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McKesson Corporation: One of the Best Healthcare Stocks to Own

McKesson Corporation: One of the Best Healthcare Stocks to Own

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Published by Stephen Castellano
If you needed to own one healthcare stock, this would be it. Originally published by Ascendere Associates LLC on January 27, 2010.

If you needed to own one healthcare stock, this would be it. Originally published by Ascendere Associates LLC on January 27, 2010.


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Published by: Stephen Castellano on Mar 15, 2010
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Steve Castellano Ascendere Associates LLCsteve@ascenderellc.com Page 1
Ascendere Associates LLC January 27, 2010Steve Castellano steve@ascenderellc.comMcKesson Corporation (NYSE: MCK)Sector: HealthcareIndustry: Healthcare DistributorsMcKesson Appears Compelling on a Standalone and Relative Value Basis
McKesson has a very strong fundamental profile in terms of ROIC momentum, various operating efficiency metrics and balancesheet strength. In addition, McKesson and other drug distributors and pharmacy benefit managers will probably increasinglyplay a major and positive role in managing health care costs. Furthermore, the long-term demand for drugs, especially genericdrugs, and other products will increase as the baby boomers age. If we experience a resurgent economy, its health caretechnology business will likely contribute to higher earnings growth and multiple expansion.Even after its impressive 75% run to a recent close of about $59, this stock still has room to appreciate. A market-drivencorrection could occur, but for portfolio managers that have an opening in a portfolio, this is probably one of the bestHealthcare Sector stocks to own at the current moment. Our confidence in this stock idea is supported by relative valuation on aROIC-adjusted basis and recently reported results that show the story is on track, as well as its strong balance sheet and solidcash flowMcKesson is currently trading at 11.7x NTM consensus EPS estimate of $4.67 versus a 5yr average of 16x and a high of 22.1xreached in 2006. Based on an academically derived WACC of 7.5% and conservative assumptions on cash flow growth, the stockdeserves to trade at a multiple of more than 19x. Even assigning a more conservative WACC of 8.5% on 10-year compoundedsales growth of 2% and EPS growth of 5%, together with a the stock deserves to trade at a 15.5-16x multiple -- or about $75 inone year.As of the time of this report -- one day after the company's report of fiscal 3Q results, the stock is down 4.5%. This is probablybecause EPS for the fiscal year ending in March will contain about $0.55 in positive non-recurring gains and guidance is up only$0.05-$0.10 for the year. Perhaps implicit in the recent negative stock price action is that this represents poor earnings qualityand a possible stagnation in positive analyst revisions as we head into the next fiscal year. However, the key metrics for earningsquality -- improving levels of ROIC, working capital management and cash flow growth -- overwhelmingly point to the overall
LTMFY+1FY+2LTM5yr AvgMCKInsiderStock Price$59.52EPS:3.10$ EPS:$4.54EPS:$4.76ROE:13.0%ROE:18.5%Owners0.2%Market Cap / SharesEBITDA/EBITDA/# of($B)$16.0 / 269P/E:19.2P/E:13.1P/E:12.5Capital26.2%Capital19.9%Analysts12EBITEBITP/B2.4P/CF7.1P/CF6.5P/CF6.3Margin1.7%Margin1.4%Debt/Cap:27.2%IncomeIncomeBeta0.82P/S:0.1P/S:0.1P/S:0.1Margin0.8%Margin0.7%Div Yld:0.8%
McKesson Corporation is ahealth care drug and supply distributioncompany supply, and is a provider of various healthcare technology solutions.Roughly 97% of revenue and 82% of operating profit is generated from itsdistribution segment and the balance fromits healthcare IT business.
McKesson Corporation has a very strong fundamental profile, is securely situated in an industry that should show considerable long-term growth, and seems undervalued relative to its historical ROIC, growth prospects and to other Healthcare stocks. As such, it isprobably one of the best Healthcare Sector stocks to own at the current moment.Conservative assumptions get us to about a 15.5-16x target multiple on NTM EPS of $4.67, or $75 -- which compares to a sell-siderange of $60-80 and average of $70. And it would not be a stretch to justify a target multiple of 19x using academically derivedWACC calculations. On a worst case basis -- one in which EPS could decline 25% next year to $3.66 and gradually resume for flat 5yrgrowth on average, we still drive a fundamental fair value of $52, which is not far from the current stock price. In short, it seems thatthe fundamentally calculated risk/reward for MCK is at an extremely compelling level.
Steve Castellano Ascendere Associates LLCsteve@ascenderellc.com Page 2quality of the company. We would also point out that McKesson has historically reported EPS and provided guidance thatincludes nonrecurring items -- which provides some justification on valuation on a historical multiple basis.A key quality that is probably not wholly embedded in the current valuation is McKesson's strong management and penchant fordeploying cash in a way that enhances value, whether through dividends, share repurchase or acquisitions. The company has$3.4b cash and equivalents and about $2.5b in total debt. From McKesson's track record, it's a believable statement when CEOJohn Hammergren states in the latest conference call transcribed by Seeking Alpha:
"...We’ve built a track record and if we choose to deploy any of our capital in acquisitions I
would hope to do so intelligently and in a way that creates more value than a share repurchasewould create for us.
So I think you’d find that we would look to the businesses that we’re in today and we bringsome knowledge. We bring some synergy. It’s unlikely that we will buy companie
s that our
shareholders could buy and we can’t add any value beyond what you could add to them to hold
them independently."Typically, acquisitions obfuscate ROIC trends by setting a lower base upon which new cash flow growth can be measuredagainst. However, despite recent acquisitions (such as the McQueary Bros. Drug Company for $190m in April 2008 andOncology Therapeutics Network Corporation for $575m in October 2007 and Per-Se Technologies in November 2006 for $1.6b)McKesson has a good track record of continuing to grow cash flow and ROIC over these periods. This is in part helped by theoccasional sale of noncore operations and, from an accounting ROIC point of view, making large repurchases of its stock. MCKseems to manage its cash flows and balance sheet to drive growth in an economically value-added and accounting value-addedmanner.
Valuation Summary
We have chosen 3 different scenarios in which to value McKesson. Numerous underlying factors can be summarized in the long-term earnings growth rates on a 8.5% WACC and 2% terminal growth rate -- 9.3%, 4.8% and essentially 0%.These various scenarios justify multiples of 19.9x, 16.2x and 12.7x on consensus EPS for the fiscal year ended March. Assigning a20% probability to flat-long-term growth ($52 near-term target), 70% to 4.8% long-term growth ($75 12-month target) and 10%to 9.3% growth ($92 12-month target) gets us a price target of $72 -- which is close enough to the $75 price target scenario thatwe truly believe in.Applying a 7.5% WACC (CAPM derived) and 3% terminal growth rate (Fed's estimate for long-term inflation) -- both of which arevery much justifiable -- could drive these price targets $10-20 higher.Furthermore, whether on multiples alone or multiples adjusted for ROIC and earnings growth, MCK shows significant relativevalue. For example, MCK is trading at 6.3x on Enterprise Value to 2010E EBITDA versus 8.5x for a peer average and 12.7xcalendar 2010E EPS versus 15.1x for the group. Even just compared to just the other two major drug distributors, CardinalHealth (15.2x 2010E PE) and Amerisource Bergen (13.7x), MCK is a bargain.This relative valuation comparison is further bolstered when comparing ROIC on a loosely defined basis -- for example, thepharmacy benefit manager Medco trades at 18.7x 2010E EPS with LTM EBITDA/Total Capital at 25.6%. Meanwhile, McKessontrades at 12.7x EPS with LTM EBITDA/Total Capital at a higher 26.2% figure. Granted, MHS estimated earnings growth is severaltimes that of MCK, but the relatively high "ROIC" coupled with a low PE and positive earnings growth makes MCK seem severelyundervalued in comparison.
Ascendere Associates LLC makes no guarantee on the accuracy of the data, estimates, assumptions or forecasts in this report.Investing in MCK or any equity entails a high degree of risk. This report is not a solicitation to buy or sale any securities.
Steve Castellano Ascendere Associates LLCsteve@ascenderellc.com Page 3

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