CAH - McKesson: Right Medication

Summary

• McKesson has seen solid growth in recent years, with strong operating momentum seen in recent times, in part aided by the pandemic.
• This momentum and a good deal of opioid litigation uncertainties disappearing made that investors were upbeat on the future.
• Shares have consequently seen solid returns, notably in recent years.
• While current earnings multiples remain modest, I believe that momentum has been very strong, warranting some profit-taking.

It has been a long time since I last covered McKesson ( MCK ) , in fact, it was 2017 when I concluded to become a buyer as investors remained cautious. Early in 2017, the company has just posted quarterly earnings, it announced a bolt-on deal for CoverMyMeds as investors were fearing that distributors would be blamed for high drug costs, something which did not make a lot of sense to me. Unfortunately, I have been proven wrong on that in the years followed not with regard to drug costs, but misuse of them.

The Background

Early in 2017, McKesson's shares traded around the $140 mark at a time when the company guided for adjusted earnings around $12.50 per share for the year, albeit that GAAP earnings only were seen around the $10 per share mark. Even with little growth reported, these were non-demanding multiples, as a net debt load of $4.3 billion worked down to a 1.5 times leverage multiple, as an 11-14 times earnings multiple looked compelling given the long-term positioning of the business.

Note that shares had come down a bit after a strong rally which pushed shares to a high of $240 in 2014, after which shares lost $100 in the time frame of less than three years, on the back of slower growth and margins, as this was the basis of my appeal back in 2017.

After all, this was a $200 billion distribution business with gross margins of just 5-6%, albeit that McKesson has grown and focused on a higher margin technology solutions business as well. With regard to high prices of drugs, I found it hard to call McKesson as a major contributor in this, posting operating margins between 1 and 2% of sales, for very slim margins.

What Now?

The optimistic tone in 2017 was a bit too early in hindsight as shares actually fell to the low $100s in 2018 and 2019, albeit that shares rallied to the $150 mark again ahead of the pandemic. Since the pandemic, shares have seen huge momentum as they rallied to $200 in 2021, broke the $300 mark earlier this spring, only to hit a high at $375 in recent times, as they now still trade at elevated levels of $350 per share.

In May 2021, McKesson posted a modest 3% increase in full year sales to $238 billion with adjusted earnings up by similar percentages to $2.8 billion, equal to $17.21 per share. If we look at this performance versus early 2017, we have seen solid growth in earnings and a stronger balance sheet, as the company furthermore guided for 2022 earnings (adjusted) at just over $19 per share. In this guidance was the assumption of a $0.60 per share contribution from Covid-19 vaccine programs (at the midpoint).

During the remainder of 2021, the company has made a lot of divestments in the European business. What further happened were a lot of settlements related to the opioid crisis, as a massive settlement has been approved in February of this year. Together with AmerisourceBergen ( ABC ) and Cardinal Health ( CAH ) , the company has reached a $19.5 billion settlement, yet the bill is split with three parties (and perhaps more) over a time frame of 18 years as well! Near-term costs related to these settlements run at just tens of millions.

Soon after this deal, McKesson reported very strong 2022 results this spring with sales up 11% to $264 billion as adjusted earnings rose 38% to $23.69 per share, on the back of huge margin gains. Adjusted earnings of $3.7 billion still come in at just over one percent of sales, albeit that GAAP earnings came in much lower on the back of a range of charges related to transaction costs, inventory adjustments, legal settlements and litigation expenses, among others.

Part of the stronger earnings growth comes from higher margin activities as well which now includes a $3.9 billion Prescription Technology solutions business and $11.6 billion Medical-Surgical solutions segment as well, on top of the core and lower-margin US pharmaceutical segment, and its international counterpart.

Net debt came in at $2.3 billion, far below adjusted earnings, let alone operating earnings, resulting in very non-demanding leverage ratios. After a very strong year, in part driven by vaccine programs related to the pandemic, the company did forecast some stagnation in 2023. The midpoint of the adjusted earnings guidance came in at $23.25 per share, indicating a tiny decline in adjusted earnings per share, in part as the vaccine contribution was expected to fall a bit.

After a very strong operational 2022, and years of share price stagnation, the valuation re-rating is still moderate. After all, trading at $350 per share, the company trades around 15 times adjusted earnings, with many of the opioids concerns behind us, with massive settlement have agreed upon. That is only partially the case, however, as hundreds of millions will have to be paid out for years to come.

In August, the first quarter results revealed continued operating momentum with sales up another 7%, as further margin gains were reported, as the full year adjusted earnings guidance was hiked by more than a dollar to $24.30 per share, although the hike is entirely due to Covid-19-related programs and revenues as many cash flows were earmarked for aggressive buybacks to reduce the share count. The fact that the guidance was hiked by about a dollar reduced the forward multiple to 14-15 times as a strong balance sheet (with net debt flattish around $3.5 billion) furthermore left room for some bolt-on M&A as well.

With a current equity valuation of over $50 billion, McKesson announced a $600 million deal for Rx Savings Solutions, a prescription price transparency and benefit insight company, with earn-outs having the potential to increase the total deal value to $875 million. These services reach more than 17 million patients which can gather personalized recommendations to lower prescription costs. With no financial details on the deal announced and the transaction valued at just 1-2% of the own valuation, this is a true bolt-on deal.

Concluding Thoughts

Still sitting on my 2017 position, I see shares having more than doubled over a five-year time period which is solid albeit that the dividend yield is close to non-existing here. While the current valuation multiples are still the same as 2017, the heavy lifting is done by revenue growth, share buybacks and modest operating margin gains, amidst a sound execution. Nonetheless, it feels as if share price performance has been a bit too strong in recent times, as the share price performance has marked meaningful outperformance versus its peers as well. I am furthermore mindful of billions in future payouts to be made in reflection of the settlements which have been reached.

Hence, I am happy to take some profits here, although the fundamental valuation reveals that valuations are still in check and far from overvalued territory here.

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