S&P Affirms Ratings and Outlook on McKesson (MCK) Following Recent M&A Activity

"The ratings affirmation is based on our expectation that the company will not sustain leverage above 2x, despite planned acquisitions," said Standard & Poor's credit analyst Tulip Lim. The company announced the acquisition of Rexall, a Canadian pharmacy drug store chain, for $2.2 billion today and last week announced plans to acquire Vantage Oncology LLC and Biologics Inc. The total consideration for all three acquisitions will be $3.4 billion. However, we expect the company will use some of its cash to fund the acquisition and are revising our assessment of liquidity to strong from exceptional.

McKesson continues to retain its important position as one of the three largest U.S. drug distributors. It has diversified customer and supplier mixes, high barriers to entry in its industry, favorable demographics, and an increase in the usage of more profitable generic drugs. However, as is typical for the industry, distribution margins are very thin. Despite some diversity with a medical products distribution business and a smaller technology business, McKesson's EBITDA margins remain only in the 2% to 3% range. This is due to its predominant focus on very low margin pharmaceutical distribution. These factors underpin our assessment of business risk as satisfactory. McKesson's primary competitors are AmerisourceBergen Corp. (ABC) and Cardinal Health Inc. The three companies make up roughly 90% of the entire drug wholesaling sector, which, in turn, distributes the vast majority of drugs dispensed in the U.S.

We revised our assessment of McKesson's liquidity to strong from exceptional because we expect the company will use some of its cash to fund the acquisitions. Further, we believe sources of cash will exceed mandatory uses by more than 1.5x, but less than 2x over the next two years. Working capital movements can be significant for the company, but we believe the company has ability to absorb high-impact, low-probability events without refinancing. The company has one maintenance covenant on its $3.5 billion revolving credit facility, a maximum debt to capital ratio. We expect debt will be at least 25% below the threshold.

The stable rating outlook on McKesson Corp. reflects our expectation that the company will generate solid free cash flow, which will enable the company to reduce leverage below 2x by the end of fiscal 2018.

We could lower the rating if the company sustains leverage at more than 2x (with no prospect for immediate improvement). With the proposed acquisitions, McKesson's debt capacity has declined, but we estimate that the company continues to have roughly $3 billion in capacity for acquisitions and share repurchases.

Although less likely, we could raise the rating if McKesson is able to reduce leverage to 1.5x or less. We would also need to be convinced that the company was committed to maintaining leverage below this level.