Mckesson (NYSE:MCK): Rapid Profit Expansion Expected Near Term; Upgrading Cardinal and McKesson to BUY - Citigroup

Citigroup's Health Care Distribution & Technology is making a fairly big call upgrading both Mckesson (NYSE:MCK) and Cardinal Health (NYSE:CAH) to Buy from Hold.

- Mckesson is added to Citi's Top Picks Live (TPL) list with a $101 price target (up from $90).

New Generic Introductions Should Provide Outsized Profits in C2012 – In the report, Citi examines the upcoming branded to generics wave set to impact the drug distributors beginning in 2011 though the end of 2015. They look at 100+ drugs that currently generate about $90 billion in revenue and their impact on wholesaler profits and margins. Firm estimates that the branded to generic conversion wave will lead to outsized profits and sustainable higher margins for the wholesalers.

The details:

Industry Top Lines Should Begin to Shrink in C2012 – One dynamic of the branded to generic drug conversion cycle is that wholesaler top lines should begin to decrease in 2012. Single source generic drugs can sell at about half the reference drug price and we believe many large customers will buy these generics direct, leading to significant leakage out of the wholesaling channel. We estimate that wholesaler revenue levels could shrink 2% to 8% in the 2012/2013 time period on a reported basis and 5% to 10% on a like for like basis, excluding acquisitions and nondrug distribution businesses.

But Gross Profits Should Expand on Mix – Within the customer base that buys generics from the wholesalers, generic drugs can be 3x to 20x as profitable as their branded drug counterparts. This should lead to both absolute higher profit levels and higher margins for the wholesalers reflecting the shifting mix to generics as a higher percentage of total drugs sold. About 50% of generic drugs dispensed in the U.S. are bought by retailers (or mail order) directly from the manufacturer, meaning the wholesalers will share the generic profit opportunity with other parts of the channel.

Difficult Comparisons Begin in 2H-2013 – We believe an underappreciated dynamic of the branded to generic conversion is the level of profits contributed by single or dual source generics, compared to multisource generics. These limited source generics can produce dollar profit levels that are 3-4x the multisource equivalent. So as many of these drugs move through their life cycles to multisource competition, the gross profit contribution from these drugs will decrease substantially. This should create difficult comparisons in 2013, as drugs including Lipitor, Lexapro, Seroquel, Plavix and Singular should all see multisource generic competition.

Upgrading Cardinal Health and McKesson to Buy, Maintain Hold on AmerisourceBergen – Our revisions make us at or near the Street High estimates on both companies for their F2012 and F2013, implying significant positive revisions which should lead to multiple expansion from current levels. Our target price on CAH goes to $51 from $44 and our target price on MCK is now $101 from $90.

Notablecalls: My poison of choice here would be MCK, as the name is added to the TPL with a very nice $101 price target.

What really makes the call interesting are the catalysts:

- Lipitor is going to launch in Nov 2011, that's 45 days from here. It's the largest drug in the world by sales which should create some excitement among investors.

- McKesson benefits when UNH brings PBM business in house. Of course that won't happen til 2013.

It's a 54 pg. note so the good people at Citi have put work into the subject. The sales will be making a lot of calls today pushing MCK & CAH to clients. Especially MCK since it was added to the Top Picks Live list. Nice defensive name too.

I expect a nice up day for MCK. $78+?

(Posting this after open)