Morningstar Magazine - April/May 2018 - 53

Premier Player
McKesson is one of the most powerful names along the
drug supply chain.
BEST IDEAS: EQUITY

Vishnu Lekraj

McKesson MCK

This article is adapted from a Morningstar equity research report dated
Feb. 1, 2018.

Stats 02/28/2018

The delivery of pharmaceuticals to consumers encompasses many firms along
the supply chain, but McKesson MCK stands out as a premier player. We
believe the firm has a wide economic moat, as its scale gives it key competitive
advantages. McKesson also plays a critical role in the pharmaceutical industry,
as many supply-chain participants depend on its services for streamlined
product distribution and procurement. Despite material large-customer contract
losses as a result of client consolidation, we believe the firm has made the
right strategic moves to offset its near-term issues and is positioned to thrive
over the next several decades.
McKesson is one of the largest pharmaceutical distributors by revenue and is
the main supplier to large pharmacy outlets CVS Health CVS mail-order
pharmacy and Walmart WMT. However, with the acquisition of half of Rite Aid
stores by Walgreens WBA, the firm has lost a material portion of its revenue.
In addition, the firm has experienced major pricing pressure, which has
weighed on profits. Nevertheless, we believe the firm has correctly adjusted its
cost basis, reformulated the pricing of its contracts, and has largely worked
through these issues.
The firm has been able to backfill a good amount of lost generic wholesale
volume through the expansion of its Albertsons and Walmart client
relationships. Further, its recent restructuring enhanced its already highly
efficient procurement and distribution operations. The firm was able to
reduce its cost structure through a head-count reorganization and is divesting
itself of its struggling healthcare IT segment. These tactical moves have
preserved operational efficiency and keeps McKesson in a prime position
within the overall healthcare market.
For the fourth quarter, McKesson reported mixed results, as an increase
in operating expense margin offset gross profit expansion. We believe a shift
toward a greater generic drug mix may have pressured these results. We
expect to see the centralized cost margin decrease given the firm's restructured
operations, and we will watch closely how this metric develops over the next
few quarters. Positively, the pricing environment seems to have stabilized
for McKesson with both branded and generic pricing headwinds lessening and
a stabilization within the small/independent client market segment.

Morningstar Rating
QQQQ

Sector
d Healthcare

Industry
Healthcare Distribution

Price
$149.23

Fair Value Estimate
$210.00

Uncertainty
Medium

Economic Moat
Wide

Stewardship Rating
Standard

Market Cap
$32.5 Billion

Price/Fair Value 02/28/2018

Fair Value Estimate Per Share

$250
210.00
200
150
149.23

Month-End Closing Price

100
50

03/2015

03/2016

03/2017

Management mentioned that pricing trends fell in line with its expectations,
and it thinks it has conservatively factored in branded inflation and generic
deflation variables into the rest of its 2018 and 2019 guidance. It also stated
that it is working through all of its retail pharmacy and branded manufacturer contracts to build in better visibility and stabilization into its pricing.
From our perspective, this will lessen the operating variability that has
plagued McKesson over the past year.
After a quarter with announcements of significant M&A (CVS/Aetna)
and potential new competitive threats, we note that even though there may be
some material changes in how the various parts of the U.S. pharmaceutical
market operates over the next several years, the need to source and deliver
drugs in a cost-effective and efficient manner will not change. This fundamental factor has formed a strong foundation for McKesson, as its core drug
wholesaling operations will be needed no matter how market dynamics shift.
We are reiterating our wide moat rating and our $210 fair value estimate. K
Vishnu Lekraj is a senior equity analyst with Morningstar Research Services.

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Table of Contents for the Digital Edition of Morningstar Magazine - April/May 2018