McKesson Corporation (NYSE:MCK) along with other pharmaceutical distribution companies such as Cardinal Health and AmerisourceBergen have been under tremendous pressure as of late due to political pressures regarding the pharmaceutical supply chain and drug pricing concerns. I recently wrote an article “McKesson Jumps 34% Off Lows – Now What” stating that the easy money had been made from the ~$150 level to the roughly ~$200 level. I also pointed out that greater than 98% of McKesson’s revenues come from pharmaceutical distribution and services domestically and abroad. Thus any impact to this business model will likely have direct negative implications with regard to revenues and EPS. At the closing of that article I stated that currently, McKesson’s P/E ratio sits at the top of its peer cohort and considering the stock has risen over 34% along with the potential erosion of the middle model, I’d be cautious buying at these levels despite additional upside based on its 52-week high of $240. Now enter the latest EpiPen fiasco and subsequent drug price scrutiny being thrusted into the spotlight. Due to a Tweet by Hillary Clinton regarding her distain for Mylan’s price increase, McKesson saw a $7 per share drop or roughly 4% drop in that same session. Since any disruption in this business model will negatively impact McKesson disproportionally compared to the insurance, pharmacy and pharmacy benefit manager (PBM) companies, I’d avoid McKesson especially after the ~30% move to the upside.
McKesson - Pharmaceutical Supply Chain Complexities
The interplay within pharmaceutical supply chain players can be a challenging dynamic to grasp. McKesson positions itself on the distribution side of the network, essentially serving as an intermediary between the drug manufacturer and the pharmacy. McKesson and other middlemen such as Cardinal Health and AmerisourceBergen purchase drugs directly from the manufacturer and then sell them to the pharmacy and capture the spread between the price they pay (to the drug marker) and the price they sell (to the pharmacy) the drugs. Below is a step-by-step breakdown of the pharmaceutical supply chain steps (Figure 1):
Step #1 – The patient pays co-pay for medication received at the pharmacy
Step #2 – Pharmacy Benefits Manager - PBM (CVS and Express Scripts) reimburses the pharmacy for the medication, PBM accepts a dispensing fee
Step #3 – Insurance companies reimburse the PBM for its members’ drugs
Step #4 – The drug manufactures pays a rebate to the PBM which is subsequently passed onto the insurance company. A portion of the rebate is retained by the PBM
Step #5 – Drug distributor (McKesson, Cardinal Health and AmerisourceBergen) pays the manufacturer in exchange for the drugs while collecting a fee in the process for distributing the drugs to pharmacies
Step #6 – The pharmacy pays the distributor and dispenses the drugs
Figure 1 – Original schematic - adopted from CNBC via Evercore ISI managing director Ross Muken
Is The Model Shifting Away From The Distribution Side?
In a previous article, I wrote that I had growing concerns about the middleman in the pharmaceutical drug supply chain. This is the bread and butter of many companies in this space, notably McKesson, Cardinal Health and AmerisourceBergen. Cardinal Health’s recent earnings report spooked investors as they lowered their full-year guidance albeit reporting top and bottom line beats for the quarter. The middleman model is slowly shifting away from the traditional means of delivering drugs to hospitals and pharmacies. More often than ever hospitals and pharmacies are establishing direct relationships with manufacturers thus buying direct. Manufacturers have increased their use of direct accounts when shortages arise thus disrupting the traditional distribution model long dominated by companies such as AmerisourceBergen, Cardinal Health and McKesson. Some drug makers will intermittently pull their products from distributors when manufacturing issues strain their supply. This action hits distributors particularly hard since they make their money by moving product. Drug distribution companies such as McKesson can continue to add value via consulting, analytics and knowledge surrounding providers’ purchasing habits. Additionally, the number of resources needed to build-out infrastructure in absorbing these duties would place a major constraint on many business models within hospitals and pharmacies.
I don’t think we’ll know the impact of this shift for some time however this is concerning considering McKesson just laid off 1,600 workers throughout the company. This move could be unrelated to the middleman business and more attributable to customer base losses. The company determined “reductions in our workforce would be necessary to align our cost structure with our business model.” Greater than 98% of McKesson’s revenues come from pharmaceutical distribution & services domestically and abroad. Any impact to this business model will likely have direct negative implications with regard to revenues and EPS.
Are McKesson’s Earnings Throughout 2016 A Red Flag?
The most recent quarterly results for Q1 2017 missed revenue by $630 million while revenue was up only 4.6% year-over-year. The quarter prior, Q4 2016, revenue targets were missed as well by $170 million while revenue was up 3.9% year-over-year. Even more, Q3 2016 results missed revenue targets again by $890 million while revenue was up 3.0% year-over-year. Although I’m not accounting for EPS or net profit figures, qualitatively, I’m looking at the overall growth from a total revenue standpoint. This figure cannot be inflated while EPS can artificially be engineered by removing shares via share repurchases. These missed revenue targets are a potential red-flag.
MCK is doing what it can to be well positioned for future growth and success in the growing healthcare space assuming the middleman model remains intact. Despite concerns of the traditional distribution model being challenged, MCK has been highly acquisitive, growing dividends over time and buying back its shares to drive shareholder value. The dividend yield isn’t impressive however the company has plenty of room to increase the payout. Its major acquisitions and partnerships via UDG Healthcare plc, Sainsbury's pharmacies, Vantage Oncology, Biologics, Rexall Health, Albertsons and Wal-Mart position MCK to continue its competitiveness in the marketplace. The recent 1,600 layoffs in concert with three consecutive quarters missing revenue targets, I’d be wary of this stock. Currently, McKesson’s P/E ratio sits at the top of its peer cohort and considering the stock has risen over 34% along with the potential erosion of the middle model, I’d be cautious buying at these levels despite additional upside based on its 52-week high of $240. Since McKesson is lever to any political induced sell-off and/or legislative action within the space I’d avoid the stock at these levels.
INO.com Contributor - Biotech
Disclosure: The author relinquished his position in MCK and has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses.