Cardinal Health (NYSE:CAH) surprised its investors by announcing a huge transaction, which was not well received, as the company warned about its profitability for both 2017 and, more importantly, 2018 as well.
Leveraging up the balance sheet during these challenged times is a move which is not welcomed by investors. This is certainly the case as investments into the medical division in the past have not resulted in substantial improvements in earnings. Amidst all these negatives, I am not automatically buying into this latest drop as the company appears to structurally underperform its peers, warranting some caution or patience for better entry opportunities.
Making A Huge Move
Cardinal Health announced that it bought a range of patient products from Medtronic (NYSE:MDT) in a huge $6.1 billion deal in order to expand its consumable medical products portfolio. The company expects to close the transaction in the first quarter of its fiscal year of 2018, as modest tax benefits could reduce the effective purchase price towards $6 billion.
The acquired businesses include the Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency businesses of Medtronic. In total, these three businesses cover 23 product categories which include brands like Argyle, Devon, Dover, Curity, Kangaroo and Kendall, among many others. Key product categories include incontinence, compression, enteral feeding, wound care and electrodes. These businesses combined generate $2.3 billion in sales with 10,000 employees, and roughly 70% of sales are generated in the US.
Few financial details have been released in either the press release or presentation other than earnings accretion numbers. Non-GAAP earnings per share are expected to improve by $0.21 in fiscal-year 2018 including a $100 million pre-tax inventory step-up valuation. With 319 million shares outstanding and taking into account the inventory step-up, that reveals that operating earnings are expected to jump by $200 million after already considering the incremental interest expenses.
Cardinal Health sees additional interest charges of $0.39 per share, which translate into $123 million after taxes. Using a 35% tax rate, that suggests that Cardinal sees pre-tax interest costs of $190 million. Based on the $0.21 per share accretion, the projected financing charges, and inventory step-up, it seems that the business might add some $400 million in operating earnings each year.
The company guides that the deal should boost 2019 earnings by $0.55 per share as further accretion is projected by 2020 and beyond based on synergies of $150 million per year. That synergy number and the projected stand-alone operating earnings number of roughly $400 million for 2018 suggest that the company could boost EBIT by $550 million in 2020.
After adding in some $25 million in depreciation charges, the deal multiple works out to 14 times current EBITDA, as this multiple drops to 10.4 times once the synergies are being fully realized.
A Big Deal
This $6 billion deal is the largest in Cardinal's history on a combined basis, but the company has been making quite a few bolt-on to medium-sized acquisitions over the past decade. It spent roughly $10 billion on dealmaking in the past decade, highlighting how large today's deal is.
Much of this dealmaking has focused on establishing its own products business away from the core distribution business. That being said, Cardinal has made deals to increase its activities in the more specialized distribution as well. Back in 2007, the company acquired respiratory care producer VIASYS in a $1.5 billion deal.
The company bolstered the pharmaceutical distribution business with the 2010 deal of Kinray, valuing that business at some $1.3 billion. Dealmaking continued in 2013 with the $2 billion purchase of AssuraMed in order to create a home-delivery platform for healthcare products.
Two large deals were announced in 2015. Generic drug distributors Harvard Drug Group was acquired in a $1.1 billion deal. Former J&J (NYSE:JNJ) Cordis business was acquired in a $2 billion deal that year as well. This deal made Cardinal a sizable player in cardiology and endovascular devices.
The company has made quite a transition as a result of this dealmaking spree. Back in 2008, revenues amounted to $91 billion as the business was organized across four segments. The healthcare supply chain service segment generated $79 billion in sales and $1.1 billion in segment earnings. The healthcare supply chain services was an $8 billion business with earnings of $300 million. Clinical technologies was a $2.9 billion segment with earnings of half a billion. The medical product and technology business generated $2.7 billion in sales and $300 million in earnings.
Cardinal spun off the clinical technology and healthcare supply chain service in a company named CareFusion in 2009. Baxter (NYSE:BAX) eventually bought the company in 2014 at the time valuing it at some $12 billion. 80% of the shares were in the hands of former shareholders of Cardinal, which were given 0.5 shares in CareFusion at the time of the spin-off in 2009. As Baxter paid $58 per share for CareFusion, original investors in Cardinal cashed $29 for the business which they still owned in 2008.
From 2009 onwards, Cardinal reported results for just two divisions: a $95 billion healthcare supply chain service business (distribution) with segment profits of $1.3 billion, and the clinical and medical production business that generated $4.6 billion in sales and $670 million in segment earnings.
It is evident that much of the growth and acquisitions have focused on the latter segment from 2009 onwards. The company renamed the core distribution business as the "Pharmaceutical" segment which now is a $109 billion business with segment earnings of $2.5 billion. Margins have actually increased as the company has focused on some higher value-added distribution activities, again resulting from past dealmaking.
The former clinical and medical production business has grown to $12.4 billion in sales and is now re-branded into the medical segment. While sales growth is spectacular (largely due to acquisitions), segment earnings came in at a disappointing $460 million last year.
Another very disappointing trend is the huge run-up in unallocated expenses. These have risen to nearly half a billion last year as the company operates just two segments. This compares to a roughly $100 million allocation a decade ago when the business still comprised four segments. Notably, the margin trends in the medical products side of the business are rather disappointing. While the segment includes distribution activities as well, Cardinal itself is also a producer of such products.
The Current Trajectory
In February, Cardinal posted its second-quarter results for its fiscal-year 2017. While sales were up 5% to $33.1 billion, operating earnings actually fell some 4% to $542 million, pressuring the already slim margins.
A loss of a pharmaceutical customer and pricing pressure explain the difficulties in the core pharmaceutical distribution segment. Sales rose 5% to $29.7 billion, yet segment profits dropped 14% to $537 million, as operating margins dropped roughly 40 basis points to just 1.8% of sales. The medical segment, which has seen long-term challenges, partially offset the pain of compressing margins in the distribution business.
Revenues were up 8% to $3.4 billion as segment profits jumped by 50% to $159 million. Despite the big improvement in margins towards 4.7% of sales, these margins remain very modest by all means. Worse, part of the improvement was artificial as last year's earnings were depressed as a result of charges related to the Cordis acquisition.
The company lowered the full-year adjusted earnings guidance from $5.40-5.60 per share to $5.35-5.50 per share. This is really more of a narrowing of the guidance rather than an actual profit warning. For your reference, GAAP earnings have lately trended roughly 25% lower than non-GAAP earnings as the vast majority of the difference between most metrics results from non-cash amortization charges. While these do not involve cash outflows directly, they result from pricey acquisitions being made in the past.
The Pro-Forma Implications
The balance sheet remained solid at the end of the second quarter. Cardinal held $1.88 billion in cash while total debt has risen to $5.46 billion for a $3.58 billion net debt load. With EBITDA running at close to $3 billion on an adjusted basis, leverage was very modest at 1.2 times.
As the company will take on roughly $6 billion in additional net debt, the pro-forma net debt position will jump towards $9.5 billion. That is a very significant amount given that EBITDA of the core operations runs at roughly $3 billion a year.
Having pegged operating earnings of the acquired business at $400 million on a stand-alone basis, the pro-forma EBITDA number will improve meaningfully. Based on D&A charges reported for Cardinal's own medical products segment, I estimate that depreciation and amortization is limited to 1% of sales. That suggests that the deal will boost EBITDA by $425 million, which suggests that EBITDA will improve to +$3.4 billion, for a 2.8 times leverage ratio.
While leverage is rising significantly, the company warned that 2017's adjusted earnings will come in at the lower end of the $5.35-5.50 per share guided range. This combination is certainly not welcomed by investors as the market capitalization of Cardinal dropped by some $3 billion on the back of the announced deal which was accompanied by a profit warning.
What is more disappointing is the guidance for the fiscal year of 2018. The company guides for non-GAAP earnings per share to be flat to down in their mid single digits in 2018. As 2017 earnings are seen around the lower end of the guidance, that implies that 2018 adjusted earnings are seen at $5.08-5.35 per share. Important to recognize is that this includes a projected net benefit of $0.21 per share from the Medtronic purchase.
That suggests that core earnings are really seen at just $4.87 to $5.16 per share (after backing out the impact of the deal), which suggests that core earnings could fall anywhere between 3% and 9% per share. This disappointing anticipated performance is driven by deflation in the pharmaceutical segment and some discrete items. This tells me that competition in the segment remains stiff amidst deflationary pricing trends.
Disappointing Performance, No Obvious Buy Yet
Long-term investors in Cardinal have little to cheer for as shares are pretty much flat compared to levels a decade ago, leaving them relying entirely on dividends for their modest returns. The ironic thing is that the enterprise value of the firm has hardly changed between early 2007 and today, as the company is still valued at levels in the low $30 billion. Of course, investors have received roughly $10 billion in value from the spin-off and sequential sale of CareFusion.
Between 2007 and today, sales are up some 50% as the company furthermore bought back 20% of its shares. What is troublesome is that despite the focus on the medical business, which should have higher margins, this has not become a reality. Gross margins for the entire company fell by a full point to 5% of sales. This margin compression and valuation multiple compression explain the lack of shareholder returns. Amidst this observation and the disappointing guidance for 2018, some investors might have some concerns about the fact that the company is increasing leverage in a big way today.
The pro-forma business now traded around 0.25 times sales on an enterprise basis and 10 times EBITDA. Both these valuations are in line with their long-term average. The company trades at just 13-14 times pro-forma earnings, but these are adjusted earnings, albeit that the adjustment largely relates to non-cash outflow related amortization charges.
That being said, the company has levered up in a big way as the track record in terms of creating value (through dealmaking) has not been evident at all after some $10 billion has already been spent on acquisitions since 2007. While the 13-14 times adjusted multiple looks decent, as the company actually delivers on a 7% cash flow yield, GAAP earnings multiples are probably more or less in line with the rest of the market.
Adding it all together, I am not automatically calling levels in the low 70s an absolute great buying opportunity with shares being flat so far in 2017. I furthermore note that Cardinal is a long-term underperformer compared to its peers McKesson (NYSE:MCK) and AmerisourceBergen (NYSE:ABC) which have doubled and tripled respectively over the past decade.
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.