My investment management firm’s portfolio has a large position in the health-care sector, and with AbbVie’s $63 billion takeover bid for Allergan earlier this week, it’s timely to review why we bought into this sector.
Q1 hedge fund letters, conference, scoops etc
Without commenting on Allergan shares of which we own, or AbbVie which we do not, health care companies in general are noncyclical — health care consumption is stable and independent of the whims of the global economy. The world’s population is aging rapidly, and as people get older they consume more health care services. This creates a strong tailwind.
These are good businesses. In general they have solid balance sheets, above-average returns on capital, and they generate a lot of cash, which is used to pay dividends and buy back stock.
These defensive features have not mattered much lately, as we are entering the 10th year of uninterrupted economic expansion. Accordingly, these companies are significantly undervalued. How undervalued? Let’s answer that question by examining two stocks in our portfolio in closer detail:
McKesson
We’ll start with McKesson. The media (mainly “60 Minutes”) has likened drug distributors’ exposure to opioid lawsuits to Philip Morris International’s $150 billion tobacco settlement. Yet comparing Philip Morris to drug distributors makes no sense. The job of these well-regulated companies is to deliver FDA-approved drugs produced by FDA-approved manufacturers and sold by DEA (Drug Enforcement Administration)-approved pharmacies.
The opioid crisis in the US is a true tragedy, but drug distributors are not responsible for it — an important point to remember when you read another heartbreaking article. The most likely conclusion to this fiasco is that drug distributors will either settle these lawsuits for a few billion dollars collectively (McKesson earns more than $3 billion a year) or they’ll get dismissed by the courts. (A Connecticut judge already dismissed one case).
Wall Street estimates McKesson’s per-share earnings will grow to $18 from $14 over the next three years (our estimates are very similar). McKesson stock is trading at about $130, and in the second of half of 2019 the company will spin off Change Healthcare, in which by our estimate is worth $20-$30 a share. If you take out Change Healthcare, investors are paying around 6-7 times earnings for this stable and still-growing business. McKesson should be trading at 13 to 17 times earnings. We’ll settle for 15 and value McKesson shares at around $250-$300. If this analysis reads like a broken record, it is — despite the additional research we’ve done, our thinking on McKesson has not changed, while the company’s fundamentals have only improved.
Walgreens Boots Alliance
Our initial analysis of Walgreens Boots Alliance projected 3%-5% revenue growth, stable margins, and earnings per share growth of about 7%-8% (helped by share buybacks). The latest quarter has thrown a wrench at these assumptions. Despite growing revenues, reimbursement pressure and the lack of new generic drugs have reduced Walgreens’s pharmaceutical margins. There is a good chance that last quarter’s performance was a bit exaggerated by temporary events, but it is likely that our assumptions of stable margins need a revisit, though we still believe volume will continue to grow as the aging population gulps more drugs.
Over the past few months we have spent a lot of time reanalyzing Walgreens, trying to figure out the worst case for earnings. Walgreens’s U.S. pharmacies historically made about $11.50 to $11.70 of (gross) profit per script filled. The average store filled about 340 scripts per day. In the latest quarter, by our estimate, Walgreens’s gross-profit-per-script declined to $11.20.
In an attempt at “killing” the business we assumed that gross profit per script declines to $9 — a drastic assumption. But even then we could not get Walgreens’s core earnings to less than $5 a share a few years out. At a conservative (no-growth) price-to-earnings of 10 times, Walgreens’s core business is worth about $50 a share. In addition, Walgreens owns 26% of AmerisourceBergen (McKesson’s competitor), which is worth another $5-$10 a share, bringing our worst-case valuation of Walgreens to $55-$60 a share. The stock’s current $52 price is just under our worst-case scenario’s fair value. Any positive development to the company should present upside for the shares.
Moreover, Walgreens’s market share has grown consistently. Walgreens and CVS Health together control almost half of the U.S. retail pharmacy market: Walgreens and CVS market shares are 22% and 24%, respectively. Their stores fill larger volumes of scripts than smaller pharmacies and thus can stay profitable at lower gross-profit-per-script. At $9 gross-profit-per-script (the assumption we used in trying to kill Walgreens stock), smaller (lower-volume) pharmacies will start dropping like flies. It is unlikely that insurance companies and the government want this; but if it happens, Walgreens will be a beneficiary, as its market share will rise at an even faster pace.
Our original expectation that Walgreens will earn $8 in a few years may prove too optimistic. Today the Street is projecting per-share earnings to grow to $6.50 from $6 over the next three years. We are not sure whether the Street is right or wrong, but we don’t totally dismiss the possibility of Walgreens earning $8 a share in a few years.
In our original analysis we valued Walgreens as a growing enterprise and thus gave it a price-to-earnings ratio of 15, so at $8 of earnings per share our fair value was $120. If Walgreens struggles to produce much growth, it will likely trade at 12-13 times earnings — deserving a per-share valuation of around $80.
Walgreens’s CEO, who owns 13% of the stock, and the company’s management are not sitting still. That is why it is dangerous to draw straight lines through the negative articles you read about Walgreens today.
The front end of the store, which occupies 80% of the real estate and generates only 25% of sales, is an underutilized asset. Walgreens is bringing LabCorp into 600 of its stores. It is working with Kroger to bring Kroger’s grocery (and lower pricing) to its stores. Walgreens has a deal with Microsoft to improve its technology. It is working on bringing Boots cosmetics to 3,000 of its stores. Boots dominates the cosmetics market in the U.K. and has its own successful private-label brand.
Yet even Walgreens’s management doesn’t succeed in growing earnings, at today’s stock price we see little downside (no permanent loss of capital).
There is also an upside to the recent setback. First, Walgreens is spending billions of dollars on share buybacks — the recent weakness in the stock is allowing the company to buy more shares. And second, the setback has brought an urgency to the company to improve its front-end store (non-pharmacy) business.
If you looked solely at the recent performance of health-care stocks, you’d think these companies were on the verge of going out of business. Nothing can be further from the truth. These companies are profitable enterprises which generate enormous cash flows that will probably only continue to grow over time.
Read This Before You Buy Your Next Stock
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).
His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”. To receive Vitaliy’s future articles by email or read his articles click here.
