For the first time in their history, The Value Guys used momentum as part of their screen for their Good Fundamentals/Good Momentum Edition. They started with the fundamental factors of sales growth greater than the industry, operating margin greater than the industry median and an expected EPS growth greater than 10%. The additional momentum screen of 52-week stock performance better than the S&P 500 was then added. Five hundred stocks passed each filter but only 71 passed all four filters. The Value Guys then picked ResMed Inc (NYSE: RMD), Union Pacific Corporation (NYSE:UNP) and McKesson Corporation (NYSE:MCK) for review in their podcast. Val Hughes’ picked MCK as his favorite of the three.
McKesson Corporation (NYSE:MCK) primarily provides pharmaceutical distribution to pharmacies and hospitals. They operate in two business segments, Distribution Services and Technology Services. Distribution Services makes up over 95% of the $123 billion of revenues the company posted in 2012.
Based in San Francisco, MCK employees 37,000 people and is the largest drug distributor amongst its competitors Cardinal Health, Inc. (NYSE:CAH) and AmerisourceBergen Corp (NYSE:ABC).
At first look, MCK’s margins and operating history are not very attractive. In the past five years, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) has averaged 1.7% and EBIT (Earnings Before Interest and Taxes) have averaged 1.6%. This is made up by ROE (Return On Equity) averaging 16.8% in the past five years. These are low margins but on a small equity base.
EBITDA margins of 1.7% don’t indicate a company with a competitive advantage. GAAP accounting isn’t presenting the investor with the economic reality of this company as shown by the Income Statement below.
Most of the revenues can viewed as a pass through. MCK receives product from the pharmaceutical companies and holds it for a short period of time prior to shipping it to the end customer. The inventory turns are so high that looking at the revenue for the Distribution Services segment as a pass through would give us a picture of the economics of MCK’s competitive position.
The proforma income statement below presents MCK’s revenues as if the cost of goods portion of the drugs purchased is viewed as a pass through. Instead of the sale price of the drugs being booked as revenue, the markup that MCK receives is booked as the revenue. It’s as if MCK is running a logistics business. If United Parcel Service, Inc. (NYSE:UPS) was running the logistics for drug distribution, they would charge for the shipping and storage of the drugs passing through their system. Just think what UPS’s revenues would be if they were posting the underlying value of the packages they shipped as revenue! If you step back from the number $122 billion in sales and think about it, that is a huge number. That puts them behind the likes of Hewlett-Packard Co. (NYSE:HPQ) at $127 billion in sales and Ford Motor Co. (NYSE:F) with $136 billion in sales and both these companies make products that they sell to end customers. MCK is a middleman, a wholesale drug dealer.
From the segment information presented in the 10-K, we know that the revenues for the Technology Solutions segment in 2012 was $3.3 billion of the $122.7 billion of total revenues for the company. We know that practically all of the cost of sales was for the Distribution Solutions segment. The segment information presents the operating income for Distributions Solutions and Technology Solutions. Making adjustments so that gross income is the same as the original income statement, the revenues for Distribution Solutions was $3.3 billion in 2012 resulting in total adjusted revenues of $6.6 billion in 2012.
The company’s margins are dramatically different when looked at with adjusted revenue. EBITDA margins now average 32.5% and EBIT average 30.1%. These kind of margins indicate MCK may have a competitive advantage.
To better look at this dynamic, it is good to look at the company with the DuPont Analysis. Using the original income statement we can decompose to see where the return on equity is coming from.
MCK has solid ROE (Return On Equity) for the past five years averaging 16.7%. This kind of ROE would indicate some competitive advantage. While a higher ROE sustained over a long time frame would potentially indicate a stronger competitive advantage, the nice thing about this level of ROE is that it’s difficult to see a new competitor being able to enter MCK’s industry with $6.8 billion in equity and be able to compete effectively enough to garner a 15% return. If the ROE for MCK was over 30%, that might attract upstarts to take the risk to enter their industry.
DuPont Analysis breaks ROE down into three components: Profit Margin, Total Asset Turnover and the Equity Multiplier (Assets/Equity). We can see from the DuPont Analysis, that while MCK posts very low profit margins, that averaged 1.02% in the past five years, the ROE is driven by Total Asset Turnover averaging 3.91 and Assets/Equity averaging 4.19. ROE is driven by high asset turns with a dose of leverage.
The neat thing about DuPont Analysis is that you can continue to break down each component and get into the weeds to see what is going on. There is no need to do that here but it is interesting that while assets turn four times per year, average Inventory Turnover was 11.5x in the past year with 12.0x in 2012. At 12x, MCK is basically emptying and restocking their warehouses every month. That’s pretty impressive operating efficiency. For perspective, that kind of Inventory Turnover is similar to Costco Wholesale Corp (NSDQ:COST) and The Kroger Co. (NYSE:KR) and higher than Wal-Mart Stores Inc. (NYSE:WMT).
Market Share and Customer Concentration
MCK has a large market share in the drug distribution business with approximately 32% of the market by revenues. With only two other large competitors and the remaining being small fragmented players, MCK is the largest competitor in an oligopoly. There are some customer-switching costs as the distribution contracts are typically multi-year contracts. The downside is that MCK may lack bargaining power with its customers as they are highly concentrated with the top ten largest customers making up 52% of revenues. Sales to their two largest customers make up 26% of total sales with CVS Caremark Corp (NYSE:CVS) at 16% of sales and Rite Aid Corp (NYSE:RAD) at 10% of sales. Wal-Mart Stores (NYSE:WMT) maintains the second largest receivables balance at 10% of receivables indicating that WMT is likely 8%-9% of sales. Luckily, it appears that the industry is fairly rational so the lack of bargaining power with customers is made up by the low competitive rivalry within the industry.
The potential of a lack of bargaining power with their customers is one of the few things that makes me nervous about MCK. One upside to this weakness is that, as long as the industry remains rational, the loss of one of their top customers could be a great entry point into the stock if the market irrationally crushes the stock price. I like MCK but the price has to be right.
Disclosure: No position in MCK.