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.
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.