Warren Buffett is an all-time great of Wall Street, so investors perk up when the Oracle of Omaha adds a new position to his portfolio. Medical products distributor McKesson Corporation (MCK -0.76%) became one of Buffett's newest holdings this year; he started a position in the first quarter of 2022 and added to it last quarter.
Buffett's investing strategy emphasizes investing in high-quality companies when they trade below their intrinsic value, what he believes the company is worth. He also likes companies that pay their shareholders, and McKesson has raised its dividend for the past 14 consecutive years. I will dive into McKesson's business and illustrate what compelled Buffett to put his money into the stock.
A pillar of the healthcare industry
Healthcare is one of the world's most complex and fragmented industries; McKesson is a healthcare products distributor whose job is getting vaccines, medical supplies, and other products from manufacturers to the professionals that treat patients. The company does more than $268 billion in annual sales, making it one of the largest companies in the world that most consumers have probably never heard of before.
The company operates four business segments:U.S. Pharmaceutical, Prescription Technology Solutions, Medical-Surgical Solutions, and International.
The U.S. pharmaceutical business is McKesson's bread and butter; it does more than 40 million pharmaceutical deliveries annually, accounting for about 80% of total revenue for the latest fiscal year (ended March 31). It does have an international presence with operations across 14 countries but recently divested its operations in the United Kingdom and Austria, so the company will likely remain U.S.-focused for the foreseeable future.
Identifying McKesson's competitive advantage
A business has multiple ways to maintain an advantage over competitors. For example, you could sell something unique for a lot of money because nobody can copy it. This is common in the pharmaceutical area of healthcare, thanks to patents. But McKesson is just a middleman; it buys products and resells them. You can see in the below chart how $268 billion in sales translates to just $4.6 billion in free cash flow, or 1.5%. In other words, the company earns just over one penny in cash for every dollar of product it sells. That's the definition of razor-thin profit margins.
MCK Revenue (TTM) data by YCharts.
But this isn't necessarily bad; McKesson is so big that it can buy products from manufacturers at lower prices than its competitors and resell them at lower prices. The thin margins you see leave no room for a competitor to come in and undercut their prices. The company's been around since the 1800s; it's mastered the game it plays.
Additionally, the company pays a dividend, which means income for investors holding shares. The company is paying $2.16 per share, a 0.61% dividend yield at the current share price. That's not going to cover your living expenses, but it's a payout that grows. The company's most recent raise was 15%, and growth has averaged 10.9% annually over the past five years. The dividend payout ratio is just 6% of McKesson's cash flow, so there is plenty of room for years of future increases. It has the look of a future Dividend Aristocrat.
The stock remains attractively valued
Buffett likes a good deal, and McKesson seemed like a bargain earlier this year. The stock's price-to-earnings ratio (P/E) has risen since the first quarter but remains reasonable at 14. Consider that the S&P 500 trades at a P/E of 19 today; the market has historically averaged 10% annual earnings-per-share (EPS) growth, the same as what analysts are looking for from McKesson over the next three to five years. McKesson potentially offers you similar earnings growth for a cheaper valuation.
MCK PE Ratio (Forward) data by YCharts.
McKesson isn't the jaw-dropping bargain it was a year ago; the stock traded at a single-digit P/E ratio in 2021. But McKesson is a blue chip stock in the all-important healthcare industry. Buffett's second-quarter buying signals that he still sees value in the stock, and the valuation hasn't dramatically increased over the past few months. Investors can consider McKesson's expected double-digit EPS growth and growing dividend as a solid add for any long-term stock portfolio.
