McKesson: Does Valuation Offset Uncertainty?
Summary
- Uncertainty hangs over the drug industry leading to depressed valuations for wholesale distributors.
o Ongoing legal proceedings related to the opioid crisis and questions over reimbursement rates have led to valuations not seen since 2008-2009.
- Drug distributors operate in an industry with long-term tailwinds.
o Over-65 years old population segment increasing.
o Generic drug trend beginning to turn favorable.
- Distributors enjoy a solid moat in the form of barriers to entry.
o Low operating margin, scale-dependent model combined with complex governmental regulations have led to an oligopoly in wholesale pharmaceutical distribution.
o McKesson provides an essential service to a growing market and is part of the “plumbing” of the pharma world.
- Fundamentals
o The business:
§ Earns exceptional returns on capital employed
§ Generates significant free cash flow
§ Employs a shareholder friendly capital allocation approach
§ Maintains a healthy balance sheet
- Recent valuation of $137 or less (near current levels) provides significant margin of safety to protect the downside and an attractive entry price.
Industry Background
McKesson operates as one of three main players in the wholesale pharmaceutical distribution industry alongside AmerisourceBergen and Cardinal Health. Overall, pharmaceutical sales in the U.S. benefit from a number of long-term tailwinds, namely:
- An aging population, specifically individuals age 65 and older. This group represents the fastest growing segment of the population and also the largest consumer of healthcare and pharmaceutical products and services. This segment is expected to reach 65 million in 2023 from ~50 million today (source: AmerisourceBergen 2019 10K)
- Ongoing introductions of new pharmaceutical technologies and drug therapies. Pharmaceutical manufacturers continue to pour billions into R&D to develop drugs to fight new and existing ailments, and the spending is only expected to increase over time.
- The drug distributors specifically stand to benefit from an increase in generic pharmaceuticals being introduced to the market. Amidst a continued governmental push to lower the cost of healthcare in conjunction with several prominent branded drugs experiencing patent expiration over the coming years, generic drug volumes are expected to rise. While McKesson’s revenues are hurt by an increased volume of generic drugs, profit margins are higher on generics leading to a net benefit in profitability if generic drugs grow in relation to their branded counterparts.
- All of these factors contribute to an estimated 4%+ CAGR in pharmaceutical sales through 2023 (source: AmerisourceBergen 2019 10K).
While these tailwinds favor the industry over the long-term, there are a few areas of uncertainty hanging over the industry which have caused depressed valuations over the past few years.
- First, drug manufacturers, distributors, and pharmacies are subject to ongoing litigation related to the well-publicized opioid crisis. While the key industry participants appear to be nearing a settlement, questions regarding the size (and timing) of the payments have created an uncertainty that Wall Street abhors.
- There has been a push in recent years to lower drug prices leading to a reduction in reimbursement rates. This has led to margin compression for McKesson and other distributors. As a result, operating margins have decreased from 2.9% in 2014 to around 2% currently (source: ValueLine)
- These factors have been the primary drivers leading McKesson to trade at valuations normally reserved for troubled businesses in cyclical industries – providing an excellent entrance point for investors willing to wait through some of the short-term noise.
Moat and Competitive Advantages
McKesson possesses a number of desirable characteristics which comprise a sizable moat for the business.
- Barriers to entry:
o Margin Profile: Entry barriers are high in the pharmaceutical distribution industry given the low operating margins. McKesson has consistently generated slightly less than 1.5% net income margins. They have been able to generate such healthy returns on capital due to their scale. Replicating this scale from a new market entrant would require accepting heavy losses for years, which is one of the primary reasons the space has become an oligopoly between the three major players.
o Regulation: Another factor inhibiting entry into the space is governmental regulation and the associated complexity. Drug distributors have stringent traceability, quality, privacy, and other requirements imposed by the DEA, FDA, DOJ, and others. Complying with and managing these mandates require expertise and infrastructure that are difficult and time-consuming to replicate, further discouraging new entrants.
- Distributors serve an essential purpose in the industry
o Moving an extremely high volume of regulated product between manufacturers and pharmacies is a complex but important aspect of the pharma industry. Pricing pressure and lawsuits aside, McKesson’s services are needed and can be thought of as the “plumbing” of the drug industry. Distributors have faced periods of major uncertainty before (especially in the early 2000’s with “channel stuffing” becoming a point of emphasis) and have adjusted and continued to drive profitability amidst a shifting landscape.
Because of these advantages, McKesson enjoys attractive economics. Ongoing capex is very low in relation to operating cash flow (~$4B of operating cash flow vs. $400M in capex for 2019) and the business is able to operate with low working capital levels (less than $1B) leading to consistent returns on tangible equity of over 100%.
o Warren Buffett has often described his “ideal business” as a company who requires very little capital and earns high returns on that capital. McKesson certainly appears to check this box.
o John Huber of Saber Capital Management recently published an article discussing the advantages of benefitting off of others capital investments (source: sabercapitalmgt.com), noting: “Getting the benefit from someone else’s debt without having to pay interest on it or pay it back is a great business model”. McKesson has essentially benefitted from the billions of dollars pharmaceutical manufacturers have spent developing drugs and the billions of dollars pharmacy companies have invested in building locations to dispense the drugs to consumers. To be sure, Huber is citing software companies such as Microsoft who have and continue to grow at a much faster clip than McKesson from this phenomenon, but the dynamic and resulting economics are still highly attractive.
Fundamentals
After adjusting for nonrecurring events and non-cash expenses McKesson has consistently generated increasing levels of free cash flow. Note the rolling 7-year trend below in operating and free cash flow growth (from December’s analyst meeting). This positive trend comes amidst a time of significant uncertainty and challenges in the industry as discussed above, which bodes well for the business when questions from some or all of the factors discussed above subside in the drug and healthcare industry.
Figure 1. McKesson Cash Flow Trends
Despite generating healthy growth in operating cash flow, the business does not require significant capital to be reinvested. This, combined with the fact that drug distributors operating at near negative working capital levels explain the attractive return on tangible capital. For the last fiscal year, McKesson generated over $3.5B in free cash flow on less than $2B of tangible invested capital (net working capital + PP&E).
Also of note, it’s not as if the business generates exceptional returns on equity due to its use of excessive leverage, as McKesson sports an investment-grade balance sheet. The company has a little over $7B in long term debt with just under $4B maturing within 5 years, all extremely manageable levels given the levels of cash consistently generated.
Capital Allocation
Historically McKesson has followed a blended approach between investing in growth M&A and returning capital to shareholders. The slide below from the December analyst day illustrates the last couple of year’s capital allocation mix.
Figure 2: 2017-2019 Capital Allocation
Over the past decade McKesson has spent roughly 40% of operating cash it has generated on share repurchases and dividend payments. Based on history investors can expect around a 5-6% total shareholder yield between buybacks and dividends over time. Particularly given the recent valuation of the shares (discussed below), I would expect and be pleased to see a continued focus from management on emphasizing share repurchases. History would support this as a likely continued priority going forward.
Valuation
Below is a comparison of McKesson’s current (as of the end of 2019) valuation on a number of different measures compared to its average since 2009. Note these items are normalized for non-recurring items and significant noncash charges that in my view aren’t representative of an ongoing operating environment.
Table 1: Historical Valuation Measures
Because of swings in working capital due to the timing of inventory fluctuations in the distribution space, I find the most appropriate and easiest valuation measure for the business to be on a pre-tax earnings basis (adjusted for non-recurring and significant non-cash expenses).
Clearly McKesson has earned exceptional rates on historical capital invested in the business, but to get a sense of forward-returns, I’ll take a look at what returns on incremental invested capital (I-ROIC) have been over the past 10 years. McKesson has retained roughly $24B (cumulative operating cash flow + net debt issuance since ’09), and has generated $2.3B growth in operating cash flow (normalized margin) over the same period. This corresponds to roughly a 10% I-ROIC, not bad. They have retained about 60% of earnings in the business, which leads to an expected compounding rate in intrinsic value of ~6.0% (I-ROIC x reinvestment rate) over the long term.
Table 2: Return on Incremental Invested Capital
So in a base-case, I would expect my returns to roughly mirror the company’s historical compounding rate + benefit from dividends and buybacks. Any change in multiple (which I think is very likely) would be the cherry on top. See the table below for an outline of expected returns over the next five years.
A note on the valuation multiple: to me, a business that operates in a highly regulated oligopoly, which is likely to grow faster than GDP for years to come, and that earns well above-average returns on its invested capital is worth at least the market average. To be conservative I’ll use 13x pretax earnings as a benchmark. This aligns with the average over the last decade. If you exclude the last two years when the stock has traded at a discount to its historical valuation because of the reasons cited above, the average price to PTEearnings is closer to 15x.
Table 3: Forward Returns
This analysis assumes that the company is revalued from its recent ~8x price/PTE (roughly $137/share) to the historical ~13x price/PTE over the next 5 years and that future dividends + buybacks average the same percentage of market cap as the last 10 years (5.4%).
The business is currently guiding for adjusted operating profit to rise 3-5% this year, which is below the historical compounding rate, but given all of the near-term headwinds mentioned above this is not surprising. Given the continued expected growth in the pharmaceutical market and aging population, the cost savings initiatives underway at the business (mentioned below), and a normalization in reimbursement rates and generic vs. branded drug mix, I don’t have any reason to believe over the long-term the business can’t continue to compound at roughly its 6% historical rate. Of course I could be wrong, but even if the business compounds at half the historical rate (3%), maintains the shareholder yield (5%), and correspondingly is valued at 10x pretax earnings, net returns would be roughly 12% per year over 5 years, still satisfactory for me.
The most attractive part of the investment in my view is the margin of safety. In a scenario in which pretax earnings decline 2.5% per year, share count remains flat, and pretax multiple remains around 8x, the investment would essentially be dead-money to slightly negative. In other words the risk of permanent loss of capital seems remote. This appears to be a classic “heads I win, tails I don’t lose much” scenario.
Key Risks
As always the investment does not come without risks, which stem from the two major uncertainties in the drug industry discussed above.
- Opioid settlement far exceeds what the market has priced-in
This is certainly a possibility, and it appears a settlement between the three distributors, two manufacturers and the states of around $50B is what lawmakers are looking for. This likely entails a roughly 50-50 split of cash and future commitments to pay for health care, law enforcement and other costs related to the epidemic.
Assuming the liabilities are shared roughly equally between the five parties (this may not ultimately be the case) this would equate to about a $10B liability for McKesson. Given the companies cash on hand and excess debt capacity, combined with the likely extended payout of the settlement, the business could comfortably handle a liability of this size.
I think it is unlikely the settlement is materially higher given the advanced talks the company is currently in combined with the fact that McKesson is simply a distributor and not a manufacturer/marketer of opioids, who presumably would face an outsized brunt of an increased settlement. Nonetheless this risk is something with which an investor needs to be comfortable.
Also, in my opinion it’s likely that as soon as the settlement has been finalized, McKesson will be re-valued higher (even if the settlement is slightly worse than anticipated) simply due to the fact that the uncertainty, which Wall Street abhors, will be cleared up.
- Gross margin compression gets worse and the business doesn’t realize the modest growth it is guiding towards.
It’s feasible that reimbursement pressure (from political initiatives or other factors) or muted drug price inflation weighs further on gross margins in the coming years and suppresses the EPS growth that the management team is targeting. I think if this is the case it’s unlikely to be too deep or prolonged given:
Drug distributors already operate with low-single digit percentage margins, and there will come a point they cannot be squeezed further. They provide an essential service not easy to replicate in the drug industry, and even if margins are cut in half (a draconian scenario in my opinion) the current valuation provides enough margin of safety to limit any significant extended erosion in share price.
The business is actively pursuing productivity and cost improvements to offset the impact of margin compression in its wholesale distribution segment and has made early progress against its targets. The company is in process of simplifying their operating model and consolidating SG&A, and has already delivered $50M of savings for H1 2020.
As noted, the current valuation is essentially a no-growth valuation which further limits downside against this risk.
- Capital Allocation
Capital allocation is a risk given the high levels of free cash flow generated annually. If management makes poor acquisition decisions, fails to buyback the stock at attractive levels, or makes a change to the dividend policy, the returns could suffer.
Given this analysis looks back over the last decade and judging by managements commentary on capital allocation, I don’t have any reason to believe their attitude will differ dramatically than in the past, which is what my assumptions are predicated on.
Conclusion
Short-term uncertainty affords long-term investors the opportunity to buy a shareholder-friendly business that generates attractive returns on capital and operates in a growing industry protected by moats at a significant discount to intrinsic value. Given the stock has run up in value a bit in recent days, to me at a price of $137 (levels McKesson has recently traded for and which the analysis was based) or less I would be a willing buyer with an adequate margin of safety.
McKesson may not be as likely to provide the homerun returns that some of the more speculative investment options could deliver, but on a risk-adjusted basis nearly 11 years into the current economic expansion cycle, buying a good business with expectations of high-teens to low-twenty’s returns and a limited downside is highly attractive to me.
Sources:
- McKesson 2010, 2013, 2016, 2019 form 10K
- ValueLine.com
- McKesson December Analyst Day Call
- Calculating ROIIC - Sabercapitalmgt.com
- “Black Edge” – Sabercapitalmgt.com
- McKesson Q1 – Q4 2019 Earnings Calls
- AmerisourceBergen 2019 10K
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.