The Centers for Medicare and Medicaid Services noted national health care spending is forecasted to expand at a compounded annual growth rate of 5.4%, reaching $6.2 trillion by 2028. The trend in health care spending was only accelerated by the pandemic and the need for the efficient and timely delivery of care is also becoming more important.
Warren Buffett (Trades, Portfolio)’s investment strategy focuses on dominant companies with a long-term competitive advantage. He often uses the analogy of toll roads and is a large investor in railroad stocks. In this case, McKesson Corp. (MCK, Financial) is the backbone of the pharmaceutical industry as it delivers one-third of all pharmaceuticals used in North America.
Buffett's Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was buying shares of the company at an average price of $271 in the first quarter, which is just 10% lower than where the stock trades today.
Let’s dive into the business model, financials and valuation to see if this stock is still a good potential value opportunity.
Business model
McKesson is one of the largest pharmaceutical distributors in the U.S. It also provides a variety of health-focused IT and care management tools. Founded in 1833, the company is one of the oldest in the U.S. Today, it has over 78,000 employees.
The business can be split into five main segments, Pharmaceutical Distribution, Wholesales Medical Supplies, Pharmacy Services & Technology, Solutions for Speciality Practices and Solutions for Biopharma.
It has a network of over 750,000 providers and more than 50,000 pharmacies. It is also the number one distributor in community oncology (cancer treatment). The company expanded to become a key vaccine distributor for the U.S. government during the Covid-19 pandemic, supplying kits for over 1 billion doses.
Source: McKesson presentation.
Growing financials
The company produced some tremendous earnings for the fourth quarter of fiscal 2022. It posted revenue of $264 billion, which represented an increase of 11%. Adjusted earnings per share increased 38% to $23.69.
While McKesson continued its planned exit from the European market, it generated cash flow from operations of $4.4 billion and free cash flow of $3.9 billion. As a distributor, the company operates with very tight margins and seems to have a business model which only makes sense when it can take advantage of its vast economies of scale. The good news is this may deter new competitors from entering the market and could be one reason why it has dominated since its founding. However, rising fuel prices and supply chain disruptions may impact these margins, which could be a risk.
McKesson has a stable balance sheet with $3.5 billion in cash and cash equivalents. Despite having $5 billion in long-term debt, the short-term debt is manageable with just $799 million in current debt.
According to the GF Value Line, which analyzes historic multiples, past financial performance and future earnings projections, the stock is significantly overvalued. However, this is in contrast to Buffett's intrinsic valuation as his conglomerate was buying shares at an average price of $271 each in the first quarter, which is just 10% lower than where the stock trades currently.
Final thoughts
McKesson is the backbone of the U.S. pharmaceutical industry as it distributes a large portion of the pharmaceuticals used in North America. This company fits Buffett's criteria of investing in market leaders with a toll road-like competitive advantage.
Despite being founded in the 1830s, the company is still growing strong and seems very forward-thinking with its strategy. The balance sheet and debt levels also appear to be manageable in the short term. The stock does seem to be trading at a higher level than historic multiples, but Berkshire Hathaway was buying shares at a slightly lower average price.
