MCK - McKesson: GLP-1 Medications Tailwinds And Massive Share Repurchase

2023-11-07 21:11:03 ET

Summary

• McKesson is a leading pharmaceutical distribution company with consistent revenue and operating profit growth.
• The company's U.S. Pharmaceutical segment contributes to the majority of its revenue and operating profits.
• McKesson's stock price is significantly undervalued, with a fair value estimated at $680 per share.

McKesson ( MCK ) is a leading pharmaceutical distribution company, generating more than 90% of its revenue in the US market. The company has consistently achieved an average growth rate of around 6% in both revenue and operating profits over the past few years. Their substantial share buyback program has facilitated McKesson in achieving double-digit EPS growth. Based on my estimates, I consider the stock price to be significantly undervalued. Therefore, I recommend a 'Strong Buy' rating with a fair value of $630 per share.

Business Overview

McKesson operates its business through four segments: U.S. Pharmaceutical, Prescription Technology Solutions, Medical-Surgical Solutions, and International. The largest segment, U.S. Pharmaceutical, contributes to 87% of the group's revenue and 64% of its operating profits. McKesson distributes a wide range of pharmaceutical products, including branded, generic, specialty, biosimilar, and over-the-counter drugs, as well as medical-surgical products. These products are supplied to group purchasing organizations ((GPOs)) and various pharmaceutical retailers. GPOs account for approximately 68% of the total consolidated sales, with their biggest customer, CVS Health Corporation (CVS), representing 27% of the total revenue.

As shown in the table below, both revenue and operating profit have been growing steadily at an average annual rate of 6%. This stability characterizes the nature of the business.

In addition, they maintain a very robust balance sheet with a gross debt leverage of 1.1x. Consistently, they have been deploying the cash generated from operations for share repurchases and dividends. Consequently, the number of outstanding shares has decreased year over year, reducing the basic shares from 209 million in FY17 to 142 million in FY22. The substantial share buyback has contributed significantly to their earnings per share growth, complementing the organic revenue and profit growth of 6%. With this combination of business expansion and share repurchases, McKesson has achieved double-digit EPS growth in recent years.

Sustainable Core Growth

The U.S. Pharmaceutical business serves customers through a network of 29 distribution centers, including two strategic redistribution centers. These facilities enable McKesson to distribute essential pharmaceutical products to a wide range of retailers, community pharmacies, institutional healthcare providers, as well as oncology, biopharma, and other Specialty Partners. These products are fundamental necessities for retailers and healthcare providers, making McKesson's U.S. Pharmaceutical business stable in nature. This segment accounts for 87% of the group's revenue and 64% of its operating profits. I am confident that this business will continue to grow in the coming years.

Additionally, as disclosed in their annual report , RxTS has connections with most electronic health record systems, over 50,000 pharmacies, approximately 900,000 providers, most pharmacy benefit managers, and health plans. RxTS also supports over 650 biopharma brands, covering a wide range of therapeutic areas. Their prescription technology solutions are used on a day-to-day basis, providing mission-critical data for healthcare providers. In short, it is a highly resilient business.

McKesson also distributes medical-surgical products, offering more than 285,000 products from national brand manufacturers as well as McKesson's own brand. Similar to pharmaceutical drugs, these medical-surgical products, such as gloves, needles, syringes, and wound care items, are essential staples in the healthcare industry, used daily by healthcare service providers.

Business Exit in Europe

In July 2021, McKesson announced its intention to exit the European market and subsequently began the process of divesting its European business. In FY19 , European Pharmaceutical Solutions accounted for approximately 12% of the group's revenue but incurred losses of $261 million. Exiting the European market seems logical as McKesson was a relatively minor player in Europe, conducting most of its business through joint ventures. For instance, in 2019, McKesson and Walgreens established a joint venture that combined both companies' pharmaceutical wholesale businesses in Germany. However, foreign joint ventures like these found it challenging to compete with local distributors. Hence, the decision to exit Europe aligns with the company's strategic direction.

Recent Quarter Review and Outlook

As McKesson's fiscal year ends at the close of March, their official recent quarter corresponds to Q2 FY24 . However, for consistency with other listed companies, I have referred to their recent quarter as Q2 FY23 , and all the quarters mentioned in this article have been adjusted accordingly. In Q2 FY23 , McKesson achieved a 10% revenue growth and a 1% increase in operating profit on a constant currency basis. Excluding certain items, adjusted earnings per diluted share increased by 14% compared to the previous year.

Due to the strong performance in the quarter, McKesson has slightly increased their full-year adjusted EPS guidance to a range of $26.8 to $27.40 from the previous range of $26.55 to $27.35. At the end of the quarter, they held $2.5 billion in cash and cash equivalents and generated $825 million in free cash flow. During the first two quarters, they repurchased $1.5 billion of their own shares and paid out $149 million in dividends. Overall, their capital allocation policy remains consistent, focused on delivering shareholder returns, and their remarkable cash generation capability continues to impress.

For the full year, McKesson's management anticipates a 13% to 15% increase in pharmaceutical revenues and a 6% to 8% rise in operating profits year over year. They attribute this growth to their generic sourcing programs and the specialty distribution of differentiated plasma and biologics business. Additionally, the full-year outlook assumes that volumes related to GLP-1 medications will remain elevated, albeit with a lower distribution margin. While the rapid growth of GLP-1 medications is positive for the dollar amount of revenue and profits, it poses challenges to their profit margins.

GLP-1 Medications Opportunities

According to Graphical Research , the GLP-1 Receptor Agonist Market size is estimated to reach USD 55.8 billion by 2032, with an impressive compound annual growth rate of 9.6%. Several companies, including Novo Nordisk (NVO), Eli Lilly (LLY), and Pfizer (PFE), are investing in GLP-1 medications.

On November 2nd, 2023, Novo Nordisk announced their earnings , reporting a remarkable 49% year-over-year growth in GLP-1 diabetes sales in constant currency. Regionally, North America experienced a 43% growth, while international operations grew by 60%.

I believe the substantial population dealing with obesity and diabetes will continue to drive strong demand for GLP-1 medications. In the North American market, the robust growth in GLP-1 medications could serve as a significant tailwind for McKesson in the coming years.

Additionally, McKesson's management highlighted the significant growth of their access solutions, driven by the authorization for GLP-1, during the earnings call . They explained that for selected prescription drugs, patients need approval from their health plans, a process that can be manual and cumbersome. McKesson offers an automated technology solution integrated within the provider's workflow. This streamlined approval process enables their customers to utilize their access solution platform, benefiting McKesson’s revenue and profitability.

Key Risks

Rite Aid's recent bankruptcy : In October 2023, Rite Aid (RAD) filed for bankruptcy, as reported by the media , due to increasing pressure from their high levels of debt. During the Q2 earnings call , McKesson’s management mentioned that they have had a working relationship with Rite Aid for over 20 years. They stated that Rite Aid's bankruptcy filing will not materially impact McKesson’s FY24 earnings. Rite Aid is just one of McKesson’s smaller clients, and even if Rite Aid closes its stores, the demand could easily shift to other pharmacies. From McKesson’s perspective, the revenue is essentially moving from one client to another. In my opinion, while there might be some minor disruptions, it won’t pose a significant long-term risk for McKesson.

Weak International Growth : McKesson’s International business accounts for more than 7% of the group's revenue but only contributes 2.7% to its operating profits. Importantly, this segment has incurred losses in the years leading up to FY22. As mentioned earlier, McKesson has been divesting its European business in recent years. Given this trend, I do not anticipate significant growth for their International business, and it may be considered non-core for the company. In Q2 FY23, the International business experienced a 44% decrease in revenue and a 35% decline in operating profits. This decline was primarily due to the divestiture of their European business.

Opioids Distribution : McKesson is currently facing numerous litigation matters related to opioid drugs. In February 2022, four U.S. companies, including three major drug wholesalers: AmerisourceBergen, Cardinal Health (CAH), and McKesson, agreed to pay approximately $26 billion to settle multiple lawsuits stemming from the deadly opioids crisis. According to media reports , McKesson's share of the settlement amounted to $21 billion.

Given the breadth of pharmaceutical drugs they distribute, it is challenging for McKesson to avoid such allegations and lawsuits related to opioids. Consequently, they have had to increase their internal control expenses to better monitor and control drug distribution, especially in light of the ongoing opioid issue.

Valuation

My assumptions for FY23 are based on the mid-point of the company’s guidance, with an expected 11% growth in revenue and a -1.9% decline in operating profit. The number of shares is estimated to reduce to 134 million in FY23, in line with their guidance.

For normalized growth, I am assuming a 6% increase in revenue with a very small margin expansion. These assumptions are derived from their historical performance on an average basis. Taking into account the significant shares buyback, the forecast indicates an expected EPS growth of over 11% in the DCF model.

The model employs a 10% discount rate, 4% terminal growth rate, and an 18.5% tax rate. After discounting all the free cash flows, the fair value of their stock price is estimated to be $680 per share. Based on this analysis, the current market price appears to be significantly undervalued.

Verdicts

McKesson's extensive pharmaceutical distribution network ensures steady growth in the U.S. market, and the increasing demand for GLP-1 medications presents a significant growth opportunity in the near term. Considering their undervalued stock price, I recommend a 'Strong Buy' rating with a fair value of $680 per share.

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