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Watercolor is by my father, Naum Katsenelson
The Stable Value Stock Is Built To Weather Market Storms
It is hard to say anything about McKesson that we have not said before
- it is a high-quality business with extremely cheap shares.
The pharmaceutical distributor should earn around $15 in 2020 and will
IPO its technology business, which will unlock another $20-30 of value.
McKesson stock is not just cheap - it's incredibly cheap. If we take
the current $127 price and take out $25 for the technology business, we
are paying about $100 for $15 of earnings - less than 7 times.
Each business has an internal business cycle. Sometimes it is linked to
the economy - such businesses are usually called "cyclical." Others
have internal industry dynamics that have nothing to do with the
economy.
McKesson, for example, benefited tremendously when billions of dollars
worth of branded drugs lost their patents and went generic between 2009
and 2015.
This wave of profitability impacted McKesson shares. Increased
profitability of generics brought new, smaller competition in the
generics space, attracted by a larger profit pie. The competitive
dynamics of drug distributors had not really changed much, but McKesson
and other distributors were overearning - their margins were too high.
Growing revenues and expanding margins resulted in tremendous earnings
growth, which brought "growthy" investors into McKesson's shareholder
base. As the generics wave sagged, McKesson's margins declined to
their normal level and so did earnings. These new shareholders fled,
driving the stock down.
That is when we bought the stock. Since then the market has new worries
about the stock. One is that Amazon.com is entering the drug
distribution business. We wrote about this non-threat earlier this year,
so we won't go into here. A second perceived threat to McKesson and
other drug distributors is political. The White House is attacking the
archaic way drugs are priced in the U.S. - and rightfully so.
Here is a brief summary of the issue. Let's say Pfizer brings a new
drug to market. Its list wholesale price is $100. Pharmacy benefit
management companies "negotiate" the price down to $60. A lot of dirty,
nontransparent things happen in the interim with rebates. We are not
going to go into that discussion, but there is a reason why we don't
own shares of pharmacy benefit management companies.
No insurer or consumer pays list price - well, kind of. The list price
doesn't matter much when many consumers have perhaps a $20 copay for
any drug and don't have health savings accounts (HSA) or
high-deductible copays that are tied to the $100 (inflated) price, not
the real $60 price. That $100 list price is under attack.
McKesson and other distributors are paid a fee by Pfizer to distribute
the new drug, based on the $100 price. Pfizer pays McKesson a 4% fee on
the $100, that is, $4. But political winds are now blowing against this
ambiguous drug industry pricing. Mr. Market is concerned about what
happens to the $4 if McKesson's fee will now be tied to the $60 price
instead of $100: Will the fee drop to $2.40?
To answer this question, we have to look at history, back to 2001. At
that time, branded manufacturers paid drug distributors for their
services by allowing the distributors to buy drugs before price
increases went into effect. If Pfizer were going to raise a drug's
price by 4% next month, for example, it would sell the drug to McKesson
for $100 today, and McKesson would hold it for a month and realize a $4
profit when it sold it to pharmacies for $104 a month later.
This arrangement worked well until a few drug companies started to abuse
the system by stuffing drug distributors' channels with too many
drugs. Let me explain the process: Let's say normal quarterly demand
for Bristol-Myers Squibb's Plavix is 5 million scripts. At $100 a
script that's $500 million in revenue a quarter. Now let's say that
in one quarter sales of BMY's other drugs fell $500 million short of
what BMY promised (guided) Wall Street.
So, instead of "disappointing" Wall Street, Bristol-Myers Squibb would
send 5 million extra doses of Plavix to distributors, stuffing
distributors' inventories but reaping an extra $500 million in sales
on shipment. Distributors were happy to oblige, because BMY kept raising
prices twice a year, and thus the larger inventory meant higher
profitability. The problem is that by sending the extra 5 million doses,
BMY borrowed from future demand. Distributors would participate in this
game for a few quarters, but drugs are not fine wine - they don't
get better with age. If distributors buy too much Plavix, they run a
risk of holding expired pills. So, after a few quarters, distributors
would stop buying Plavix, causing its sales to fall off the cliff.
In 2004 Bristol-Myers Squibb paid a $150 million fine
for stuffing
distributors' channels with $1.5 billion worth of drugs, and the
pharmaceutical industry was forced to change how it pays for drug
distribution.
As things now stand, pharma companies need distributors, but pharma
companies lack the scale to distribute their drugs to thousands of
pharmacies. Also, logistics and distribution lie far outside their core
expertise. I remember in mid-2000 there was a lot of uncertainty about
how distributors were going to get paid. At the time I recall our firm
owned McKesson's competitor Cardinal Health in our portfolio. It all
worked out: pharma companies started to pay distributors a "fee for
service." In other words, how the $4 fee was computed changed, but the
$4 did not.
There's no reason to believe that this time will be different - the
service that distributors provide is as important today as it was then,
and the industry's structure has not changed, either - three
distributors control over 90% of the market.
The overhang from Washington on wholesale pricing does create
uncertainty, and the math of how the industry comes up with that $4 is
problematic, but it is unlikely to turn into a number less than $4.
Let's not stop there. Let's assume that this time is different.
Let's assume that $4 goes to a lower number. What impact would that
have on a drug distributor? About 70% of McKesson's revenue comes from
branded drugs, but these have lower margins than generic drugs and thus
bring only around 30% of profits. So, if $4 goes to $2.40, then
McKesson's earnings would decline about 18%, from $15 to around $12.
This worst-case, low-probability scenario reduces McKesson's earnings
power and thus its fair value from $250 to $200. Which brings us to the
essence of value investing: heads we win, tails we get less, but we
still win.
Digital Painting is by my brother Alex Katsenelson
Netrebko & Garanca
I wanted to share with you an aria from opera Lakme by French composer
Leo Delibes. Ironically it is known as British Airways' theme song. It
is sung by two of my favorite sopranos Anna Netrebko from Russia and
Elina Garanca from Latvia. I have to be honest, I am not sure I am very
objective in judging their voices, as I am probably smitten by their
beauty. I take it back, their voices are simply incredible.
Click here to listen
**Vitaliy Katsenelson, CFA**
Student of Life
I am the CEO at IMA, which is anything but your average investment firm.
(Why? Get our company brochure here
, or simply visit our website
).
In a brief moment of senility, Forbes magazine called me "the new
Benjamin Graham."
I've written two books on investing, which
were published by John Wiley & Sons and have been translated into eight
languages. (I'm working on a third - you can read a chapter from it,
titled "The 6 Commandments of Value Investing" here
).
And if you prefer listening, audio versions of my articles are published
weekly at investor.fm .
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