McKesson Buy Recommendation: $180 Target (50% upside, multi-year

time horizon) 10/29/16

Conclusion: I am recommending MCK as a buy at current levels. It is a dominant
business in an oligopoly industry and high barriers to entry. It has a track record of
consistent growth, strong returns, good capital allocation, and an excellent balance
sheet. While the stock has been recently hit due to various issues, some of which
are definitely longer term in nature, it has a very durable and defensive business
model. I believe the market is discounting an overly negative scenario, and at
current levels there is a significant margin of safety for equity holders.
Business Model
Distribution Business
McKesson is the largest of the three biggest pharmaceutical distributors in the US,
and among the largest globally. These companies control an extremely important
part of the infrastructure that efficiently gets pharmaceuticals from manufacturers
to patients. Pharmaceutical distributors acquired prescription medicines from
manufacturers for storage in warehouses and distribution centers, which is then
processed and delivered to providers around the country.
Like most distribution businesses, this is a spread business. Typically, fees are
structured as a percentage of the wholesale acquisition cost (WAC). Thus, the two
drivers of profitability for distributors are pricing and the negotiated spread. The
spread varies depending on the type of drug as branded drugs typically command
the thinnest spreads, while generics offer the best spreads.
Healthcare IT Business
McKesson also has its Technology Solutions unit, which is primarily a healthcare IT
provider. While it only accounts for 2% of LTM revenue, it presented 11% of total
operating profit. Under a plan revealed last June, the company will combine a
majority of this unit with revenue cycle management firm Change Healthcare to
form a new company. McKesson will hold 70% ownership once the transaction is
finalized.
Investment Thesis

McKesson is the largest of the three biggest pharmaceutical distributors in

the US, and among the largest globally. Distributors control an extremely
important part of the infrastructure that efficiently gets pharmaceuticals
from manufacturers to patients.
Together with AmerisourceBergen and Cardinal Health, the three
distributors exist in an oligopoly market and represent, combined, over
80% of market share. Scale is a necessity in this function, and a growing,
consolidated market generally results in rational competitive behavior.
The extremely high barriers to entry and oligopoly structure have helped
these companies consistently generate strong returns, even through
recessions.
U.S. prescription drug expenditures are expected to grow significantly,
driven by new drug therapies, volume growth of existing therapies and
rising prices for branded drugs. Pharmaceutical distributors positioned

themselves as indispensible intermediaries of the modern healthcare

supply chain, and will be at the forefront of cost containment, which is an
increasingly prominent priority in American and global healthcare.
McKesson is best positioned among the pharmaceutical distributors in two
important growing segments, generic sourcing and specialty fulfillment.
While these segments currently comprise a minority of revenue, generic
and specialty distribution are more profitable than traditional branded
distributions, and should drive margin expansion as is becomes a larger
contributor to revenue.
McKesson is a strong free cash flow generator (LTM FCF yield is a
considerable 17%, after the recent move downwards), with an excellent
balance sheet (0.6x net debt/LTM EBITDA) and a consistent mid-high teens
ROIC track record.
The company is a strong capital allocator. M&A will continue to be a focus,
and it has a proven record of accretive acquisitions which is evidenced by
their historical CFROI. It also returns a significant amount of cash to
shareholders via dividends, as well as share repurchases, which have been
used judiciously. Low leverage offers additional optionality for future M&A
or buyback considerations.
Using fairly conservative assumptions (please see valuation section and
accompanying spreadsheet for greater detail), my estimated target value
implies upside of 50%, while the bull case indicates upside of almost
double that. A bear case scenario indicates limited downside from current
levels. This incorporates the assumption of the $4bn share buyback, which
was just authorized by the company.
I believe the planned divestiture of its HCIT business is a good move.
Given its lack of strategic value, mid-tier industry standing, and
problematic operational history (it has been a chronically impaired asset
since its purchase), giving up day to day control to focus on the core
business is likely a good move.

Investor Concerns and Other Risks

Stock has been down over 40% YTD due to concerns around pricing,
contract losses and, most recently, the news of a raid by Germanys
antitrust regulators into one of McKessons German subsidiaries. My take
on these issues below:
o While pricing is definitely entering a new normal in this new era of
consolidation among retail pharmacies, generic pricing concerns are
likely overblown in the long term. As consolidation continues in the
market, pricing will likely continue to cause near term headwinds.
However in the coming years, tens of billions of dollars of drugs are
expected to go off patent and be subject to generic competition, which
should improve the company's gross and operating margins as the mix
improves to higher margin generics/specialty.
o Given the news of Walgreens acquisition (WAG) of Rite-Aid (RAD), most
are assuming that WAG will take over sourcing and distribution for
RAD, which is currently serviced by MCK (and consensus seems to
reflect this view). While the FTC has yet to approve to deal, the
company has already made the prudent move of resetting 2017 and
2018 earnings expectations, and revising guidance down. While this
development has made investors nervous, I believe it does not reflect

on the strength and competitiveness of McKessons business model.

The recent Walmart strategic sourcing contract win shows that MCK's
pricing is competitive and should begin to restore investor confidence
in their operations and importance in the evolving healthcare supply
chain. My base case does not assume that MCK retains the RAD
business, which ends at the end of 2017.
While the news of a raid by antitrust authorities in their German
operations is concerning, it should be immaterial for the group in the
long term. Germany is thought to represent only 3% of sales, less than
that in profit, and even less so proportionate stake terms, considering
MCKs 75% ownership in Celesio. While I await greater clarity and
detail around this development (and particularly around potential fines,
which I assume to be proportionate immaterial), I am confident in
Celesio and McKessons prospects, given the strong and growing
secular demand for their services.

Valuation (please see accompanying spreadsheet for more detail and rationale
behind inputs)