Private Equity Still Likes Distribution

The lead story in Monday’s NAW Smartbrief highlighted a recent Wall Street Journal article looking at drug wholesaler McKesson (MCK) as a possible takeover target. (See In McKesson, Some Foresee 'Value' Lesson.)

Despite the slowdown in M&A activity that I predicted in June, wholesale distribution will remain attractive to financial buyers. The prospects for a McKesson buyout highlight why private equity likes our industry.

Here’s a key quote from the WSJ article: “Rick Schnall, a senior executive of buyout firm Clayton, Dubilier & Rice, said McKesson has one of the best managements in the health-care business. He said "many private-equity firms would love to figure out a way" to buy it, though he said it is unlikely that such big deals will take place until difficulties in the credit markets pass.”

For those who don’t know, CD&R is a top-tier buyout fund that has been very successful with distribution businesses. They are currently invested in large distributors of electrical supplies (Rexel), lab supplies (VWR), food (US Foodservice), and building supplies (HD Supply). Click here to see a selection from their current portfolio. CD&R is one of the funds that I discuss in Chapter Five of Facing the Forces of Change®: Lead the Way in the Supply Chain.

I’ve been thinking about a drug wholesaler go-private buyout transaction for some time. As I see it, McKesson is the most logical buyout target among the Big 3 drug wholesalers due to its business mix, current operating platform, and age of the management team. McKesson has two distinct business segments – they are a drug distributor as well as the largest healthcare information technology company.

A buyout would provide a platform for a transformational restructuring and open up some intriguing domestic and international acquisition opportunities. Cardinal Health (CAH) is even more diverse but is in the midst of its own restructuring under new CEO Kerry Clark. AmerisourceBergen (ABC) is more narrowly focused on distribution but has a less centralized logistics platform, limiting its ability to serve large retail chains. McKesson’s acquisition of OTN improves the company's leverage with customers in the fast growing specialty distribution business.

McKesson also has very little debt due to the fee-for-service transformation that cut required wholesaler inventory levels in half. In fact, McKesson’s Net Debt-to-EBIDTA ratio was actually negative (!) based on second quarter financials, making the company especially attractive to private equity. (Net Debt = Short Term Debt + Long Term Debt – Cash & Cash Equivalents, so the numerator in this ratio is negative.) Keep in mind that a financial buyer is effectively purchasing the cash flow generated by a business and may finance the purchase by borrowing against the assets and future cash flows of the acquired company.

The drug wholesaling business has many risks, including ever-more powerful retail customers who squeeze margins and threaten to buy directly. Nonetheless, McKesson operates in a wholesale distribution line of trade that is insulated from global competition, just like other popular target industries for private equity such as facilities maintenance, construction supplies, and building materials. McKesson’s enterprise value is $17.1 billion, which is plausibly affordable once the credit markets settle down.

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