MCK – Mckesson Corp: Outperforming Peers

By CrossProfit

05/15/2007

The big three distributors dominating the pharmaceutical distribution market in the US are; Cardinal Health (CAH), Mckesson Corp. (MCK) and AmerisourceBergen (ABC). Market cap is approximately $26.6B, $17.9B and $9.8B respectively.

For years this segment has enjoyed strong year over year growth in excess of 20% per annum. As stated in a previous article from 08/2006, organic growth was anticipated to slow down in 2007. Based on first quarter results (calendar year); this is precisely what has transpired. MCK revenue increased 6% YOY. Earnings however, were up 17%, beating the consensus by $0.06 per share.

Out of the big three, MCK has outperformed its peers, so far and by far.

Revenue Growth

Back in August 2006 we calculated MCK’s 2007 revenue growth coming in at 5.5%. Currently we are on track as the first quarter (FY2007 Q4) came in at 6% and is the easiest quarter to beat.

The Wall Street Journal ran an article on 05/06/2007 calling MCK a possible acquisition target due to its above average free cash flow. As mentioned in the article, this is pure speculation as there are no indications that MCK is for sale. We would add that the premium to current prices would need to be substantial for the board to justify an endorsement. Expectations from MCK are high and Standard & Poor’s analyst, Seligman, recently raised his target price to $79.00! We think this is a tad high. Current EOL (02/2008) is pegged at $67.40. Perhaps had the stock not appreciated 18% from the beginning of 2007, there might be some merit to this speculation.

Margins

In this cut throat business, pharmaceutical distributors work on 1% to 3% margins. MCK put in a stellar quarterly performance due in part to higher margins on generics. It is uncertain if the above normal industry margins for generics is sustainable over the long term or will eventually revert to industry standards as competition sets in. For now (2007 & 2008), this is the bright spot.

MCK is growing revenue in other higher margin areas such as its medical imaging unit.

The risk to all the good news is the unlikely possibility of a deep recession. No one is suggesting that a recession in pharmaceutical wholesale in particular and health services in general is in the cards; as unlikely as it may be, one prepares for a downturn before it is upon them.

Currently, we don’t see MCK management taking any defensive cautionary steps. This could become an issue as early as 2008. The balance sheet today is strong enough to deal with unforeseen contingencies.

Earnings per Share

MCK’s Q4 results put a nice finishing touch to FY2007 (ended March). EPS came in at FY2007 $3.17 and Q4 $0.85.

The CrossProfit 2007 calendar year EPS estimate from 02/2007 remains at $3.60. We noticed that this is the same exact EPS figure calculated for rival Cardinal Health (CAH), though the share count is different so there is no real meaning, just one of those eerie coincidences.

Noticing the trend in revenue growth, MCK plans to maintain EPS growth in part through a recently announce share buyback program. In essence, the share buybacks will buoy EPS while the real overall business growth rate, for revenues, continues to slow. This could work for a year or two until it becomes apparent that that the business has matured and should no longer be considered a growth company. As mentioned in our previous article, on lower growth, P/E multiples start to contract.

There is no change to the evaluation line (symbol = MCK).

Disclosure: No conflicts.