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McKesson: Why the Best is Yet to Come
You can listen to a professional narration of this article below:
Article available in Spanish here.
We have owned McKesson and its competitor Cardinal Health a few times over the last twenty years. This time around, we bought McKesson in November 2016 when the stock almost halved from a previous high. Going into 2015, MCK’s business was overearning; it was benefiting from patent expirations of branded drugs. As a patent expires, a generic drug company that challenges the branded patent and drug distributors makes temporarily high profits for six months. In 2014–2015 there was a tsunami of branded drugs going generic.
In 2015 MCK was owned by growth investors that were looking for a continuation of double-digit earnings growth and price-to-earnings expansion. In 2016, earnings did not expand but contracted, and growth investors ran for the exits. The stock collapsed. This is when we made our first purchase (in this most recent ownership period). Our rationale was simple: We normalized (lowered) MCK’s margins to pre-branded expiration levels, and the stock looked attractive. There was a lot to like – three drug distributors (McKesson is the largest) control over 90% of the drug distribution market. All three distributors are at scale and none has a competitive advantage against the others, thus none has a reason to start a price war.
Our thesis started to play out. Earnings stopped declining and were about to start growing, and then… Amazon announced that it was entering the retail pharmacy space. MCK stock dropped, and we added to our position. The market had misunderstood the industry structure. Amazon was not going to be competing with McKesson. McKesson has highly specialized warehouses; in fact, it is the Amazon of drug distribution. Amazon will be selling drugs online, and it doesn’t have and most likely is never going to have enough scale to be a formidable competitor to a major drug distributor (read my article).
Our thesis began to prove out. The market started to agree with us, and then… States sued drug distributors for their complicity in the opioid epidemic. I wrote a lengthy article on this topic. Bottom line: Drug distributors were not responsible for the opioid crisis, but they were the largest identifiable entity, and thus they got sued. The drug distributors could have fought and probably would have won, but the lawsuits would have been a long haul, and thus they have settled with the states.
The opioid mess is mostly behind us. What we have today in MCK is the largest drug distributor in the US, with a very stable and growing business – revenues are growing about 3–5% a year (depending on the level of inflation, maybe even higher). It is a very cash-generative business, doesn’t need much capital to grow, and has a very high return on capital. McKesson has a significant competitive advantage against new entrants. It carries very little debt.
Owning the stock was very stressful at times (this is how opportunities are created) over the last few years but also very rewarding. After accounting for about $25 we made for McKesson’s distribution of shares in Change Healthcare last year, MCK returned about 15–20% a year (this number will vary from client to client).
But the best is yet to come for MCK.
As of this writing MCK is a $220 stock. Its immediate earnings power is around $21 (up from $13–15 at the time of our first purchase). Historically, MCK has traded at about 15–17 times earnings, which would suggest the potential for a $315–350 stock price. The combination of revenue growth and share buybacks should result in high single-digit earnings growth. In four years, we get earnings of about $27–30, which gives us a price of about $400–500.
McKesson is a perfect business for the uncertain environment that lies ahead of us. The demand for its product is not dependent on the whims of the global economy. It can pass price increases on to its customers.
Pause for a second and ask yourself a question: How does the silliness of the stock prices of AMC, GameStop, or some overpriced electric vehicle company impact McKesson? It doesn’t.
This is a continuation of my journey into musicals (I discussed Juno and Avos last time).
In the early 1990s I was mesmerized by Evita, a musical composed by Andrew Lloyd Weber.
Let’s take a small detour and talk about Andrew Lloyd Weber. Weber composed Evita, Jesus Christ Super Star, Phantom of the Opera, Cats, Sunset Boulevard, and many other musicals. In 2001 the New York Times called him “the most commercially successful composer in history.” What is interesting is that Weber composed another dozen musicals that saw the light of day for only a very short time and were then consigned to obscurity. Failure is an important constant of success, even for creative giants like Sir Andrew Lloyd Weber (he was knighted by the Queen in 1992).
If you’d like to relive Weber’s best musicals and meet Sir Genius, watch this three-part concert:
Click here to listen.
Evita is a musical about Eva “Evita” Peron. Eva comes from a poor family in Argentina. She meets Juan Peron – a future three-time president of Argentina. During Peron’s presidency Argentina fell in love with Evita. Evita tragically dies of cancer at the tender age of 33. A lot of political events happen in between and some romance, but this sums up the musical. I must admit, I am somewhat indifferent to the story line of this musical. I don’t see many redeeming qualities in Juan Peron. And unlike Argentina, I did not fall in love with Evita. But I love the music. Pop singer Madonna and Antonio Banderas did a terrific job starring in the 1996 movie.
Here are my favorite songs:
Click here to listen.
Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to firstname.lastname@example.org.
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