EUR 850.00 For Business Accounts Only

Morningstar | McKesson Reports a Solid Quarter as Potential Shifts in Market Dynamics Take Center Stage

Even though there may be some material changes in how the various parts of 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. Thus, we are reiterating our wide moat rating and our $210 fair value for the drug distributor.

For the first quarter, McKesson reported solid results as gross profit expansion was offset by a moderate increase in centralized costs, with the net result being a slight 5-basis-point decrease in adjusted operating margin to 1.63%. The firm continues to realign its operations and improve its distribution efficiency. We have factored these issues into our outlook as we have modeled operating margin for the firm’s core distribution business to fall for fiscal 2019 to 1.59% from an adjusted 1.96% (0.71% on a GAAP basis) at the end of fiscal 2018. We expect profits to begin to expand beginning in fiscal 2020, but not by a significant amount. We have modeled in drug distribution operating margins to expand moderately to only 1.84% and overall firmwide operating margins to increase to 1.5% by the end of fiscal 2023. We believe this represents a conservative outlook for the firm’s profit expansion efforts.

Branded pricing and the reformulation with how manufacturers approach setting their pricing was a major topic on the earnings call and has been 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, if at all, and the complexity of the pharmaceutical market will likely dictate a slow pace of change. Additionally, if there were to be a set standard price, or discount for all branded buyers, the overall costs of these products would likely 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.

We believe it’s also important for investors to factor in the critical role drug distributors play in the operations of branded manufacturers. The major three wholesalers (AmerisourceBergen, Cardinal Health, McKesson) are essential in the development of an appealing drug, the determination of market demand, product production runs/inventory management, and global distribution. These services are largely compensated through a fixed fee structure and will likely remain so under a scenario where aggregate branded pricing is altered significantly.