single-payer markets, should it come to that.
Another reason is uncertainty over opioid litigation. A few weeks ago, that uncertainty lifted. McKesson agreed to pay $8.1 billion to settle the charges against it. AmerisourceBergen, Cardinal Health, and Johnson & Johnson reached similar agreements. They will make payments over 18 years, and McKesson will reap $1.4 billion in offsetting tax benefits. Net annual payments will run about $370 million, or about 10% of annual income.
Last but not least, the market has been worried about pricing. Generics have been deflating, which is a short-term headwind to McKesson. These things tend to be cyclical, and I see no reason to worry about the long-run trend. Branded drugs have continued to increase in price but at a decreasing rate. Some are afraid of government-enforced price controls or an end to the murky rebate system. Since McKesson earns a fee for service, they should come out fine no matter how the rules are redrawn. They might have to renegotiate contracts to tie their fees to something other than WAC (wholesaler acquisition cost), but that’s not the end of the world. So long as McKesson can provide a mission-critical service more efficiently and effectively than anyone else, they’ll get paid.
Capital Allocation
I admire all of the pharmaceutical wholesalers and think they’re all likely to produce good shareholder returns. McKesson distinguishes itself with top-notch capital allocation and a 15% valuation discount to AmerisourceBergen.
McKesson’s managers have been doing exactly what they should when their stock is cheap and cash flow is plentiful — buy back shares. Last year McKesson exchanged their remaining stake in Change Healthcare for its own shares. In doing so, McKesson repurchased 15.4 million shares — 10% of the company — at around $132 per share. That’s 25% below where the stock trades today.
Buybacks are nothing new for McKesson. Shares outstanding declined at a 4.4% annual pace over the fifteen years between 2005 and 2019. Over that period, the stock’s median PE was 14x. If its valuation remains around 10x earnings, McKesson ought to be able to retire shares at an even faster pace in the future. McKesson also pays a small dividend and yields about 1%. Overall, shareholders are likely to see 5-6% of their capital coming back to them each year.
McKesson retains about half of its capital and reinvests it in organic and inorganic growth. Historically, McKesson has made bolt-on acquisitions to acquire smaller distributors and ancillary pharmacy service providers. The more deeply ingrained McKesson is in its client’s business, the sticker that business becomes. McKesson earns about 25% on capital and over 50% on equity. These have been trending up, implying high incremental returns on capital.
Conclusion
Warren Buffett says, “You pay a high price for a cheery consensus on Wall Street.” Inverting, we can conclude that you can get bargains by wading into uncertain situations.
McKesson faces uncertainty, but I think it more than makes up for it with its strong competitive position, rock-solid value proposition, and rock-bottom valuation. The opioid settlement puts that saga to rest and is a manageable sum relative to McKesson’s earnings.
Time heals all wounds, and eventually, I’d expect McKesson to re-rate towards its median PE of 14x. Over five years, that would add 7% to annual returns. Adding in a 1% dividend yield and 5% buyback yield, shareholders could be looking at 13% annual returns before considering growth.
Growth, however, is the reason I like McKesson. McKesson benefits from the entire pharmaceutical industry’s growth by owning a “toll bridge” between manufacturers and consumers. Pharmaceutical consumption is poised to grow, and prices are likely to increase. This tailwind should allow McKesson to grow for a long time.
If McKesson doesn’t grow, at least buyers at today’s price have paid nothing for that growth. Unlike Tesla, which trades at over 1,000x earnings, McKesson doesn’t need growth to justify its current price. Therefore, McKesson looks like an asymmetric risk — “heads I win, tails I don’t lose much.”
All told, McKesson is the quintessential “defensive growth” stock to me. Because it is not cyclical, McKesson is likely to grow slowly but steadily no matter what the economy does. In a protracted downturn, it could be a source of value to sell and “upgrade” into a higher-growth compounder when those are on sale. In the meantime, McKesson is likely to produce substantially better returns than cash.
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