Is McKesson Investable Again?

January 11, 2017

Originally published in partnership with INO.com

http://www.ino.com/blog/2017/01/is-mckesson-investable-again/#.WHWqIvkrLIU 

 

Introduction

 

Is McKesson investable again now that the fallout over its missed Q2 2017 numbers has been absorbed and the negative sentiment priced into the stock. Although this was the fourth consecutive quarter in which McKesson has missed revenue targets, McKesson has sold off by ~$100 per share or 42% from its all-time highs in May of 2015 falling from $240 to roughly $140 as of recent trading (Figure 1). In February I wrote a piece on McKesson stating that I felt McKesson presented a buying opportunity when the stock sank to a 52-week low of $148 per share. As that call began to come to fruition, I wrote a series of follow-up articles voicing caution as the share price appreciated. As shares appreciated ~30% by reaching the ~$200 level in the summer, I was hesitant due to pressures regarding the pharmaceutical supply chain and earnings from other pharmaceutical wholesalers such as Cardinal Health. At that time, I had relinquished my position in McKesson due to the run-up in share price and the growing concerns of the business model in combination with social and political pressures. As these pressures mounted the stock witnessed another double-digit fall from the ~$200 level to ~$125 during the back half of 2016. Now that the stock has stabilized at the $140 level, boasts a reasonable P/E ratio, more certainty surrounding the political backdrop and acquisitions coming full circle, McKesson may be an investable stock once again.

 

 

Figure 1 – Google finance graph depicting McKesson’s sustained sell-off throughout the back-half of 2015 and throughout 2016

 

McKesson’s First 52-Week Low

 

In February, McKesson was faced with an increasingly challenging healthcare landscape as political posturing, drug pricing scrutiny, overall sentiment towards pharmaceutical companies due to price gouging allegations and the overall rotation out of healthcare related stocks. I felt this confluence of events unfairly hit McKesson’s stock, falling from $240 to $148 or 39% in just 9 months through February 2016. McKesson appeared very attractive considering its EPS growth, dividend payout, acquisitive mindset and share buyback program however concerns remained. Despite these concerns EPS and revenue were still strong and I felt the sell-off was unjustified. Looking at the most recent quarterly numbers (at the time in February), sustained growth was intact. For the 2016 fiscal year, McKesson had revenues of that were up 7%. After that recommendation, the stock had appreciated from the ~$150 level to the ~$200 level or ~34%. After this run-up in the share price and the red flags that I outlined leading up to this appreciation (outlined below), I stated that I sold my position in McKesson.

 

Three Major Headwinds

 

My number one concern regarding McKesson was drug pricing concerns with the negative social and political backdrop. McKesson along with other pharmaceutical distribution companies such as Cardinal Health and AmerisourceBergen have been under tremendous pressure as of late due to political pressures regarding the pharmaceutical supply chain and drug pricing concerns. I felt the easy money had been made from the ~$150 level to the roughly ~$200 level. I also pointed out that greater than 98% of McKesson’s revenues come from pharmaceutical distribution and services domestically and abroad. Thus any impact to this business model will likely have direct negative implications with regard to revenues and EPS.

 

My second concern with regard to the middleman in the pharmaceutical drug supply chain. This is the bread and butter of many companies in this space, notably McKesson, Cardinal Health, and AmerisourceBergen. There’s evidence that suggests the middleman model is slowly shifting away from the traditional means of delivering drugs to hospitals and pharmacies in a more economically-friendly manner. More often than ever hospitals and pharmacies are establishing direct relationships with manufacturers thus buying direct. Manufacturers have increased their use of direct accounts when shortages arise thus disrupting the traditional distribution model long dominated by companies such as AmerisourceBergen, Cardinal Health, and McKesson. This action hits distributors particularly hard since they make their money by moving product within the supply chain where 98% of McKesson’s revenue comes from this distribution space.

 

My third concern was the prior quarterly results for Q1 2017 that missed revenue targets by $630 million while revenue was up only 4.6% year-over-year. The quarter prior, Q4 2016, revenue targets were missed as well by $170 million while revenue was up 3.9% year-over-year. Even more, Q3 2016 results missed revenue targets again by $890 million while revenue was up 3.0% year-over-year. This revenue figure cannot be inflated while EPS can artificially be engineered by removing shares via share repurchases. These missed revenue targets were a potential red-flag and enter the most recent Q2 2017 revenue miss of $1.25 billion and guide-down cratered the shares.

 

The Headwinds Culminate

 

The fallout from the most recent quarter saw the culmination of headwinds leading up to the $200 level. As a result of these headwinds, I relinquished my position near the $180 level as a result of losing confidence in the business model considering the current climate. There’s been a long and sustained backlash against drug prices, drug manufacturers, and wholesalers. McKesson, the largest wholesale drug distributors, lost a quarter of its market value after disclosing that competition and a slowdown in price inflation for brand-name drugs would reduce its profits for its current fiscal year. McKesson said it has been forced to lower the prices it charges to independently owned pharmacies to match the prices charged by competing wholesalers looking to gain market share. “We have made a very significant change in our pricing practice to match where the market is today,” McKesson CEO. McKesson contracts with manufacturers to distribute drugs to customers including retail pharmacies and hospitals. A slowdown in price increases is beginning to hurt its profit margins.

 

Is McKesson Investable Again?

 

McKesson has made a series of acquisitions and partnerships to position itself for future growth and success in the healthcare space however the middleman model appears to be encountering headwinds. Albeit concerns regarding the traditional distribution model are being challenged, McKesson has been highly acquisitive, growing dividends over time and buying back its shares to drive shareholder value. Despite its major acquisitions and partnerships (UDG Healthcare plc, Sainsbury's pharmacies, Vantage Oncology, Biologics, Rexall Health, Albertsons and Wal-Mart) in an effort to position itself for growth, these efforts have been overcome by drug pricing concerns, political backdrop, middleman pressures, pricing competition and declining revenues. The potential erosion of the middle model, political pressures and backlash against all things drug related remain headwinds for McKesson. After this huge sell-off, McKesson may present a new entry point however be aware that currently McKesson’s P/E ratio (P/E of 16) sits in the middle of its peer group (AmerisourceBergen, P/E of 12.5 and Cardinal Health, P/E of 17.5).

 

The political and social fallout with regard to drug pricing, price competition within the space and middleman model headwinds have taken hold. McKesson witnessed a subsequent and sustained sell-off as these events unfolded, heightened during the presidential election. The stock sold-off by over $100 per share from its 2015 highs to now settling in the $130-$140 range with an attractive P/E ratio from historical numbers. Along with the divided, share repurchases, acquisitions, inroads into Canada, adjustments to the pricing competition landscape and overall business alignment, I think McKesson deserves a fresh look for potential investing. If these collective measures reign in declining revenues and reaccelerate growth then this stock could be poised for a rebound.         

 

Disclosure: The author does not hold shares of McKesson and is currently on his watch list. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses.

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