Ascendere Associates LLC Steve Castellano McKesson Corporation (NYSE: MCK) Sector: Healthcare Industry: Healthcare Distributors
January 27, 2010 [email protected]
McKesson Corporation has a very strong fundamental profile, is securely situated in an industry that should show considerable longterm growth, and seems undervalued relative to its historical ROIC, growth prospects and to other Healthcare stocks. As such, it is probably one of the best Healthcare Sector stocks to own at the current moment. Conservative assumptions get us to about a 15.5-16x target multiple on NTM EPS of $4.67, or $75 -- which compares to a sell-side range of $60-80 and average of $70. And it would not be a stretch to justify a target multiple of 19x using academically derived WACC calculations. On a worst case basis -- one in which EPS could decline 25% next year to $3.66 and gradually resume for flat 5yr growth on average, we still drive a fundamental fair value of $52, which is not far from the current stock price. In short, it seems that the fundamentally calculated risk/reward for MCK is at an extremely compelling level.
LTM MCK Stock Price $59.52 EPS: $ 3.10
5yr Avg Insider Ownership0.2% # of Analysts
Market Cap / Shares ($B) $16.0 / 269
EBITDA/ 12.5 Capital EBIT Margin Income Margin
EBITDA/ 26.2% Capital 19.9% EBIT Margin Income Margin
Description: McKesson Corporation is a health care drug and supply distribution company supply, and is a provider of various healthcare technology solutions. Roughly 97% of revenue and 82% of operating profit is generated from its distribution segment and the balance from its healthcare IT business.
McKesson Appears Compelling on a Standalone and Relative Value Basis McKesson has a very strong fundamental profile in terms of ROIC momentum, various operating efficiency metrics and balance sheet strength. In addition, McKesson and other drug distributors and pharmacy benefit managers will probably increasingly play a major and positive role in managing health care costs. Furthermore, the long-term demand for drugs, especially generic drugs, and other products will increase as the baby boomers age. If we experience a resurgent economy, its health care technology business will likely contribute to higher earnings growth and multiple expansion. Even after its impressive 75% run to a recent close of about $59, this stock still has room to appreciate. A market-driven correction could occur, but for portfolio managers that have an opening in a portfolio, this is probably one of the best Healthcare Sector stocks to own at the current moment. Our confidence in this stock idea is supported by relative valuation on a ROIC-adjusted basis and recently reported results that show the story is on track, as well as its strong balance sheet and solid cash flow McKesson is currently trading at 11.7x NTM consensus EPS estimate of $4.67 versus a 5yr average of 16x and a high of 22.1x reached in 2006. Based on an academically derived WACC of 7.5% and conservative assumptions on cash flow growth, the stock deserves to trade at a multiple of more than 19x. Even assigning a more conservative WACC of 8.5% on 10-year compounded sales growth of 2% and EPS growth of 5%, together with a the stock deserves to trade at a 15.5-16x multiple -- or about $75 in one year. As of the time of this report -- one day after the company's report of fiscal 3Q results, the stock is down 4.5%. This is probably because EPS for the fiscal year ending in March will contain about $0.55 in positive non-recurring gains and guidance is up only $0.05-$0.10 for the year. Perhaps implicit in the recent negative stock price action is that this represents poor earnings quality and a possible stagnation in positive analyst revisions as we head into the next fiscal year. However, the key metrics for earnings quality -- improving levels of ROIC, working capital management and cash flow growth -- overwhelmingly point to the overall Steve Castellano [email protected] Ascendere Associates LLC Page 1
quality of the company. We would also point out that McKesson has historically reported EPS and provided guidance that includes nonrecurring items -- which provides some justification on valuation on a historical multiple basis. A key quality that is probably not wholly embedded in the current valuation is McKesson's strong management and penchant for deploying cash in a way that enhances value, whether through dividends, share repurchase or acquisitions. The company has $3.4b cash and equivalents and about $2.5b in total debt. From McKesson's track record, it's a believable statement when CEO John Hammergren states in the latest conference call transcribed by Seeking Alpha: "...Weve built a track record and if we choose to deploy any of our capital in acquisitions I would hope to do so intelligently and in a way that creates more value than a share repurchase would create for us. So I think youd find that we would look to the businesses that were in today and we bring some knowledge. We bring some synergy. Its unlikely that we will buy companies that our shareholders could buy and we cant add any value beyond what you could add to them to hold them independently." Typically, acquisitions obfuscate ROIC trends by setting a lower base upon which new cash flow growth can be measured against. However, despite recent acquisitions (such as the McQueary Bros. Drug Company for $190m in April 2008 and Oncology Therapeutics Network Corporation for $575m in October 2007 and Per-Se Technologies in November 2006 for $1.6b) McKesson has a good track record of continuing to grow cash flow and ROIC over these periods. This is in part helped by the occasional sale of noncore operations and, from an accounting ROIC point of view, making large repurchases of its stock. MCK seems to manage its cash flows and balance sheet to drive growth in an economically value-added and accounting value-added manner. Valuation Summary We have chosen 3 different scenarios in which to value McKesson. Numerous underlying factors can be summarized in the longterm earnings growth rates on a 8.5% WACC and 2% terminal growth rate -- 9.3%, 4.8% and essentially 0%. These various scenarios justify multiples of 19.9x, 16.2x and 12.7x on consensus EPS for the fiscal year ended March. Assigning a 20% probability to flat-long-term growth ($52 near-term target), 70% to 4.8% long-term growth ($75 12-month target) and 10% to 9.3% growth ($92 12-month target) gets us a price target of $72 -- which is close enough to the $75 price target scenario that we truly believe in. Applying a 7.5% WACC (CAPM derived) and 3% terminal growth rate (Fed's estimate for long-term inflation) -- both of which are very much justifiable -- could drive these price targets $10-20 higher. Furthermore, whether on multiples alone or multiples adjusted for ROIC and earnings growth, MCK shows significant relative value. For example, MCK is trading at 6.3x on Enterprise Value to 2010E EBITDA versus 8.5x for a peer average and 12.7x calendar 2010E EPS versus 15.1x for the group. Even just compared to just the other two major drug distributors, Cardinal Health (15.2x 2010E PE) and Amerisource Bergen (13.7x), MCK is a bargain. This relative valuation comparison is further bolstered when comparing ROIC on a loosely defined basis -- for example, the pharmacy benefit manager Medco trades at 18.7x 2010E EPS with LTM EBITDA/Total Capital at 25.6%. Meanwhile, McKesson trades at 12.7x EPS with LTM EBITDA/Total Capital at a higher 26.2% figure. Granted, MHS estimated earnings growth is several times that of MCK, but the relatively high "ROIC" coupled with a low PE and positive earnings growth makes MCK seem severely undervalued in comparison. Risks Ascendere Associates LLC makes no guarantee on the accuracy of the data, estimates, assumptions or forecasts in this report. Investing in MCK or any equity entails a high degree of risk. This report is not a solicitation to buy or sale any securities. Steve Castellano [email protected] Ascendere Associates LLC Page 2
Steve Castellano [email protected]
Ascendere Associates LLC Page 3
About Ascendere Associates LLCJ. Stephen Castellano Steve founded Ascendere Associates LLC to provide custom equity research and financial consulting services for institutional clients. Steve has been involved in equity research, strategic studies and financial writing since 1995, and has more than 10 years of experience in equity research analysis. At PaineWebber, Warburg Dillon Read and Credit Lyonnais Securities he developed fundamental equity valuation models and conducted in-depth research on the steel and telecom services industries. At Boston Private Value Investors, he developed quantitative models for stock idea generation and also provided general fundamental equity research coverage. Steve received a MBA from the F. W. Olin School of Business at Babson College (2005) and a BA from Oberlin College (1993). Steves career history is highlighted below: Ascendere Associates LLC (2009-Present) Boston Private Value Investors , Equity Research, Equity Research Analyst (2005-2009) Pyramid Research, Contract Consultant, Telecom Services (2002-2003) Credit Lyonnais Securities (USA), Equity Research, Telecom Services, Vice President (2000-2001) Warburg Dillon Read, Equity Research, Telecom Ser