McKesson's Promising Prognosis

S&P says the health-care distribution giant will reap above-average earnings growth and control costs. It has S&P's highest rating

In terms of annual revenue, McKesson (MCK) is the No. 1 pharmaceutical distributor in the U.S., Canada, and Mexico, the largest health-care IT provider, and the largest distributor of medical-surgical products to physicians and extended care markets. We believe that by leveraging its leading position in these markets to enhance "one-stop shopping" and increase cross-selling, the health-care distribution giant will continue to penetrate its core customer markets and generate above-average revenue and earnings growth.

We think that McKesson will continue to post above-average revenue and earnings growth over the next three to five years, at least, on rising demand for drugs and health-care IT products, and services and cost controls. Given our view of the health-care distributor's promising growth prospects and its compelling valuation, we have a 5-STARS (strong buy) recommendation on the shares.

Beginning in fiscal 2008 (ending March), McKesson will report its results in two segments. The McKesson Distribution Solutions segment will include what was previously reported as the company's Pharmaceutical Solutions and Medical-Surgical Solutions units. The McKesson Technology Solutions segment will include the company's Provider Technologies unit and its Payor business, which provides services and software products to payors (e.g., health insurers), employers, and government organizations to help manage the cost and quality of care. (Our earnings model utilizes pro forma fiscal 2006 and fiscal 2007 income statements reflecting the new segment breakdown, as provided by McKesson from a recent 8-K filing, but adjusted for nonrecurring items.)

The McKesson Distribution Solutions segment (98% of total revenues in fiscal 2007) is a leading distributor of branded and generic drugs, medical-surgical supplies and equipment, and health and beauty care products throughout North America. This business also provides medical management and specialty pharmaceutical solutions for biotech and pharmaceutical manufacturers as well as software and consulting and outsourcing services to pharmacies. Through McKesson's investment in Parata Systems, it sells automated pharmaceutical dispensing systems for retail pharmacies.

Overseas Opportunities

We expect revenues and operating margins to expand at the McKesson Distribution Solutions segment, fueled by the company's concentration on the relatively faster-growing, higher-margin products and services in both pharmaceutical and medical-surgical distribution. In particular, segment revenues will benefit from the slew of new generic and specialty drugs that we foresee, as well as increasing enrollment in the Medicare Prescription Drug Program and higher penetration of Mexico and Canada. Margins should improve on cost controls and, in our view, generic drug volumes rising as a percentage of sales.

The McKesson Technology Solutions segment (2%) delivers enterprise-wide patient-care, clinical, financial, supply-chain, and strategic-management software solutions; pharmacy automation for hospitals; and connectivity, outsourcing, and other services, to health-care organizations in the U.S., Canada, the U.K., Ireland, France, the Netherlands, Australia, New Zealand, and Israel. Its customers include hospitals, physicians, home-care providers, retail pharmacies, and payors.

Revenues will grow at the McKesson Technology Solutions segment, propelled mainly by strong demand for its high-margin clinical software and medical imaging solutions. We also see impetus from federal government initiatives to convert all medical records to electronic form, hospitals' efforts to cut medical errors, and providers' and payors' interest in improving operating efficiency and reducing administrative costs. Moreover, we expect the segment to enjoy healthy growth not only in the U.S., but also overseas, and view the strong demand for its products and services as sustainable through at least the next three to five years. Segment revenue and earnings should continue to grow faster than those of the company as a whole, by our analysis.

Better Mix of Products

We look for total revenue growth of 7.3% in fiscal 2008, following fiscal 2007's 6.9% increase, with top-line growth accelerating on a quarterly basis. Significant generic drug launches and continuing healthy increases in medical-surgical sales to the alternate site market are key parts of this growth. (McKesson defines the alternate site market as consisting of physician offices, surgery centers, occupational health, home care, and extended care, which are benefiting from the migration of care and procedures out of the hospital.) In addition, we see a boost in Technology Solutions sales, on both the Per-Se Technologies acquisition (see below) and strong organic growth.

We project company-wide operating margins to continue to widen gradually over the longer term, partly on an improving product mix and cost controls in Distribution Solutions. Key drivers in this improving performance are: increased sales of generics and private-label products; McKesson's intention to increase international product sourcing and product development; the September, 2006, divestiture of the underperforming acute care medical-surgical distribution business; and an ongoing Six Sigma operating efficiency program.

Also, we look for the high-margin Technology Solutions segment to grow as a percentage of total revenue. For fiscal 2008 and fiscal 2009, we expect margins to benefit from synergies realized from the integration of Per-Se. We believe the segment's operating margin would be even wider, if not for McKesson's intention to increase R&D and sales and marketing spending, which we view as investments for long-term performance.

All told, we look for fiscal 2008 operating EPS to grow 17.5% to $3.35, and expect the March (or fourth) quarter to exhibit the strongest performance in fiscal 2008, partly owing to the timing of generics launches. In fiscal 2009, we see EPS of $3.85, representing growth of 15%.

Few Takeover Prospects

Operating and free cash flow will remain healthy, by our analysis, given the fewer working capital and capital expenditure requirements. That said, over the longer term, we believe McKesson will be able to sustain double-digit EPS growth, as we expect capital to continue to be deployed toward share repurchases. According to the company, 10 million of 36 million options outstanding are set to expire in the next two years, 9 million of which are out of the money, and new issuances are minor. Hence, in the years ahead, EPS leverage from the repurchases will expand as the stock option overhang declines, we believe.

Our earnings model excludes future acquisitions, which we think will remain necessary for McKesson to remain competitive in its core distribution and IT businesses. Still, given the consolidation that has already occurred within the "pure play" pharmaceutical distribution market and McKesson's already-nationwide footprint, we believe it has few domestic takeover prospects in this space. The company's last significant acquisition of a pharmaceutical distributor was that of D&K Healthcare Resources in August, 2005, which enabled it to penetrate the Midwest and South.

However, we think McKesson will continue to look for acquisitions that improve the service capabilities of its pharmaceutical distribution business. We also expect it to continue to seek prospects in the very fragmented medical-surgical distribution market, following its early fiscal 2007 purchase of Sterling Medical Services, a national distributor of medical supplies and health management services to the home-care market.

Given the Technology Solutions segment's rapidly growing impact on companywide revenue and earnings, McKesson will continue to focus particular attention on acquisition prospects in the health-care IT market, in our view. Recent small transactions include the May, 2006, acquisition of HealthCom Partners, a provider of patient billing solutions, and the June, 2006, acquisition of RelayHealth, a provider of online physician-patient communication services. One of its largest transactions in recent years was the January, 2007 acquisition of Per-Se Technologies, a leading provider of financial and administrative health-care solutions for hospitals, physicians, and retail pharmacies, for $1.8 billion. McKesson expects this acquisition will be neutral to marginally dilutive to fiscal 2008 EPS and add to earnings thereafter.

The Stock's Compelling Valuation

McKesson has superior financial flexibility, in our view. While operating cash flow in fiscal 2007 was $1.539 billion, below the $2.738 billion garnered in fiscal 2006, we still view this as a healthy level. The shortfall was mainly due to increases in inventory to support growth and the timing of inventory receipts. The company indicated that it sees operating cash flow in excess of $1 billion in fiscal 2008. Given low working capital requirements, we expect operating cash flow to grow strongly for the next three to five years, while low capital expenditure requirements should help lift free cash flow as well. Moreover, although its gross debt-to-capital ratio expanded to 24% in fiscal 2007, after dropping to 14% in fiscal 2006 from 25% in fiscal 2003, McKesson said that it would be comfortable at a target ratio of 30% to 40%. The company had about $2 billion in cash and cash equivalents as of Mar. 31, 2007.

MCK shares recently traded at 18.5 times our calendar 2007 EPS estimate of $3.22, compared with the S&P 500-stock index's 16.2 times, and the health-care distributor peer average of 19.2 times. We believe the shares should trade at a premium to the S&P 500, as our estimated EPS growth rate of 17.5% for fiscal 2008 exceeds the 7.3% growth in operating earnings that Standard & Poor's expects for the index in calendar 2007. We also believe that McKesson should trade at a premium to peers, based on our view that its fast-growing Technologies Solutions segment has better performance characteristics than the non-distribution businesses of its peers. Our 12-month target price of $79 is based on a projected P/E multiple of 21.5 times, compared with the 20 times we expect for peers (reflecting our favorable view of the health-care distribution group's long-term prospects), applied to our calendar 2008 EPS estimate of $3.68.

Our discounted cash flow model also suggests McKesson's intrinsic value is about $79 a share.

Our target price implies a total return of more than 30% over the next 12 months.

Pricing Challenges

Overall, we believe McKesson meets most of the criteria for good corporate governance. Positive practices we see: There is only one inside director and no affiliated outsiders on the board; only independent directors serve on the audit, compensation, and governance committees; and there is no poison pill in place. However, the board is classified, the positions of chairman and chief executive are combined, and shareholders face significant hurdles in attempting to change company policies.

Risks to our recommendation and target price, in our view, include competitive pricing, the loss of large accounts, resistance to price increases by the company's accounts, unfavorable changes in future contracts with pharmaceutical manufacturers, and unfavorable regulatory changes. In addition, McKesson is a consolidator in the health-care distribution subindustry and, as such, it may face integration risks in future acquisitions.

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