You might be a bit surprised about this article as my last bullish article on Cardinal Health (NYSE:CAH) was only published in March 2022. But I recently sold my Cardinal Health position, and I am actually not so bullish about the stock anymore. The stock might still be undervalued, but I don't consider Cardinal Health being a great long-term investment anymore. And it is not that the business changed in any major way in the last few weeks - it is rather that my investment philosophy might be changing a bit. But let me explain.
You probably know that I focus on companies with a wide economic moat that could be a great long-term investment. But a few weeks ago, I also sold Compass Minerals International (CMP) for a similar reason (which was certainly a good decision) and now I sold Cardinal Health as well. I previously characterized both companies as wide moat businesses and great long-term investments.
However, Compass Minerals International as well as Cardinal Health are probably two prominent examples that an economic moat is not enough to make a company (or stock) a great long-term investment. I still think that a business with a wide economic moat will be able to fend off competitors and perform quite well. And I also think a wide economic moat will enable a business to survive terrible management. But maybe the management team is more important than I acknowledge in the past. In my last article about Compass Minerals, I wrote:
"And while management won't be able to destroy the economic moat Compass Minerals has, it can still make the wrong decisions and a company might underperform due to mediocre management. The CEO Kevin S. Crutchfield is criticized quite often for not being shareholder friendly and not making the best decisions. Also the fact that he was chairman and CEO in 2015 when Alpha Natural Resources filed for chapter 11 bankruptcy is supporting that bad feeling. The last three years are also not making me confident about the current management."
Cardinal Health seems to be able to keep earnings per share as well as free cash flow stable. But it also seems like Cardinal Health's management is not able to come up with a strategy to increase profitability or generate a higher free cash flow (or widen the moat, for example).
Hence, I might have to change my investment philosophy and not just focus on undervalued stocks and businesses with a wide economic moat. I probably must pay more attention to management and to the question if a business has a solid growth strategy. A "moaty" business by itself is not enough as it will just protect the existing business against competitors.
In future articles, I will probably have to put more emphasis on management - and this might include aspects like management's compensation (it is for example a red flag if management is excessively using stock-based compensation). It could also include the character of key management officials (this includes aspects like being open about mistakes or the ability to make tough decisions) and, of course, managements' ability to run the business well by being self-confident and have the ability to follow through with a strategy.
And after Cardinal Health reported mediocre results once again and had to lower its guidance for fiscal 2022, I decided to sell the stock. In the last quarter, Cardinal Health could still grow its top line from $39,275 million in the same quarter last year to $44,836 million - resulting in 14.2% year-over-year revenue growth. And while top line growth is quite impressive, operating earnings declined from $473 million in the same quarter last year to an operating loss of $97 million this quarter. And diluted earnings per share declined from $0.40 in the same quarter last year to a loss per share of $5.05.
And aside from the disappointing Q3 results, Cardinal Health also lowered its guidance for fiscal 2022 and is expecting non-GAAP earnings per share only in a range between $5.15 and $5.25 (instead of $5.15 to $5.50 before).
And when looking at the last few quarters, we see solid top line growth, but gross profit is fluctuating wildly.
Right now, it takes a lot of imagination to see a company that will perform with consistency again - only the top line growth is showing that consistency, most other metrics seem to fluctuate quite heavily.
And the list of problems and challenges Cardinal Health is facing right now seems to be even longer. For starters, Cardinal Health missed earnings expectations quite often in the last few quarters, which is also not a good sign that management is able to perform.
And of course, the opioid charges are also not helpful although most settlement trials have come to an end. Cardinal Health must pay $6.4 billion over the next 18 years as part of the nationwide settlement. However, other trials followed, and Cardinal Health must pay $160.5 million in a settlement with Washington.
When looking at the metrics, it should at least be allowed to raise the question if Cardinal Health still has an economic moat around its business (I claimed myself it has one and still think a moat is in place). However, operating margin and gross margin are both declining over the last few years and return on invested capital was only 5.67% on average during the last ten years (even when excluding the year 2020, we don't get a RoIC above 10%). And it was above 10% only in six out of ten years.
When looking at the performance of Cardinal Health over the last 30 years, it is difficult to argue that we are seeing an outperformance of Cardinal Health (dividends are included). Of course, we can argue that the S&P 500 (SPY) is trading rather close to all-time highs, while Cardinal Health is trading for low valuation multiples right now.
And while Cardinal Health could increase revenue, the bottom line and free cash flow could not really improve. When looking at the gross margin and operating margin over the last 30 years, we also see a negative and long-lasting trend. In the last 15 years, Cardinal Health was trading below the average gross and operating margin of the last three decades, which is not a good sign.
Investing in Cardinal Health might not have been the best decision. But an even bigger mistake was not investing in McKesson instead. In my first article about McKesson (published in February 2018), I already identified the company as a clear market leader in this segment. And when looking at the margins during the last few years, especially operating margin constantly declined for Cardinal Health in the last few years and the company has now the lowest operating margin of all three major distributors. But we must point out that McKesson had a declining operating margin in the last few years as well.
When looking at the stock performance during the last ten years, Cardinal Health clearly underperformed its two competitors. That underperformance is even getting worse when looking at the last few years. All three stocks struggled in the years following 2015, but while AmerisourceBergen (ABC) and McKesson are increasing in value again, Cardinal Health is still stagnating near its lows.
Although I have written about McKesson quite often and I always stated that the stock was deeply undervalued, I somehow did not pull the trigger (a mistake). Instead, I bought Cardinal Health as McKesson had already increased in value while Cardinal Health was still trading close to its lows (nonsense and another huge mistake).
One of the reasons I sold Cardinal Health now is the opportunity provided by the market in the last few weeks to purchase other stocks for a discount. In my article "Identifying Opportunities in Turbulent Times", I showed nine other potential stocks that could be a good investment right now, and with many high-quality businesses declining 50% or more, we could find many better investments than Cardinal Health (in my opinion). With the cash generated by the sale of Cardinal Health, I increased my stake in Starbucks (SBUX) and started a position in PayPal (PYPL). And these are only a few examples of companies (and stocks) that I consider undervalued right now.
Despite all the negativity in this article, I still think Cardinal Health could be a solid investment for two different reasons. First, if management can achieve growth again and will find a strategy to grow the business in the years to come, the stock is probably undervalued right now. Analysts seem also quite optimistic that Cardinal Health can grow earnings per share in the high-single digits or even low-double digits in the next few years.
Second, if Cardinal Health should be able to break out of its sideways range, we could see an upward wave and the stock moving higher.
Finally, we should not ignore that Cardinal Health is a rather recession-proof business. As I have frequently written in many articles during the last few weeks and months - for example, in my "Identifying Opportunities in Turbulent Times" article - I expect a severe recession and severe bear market in the coming quarters (probably in 2023). And Cardinal Health is a business that should perform quite well in a recession, and considering that the stock is trading for rather low valuation multiples, we also might see limited downside potential in the coming quarters.
While I still see the potential of Cardinal Health's stock moving higher over the next few years, I don't want to sit around to find out if management can turn the ship around and translate the company's top line growth also into bottom line growth. And fortunately, the market was offering several better investments in the last few weeks, and I decided to sell my Cardinal Health position and purchased other assets instead.
Cardinal Health probably has a wide economic moat around its business, but without a clear growth strategy, the stock will probably continue its mediocre performance. Nevertheless, based on valuation aspects, the stock is a "Buy", but based on most other aspects, it is rather a "Hold" right now.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of PYPL, SBUX either through stock ownership, options, or other derivatives. 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.