McKesson: A Case Study on the Oldest and Largest Healthcare Company in the Nation

McKesson isn’t always a household name even though the company ranks 5th in the Fortune 500 for 2017, with revenue’s topping $192 billion.  I was recently looking at the healthcare industry for value and wanted to better understand this company and it’s history.

The companies share price peaked in 2015 at $240 per share.  Now after falling to $140 last year and now it is hovering in the $160’s.

McKesson Company: A Brief History

John McKesson and Charles Olcott founded the company in 1833 in New York City with the intention of importing and selling drugs and chemicals.  Eventually the company began distributing drugs and manufacturing them by the late 1850’s.  The primary distribution method: covered wagon.  Yes, the company has deep roots in the American settlement.

As the company grew throughout the years, they added additional products to their distribution, like alcohol and chemicals.

In the 1990’s they sold off the alcohol and chemicals businesses  to focus specifically on healthcare.   In the late 90’s McKesson made it’s largest acquisition ever, HBO and Company, a healthcare IT company.  This acquisition proved to be an immediate bust due to revenue recognition issues.  But over time, the investment in this company paid off.

Today’s Company Structure

Today there are two major business units:

  • McKesson Distribution Solutions – It includes sub-business units; US Pharma, Medical-Surgical, Specialty Health, Pharmacy Systems, McKesson Canada and it acquired Celesio (European distribution business) a few years ago.
  • McKesson Technology Solutions-  This business includes Imaging and Workflow Systems, Enterprise Information Systems, Business Performance Systems, Relay Health Pharmacy and McKesson Health Systems.  EIS and Relay Health Pharmacy will stay with McKesson, but the other BU’s are being merged with Change Healthcare to form a new company that will IPO in the future.

Revenues by Business Unit:

Earnings by Business Unit:

Today McKesson has a Durable Competitive Advantage

McKesson operates in an oligopoly.  Along with the two competitors, Amerisource Bergen and Cardinal Health, combined they own 90% of the distribution market share of pharmaceuticals in the United States.

It will be extremely difficult for new entrants to replicate the size and scale of the distribution network that these three companies have.  McKesson has an efficient distribution network and logistical expertise that has been built up over the years.   This size and scale enables them to negotiate favorable pricing discounts from drug manufacturer’s.

However, the real key to McKesson’s ability to generate outsized returns has been in managements shareholder friendly capital allocation ability.  They split the ever increasing free cash flow between targeted acquisitions, share repurchases when the valuation is low and a small dividend.  If management continues with outstanding capital allocation, the company should continue to generate outsized returns assuming regular earnings growth in core operations.

Risk

Amazon has stated goals of entering this market.  It is advisable for investors to watch how Amazon’s strategy transpires.  If we take clues from their investment in Whole Foods Market, it might be easier to just acquire one of these companies for the distribution.  But this of course, is pure speculation on my part.

Recent Challenges

The company has undergone a rough couple years.  There are a number of factors contributing to it, but McKesson explained that the pressures the company faces are:

  • Less Profitable Generic Launches  then Previous Years
  • Moderation of Pharmacuetical Manufacturer Pricing Trends
  • Customer Pricing
  • Customer Consolidation

We know that McKesson’s profit margins are thin.  Margins usually hover somewhere around 1%. When all four of these challenges are occurring at the same time, it really effects their ability to grow earnings.  However, even with the stock price pull back, earnings and adjusted earnings continue to rise.

Excellent History of Capital Allocation

This company has had an excellent track record of capital allocation.  McKesson’s strategy focuses on acquisitions and stock repurchases.  If you are interested in a dividend yield, I would look elsewhere.

Acquisitions:

The company has a history of making many acquisitions, with the largest recent on back in 2013 of Celesio.  Please see the screenshot from crunchbase.  They did make on larger one in 1998 of HBO & Co, which became the Technology Solutions business unit.

Share Repurchases

The company routinely repurchases shares on the open market with surplus capital.  They have an outstanding track record of reducing share count over the years.  They took a break from repurchases in 2015 to pay back debt it issued for the Celesio acquisition.  This was a great use of capital as the companies valuation in 2015 was stretched.  In 2017, the company started aggressively buying back shares again retiring almost 4% of the companies outstanding shares.

Again, this will be likely great use of capital because of the current lower valuation.

2013 2014 2015 2016 2017
239 233 235 233 223

Dividends

McKesson does pay a dividend, but I would look at other companies in the industry if a dividend yield is important to you.  Today the companies yield is .68%.  Based on history, the company raises its dividend by about .04 to .06 a share every two years.  Currently they are paying out $1.12 out of 12.54 in adjusted earnings for 2017 fiscal year.  This is a very sustainable dividend growth rate given the companies, low payout ratio of 8.9% , low debt position and earnings growth potential.

On July 26th, the company announced that its quarterly dividend will be increased 21% to $.34 a share.  On an annualized basis you will get $1.36 per share returned to you in cash.

Backtesting

I starting investing in 2001 when I was a senior in college with spare money from working while I went to school.   Had you bought $10,000 at this time  and held until now, how would you have done?

Well if you bought the $10,000 on your first opportunity after ringing in the new year for 2001, you would have picked up about 285 shares of the company at $35.14 a share for $10,014.9 plus and costs of commission.

What happens if you held on until today?  Two scenarios unfold:

Pocket the Dividends

If you  decided to not reinvest the dividends you would still have 285 shares of the company.  McKesson has not split the shares since 1998.  On those 285 shares, you would have collected $9.44 in the form of cash dividends.  This equates $2,690.4 sent to your checking account.  This investment income could have been spent or reinvested into other businesses.  Either way, it represents a cash payback of 26.90% on your investment.

Those same 285 shares have a market rate of $165.83, on 7/21/2017.  This would mean you could sell your shares on the open market for $47,261.55, for a total capital gain of 372%.  For the same time period, the S&P500 returned 82.75%

If we add the $2,690.4 to the 47,261.55 we would have a total value to you, the investor of $49,951.95.  This equates to a total return of 399%

Reinvest the Dividends

If instead of pocketing the dividends, you instead decided to check the box to immediately reinvest the dividends back into buying more McKesson stock, your share count would have grown to 320 shares over the years.  At $165.83, your total $10,014.9 investment back in 2001 would be worth $53,100.80.  This equals a total return of 430%.

Conclusion

McKesson has preformed wonderfully over the years.  Even with the stock plummeting 32% from its high of 243.63 to 165.83 today, the investor has done extremely well for himself.  We know that past performance has no indication of future returns, however given the track record we may increase our position in this company.  How confident are you that management can continue to allocate capital favorable to generate outsized returns over the next five to ten years?

 

 

 

 

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