McKesson: Time To Get More Cautious

seekingalpha04-30

McKesson reported solid third-quarter results, but while revenue increased at a high pace, the bottom line is fluctuating.We can expect the company to grow its top line at least in the mid-single ...

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I did not lose any money, but I missed out on an opportunity I saw, but did not make the investment. In February 2018, I called McKesson one of the cheapest stocks in the market (267% return since then compared to 92% of the S&P 500). And in August 2018, I asked Mr. Market why he was punishing McKesson (the stock was trading for $124 at that point and would have resulted in a 330% return vs. 78% for the S&P 500). And the long term, McKesson clearly outperformed - indicating a wide economic moat. Data by YCharts And I continued to state in some articles that McKesson is undervalued. The last time I pointed this out was in my previous article published in September 2023. In the meantime, McKesson gained another 28% and outperformed the S&P 500 again (14% gain). In my last article, I claimed that McKesson is still trading for a huge discount, but now I see things a little differently, and in the following article I explain why. We start by looking at the last quarterly results. Last Results To be honest, McKesson is missing the stability and consistency in its result I usually want to see from high-quality businesses. And the third quarter results are no exception. At least, revenue is growing at a solid pace and increased from $70,490 million in Q3/23 to $80,898 million in Q3/24 - resulting in 14.8% year-over-year growth. Despite the double-digit top-line growth, operating income declined by 48.3% YoY from $1,241 million in the same quarter last year to $642 million this quarter. And finally, diluted earnings per share declined from $7.66 in Q3/23 to $4.42 in Q3/24 - resulting in a 42.3% YoY decline. McKesson Q3/24 Presentation We can also look at adjusted earnings per share and see more stability. Adjusted earnings per diluted share increased from $6.90 in the same quarter last year to $7.74 this quarter - an increase of 12.2% YoY. When looking at the results for the first nine months of the year, the picture is more or less similar to the third quarter. Revenue increased in the double-digits and adjusted earnings per diluted share increased 13% from $18.78 in the first nine months of 2023 to $21.24 in the first nine months of 2024. Looking at the segments, we see huge differences between the four. The most important segment - at least from a revenue perspective - is the U.S. Pharmaceutical segment, which generated $73,023 million in revenue (and therefore more than 90% of total revenue). But with an operating margin of only 0.42%, this segment has razor-thin margins and generated only $307 million in operating income. From a margin perspective, the most interesting segment for McKesson is Prescription Technology Solutions. In Q3/24, this segment generated $178 million in operating income on only $1,205 million in revenue, resulting in an operating margin of 14.77%. It is not untypical for businesses to have several segments with different operating margins - but in the case of McKesson, this is an extreme range. The other two segments are in-between these two. The International segment generated $3,639 million in revenue and with an operating margin of 3.46% it generated $126 million in operating income. The fourth and final segment is the Medical-Surgical Solutions segment, which generated $3,031 million in revenue and $268 million in operating income, resulting in an operating margin of 8.84%. Outlook Fiscal 2024 In case of McKesson, fiscal 2024 is already over (but fourth quarter results are not published yet). But during the last earnings call, management could already offer a rather narrow range and is expecting adjusted diluted earnings per share to be between $27.25 and $27.65. Not only would this result in about 5% to 7% growth compared to the previous year, but management also raised the range compared to the previous guidance. McKesson Q3/24 Presentation Dividend and Share Buybacks McKesson continues to follow its strategy of a low dividend and aggressive share buybacks. Right now, McKesson is paying a quarterly dividend of $0.62 resulting in an annual dividend of $2.48 and a dividend yield of less than 0.5%. The company increased its dividend with a CAGR of 9.71% in the last five years, but it is still paying out only a small fraction of its earnings. In the last four quarters, McKesson paid out $308 million in dividends and generated a free cash flow of $2,892 million, resulting in a payout ratio slightly above 10%. We should also point out that McKesson increased its dividend for 16 years in a row, but due to the low dividend yield, almost nobody will focus on the dividend or invest in the stock due to the dividend. Data by YCharts Instead, management is focusing on share buybacks. Since March 2014, the company reduced the number of outstanding shares from 233 million to 133 million right now - a decrease of 43% and the company did not start share buybacks before 2016. McKesson JPM Healthcare Conference Presentation And when looking at the long-term financial framework, management will continue its aggressive share buybacks. Capital allocation should contribute about 6% to EPS growth annually, and I assume management is talking about share buybacks here. Growth When looking at the long-term financial framework, about 6% to 8% of growth must stem from organic growth and operating leverage (reducing costs, improving margins). When looking at the last ten years, revenue increased with a CAGR of 8.49% and this would already be enough to reach the target. And growing in the mid-single digits seems likely in the coming years, with top-line growth stemming from the oncology platform and GLP-1 medications. McKesson is constantly trying to expand its oncology platform and also trying to push constantly for higher margins. Recently, the company expanded its footprint with the addition of Nashville Oncology Associates and SCRI Oncology Partners. McKesson JPM Healthcare Conference Presentation Additionally, we can see that certain pharmaceuticals are contributing in a major way. Right now, the success of GLP-1 medications (especially from Novo Nordisk and Eli Lilly) is contributing to overall results. In the third quarter, GLP-1 revenues were $7.5 billion and therefore already responsible for about 10% of total revenue. And compared to the same quarter last year, the revenues from GLP-1 increased about 60%. And although McKesson's management pointed out during the earnings call that growth from GLP-1 might slow down in the fourth quarter, growth in the next few years seems likely. According to a report by Morgan Stanley, sales of GLP-1 medications are expected to be around $80 billion by 2030 (see following chart). Morgan Stanley And McKesson will also try to improve its margins in the years to come, although we see huge fluctuations in the last few years. Gross margin declined in the last ten years; operating margin was more or less stable. But as margins are so low - net profit margin is about 1%, the small fluctuation could have a huge impact. Intrinsic Value Calculation It is interesting to see that other analysts see the stock as overvalued. In my opinion, McKesson could still be deeply undervalued. Let's calculate an intrinsic value for McKesson using a discount cash flow calculation. As always, we calculate with the last reported number of diluted outstanding shares (132.5 million) and a 10% discount rate (as this is the annual return I like to achieve with my investments). Additionally, we take management's long-term target and assume 12% growth for the next ten years. As always, we calculate 6% growth in ten years from now till perpetuity. As a basis for our calculation, we can take the free cash flow of the last ten years ($2,892 million). When calculating with these assumptions, we get an intrinsic value of $833.96 for McKesson. Taking the current share price of $535, this is implying a discount of 36% right now. And now we can discuss how realistic these assumptions are. Free cash flow in the last four quarters was actually below the average of the last few years and can be seen as a very realistic assumption. Data by YCharts Now we can look at the growth rates. I already mentioned above that McKesson is lacking the consistency I usually want to see, and hence growth rates in the past also fluctuated heavily. Nevertheless, in the last ten years, McKesson grew its bottom line with a CAGR of 16.17% making 12% growth for the next 10 years certainly realistic. And looking at past growth rates is certainly important and can tell us a lot about a business, but considering what might be ahead of us (a major correction) I think 12% growth could be a little too optimistic. Despite McKesson having an economic moat around the business and the delivery of pharmaceuticals being important in every economic environment (making the business recession-resilient), I think we should be a little more cautious and maybe assume only growth rates in the high single digits (8-9%) being fully prepared for McKesson to actually decline in the next few years as well. But even when calculating with 8% for the next ten years, we get an intrinsic value of $628.72, and the stock is still a bit undervalued. Sentiment Playing A Role Despite the stock being undervalued from a fundamental point of view, I am still not bullish anymore. When focusing on fundamentals (and the resulting intrinsic value for the stock) we could be bullish, and I am still convinced that in the long run, the performance of a business is driving the stock price of an individual business. But in the mid-term and especially in the short-term, investor sentiment is driving stock prices. Otherwise, it can't be explained why Meta Platforms (META) was trading for only $100 a few quarters ago or McKesson also trading close to $100 a few years ago. And both stocks are now trading for a multiple of that price. Investor sentiment might also be the answer to why some stocks that seem deeply undervalued from a fundamental point of view actually shot higher, while others remain at these low price levels for several quarters or years. We can pick four companies (and stocks) that are (or were deeply) undervalued in the recent past: McKesson, Meta Platforms, Alibaba (BABA), and PayPal (PYPL). When looking for common characteristics, about $50 for PayPal, about $60 for Alibaba and about $100 for Meta Platforms and McKesson were deeply undervalued and unjustified stock prices. But while Meta Platforms and McKesson moved much higher, Alibaba and PayPal are remaining more or less at these depressed levels. All four companies have in common that they were trading at extremely low valuation multiples (low double digits or even single digits). Aside from trading for extremely low valuation multiples, all four are also companies growing at a solid (or rather high) pace. Of course, all struggled a bit when the stock price declined. One of the interesting questions now is: What drove the stock price of Meta Platforms and McKesson higher, and why are Alibaba and PayPal still struggling. The answer (in my opinion): sentiment. In the case of Meta Platforms and McKesson, sentiment among investors changed. And it probably needs a clear sign for investor sentiment to change. It needs a clear sign that growth rates are accelerating again or positive narratives surrounding the company, which make investors more confident again. If a company is just continuing to perform in a similar way as before (for example with similar growth rates), the stock will remain undervalued, and we won't see any sentiment change. Undervaluation alone is probably not enough to drive a stock price higher - the stock might move a little bit higher but will remain deeply undervalued. It needs some kind of catalyst for investor sentiment to change. It probably won't come as a surprise that sentiment changes can work in both ways. When investor sentiment changes in the case of a deeply undervalued stock, the stock might shoot up within just a few quarters, but changing sentiment can also make stocks tumble (even the stocks of companies performing well). In my opinion, we are headed for another major recession/depression making me very cautious about investment in stocks. It is not a surprise that the word depression rather describing a mood or state of mind as an economic depression has a lot to do with the sentiment of investors (by the way, I am not saying that clinical depression is just some kind of mood or that these people have the wrong mindset - to use a common buzzword - as such a statement would be nonsense). Summing Up Although McKesson could still be seen as slightly undervalued right now, I would not argue for an investment at this point - mostly due to two reasons: The stock has run up from about $100 to over $500 and at some point, a correction is likely. Just arguing that a stock has increased 5x and therefore a correction is likely is not very scientific. Nevertheless, stock prices (and asset prices) are always moving in waves and when McKesson is coming close to $600 a correction seems likely as we have the 2.618 Fibonacci extension of the previous upward wave - a realistic target for an upward wave before the next corrective wave will follow (symbolized by my white arrow). Hence, we can argue for the possibility of lower entry prices in the coming months and quarters. McKesson Monthly Chart (Author's work using TradingView)  And not only can we argue for a correction in the case of McKesson, but the risk of the entire stock market also running against the wall and the economy headed for a recession or depression is high. 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