Magic Formula Stock Review: McKesson (MCK)
McKesson (MCK) is one of the major pharmaceutical and medical supplies distributors in North America, and also one of the top providers of healthcare software services. The company has two divisions. The first is Distribution Services (97.1% of fiscal 2009 revenue, 73.5% of profits). This segment supplies both small independent and large national pharmacy chains with drugs, as well as health and beauty care products. The division also has a medical-surgical distribution arm, supplying doctor's offices and care facilities with general supplies like rubber gloves, surgical soap, and so forth.
The second division is Technology Solutions (2.9% of revenues but over 26% of profits). The software solutions developed and sold by this division are diverse and cover healthcare related tasks ranging from clinical data management to financial planning and supply chain management. Customers include hospitals, independent physicians and practices, home care providers, and pharmacies.
There are a lot of good qualities to this business, and MagicDiligence believes McKesson is a very good Magic Formula choice, possibly a consideration for a future Top Buy pick. Solid arguments can be made for all three of the primary factors I look for: growth potential, competitive position, and financial health. Let's take a look at each.
First, growth potential. The main driver here will be the Technology Solutions arm, which has generally been growing faster than Distribution and carries significantly higher gross margins (46.4% vs. 3.8%, respectively). The federal government has focused on reducing healthcare costs, and the expanded use of information technology to improve the efficiency of data management will benefit McKesson. Stimulus spending has also been earmarked for this purpose, and management has indicated a strong pipeline that should start converting to bookings next year.
In the Distribution segment, the broad trend towards generic prescription drugs and a massive branded drug patent cliff in the next 3-5 years favor the company. Generic distribution is higher margin than branded drugs, as scale is critical to generics makers and distributors like McKesson are key in driving volume. Demographics in North America are favorable too. As the "baby boom" generation reaches retirement age, increased pharmaceutical sales are inevitable.
Finally, the company's diverse product offering allows it to cross-sell. A hospital or office that utilizes McKesson for drug and supply sourcing can be marketed the firm's software products. Overall, McKesson should be able to increase profits at a low double-digit rate over the next few years.
The firm also has a very strong competitive position. McKesson is one of only 3 major pharmaceutical distributors, the other two being Cardinal Health (CAH) and AmerisourceBergen (ABC). Operating margins are very low in this business (barely over 1%), making economies of scale a major roadblock to new competitors. It is unlikely that the existing oligarchy will be broken any time soon. The Technology business benefits from high switching costs. Once a hospital or practice integrates McKesson's software, it is time consuming and costly to switch to a competitor, unless there are significant reasons to do so. Competitive position is strong and durable.
Financially, the firm is in good condition. Cash on the balance sheet is $3.2 billion, vs. about $2.3 billion in total debt, and only $217 million due in the next year. Drug distribution is a reliable business, largely recession-proof, and with over a billion in annual free cash flow, financial health is fine. Operating margins have been creeping upwards, from 1.2% in 2005 to about 1.7% currently, due to the increasing contribution from software products and services. This trend should continue.
There are some real risks to consider. McKesson's largest customer is Caremark, providing about 14% of sales. Caremark was acquired by retail pharmacy CVS (CVS) in 2007, and CVS utilizes competitor Cardinal Health for distribution. CVS could decide to consolidate Caremark onto Cardinal at any time, which would be a significant event for McKesson. Also, another 12% of sales comes from Rite Aid (RAD), a company in horrible financial shape with real bankruptcy risk. It is not inconceivable that McKesson loses up to 26% of sales if these two worst case scenarios took place over the one-year Magic Formula holding period.
More generally, large drugstore chains and pharmacy benefit managers (PBMs - mail order suppliers like ExpressScripts ESRX) have been gaining share from small independent pharmacies for more than a decade. PBMs handle the "last leg" of distribution on their own, and bulk supply to these companies is very low margin, about 0.5%. Large drugstores have the ability to deal directly with drug suppliers and distribute to their own retail locations (although most do not - yet). Long-term, the importance of McKesson and its direct competitors will likely be marginalized.
Still, with an 11.4% earnings yield (11.8% against expected 2011 results), this an attractive stock over the next 12 months. Barring one of the major risks outlined above, and assuming growth of about 8% annually, the stock could be worth close to $100. It is a good choice for a Magic Formula position today.