In spite of the impact of the coronavirus pandemic on corporate earnings, the S&P 500 has rallied 17% in the last 12 months. Due to this rally, the benchmark index is currently trading at an all-time high and at a trailing price-to-earnings ratio of 38.9. Consequently, it has become extremely hard for investors to identify growth stocks that are cheaply valued.
McKesson (MCK) is a bright exception, as it is a dividend growth stock with a forward price-to-earnings ratio of only 11.2. McKesson is also a significant holding of Baupost Group, which is well-known for its risk-averse investing philosophy. Thanks to its decent growth prospects and its cheap valuation, McKesson is an attractive dividend challenger for both income-oriented and growth-oriented investors.
McKesson is the largest pharmaceutical distributor in the U.S., providing pharmaceuticals and medical supplies both in the U.S. and in international markets. 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 is also ranked #8 on the Fortune 500 list, with $234 billion in annual revenues and a market capitalization of $30 billion.
The healthcare sector is one of the most resilient sectors during the coronavirus crisis. McKesson certainly fits this rule, as its products are essential for consumers who do not curtail their consumption even under the worst economic conditions.
In the latest quarter, McKesson grew its revenue 6% over the prior year’s quarter thanks to market growth in its U.S. pharmaceutical business and higher volumes from retail national account customers. The company also reduced its share count by 11% while it also enjoyed a lower tax rate. As a result, it grew its adjusted earnings per share 33%, from $3.60 to $4.80. Notably, McKesson has exceeded the analysts’ earnings-per-share estimates for 10 consecutive quarters.
In addition, McKesson expects to maintain its strong business momentum for many more quarters. It also raised its guidance for its earnings per share in fiscal 2021, from $14.70-$15.50 to $16.00-$16.50. At the midpoint, this guidance implies 9% earnings-per-share growth over the prior year, and it is a strong confirmation of the company’s resilience during the pandemic.
McKesson has a reliable and consistent performance record. It 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.
McKesson has always pursued growth via bolt-on acquisitions, expansion of its market share, and aggressive share repurchases. These will remain the primary earnings-per-share growth drivers for the foreseeable future. It is also worth noting that the stock is trading at only 11.2 times its expected earnings and hence the plentiful share repurchases of the company greatly enhance shareholder value. We believe it is prudent to assume 6.0% earnings-per-share growth over the next five years.
McKesson froze its dividend in 2013 and hence it has raised its dividend for seven consecutive years. It is thus a Dividend Challenger. The stock is currently paying a 1% dividend yield. Therefore, the stock is not suitable for most income-oriented investors, particularly for those who are close to their retirement phase.
On the other hand, it is important to note the extremely low payout ratio, which currently stands at 11%. This means that 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 greatly enhance shareholder value and hence they are likely to benefit the shareholders of the company in the long run. A low payout ratio also leaves more room for high dividend growth in the future.
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 the stock with a margin of safety, we assume a fair price-to-earnings ratio of 12.0. If the stock of McKesson reaches our assumed 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 return is attractive, especially given the full valuation of the broad market and the favorable risk/reward profile of McKesson.
Due to the breathtaking rally of numerous technology-stocks and the “mundane” business model of McKesson, the stock has fallen out of favor. However, the market is likely to reward the stock with a more reasonable valuation at some point in the future. As a result, McKesson is likely to highly reward those who purchase it around its current price, with dividend growth and a satisfactory total return.
Bob Ciura has worked at Sure Dividend since October 2016. He oversees all content for Sure Dividend and its partner sites. Bob received a Bachelor’s degree in Finance from DePaul University, and an MBA with a concentration in Investments from the University of Notre Dame.
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