McKesson Corporation: Good Company, Fair Investment

Valuation

In my previous analysis, I determined McKesson Corporation (NYSE:MCK) to be a solid and well run company with some competitive advantage.  That is not enough to make an investment.  As a value investor, I have to see a discount to a conservative estimate of a company’s intrinsic value in order to warrant an investment.

The future demographics look good for MCK.  The U.S. Census Bureau forecasts growth of 2.1% annually in the 65-84 year old age group and 2.8% annually in the 85 and over age group with total growth for both age groups coming in at 2.2% for the 2000 to 2010 period.

Obviously, a growing older population bodes well for a drug distributor since older people take more medication.

The U.S. Bureau of Labor forecasts real GDP at 3.0% annually for the 2010-2020 period and the investment firm GMO forecasts normalized inflation over the next 15 years to be 2.2%.  It seems reasonable to me to forecast MCK’s revenue growth at 5% annually for the next five years.  Basically, I’m looking at 3% real growth in distribution revenue and 2% for inflation.  I believe this to be conservative since I’m in the higher inflation camp.  However, I have to defer to GMO’s 15-year normalized forecast since they have one of the most robust forecasting methodologies around and a hell of a historical track record.

Additionally, all of my 5-year forecasts are viewed more as conservative normalized figures.

I’m forecasting Costs Of Goods Sold (COGS) to expand 20 bps to 94.8% and Sales, General & Administrative (SG&A) to remain flat at 2.9%.  Both are conservative and less optimistic since there is a possibility that COGS could decline as more generic drugs are distributed by MCK since they have higher margins.  There is also the possibility that SG&A should compress over time as MCK continues to improve operational efficiency and gain more scale.

Assuming continued share buybacks and the payout ratio remaining at 15%, I arrive at diluted EPS of $10.34 in year five.  With the industry average P/E of 14.3, MCK’s 5-year average P/E of 16.2 and the S&P 500’s current average P/E of 14.9, I am using a market multiple of 15.  This assumes some compression in MCK’s P/E while it remains above the industry average.

Using a modified Dividend Discount Model (DDM), I arrive at an intrinsic value of $100.20 per share.  With the stock trading at $98.00, there is very little discount to intrinsic value.   I would prefer to buy these shares at a 20% to 25% discount to intrinsic value.  That would put the current entry point at the $75 to $80 range.

While I am skeptical of using EBITDA since it excludes the real costs that are interest and taxes along with depreciation and amortization which are accrual estimates of real costs, I have included it in my analysis since The Value Guys use EBITDA as a proxy for cash flow in their discussions.  I suspect that Val Hughes does more extensive modeling in the value shop he runs and uses EBITDA as a quick view into a business.

I would not value a business using EBITDA alone.  However, I do find some value in deconstructing the income statement into EBITDA, EBIT and EBT and finally NI to see where the costs are.  There is also some value in EBITDA in that others use it to value companies, especially private equity companies.  A lot of Mergers & Acquisitions (M&A) are transacted with EV/EBITDA multiples in mind.  So EBITDA gives some view of the potential of a company if it is a possible M&A target.  It shows what the upside potential is.  Some might describe me as more pessimistic.  I like to think of it as being realistic.  I like to look at the downside and base line scenarios.  However, it also helps to look at the upside for a frame of reference.  In this case, I don’t think MCK is a potential take over target, so I wouldn’t even bother to look at EV/EBITDA as a proxy for the company’s upside potential.

Interestingly, in the podcast, Val Hughes said that at the time of their podcast that MCK was trading at around 8.5x EBITDA.   Val said that the all time high for MCK is trading at 11x EBITDA and that he would look to sell at the high-end of the range.   Putting my valuation into that frame of reference, I would look to be buying at 8x EBITDA and selling at 10x EBITDA.  So currently, that would be buying at $82 and selling at around $102.  This works for MCK because the company doesn’t have any excessive cap-ex requirements or leverage.

I’m sticking to my official answer though.  My intrinsic value estimate is $100.20 and it’s a potential buy at the $75 to $80 range.  Otherwise, I’d sit on the sidelines.

Disclosure:  No position in MCK

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