Description

MCK is one of the big 3 drug wholesaler / distribution co's (ABC, MCK, & CAH).  An MCK investment offers protected downside and 20% return upside to a reasonable base case scenario.  MCK trades at a slight discount to CAH (it is in line with ABC) but has underappreciated upside to #'s because of its accretive acquisition of US Oncology and earnings growth from margin recovery in its hospital IT business ("HCIT").  HCIT deserves to trade at a higher multiple than the distribution business and is currently suffering from a cyclical downturn in Hospital CapEx.  There is no current management desire to spin HCIT, although this is an increasing demand of MCK shareholders.  HCIT would be the largest public healthcare IT business, and even if it traded at a discount to better-positioned comps such as CERN and MDRX, achieving a reasonable 9.5x EBITDA multiple would add $3 / share to the MCK price target.

MCK's EBIT growth tailwind should come from:  1)  the accretive USON acquisition, 2)  the strong 2011-2013 generics conversion cycle, and 3) recovery of the HCIT business.  Street estimates are likely too conservative given these tailwinds (see estimates bridge and variance below).  Management is shareholder friendly and tends to guide conservatively (note the summer 2010 ASR and MCK's 5 year tradition of linking bonuses to beating EPS guidance).

The generics cycle benefits all drug distributors as generic EBIT $'s per pill sold can be 3-5x branded EBIT $'s per pill.  Drug distributors get very thin EBIT margins (0.5% to 1.5%) on their branded drug sales to their drugstore customers, but can earn 5-15% margins on generics.  During the exclusivity period (1^st year of generic sales) is when the EBIT $ accretion effect is the highest (price compression from multi-source generic competition has not yet compressed sales $'s by 50%+ per pill).  Distributors continue to earn higher EBIT $'s per pill relative to branded when the drug transitions to a multi-source generic (see transition model below).  It is also relevant to MCK that the 2011 generic conversion schedule is heavily weighted towards specialty (oncology) drugs.  MCK is now a close 2^nd to ABC in specialty drug market share after the U.S. Oncology acquisition.  Because of USON, MCK will show a relatively stronger benefit from this coming generic cycle vs past ones (2008, 2006, 2002).  In the past, drug distributors multiples traded on par with PBM multiples in strong generics cycles (they are now at a significant discount).  The 2.5x EBITDA multiple gap between distributors and PBMs should start to narrow, especially as distributors continue to repurchase shares as they benefit from the freeing of working capital $'s in the transition to higher % generic penetration (could be $1B of extra cash to MCK over the next 2-3 years).

MCK, in particular, should also benefit from a 2011 trend in healthcare of analyst and company reporting towards adjusted EPS #'s (excluding non cash amortization of intangibles resulting from acquisitions).  MCK has hinted that they may switch to this reporting method in 2011 (note that MHS has switched to this approach and receives a 15x multiple on adjusted EPS).  See Lazard's recent note ranking MCK as near the top in divergence between GAAP EPS and adjusted EPS (50c effect).

MCK CEO John Hammergren has hit the tape with significant stock sales recently, but he still has significant underlying options exposure.  Hammergren is shareholder friendly ($1.5B of buybacks in the last 12 months), and he has successfully restored MCK's credibility after its large and extremely overpriced acquisition of HBOC 11 years ago.  Hammergren was facing significant option expirations in 2010 (and tax bills) based on incentive comp awards from his 2001 start as CEO. 

Catalyst