Theres Nothing Generic About McKesson

January 5, 2010

McKesson Corporation Investment Thesis

Recent Valuation Multiples:

11.66x 11E Earnings (ex-cash)* 6.4 EV / 2011E EBITDA

Company also owns an industry leading Healthcare IT & services unit Both segments are benefiting from favorable demographic trends and have meaningful growth potential Intrinsic value of the business not currently reflected in the market
Significantly undervalued on a sum-ofthe-parts basis
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Capitalization: Equity Market Value: $18.3bn Enterprise Value: $17.5bn

*Note: cash adjusted to reflect 12/30 US Oncology acquisition

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Ticker: MCK Stock Price: $72.33

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Prolific free cash flow generator Predictable recurring revenue streams

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High quality, dominant drug distribution business

Company Overview

MCK has over 175 years of operating history and is ranked #14 on the Forbes 500 list with over $100bn in revenues.

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MCK also operates a technology segment which sells enterprise-software that helps customers including pharmacies, doctors and hospitals manage clinical data, revenue and inventory, automate processes, streamline communications and eliminate the need for paper prescriptions and medical records.

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McKessons (MCK) primary business is drug distribution. MCK acts as the middleman delivering drugs from pharmaceutical companies to users such as pharmacies and hospitals.

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McKessons Two Businesses

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McKesson Distribution Solutions (MDS)

~97% Revenues ~1.5-2% EBIT Margins

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Distributes pharmaceuticals and health and beauty products to retail pharmacies and institutional providers like hospitals and health systems

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Provides software, automation, services and consulting to hospitals, physician offices, imaging centers, home health care agencies and payors

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MCK operates in two business segments

McKesson Technology Solutions (MTS)

~3% Revenues ~10-12% EBIT Margins

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McKessons Two Businesses (contd)

Positive Factors McKesson Distribution Solutions (MDS) Market leader in oligopoly industry
Top 3 players ~90% of revs; MCK 35%

McKesson Technology Solutions (MTS) Strong market position in fragmented industry Stimulus spending and digitization of health records driving growth Sticky customer base and strong customer captivity due to high switching costs and niche target markets Products used by 50% of hospitals and 70% of those with over 200 beds High margin, high multiple business

At current levels, the market is not giving any credit to the value of MCKs Health Care IT (HCIT) unit despite it contributing 15-20% of MCKs net income. Analysts and investors tend to value MCK based on its consolidated earnings rather than valuing each of its two business separately, which leads to drastic mispricing. In order to realize and unlock the intrinsic value of the business, management should consider spinning off MCKs technology segment, MTS
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Multiple secular tailwinds driving growth High barriers to entry and huge moat due to economies of scale and irreplicable network Recession resistant business Low regulatory exposure Limited inventory risk Low margin, low multiple business

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But first, a little more about McKesson

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Prudent Capital Deployment

Over time, MCKs management team has proven themselves to be good allocators of capital by using the companys substantial free cash flow to increase dividends and share buybacks and execute accretive acquisitions

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Source: MCK Company Presentation

Prudent Capital Deployment (contd)

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Given its ability to generate significant cash flow, MCK should continue to be able to conduct substantial share repurchases over time

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MCK recently increased its buyback program by $1bn, raising the total authorized share repurchase amount to ~$1.53bn or roughly 8.5% of its current shares outstanding

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Source: MCK Company Presentation

High Returns on Equity

With its low fixed-cost structure, McKesson generates high returns on equity

20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2010

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2009

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2008

Return on Equity

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2007

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2006

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Source: McKesson 10K

Strong Free Cash Flow Generation

$8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $$(1.00) FY 2005 FY 2006

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FY 2007 FCFPS

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FY 2008 EPS FY 2009

$9.00

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MCKs depreciation and amortization expense typically exceeds capital expenditures, leading to FCF per share that far greater than GAAP EPS

FY 2010

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Source: Bloomberg

Strong Balance Sheet

600 500 400 300 200 100 0 2012 2013

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2014

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Debt Maturities (in millions)

2017

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MCK has over $2.5bn of cash(1), a modest net cash position, ample interest coverage (~11x) and a staggered debt maturity schedule

2019

2027

Source: McKesson 10K (1) cash adjusted to reflect 12/30 US Oncology acquisition

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New Business Model

MCKs business model is shifting towards one that allows for more stable, predictable revenues, less inventory risk and lessens the extent to which MCKs profits are subject to swings in the prices of drugs

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Whereas in the past the company operated as more of a reseller of drugs, MCK and other drug distributors have been moving to a fee-for-service (FFS) model under which it is paid by manufacturers to distribute their drugs in exchange for a fee.

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Secular tailwinds

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Favorable Demographics and Govt Policy Driving Demand

Massive amount of upcoming drug patent expirations, leading to a surge in the availability of generic drugs which carry higher profit margins Pharmaceutical consumption and utilization on the rise due to expansion of healthcare coverage and aging of baby boomers Government policy and stimulus programs to drive revenue growth in MCKs technology segment

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MCKs two businesses should benefit from a number of secular tailwinds as well as increases in government spending

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Favorable Demographics and Govt Policy Driving Demand (contd)

McKesson earns a higher profit margin on generic versus branded drugs by a factor of 3-5x(1). Given the upcoming patent expiration cliff, MCK is poised to benefit from a shift to generics as over $100bn in brand name drugs come off patent

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Source: Goldman Sachs (1) According to company estimates

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Favorable Demographics and Govt Policy Driving Demand (contd)

Total pharmaceutical consumption should increase as healthcare reform enables millions of people to receive health insurance for the first time which will serve as a further boon to McKessons distribution business

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Source: Goldman Sachs

Favorable Demographics and Govt Policy Driving Demand (contd)

Persons aged 65 and over, the largest consumers of pharmaceutical drugs, are currently and projected to be the fastest growing segment of the US population for years to come...

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Source: US Census

Favorable Demographics and Govt Policy Driving Demand (contd)

13.03% 24.11% 26.21%

18.20%

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2010 US population composition by age segment

Projected 2025 US population composition by age segment

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and will continue to grow as a proportion of the US population

Projected 2050 US population composition by age segment
21.13%

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23.41%

22.42%

9.85%

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23.59%

8.92%

8.67% 22.80% 24.98%

26.80%

25.88%

Under 18 years 25 to 44 years 65 years and over

18 to 24 years 45 to 64 years

Under 18 years 25 to 44 years 65 years and over

18 to 24 years 45 to 64 years

Under 18 years 25 to 44 years 65 years and over

18 to 24 years 45 to 64 years

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Source: US Census

Favorable Demographics and Govt Policy Driving Demand (contd)

The number of persons aged 65 and older is growing by millions every year

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Source: US Census

Favorable Demographics and Govt Policy Driving Demand (contd)

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which should give rise to an increase in pharmaceutical utilization and further drive growth for MCK

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Source: SIG

Favorable Demographics and Govt Policy Driving Demand (contd)

A component of the Feb. 2009 $787bn American Recovery and Reinvestment Act (ARRA) called the HITECH act provides approximately $19bn in incentives to physicians and hospitals for the implementation of Electronic Health Records (EHR). This coincides with Obama Adminstrations goal of having EHR for every American by 2015. Payments will begin in 2011. Qualification for stimulus money is subject to meaningful use rules and tests MCK is working with clients to ensure they have the right resources to qualify for the stimulus money 20% of the 500,000 non-hospital physicians in the US currently have EHR in place; according to CBO estimates, by 2014 this number will be 85% and 90% in 2019 in light of ARRA 10% of the 5,100 hospitals in the US currently have EHR in place; according to CBO estimates, this figure will grow to 55% by 2014 and 70% by 2019 in light of ARRA

MCKs IT segment is likely to be one of the main beneficiaries of this incremental stimulus spending

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So what is the company worth?

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McKesson Distribution Solutions (MDS) Peer Analysis

Market Cap (mm) Enterprise Value 2010E Sales P / 2010E EPS P / 2011E EPS P / 2012E EPS

$18,304 $17,533 $110,016 16.04 13.62 12.43

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McKesson

Cardinal Health
$13,568 $12,995

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Amerisourcebergen
$9,523 $9,208 $78,536 15.81 14.12 12.72

Median
$11,421 $10,977 $88,405 16.11 14.48 13.11

$98,274 16.41 14.84 13.50

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Data based on 1/5/11 closing prices

McKesson Technology Solutions (MTS) Peer Analysis

Market Cap (mm) Enterprise Value 2010E Sales P / 2010E EPS P / 2011E EPS P / 2012E EPS

$7,825.0 $7,379 $1,853 32.35 26.83 22.38

$3,749 $4,135 $1,249 27.20 22.88 19.54

$2,044 $1,938 $332

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Cerner

Allscripts

Quality Systems Athenahealth Computer Programs & Systems

$1,429 $501 $486 $150 32.88 29.87 22.08 $1,341 $244 74.45 55.59 40.87

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Median
$2,044 $1,938 $332 32.88 27.69 22.38

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37.16 27.69 22.85

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Data based on 1/5/11 closing prices

Sum-Of-The-Parts Analysis
Operating Profit (1) Interest Expense (2) Pre-Tax Income Income Tax (3) Net Income Shares Outstanding (4) EPS Estimated P/E Multiple (5)
Distribution Solutions Technology Solutions Implied Value Per Share $1,864 147 $1,717 566.6

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Distribution Solutions CY 2011

Technology Solutions CY 2011 $355 28 $327 107.9 $219.1 232 $0.94 High* 14.84 29.9 High

$1,150.4 232

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$4.96 Low 14.12 22.9 Low

Distribution Solutions Technology Solutions Combined Current Price: $72.33 % Upside

*Athenahealth P/E excluded as outlier

$70.01 $21.61 $91.62 26.7%

$73.58 $28.21 $101.79 40.7%

Based on the implied value of the MDS segment, MCKs current stock price only reflects the value of its distribution business

Currently, the market is ascribing zero value to MCKs IT business. Said differently, at todays price levels you are buying MCKs high quality distribution business at an attractive price and effectively getting its high-margin, high multiple technology business for free
Refer to notes on final slide for assumptions used

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Note: Current Weakness in MTS Segment Masks Potential For the first half of FY 2011, the MTS segment has seen a (temporary) decline in operating profits by ~64% due to increased investment, a one-time non-cash impairment charge and revenue recognition delays. Management expects a strong second half of FY11 for MTS as investment slows, certain development issues are resolved and implementation schedules come online Consequently, investors are being overly pessimistic about the health and profitability of the MTS segment, allowing for a more attractive entry point

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Spin-off rationale

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Spin-off Rationale

Cross-selling opportunities still exist but given the level of penetration MTS has achieved, they have grown less important
MCK can choose to spin out the majority of MTS while retaining a stub holding in the spun-off entity to continue to build and grow the business while still unlocking its value for shareholders

The two businesses have very different growth and margin profiles and thus deserve vastly different earnings multiples. As a result, in its current form, the market has a difficult time assigning fair value to MCK Give shareholders a choice whether to hold the low-margin distribution business , the high-margin IT business or both Highlight the intrinsic value of the business
As a standalone entity, MTS would become 2nd largest publicly traded HCIT company by market cap (1)

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MTS products are already deeply penetrated and thus there are few if any remaining synergies between the two businesses

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The MTS business is the byproduct of a merger between HBO & Co. and MCK in 1999 and its subsequent build-out both organically and through a series of acquisitions

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(1) Based on peer multiples and estimated earnings

The Transaction Is Not Without Precedence In order to re-focus on its core distribution business, McKesson competitor Cardinal Health (CAH) spun off its non-core tech assets in August 2009 into a separate entity, CareFusion (CFN), on a 1:2 basis At the time, Cardinal Health retained a 19% equity stake in CareFusion CareFusion is comprised of what was formerly Cardinal Healths high-margin, high growth clinical and medical products businesses
When taking into account the CareFusion shares received as a result of the spin-off and the appreciation of both Cardinal Health and CareFusion since the spin-off, investors that owned CAH as of the record date of August 25th, 2009 have earned a return of 49.5% versus a return on the S&P 500 of 24% over the same period

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Risk factors

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Risks
Disintermediation

Loss of key customer(s)

Top 10 customers comprise ~52% of revenues CVS ~15%, Rite-Aid 12%

Contract turnover is fairly rare in the industry In light its financial condition, investors can protect against Rite-Aid bankruptcy risk by owning RAD CDS and/or shorting its common equity

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Distribution business models are efficient and make economic sense Distributors in all industries allow their respective clients to focus on their own core competencies MCK and other drug distributors are akin to off-balance sheet financing and help businesses keep their cost structure down

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Pharmaceutical companies may decide to distribute drugs entirely themselves

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Conclusion

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Conclusion High quality business with strong competitive position, recurring revenue streams and multiple secular tailwinds Attractive valuation on a consolidated basis Trading at a significant discount to fair value on a sum-of-theparts basis Spin-off opportunity presents catalyst to realize value
Shares do not currently reflect value of highly profitable IT segment

Upside potential: 27-41%

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Assumptions used
CY2011 operating profit is based on consensus estimates and allocates 84% to the MDS segment and 16% to the MTS segment based on historical precedent Interest expense is computed based on historical interest cost and is allocated 84% to the MDS segment and 16% to the MTS segment; conservative estimate as MCK has been paying down debt The tax rate is assumed to be 33% based on historical precedent and management guidance Share outstanding is based on the assumption that the full $1.53bn share buyback program is exercised, resulting in a share count reduction of 21mm shares Earnings multiples are for CY11 are based on those of the comparables listed in the peer slides, with the exception of Athenahealth which was excluded as an outlier

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