Cardinal Health: Valuation Unjustified By Declining Revenue And The Weak Support For Its Dividend

| About: Cardinal Health (CAH)

As a dividend growth investor, I love to invest in a company for years, ideally forever. Today, I regret to say, I sold my position in Cardinal Health Care (NYSE:CAH) as its stock price reached a 6-year high. Cardinal Health exhibits declining revenue (an 11.90 percent, quarter-to-quarter revenue decline), with an uninspiring narrative from a rating agency. The company has grown a dividend, now at only 1.7% with a payout ratio in excess of 100 percent of earnings.

Cardinal Health Fit My Need for Mid-Cap Dividend Growth Companies

Last February, I purchased Cardinal Health as part of my strategy to counter weight my holding in large-cap dividend growth companies with mid-cap discoveries. With a market cap of $24.6 billion, Cardinal is one tenth the size of the average capitalization (of $256 billion) in my holdings of Exxon (NYSE:XOM), Coke (NYSE:KO), Procter and Gamble (NYSE:PG), and Walmart (NYSE:WMT).

Cardinal Health provides pharmaceutical and medical products and services internationally. The company, headquartered in Dublin, Ohio, operates in two segments, pharmaceutical and medical.

Key features that attract me are that Cardinal Health is:

  • Well-positioned as a market leader and innovator in the pharma and medical industries

  • Positioned to benefit from overall industry trends, including brand-to-generic conversions, favorable drug pricing, and base business growth

  • Now a dividend contender, having raised distributions for 17 consecutive years (according to the CCC table). I can hold the stock for 7 years and see it develop into a dividend champion.

Twelve months ago, Cardinal traded at $46.54 per share (2/19/2013). Cardinal closed recently (2/25/14) at $72.00. I held Cardinal in a taxable-now account. So, the benefit of realizing a long-term capital gain (versus short-term) is important to my investment performance. I took my 54 percent long-term capital gain in light of the company's prospects and uncertainty of a growing dividend.

I am not bearish on the company; I am simply surprised by the strength in the stock price given the fundamentals that the company now exhibits.

Credit Ratings and New Ventures

On February 12, 2014, Fitch Ratings provided a good summary of Cardinal Health's business challenges (Fitch) as it affirmed Cardinal's credit ratings, including the long-term Issuer Default Rating at 'BBB+'. My reading is that Cardinal will find it difficult to maintain dividend growth for the 7 years required for it to become a dividend champion.

Fitch's affirmation included the following observations:

  • The steady pharmaceutical demand contributes to exceptionally stable operating profiles for Cardinal, excluding recent contract switches. Base business growth can offset the estimated $230 million of lost EBITDA from expired contracts with Express Scripts, Inc. (NASDAQ:ESRX) and Walgreen Co. (WAG). Fitch projects modestly higher EBITDA in fiscal 2014 and 2015 compared to 2013, despite the loss of about $30 billion in annual sales.

  • Cardinal's material under representation in specialty drug distribution could hinder intermediate-term growth and profitability. The acquisition of AssuraMed and Cardinal's plans for growing its Medical business present growth opportunities, but could also introduce new operating risk (e.g. product liability) depending on the strategies pursued.

  • Cardinal's joint venture with CVS Caremark Corp. (NYSE:CVS) and the anticipated introduction of biosimilar drugs to the U.S. drug channel should support margins beginning in 2015-2016.

Fitch expects Cardinal to generate cash sufficient to fund operations, shareholder payouts, targeted M&A, and debt service. Currently, Cardinal has limited room for additional long-term debt at the 'BBB+' rating. Fitch does not anticipate an upgrade to 'A-' in the intermediate term.

A downgrade to 'BBB' could result from transactions that cause debt leverage to increase. Debt-funded shareholder-friendly activities could precipitate the negative rating action. The development of a material competitive gap between Cardinal and its peers, possibly arising from the firm's lagging position in specialty distribution, could also pressure ratings.

I believe that Cardinal is innovative, but Cardinal may be speculative. The KEW Group (KEW), announced on February 24, 2014, the acquisition of a round of financing, including with Cardinal Health (CAH).

My Return to Cardinal Health

The fundamentals I need to return as an owner to Cardinal Health are a dividend yield above 2 percent and a payout ratio of less than 60 percent. For this to happen, Cardinal must transition through the loss of contracts with Express Scripts and Walgreen Company with no loss in earnings, in my estimation. Alternatively, Cardinal could cut its dividend (and its stock price) and begin to re-establish itself as a dividend contender.

I will continue to seek out an opportunity such as that offered by Cardinal Health last year. Looking recently at two dividend strategy ETFs, I see that the SDY (NYSEARCA:SDY) exhibits a P/E ratio of 19.4, a price-to-book ratio of 2.6, and price-to-cash flow ratio of 11.0; the VIG (NYSEARCA:VIG) shows similar high values. I'm sure that the company I seek is among the holdings in these ETFs. Knowing that this is a market of stocks, not a stock market, I intend to find that company.


I provided a description of my investment decisions for informational and educational purposes. The information in this document is believed to be accurate, but you should independently verify key information before making a buy or sell decision. My commentary does not constitute investment advice. The information I provided should only be factored into an investor's overall opinion forming process.

Disclosure: I am long KO, PG, WMT, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.