McKesson Corporation (NYSE: MCK) is the global leader in the medical supply wholesale sector, with over $180 billion in total annual sales.  And despite steady gains of late, few investors are showing much excitement about its prospects, a fact that makes me pretty excited since I like a good “under the radar” contrarian stock pick.  I recommended MCK in the premier issue of Breakthrough Tech Profits and it has moved steadily higher since, reaching the upper end of the recommended buy range by having delivered a nice pop in its share price recently. 

Higher Guidance Delivers Stock Pop

Investors got a nice surprise from McKesson on June 29 when the company increased its earnings guidance for fiscal year 2017 to $13.43–13.93, up from the previous expectation of $13.30–$13.80 as it continues with its restructuring plan.  Broken down, growth expectations for the different parts of the company include high single digits at the Distribution Solutions segment driven by market expansion and acquisitions in fiscal 2017. The Pharmaceutical distribution and services business in North America is projected to grow in the high single digits as well, while the fastest growth is expected in the International Pharmaceutical distribution and services where the company expects low double digits increases. Revenues at the Medical-Surgical distribution and services division are projected to grow in the mid-single digits.  All growth rates expectations are based on the adoption on new accounting standards that relate to stock compensation programs and foreign currency risk. 

History of Earnings Beating Expectations

McKesson has a history of beating earnings expectations so the guidance upgrade is not out of character. The company, which uses IBM designed software to create and work out future risk scenarios and create contingencies, is also busy trimming its less profitable segments.  For example, it’s now merging its IT business with Change Healthcare, a company whose majority owner is the Blackstone group.   The combined entity will be funded by $6.1 billion in debt and is slated to go public as an independent entity after the deal closes.   This transaction takes one of McKesson’s least profitable units off the company’s balance sheet, giving it more room to focus on its core businesses and its expansion into cancer treatment related medical practices.

Headwinds for Health Care Sector Ahead

Let’s look at some basic facts of the times in which we are living.  The healthcare sector is going to be bumpy over the next few years because the purse is shrinking.  The bottom line is that insurance companies don’t want to pay anyone; physicians, hospitals, or wholesalers any more than they can get away with because their profit margins have been squeezed by the implementation of the Affordable Care Act.  And as the population ages, the financially strapped Medicare program is desperately trying to transition from a fee-for-service payer to the HMO style of bundled payments over the next few years, further cutting the amount of money available to the service and product side of the system.

There are two very practical ways that a healthcare company can remain profitable in this emerging new system: One is to be huge, and the other is to be in a niche that even the stingiest payer can’t ignore.  That’s why I like McKesson; it is dominant, it is global and it is also niche as the distributor of any type of medical supply you can think of to anyone providing products ranging from simple bandages to sophisticated cancer drugs to drug stores, hospitals, surgery centers, and individual physician offices.  In other words, the only way McKesson won’t be able to sell something to someone is if the whole global economy crashes.  And as more care is delivered at home, due to changing Medicare rules, these multiple sales channels will transition and McKesson will focus its efforts to where the market is leaning.

Management is the Key

Consider the fact that McKesson is raising its guidance at a time when the healthcare sector as a whole is on the verge of shrinking.  The bottom line is that Wall Street seems to have gotten it wrong as they focused on the negative short term prospects for McKesson after the company lost a big contract when Walgreens merged with Europe’s Boots Alliance.  However, bad luck often creates value and patient investors can turn a company’s short term bad luck into profits under the right circumstances such as when bad luck hits a company that has excellent management. McKesson proved their mettle when they replaced Walgreens Boots Alliance with Wal-Mart and Albertson’s, two leading retail pharmacies in the U.S. with margins are still better than in most other areas of the world. 

I expect some backing and filling as the stock nears the $200 area and also with approaching earnings on July 27.  Any consolidation should be used to add to the position which we plan to hold for at least two years.

Portfolio Summary

This Week’s Changes:

SOLD – White Wave Foods Company (WWAV) –  Sold on 7/07/2016 at $56.25 after company received buyout offer from DANONE Group. Bought 3/21/16 at $40.64. Total Return +38.3%.