Cardinal Health: Exciting Opportunity In A Boring Industry

Summary

• Cardinal Health Inc. makes an attractive 11-15% annual free cash flow yield.
• The company offers high investor safety with a strong balance sheet, leading industry position, and Dividend Aristocrat status.
• CAH has over 100% upside, and it's at a price where we could expect to see over 15% annual returns.

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In this day and age, it seems like every stock is wildly overpriced. In a world full of sky-high valuations and huge expectations, in most cases, the fundamental value train has completely jumped the rails, and is sinking fast down into the deep blue sea...

Fortunately, if you’re a fundamental investor, or someone that likes to see low-risk, high returns from their stocks, Cardinal Health (NYSE:CAH) may be a great opportunity for you. Cardinal Health is a healthcare wholesaler company that sells supplies to CVS Health Corporation (CVS) pharmacies and about 90% of US hospitals. Cardinal Health has neared a good buy price because of its stable cash flows, expected growth, and low levels of risk. Cardinal Health could make us very attractive returns.

Cash Flows

Image Source: Author, with data from Seeking Alpha (Millions of Dollars)

To estimate the annual free cash flow that CAH is likely to generate, I looked at the company's annual free cash flows over the past 10 years. Of course, we can’t predict future free cash flows solely by looking at past results, but it can be a great place to start. I estimate that the company’s normalized free cash flow (the FCF Cardinal Health should make in a normal year) is somewhere between $2 Billion and $2.5 Billion. With CAH’s market cap around $17.5B, we should see somewhere between an 11 and 15% annual free cash flow yield, at the current share price. From this, the company is able to return about $1B annually direct to shareholders through buybacks and dividends.

I used Mohnish Pabrai’s version of the Discounted Cash Flow Model to find the fair value of Cardinal Health. Since we were able to find normalized FCF, I set my Year 1 free cash flow at $2.2 Billion. Setting the first year free cash flow is the first step in estimating a company’s intrinsic value.

Expected Growth

Image Source: Author, with data from Seeking Alpha

Next, it’s important for us to estimate Cardinal Health’s growth. A company’s future growth helps to define its present fair value, so we can determine what a fair price to pay for the stock today is.

I expect CAH to see about 5-7% annual growth in their free cash flows over the next 10 years. This makes the stock even more valuable today, because we expect to see greater cash flows in the future. We love companies that grow their cash flows and give their investors micro-raises each year.

Let me give you a real quick breakdown on how I got the 6% projected annual growth. First, I looked at past Free Cash Flow trends, and saw that free cash flow had doubled in the last 10 years. Therefore, I think it would be reasonable for FCF to double again in 10-14 years. Since Cardinal Health is nearing maturity, it’s reasonable for CAH to continue growing at roughly the same rate that it has in the past.

And there’s one more way that I got this growth rate. One of the best ways to project future growth is to find what returns a company makes from the money it keeps - because these returns will one day become future growth.

I used a formula that multiplies the average FCF Retention Ratio over the past 5 years * the 10 year average ROIC. This sounds super complicated, but it’s actually pretty simple. Basically, you find the retention ratio (what percentage of Free Cash Flow is NOT used to pay dividends), and you multiply it by the business’s long-term return on invested capital. This shows you what future returns the company is likely to make on the free cash flow it keeps. This formula is awesome for us investors, because it gives us a great insight on what the company’s future growth is likely to be.

When I used the formula to get the projected growth, I took the 5 year FCF retention ratio of 64.4% and multiplied it by the 10 year ROIC of 10%. From this calculation, we should expect to see about 6.4% annual growth. We should expect to see a conservative 5-7% annual free cash flow growth for the next 10 years.

Risks

Finally, we have to check out the risks associated with this stock, because we want to know if there’s any reason that this company could fail to deliver us high returns. We want to find if there’s any possible reason that the company would not be able to hit their free cash flow projections, because free cash flows will be what delivers us high returns.

Finding risks in stocks before you buy them is absolutely crucial to making sure you pick good stocks. You never want to wake up at 3 AM in a cold sweat wondering if you’re about to lose money from a risky investment.

Two of the biggest risks that Cardinal Health faces are government regulation and increased competition. For years, healthcare companies have enjoyed strong pricing power, and they’ve been able to charge very high prices for their goods. There is a risk that the government could set stronger regulations on the industry, so consumers don’t have to pay such high prices for drugs. Cardinal Health has also been facing increased competition, hindering their pricing power.

Ultimately, I wouldn’t consider either of these industry-wide trends to be too much of an issue. Cardinal Health serves about 90% of all US hospitals - they’re one of the biggest companies in the space. Even if their margins do decrease, these headwinds will affect the entire industry. At the end of the day, while increased competition and government regulation may put a damper on the entire industry, I don’t think it will do much to strip away at Cardinal Health’s competitive advantage in the marketplace.

Balance Sheet

It’s always important to make sure a stock has a strong balance sheet, so they’ll be able to weather future storms. Cardinal Health has a solid Balance Sheet, with a Current Ratio greater than 1, and very reasonable debt. Even though they have a total debt-equity ratio of about 3 on their most recent Balance Sheet, they only have about $6 Billion in debt. This really isn’t anything to be concerned about, since they make about $2-2.5 Billion annually in cash flows, and could easily pay off the debt in just a few years if they decided to. Overall, they have a strong Balance Sheet.

Dividend Safety

Cardinal Health is a dividend aristocrat, which means that they’ve grown their annual dividend payments for over 25 consecutive years. On top of having ample cash flows to support dividend payments (with a FCF payout ratio of only 35%), the company’s dividend aristocrat status adds to the company’s investment safety for two reasons.

First, management will feel more compelled to continue raising their dividends for investors like us, because they don’t want to break their 34 year streak. And second, companies that have reached dividend aristocrat status are more likely to have carved out a strong competitive advantage in their niche.

Competitive Advantage

CAH is the third company behind McKesson Corporation (MCK) and AmerisourceBergen Corporation (ABC) in the pharmaceutical distribution space. They’ve also just renewed their contract with CVS as well. I would estimate that Cardinal Health’s main competitive advantage is that they have high switching costs, because hospitals and pharmacies rely on CAH’s products. Companies that rely on Cardinal Health’s products would have a lot of steps to go through if they were to decide to switch suppliers, and it would likely be a long, arduous process. This pain works in Cardinal Health’s favor, because customers have a higher incentive to stay with Cardinal. Cardinal Health has staying power in their industry, because they’ve built key relationships.

Valuation

Image Source: Author, with data from Seeking Alpha

Valuing a stock is one of the most important steps in doing a careful analysis. I firmly believe that even the best stock is only a buy - at the right price. I’ll share with you my valuation for CAH.

Right now, CAH is trading around $59. I would like to see the price fall back down to around $53/share, because this is the price where I would expect to see 22% annual returns based on expected cash flows and growth. Additionally, for this valuation, I used a 7.5% discount rate, and I found the year 10 terminal value by multiplying year 10 expected free cash flow by their 10 year average price to free cash flow ratio, which is 9.8.

The price could easily fall back to $53, since it was lower than $53 within the past 30 days. I am confident that in the low 50s, this stock would offer a high return for investors, and I’d hope to start a position near this price.

Recap

At the right price, Cardinal Health has over 100% upside and can yield investors around 22% annual returns, because of its strong cash flows, expected growth, and safety in its balance sheet, dividend and competitive advantage. I hope to start building a position in Cardinal Health if the stock falls back down to the low 50s. Thank you very much for reading, and I hope that you have a great rest of your day.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CAH over 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.