“McKesson (MCK) Soars to 52-Week High, Time to Cash Out?” cries out a recent posting by a respectable equity research firm.
My students do not believe so, given that they estimate MCK’s intrinsic value to be US$203.76, even accounting for reports last Tuesday of a settlement offer for the role the company played in the U.S. opioid crisis.
McKesson is one of the world’s largest distributors of branded and generic drugs, and medical materials with a market cap of US$27.6-billion, annual revenue of more than US$214-billion and coverage by 19 analysts. Its biggest business is pharmaceutical distribution to independent U.S. drugstores. Outside of United States, it has a retail pharmacy chain in Europe and in Canada.
In case you did not notice it, MCK released its first-quarter earnings on July 31, beating handsomely the consensus estimate by 8.9 per cent. Its bottom line improved by 14.1 per cent year-to-year. Revenue also beat estimates.
Consequently, the stock hit a 52-week high of $149.99. McKesson had gained 34.2 per cent to that point, well above the industry and peers.
After the announcement of the lawsuits, the stock fell to below $140. Its stock was trading close to the 52-week low of $108.34 only a few months ago.
At the time, I wrote an article based on my students’ report in which I argued the stock was a Buffett-like stock with large moat.
I had concluded by saying, “Normally, it is quite difficult to find cheap Buffett-like stocks, but McKesson is very close to be truly undervalued..
My students still hold this belief.
MCK’s share price increase has been driven by a combination of contract renewals, operational improvements, deliverance of strategic promises, and stabilization in the health care market, alleviating the market’s previous concerns regarding Amazon disruption. Amazon has also recently announced that it will no longer go after low margin business and this probably includes the industry in which MCK operates with a typical operating margin of 1.3-1.6 per cent.
The Amazon fear hanged over the company for the last couple of years.
On Oct. 27, 2017, a report from St. Louis Post-Dispatch showed that Amazon had acquired wholesale pharmacy licences in 12 U.S. states, including Michigan, Nevada, New Jersey and Tennessee, to name a few. As Amazon had been selling over-the-counter drugs for years, there was speculation that Amazon was moving into the prescription-drug delivery business.
Right after the news was released, share prices of three of the largest pharmaceutical distributors in the United States − McKesson, Cardinal Health Inc. and AmerisourceBergen Corp., who collectively control over 90 per cent of the market − dropped between 7 per cent and 12 per cent over a few days.
Moreover, on Jan. 30, 2018, Amazon, with Berkshire Hathaway Inc. and JPMorgan Chase & Co., announced the formation of an independent venture that aims to improve the cost and quality of health care for their U.S. employees. The venture was to focus on technology services to simplify the health-care system.
Following the news, the share prices of McKesson and pharmacy chain Walgreen Co. dropped by nearly 20 per cent, wiping out most of the gains they have accrued over the previous several months.
The fear at the time was that Amazon would disrupt the health-care industry. My students did not believe so, and that is why they recommended the company for the Ivey Value Fund.
They did not believe that Amazon could compete and win in an industry when the incumbents were no longer underestimating its capabilities and were watching and reacting to every move Amazon made. They believed the market was overreacting?
They did not believe Amazon was really a threat to McKesson’s distribution business, because distributing and selling drugs is not like selling or distributing anything else. Amazon has history of disrupting high-margin businesses; why would it consider disrupting a business with gross margins of 3 per cent to 5 per cent and less than 2-per-cent operating margins? The recent announcement by Amazon substantiates this belief.
McKesson is a long-term investment with strong fundamentals operating in a demand inelastic and non-cyclical market. According to my students, who follow the stock for the Ivey Value Fund, McKesson possesses and delivers the following.
First, customer service. McKesson has renewed its contracts with RiteAid (to 2030) and CVS (to June 2023). Considering that CVS accounted for 19.4 per cent and 31.9 per cent of total consolidated fiscal year 2019 revenue and accounts receivables, respectively, McKesson’s long-term relationship with its major clients contributes to its sustainability.
Second, efficient operations. Management has updated its cost savings plan to US$400-500 million by fiscal 2021. MCK’s operating margin has increased from 1.40 per cent to 1.53 per cent year-to-year and continues to improve.
Third, strategic investment. McKesson has been strategically diversifying into high-return growth areas in response to the industry headwinds in generic and traditional sourcing. Among others, MCK acquired Medical Specialties Distributors for US$800-million in fiscal 2018 and experienced 18.8-per-cent revenue growth in its Medical-Surgical Solutions division for the third quarter of FY19. McKesson’s M&A activities are expected to continue. Forth, Change Healthcare IPO. The IPO brought in US$888-million. Following the completion of the IPO, McKesson’s share of Change Healthcare declined to 58.5 per cent from the 70 per cent that it previously owned.
The stock currently trades at about 10 times estimated fiscal 2020 EPS and has a P/B of about 3.5 times. For quality Buffett-like stocks, MCK looks like a good deal. Nevertheless, when accounting for a 33-per-cent margin of safety the stock price is currently trading above the entry price of $135.70, making the stock not truly undervalued and hence a hold at this point rather than a buy.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, Western University.
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