- Cardinal Health is a medical distributor with two business segments - pharmaceutical and medical.
- Despite a wide economic moat, Cardinal Health could increase revenue only 4% annually over the last decade.
- Cardinal Health is facing a few risks like the ongoing discussion about extreme healthcare costs or the opioid epidemic.
- The stock is just fairly valued currently, but investors can at least count on annual dividend increases as the company is on its path to becoming a dividend aristocrat.
Cardinal Health (NYSE: NYSE:CAH) is a global, integrated healthcare services and products company. It is providing customized solutions for hospitals as well as healthcare systems, pharmacies and ambulatory surgery centers and physician offices worldwide although most of its $130 billion in revenue is generated in the United States. Cardinal Health is also a company that seemed to be left out in the stock market rally of the last few years - very similar to other companies operating as medical distributors. While McKesson Corporation (NYSE: MCK) lost 35% in value over the last three years and Owens & Minor Inc. (NYSE: OMI) lost even more than 50% in the same time frame, Cardinal Health declined only 22% since March 2015 and therefore outperformed a few of its peers. But compared to the broader US stock market, the company underperformed extremely as the S&P 500 gained 27% in the same time frame.
After we already analyzed McKesson as undervalued medical distributor and Owens & Minor as good pick for income investors due to its high dividend yield, we now take a closer look at Cardinal Health.
If we look at Cardinal Health over the last ten years, we can state that revenue is in an upward trend (grew about 4.3% annually), but earnings per share didn't really increase over the last decade and were very volatile (as high as $4.32 in 2016 and as low as $0.97 in 2013). Especially the net income margin declined over the last years and led to a stagnating net income despite revenue growth. In 2013 and 2014 revenue declined drastically (for a company that big), but since then revenue as well as earnings per share seem to be back on the right track to growth.
Cardinal Health has divided its business in two different segments - the pharmaceutical segment and the medical segment. The pharmaceutical segment distributes branded and generic pharmaceutical, specialty pharmaceutical and over-the-counter healthcare and consumer products in the United States. Cardinal Health's pharmaceutical segment also provides different services to pharmaceutical manufacturers as well as healthcare providers to support development, marketing and distribution of specialty pharmaceutical products. Being responsible for almost 90% of the $130 billion in revenue, the pharmaceutical segment generated $116.5 billion in 2017, but only a segment profit of $2.2 billion leading to a profit margin of 1.89% for the segment. Although revenue for the pharmaceutical segment grew 7% YoY, the segment profit declined 12% in comparison to 2016.
The medical segment is not just operating in the United States, but also in Canada, Europe as well as Asia and some other markets. It manufactures, sources and distributes Cardinal Health branded medical, surgical and laboratory products. Additionally, the company provides supply chain services and solutions to different hospitals, ambulatory surgery centers, clinical laboratories and other healthcare providers. The medical segment on the other hand is just generating an annual revenue of $13.5 billion in 2017, the segment profit was $572 million in 2017 leading to a profit margin for the segment of 4.24% and therefore more than twice as high as the pharmaceutical segment profit margin. Revenue of the medical segment increased 9% YoY and the segment profit increased even 25%.
If we look at margins and the annual changes for the two segments, we get a mixed picture. Over the last ten years, profit margin for the pharmaceutical segments has always been higher than the profit margin for the medical segment. But the profit margin for the medical segment was constantly improving over the last decade. In the past decade, profit from the pharmaceutical segment could improve in most years but declined in 2017 significantly - profit from the medical segment suffered a double-digit decline in 2011 and 2012, but could increase especially in 2017 (+25%).
Like most pharmaceutical retailer and distributors, Cardinal Health is also dependent on the introduction of new products and launches and it also plays a role if these are brand products or generic products. But there are a few other aspects that should concern investors over the next few years.
A first threat - at least according to stock price action - is the entry of Amazon (Nasdaq: AMZN) into the medical supplies segment. After the disruption of retail - for example Target (NYSE: TGT) and Kroger (NYSE: KR) - it is currently the medical supplies segment as well as the distribution segment (UPS (NYSE: UPS) or FedEx Corporation (NYSE: FDX) as latest victims). I personally are at a point where I can't take the announcement and especially the following "panic" serious any more. But I am more than pleased for every new sector Amazon and Jeff Bezos announce to enter, because it usually creates good entry points as the stocks in most cases drop more than just a few percent.
Aside from Amazon, there seems to be a second risk that is much harder to assess right now and therefore potentially dangerous: the ongoing discussion about the opioid epidemic and the accusation as well as lawsuits that could be filed against distributors like Cardinal Health or McKesson. About two weeks ago it was reported, that the Kentucky attorney general sued Cardinal Health. Contrary to the omnipresent Amazon threat that is shifting from industry to industry and creating cheap stock prices, I see here more potential for long-lasting effects and not just short-term confusion. Cardinal Health' business depends on rigorous regulatory and licensing requirements. These regulations are mostly a good thing as they contribute to Cardinal Health's wide moat, but regulations can be changed. With the ongoing discussion about the opioid epidemic as well as the healthcare system being much too expensive, we have to pay close attention to political aspects and to what is decided in Washington. So, Cardinal Health is not just in danger of being sued, but potentially has to react to regulatory changes.
A third risk is the somewhat missing diversification of Cardinal Health. A company should be diversified regarding its suppliers as well as its customers. If a supplier terminates its contract the effect on revenue is not so dramatic and products obtained from the five largest suppliers account for 27% of Cardinal Health's revenue, but no single supplier accounts for more than 7% of revenue. And although it is challenging if a contract with a supplier is terminated, the risk of losing a supplier is subordinate to losing a customer. The two largest customers of Cardinal Health account for one third of total revenue. CVS Health Corporation (NYSE: CVS) is the largest customer and accounts for 23% of fiscal 2017 revenue and if CVS does not extend the current contract for the time after June 2019, the results of operations could be affected dramatically. The second largest customer, Optum Rx, accounts for 11% of 2017 total revenue and the five largest customers (including Optum Rx and CVS) account for 50% of fiscal 2017 revenue.
But when talking about Cardinal Health we should not just focus on the risk factors, but also mention the wide economic moat the company has. Similar to other medical distribution companies like McKesson or companies focused on collecting and disposing of medical waste like Stericycle (Nasdaq: SRCL), Cardinal Health also has a competitive advantage due to its distribution network: "Large distribution networks are extremely hard to replicate and are often the source of very wide economic moats."
Large and dense distribution networks create huge scale-based cost advantages for two different reasons - the extremely high costs upfront to build a distribution network and the rather low costs to serve additional customers in an already existing distribution network. Creating a distribution network in a large country like the United States is a complicated and expensive task with extremely high fixed costs at the beginning - buying trucks, trains or airplanes, the salary for the drivers or pilots, costs for gas and the costs for building distribution centers. These costs make it difficult for competitors to enter the market, because a company needs a lot of cash before it can even begin its operations. The second challenge are the extremely low prices a company with an already existing distribution network can offer. Delivering more products on an already existing route doesn't cause high additional costs, because the greater part of the costs is a constant (salary, costs for trucks and maintenance). This is good for the profitability and margins of already existing companies because margins improve with every additional product that is delivered. And the low additional costs make it easier for existing companies to offer extremely low prices for customers, that new companies usually can't match.
Intrinsic Value Calculation
Despite the existing moat of Cardinal Health, revenue increased only about 4% annually for the last decade and although earnings per share were extremely volatile in the same time frame I think it is safe to assume that over the next decades, the company can increase its earnings per share as well as the free cash flow at a growth rate of 3% per year. If we take the free cash flow of the last four quarters as basis and calculate with a 10% discount rate, the intrinsic value of Cardinal Health is $73.50 and the stock is slightly undervalued right now.
Cardinal Health is certainly fairly valued right now, but if the stock is a good investment mostly depends on the question if the company can grow more than only a few percentage points annually in the years to come. If the past is any indication, Cardinal Health will only grow in the single digits in the years to come. Without a catalyst or a fundamental change, I think there are better picks right now.
Of course, we have the wide moat that usually enables a company to grow more than just a few percentage points a year. However, Cardinal Health wasn't able to grow its revenue more than 4% annually in the past decade despite the existing moat - why should the moat enable the company to grow at higher rates in the next decades?
Almost Dividend Aristocrat
While Cardinal Health couldn't increase its earnings per share over the last ten years, the company increased its dividend for 21 consecutive years. Since 2008 the dividend increased from $0.50 to $1.85 right now and as the EPS didn't really increase, the payout ratio increased from about 14% to 43% last year. In the last 10 years, Cardinal Health increased the dividend more than 15% annually and although the dividend is very safe, it would be really important for Cardinal Health to increase its earnings per share or the dividend growth rate will decline over the next years. For the full year 2018, the company is expecting a non-GAAP EPS between $4.85 and $5.10 and for 2019, the company at least expects a non-GAAP EPS of $5.60 and Cardinal Health seems to be on the right path.
Cardinal Health is certainly not a bad investment as it has a wide moat protecting its business, an acceptable dividend yield as well as a long history of dividend increases and its valuation is acceptable. But if you want to invest in medical distributors there are better picks right now. If focused on high dividend yields, Owens & Minor is certainly worth looking into although I am not sure if OMI will outperform Cardinal Health over the long term. McKesson on the other hand seems to be the top pick right now if you want to invest in a medical distributor.
Don't get me wrong, investing in Cardinal Health is certainly not a bad idea and the company is certainly a better pick than most other stocks in the current overvalued market. However, for Cardinal Health to be undervalued and hence a top pick, the stock has to drop at least to former lows of $55 again.
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 Dorsay, Pat (2008): The little book that builds wealth: The knockout formula for finding great investments, p.95.
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Analyst’s Disclosure: I am/we are long TGT, SRCL. 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.
If not stated otherwise, all charts are my own work based on numbers from Morningstar and Cardinal Health's SEC filings.
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