Undervalued Dividend Growth Stock of the Week: McKesson Corporation (MCK)

Famed economist John Maynard Keynes once predicted that people in progressive/developed countries would be working 15-hour workweeks, as abundance and the power of capitalism would end up providing enough basic needs and lifestyle desires at a level of work that was much less than historically necessary.

He had a vision of the future where one of humanity’s biggest challenges would be how to spend so much leisure time.

While Keynes was right about the living standards in progressive/developed countries increasing dramatically over time, allowing for the possibility of dramatically less work, he failed to account for humanity’s never-ending desire for “more”.

In addition, without a massive “buy in” from employers all over the world, the traditional workweek structure remains largely unchanged, which further limits flexibility for the worker class.

Many people are actually working more than ever.

Some are even working themselves to exhaustion… or death.

Indeed, the Japanese have a term for working to death – Karōshi literally translates to “overwork death”.

What?!

I believe if Keynes were alive today, he’d be astonished that people continue to work long hours at intensely stressful jobs, even though it’s not really all that necessary any more.

Fortunately, there’s a way out of the madness.

The solution I propose is quite simple: one just needs to live below their means and invest for the long term in high-quality dividend growth stocks at appealing valuations.

It’s the solution I personally used to become financially free at just 33 years old.

By living below my means and investing in high-quality dividend growth stocks, I built up a real-life six-figure portfolio that generates five-figure dividend income for me.

Perhaps best of all, this totally passive dividend income should continue to grow faster than inflation over the long haul, growing my purchasing power.

Financial freedom can allow you to spend your time as you choose and generally go about life without financial worries, thus being able to commit to something akin to Keynes vision of an “economic utopia”.

That’s because passive income bypasses the traditional relationship between time and money, where one needs to exchange the former for the latter. If you can pay your bills without having to work, you can pick and choose your pursuits and activities without focusing on money.

Living below your means is straightforward. One just has to spend much less than they earn. This will result in a lot of excess capital buildup.

Once you’re able to accomplish that, the time comes to intelligently invest the excess capital.

In my view, it’s pretty tough to beat dividend growth investing.

The investment strategy involves buying high-quality stocks that pay increasing dividends.

One buys these stocks at a good price.

And then they’re held for the long haul, whereby one collects that growing passive income for years – or even for the rest of their life.

You can find more than 800 dividend growth stocks by checking out David Fish’s Dividend Champions, Contenders, and Challengers list. It’s an invaluable compilation of all US-listed stocks that have paid increasing dividends for at least the last five consecutive years.

Dividend growth investing can allow one to “have their cake and eat it, too”, as the strategy can increase one’s wealth and passive income.

The growing dividend income is a great source of passive income. In addition, as a great business becomes worth more over time (due to selling more products and/or services, thus increasing profit), the stock investment generally becomes worth more.

However, it’s important not to go out and buy random dividend growth stocks at random prices.

One should always make sure they’re investing in great businesses they understand.

So that involves the fundamentals passing muster, looking at competitive advantages, and being certain a business falls within one’s circle of competence.

But even great businesses can be relatively subpar investments (especially over the short term) if the price paid is far too high.

Just like with anything else in life, stocks feature price and value.

Price is what you’re going to pay, but value is what you’re getting for your money.

Price is cost. Value is worth. As you can imagine, it’s value that’s the far more germane piece of information.

Value gives context to price. Value tells you whether or not the price is appropriate.

And when price is far below value, major long-term financial benefits are available to the investor.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

This is all relative to what the same stock would offer if it were fairly valued or overvalued.

First, price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield not only positively impacts current and ongoing income, but it also positively impacts total return – total return is simply comprised of dividends/distributions and capital gain.

The aggregate dividend income obviously benefits by virtue of the higher yield, which thus increases the possible dividend income one can receive on the investment.

In addition, capital gain is also positively impacted, as the “upside” that exists between the lower price paid and higher intrinsic value will likely manifest itself in the form of capital gain.

That’s on top of whatever long-term upside that already exists as a company’s stock become worth more as the company increases its profit.

This gap between price and value also reduces one’s risk.

That’s because a margin of safety, or “buffer”, is created when the price paid is far below intrinsic value.

If a stock that’s worth $100 is purchased for $75, that’s $25/share worth of buffer that serves to protect the investor’s downside, as only a significant negative event could actually reduce the intrinsic value of the stock far enough so that the investment becomes worth less than what was paid.

Price is almost always known. It only takes a second to pull up a quote for any stock ticker.

Value, however, is a bit more difficult to come by.

Fortunately, there are a number of tools and resources that can help any investor estimate the intrinsic value for just about any dividend growth stock out there.

One such resource, available right here on the site, is Dave Van Knapp’s valuation guide, which is part of an overarching series of lessons on the strategy of dividend growth investing.

Dave’s valuation lesson greatly simplifies the valuation process, which makes it much easier for an investor to make sure they’re paying the right price (that being one that’s as far below intrinsic value as possible).

With all this in mind, one can see why undervalued high-quality dividend growth stocks are such appealing long-term investments.

But I won’t leave you there.

I’m going to reveal a dividend growth stock that right now appears to be priced well below intrinsic value, which could be an excellent long-term investment opportunity…

McKesson Corporation (MCK) is the largest distributor of pharmaceuticals in the United States, providing drugs, medical products, and related supplies to a variety of healthcare customers.

The pharmaceutical distribution industry is really interesting.

One one hand, an investor has to accept very low margins. Net margin of around 1% is not uncommon, which means a company in this industry has to distribute a lot of product in order to turn a decent profit.

However, this industry is an oligopoly, with only three major players doing almost all of the business in the country.

And McKesson is the biggest of the three.

Moreover, as our country grows larger, older, and richer, demand for access to quality and necessary medication should only rise, which bodes well for the oligopoly.

That also bodes well for McKesson’s dividend, which has steadily increased for nine consecutive years.

With a five-year dividend growth rate of 7.5%, the passive income coming from this stock is certainly growing faster than inflation.

Plus, this is one of the few dividend growth stocks where dividend growth has been accelerating as of late: the most recent dividend increase was over 16%.

And with a payout ratio of just 8.7% (one of the lowest I’m aware of), the company could continue growing the dividend well into the double digits for many years to come, even absent matching earnings growth.

The drawback to that low payout ratio, of course, is the low yield.

At only 0.68%, this is a dividend growth stock that’s probably more appropriate for young investors that have a very long-term investment horizon, where they can allow that potential runway of growth compound in their favor.

An investor more in need of current income (such as older investors) would probably find the growth/yield dynamic too disadvantageous.

That said, the dividend growth should remain quite impressive for many years to come.

Part of that assumption is built on the fact that the payout ratio is so low.

But there’s also the underlying growth of the company, which further supports that thesis.

In order to show what the overall earnings power of the company looks like, we’ll first look at what McKesson has done over the last decade in terms of top-line and bottom-line growth.

We’ll then compare that to a near-term forecast for profit growth.

Fusing these numbers together somewhat, we should have a pretty good idea as to what kind of profit growth McKesson is generating.

From fiscal years 2008 to 2017, the company increased its revenue from $101.703 billion to $198.533 billion. That’s a compound annual growth rate of 7.72%.

I generally look for mid-single-digit revenue growth from mature companies. McKesson passes with flying colors. Furthermore, this is even more impressive considering the large base from which they’re working. Almost $200 billion in revenue makes it hard to move that dial.

Meanwhile, earnings per share grew from $3.32 to $22.73 over this same period, which is a CAGR of 23.83%.

FY 2017 included a large one-time gain from a $3.4 billion joint venture with Change Healthcare. Adjusted EPS for FY 2017 came in at $12.91. Notably, this adjusted figure favorably excludes a large goodwill impairment of $1.26 from Q2 2017.

It’s still not totally accurate to compare GAAP EPS to adjusted EPS, but this is the best we can do in order to get a more relevant snapshot.

Using adjusted EPS for FY 2017, the CAGR for EPS over this period is 16.29%.

Excess bottom-line growth was driven largely by share buybacks: the outstanding share count is down by about 25% over the last ten years.

Looking forward, CFRA anticipates 6% compound annual EPS growth from McKesson over the next three years, which would be a notable drop from what the company has historically generated.
CFRA believes price competition will only intensify, which is on top of a less favorable pricing environment for branded and generic drugs.

Still, even if this drop in earnings growth were to pass, McKesson’s very low payout ratio leaves plenty of room for double-digit dividend growth for years to come.

One other area of the company’s fundamentals that further provides flexibility is the balance sheet.

With a long-term debt/equity ratio of 0.66 and an interest coverage ratio over 23, the company is well capitalized with no undue duress from debt, which further exemplifies the quality of the business.

Profitability, as mentioned earlier, isn’t necessarily a strong suit for McKesson, which is due to the very business model (and not indicative of a problem with the company specifically).

But the company has averaged net margin of 1.04% and return on equity of 21.04% over the last five years, which is certainly competitive and in line with the industry.

Overall, McKesson is a high-quality business operating about as well as possible within an industry that’s practically necessary, favored by an oligopoly structure.

Pricing pressure and low margins constrain the company somewhat, but demographic trends serve as a powerful tailwind for the long term.

Yet while the business continues to perform well, the stock is down almost 15% over the last year.

And this could be an opportunity, as the stock now appears to be undervalued.

The stock’s P/E ratio is 12.80 (using adjusted EPS for FY 2017). That’s not only well below the broader market, it’s also substantially below the stock’s own five-year average P/E ratio of 22.8. Moreover, investors are also paying much less for the company’s book value and cash flow than they typically do.

So the stock seems cheap, but how cheap might it be? What’s a reasonable estimate of the stock’s intrinsic value?

I valued shares using a two-stage dividend discount model analysis to account for the low yield and high growth.

I factored in a 10% discount rate, a dividend growth rate of 20% for the first 10 years, and a terminal dividend growth rate of 8%.

These growth assumptions are on the high end of what I normally allow for, but the payout ratio is low enough to sustain this kind of dividend growth for many years to come, and that’s before factoring in underlying earnings growth.

The DDM analysis gives me a fair value of $163.02.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis concludes that the stock is roughly fairly valued here, which is surprising considering the disconnect between the current valuation and the historical valuation. However, few stocks will have a lower payout ratio (and thus such dividend growth potential), which skews the DDM a little bit. And this is a great example of why I like to compare my analysis and perspective to what professional analysts come up with.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates MCK as a 4-star stock, with a fair value estimate of $210.00.

CFRA (formerly S&P Capital IQ) is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates MCK as a 3-star “HOLD”, with a fair value calculation of $213.60.

We can obviously see that my valuation was very much on the conservative side. Averaging the three numbers out gives us a final valuation of $195.54, which would indicate the stock is potentially 18% undervalued right now.

Bottom line: McKesson Corporation (MCK) is a great business that is operating at a high level. An oligopoly of an industry, favorable demographic trends, and the absolute need for and ubiquity of the products it distributes all bode well for the company and its long-term investors. On top of all of that, the possibility of 18% upside means this is an opportunity that should be strongly considered.

— Jason Fieber

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