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McKesson's Our Favorite Undervalued Healthcare Distributor

We like its improving operational dynamics and less uncertain near-term environment.

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Healthcare-related distributors have had a rough couple of months, with the stocks of medical, dental/veterinarian, and pharmaceutical wholesalers falling by material amounts. Of note, dental/veterinarian distributor  Patterson PDCO and medical distributor  Owens & Minor (OMI) have both fallen into materially undervalued territory.

However, we believe investors should look to drug distributor  McKesson (MCK) as the best opportunity, given its wide economic moat, clearer near-term operational outlook, improving quarterly results, and undervalued stock.

We believe investors looking for exposure to healthcare distribution will be well served over the long term by owning McKesson, given its stalwart position in the pharmaceutical supply chain.

While we believe Patterson has some long-term positives ahead, it faces great uncertainty over the near term. Increased competition in the dental supply market and a changing operating environment have pressured its operations. From what we can gather, the dental consumables market has seen a moderate shift in which many dental products are now being sourced through alternative wholesalers, particularly from website/online channels that aggregate consumable products from many suppliers across the United States. Many client dental supply contracts for Patterson are not exclusive, so dental practices are able to source products from other suppliers outside of their primary wholesaler.

In response, Patterson has tried to retool its respective sales and marketing divisions. We also believe it has lowered the prices for certain consumable products to preserve market share, hurting gross margins. Additionally, Patterson announced June 1 that CEO and chairman Scott Anderson was stepping down immediately. Former CEO Jim Wiltz will serve as interim CEO until the position is filled permanently. We believe these headwinds have created significant near-term uncertainty for Patterson.

Owens & Minor faces a similar situation, as it has reported consistent decreases in its top and bottom lines over the past several quarters. Owens has had to contend with increased competition, contract losses, and significant management turnover over the past few years.

While we are encouraged by the tactical moves executed by the fairly new management team over the past year, we are concerned about the ultimate outcome for Owens. The operating efficiency strategy that CEO Paul Phipps has rolled out is a major step in the right direction; it includes building more efficiency into the company’s infrastructure and realigning its client book toward higher-value services.

However, we are uncertain if this will be enough to overcome the obstacles ahead. These obstacles include a major new competitor,  Cardinal Health (CAH), which has the resources and drive to make significant inroads into the consumables market. With that as the backdrop, we would not be overly surprised to see Owens pursue strategic alternatives over the medium term.

Given the near-term uncertainty enveloping Patterson and Owens, we believe McKesson provides a cleaner opportunity to own a high-quality healthcare distributor. While McKesson recently reported a solid quarter, its stock remains deeply undervalued and continues to be one of our Best Ideas. From our perspective, during fiscal 2016 and 2017, certain market participants extrapolated near-term headwinds into the long term. As McKesson’s fiscal fourth-quarter results indicate, these headwinds have started to abate and have not impaired the company’s long-term outlook. McKesson is still positioned to take advantage of the secular tailwinds blowing through the pharmaceutical space.

These positive developments were bolstered by management’s outlook regarding fading competition in the small/independent client segment. McKesson was forced to match lower generic drug pricing during the last part of fiscal 2017 in order to preserve volume among this client subset. However, this dynamic has stabilized as management said generic pricing concessions to independent clients has moderated. Additionally, management expects branded inflation to be in the low to mid-single digits for fiscal 2018. We believe this is a prudent outlook as management was too aggressive with its initial fiscal 2017 branded pricing assumptions, which assumed high-single-digit to double-digit pricing increases for certain branded products. Improving operational dynamics and a less uncertain near-term environment make McKesson it a more advantageous opportunity, in our opinion.

Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.