The following article from Vitaliy Katsenelson, CIO of Colorado-based investment management firm IMA, includes discussion of companies that are mentioned only for educational purposes; no investment recommendations are intended. Go to Vitaliy’s Contrarian Edge website (www.contrarianedge.com) for more articles. You can sign up to receive articles by email at the site.
McKesson is one of the top three drug distributors in the U.S. McKesson (ticker: MCK), Cardinal Health (CAH) and AmerisourceBergen (ABC) are all about the same size and together control over 90 percent of the pharmaceuticals distribution market.
The fact that all three companies are a similar size is very important to the long-term health of the industry — and thus to McKesson’s long-term earnings power. When you have a sector dominated by a few (let’s say three or four) players of different sizes, a smaller company may feel that it is at a competitive disadvantage and start a price war (forgoing short-term profitability) to gain additional market share — and thus undermine the industry’s stable pricing structure.
The wireless sector in the U.S. is a great example of that: There are four players, but AT&T and Verizon are double the size of T-Mobile and Sprint. After Sprint’s overture to buy T-Mobile was blocked by regulators, T-Mobile initiated a price war that, combined with its creative marketing, allowed it to steal customers from Verizon and AT&T — a win for consumers, but it flatlined AT&T and Verizon earnings.
Back to drug distributors. Since all the players are approximately the same size, we are unlikely to see a price war, though there may be healthy short-term flare-ups of competition.
We have owned Cardinal Health and McKesson (more than once) in the past and know this business well. Think of these companies as railroads for prescriptions and generic drugs in the U.S. Pfizer, for instance, doesn’t want to deal with hundreds of pharmacies, nor does it have the scale to do so. Pfizer pays McKesson a small fee to distribute its drugs to pharmacies and hospitals.
The drug distribution industry was affected by the deceleration of pharmaceuticals price inflation in the second half of 2016 — it was political season, and pharma companies did not want to give politicians extra ammunition. (Mylan and a few others had done plenty of that already.)
You may hate this as an American consumer, but pharmaceuticals price inflation is a fact of life. We are less likely to see EpiPen-like increases going forward, but on its latest earnings call McKesson projected mid- to high-single-digit price inflation for branded drugs. The CEO of Allergan, at a conference in early January, basically said that the company will be raising prices once (not twice!) a year by mid single digits.
Here is how we view McKesson: It’s an oligopolylike business with a high return on capital, a terrific balance sheet (it could pay off all its debt in one year), and great cash flows. It is organically growing revenue 5 to 6 percent a year and returning cash to us through share buybacks and dividends.
Let’s focus on cash flows a bit further. McKesson generates about $3 billion a year of free cash flows — cash earnings that are left after a company has paid for all its ongoing expenses and invested in fixed assets (equipment, buildings, etc.) required to maintain its current earnings power. The beauty of McKesson’s business is that it doesn’t consume a lot of capital, and so incremental growth doesn’t cost much. Thus the company can grow revenue and net income 5 to 6 percent a year without much incremental investment.
McKesson’s management has several options for what it can do with $3 billion of free cash flow: It can increase its dividend (McKesson pays a small dividend of 0.8 percent that it has promised to raise over time); it can buy back its own stock if it is cheap (McKesson has done some of that); it can pay down debt (it has little debt, so paying that down is not a high priority); or, finally, it can make acquisitions that will add to McKesson’s growth. (McKesson has made acquisitions from time to time.)
If McKesson management spends its free cash flow wisely on dividends, buying back stock or making acquisitions, then 5 to 6 percent organic growth will accelerate to the mid teens. McKesson is a growing business of very high quality, and we paid only about 10 times earnings, or less than half of what the stock market is paying for the privilege of owning Coca-Cola.