The $33.1 billion California-based medical distributor reported its first quarter earnings recently. McKesson delivered 2.7% year-over-year revenue growth to $51.05 billion and a contrasting 43% drop in profit to $309 million (0.6% margin compared to 1.1%).
Interestingly, McKesson’s overall expenses actually declined by 0.4% but the company recorded $120 million losses in relation to its equity investment in Change Healthcare that helped push down its profits in the quarter.
According to filings, there were no material intervening events at the 70% Mckesson-owned joint venture, Change Healthcare, during June 2017. Nonetheless, the company recorded the losses, which included transaction and integration expenses incurred by the joint venture and amortization expenses associated with equity method intangible assets.
In addition, the company expects its adjusted EPS to be in the range of $11.80 to $12.50 by fiscal year end 2018 compared to $12.52 and $12.91 in fiscal years 2016 and 2017. This wound indicate a possible 5.9% decline from fiscal year 2017 adjusted EPS.
“McKesson's first-quarter operating results were consistent with our expectations.
“We’re off to a solid start to the year and are raising our previous Fiscal 2018 Adjusted Earnings outlook to a range of $11.80 to $12.50 per diluted share. In addition, we generated strong first-quarter cash flows, which allowed us to allocate capital in line with our portfolio approach to capital deployment.”
John H. Hammergren, chairman and chief executive officer
Valuations
McKesson is undervalued compared to peers. According to GuruFocus data, the company had trailing P/E ratio 7.2 times vs. industry median 20.1 times, P/B ratio 2.94 times vs. 2.38 times, and P/S ratio 0.17 times vs. 0.91 times.
The company also had a trailing dividend yield 0.71% with 5% payout ratio.
Average 2018 revenue and EPS estimates indicated forward multiples 0.16 times and 13 times.
Total returns
McKesson has outperformed the broader S&P 500 index so far this year with 12.37% total returns vs. the index’s 11.86%.
McKesson
McKesson Corp. was founded 184 years ago in 1833. According to its recent annual filing, the company is currently ranked fifth on the FORTUNE 500 and is a global leader in health care supply chain management solutions, retail pharmacy, community oncology and specialty care and health care information technology.
McKesson partners with pharmaceutical manufacturers, providers, pharmacies, governments and other organizations in health care to help provide the right medicines, medical products and healthcare services to the right patients at the right time, safely and cost-effectively.
In its recent fiscal year, the company generated 82.8% or $164.4 billion of its revenue in the U.S.
The company operates its business through two segments: McKesson Distribution Solutions and McKesson Technology Solutions.
McKesson Distribution Solutions
The Distribution Solutions segment distributes branded and generic pharmaceutical drugs and other healthcare-related products internationally and provides practice management, technology, clinical support and business solutions to community-based oncology and other specialty practices.
This segment also provides specialty pharmaceutical solutions for pharmaceutical manufacturers including offering multiple distribution channels and clinical trial access to our network of oncology physicians.
The division also provides medical-surgical supply distribution, logistics and other services to health care providers within the U.S. Additionally, this segment operates retail pharmacy chains in Europe and Canada, and supports independent pharmacy networks within North America and Europe.
The Distribution business also supplies integrated pharmacy management systems, automated dispensing systems and related services to retail, outpatient, central fill, specialty and mail order pharmacies.
In the recent quarter, revenue in the distribution business grew 3.9% year over year to $50.93 billion — nearly 100% of revenue. The segment also delivered an operating margin of 1.4% compared to 1.9% in the prior-year period.
McKesson Technology Solutions
The Technology Solutions segment provides clinical, financial and supply chain management solutions to healthcare organizations and includes McKesson’s equity method investment in Change Healthcare (1). Change Healthcare is a health care technology company which provides software and analytics, network solutions and technology-enabled services that will deliver wide-ranging financial, operational and clinical benefits to payers, providers and consumers.
Revenue in the first quarter for the Technology business fell 83% year over year to $120 million and delivered $78 million in operating losses compared to $168 million last year period.
According to filings, the company’s Technology Solutions revenues for the first quarter of 2018 decreased primarily due to the deconsolidation of the Core MTS Business (part of Change Health adjustments) and the transition of McKesson’s RelayHealth Pharmacy business to its Distribution Solutions segment in April 2017.
As a result, revenues for the first quarter of 2018 represent the results of McKesson’s Enterprise Information Solutions business.
Sales and profits
In the past three years, McKesson’s revenue growth averaged 13%, profit also increased by 58.9%, while profit margin averaged 1.52%.
Cash, debt and book value
As of June, McKesson had $2.34 billion in cash and cash equivalents and $7.95 billion in debt with debt-equity ratio 0.7 times vs. 0.88 times the year-prior period. Overall debt has declined by $158 million while equity has climbed by $2.05 billion.
Of McKesson's $61.8 billion assets, 25.9% were identified as goodwill and intangible assets while book value has risen by 22.2% year over year to $11.3 billion.
Cash flow
In the first quarter, McKesson’s cash flow from operations dropped by 60% to $741 million primary due to lower profits. The company also had a little higher outflows in its receivables and lower cash intake in relation to its drafts and accounts payables resulting in lower cash flow.
Capital expenditures were $118 million leaving McKesson with $623 million in free cash flow compared to $1.75 billion in the year prior period. The company also provided 58% of its free cash flow in shareholder payouts, mostly buybacks, in the quarter.
McKesson also allocated $722 million in debt repayments net any issuances.
The cash flow summary
In the past three years, McKesson raised $395 million from its share issuances, reduced its overall debt by $1.79 billion (net debt issuances and other activities), allocated $1.78 billion in capital expenditures, generated $9.74 billion in free cash flow and provided $5.1 billion in shareholder payouts at an average payout ratio of 50%.
Conclusion
McKesson’s first quarter operations appeared to be a period of adjustment. Certain parts of the company’s less important (in terms of revenue generation) were shuffled to its main distributor business resulting to expenses that led to poor profitability. In addition, the company’s self-defined adjusted EPS figure also indicates a weaker result for the coming fiscal year from prior year operations.
Meanwhile, the shuffling did somehow made sense when McKesson announced in early August that it would now actually sell its Enterprise Information Solutions business to Allscripts for $185 million.
Nonetheless, McKesson has kept busy too in acquiring relevant businesses. In the first quarter of 2017, the company completed its acquisitions of Vantage Oncology Holdings LLC and a couple more companies for $1.8 billion.
Meanwhile, the company had a less leveraged balance sheet compared to last year at 0.7 times debt-equity ratio accompanied by nearly a quarter of its assets in blue sky elements (goodwill and intangibles). McKesson also has kept prudent cash flow management in recent years having averaged payout ratio of 50%.
Analysts have an average price target of $175 a share vs. $157.26 at the time of writing. Applying analysts revenue estimates and three-year P/S average followed by a 15% margin indicated per share figure of $193.9 a share.
Absent any headline risks that the behemoth Amazon would engage in drug distribution, McKesson is a buy with $175 a share target price.
Notes
(1) Company filings
On June 28, 2016, we entered into a contribution agreement (“Contribution Agreement”) with Change Healthcare Holdings, Inc. (“Change”), a Delaware corporation, and others including shareholders of Change to form a joint venture, Change Healthcare. On December 21, 2016, we received notification from the Department of Justice that their review was closed and the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, was terminated. On March 1, 2017, the transaction closed upon satisfaction ofall otherclosing conditions pursuant to the Contribution Agreement. Under the terms of the Contribution Agreement, we contributed the majority of our McKesson Technology Solutions businesses (“Core MTS Business”) to Change Healthcare. We retained our RelayHealth Pharmacy and Enterprise Information Solutions (“EIS”) businesses. Change contributed substantially all of its businesses to the joint venture excluding its pharmacy switch and prescription routing business. In exchange for the contribution, we own 70% of the joint venture with the remaining equity ownership held by Change shareholders.
Disclosure: I do not have shares in any of the companies mentioned.
