2 Major Trends in McKesson's Favor

Without much fanfare, health care giant McKesson (NYSE: MCK  ) steadily racked up solid gains of 27% over the past year and 67% over the last three years. How did the company achieve these kinds of returns? More importantly, can McKesson keep it up? The answers lie to a large degree in examining the following two major trends powering the company's growth. 

1. Higher profits from generics
McKesson's revenue growth over the past few years isn't too shabby. However, profits grew even faster.

MCK Revenue TTM Chart

MCK Revenue TTM data by YCharts.

A significant factor behind the company's strong profit growth is the increased use of generic drugs. If you have any doubts about how much cheaper generic drugs are compared to brand drugs, simply look at the prescription price index compiled by pharmacy benefits manager Express Scripts (NASDAQ: ESRX  ) .

Source: Express Scripts.

This index measures the relative inflationary impact on brand drugs and generic drugs. The chart shows that brand drugs that cost $100 at the beginning of 2008 cost more than $160 in the third quarter of 2012, while generic drugs that cost $100 in early 2008 cost slightly over $60 at the end of the period shown. This gap represents a 100% price differential between brand and generic drugs.  

Deflation in generic drug costs stemmed from the so-called patent cliff. Many brand drugs with large sales volumes lost patent protection over the past few years. As more generic drugs came on the market, McKesson (and PBMs such as Express Scripts) benefited from improved profit margins.

Will this trend continue? Yes and no. I wrote several weeks ago that the patent cliff is facing its own cliff. Fewer drugs will go off patent over the next few years than in recent history. 

Source: Medco Health Solutions, Express Scripts.

2013 will see a definite fall-off in the number of high-sales drugs going off patent. However, we should note a couple of things. First, the years from 2014 through 2016 will bring a temporary resurgence in new generics. Also, even as the trend wanes, companies like McKesson will continue to reap the rewards from the accumulated effects of the large number of generic drugs on the market. The generic trend should remain squarely in McKesson's favor.

2. Regulatory changes
McKesson's distribution of pharmaceuticals and health-care supplies accounts for 97% of its total revenue, while its technology solutions segment makes up only 3%. However, profit generation is another story. Technology solutions brings in a significant 23% of total gross profit.

 

Source: Company 10Q Report.

McKesson's technology solutions business segment has benefited from the growing amount of changes in health-care regulations in the U.S. over the last several years.  The Health Information Technology for Economic and Clinical Health Act of 2009, commonly referred to as HITECH, ushered in a new world for health-care providers.

Some of the most significant changes involved financial incentives for providers to use electronic health systems that were certified. These incentives spurred many providers to adopt new technology, which helped boost sales for McKesson and rivals including AllScripts (NASDAQ: MDRX  ) and Cerner (NASDAQ: CERN  ) .

With the biggest boom of adoption of certified systems now in the rearview mirror, can McKesson continue to profit from the trend of increased regulation? Yes, because more regulatory changes are on the horizon.

The emergence of new payment models could present the best opportunity for McKesson to capitalize on this trend. McKesson appears positioned to be a leader, along with a few other companies such as MedAssets (NASDAQ: MDAS  ) , in a relatively new reimbursement method called bundled payments. They involve paying providers for an entire episode of care that spans multiple care settings rather than for each service performed.

While the concept of bundled payments is still evolving, I look for it to gain increasing traction because of its potential to control total costs. With its strong revenue management expertise, McKesson should experience continued growth in its technology solutions segment.

Friend of the trends
Investors can profit by picking companies that stand to benefit from favorable trends. McKesson, in my view, is one of those companies. It seems unlikely that either of the two trends discussed above will die down over the next few years.

McKesson trades at a forward price-to-earnings ratio of 12.5. That multiple is near the low end of its P/E range over the last five years. My projection is that the stock will continue the solid pace of gains experienced recently. These trends could be your friends.

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