McKesson Corp. is bullish on Canada. With its purchase of roughly 450 Rexall pharmacies, a deal that closed in December, the San Francisco-based company now owns about a quarter of this country's drugstores. Its wholesale drug business here traces its roots back to 1905 and the National Drug and Chemical Co. of Canada, later renamed Medis and bought by McKesson in 1991. In 2015, subsidiary McKesson Canada posted nearly $11-billion (U.S.) in sales here, making it, by The Globe and Mail's estimation, Canada's sixth-biggest private company.
In and of themselves, however, these facts are insufficient to justify investing in McKesson shares. The real buy case is that the stock, battered by poor results and broad concerns about the near term, is a compelling value for investors with an eye to the long term.
Certainly, patience is needed for the drug-distribution industry, where McKesson and two others – Cardinal Health and AmerisourceBergen – form an oligopoly with an estimated 90 per cent of the market. Analyst Eric Coldwell of Robert W. Baird, in removing his "buy" rating from McKesson in October, called the previous 18 months for the group "brutal," with poor launches of generic drugs, foreign-currency problems and customer losses. He said he "thought the healing process might be near," but McKesson and its competitors said they were beginning to compete more aggressively among themselves on price. "Despite all the external, uncontrollable challenges, the one thing we thought we could count on was rational behaviour," Mr. Coldwell wrote. He now has a neutral rating on the shares with a price target of $145. McKesson stock closed Monday at $139.82.
McKesson's full-year 2016 results, released late last month, assuaged no one. The shares lost 8 per cent of their value and have yet to recover. The drug distributors, despite their massive scale and lack of competition, have razor-thin operating profit margins of 1 per cent to 2 per cent. And fears of short-term problems with pricing or sales translate into terror over potential sharp declines in profit.
"Our cautious overall view on the pharma distributors is based primarily on a less favourable backdrop in the near term, based on uncertainty around drug-price inflation, generic deflation and the competitive environment," wrote Lisa Gill of JPMorgan, as she too pulled her "overweight" rating in favour of a "neutral" last month.
As well, McKesson has its particular challenges, analysts note; if Walgreen Boots Alliance Inc. succeeds in buying Rite Aid Corp., McKesson will lose a major customer in Rite Aid. McKesson's deal to combine most of its Technology Solutions business with Nashville-based Change Healthcare to create a tech firm with annual revenue of $3.4-billion may hurt earnings in the near term, a number of analysts believe. And Mr. Coldwell of Baird says McKesson "has seemingly been more exposed to moderating drug-pricing trends."
Ms. Gill, however, says she can "still point to an attractive model over the longer term," and Mr. Coldwell of Baird says he believes McKesson is "a core long-term holding" with potential for long-term earnings-per-share growth of around 10 per cent annually, an excellent balance sheet, and cash flow that can easily support reinvestment in its business, mergers and acquisitions, and healthy share repurchase activity.
This points to a classic problem with sell-side analysts: Their target prices are, typically, for the next 12 months, not more; and when they rightly cannot see "catalysts" to an imminent boost in the share price, they get cautious and pull their "buy" recommendations. Indeed, of 18 analysts covering the stock, according to Bloomberg, just five have buys, while 12 have holds, and one slaps the sell label on it.
One of the buys, perhaps unsurprisingly, comes from Morningstar, which eschews 12-month targets and instead calculates the present value of what it believes a firm's future cash flows will be. Stocks trading at the greatest risk-adjusted discount to the Morningstar fair-value estimate get the highest star ratings – and McKesson, after its recent decline, is one of just 14 stocks with the top five-star rating, out of a universe of 977.
Morningstar analyst Vishnu Lekraj says the long-term fundamentals of the industry remain solid, and the fact that management maintained its earnings guidance points to "a steadying of its operating environment." He has a $200 fair-value estimate on the shares. "We believe McKesson's stock is deeply undervalued, and combining this dynamic with strong long-term trends makes it one of our best ideas."
Mr. Lekraj writes that McKesson's scale gives it key competitive advantages, and many companies in the pharmaceutical supply chain depend on it for product distribution and procurement. "These fundamentals have not changed and should lead to outsized economic profits over the next several decades."
Note the time frame – "several decades," not several months. There's little assurance that the stock will be a winner in 2017. Your portfolio, however, should be built to last longer; as is McKesson.