Distributing Health
In the intricate web of the global economy, the healthcare supply chain and pharmaceutical distribution sector play a crucial yet understated role. This sector, operating away from the spotlight, forms the backbone of healthcare delivery, ensuring the steady flow of medicines and medical supplies. Its importance, though not always prominently featured, is affirmed by consistent growth and resilience, indicative of its foundational place in the healthcare system.
Central to the sector’s relevance is its capacity for adaptation, rooted in a nuanced understanding of the complex healthcare environment. The integration of technologies like health information systems and efficient logistics, while not always conspicuous, has significantly improved the distribution and management of pharmaceuticals and healthcare supplies. This quiet revolution has subtly enhanced operational efficiencies across the healthcare spectrum.
With a blend of technological advancement and practical expertise, the sector is poised for steady growth. We will present a leading company in the pharmaceutical distribution industry, but first, let’s delve into a short update on the economy and markets, and the Smart Investor calendar.
Economy and Markets: Looking Forward
There are several important reports scheduled to be published in the next few days.
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Later today, the Bureau of Labor Statistics will publish November’s Producer Price Index (PPI) report, which reflects input prices for producers and manufacturers. Since PPI measures the costs of producing consumer goods, which directly affects retail pricing, PPI is seen as a good pre-indicator of inflationary pressures, i.e., a leading indicator for the next month’s CPI. Thus, the PPI serves the policymakers in shaping their overall inflation outlook.
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On Thursday, the U.S. Census Bureau will release November’s Retail Sales data. This report provides information on how much money consumers are spending on various durable and non-durable goods. Since the report tracks the amount of spending in an economy, it helps to gauge the economy’s health and consumer spending habits, as well as the level of the buy-side inflation pressures.
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On Friday, we will receive the preliminary readings on December’s S&P Global Manufacturing PMI and Services PMI reports. The Manufacturing PMI captures business conditions in the manufacturing sector, which contributes a significant part of total GDP; thus, the manufacturing PMI is an important indicator of business conditions and the overall economic condition in the U.S. Services PMI captures business conditions in the services sector; it is a crucial indicator since the services sector is responsible for almost 80% of total U.S. GDP. PMI indices are leading economic indicators used by economists and analysts to gain timely insights into changing economic conditions since the direction and rate of change in the PMIs usually precede changes in the overall economy.
As for the stock calendar, the Q3 2023 earnings season for Smart Investor Portfolio companies has ended, but there are still companies whose reporting schedule is shaped differently. Thus, Accenture (ACN) is scheduled to report its fiscal Q1 2024 this week.
The ex-dividend dates for Wesco International (WCC), Taiwan Semiconductor (TSM), Textron (TXT), Amphenol (APH), and Broadcom (AVGO) are coming in the next several days.
Today, we are adding the stock of the largest pharmaceutical distributor in North America, featuring strong cash-generation ability, great growth prospects, and unwavering alignment with shareholder interests.
To make room for this valuable addition, we are letting go of a healthy and profitable company, whose stock is expected to continue being pressured by a cyclical weakness in its end-markets.
New Addition: McKesson Corporation (MCK)
McKesson Corp. is a global leader in healthcare supplies, retail pharmacy, and pharmaceutical distribution. The company distributes pharmaceuticals and provides health information technology, medical supplies, and care management tools in the U.S. and internationally. Through its retail subsidiary franchise Health Mart, McKesson runs the fourth-largest pharmacy chain in the U.S. The company is also the nation’s largest drug distributor, delivering a third of all pharmaceuticals used in North America.
The company was founded in New York in 1828 as an importer and wholesaler of botanical drugs. It grew and expanded through the years, establishing the first-ever nationwide wholesale pharmaceutical drug distribution network and by the 1960s becoming the largest U.S. distributor of wholesale pharmaceutical drugs, beverages, and chemicals.
Since the 1990s, McKesson has expanded its business beyond pharmaceutical distribution, as well as its geographical presence, through numerous acquisitions and strategic joint ventures. One of the most important such ventures was the establishment of a joint venture between McKesson’s U.S. Oncology Research and HCA Healthcare’s Sarah Cannon Research Institute to transform oncology research, accelerate drug development, and increase availability and access to clinical trials in the community setting. McKesson’s most notable recent acquisition is a buyout of a pharma-tech firm Rx Savings Solutions for $875 million in September 2022.
In addition, the company has established McKesson Ventures, a venture capital fund investing in healthcare technology and services startups. This establishment aligns with McKesson’s innovation drive, seen throughout its history. The company was an early adopter of technologies like bar-code scanning for distribution, pharmacy robotics, and RFID (radiofrequency) tags.
Thanks to its extensive network infrastructure for the health care industry, during the Covid-19 pandemic McKesson was the U.S. government’s key centralized distributor of vaccines, delivering hundreds of millions of Covid -19 vaccine doses and ancillary supply kits. The company, through its European subsidiary, served as one of the major distributors of Covid-19 vaccines in several European countries.
Today, McKesson ranks as #9 on the Fortune 500 list of the largest U.S. companies by revenue. In fiscal 2023, the company reported an annual revenue of $277 billion. It commands a market capitalization of $61.5 billion and a workforce of 48,000 employees in the U.S., Canada, the U.K., and Europe.
McKesson operates through four segments: U.S. Pharmaceutical, Prescription Technology Solutions, Medical-Surgical Solutions, and McKesson International.
The U.S. Pharmaceutical segment distributes branded, generic, specialty, biosimilar, and over-the-counter drugs and other healthcare-related products in the United States. The segment also provides management, technology, clinical support, and business solutions to community-based oncology and other specialty practices; it also sells financial, operational, and clinical solutions to pharmacies, and provides consulting, outsourcing, technological, and other services.
The Prescription Technology Solutions (RxTS) segment helps solve medication access, affordability, and adherence challenges for patients by connecting patients, pharmacies, providers, pharmacy benefit managers, health plans, and biopharma companies. The segment offers prescription price transparency, benefit insights, dispensing support services, third-party logistics, and wholesale distribution support. It has been “a key catalyst for McKesson’s revenue and profit growth in recent years, exhibiting margins much greater than the traditional pharmaceutical distribution operations,” according to Fitch Ratings.
The Medical-Surgical Solutions segment provides medical-surgical supply distribution, logistics, and other services to healthcare providers, including physician offices, surgery centers, nursing homes, hospital reference labs, and home healthcare agencies. The segment offers more than 285,000 branded medical-surgical products, as well as McKesson’s own line of products, through a network of distribution centers in the U.S.
The International segment offers distribution and services to wholesale, institutional, and retail customers in Europe and Canada. However, in 2021, McKesson announced its intention to exit the European market and began the process of divesting its European business, which accounted for about 10% of revenues but was unprofitable on the bottom line. In contrast to its leading U.S. and Canadian market positions, the company held a relatively tiny market share on the continent, making it harder to compete with local distributors.
McKesson holds a commanding position in the healthcare supply chain and pharmaceutical distribution sectors in North America, underpinned by a strong focus on technological innovation and partnerships, enhancing efficiency and effectiveness in healthcare delivery. The company’s seemingly simple drug-delivery business is not easy to replicate, as the handling of tightly regulated medications and adherence to strict deadlines of transportation of sensitive products, requires seamless logistics and management framework, which present high entry barriers to potential competitors.
While it doesn’t produce drugs, McKesson capitalizes on the ever-growing demand for medicines. The accent of weight-loss drugs such as Eli Lilly’s (LLY) Mounjaro and Novo Nordisk’s (NVO) Ozempic has already substantially increased the volumes of drugs delivered by MCK and is expected to propel them significantly higher in the coming years. Thus, MCK emerges as an indirect, but nonetheless significant benefactor of the pharma industry’s advance, without the risks of the costly and uncertain development process.
In addition, McKesson benefits from an ongoing surge in demand for generic drugs, which are a higher-margin business despite their lower tag. MCK’s generic sourcing joint venture with Walmart (WMT), ClarusONE, has delivered an increasingly larger contribution to the company’s top line in recent quarters.
McKesson’s financial health would be stellar, if not for its heavy debt load. Although the company has significantly reduced its debt in recent years, it remains very high, with the net debt amounting to $4.8 billion at the end of the latest reported quarter. However, the debt is well-covered by operating cash flow, while the interest payments are covered by EBIT many times over.
Besides, McKesson’s debt is highly rated by the global credit rating agencies, underscoring the company’s ability to easily manage its liabilities: it carries a rating of “A-“at Fitch, “BBB+” at Standard & Poor’s, and “Baa1” at Moody’s. While S&P and Moody’s assign the company’s debt the second-highest notch within the rating scale, Fitch has upgraded it in May 2023 to the top rating level “based on MCK’s significantly improved leverage and business profile over the past five years.” In addition, the rating upgrade was supported by the company’s divesting from its European operations, which is expected to increase profitability and reduce business risks.
Particularly, Fitch applauded McKesson’s stable operating profile, supporting “consistent cash generation and solid liquidity,” as well as its leading market position “in the pharmaceutical and non-acute care medical distribution industries, including specialty pharmaceuticals, in the U.S. and Canada.” In addition, the agency said that MCK’s “leverage and business risk profile declined significantly over the past five years, reflecting the repayment of maturities of long-term debt.” Fitch added that “the streamlining of MCK’s business portfolio and increase in its focus on oncology and biopharma services by leveraging existing strengths or through selective tuck-in acquisitions are expected to enhance margins and cash flows while limiting significant business and financial risks.”
As for capital efficiency, McKesson features industry-beating metrics. While the Return on Equity (ROE) metric is irrelevant due to the high debt level, its Return on Assets (ROA) of 5.5% is much higher than the average for its peers, while its Return on Invested Capital (ROIC) of 19.5 position the company in the top 10% of its industry.
The company’s robust profitability is reflected in its cash generation way more than in its margins. The pharma distribution is a low-margin business overall, and MCK’s net profit margin of ~1.5% is in line with its peer average. But low margins don’t stop the company from generating vast amounts of cash from operations: thus, it ended its fiscal 2023 with $5.2 billion in cash flow from operations, a 16.5% increase from the previous year, and $4.5 billion in free cash flow, an increase of 11% year-on-year.
On November 1, 2023, McKesson reported its fiscal Q2 2024 (ended September 30, 2023), a fourth consecutive quarter in which it surpassed analysts’ revenue and earnings-per-share estimates. In FQ2, revenue rose by 10% year-on-year, primarily driven by growth in the U.S. Pharmaceutical segment which resulted from increased volumes, as well as by a strong growth in the Prescription Technology Solutions segment. Medical-Surgical Solutions segment’s revenues were flat year-on-year because of a significantly lower demand for Covid-19 vaccines and kits.
The ongoing divestitures of the company’s European business weighed on the International segment revenues, which declined compared to the previous year; however, the exit from Europe is expected to strengthen the bottom lines after the company completes the process. Adjusted EPS rose by 3% year-over-year in FQ2, following three quarters of double-digit growth. Slower earnings-per-share growth was mainly attributed to pre-tax losses of approximately $10 million associated with McKesson Ventures’ equity investments. All-in-all, revenue and EPS growth in the quarter are quite commendable given the weakness of the International segment and the absence of Covid-19 income.
Following better-than-expected fiscal H1 2024, McKesson’s management lifted its full-year fiscal 2024 revenue and adjusted EPS guidance. The company now expects revenues to grow 8-12% year-over-year, versus the previous outlook of 7-12% increase. FY 2024 earnings-per-share estimate was increased from $26.55-$27.35 to $26.80-$27.40.
Despite the company’s size and market reach, its stock has been largely flying under the investors’ radar. Despite that, its performance has been stellar, especially given that MCK belongs to an industry associated with stability, and not so much with high growth rates. In the past three years, McKesson’s stock has risen by 165%, far outpacing VanEck Pharmaceutical ETF’s (PPH) 20% gain. More recently, MCK shares have registered stable, uninterrupted growth from their recent lows in March 2023, resulting in a 12-month gain of 22%. That, compared with PPH’s very volatile ride in the same period, which left the ETF with just a 1% increase, despite its large holdings of high-flying weight-loss drug producers LLY and NVO.
Notwithstanding its strong stock outperformance, MCK is still trading at modest valuations. Its TTM P/E of 18.2 and a Forward P/E of 19.6 represent 40% and 30% discounts to the Healthcare sector’s averages. McKesson trades at the bottom of the price range for its industry peers, and, given its robust earnings and cash flows, its current price is much lower than its fair value.
After stellar FQ2 results, analysts from JP Morgan, Robert W. Baird, Morgan Stanley, and others have lifted their price targets for McKesson’s stock. TipRanks-scored top Wall Street analysts see an additional upside of 7.3% for the stock in the next 12 months; given its strong fundamentals and performance, it may well surprise on the upside.
McKesson Corp. carries a TipRanks Smart Score rating of 9/10 (“Outperform”) with a “Strong Buy” recommendation:
In addition to stock price appreciation, MCK’s shareholders are rewarded through dividend payments, distributed quarterly since 2009. Although the company’s current dividend yield is a low 0.51%, its more than modest payout ratio of 8.5% and a 15-year history of uninterrupted annual payout increases suggest that McKesson will continue raising its dividends in the years to come.
But the shareholder rewards don’t end with dividends, as McKesson also performs buybacks within its share repurchase authorization. In August 2023, the company approved a $6 billion increase to its existing share repurchase program, bringing its total authorization to nearly $9 billion. During fiscal H1 2024, MCK repurchased $1.5 billion of shares, after FY 2023 buybacks amounting to $3.6 billion.
Given all of the above, we view McKesson Corp.’s stock as a winning combination of quality and income compounded, and as such, a valuable long-term addition to the Smart Investor portfolio.
New Deletion: Axcelis Technologies (ACLS)
Axcelis Technologies, Inc. designs, manufactures, and services ion implantation equipment used in the fabrication of semiconductor chips. The company offers high-current, high-energy, and medium-current ion implanters for various applications in distinct market segments worldwide.
Ion implantation is one of the principal steps in the process of the fabrication of transistors, diodes, resistors, and capacitors, among other components on semiconductor chips. The ion implanter market is very concentrated, with Applied Materials (AMAT), a Smart Portfolio company, holding around 60%, and Axcelis commanding ~30%. In contrast to AMAT, the ACLS product suite is more concentrated on auto chip implanters and industrial/IoT chips. The lion’s share of the company’s revenue growth is attributed to products for silicon-carbide semiconductors (SiCs), used in electric vehicle (EV) production.
While most of the memory chipmakers suffered a strong correction in 2022, auto and industrial chip producers held up well up until September this year, mostly thanks to an outlook for a continued surge in demand as new automobiles and machines require increasing amounts of high technology components. However, the Q3 reporting season reflected the beginning of a correction in the market, as high interest rates are seeping through the economy, depressing demand for big-ticket items from businesses and consumers. In addition, China – one of the most important auto and industrial chip markets – is going through a troubling economic patch, which adds to the market’s uncertainties.
Various companies in the EV, solar, and other industries associated with the demand for industrial chips, reported softening revenues in Q3 and gave weaker outlooks for Q4 and further, confirming the end market’s slowdown. Axcelis itself reported very strong quarterly results in Q3, but its guidance for the fourth quarter included a softer revenue growth outlook.
We still believe that Axcelis, with its perfect financial health, stellar profitability, and outstanding business performance, is positioned to greatly profit from the secular trends of electrification and digitalization in the medium- to long-term timeframe. We view the company as a great long-term investment for those who can outwait the cyclical downturn in auto and industrial chips.However, with the heightened economic uncertainty and the Fed’s monetary tightening still working its way through the economy, while international demand is expected to be depressed, the industrial semiconductor market may encounter strong headwinds in the next quarters. Axcelis may encounter increased stock turbulence because of its modest market capitalization of just over $4 billion, and due to the fact that its share price surged earlier this year, leaving it more vulnerable to sentiment setbacks.
While we may reevaluate the company for reentrance into the Smart Investor portfolio when the dust settles over the auto and industrial chip market, at the moment we prefer to be on the safe side and see it as appropriate to sell the stock.
Charter Members of the 30% Winners Club
*The 30% Winners Club includes stocks from the Smart Investor Portfolio that have risen at least 30% since their purchase dates.
The markets had another winning week, but one of the Club’s members missed the rally. After ORCL reported fiscal second-quarter revenue that fell short of analyst expectations, it tumbled over 12%, falling below the 30% threshold.
We believe that the IT giant will recover eventually, but while we are waiting for its return, our exclusive club’s ranks now include only four stocks: GE, AVGO, ANET, and CDW.
However, there is a lot of action happening below the 30% threshold, with several companies competing for entrance to the Winners Club. This week, the next in line to enter the ranks is Molina Healthcare (MOH) with over 27% gain since purchase. Will it be able to close the gap? Or will the second runner-up, Wesco International (WCC), which has had a stellar run in the past month, outrun it to the finish line?
What’s Next?
Our next commentary will come out on Wednesday, December 20th, before the market opens.
Until then – we wish you a world of investment success!
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Disclaimer
The information contained in this article represents the views and opinions of the writer only, and not the views or opinions of TipRanks or its affiliates and should be considered for informational purposes only. TipRanks makes no warranties about the completeness, accuracy, or reliability of such information. Nothing in this article should be taken as a recommendation or solicitation to purchase or sell securities. Nothing in the article constitutes legal, professional, investment and/or financial advice and/or takes into account the specific needs and/or requirements of an individual, nor does any information in the article constitute a comprehensive or complete statement of the matters or subject discussed therein. TipRanks and its affiliates disclaim all liability or responsibility with respect to the content of the article, and any action taken upon the information in the article is at your own and sole risk. The link to this article does not constitute an endorsement or recommendation by TipRanks or its affiliates. Past performance is not indicative of future results, prices, or performance.
