McKesson Is Deeply Discounted

Despite the tumult that has engulfed its operating environment, we believe

While we believe there may be some material changes in how the U.S. pharmaceutical market operates over the next several years, the need to source and deliver drugs efficiently and cost-effectively will not change. We believe this fundamental factor has formed a strong foundation for McKesson, as its core drug wholesaling operations will be needed by both drug manufacturers and retail pharmacies no matter how any market dynamics shift.

McKesson’s management reported that it has moved the portion of branded contract compensation tied to a variable gross pricing component to 5% from 10%. We think this development is highly positive and positions McKesson advantageously, since we expect the growth in branded gross pricing to remain well below historical norms over the foreseeable future. Most of the company’s branded manufacturer compensation is fixed-fee arrangements, and we believe the remaining variable balance will eventually migrate to this structure. From our perspective, this dynamic will add more stability to drug distributors' results and help McKesson better manage its branded services.

Branded pricing and reformulating how manufacturers approach price-setting remain top of mind for investors. There is a fear that branded manufacturers will slow the growth or be mandated to revamp their pricing strategies, which could affect the profit profile of drug distributors. However, we believe any major overhaul will be gradual, given the complexity of the pharmaceutical market. Additionally, if there were to be a set standard price, or discount for all branded buyers, the overall costs of these products would probably increase, since manufacturers would be motivated to set a higher standard initial price or institute only a minuscule discount for all buyers, from our perspective.

McKesson’s international operations remain a major pain point, and the company reported it is still in the process of restructuring its overseas businesses. In particular, the company’s U.K. operations remain challenged as the centralized government instituted greater-than-expected pharmacy reimbursement cuts. Accordingly, McKesson has sought to close underperforming pharmacies and revamp its overall cost structure in the region. While the company’s international operations have been a material drag over the past several quarters, we believe the generic purchasing volume gained through the acquisition of Celesio was necessary and gives McKesson the ability to leverage lower generic product pricing throughout its entire business.

Large Market Share Is Key Advantage We believe the three major pharmaceutical distributors possess wide economic moats, as they are able to turn their significant market share into key competitive advantages. Each distributor also plays a critical role between manufacturers and retail outlets, solidifying long-term outsize returns. According to the Centers for Medicare & Medicaid Services, the estimated total amount of retail pharmaceutical spending in the United States is close to $400 billion. The majority of this spending flows through the operations of the major three pharmaceutical distributors. This dominance allows key market variables to develop that drive robust and sustainable economic profits for these players.

We estimate AmerisourceBergen ABC, Cardinal Health CAH, and McKesson have a combined market share of approximately 90%. Combining this dynamic with slim industry profits keeps new entrants at bay. A new player would have a tough time carving out enough share to efficiently leverage its distribution assets into positive economic profits. This dynamic solidifies the long-term competitive position of the major three drug distributors. These companies are also able to obtain deep pricing discounts from drug manufacturers that many of their customers cannot acquire on their own. This dynamic makes these players an essential cog in the pharmaceutical industry.

More critically, McKesson's colossal distribution operations allow the company to build excellent asset efficiency. Effective route density, efficient warehousing infrastructure, and unparalleled logistical expertise have driven decent asset returns. However, the ability to effectively manage its capital base is the true driver of outsize returns for McKesson. The company is able to produce top-tier asset turns, cash conversion, and inventory management metrics that have led to outsize returns on invested capital, a trend we believe will last over the next several years.