Despite the coronavirus crisis, the S&P 500 has rallied 16% in the last 12 months and thus it has climbed to a new all-time high. As a result, it has become challenging for investors to identify cheaply valued stocks with promising growth prospects. McKesson (MCK) is a bright exception, as it is cheaply valued and has decent growth prospects ahead. It is also one of the top 10 holdings of Glenview Capital, which is well known for its focus on “Growth at a Reasonable Price” (GARP) investing strategy. The investors who follow this strategy should certainly put McKesson on their radar.

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Business overview

McKesson is the largest pharmaceutical distributor in the U.S. and provides pharmaceuticals and medical supplies both in the U.S. and internationally. The company has access to approximately one-third of all the U.S. pharmacies and has more than 275,000 stock-keeping units (SKUs) of branded and private label medical supplies. It has generated revenues of $234 billion in the last 12 months and thus it is ranked #8 on the Fortune 500 list.

The healthcare sector, which has always proved resilient to recessions, has proved resilient once again during the ongoing recession, which has been caused by the coronavirus crisis. McKesson is not an exception, as it offers products that are essential to consumers and hence the latter do not curtail their consumption of these products even under the worst economic conditions.

In the most recent quarter, McKesson grew its revenue 6% thanks to growth in the U.S. pharmaceutical business, which resulted primarily from market growth and increased volumes from retail national account customers. The company also reduced its share count by 11% over the prior year’s quarter while its tax rate decreased. As a result, McKesson grew its adjusted earnings per share 33%, from $3.60 to $4.80.

Even better, management expects the strong business momentum to remain in place for the foreseeable future. It thus raised its guidance for the earnings per share in fiscal 2021, which ends in March-2021, from $14.70-$15.50 to $16.00-$16.50. At the mid-point, this is a 7.6% increase in the expected earnings per share, which proves that the company is enjoying strong momentum despite the pandemic. It is also impressive that McKesson has exceeded the analysts’ earnings-per-share estimates for 10 consecutive quarters.

Growth

McKesson has an admirable and consistent growth record. The company has grown its earnings per share in 9 of the last 10 years, at a 12.9% average annual rate over the last decade. A consistent growth record is paramount, as it is a testament to the strength of the business model and the quality of management.

Despite the pandemic, McKesson is on track to post record earnings per share this year. However, as the company has grown in size, it will find it increasingly hard to continue growing at its historical rate. On the one hand, McKesson will keep growing its bottom line thanks to bolt-on acquisitions, revenue growth, and meaningful share repurchases, which enhance shareholder value thanks to the cheap valuation of the stock. On the other hand, it is prudent to assume that McKesson will grow its earnings per share by about 6.0% per year over the next five years, just to be on the safe side.

Dividend

McKesson froze its dividend in 2013 and hence it has raised its dividend for only seven consecutive years. In addition, it is offering just a 0.9% dividend yield. As a result, the stock is not suitable for income-oriented investors who do not have a very long-term investing horizon.

However, investors should note that the payout ratio is extremely low, at 11%. In other words, McKesson could offer a much higher dividend but it has chosen a low dividend in favor of aggressive share repurchases. Given the cheap valuation of the stock, share repurchases significantly enhance shareholder value. Therefore, management should be praised for its efficient capital management, which is likely to greatly benefit the long-term shareholders of the stock.

Valuation – Expected Return

McKesson is currently trading at a forward price-to-earnings ratio of 11.2, which is much lower than the average price-to-earnings ratio of 14.2 of the stock over the last decade. In order to calculate the expected 5-year return of McKesson with a margin of safety, we assume a fair earnings multiple of 12.0 for the stock. If the stock reaches our fair valuation level over the next five years, it will enjoy a 1.4% annualized boost in its returns.

Given also the aforementioned 6.0% expected earnings-per-share growth and its 0.9% dividend yield, McKesson is likely to offer an 8.4% average annual total return over the next five years. This expected return may not be exciting but it is certainly attractive, particularly given the rich valuation of the broad market and the cheap valuation of McKesson, which may lead to greater actual returns than our somewhat conservative estimate.

Competitive advantage

McKesson continuously tries to adapt to the changing needs of its customers. It also enjoys great economies of scale and strong pricing power thanks to this scale. These features form a material competitive advantage, which protects the company from the increasing pressure of regulatory authorities for lower prices.

Final thoughts

Due to its somewhat “boring” business model and its low dividend yield, McKesson passes under the radar of most income-oriented investors. However, the company has a consistent growth record and decent growth prospects ahead. As the stock is cheaply valued, it can offer attractive returns in the upcoming years, with a very low level of risk.