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Theres Nothing Generic About McKessonJanuary 5, 2010
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McKesson Corporation Investment Thesis
High quality, dominant drugdistribution business Prolific free cash flow generator
Predictable recurring revenue streams
Company also owns an industry leadingHealthcare IT & services unit
Both segments are benefiting fromfavorable demographic trends andhave meaningful growth potential
Intrinsic value of the business not
currently reflected in the market Significantly undervalued on a sum-of-
the-parts basis
Ticker: MCK
Stock Price: $72.33
Recent Valuation
Multiples:11.66x 11E Earnings (ex-cash)*
6.4 EV / 2011E EBITDA
Capitalization:
Equity Market
Value: $18.3bn
Enterprise
Value: $17.5bn
*Note: cash adjusted to reflect 12/30 USOncology acquisition
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Company Overview
McKessons (MCK) primary business is drug distribution. MCK acts as themiddleman delivering drugs from pharmaceutical companies to users such
as pharmacies and hospitals.
MCK also operates a technology segment which sells enterprise-softwarethat helps customers including pharmacies, doctors and hospitals manageclinical data, revenue and inventory, automate processes, streamline
communications and eliminate the need for paper prescriptions and medicalrecords.
MCK has over 175 years of operating history and is ranked #14 on theForbes 500 list with over $100bn in revenues.
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McKessons Two Businesses
MCK operates in two business segments
McKesson DistributionSolutions (MDS)
McKesson Technology
Solutions (MTS)
Distributes pharmaceuticalsand health and beautyproducts to retail pharmacies
and institutional providerslike hospitals and healthsystems
Provides software,automation, services andconsulting to hospitals,
physician offices, imagingcenters, home health careagencies and payors
~97% Revenues ~3% Revenues
~1.5-2% EBIT Margins ~10-12% EBIT Margins
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McKessons Two Businesses (contd)
Market leader in oligopoly industry Top 3 players ~90% of revs; MCK
35%
Multiple secular tailwinds driving
growth High barriers to entry and huge moat
due to economies of scale andirreplicable network
Recession resistant business
Low regulatory exposure Limited inventory risk
Low margin, low multiple business
Strong market position infragmented industry
Stimulus spending and digitization ofhealth records driving growth
Sticky customer base and strongcustomer captivity due to highswitching costs and niche targetmarkets
Products used by 50% of hospitalsand 70% of those with over 200 beds
High margin, high multiple business
At current levels, the market is not giving any credit to the value of MCKs HealthCare IT (HCIT) unit despite it contributing 15-20% of MCKs net income. Analysts
and investors tend to value MCK based on its consolidated earnings rather than
valuing each of its two business separately, which leads to drastic mispricing.
In order to realize and unlock the intrinsic value of the business, managementshould consider spinning off MCKs technology segment, MTS
Positive Factors McKesson Technology Solutions (MTS)McKesson Distribution Solutions (MDS)
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But first, a little more about McKesson
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Prudent Capital Deployment
Over time, MCKs management team has proven themselves to be good allocators of
capital by using the companys substantial free cash flow to increase dividends and
share buybacks and execute accretive acquisitions
Source: MCK Company Presentation
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Prudent Capital Deployment (contd)
Given its ability to generate significant cash flow, MCK should continue to be able to
conduct substantial share repurchases over time
MCK recently increased its buyback program by $1bn, raising the total authorized sharerepurchase amount to ~$1.53bn or roughly 8.5% of its current shares outstanding
Source: MCK Company Presentation
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High Returns on Equity
With its low fixed-cost structure, McKesson generates high returns on equity
0%2%
4%
6%
8%
10%12%
14%
16%
18%
20%
2010 2009 2008 2007 2006
Return on Equity
Source: McKesson 10K
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Strong Free Cash Flow Generation
MCKs depreciation and amortization expense typically exceeds capital expenditures,
leading to FCF per share that far greater than GAAP EPS
$(1.00)
$-
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
$9.00
FY 2005 FY 2006 FY 2007 FY 2008 FY 2009 FY 2010
FCFPS EPS
Source: Bloomberg
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Strong Balance Sheet
MCK has over $2.5bn of cash(1), a modest net cash position, ample interest coverage (~11x) and
a staggered debt maturity schedule
0
100
200
300
400
500
600
2012 2013 2014 2017 2019 2027
Debt Maturities(in millions)
Source: McKesson 10K
(1) cash adjusted to reflect 12/30 US Oncology acquisition
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New Business Model
Whereas in the past the company operated as more of areseller of drugs, MCK and other drug distributors have beenmoving to a fee-for-service (FFS) model under which it ispaid by manufacturers to distribute their drugs in exchange
for a fee.
MCKs business model is shifting towards one that allows for more stable, predictablerevenues, less inventory risk and lessens the extent to which MCKs profits aresubject to swings in the prices of drugs
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Secular tailwinds
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Favorable Demographics and Govt Policy Driving Demand
Massive amount of upcoming drug patent expirations, leading
to a surge in the availability of generic drugs which carry
higher profit margins
Pharmaceutical consumption and utilization on the rise due to
expansion of healthcare coverage and aging of baby boomers Government policy and stimulus programs to drive revenue
growth in MCKs technology segment
MCKs two businesses should benefit from a number of secular tailwinds as well as
increases in government spending
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Favorable Demographics and Govt Policy Driving Demand (contd)
McKesson earns a higher profit margin on generic versus branded drugs by a factor of3-5x(1). Given the upcoming patent expiration cliff, MCK is poised to benefit from a
shift to generics as over $100bn in brand name drugs come off patent
Source: Goldman Sachs
(1) According to company estimates
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Favorable Demographics and Govt Policy Driving Demand (contd)
Total pharmaceutical consumption should increase as healthcare reform enablesmillions of people to receive health insurance for the first time which will serve as a
further boon to McKessons distribution business
Source: Goldman Sachs
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Favorable Demographics and Govt Policy Driving Demand (contd)
Persons aged 65 and over, the largest consumers of pharmaceutical drugs, arecurrently and projected to be the fastest growing segment of the US population for
years to come...
Source: US Census
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Favorable Demographics and Govt Policy Driving Demand (contd)
and will continue to grow as a proportion of the US population
Source: US Census
24.11%
9.85%
26.80%
26.21%
13.03%
2010 US population
composition by age
segment
Under 18 years 18 to 24 years
25 to 44 years 45 to 64 years
65 years and over
23.41%
8.92%
25.88%
23.59%
18.20%
Projected 2025 US
population composition by
age segment
Under 18 years 18 to 24 years
25 to 44 years 45 to 64 years
65 years and over
22.42%
8.67%
24.98%
22.80%
21.13%
Projected 2050 US
population compositionby age segment
Under 18 years 18 to 24 years
25 to 44 years 45 to 64 years
65 years and over
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Favorable Demographics and Govt Policy Driving Demand (contd)
The number of persons aged 65 and older is growing by millions every year
Source: US Census
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Favorable Demographics and Govt Policy Driving Demand (contd)
which should give rise to an increase in pharmaceutical utilization and further drivegrowth for MCK
Source: SIG
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Favorable Demographics and Govt Policy Driving Demand (contd)
A component of the Feb. 2009 $787bn American Recovery and Reinvestment Act (ARRA)called the HITECH act provides approximately $19bn in incentives to physicians and hospitals
for the implementation of Electronic Health Records (EHR). This coincides with Obama
Adminstrations goal of having EHR for every American by 2015. Payments will begin in 2011.
Qualification for stimulus money is subject to meaningful use rules and tests
MCK is working with clients to ensure they have the right resources to qualify for thestimulus money
20% of the 500,000 non-hospital physicians in the US currently have EHR in place; according
to CBO estimates, by 2014 this number will be 85% and 90% in 2019 in light of ARRA
10% of the 5,100 hospitals in the US currently have EHR in place; according to CBO estimates,
this figure will grow to 55% by 2014 and 70% by 2019 in light of ARRA
MCKs IT segment is likely to be one of the main beneficiaries of this
incremental stimulus spending
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So what is the company worth?
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McKesson Distribution Solutions (MDS) Peer Analysis
Data based on 1/5/11 closing prices
McKesson Cardinal Health Amerisourcebergen Median
Market Cap (mm) $18,304 $13,568 $9,523 $11,421Enterprise Value $17,533 $12,995 $9,208 $10,977
2010E Sales $110,016 $98,274 $78,536 $88,405
P / 2010E EPS 16.04 16.41 15.81 16.11
P / 2011E EPS 13.62 14.84 14.12 14.48
P / 2012E EPS 12.43 13.50 12.72 13.11
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McKesson Technology Solutions (MTS) Peer Analysis
Cerner Allscripts Quality Systems Athenahealth Computer Programs & Systems Median
Market Cap (mm) $7,825.0 $3,749 $2,044 $1,429 $501 $2,044
Enterprise Value $7,379 $4,135 $1,938 $1,341 $486 $1,938
2010E Sales $1,853 $1,249 $332 $244 $150 $332
P / 2010E EPS 32.35 27.20 37.16 74.45 32.88 32.88
P / 2011E EPS 26.83 22.88 27.69 55.59 29.87 27.69
P / 2012E EPS 22.38 19.54 22.85 40.87 22.08 22.38
Data based on 1/5/11 closing prices
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Sum-Of-The-Parts Analysis
Currently, the market is ascribing zero value to MCKs IT business. Said differently, at todaysprice levels you are buying MCKs high quality distribution business at an attractive price and
effectively getting its high-margin, high multiple technology business for free
Refer to notes on final slide for assumptions used
Based on the
implied value of
the MDS
segment, MCKs
current stock
price only
reflects the value
of its distribution
business
Distribution Technology
Solutions SolutionsCY 2011 CY 2011
Operating Profit(1)
$1,864 $355
Interest Expense(2)
147 28
Pre-Tax Income $1,717 $327
Income Tax(3)
566.6 107.9
Net Income $1,150.4 $219.1
Shares Outstanding(4)
232 232
EPS $4.96 $0.94
Estimated P/E Multiple(5)
Low High*
Distribution Solutions 14.12 14.84
Technology Solutions 22.9 29.9
Implied Value Per Share Low High
Distribution Solutions $70.01 $73.58
Technology Solutions $21.61 $28.21
Combined $91.62 $101.79
Current Price: $72.33% Upside 26.7% 40.7%
*Athenahealth P/E excluded as outlier
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Note: Current Weakness in MTS Segment Masks Potential
For the first half of FY 2011, the MTS segment has seen a(temporary) decline in operating profits by ~64% due toincreased investment, a one-time non-cash impairmentcharge and revenue recognition delays.
Management expects a strong second half of FY11 for MTS asinvestment slows, certain development issues are resolvedand implementation schedules come online
Consequently, investors are being overly pessimistic aboutthe health and profitability of the MTS segment, allowing fora more attractive entry point
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Spin-off rationale
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Spin-off Rationale
MTS products are already deeply penetrated and thus there are few if any
remaining synergies between the two businesses
Cross-selling opportunities still exist but given the level of penetration MTS hasachieved, they have grown less important MCK can choose to spin out the majority of MTS while retaining a stub holding in the spun-off entity to
continue to build and grow the business while still unlocking its value for shareholders
The two businesses have very different growth and margin profiles and thus
deserve vastly different earnings multiples. As a result, in its current form, the
market has a difficult time assigning fair value to MCK
Give shareholders a choice whether to hold the low-margin distribution business ,
the high-margin IT business or both
Highlight the intrinsic value of the business
The MTS business is the byproduct of a merger between HBO & Co. and MCK in 1999 and its subsequent
build-out both organically and through a series of acquisitions
As a standalone entity, MTS would become 2nd largest publicly traded HCIT company by market cap (1)
(1) Based on peer multiples and estimated earnings
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The Transaction Is Not Without Precedence
In order to re-focus on its core distribution business,McKesson competitor Cardinal Health (CAH) spun off itsnon-core tech assets in August 2009 into a separate entity,CareFusion (CFN), on a 1:2 basis
At the time, Cardinal Health retained a 19% equity stake inCareFusion
CareFusion is comprised of what was formerly Cardinal
Healths high-margin, high growth clinical and medicalproducts businesses
When taking into account the CareFusion shares received as a result of the spin-off and theappreciation of both Cardinal Health and CareFusion since the spin-off, investors that owned
CAH as of the record date of August 25th
, 2009 have earned a return of 49.5% versus a returnon the S&P 500 of 24% over the same period
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Risk factors
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Risks
Disintermediation
Loss of key customer(s)
Top 10 customers comprise ~52% of revenues
CVS ~15%, Rite-Aid 12%
Contract turnover is fairly rare in the industry
In light its financial condition, investors can protect against Rite-Aid bankruptcy risk by owning RAD
CDS and/or shorting its common equity
Pharmaceutical companies may decide to distribute drugs entirely themselves
Distribution business models are efficient and make economic sense
Distributors in all industries allow their respective clients to focus on their own core
competencies
MCK and other drug distributors are akin to off-balance sheet financing and help businesses
keep their cost structure down
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Conclusion
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Conclusion
High quality business with strong competitive position,
recurring revenue streams and multiple secular tailwinds
Attractive valuation on a consolidated basis
Trading at a significant discount to fair value on a sum-of-the-parts basis
Spin-off opportunity presents catalyst to realize value
Shares do not currently reflect value of highly profitable IT segment
Upside potential: 27-41%
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Assumptions used
CY2011 operating profit is based on consensus estimates and allocates84% to the MDS segment and 16% to the MTS segment based onhistorical precedent
Interest expense is computed based on historical interest cost and isallocated 84% to the MDS segment and 16% to the MTS segment;
conservative estimate as MCK has been paying down debt The tax rate is assumed to be 33% based on historical precedent and
management guidance
Share outstanding is based on the assumption that the full $1.53bn sharebuyback program is exercised, resulting in a share count reduction of
21mm shares Earnings multiples are for CY11 are based on those of the comparables
listed in the peer slides, with the exception of Athenahealth which wasexcluded as an outlier