Big Premium in the McKesson–McQueary McDeal

Apologies for yet another McKesson (MCK) post, but I certainly can’t ignore this week’s news given that I wrote on Tuesday about the company’s active efforts to alter its business mix.

McKesson (MCK) is acquiring McQueary Brothers Drug Company, one the few remaining regional drug wholesalers in the U.S. (See the official announcement.) McKesson is paying a substantial premium for the McQueary’s business, although the deal could be justified given today’s pharmacy industry dynamics. Will the higher price lure the remaining regional wholesalers to sell out, further concentrating the channel for manufacturers and independent pharmacies?

PAYING A PREMIUM

Here’s my math.

McQueary Brothers is one of the few wholesalers that does not report its sales in HDMA’s Factbook. However, the press release states that McQueary serves “more than 400 independents.” Assuming typical purchase levels by an independent pharmacy ($1.5-2M per year), McQueary’s revenues are probably in the range of $600-$800 million. Let’s say $700 million as a round number.

The purchase price was $190 million, implying a price/revenue ratio of about 0.27X. For those of you keeping score at home, this ratio is more than twice the comparable figures of other recent acquisitions, such as D&K by McKesson or Bellco by AmerisourceBergen (ABC). I presume an EBITDA multiple would reflect a similar 2X+ premium.

At first blush, this premium may seem surprising given the limited number of possible buyers (um, 3?) and the potential risk of a distress sale if independents come under further pressure. As I wrote back in March 2007: “Industries do not consolidate forever (even drug wholesaling). I expect that the remaining regional wholesalers will be looking for a reasonable exit strategy, too.”

BUT STILL A GOOD DEAL

However, McKesson’s desire to win this deal at a higher purchase price makes sense once we consider today’s pharmacy realities:

1) Smaller retail pharmacy customers rely on a wholesaler for many more supply chain services than a self-distributing chain. Thus, the threat of disintermediation is low and the gross margins are generally higher for the wholesaler. (More details: Trouble Ahead for Independent Pharmacies.)

2) Smaller buyers – regional chains, independents, supermarkets, etc. – buy their generic drugs via wholesalers, which also boosts a wholesaler’s gross margins. (More details: CVS' Channel Power.)

3) McKesson has been actively trying to deepen its relationships with customers, either through ownership (such as the OTN acquisition) or through a franchise relationship such as the nearly-2,000 pharmacies participating in HealthMart.

As a bonus, McKesson gets a small top-line boost from an (improbably) growing segment and can easily fund the deal given its extremely low levels of debt.

So what’s next? Will the McQueary buyout premium trigger a final feeding frenzy for the remaining regionals? Will manufacturers take action to address the unsettling levels of concentration in wholesale and pharmacy channels?

Any brave souls care to venture a guess?

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And before you ask, no, that’s not a picture of younger me above. Everyone knows that I don’t wear yellow.