Agreeing To Buy Cardinal Health With A 3% Yield

| About: Cardinal Health (CAH)
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Summary

It’s quite difficult to find a time when shares of Cardinal Health traded with a 3% yield.

If you like the business but would prefer a “better” price/valuation, you don’t have to just sit and wait to see what happens.

This article talks about getting paid to agree to buy Cardinal Health with a 3% yield.

As far as I can tell, you'd be hard pressed to find a period where shares of health care distributor Cardinal Health (NYSE:CAH) traded with a 3% starting dividend yield. For a long time (think turn of the millennium through 2006) the payout ratio was under 10% of profits. With that starting point it's awfully difficult to see a 3% beginning yield (requiring a P/E ratio of about 3.3 or less). From there the dividend began increasing materially - with the payout ratio going from 8% of profits up to 35% or thereabouts - but so too did the share price.

During the depths of the recession you had a low share price of about $25, with a corresponding payout of $0.70 on an annual basis (equating to a yield of 2.8%). And this year you had a low price near $63, with a $0.4489 quarterly dividend, the yield got up to 2.85%. But other than that, the security has not come close that close to this mark. Let's store this information away and continue with the thrust of the commentary.

In a previous article I highlighted why Cardinal Health had my attention. In that article I detailed a few risks, but also some areas of interest for the security. Namely: a materially lower share price, a solid business, a strong record of increasing its payout with still a comparatively lower payout ratio, a lower valuation and the expectation for robust growth in the years ahead.

One ought to come up with your own expectations about the business, but there are three basic takeaways that you can have. You might believe that Cardinal Health is a great business at a fair price. You might believe that it's a great business, but would prefer a lower price (or I suppose "demand" is more accurate, we always prefer a lower price). Or you could dislike the business altogether.

In the last scenario you're not going to be interested in partnering with the company at all. In the first scenario you can simply buy shares outright (or agree to buy near today's price in the short-term). However, if you'd like to own shares but would prefer to do so at a lower price you're sort of in the middle. Let's focus on this circumstance.

The traditional alternatives are either to "wait and see" what happens, perhaps hoping for the lower price. Or else setting up a limit order and seeing if it ever transacts. Those actions have pros and cons, but they are not your only alternative. You can put up capital today, express your sentiment to buy at a given price, and get paid regardless for doing so.

Let's take a look at what that could look like using the available put options for the January 2018 expiration date:

Note: I have no affinity for this expiration date (many prefer shorter time periods) but it does give you a long-term view of some agreements that are out there.

The first column lists the strike price, or the price at which you would be willing to buy 100 shares of Cardinal Health. The next column details the "net" premium which takes the most recent bid less $0.15 per share for frictional expenses. The third column indicates the upfront cash flow yield (which may be taxed differently than dividends) that you would receive for making the agreement based on the amount of capital needed to be set aside.

The fifth column indicates the starting dividend yield that this would imply for Cardinal Health, assuming the same payout as today. It's very likely that you would see a higher payout, so this number could actually be understated. Finally, you have the discount that each agreement would represent based on today's share price.

Remember from above when I was talking about it being difficult to buy shares of Cardinal Health with a 3% yield? Well here's a whole handful of examples where you could at least get paid to agree to buy at that mark. It should be noted that as the payout ratio increases, this mark becomes more and more realizable, but still this is often a "high water mark" for some.

Let' pick a scenario to work with. Suppose you'd like to partner with Cardinal Health, but not necessarily at $72. You're interested, but not yet compelled. You could wait and see, set a limit order, invest elsewhere, or you could look at something like the $65 put option.

By setting aside $6,500 today (plus frictional expenses, less proceeds we're about to talk about) you would receive ~$455 in upfront cash flow. That's yours to keep regardless of what happens. You could choose to spend it all or reallocate it here or something else. You made an agreement to buy shares of Cardinal Health at $65 per share in the coming year. In effect you sold insurance for those worried (or speculating) that the share price might decline in the short term.

Now one of two basic things occurs once you make this agreement: either it is exercised or it is not.

If the option is not exercised, you still have the ~$455 in option proceeds and your $6,500 is "released" and available to be reallocated once more. The bad news is that you didn't get to buy shares in a business that you wanted to partner with. If the price later went to $80 or $90 you are still "stuck" with just your upfront option premium. Your consolation prize would be a 7% return in about a year - good, not great.

If the option is exercised, you would purchase shares at $65 and your taxable cost basis would be close to $60.50, good for a starting yield (before thinking about an increased payout) of 3%. That's a discount of about 16% as compared to the current price (a price, by the way, that is already down materially this year.)

Now many will point out that this sort of agreement does not prevent you from a loss, which is true. Shares could later trade at say $50, and your cost basis would be closer to $60. Yet it should be evident that this situation is much better than if you had simply bought shares outright at ~$72. The risk with selling a put option against a security that you're happy to partner with, in my view, is not the agreement being exercised. Instead, its seeing shares of a business you want to own move materially higher and generating only "nominal" option premium gains.

Of course you're not limited to this single agreement. There are all sorts of timelines and strike prices out there that you can choose from. The idea is simply that you are not an idle party in this arrangement. If you see a business that you like, but you're not yet compelled by the price, you're not destined to twiddle your thumbs and wait. Instead, quite often you can express your willingness to buy at a certain price and get paid a reasonable sum for doing so.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.