McKesson (MCK) has shown signs of life as of late with a recent rally from $135 to $162 or a 20% move to the upside. The stock has demonstrated resilience over the past 12 months as this identical move occurred earlier in the year as well. There’s been a tremendous amount of pressure on the pharmaceutical supply chain players due to public and governmental outcries over drug pricing with subsequent fierce pricing competition within the space, opioid epidemic, Amazon potentially entering the fray and possible erosion of the pharmaceutical wholesaler model. Social and political pressures over drug pricing and opioids have exacerbated these issues translating into slowing drug price increases and increased scrutiny on sales which negatively impacts McKesson’s ability to capture larger margins and volume of business. McKesson had missed several revenue targets for six consecutive quarters until its most recent quarterly earnings beat for Q2 FY2018. McKesson has paid dearly for this string of revenue misses, shedding over 44% of its market cap falling $106 per share from its all-time highs in May of 2015 falling from $240 to roughly $134 as of its recent Q3 2017 miss (Figure 1). McKesson has made a string of acquisitions throughout this time frame to circumvent the exogenous events related to its deteriorating business. As McKesson tries to navigate these challenging waters, I feel long term the stock has more upside starting with its most recent earnings beat catalyst.
Figure 1 – Google Finance 3-year chart for McKesson
Opioids and Pharmaceutical Drug Wholesalers
60 Minutes recently aired a piece on the opioid epidemic unfolding in the U.S., which was highly critical of the pharmaceutical drug wholesalers and their alleged role in this crisis. An interview was conducted with DEA whistleblower Joe Rannazzisi who stated that distributors have turned a blind eye to opioids being diverted for illicit usage. The three main pharmaceutical drug wholesalers that were singled out were AmerisourceBergen (ABC), McKesson (MCK) and Cardinal Health (CAH) which all sold off significantly once the report surfaced. Opioid-related stocks were also negatively impacted as a result which consisted of a basket of micro-cap and small-cap stocks.
As a result of these opioid allegations, the state of California is considering revoking Cardinal Health’s license. California alleges that Cardinal Health failed to disclose unusual sales of an opioid painkiller and three other tightly regulated medications from its Valencia, CA facility to Pacific Plaza Pharmacy. The report alleges that Cardinal Health sold increasingly large quantities of controlled substances which state officials called “red flags”. It’s noteworthy to point out that Cardinal Health has eight additional locations throughout the state for business continuity if the state revokes its Valencia operations. Overall, the drug wholesalers have witnessed massive sell-offs since 2016 so much of the negative sentiment has been factored into the share prices of McKesson, Cardinal Health and Amerisource Bergen.
The Washington Post reported that the DEA was ready to move on McKesson since they could prove that the drug wholesaler failed to report suspicious orders of opioids despite repeated warnings. The DEA wanted to revoke controlled substance distribution licenses at some of McKesson's 30 warehouses and fine the company than $1B. However, lawyers at the DEA and Department of Justice reached a deal with McKesson that resulted in retaining all of its DEA registrations, temporarily suspend controlled substance shipments at four distribution centers and pay a $150M fine, its second related to opioid shipments.
Pharmaceutical Supply Chain Shift:
The middleman portion of the pharmaceutical drug supply chain 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 such as the recent CVS deal to supply the generic EpiPens. Manufacturers have increased their use of direct accounts thus disrupting the traditional distribution model long dominated by companies such as McKesson. This action hits distributors particularly hard since they make their money by moving product within the supply chain where greater than 95% of McKesson’s revenue comes from this distribution space. After last quarter McKesson stated that competition and a slowdown in price inflation for brand-name drugs would reduce its profits. 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.
McKesson’s Acquisitions – Potential Catalysts For Growth
Despite these issues, McKesson has made a series of acquisitions and partnerships over the last two years to position itself for future growth. Albeit concerns regarding the traditional distribution model are being challenged and pricing competition has taken hold in the space, 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, Wal-Mart and CoverMyMeds) 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. McKesson recently announced intended acquisition of Canadian pharmacy group Uniprix. Uniprix operates 330 independent pharmacies and in 2009 it rejected McKesson’s takeover offer. Recently, McKesson acquired RxCrossroads from CVS Health for $735 million to expand services and solutions for our manufacturer partners. RxCrossroads provides commercial support, customized pharmacy dispensing and logistics services to pharmaceutical and biotechnology manufacturers. McKesson expects the impact of this transaction to be approximately 20 cents accretive to adjusted earnings per diluted share by the third year following the close of the transaction.
McKesson has witnessed a multi-year sell-off after missing revenue targets for six consecutive quarters up until its most recent quarterly beat. In addition to the missed revenue targets, McKesson along with others in the space have been faced with an increasingly challenging healthcare landscape as political posturing, drug pricing scrutiny, overall negative sentiment towards pharmaceutical companies due to price gouging allegations, opioids and the overall rotation out of healthcare related stocks. Despite these issues, McKesson has made a series of acquisitions and partnerships to position itself for future growth. Its major acquisitions and partnerships (UDG Healthcare plc, Sainsbury's pharmacies, Vantage Oncology, Biologics, Rexall Health, Albertsons, Wal-Mart, CoverMyMeds and RxCrossroads) were made in an effort to position itself for growth and diversification. As these collective measures stabilize revenues and potentially reaccelerate growth then this stock could be poised for a rebound over the intermediate term. This upcoming earnings announcement will be a barometer for this sustained turn in the business. If McKesson can beat for a second consecutive quarter then a sustained stock appreciation could be underway.
Disclosure: The author does not currently hold shares of McKesson however opportunistically trades the stock. 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. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.