Cardinal Health: Divesting to Survive

Among the many reasons given for spinning off a company, time and again managements tout promises to unlock value. Was that the case when Cardinal Health (CAH) released CareFusion (CFN) from its reins and allowed it to run free as a stand-alone publicly traded company that officially began trading on September 1?

After adjusting for what remains of CAH to account for total sales that are about 5% lower (despite a 33% drop in assets), CAH is still a dominant North American pharmaceutical and medical supply distributor. Since CFN accounted for the majority of capital expenditures, rental and research & development, (95%, 90%, and 99%, respectively), as well as virtually all of the international manufacturing and sales operations, CFN is characteristic of a growth company while CAH is not. Leaving with CFN were products in global markets, an innovation engine and high growth prospects, key characteristics necessary to compete in the medical instruments and supplies industry. Staying with CAH is a large distributor of drugs and supplies with national scale, negotiating power and single-digit growth.

Let us step back a bit and look at CAH’s history since 1996 when it began to expand its operations with mergers, launching the beginning of a legacy of acquisitions, restructurings, and diverted attention away from wholesale distribution of pharmaceuticals and medical supplies. In fiscal year (ends in June) 1996, CAH merged with Medicine Shoppe and Pyxis, increasing its exposure into retail pharmacy services and medication management systems, respectively. In 1999, CAH merged with Scherer (manufacturer of drug delivery systems) and Allegiance (distributor and manufacturer of medical, surgical and respiratory therapy products). All of these, plus more, were done under the leadership of founder and CEO, Robert Walter.

Then, in 2006, newly appointed CEO, Kerry Clark, inherited a global restructuring program called One Cardinal Health that more or less attempted to refocus the company’s attention to its core businesses and divest underperforming and non-core operations. The result is a little over 3 years of restructuring, closed manufacturing facilities, a DEA license suspension for problems with controlled substance distribution, several divestitures and now finally the spin-off of CareFusion. Which brings CAH right back to where it started before all the merger and acquisition activity that took off in 1996. The remaining company distributes pharmaceuticals and medical supplies at wholesale, just like it did in the early ‘90s.

Were all the acquisitions and divestitures worth it? One way to answer this is to look at how its competitors, McKesson (MCK) and AmerisourseBergen (ABC), performed as they have mostly remained purely wholesale distributors.

From 1996 to 2001, CAH’s corporate performance was not as good as ABC (fiscal year ends in September), which was known as AmeriSource Health at that time. Then AmeriSource merged with its competitor, Bergen Brunswig in 2001 and CAH’s EMs performed better after that. The impact to ABC’s EM in 2001 demonstrates the negative impact to economic profitability when a company completes a major merger or acquisition. In effect, large transactions tend to destroy wealth.

CAH continued to expand its core wholesale distribution business as well as acquire small, higher-margin clinical and medical product lines. ABC, on the other hand, struggled as a larger company that was divided into traditional pharmaceutical distribution to hospitals, physicians, and pharmacies in its AmeriSource business, and institutional pharmacy services to long-term care facilities with its Bergen business. Additionally, ABC’s aspirations to significantly increase its distribution capacity took its toll on EM, until it divested its long-term care business in 2007. After that divestiture, ABC’s EMs outperformed CAH.

Compared to MCK (fiscal year ends in March), CAH performed like a rock star in all the years until fiscal 2007. MCK has grown through acquisitions, just like its competitors, but they have mostly remained within its expertise of wholesale pharmaceutical and medical-surgical product distribution. However, MCK was an early acquirer of IT-based businesses, including electronic medical record management software, health care information systems and Internet-based physician-client communication applications. In fiscal 1999, MCK divested its only non-health care segment that distributed bottled drinking water to retail outlets, a very small part of its overall business.

As a result, MCK has maintained a focus in only two segments; Distribution Solutions (pharmaceuticals, medical supplies and equipment) and Technology Solutions (health care information technology). CAH’s EM underperformance since fiscal 2007 stems mostly from massive restructuring efforts and several distractions, most of which are complete and resolved.

All in all, CAH is back to its roots, with its business segment structure composed of only the Pharmaceutical and Medical segments. Its Clinical & Medical Products segment was spun off and is now CareFusion. The only remaining divestitures, mentioned so far, are Martindale and SpecialyScripts. Taking these business divestitures into account, as well as the company’s pro forma financial statements as a stand-alone business, CAH shares look attractive. We project very low sales growth and EBITDA margin expansion that may result from optimizing its drug and medical supply distribution, while controlling costs. It seems that our projections are in-line with major competitors, and even a little too pessimistic.

CFN will compete as a stand-alone company against a variety of peers, three of which are compared below. The company's market capitalization is above $4 billlion and is included in the S&P 500. CFN’s management has stated that they hope to achieve long-term sales growth in the mid-single digits and earnings growth in the range of 11% - 15%. While fiscal 2010 will be a challenging year, due to hospitals’ tightfisted spending on capital equipment, CFN may not grow its top and bottom lines as much as its long-term goal in the first year as a publicly traded company. Adjusted EPS guidance for fiscal 2010 of $1.10 - $1.20 is about 20% lower than the proforma adjusted EPS earned in fiscal 2009. Management claims that much of this is due to $100 million or so of additional costs the company needs to incur to maintain documentation and personnel to handle the day-to-day activities as a public company, as well as additional employee compensation and higher R&D spend.

CFN claims that the additional R&D investments will pay off in a few years. This is critically important, as differentiation in terms of technologically advanced medical products is the key to success in this industry. Given management’s optimism and their stated focus on growing margins beyond the suppressed levels in this fiscal 2010, CFN shares also look attractive.

Still, for CAH and for CFN, we'll be more comfortable with our full-year projections after we hear what management has to say about its fiscal Q1 2010. CAH, although more focused on its core businesses, may have to continue to restructure portions of its segments or dissolve certain businesses. Those types of initiatives can be difficult to model. Additionally, CFN operates in growing industries, but health care reform, timing of resumed hospital spending, future R&D success and operating outside of the CAH umbrella are all unknowns.

From where these companies stand today, CAH looks to have actually done in the CFN spinoff what it said it was going to do: unlock value. Hopefully, they keep the acquisitions to a minimum.